Outsourcing, Complementary Innovations and Growth

Figure 2: Intermediate Supplier Bargaining Power

Figure 2:

faster pace of innovation than vertical integration when the bargaining weight of suppliers takes
intermediate values. In particular, the supplier weight that yields the maximum speed of innovation
is the critical ω that just sets r in (24) equal to one:

*         ^km

ω = —7-----;-----∙

^ks (1 ^{- a) +} k_m

For ω = ω*, the same number of suppliers and assemblers enter the market (m = s), so search costs
are minimized as both groups are certain of being matched. In other words, in the search process
the negative intra-group externalities exactly offset the positive inter-group externalities. For higher
ω > ω*, we have r > 1 and thus η (r) = 1. Accordingly, a higher bargaining weight has no impact
on the matching probability of final assemblers leaving only a negative effect on their returns, their
incentives to enter, and hence innovation. The critical value ω* is increasing in a and decreasing
in k_s∣k_m: a larger bargaining weight of suppliers is needed to compensate the stronger incentive to
enter final assemblers have when product differentiation rises and their relative entry costs fall.

The bottom panel in Figure 2 compares the profitability of vertical integration with that of
outsourcing showing that the latter is preferred by firms in the region of ω such that the number

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