Economic Theory

, Volume 38, Issue 3, pp 485–515 | Cite as

Outsourcing of innovation

  • Edwin L.-C. Lai
  • Raymond Riezman
  • Ping Wang


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 


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Copyright information

© Springer-Verlag 2007

Authors and Affiliations

  1. 1.Research DepartmentFederal Reserve Bank of DallasDallasUSA
  2. 2.Department of EconomicsUniversity of IowaIowa CityUSA
  3. 3.Washington University in St. LouisSt. LouisUSA
  4. 4.NBERCambridgeUSA

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