Strategic outsourcing with technology transfer under price competition

We construct a model to show that outsourcing of a crucial input can occur even though it can be produced in-house at a lower cost. There are two firms producing differentiated goods and competing in prices, and only one of them possesses input production technology which is superior to that of an independent input supplier. We show that if the degree of product differentiation is small or the technological gap between two input producing firms is small, strategic outsourcing will occur. Technology transfer in the form of patent sale will act as a commitment that the firm will outsource. While the outsourcing firm gains, consumers’ welfare as well as social welfare goes down. Interestingly, sometimes rival firm’s profit might increase. The paper brings into focus some competition policy concerns.