Design Outsourcing in a Differentiated Product Market: The Role of Bargaining and Scope Economies

Abstract

In the electronics industry and beyond, original design manufacturers (ODMs) provide a full spectrum of services, ranging from design and development to manufacturing, to original equipment manufacturers (OEMs). Through resource pooling, ODMs benefit from scope economies when designing different products for multiple OEMs. Such design outsourcing practices, however, stir concerns that it may dilute product differentiation and subsequently intensify market competition. To examine the strategic impact of design outsourcing, we develop a game-theoretical model with a single ODM and two competing OEMs. The ODM has two divisions to serve the OEMs separately. The OEMs engage in a differentiated price competition over the Hotelling Line with product locations endogenously chosen by the parties who design the products. A wholesale-price contract is negotiated bilaterally between an ODM division and her OEM customer, and design outsourcing may reduce an OEM’s bargaining power. We compare two scenarios: (1)The ODM divisions establish dedicated resources and act as independent profit maximizers; (2)The ODM divisions cooperate through resource pooling and benefit from scope economies in both design and manufacturing. Our results highlight the role of bargaining in shaping the OEMs’ design sourcing decisions. In particular, whether the OEMs outsource design in equilibrium critically depends on the degree of asymmetry between their bargaining powers vis-a-vis the ODM. With similar bargaining power, the OEMs are more likely to outsource when they become stronger relative to the ODM. With significantly different bargaining power, surprisingly, the strong OEM tends to insource while the weak one tends to outsource. Scope economies may induce the ODM to decrease product differentiation between the products she designs for her OEM customers, and this tendency increases as the OEMs’ bargaining power strengthens. Ceding bargaining power, therefore, can be used by an OEM as an incentive lever to influence the ODM’s design decisions.

Keywords: Design Outsourcing, Nash Bargaining, Scope Economies, Original Design Manufacturing, Product Differentiation