Insourcing versus outsourcing in a vertical structure

We study an agency model with vertical hierarchy—the principal, the prime‐agent and the subagent. The principal faces a project that needs both agents' services. Due to costly communication, the principal receives a report only from the prime‐agent, who receives a report from the subagent. The principal can directly incentivize each agent by setting individual transfers (insourcing), or sets only one overall transfer to an independent organization in which the prime‐agent hires the subagent (outsourcing). We show that insourcing is always optimal when the principal can perfectly process the prime‐agent's report. When the principal's information process is limited, however, outsourcing can be the prevailing mode of operation. In addition, insourcing under limited information process is prone to collusion between the agents, whereas no possibility of collusion arises with outsourcing.