Strategic Second Sourcing by Multinationals

Multinationals often serve foreign markets by producing domestically and exporting as well as by investing directly in foreign production facilities. We argue that if the multinational competes in an oligopolistic market characterized by strategic complements then there are strategic reasons to use two production facilities -committing to a second source allows the firm to keep average cost low while at the same time increasing its marginal cost. The increase in marginal cost softens product market competition resulting in higher profits. In our model, firms can sink capacity domestically, where the constant marginal cost is known, sink capacity in the foreign country, where the constant marginal cost is uncertain, or do both. In the absence of strategic considerations, the firm usually chooses to either export or use foreign direct investment -it rarely uses both sources of production. In contrast, price competition in the product market makes it much more likely that the firm will choose to use a second source. In fact, there are cases in which the firm sinks capacity in both locations even in the absence of cost uncertainty. We argue that this theory also has implications for the “make or buy” literature in production management and the literature on second sourcing in industrial organization. Finally, we show that the practice of second sourcing has implications for the degree of exchange rate pass through when the uncertainty about foreign costs is driven by fluctuations in the exchange rate. JEL Codes: F1, L1