Integration or Outsourcing: Combining Ex Ante Distortions and Ex Post Inefficiencies
Abstract: Final good production often requires a firm’s headquarter services and a foreign supplier’s manufacturing input. With incomplete contracts, firms that decide whether to source this input from an integrated or an outsourced supplier do not only have to consider the ex ante production incentives that influence the own and the supplier’s underinvestment problem. Instead, firms also have to take into account the ex post risk that the supplier absorbs the producer’s knowledge to become a competitor for the final good, both under outsourcing and integration. In line with the outcome of the knowledge protection approach, with an exogenous probability of such ex post inefficiencies associated with one particular organizational form, this organizational form becomes less likely. However, considering the supplier’s incentives to become a competitor, integrated suppliers are more likely to become a competitor than outsourced suppliers such that outsourcing becomes per se more likely. As a competitor lowers the producer’s profit, the producer might have an incentive to deter the supplier from becoming a competitor. More precisely, the producer has this incentive whenever the supplier’s manufacturing input is not too important for the production.