Quality investment, and the contract manufacturer’s encroachment

Abstract This paper studies a supply chain in which the incumbent original equipment manufacturer is the quality leader and the encroaching contract manufacturer is the quality follower acting as a free rider for the former’s investment in quality improvement. Investigations were made into the contract manufacturer’s encroaching conditions and the original equipment manufacturer’s strategies of investment in quality improvement to deter the contract manufacturer’s encroachment. Results show that, different from the traditional encroachment, the contract manufacturer always has the incentive to encroach on the original equipment manufacturer’s final market if there is no quality investment opportunity. However, if quality investment is attainable for the original equipment manufacturer, there exists a threshold for the contract manufacturer’s imitating capability, in excess of which the contract manufacturer will encroach on the original equipment manufacturer’s final market. The structure of quality improvement plays a critical role regarding deterring the contract manufacturer’s imitation and encroachment, and the encroachment is conditional when the contract manufacturer’s imitating ability is relatively weak. Moreover, the threat of the potential entrant will facilitate the original equipment manufacturer’s quality investment, even though the quality investment per se is unprofitable. Under certain conditions with quality investment, the contract manufacturer’s encroachment can improve the original equipment manufacturer’s profit, thus achieving a win–win outcome.