Outsourcing under Competition and Scale Economies: When to Choose a Competitor as a Supplier

In highly competitive industries, many original equipment manufacturers (OEMs) increasingly outsource production to reduce costs. We study an OEM's outsourcing decision between a third-party supplier and a vertically integrated firm that manufactures in house and competes with the OEM in the consumer market (i.e., an integrated competitor). Our setting explicitly considers two important aspects of the sourcing decision. First, we capture the competition between the two sourcing alternatives through interdependent repeated bilateral wholesale-price negotiations in which the negotiating parties' disagreement payoffs are endogenous. Specifically, in the negotiation between the OEM and either supplier, the negotiating parties' disagreement payoffs are given by the profits that would result if the OEM sourced from the other supplier. Second, we capture the economies of scale involved with production in that either supplier derives positive externalities from increasing his total production quantity. We show that, for given wholesale prices-counter to intuition-it is not optimal for the OEM to always choose the supplier offering the lower wholesale price. In the absence of either competition or economies of scale, the OEM always simply prefers the source with the lower wholesale price. However, in the presence of both economies of scale and competition in the focal market, the OEM may be better off sourcing from the third-party supplier even at a higher wholesale price. When equilibrium wholesale prices are determined through simultaneous bilateral negotiations between the OEM and the two potential suppliers, sourcing from the integrated competitor might be more profitable when scale economies are strong and competition is weak. We investigate the robustness of our findings and find that our structural results continue to hold for several model relaxations and extensions. We also show that in the absence of restrictive capacity constraints, the OEM always prefers sourcing exclusively from one of the suppliers to dual sourcing. Our findings demonstrate the importance for managers to account for both the extent of scale economies and the competitive dynamics in the consumer market when deciding their supply mode.