Consider Outsourcing Even What You Do Best

Abstract:     
In recent years, outsourcing has become a common practice for firms operating domestically as well as globally. The academic and professional literature discusses numerous factors that influence outsourcing decisions, including the commonly used argument that activities that are not within the core competencies of a firm should be outsourced.

In this paper we show that firms may wish to outsource even the manufacture of a product with respect to which they enjoy a competitive advantage. Furthermore, we provide an explanation as to why firms may decide not to outsource non-core products, although their competitors can produce them at a lower cost.

Our model provides an explanation for the often coexistence of rivalrous and buyer-supplier relationship between firms in different markets or even the same product market. Specifically, we show that the understanding of outsourcing (or lack of outsourcing) arrangements should be based on analysis of the strategic interaction across markets between the parties in the outsourcing arrangements. Furthermore, in analyzing outsourcing, we should not only analyze the production cost of the product being considered, but also consider the costs and benefits associated with cross-product synergies of the firms.

Our analysis demonstrates that outsourcing may enable firms to achieve tacit collusion in the presence of restrictions on explicit cooperation. However, we show that consumers may benefit from outsourcing in spite of its seemingly adverse impact on competition.

Number of Pages in PDF File: 36

JEL Classification: M41, M11, L40, L20, L13, K21, D43, C70

working papers series