Competition and outsourcing with scale economies

Scale economies are commonplace in operations, yet because of analytical challenges, relatively little is known about how firms should compete in their presence. This paper presents a model of competition between two firms that face scale economies; (i.e., each firm's cost per unit of demand is decreasing in demand). A general framework is used, which incorporates competition between two service providers with price- and time-sensitive demand (a queuing game), and competition between two retailers with fixed-ordering costs and price-sensitive consumers (an Economic Order Quantity game). Reasonably general conditions are provided under which there exists at most one equilibrium, with both firms participating in the market. We demonstrate, in the context of the queuing game, that the lower cost firm in equilibrium may have a higher market share and a higher price, an enviable situation. We also allow each firm to outsource their production process to a supplier. Even if the supplier's technology is no better than the firms' technology and the supplier is required to establish dedicated capacity (so the supplier's scale can be no greater than either firm's scale), we show that the firms strictly prefer to outsource. We conclude that scale economies provide a strong motivation for outsourcing that has not previously been identified in the literature.