Supplier selection of a critical component when the production process can be improved

In this paper, we consider the scenario where an original equipment manufacturer (OEM) has decided to outsource the production of a critical component. There are two potential suppliers: one of them is an independent supplier, while the other is a manufacturer that sells a competing product. The customers are heterogeneous in taste preferences, and the firms have products that are horizontally differentiated. Firms can perform R&D activity to improve the production process of this critical component, resulting in a larger customer value. The OEM needs to decide (1) whether to outsource the production of the component to the independent supplier or to the competitor, and (2) whether the OEM or the supplier should invest in the improvement of the production process of the component. We find that it may be optimal to outsource to the competitor and let the competitor be responsible for improving the production process, even though the competitor has the highest cost. We also find that when it is optimal to outsource the production to the independent supplier, the competitor is worse off if the OEM uses the more costly firm to improve the process.