A Bargaining Perspective on Strategic Outsourcing and Supply Competition

Abstract

This paper considers the outsourcing choice of a downstream firm with its own upstream production assets. Using both a standard linear pricing model and a bilateral bargaining approach, we examine the equilibrium pricing outcomes that emerge if there are two downstream and two upstream assets. We then characterize the downstream firm's decision as to whether to outsource to an independent or established upstream firm. In so doing, it faces a trade-off between lower prices afforded by independent competition and higher asset value associated with the consolidation of upstream assets. We show that, while under a standard approach, this choice is resolved in favor of independent upstream production, when efficient, non-linear pricing is feasible, outsourcing is to an established firm. This suggests the importance of pricing structure in evaluating the nature of strategic outsourcing behavior.

Keywords: Outsourcing, vertical integration, double marginalization, bargaining, competition

JEL Classification: L42