ABSTRACT: The trend toward outsourcing manufacturing as well as product design and other service activities is well-established and apparently accelerating. Within this trend, however, there are examples that are not well-explained by existing theory. In particular, we observe firms outsourcing to suppliers that enjoy no external economies of scale, upstream concentration in ownership, or access to significantly cheaper labor. To explore these seemingly anomalous decisions, we develop a model of outsourcing where decisions are affected by the product design variables of (1) modularity, defined as the ability to use a generic, externally designed or procured component without a significant loss of performance; (2) relevance, defined as the importance of a component’s performance to the customer or a component’s impact on a product’s variable cost; and (3) development, or fixed costs associated with a component. A key insight is that seemingly perverse outsourcing decisions are rational when competing vertically integrated firms have incentives to overinvest and face the losing outcome of a prisoners ’ dilemma when both development costs and relevance are high. The cost of this investment competition can be larger than the markup of an equally or less concentrated supplier industry even if the supplier(s) does(do) not achieve advantages of scale by serving additional markets. Unexpectedly, we also find that components of low relevance can more profitably be kept in house even in the presence of large additional markets for these components.