Quality spillover, tariff, and multinational firms' local sourcing strategies

Abstract It is prevalent for multinational firms (MNFs) to enter a market by importing products of superior quality, and then engage in local competition with domestic manufacturers (DMs). Alternatively, many MNFs voluntarily expose themselves to the risk of quality spillover by strategically sourcing from DMs to avoid the tariff burden. In this paper, we consider a DM and an MNF that strategically choose whether to source from the DM, and characterize the tradeoff between the tariff burden and the potential loss due to quality spillover. We analyze the supply chain parties' preferences over the MNF's sourcing strategies and the impact of the government's tariff regulation. We show that the MNF prefers domestic sourcing (DS) when the risk of quality spillover is low, while the manufacturer usually sees an opposite preference. However, we find that there exists a win‐win zone where both MNF and DM prefer the MNF's domestic sourcing simultaneously. From the government's perspective, DS always results in more output of high‐quality products, and more social welfare when quality spillover is sufficiently valuable. Interestingly, we find that, even if the quality spillover is limited, more social welfare can be obtained under DS, if the tariff rate is either low or high. The government is hence able to facilitate the incentive alignment between the MNF and the DM by adjusting the tariff regulation, which improves product quality and social welfare in the domestic market, although there exist some danger zones where the regulation is inefficient.