Outsourcing and the Supply Base

One of the major explanations of increasing outsourcing activities is decreasing communication or search cost. However, some argue that it cannot explain the recent trend of firms utilizing smaller supply bases while increasing the degree of outsourcing, which has been documented as the “move to the middle hypothesis”. We use a principal-agent framework model to examine this issue. Our numerical results support the argument that the viewpoint of communication or search cost alone cannot explain the phenomenon. We show that firms prefer a smaller supply base when the non-contractible investment is valuable. Also, a firm might use outsourcing strategy even when communication or search cost is high.