Outsourcing Innovation in a Durable Good Monopoly

Abstract

Make-or-buy decision of a durable-good monopolist is analyzed when the quality of an existing product may be improved through investment. Outsourcing generates a hold-up problem which leads to underinvestment in product development. But the very inefficiency in investment also helps the monopolist's initial sales as it makes the existing product less likely to become obsolete. Outsourcing is shown to outperform vertical integration when the value of the improvement is relatively small. The strategic motive for outsourcing identified in the analysis sheds new light on the “core competence” argument commonly used in management literature.