Competition and Outsourcing with Scale Economies

TLDR

Scale economies are common in operations, but little is known about how firms should compete when they exist. The study develops a model of competition between two firms that experience scale economies, where cost per unit decreases with demand. Using a general framework that includes a queuing game for service providers and an EOQ game for retailers, the model also allows each firm to outsource production to a supplier. The analysis shows that, under general conditions, a unique equilibrium exists with both firms active; the lower‑cost firm can command higher market share and price, and even when the supplier’s technology is no better and capacity is limited, firms prefer outsourcing, highlighting scale economies as a strong incentive for outsourcing.

Abstract

Scale economies are commonplace in operations, yet because of analytical challenges, relatively little is known about how firms should compete in their presence. This paper presents a model of competition between two firms that face scale economies; (i.e., each firm's cost per unit of demand is decreasing in demand). A general framework is used, which incorporates competition between two service providers with price- and time-sensitive demand (a queuing game), and competition between two retailers with fixed-ordering costs and pricesensitive consumers (an Economic Order Quantity game). Reasonably general conditions are provided under which there exists at most one equilibrium, with both firms participating in the market. We demonstrate, in the context of the queuing game, that the lower cost firm in equilibrium may have a higher market share and a higher price, an enviable situation. We also allow each firm to outsource their production process to a supplier. Even if the supplier's technology is no better than the firms' technology and the supplier is required to establish dedicated capacity (so the supplier's scale can be no greater than either firm's scale), we show that the firms strictly prefer to outsource. We conclude that scale economies provide a strong motivation for outsourcing that has not previously been identified in the literature.