Competition and Outsourcing with Scale Economies

Scale economies are commonplace in operations, yet, due to analytical challenges, relatively little is known about how ...rms should compete in their presence. This paper presents a model of competition between two ...rms that face scale economies; i.e., each ...rm’s cost per unit of demand is decreasing in demand. A general framework is used, which incorporates competition between two service providers with price and time sensitive demand (a queuing game) and competition between two retailers with ...xed ordering costs and price sensitive consumers (an EOQ game). Reasonably general conditions are provided under which there exists at most one equilibrium with both ...rms participating in the market. We demonstrate, in the context of the queuing game, that the lower cost ...rm in equilibrium may have higher market share and a higher price, an enviable situation. We also allow each ...rm to outsource their production process to a supplier or to their customers (e.g., co-production). Even if the supplier’s technology is no better than the ...rms’ technology and the supplier is required to establish dedicated capacity (so the supplier’s scale can be no greater than either ...rm’s scale), we show that the ...rms strictly prefer to outsource. We conclude that scale economies provide a strong motivation for outsourcing that has not previously been identi...ed in the literature. ¤Thanks is extended to the seminar participants at the following universities: the Department of Operations Research, University of North Carolina; the Department of Industrial and Operations Engineering, Univeristy of Michigan; the Graduate School of Business, Stanford University; the Anderson School of Business, Univeristy of California at Los Angeles; the 1999 MIT Summer Camp, Sloan School of Business, MIT; the Operations Management Department, University of Michigan; and the Management Department, University of Texas at Austin. Thanks is also extended to Philip Afeche, Frances Frei, Noah Gans, Martin Lariviere and Erica Plambeck for their many helpful comments. The previous version of this paper was titled “Service Competition, Outsourcing and Co-Production in a Queuing Game.” An electronic copy is available from the ...rst author’s web page. Scales economies are commonplace in operations. But while there is a considerable operations management literature that identi...es scale economies and develops strategies to exploit them, relatively little is known about how ...rms should compete in their presence. Even the economics literature on competition among ...rms generally assumes constant or decreasing returns to scale, so as to avoid the signi...cant analytical complications scale economies create (Vives, 1999). Nevertheless, research is needed on this challenge. This paper studies competition between two ...rms that face scale economies; i.e., cost per unit of demand is decreasing in demand. A general framework is employed: it includes, among others, competition between service providers (i.e., a queuing game) and competition between two retailers with ...xed ordering costs (i.e., an Economic Order Quantity game). Firms compete for demand with two instruments: the explicit prices they charge consumers and the operational performance levels they deliver. An example of the latter in the context of the queuing game is the ...rm’s expected service time, where faster service means better operational performance. Competition with scale economies is brutal for two reasons. First, a ...rm must capture a positive threshold of demand or else it is not pro...table (i.e., small players cannot be profitable). Second, scale economies increase price competition: a price cut increases demand, which lowers the average cost per unit of demand. As a result, an equilibrium may not exist, even with symmetric ...rms (i.e., ...rms with the same cost and demand). However, when an equilibrium exists in which both ...rms have positive demand, then it is unique, under reasonable conditions. Hence, competition in this setting does have some structure. We show that the low cost ...rm always has a higher market share in equilibrium, which is not surprising. What is unexpected is that the low cost ...rm can also have the higher price, which is certainly an enviable position: the ...rm uses its lower cost to dominate with operational performance, which allows the ...rm to charge a premium and capture more demand than its rival. As an added bonus, the higher demand also allows the ...rm to operate more e¢ciently than its rival. Furthermore, in low margin conditions a small cost advantage can yield an enormous pro...t advantage even if it does not result in a large market share di¤erence. In this environment, ...rms could bene...t from any strategy that mitigates price competitiveness. We show that outsourcing is one such strategy. We suppose that there exists a