Economic Theory

, Volume 38, Issue 3, pp 485-515

First online:

Outsourcing of innovation

  • Edwin L.-C. LaiAffiliated withResearch Department, Federal Reserve Bank of Dallas
  • , Raymond RiezmanAffiliated withDepartment of Economics, University of Iowa Email author 
  • , Ping WangAffiliated withWashington University in St. LouisNBER

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This paper looks at the outsourcing of research and development (R&D) activities. We consider cost reducing R&D and allow manufacturing firms to decide whether to outsource the project to research subcontractors or carry out the research in-house. We use a principal-agent framework and consider fixed and revenue-sharing contracts. We solve for the optimal contract under these constraints. We find that allowing for revenue-sharing contracts increases the chance of outsourcing and improves economic efficiency. However, the principal may still find it optimal to choose a contract that allows the leakage to occur—a second-best outcome when leakage cannot be monitored or verified. Stronger protection of trade secrets can induce more R&D outsourcing without inhibiting technology diffusion and increase economic efficiency, as long as it does not significantly lengthen the product cycle.


R&D outsourcing Principal-agent problem Fixed versus revenue-sharing contract

JEL Classification

D21 O31 L14