|
Article Excerpt
I. Introduction
If you buy a notebook computer or a personal digital assistant (PDA) today, the chances are that it is designed by a company that you have never heard before. The list of products does not stop here. In consumer electronics alone, an increasing number of products such as MP3 players, digital cameras, and mobile phones are designed through outsourcing but sold under top brands. The trend seems to be spreading to other sectors, too.
Although outsourcing in general has been the subject of considerable interest recently, outsourcing product innovation has not been paid much attention in the literature. A notable exception is Aghion and Tirole (1994), which adopts an incomplete-contract approach to analyze the make-or-buy decision in the production of innovation. Their analysis focuses on the development of innovation and hence abstracts away from the pricing or marketing of innovation so developed. But pricing and product development are inter-related problems, especially in durable-good markets where such a practice seems to be most pronounced. This article attempts to find a role of outsourcing from the interaction between the two problems.
Consider a durable-good monopolist who has the capability to improve the quality of its product. The firm may develop an improved product in house or may outsource the development to a contractor. Assuming that contracts are incomplete, outsourcing involves a hold-up problem, which leads to insufficient investment in product development. Meanwhile, the monopolist seller faces a well-known dynamic pricing constraint inherent in durable-good sales. This means that a durable good must be sold at a price below its intrinsic value. Otherwise, consumers would not make a purchase because they expect that their purchase will become economically obsolete once the monopolist introduces an improved product. In relation to the development decision, however, the pricing constraint becomes the source of a commitment problem for the monopolist (Waldman (1996), Fishman and Rob (2000)). Although frequent product improvements will suppress the sales price hence the profits, the monopolist has an incentive to speed up the development once the sales of the current product has been made to the consumers. Consequently, the monopolist will have an overinvestment problem if the development is done in house.
It is not difficult to see then why outsourcing may be preferred over vertical integration. Although the hold-up problem associated with outsourcing has a negative effect of reducing the investment in product improvement, the inefficiency in investment also relaxes the pricing constraint and hence has a positive effect of boosting the sales of the original product. Which of the two forms of organization gets selected will depend on the relative size of the two effects.
Outsourcing is a useful strategic option for the monopolist but its welfare effect is in general ambiguous. On the one hand, outsourcing reduces social welfare because it causes inefficiency in product improvement. On the other hand, it may improve the monopolist's profitability and hence provide an added incentive to develop the original product. This implies that outsourcing must be socially wasteful if it is adopted when the original product can be developed profitably in house. If the profits under vertical integration are not sufficient to cover the development cost, however, outsourcing may be the only way to bring out a valuable innovation to market. Despite its inefficiency in subsequent product improvement, outsourcing improves social welfare in this case.
The model predicts that relatively less significant improvements are outsourced while more significant ones are made in house. When the value of improvement is relatively small, the sales of the original product must be more important than the sales of an improved product. Outsourcing must be the better alternative in this case because generating hold-up will have more positive than negative effect on profits. The case for vertical integration will be the exact opposite, i.e., it should be the preferred mode of organization when the improvement has a relatively large value. Although the validity of this claim needs to be verified by rigorous empirical evidence, a casual observation suggests that it is consistent with actual practice. (2) Such a prediction, however, does not follow easily from a standard hold-up model, which focuses only on the incentive for product improvement.
In management literature, "core competence" argument has been commonly used as an explanation for outsourcing. In the context of research and development, it suggests that firms can raise profitability by performing only "core" R&D and outsourcing non-core R&D activities. In a nutshell, the argument emphasizes potential gains from specialization associated with outsourcing. (3) The framework developed in this article, however, provides a different interpretation of this popular idea. Once the development of an original product is identified as core and the development of an improved product as non-core R&D, the current analysis suggests that outsourcing non-core R&D, which helps the sales of the pioneering innovation, will increase the profitability of core R&D. This implies that gains from outsourcing may not come from a better capability for core R&D as commonly believed but from a better return on the investment in such activities.
This article takes a view that outsourcing may be adopted not because of its intrinsic benefits or cost advantages relative to vertical integration but precisely because of the hold-up problem that it entails. (4) In the analysis, outsourcing plays a "strategic" role in the sense that it mitigates the commitment problem faced by the monopolist. Although in a quite different setting, Chen (2005) considers such a strategic effect of outsourcing or vertical disintegration. The idea is that a vertically integrated firm may divest its upstream division in order to make a commitment not to discriminate against its downstream competitors. The audiences for commitment are the rival firms in the downstream market. In this article, consumers are the audience for the monopolist's commitment.
The rest of the article is organized as follows. Section 2 introduces the basic model. The main result is presented in section 3 in which the strategic role of outsourcing is identified and a comparison is made between the two modes of organization. Section 4 examines possible alternatives to outsourcing such as rental and buyback schemes. Also, the incentive for pioneering innovation is discussed by extending the basic model. Concluding remarks follow in section 5.
II. Basic Model
There is a firm, the "pioneer", with a technology to produce a durable good, and a continuum of identical consumers. Each consumer has a unit demand of the good, i.e., buys either zero or one unit but not more. The per-period utility of a representative consumer is given by u = v - p, where v(p) denotes the quality (price) of the good. It is assumed that a consumer chooses to...
|
