Optimal Second-Stage Outsourcing

Abstract

Manufacturers have recently begun outsourcing product assembly and completion tasks to their suppliers. Such outsourcing solves several contracting problems, but generates new incentive frictions between manufacturers and their suppliers. In this paper, we analyze a manufacturer's decision to outsource an assembly task to a pre-established supplier. We find that outsourcing becomes more attractive when either the supplier has high component costs or when the assembly task being delegated is relatively costly. Outsourcing becomes less attractive when the supplier is unable to accept large levels of liability. We find that the manufacturer will conduct more testing when she outsources assembly to her supplier as opposed to assembling products in-house. Lastly, the manufacturer is shown to prefer limiting the number of ways end-products can be assembled, and the smaller the number of assembly methods, the less she favors outsourcing.

Keywords: outsourcing, limited liability, moral hazard, supply chain

JEL Classification: D20, D23, M40, M46