Strategic Outsourcing for Competing OEMs that Face Cost Reduction Opportunities

This paper explores production and outsourcing decisions for two original equipment manufacturers (OEM)who produce partially substitutable products and have opportunities to invest in reducing the manufacturing cost. In such an environment, competition drives both OEMs to set lower prices and invest more than would occur in the first-best solution, particularly when product substitutability is high. However, outsourcing provides a mechanism by which the two OEMs can credibly signal that they will not over-invest in cost reduction, mitigating mutually destructive cost competition. Our paper explores the role that an external supplier(s) can play in dampening competition between the OEMs when there are opportunities to invest in cost reduction. In particular, we characterize the conditions under which a supplier can profitably enter the market by inducing the OEMs to outsource production. We first examine a basic model of two identical OEMs in which there is a single common supplier and a single component that is a candidate for outsourcing. Later, we extend the basic model to allow for market asymmetry, more than one supplier, and more than one component that might be outsourced. (Supply Chain Management, Outsourcing, Channels of Distribution, Cost Competition) ∗The University of Texas at Austin, Management Department, CBA 4.202, Austin, TX 78712, [email protected] †The University of Texas at Austin, Department of Management Science and Information Systems, CBA 5.202, Austin, TX 78712, [email protected] ‡The University of Texas at Austin, Department of Management Science and Information Systems, CBA 5.202, Austin, TX 78712, [email protected]