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Outsourcing, Competition, and Costs

Alexei Alexandrov
Assistant Professor of Economics and Management

What would lead a company to outsource to the same subcontractor as its competitors, and when does doing so raise prices and negatively affect consumers?

In his paper, “Strategic Outsourcing, Pricing, and Consumer Welfare,” Alexei Alexandrov, Simon Schoolassistant professor of economics and management, built a model to study how joint outsourcing affects not only a company’s pricing decisions, but also consumer welfare.

There are plenty of current examples of joint outsourcing. More than 60 percent of auto parts suppliers make parts for all three major US car manufacturers. In the electronics industry, the same original equipment manufacturer supplies several competitors.

Competing firms outsource to a common supplier if production shows economies of scale. Alexandrov found that joint outsourcing helps firms realize savings between industry average costs and marginal, or per-unit, costs.

“Joint outsourcing removes firms’ costs, and it does not matter how much the joint subcontractor charges, since the cost is immediately passed down to the consumers,” Alexandrov writes.

The reason for the price increase: Outsourcing allows firms to transform the production cost—in which the cost of items varies—into a constant per-unit procurement cost, which is fully passed down to consumers.If the overall costs remain the same but the per-unit costs are higher, it’s good news for the company—but not for consumers, Alexandrov writes.

“If the industry average cost is greater than the firm’s per-unit costs, then consumers are going to suffer. The price to consumers will increase. “

Consumers fare better when each firm’s marginal cost, without outsourcing, is higher than the average cost or the wholesale price of the subcontractor.

This tells both managers and regulators that outsourcing can be profitable even if the subcontractor possesses the same technology, or even worse technology than the firm itself, he says.

Regulators should examine joint outsourcing and joint venture agreements, Alexandrov argues.

“When economies of scale are evident, conditions are good for outsourcing, and it is beneficial to consumers. But if the average cost of the subcontractor is larger than the marginal cost of each firm, then outsourcing is detrimental to consumers.”

The implications of joint ventures are even less promising, he adds, noting that linear costs are sufficient to guarantee lower industry output after a joint venture has been established.

“Managers should not be purely looking for marginal cost reductions and regulators should not assume that firms profiting from outsourcing implies lower costs for the firms and lower prices for consumers,” Alexandrov writes.

Researchers have studied joint outsourcing before, but Alexandrov is the first to study how it affects consumers.

Read the full paper “Strategic Outsourcing, Pricing, and Consumer Welfare,” on the Social Science Research Network Web site.