Horizontal Outsourcing and Price Competition: The Role of Sole Sourcing Commitment

Previous studies on horizontal outsourcing between competing duopolists emphasize cost factors such as economies of scale and/or variable cost advantages in Cournot markets as potential explanations. This paper studies horizontal outsourcing when two competing firms engage in Bertrand competition, and highlights the important role of sole sourcing commitment. We adopt the framework of a duopolistic multi-stage game that comprises of an incumbent and an entrant. The incumbent has the technology know-how to make a key component in-house, and the entrant, who is a rival of the incumbent in the downstream market, can source the component either from the incumbent or from a supplier that does not participate in the end product market. We find that if the entrant commits to sole sourcing, horizontal outsourcing can occur when the incumbent has a component cost advantage or even a small cost disadvantage over the alternative supplier. Specifically, if the component cost gap is small, horizontal outsourcing may soften downstream market competition and benefit both firms at the expense of inducing higher prices for the consumers. If the incumbent has a significant cost advantage, horizontal outsourcing may lead to increased downstream price competition by expanding the total supply of end products. Without sole sourcing commitment, horizontal outsourcing occurs only if the incumbent has a cost advantage, and it always strengthens downstream price competition and benefits the consumers. In contrast, when the firms engage in downstream Cournot competition, sole sourcing commitment has no impact on the adoption of horizontal outsourcing, and the entrant sources from her rival only when the incumbent enjoys a significant component cost advantage. Finally, we also study various model extensions to confirm the robustness of our main results to key model assumptions.