Buying from a Competitor : A Model of Knowledge Sharing and Innovation

Many firms buy a production input from a competitor. However, managers often worry that this supply relationship may give their competitor valuable knowledge about new product innovations. We develop a two-period model in which a firm can buy an input from a competitor or a third party in each period, and in order to innovate, the firm must invest in improving the input and must share the resulting knowledge with its chosen supplier. We find that buying from the competitor: (1) mitigates price competition in the consumer market, and (2) puts the competitor in a stronger negotiating position in the second period if the focal firm invests in innovation. We derive the equilibrium in which the focal firm chooses whether to buy the input from its competitor or the third party, and then decides whether to innovate and share knowledge. If the value of the innovation is sufficiently low or sufficiently high, the firm buys from its competitor. However, if the value of innovation lies in an intermediate range, and there is sufficient horizontal product differentiation, then the firm buys from the third party to ensure innovation occurs in equilibrium