GEP Research Paper 05/26
Profit Reducing Outsourcing
Sugata Marjit and Arijit Mukherjee
Abstract
Recent empirical evidences show negative relationship between outsourcing and profitability. This paper provides a theoretical explanation for this phenomenon. In an oligopoly model, we show that firms earn lower profits in the outsourcing equilibrium compared to the situation where neither firm does outsourcing, and it holds irrespective of the intensity of competition. So, outsourcing creates prisoner's dilemma. We show that whether outsourcing is likely to reduce profit under more intense competition (measured by the degree of product differentiation, number of firm and the type of product market competition, viz., Cournot and Bertrand competition) is ambiguous. We further show that outsourcing may be “excessive” and will hurt overall welfare.
Issued in September 2005.
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