Offshoring in a Vertically Differentiated Industry

Abstract

We examine the profitability of offshoring when quality is costly. Two vertically differentiated firms buy inputs domestically or offshore cheaply from developing countries. When the cost difference is independent of quality, equilibrium quality and profits are unchanged if both offshore. However, if cost difference is declining in quality, offshoring leads to lower (equilibrium) quality and lower profits for both firms. If only one firm can offshore, the profits of that firm increases at the cost of its rival. If the offshoring firm is low (high) quality, equilibrium quality of both firms increase (decline) but this is never an equilibrium when both can offshore.