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INTERNATIONAL ORIGINAL EQUIPMENT MANUFACTURING AND ORIGINAL DESIGN MANUFACTURING CONTRACTS WITH QUALITY-DIFFERENTIATED PRODUCTS

By Fang-yueh Chen and Tsai-chen Shen

Abstract

We build a model of international subcontracting in quality-differentiated goods. Assuming no entry in an original equipment manufacturing (OEM) market, we show that the foreign outsourcer will choose an original design manufacturing (ODM) contract only if the subcontractor is good enough at product design. However, the product quality with the ODM contract is not necessarily higher than that with the OEM contract. When the subcontracting market becomes perfectly competitive, the outsourcer will always choose an OEM contract. In a two-period model with learning and entry effects, the foreign outsourcer chooses between different modes of manufacturing contracts. We demonstrate that a laissez-faire policy on research and development (R&D) activity may be optimal even if the subcontracting firm can only obtain an OEM contract. In the case where the OEM market becomes perfectly competitive in the second period, we predict that a positive R&D subsidy in the first period can help the domestic subcontractor obtain OEM-ODM contracts and, as a result, national welfare rises. Copyright 2010 The Authors. Journal compilation 2010 Blackwell Publishing Asia Pty Ltd

DOI identifier: 10.1111/j.1468-0106.2010.00504.x
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