Efficient organization of production: Nested versus horizontal outsourcing

We characterize equilibrium and efficient modes of production by comparing nested (vertical) outsourcing with horizontal outsourcing. Nested outsourcing is found to be inefficient unless the cost of monitoring outsourced production lines increases sharply with the number of subcontractors and not only with the number of outsourced components. We characterize a market failure in which nested outsourcing is the market outcome even though horizontal outsourcing is the efficient outsourcing mode. This failure occurs at an intermediate range of the costs of monitoring outsourcing to several subcontractors.