Outsourcing and Value Chain Climbing: Vertical Coopetition in Buyer-supplier Supply Chains under Demand Uncertainty When the Supplier is Powerful

Abstract

We study the supplier's value chain climbing behavior in a two-level supply chain consisting of a buyer and a supplier, where the buyer outsources its production to the supplier in the first stage, and the supplier may enter the market and compete with the buyer in the second stage. We model the problem as a two-stage game, assuming the supplier is relatively powerful and sets the outsourcing price. We show how the buyer decides on the outsourcing strategy and/or in-house production quantities, and obtain three equilibria, depending on the attitudes of the buyer to the supplier's value chain climbing behavior: (1) complete outsourcing in Stage 1; (2) complete in-house production in Stage 1; and (3) partial outsourcing in Stage 1. We identify a few properties of each equilibrium and examine if outsourcing reduces production costs under various conditions. Our computational study analyzes the optimal outsourcing strategies, expected profits, and the impact of demand uncertainty. The computational results indicate that a buyer may switch from outsourcing to in-house production if product prices are high or production costs are low. Additionally, the demand distribution affects both the speed and direction of this shift.