Managing R&D in Vertical Relationships

16 Pages Posted: 22 May 2019

See all articles by Chifeng Dai

Chifeng Dai

Southern Illinois University at Carbondale - Department of Economics

Dongsoo Shin

Santa Clara University - Leavey School of Business

Date Written: July 2019

Abstract

We study the optimal strategy for research and development (R&D) in a buyer‐supplier relationship. The buyer chooses whether to (1) insource a cost‐reducing R&D to its own research‐subunit or to (2) outsource it to its manufacturing supplier. The buyer cannot observe the R&D effort in either case, but can better observe the R&D result when the R&D is conducted internally. According to our analysis, the buyer prefers insourcing R&D to mitigate information asymmetry when the R&D cost is either small or large. When the R&D cost is intermediate, however, the buyer prefers outsourcing R&D, and can achieve the full information outcome (first‐best outcome) despite the information asymmetry associated with outsourcing R&D. Moreover, the buyer's preference for outsourcing high‐cost R&D increases when the R&D is more likely to succeed or to generate significant cost reductions, or the R&D result is more difficult to predict. Our analysis provides a theoretical explanation for the increasing trend of outsourcing innovation to manufacturing suppliers.

JEL Classification: D82, L22, L23

Suggested Citation

Dai, Chifeng and Shin, Dongsoo, Managing R&D in Vertical Relationships (July 2019). Economic Inquiry, Vol. 57, Issue 3, pp. 1510-1525, 2019. Available at SSRN: https://ssrn.com/abstract=3392587 or http://dx.doi.org/10.1111/ecin.12784

Chifeng Dai (Contact Author)

Southern Illinois University at Carbondale - Department of Economics ( email )

Mail Code 4515
Carbondale, IL 62901-4515
United States

Dongsoo Shin

Santa Clara University - Leavey School of Business ( email )

500 El Camino Real
Santa Clara, CA California 95053
United States

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