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Sourcing strategies in a price and quality competition

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Abstract

In a price competition between two original equipment manufacturers (OEMs), we investigate under which conditions each OEM chooses to outsource its production to a contract manufacturer (CM) under the assumption that outsourcing improves product quality but may come with a higher cost. A characterization of subgame perfect Nash equilibrium also reveals the two OEMs’ optimal pricing strategies in each case of insourcing versus outsourcing decisions. Later, in an extension of our model, we assume that there are two competing CMs that aim to attract outsourcing OEMs by setting a sufficiently low price level, and we further analyze how equilibrium sourcing and pricing strategies change compared to those in the main model.

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Notes

  1. As apparent in the latter example, it is surely possible for an OEM to partially outsource its production, by producing certain components in house while outsourcing the production of the remaining components.

  2. In a sense, CM is specialized in the production of the outsourceable component and able to supply a higher-quality product.

  3. It is worth noting that the nature of outsourcing could be reversed in our model. That is, one can assume that outsourcing production is less costly for sure, as common in the textile industry, and then let CM optimally determine its product quality, which could turn out to be lower than OEM’s insourcing quality in equilibrium, so that there is still a cost versus quality trade-off in an outsourcing decision.

  4. The reader is referred to Concluding Remarks for details and other real-life examples.

  5. There are also studies on the effect of learning-by-doing (see Gray et al. 2009), the effect of two-part tariffs in outsourcing contracts (see Feng and Lu 2013), when a CM is a potential competitor for an OEM (see Wang et al. 2013), whether to outsource to a third-party supplier or to a competing OEM (see Pun 2015), and whether to outsource to an environmentally responsible supplier (see Guo et al. 2016).

  6. It can be argued that Xiao et al. (2014) and Yoo et al. (2021) assume special cases of this demand function in the analysis of outsourcing strategies.

  7. The simultaneous nature of the second stage game is captured by the dashed line connecting Firm 2’s decision nodes in the figure.

  8. For other model interpretations, \(C_I\) could be the additional unit cost of producing the outsourceable component in house.

  9. It is worth noting that the case of full outsourcing where CM produces all components of the final product is captured in our model. If one simply assumes that \(C = 0\), this can be interpreted as if there is no manufacturing process handled by an outsourcing OEM.

  10. It is worth reminding that these results are presented under the assumption that \(\overline{P_{t,1}} > \overline{P_{t,2}}\) (i.e., \(r > 1\)). If the converse inequality holds, then for sufficiently low values of r, implying a significant demand advantage for firm 2, it would be firm t’s optimal strategy to supply its technology only to firm 2.

  11. The prices \(P_a\) and \(P_b\) and marginal costs \(C_a\) and \(C_b\) replace the notation \(P_t\) and \(C_t\) used in the previous section, respectively.

  12. The implicit equilibrium characterization for the generalized version is available upon request.

  13. An additional condition that needs to be satisfied is that their pricing strategies yield non-negative profits to the respective CMs. Yet, this condition is easily satisfied if T is sufficiently high.

  14. As mentioned earlier, the common CM has a substantial market power in the main model, and this is one of the reasons why there can be an equilibrium where all benefit is collected by the CM. Our model extension can partially solve this issue, since the introduction of another supplier gives a considerable outside option to the two OEMs, which arguably makes the model more realistic.

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  1. School of Business, ADA University, Ahmadbay Aghaoglu Street 61, AZ1008, Baku, Azerbaijan

    Kerim Keskin

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I would like to thank the editor and two anonymous reviewers for helpful comments and suggestions. I also thank Shakiba Mikaeili Khiavi for her research assistance. The usual disclaimer applies.

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Keskin, K. Sourcing strategies in a price and quality competition. Cent Eur J Oper Res (2024). https://doi.org/10.1007/s10100-024-00904-5

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