Managing Innovation in Vertical Relationships

We study the structure of an optimal management for innovative activities. The top management of a buyer hires a supplier for production. The production e¢ ciency can be enhanced by investing in R&D before production. The buyer chooses between using its own subunit for the R&D, or outsourcing the task to the supplier (integration of R&D and production). Our analysis reveals that (i) when the R&D cost is small, the buyer prefers inhouse R&D, (ii) when the R&D cost is intermediate, the buyer prefers outsourcing R&D, and (iii) when the R&D cost is large, the buyer prefers in-house or outsourcing R&D, depending on the parameter. Within the regime in which R&D outsourcing prevails, the optimal production levels may have “partial bunching”for successful yet less favorable R&D results, depending on the R&D cost. Thus, motivating R&D may require that less favorable R&D results be overly and equally appreciated, unless the R&D is a failure. Keywords: Innovation, In-house R&D, Outsourcing R&D. JEL Classi…cation: D82, L22, L23 1 Introduction The issue of insourcing vs. outsourcing has constantly been considered important.1 As the popularity of outsourcing grows,2 organizations tend to outsource not only their production, but also upstream or innovative activities, such as R&D. For example, there are numerous …rms that contract with suppliers such as Flextronics International Ltd. and Applied Engineering Inc. for various services, from OEM manufacturing to fully integrated services that involves R&D and design as well. For some government projects, their R&Ds are conducted in-house and only the manufacturing services are contracted with private companies, but for other projects, both R&D and manufacturing are completely outsourced. The examples for outsourcing only R&D task or both R&D and production tasks abound. The objective of this paper is to analyze the structure of an optimal R&D policy in a buyer-supplier relationship. In particular, we want to study why the buyer (the project owner) sometimes purchases only the manufacturing service from the supplier, and sometimes both the R&D and the manufacturing services. We employ an agency framework in which the buyer chooses between in-house and outsourcing R&D, while the …nal output is always produced by the supplier.3 If the buyer chooses in-house R&D, then the task is conducted by a subunit of the buyer, and the supplier engages in production using the R&D result delivered from the subunit. If the buyer chooses to outsource the R&D, the supplier conducts the R&D and uses the result to produce the …nal output. The buyer monitors the R&D e¤ort, regardless of which party conducts the R&D. The buyer’s monitoring is more e¢ cient for in-house R&D in that, if the buyer’s own subunit shirks, then it gets caught with a higher probability. The buyer cannot observe the R&D result in any case.4 When the R&D is conducted in-house, the buyer’s only concern is the subunit’s hidden action for the R&D e¤ort. Since the subunit does not produce the output, thus not using the R&D result, it does not have any incentive to misreport the R&D result. However, the subunit has an incentive to shirk on the R&D e¤ort so that it can privately reap the cost of R&D. Therefore, although there is no hidden information problem associate with the R&D result, the buyer must motivate its own subunit to engage in the R&D activity. And the supplier’s production is always at the …rst-best level (the marginal bene…t equals See Coase (1937) and Williamson (1985) for seminal works. See Harrison and Kelley (1993). Therefore, we are implicitly assuming that the buyer does not have the production capacity, or the opportunity cost of production for the buyer is too high. Our result does not change when the buyer observe the R&D result when the task is conducted in-house.