The Effect of Learning and Integration Investment on Manufacturing Outsourcing Decisions: A Game Theoretic Approach

Abstract

We introduce a two-period Stackelberg game of a supplier and buyer. We recognize that learning based on manufacturing experience has many advantages. Consistent with much of the literature, we assume both the buyer and supplier realize reductions in their respective production costs in period 2 due to volume-based learning from period 1 production. Additionally, we introduce another learning concept, the future value, to capture the benefits of transferring current manufacturing experience for the design and development of future products and technologies. In contrast to the literature, we allow the supplier two mechanisms to impact the buyer’s outsourcing decision: price and the investment in integration process improvement that reduces the buyer’s unit cost of integration. Integration process improvement may include the investment in new materials, specialized technology, or the re-design of the integration process. Conditions are given whereby the buyer partially outsources component demand as opposed to fully outsourcing or fully producing in-house. We explore when the supplier’s price and investment in integration technology are substitute strategies versus complements. We analyze the effect on the buyer and supplier’s decisions due to: the buyer’s base integration cost, the supplier’s cost of integration process improvement, the rates of learning for both the buyer and supplier, and dynamic demand.

Keywords: Integration Process Improvement, Volume-Based Learning, Partial Outsourcing, Stackelberg Game

JEL Classification: C72