Exploring optimal outsourcing strategy with and without transfer payment

Abstract

This study investigates an original equipment manufacturer's (OEM's) outsourcing choice between a competing manufacturer (CP) and a non‐competing manufacturer (NP). We develop a benchmark self‐produce strategy and two outsourcing strategies to differentiate two manufacturing service providers, and examine the optimal strategy alongside an analysis of the respective incentives (e.g., a lump‐sum payment) from the two service providers. The optimal strategy depends on the difference in production efficiency, degree of product substitution, and joint effect of the transfer payments. The transfer payments contribute to a greater range of Pareto improvements, increasing the possibility of outsourcing cooperation while highlighting the role of competition intensity on the model and outsourcing cooperation partner. Effect analysis shows that in the absence of transfer payment, the optimal strategy is beneficial to social welfare. With transfer payment, the optimal strategy is changed and the firms will be more profitable, but at the expense of customers' surplus, which may result in worse social welfare. An extended analysis of mixed strategies, in which the OEM produces part of the products and outsources the rest to CP/NP, shows that while the mixed‐CP strategy can be an optimal choice, the mixed‐NP strategy will degenerate to either self‐produce or complete outsourcing to NP under certain conditions.