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Outsourcing versus technology transfer: Hotelling meets Stackelberg

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Abstract

We consider a Hotelling duopoly with two firms \(A\) and \(B\) in the final good market. Both can produce the required intermediate good, firm \(B\) having a lower cost due to a superior technology. We compare two contracts: outsourcing (\(A\) orders the intermediate good from \(B\)) and technology transfer (\(B\) transfers its technology to \(A\)). An outsourcing order is equivalent to building an endogenous capacity and it generates a Stackelberg leadership effect for firm \(A,\) which is absent in technology transfer. We show that compared to the situation of no contracts there are always Pareto improving outsourcing contracts (making both firms better off and all consumers at least weakly better off), but no Pareto improving technology transfer contracts. It is also shown that if firm \(B\) has a relatively large bargaining power in its negotiations with \(A,\) then both firms prefer technology transfer while all consumers prefer outsourcing.

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Notes

  1. See, e.g., Hummels et al. (2001) and Amiti and Wei (2005) for evidence of the growth of international outsourcing. For a discussion of diverse factors that drive outsourcing, see, e.g., Jarillo (1993), Vidal and Goetschalckx (1997), Domberger (1998) and Vagadia (2007).

  2. For some recent empirical evidence on the growth of technology transfer across firms, see, e.g., Mendi (2005), Nagaoka (2005), Branstetter et al. (2006) and Wakasugi and Ito (2009).

  3. The location in the Hotelling model can literally stand for geographic location or it could correspond to product characteristic. See, e.g., Anderson et al. (1992) and Gabszewicz and Thisse (1992) for different interpretations of the Hotelling model.

  4. We consider unit pricing policies for outsourcing and unit royalty policies for technology transfer because they are most frequently observed in practice. See Robinson and Kalakota (2004) and Vagadia (2007) for evidence on outsourcing. For technology transfer, see Mendi (2005) and Nagaoka (2005).

  5. When firms \(A\) and \(B\) compete in quantities as Cournot duopolists, \(A\)’s outsourcing order corresponds to the Stackelberg leader output (see Baake et al. 1999; Chen et al. 2011). See Sect. 2 for a more detailed discussion.

  6. When a firm outsources to a supplier which is its competing rival in the final good market, it is called horizontal outsourcing.

  7. The primary focus of Shy and Stenbacka (2003) is vertical outsourcing (i.e. firms outsource to an outside supplier), although they consider horizontal outsourcing as well.

  8. This literature is large (see, e.g., Riordan and Williamson 1985; Milgrom and Roberts 1990) and we do not attempt to summarize it here. See Williamson (2002) for a comprehensive overview.

  9. Note that we consider the transportation cost of a consumer to be linear in distance \(x,\) given by \(\tau x.\) When the market is covered, the quadratic transportation cost \(\tau x^2\) will generate the same demands and profits for firms.

  10. Instead of explicitly modeling the bargaining process through which \(A\) and \(B\) determine \(\omega ,\) we completely characterize the outcomes for all possible values of \(\omega .\) The solution of a particular bargaining process with specific bargaining powers of \(A\) and \(B\) can be immediately obtained from our conclusions. See Sect. 5.2

  11. Since the maximum demand that a firm can have is 1, there is no loss of generality in restricting \(K\le 1.\) In our model firms \(A\) and \(B\) negotiate on the price \(\omega \) and then \(A\) chooses the outsourcing order \(K.\) Alternatively, one can allow \(A\) and \(B\) to negotiate on both \(\omega \) and \(K.\) Our qualitative conclusions remain unaltered under this alternative.

  12. When \(K=0, \mathbb H ^K(\overline{c},\underline{c})\) becomes the standard Hotelling duopoly game \(\mathbb H (\overline{c},\underline{c}).\)

  13. The analysis of this section is similar to Matsumura et al. (2010) who consider the problem of technology transfer via royalty licensing between firms that compete in a Hotelling duopoly with endogenous locations. However, their primary objective is to determine the optimal royalty for the firm with superior technology (and then resolve the equilibrium existence problem), while we characterize the market outcomes for all \(\omega ,\) which are then compared with the corresponding outcomes under outsourcing.

  14. When \(\omega =\overline{c},\) firm \(A\)’s effective cost under the superior technology is the same as its cost with its own technology. However, firm \(A\) obtains \(\Phi ^0_A\) if it uses its own technology, while it obtains \(\tau /2>\Phi ^0_A\) by accepting to have the superior technology from firm \(B.\) So firm \(A\) will accept a technology transfer contract with \(\omega =\overline{c}.\)

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Acknowledgments

We express our sincere gratitude to two anonymous reviewers for their insightful comments and suggestions. We also thank the seminar participants at Jadavpur, Ryerson and Stony Brook, as well as 2010 IIOC, Vancouver; 2009 Annual Conference on Economic Growth and Development, ISI Delhi; 2009 NARSC, San Francisco; 2009 ASSET, Istanbul; and 2009 CEA, Toronto. A part of the revision for this paper was carried out when Sen was visiting Indian Statistical Institute Calcutta, and Jadavpur University, whose warm hospitality is gratefully acknowledged. We gratefully acknowledge research support from the Faculty of Arts, Ryerson University. This work started when Pierce was a graduate student at Ryerson University. Industry Canada has no involvement in this research.

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  1. Small Business Branch, Industry Canada, 235 Queen Street, Ottawa, ON, K1A 0H5, Canada

    Andrea Pierce

  2. Department of Economics, Ryerson University, 380 Victoria Street, Toronto, ON, M5B 2K3, Canada

    Debapriya Sen

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Pierce, A., Sen, D. Outsourcing versus technology transfer: Hotelling meets Stackelberg. J Econ 111, 263–287 (2014). https://doi.org/10.1007/s00712-012-0328-y

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