Outsourcing under incomplete information

Abstract

Purpose The purpose of this paper is to show that outsourcing can occur as outcome of a separating or pooling perfect Bayesian equilibrium although it is not profitable under complete information. Therefore, asymmetric information can itself be a reason for outsourcing. Design/methodology/approach The present paper constructs a model of two firms interacting in the product market under asymmetric information where one firm has private information about its technological capability, and it has the option to produce inputs in-house or buy inputs from an input market. However, using outsourced inputs involves a fixed cost at the plant level. The model solves for perfect Bayesian equilibrium. Findings There are situations when under complete information, outsourcing of the input will not occur, but, under incomplete information, either only the low-cost type or both high and low-cost types will go for outsourcing, and there always exist reasonable beliefs supporting these equilibria. In particular, when the fixed cost is neither too small not too large, a separating equilibrium occurs in which the low-cost type outsources inputs from the input market but the high-cost type produces in-house; hence, outsourcing signals the firm’s type. Outsourcing by only the high-cost type firm will never occur in equilibrium. Originality/value That incomplete or asymmetric information can itself be a reason for strategic outsourcing is never identified in the literature. The present paper is an attempt to fill this gap and raise the issue of outsourcing in an incomplete information environment.