Strategic outsourcing and quality choice: Is a vertical integration model sustainable?

This paper uses two versions of a vertical product differentiation model with price competition to investigate how strategic behavior between rival firms influences which organizational production mode each firm adopts: that is, either vertical integration or outsourcing. We show that not only a symmetric configuration, where both high- and low-quality firms outsource, but also an asymmetric configuration, where the high-quality firm produces in-house whereas the low-quality firm outsources, are acceptable as a subgame-perfect equilibrium outcome. We explore the implications of these results in light of the recent slump in business of Japanese electronics enterprises in the flat-panel television industry.