A New Strategic Element to the Make-or-Buy Decision

Abstract We study the strategic interaction between a downstream firm’s make-or-buy decision and an upstream firm’s investment decision. Our findings show that a downstream firm may have an incentive to make an essential input internally rather than to buy the input from a more cost-efficient supplier. By doing so, the downstream firm can deter the supplier from undertaking cost-reducing investments, which thereby increases the input price for its rivals who depend on the same supplier. This strategic element to the make-or-buy decision can result in underinvestment and an inefficient production pattern within the industry. Moreover, this adverse effect is more pronounced when the investment can generate greater efficiency gains.