Outsourcing and Quality Choice: A Bargaining Perspective

Abstract This study investigates quality choices when a product version is outsourced compared to full in-house production of all product versions. Our findings suggest that outsourcing the high-end version leads to improvements in the quality of the low-end version, as the firm seeks to strengthen its bargaining position with the contractor to secure a lower wholesale price for the outsourced high-end version. In situations involving asymmetric information, this effect can help alleviate the downward distortion of low-end quality, thereby enhancing overall welfare. However, outsourcing may also result in a level of low-end quality that exceeds the socially optimal level. The key drivers of this trade-off are the proportion of high-type versus low-type consumers, which determines who is served in the event of a negotiation failure, and the relative bargaining power of firms and contractors, which defines the relative weight of the agreement and disagreement payoffs in setting quality. On the other hand, outsourcing low-end versions is less likely to contribute to social welfare improvement, as it diminishes the quality of the in-house, high-end versions. The study also shows that while outsourcing affects quality choice, the outcomes are largely unaffected by the specifics of outsourcing arrangements and game timing.