Optimal Second-Stage Outsourcing

Manufacturers have recently begun outsourcing product assembly and completion tasks to their suppliers. Such outsourcing solves several contracting problems but generates new incentive frictions between manufacturers and their suppliers. In this paper, we analyze a manufacturer's decision to outsource an assembly (second-stage) task to a preestablished supplier. We find that outsourcing second-stage tasks becomes more attractive as the cost of either the first- or second-stage activity rises. Outsourcing becomes less attractive when the supplier is unable to accept large levels of liability. The manufacturer is shown to prefer more testing when she outsources assembly to her supplier as opposed to when she assembles products in house. Last, we find that the contracting frictions identified persist when the supplier's work can be tested individually, albeit imperfectly.