Strategic outsourcing for competing OEMs that face cost reduction opportunities

This paper explores production and outsourcing decisions for two Original Equipment Manufacturers (OEMs) who produce partially substitutable products and have opportunities to invest in reducing the manufacturing cost. In such an environment, competition drives both OEMs to set lower prices and invest more than would maximize their combined profits, particularly when product substitutability is high. However, outsourcing provides a mechanism by which the two OEMs can credibly signal that they will not overinvest in cost reduction, mitigating a mutually destructive cost competition. Our paper explores the role that an external supplier(s) can play in dampening competition between the OEMs when there are opportunities to invest in cost reduction. In particular, we characterize the conditions under which a supplier can profitably enter the market by inducing the OEMs to outsource production. We first examine a basic model of two identical OEMs in which there is a single common supplier and a single component that is a candidate for outsourcing. Later, we extend the basic model to allow for market asymmetry, two suppliers, and more than one component that might be outsourced.