The Strategic Perils of Low Cost Outsourcing

Abstract

The existing outsourcing literature has generally overlooked the cost differential and contract negotiations between manufacturers and suppliers (by assuming identical cost structures and adopting Stackelberg-game based models). One fundamental question that yet to be addressed is whether upstream suppliers' cost efficiency is always beneficial to downstream manufacturers in the presence of competition and negotiations. In other words, does low cost outsourcing always lead to a win-win outcome? To answer this question, we adopt a multi-unit bilateral bargaining framework to investigate competing manufacturers' sourcing decisions. We analyze two supply chain structures: one-to-one channels, in which each manufacturer may outsource to an exclusive supplier; and one-to-two channels, in which each manufacturer may outsource to a common supplier. We show that, under both structures, low cost outsourcing may lead to a win-lose outcome in which the suppliers gain and the manufacturers lose. This happens because suppliers' cost advantage may backfire on competing manufacturers through two negative effects. First, a decrease of upstream cost weakens a manufacturer's bargaining position by reducing her disagreement payoff (i.e., her insourcing profit) because the competing manufacturer can obtain a low cost position through outsourcing. Second, in one-to-two channels, the common supplier's bargaining position is strengthened with a lower cost because his disagreement payoff increases (i.e., his profit from serving only one manufacturer increases). The endogeneity of disagreement payoffs in our model highlights the importance of modeling firm negotiations under competition.

Moreover, we identify an interesting bargaining externality between competing manufacturers when they outsource to a common supplier. Because the supplier engages in two negotiations, his share of profit from the trade with one manufacturer affects the total surplus of the trade with the other manufacturer. Due to this externality, surprisingly, as a manufacturer's bargaining power decreases, her profit under outsourcing may increase and it may be more likely for her to outsource.

Keywords: Outsourcing, Multiunit Bilateral Bargaining, Competition, Supplier Cost Advantage