Production, Manufacturing and Logistics Outsourcing suppliers as downstream competitors: Biting the hand that feeds Wei Shi Lim * , Soo Jiuan Tan 1 NUS Business School, National University of Singapore, BIZ 1 Building #04-19, 1 Business Link, Singapore 117592, Singapore article info Article history: Received 18 December 2007 Accepted 5 August 2009 Available online 12 August 2009 Keywords: Outsourcing Supply chain management Supplier opportunism Game theory abstract In this paper, we highlight an aspect of supplier opportunism in the outsourcing paradox that has largely been ignored by extant research – the supplier as a direct competitor of the buyer firm. In light of this paradox, we offer a game-theoretic framework in which we identify conditions under which firms could alleviate or mitigate this outsourcing problem. Our results show that apart from transaction costs, firm- level capabilities (both ordinary and dynamic) play important roles in determining the make only, buy only, or make-and-buy options a firm could exercise in countering the threat of the supplier as a potential competitor in the downstream marketplace. Ó 2009 Elsevier B.V. All rights reserved. 1. Introduction The conventional argument in favor of outsourcing proposes that by doing so, companies should be able to ‘‘improve their level of ser- vice, cut costs and free up time and capital to concentrate on what is most important – how they differentiate themselves and compete”, (Bendor-Samuel, 1999). Spiegel (1993) also suggested that by subcontracting production to a potential rival firm, the incumbent firm can lessen the incentive of the former to develop its own final product and enter the downstream market as a competitor. However, this sug- gestion on horizontal subcontracting is based on the premise that there is no cost asymmetry between the firms and so ‘‘subcontracting can always deter entry because it makes both the incumbent and the potential entrant better off”, (Spiegel, 1993, p. 584). Recent market trends however show that supplier opportunism accruing from the supplier competing for a share of the buyer’s market after learning from the outsourcing experience is on the rise, especially where international outsourcing is involved. According to Doole and Lowe (2004), ‘‘in the 1980s a number of US businesses in many business sectors outsourced to Asian firms who subsequently opened up as competitors”, (p. 156). For instance, Goldstar, Samsung, Kia, and Daewoo are some South Korean companies which managed to build up their product lead- ership in their respective areas through their early OEM-supply contracts with Western companies (Prahalad and Hamel, 1990). Although outsourcing allows these manufacturers to increase short-term return on assets, minimize fixed costs, and increase flexibility, the long- term cost could be the multinational’s inability to compete against the expanding number of local manufacturers in these markets due to its failure to take more direct control over sourcing, engineering, manufacturing, and marketing activities (Koudal, 2005). Hence, we are not optimistic that subcontracting or outsourcing could be effective in deterring market entry by the subcontractors. Instead, we deem that a firm faces a paradox in its outsourcing decision: cost efficiency gains in the short run versus the prospect of unknowingly nurturing its outsourcing suppliers to compete against itself in the long run. In the transaction cost economics (TCE) literature, the opportunistic behavior of the supplier has always been framed in terms of transferring or salvaging specific learning or assets from one buyer to another (e.g., Anderson and Weitz, 1986; Monteverde and Teece, 1982; Pisano, 1990), or in terms of the supplier’s ability to demand higher than market prices (Ngwenyama and Bryson, 1999). For instance, in the automobile industry, it has been pointed out that automakers depen- dent on suppliers’ engineering capabilities may lose some negotiation power (Pfeffer and Salancik, 1978; Porter, 1980), their basic design and styling ideas may leak to competitors through shared suppliers, and their loss of engineering expertise in core component areas can render them vulnerable in technological capability (Takeishi, 2002). In services, firms that outsourced their information systems run the risks of losing their competencies to the outsourcer and immediate control of their important value chain activities (Ngwenyama and Bry- son, 1999), while e-commerce firms face the risk of unwittingly giving the competitors an advantage through defective performance by the supplier (Sharp, 2007). However, supplier opportunism has never been framed in terms of presenting itself as a direct competitor. Hence, 0377-2217/$ - see front matter Ó 2009 Elsevier B.V. All rights reserved. doi:10.1016/j.ejor.2009.08.006 * Corresponding author. Tel.: +65 6516 6263; fax: +65 6779 5941. E-mail addresses: weishi@nus.edu.sg (W.S. Lim), biztansj@nus.edu.sg (S.J. Tan). 1 Tel.: +65 6516 6206; fax: +65 6779 5941. European Journal of Operational Research 203 (2010) 360–369 Contents lists available at ScienceDirect European Journal of Operational Research journal homepage: www.elsevier.com/locate/ejor