Sourcing Strategy of Original Equipment Manufacturer with Quality Competition

We develop game-theoretic models to study the sourcing strategy of an original equipment manufacturer (OEM) in the presence of a competing contract manufacturer (CCM). The OEM sells the product in a high-quality brand and has three strategy options: producing the product in house or outsourcing production to either a CCM or a noncompeting contract manufacturer (NCM). At the same time, the CCM provides its own product in a low-quality brand. We show that when the product qualities are exogenous, the OEM's sourcing strategy decision depends on the OEM brand's efficiency in producing and selling the product (the difference between quality and production cost), relative to that of the CCM brand. Interestingly, the OEM may prefer outsourcing to a CCM to soften price competition, even though this will mean a higher wholesale price; the CCM also prefers to produce for the OEM, even though its total demand may decrease. When the product qualities are endogenous, however, with quality competition, the OEM prefers either insourcing or outsourcing to an NCM to increase quality differentiation, depending on its cost disadvantage in producing the high-quality product.