Fan, Xiaoshuai; Körpeoğlu, Ersin; Li, Cuihong; (2022) Sourcing Innovation and Production. SSRN: Amsterdam, Netherlands.

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Abstract

We consider a buyer firm that sources the design and production of an innovative product from two suppliers. The value of a supplier's design depends on the supplier's effort, while the production cost is the supplier's private information. A supplier can potentially produce the design of another supplier, albeit at a switching cost added to the production cost. Hence, a sourcing mechanism of an innovative product should both motivate suppliers' innovation efforts to improve the design value and identify low-cost production solutions. We first investigate two sourcing mechanisms commonly observed in practice, under which the buyer commits to sourcing the design and the production jointly or separately. We then compare these two mechanisms with a no-commitment mechanism in which the buyer specifies the rules to select suppliers for design and production after receiving the designs submitted by suppliers. We also consider an enhanced-commitment mechanism in which the buyer commits to using the supplier who provides the best design for production. We compare the buyer's profit in each mechanism, and show that the mechanism of choice depends on the switching cost and the cost (effectiveness) of innovation investment to improve design values, because each mechanism has different capability to motivate innovation efforts and to achieve efficient design and production allocations. Our findings provide valuable managerial insights for practitioners and help explain why certain mechanisms are common in different industries.

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