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Learning by supplying and competition threat

Abstract

This study proposes a model of learning by supplying in an international outsourcing framework, where the supplier of a relationship-specific input can reverse engineer and become a competitor to its partner in the final goods market. Transmitting knowledge to a more capable supplier therefore creates competitive threat despite the benefits it brings within an outsourcing relationship. In particular, in markets with less differentiated products and for standard inputs that require less knowledge to be shared, choosing an intermediate capability level supplier prompts a strategic expansion of output to deter supplier entry in the final goods market, resulting in higher profits and welfare. A highly capable supplier is instead accommodated as a rival and is a source of royalty income when the relationship-specific input embeds more knowledge about the final product and when the competing varieties are differentiated.

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Notes

  1. 1.

    Samsung developed its capability by undertaking GE’s production. Please refer to pp. 136–140 of Kim (1997), and pp. 202–206 of Cyhn (2002). The Korean automobile industry instead began from basic assembly and input production for foreign automobile companies. Please refer to Kim (1997), pp. 105–130, for details.

  2. 2.

    Chu (2009) provides a detailed illustration of the transition from OEM to OBM in East Asia, and finds that the Chinese and Korean firms tend to be more active in following this path than Taiwanese firms.

  3. 3.

    Boeing Japan’s report “Made with Japan: A Partnership on the Frontiers of Aerospace,”, page 6. Available online at: http://www.boeing.jp/resources/ja_JP/Boeing-in-Japan/Made-with-Japan/1122_boeing_cb13_final.pdf. According to the report, Mitsubishi also designs and produces the wings of the 787. Furthermore, this is the first time that Boeing has entrusted such a critical component to an outside supplier.

  4. 4.

    In Zigic (2000) and Naghavi (2007), an N engages in a predatory level of R&D to deter S from entering the final goods market.

  5. 5.

    For an overview of the literature on IP rights as an alternative determinant of reverse-engineering costs, see among others Chin and Grossman (1990), Deardorff (1992), Helpman (2003), Vishwasrao (1994), Zigic (1998, 2000), Saggi (1999), Yang and Maskus (2001), Markusen (2001), Glass and Saggi (2002), Glass (2004), Grossman and Lai (2004), Mukherjee and Pennings (2004), Naghavi (2007), Leahy and Naghavi (2010), Mukherjee (2017), Ghosh et al. (2018), and Ghosh and Ishikawa (2018).

  6. 6.

    See also Acemoglu et al. (2007), Naghavi and Ottaviano (2009), Van Biesebroeck and Zhang (2014), and Schwarz and Suedekum (2014) for further applications of these models.

  7. 7.

    This includes Pack and Saggi (2001), Chen et al. (2004, 2011), and Mukherjee and Tsai (2013) among others.

  8. 8.

    This assumption is also applied in Pack and Saggi (2001) and Naghavi and Ottaviano (2009) with the objective to highlight the cost-saving characteristic of offshoring with N only supplying the home market.

  9. 9.

    This assumption is justified by interpreting \(w_{j}\) as the productivity of labor in producing \(q_{0}\) in region j. In other words, we assume that, in the North, a unit of labor is capable of producing \(\theta _{N}\) units of \(q_{0}\), while in the South, a unit of labor can only produce \(\theta _{S}\) units of \(q_{0}\), where \(\theta _{N}>\theta _{S}\). Since the price for each unit of \(q_{0}\) is 1 and the homogeneous sector is perfectly competitive, it must be that the wage of each unit of labor is equal to its marginal productivity. In other words, \(p_{0}\theta _{N}=\theta _{N}=MPL_{N}=w_{N}\) and \(p_{0}\theta _{S}=\theta _{S}=MPL_{S}=w_{S}\). We can further normalize Southern productivity such that \(\theta _{N}>\theta _{S}=1\) and, hence, \(w_{N}>w_{S}=p_{0}=1\).

  10. 10.

    Note that supplier capability does not only apply to their effort within the relationship, but also to their learning and innovation capacity that determines their individual benefits. Firms can therefore obtain this information by observing supplier-specific characteristics, such as its history of patents.

  11. 11.

    We focus only on the interesting case where \(e<{\overline{e}}\).

  12. 12.

    Let \({\overline{e}}\equiv \frac{\sqrt{33}}{3}-1\approx 0.915\). \(\zeta ^{D}\) tends to infinity when \(e\rightarrow {\overline{e}}\) (Please refer to Online Appendix A.3). For \(\zeta \ge \zeta ^{P}\), when e is larger than \(\overline{e }\), the effect of e on \(q_{N}^{P}\left( e,\zeta \right)\) always dominates the effect of \(\zeta\), causing \(q_{N}^{P}\left( e,\zeta \right)\) to be very small. As a result, N would never prefer the Stackelberg scheme in this case and strategic predation always prevails.

  13. 13.

    This is reminiscent of Defever and Toubal (2013) who show profits from outsourcing to rise with firm productivity, with the effect magnified for contract intensive inputs, a proxy obtained by measuring input relation-specificity (Nunn 2007). In a parallel manner, pairing with a more capable supplier in our framework increases profits, but more so when sourcing more knowledge intensive inputs.

