In-house production vs. outsourcing: the effect of volume-based learning on quality competition

This paper considers an original equipment manufacturer (OEM) who outsources finished products to a contract manufacturer (CM), who adopts the OEM's existing technology and achieves quality improvement through learning-by-doing. Besides the role of upstream partner, the CM also becomes a downstream competitor. We examine learning-by-doing and quality dynamically under a two-period model - both for cases when quality competition exists and does not exist. We identify the conditions under which pure outsourcing, partial outsourcing, or non-outsourcing is most advantageous. When there is no quality competition and when the CM's quality improvement does not hurt the OEM's future demand, we find that it would still be beneficial for the OEM to apply a partial outsourcing strategy. When quality competition exists, the OEM's decision in the second period follows the same pattern as the non-competition case, while the CM's wholesale price depends on the tradeoff between selling through the OEM and selling independently.