In Defense of Limited Manufacturing Cost Control: Disciplining Acquisition of Private Information by Suppliers

Abstract

ABSTRACT When a firm's input supplier can acquire and misreport private information to gain an edge in negotiations, we show that the firm can blunt the supplier's informational advantage by permitting inefficiencies in its own internal production. Specifically, we establish that a modest increase in the cost of the input(s) a firm makes internally credibly commits it to be more aggressive in negotiations with a supplier for the input(s) the firm buys. Recognizing that its potential information rents will be limited, the supplier, in turn, becomes less aggressive in information acquisition. The paper fully characterizes the equilibrium—the firm's investments, the supplier's information acquisition and reporting decisions, and the terms of trade—to demonstrate that often-maligned internal bloat can be an endogenous facilitator of efficient outsourcing.