Asymmetric Cost of Innovation, Sourcing, and Vertical Differentiation

Firms that are more efficient in innovation often sell their high-quality components to less efficient competitors that make similar products. Such sourcing practice reduces product vertical differentiation and intensifies market competition. We study when the efficient firm (firm 1) should provide sourcing, when the inefficient firm (firm 2) should source, and implications of such sourcing practice for consumers. We analyze two dynamic games, one under no-sourcing where the firms compete in quality and price, and the other under sourcing where they share identical quality set by firm 1 and compete in price. We show that if firm 1 has sufficient innovation cost advantage, then firm 2 gives up vertical differentiation and prefers a higher wholesale price in sourcing. Otherwise firm 2 may maintain differentiation and do not source even if sourcing is free. On the contrary, giving up quality distinction and sharing quality with firm 2 generally benefits firm 1, as it gains monopolistic power in setting quality or earns significant sourcing profit in a more competitive market. Interestingly, centralized innovation under sourcing where all investments are pooled to the efficient firm 1 may yield inferior and more expensive quality than decentralized innovation in no-sourcing, due to firm 1 exploiting its monopolistic position. Our findings reveal that efficient firms may offer sourcing to gain monopoly power and extract more value from consumers. Such value extraction could be worsened, rather than mitigated, by product market competition