Sourcing decision in the presence of a complementary component

Abstract Studies on the make-or-buy decision traditionally focus on the sourcing decision of one component. Yet most products consist of multiple components that influence product quality simultaneously. These components are often provided by different suppliers, and therefore, strategic interactions may arise because of the interdependence. However, little is known about how the interactions influence the sourcing decision. Using a game theoretical model, we study the sourcing decision of a manufacturer in the presence of a complementary component. Different from typical sourcing options (make or buy), the presence of the complementary component classifies the manufacturer's sourcing options as follows: (a) produce the component in-house, (b) outsource to an incumbent supplier that provides the complementary component, and (c) outsource to an entrant supplier that provides the specific component only. We demonstrate that each sourcing strategy can be optimal depending on the relative efficiency in the quality investment between firms. Interestingly, we show that the manufacturer may prefer outsourcing even if the supplier has a relatively lower efficiency in quality investment than the manufacturer. Such behavior is not observed in the benchmark case without a complementary component, indicating that the presence of the complementary component is the driving force. We reveal that two strategic effects (the appropriation effect and the spillover effect) result in this counter-intuitive behavior. Lastly, we consider diverse extensions and examine their impacts on the sourcing decision.