  14. 14.

    We can easily show that \(\frac{CS^{P}\left( \zeta ^{D}\right) }{CS^{D}}=\frac{ 4\left( 4-4e^{2}+e\left( 4-3e^{2}\right) +2e\sqrt{e\left( 1-e\right) \left( 4-3e^{2}\right) }\right) ^{2}}{e^{2} \left( 128-32e-156e^{2}+36e^{3}+33e^{4}\right) }>1\) holds throughout \(e\in \left[ 0,{\overline{e}}\right)\).

  15. 15.

    To see this, in Online Appendix A.7 and A.9 we show that the Stackelberg limit profit and total surplus are independent of \(\gamma\), while the maximum profit and total surplus with strategic predation are always increasing in \(\gamma\), and outperform those under Stackelberg if e is sufficiently large.

  16. 16.

    Note that learning by supplying in this case raises the consumer surplus but reduces the producer surplus. To see that the consumer surplus increases in this case, recall that the consumer surplus equals \(\frac{1}{2} \left( a-p_{N}\right) q_{N}\) for \(\zeta <\zeta ^{D}\). Because \(q_{N}^{P}\left( e,\zeta \right) >q_{N}^{M}\) and hence \(p\left( q_{N}^{M} \right) >p\left( q_{N}^{P}\left( e,\zeta \right) \right)\), it follows that \(CS^{D}\ge CS_{no}\). To see that the producer surplus decreases for \(\zeta \in \left[ \zeta ^{M},\zeta ^{D}\right)\), note that \(q_{N}^{P}>q_{N}^{M}\) implies that \(R^{M}\left( q_{N}\right) \ge R^{M}\left( q_{N}^{P}\right)\). Since \(PS^{no}\) equals to the profit under natural monopoly, it follows that \(PS^{no}\ge \Pi _{N}^{*}\).

  17. 17.

    To see that the consumer surplus increases, note that direct comparison between \(CS^{D}\) and \(CS^{no}\) shows that \(CS^{D}\ge CS^{no}\) if and only if \(-3e^{4}+36e^{3}-60e^{2}-32e+64\ge 0\). It is readily checked that this condition holds for \(e\in \left( 0,1\right)\). To see the possibility that the producer surplus can decrease, note that \(PS^{no}\) equals to the profit under natural monopoly, and is greater than \(\Pi _{N}\left( q_{N}^{P}\left( e, \zeta \right) \right)\) for all \(\zeta\). Recall from Proposition 3 that at \(\zeta ^{D}\), \(\Pi _{N}^{*}\) jumps downwards from \(\Pi _{N}\left( q_{N}^{P}\left( e,\zeta ^{D}\right) \right)\) to \(\Pi _{N}\left( q_{N}^{D},\zeta ^{D}\right)\), we conclude that \(PS^{no}\ge \Pi _{N}\left( q_{N}^{D},\zeta \right)\) holds for some range of \(\zeta >\zeta ^{D}\).

  18. 18.

    This is done by simply comparing \(\pi _{NH}\) with the maximum profit in each market structure when outsourcing emerges, i.e., \(\Pi \left( \zeta ^{P}\right)\) for natural monopoly, (26) for strategic predation, and (27) for Stackelberg.

  19. 19.

    We can rewrite equation (21) as \(2\Pi _{N}^{*}\ge \frac{m^{2}}{4}-w_{S}f_{M}\). Observe that its left-hand side depends on \(\zeta\), while its right-hand side is a constant independent of \(\zeta\). Therefore, the condition for outsourcing to emerge is derived by replacing \(\Pi _{N}^{*}\) on the left-hand side of (21) with the maximum profit in each market structure, i.e., \(\Pi \left( \zeta ^{P} \right)\) for natural monopoly, (26) for strategic predation, and (27) for Stackelberg.

  20. 20.

    See https://ustr.gov/issue-areas/enforcement/section-301-investigations/section-301-china/investigation.

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Acknowledgements

We are grateful to Tse-Chien Hsu, Wen-Tai Hsu, Ching-I Huang, Bih-Jane Liu, Yasuhiro Sato, Takatoshi Tabuchi, Jacques Thisse, Tsung-Sheng Tsai, Cheng-Chen Yang, and the participants of 2016 Osaka Conference on Spatial and Urban Economics for very helpful comments. Financial support from the Academia Sinica IA-105-H04 is gratefully acknowledged.

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Chen, YF., Naghavi, A. & Peng, SK. Learning by supplying and competition threat. Rev World Econ 157, 121–148 (2021). https://doi.org/10.1007/s10290-020-00386-y

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Keywords

  • International outsourcing
  • Supplier heterogeneity
  • Competitive threat
  • Reverse engineering
  • Strategic predation
  • Technological capability
  • Learning by supplying
  • Royalty payment
  • Knowledge intensity

JEL Classification

  • F12
  • F23
  • L13
  • L22
  • L24
  • D23
  • O34