Outsourcing, Information Leakage and Consulting Firms

Abstract

This paper offers a general equilibrium model to analyze the problem of investment in R&D of firms that also face the decision between outsourcing and "in-house" production in the presence of R&D information leakage. A contractor hired by a firm learns the firm’s technology and can diffuse the information to other firms, either by selling it or by “spilling” it involuntarily. I find that information leakage concerns have the tendency to concentrate the outsourcing market with respect to a situation in which information leakage is not an issue. In particular, despite the fact that the original outsourcing market is perfectly competitive, I find that when a market for information arises in equilibrium, such a market is always monopolistic. I show that a market for information arises when contractors have a positive but low degree of control on the information they hold. If contractors do not have any control on the information they hold, the market splits into a positive measure of technologically advanced firms that never outsource and a positive measure of low-tech firms that always outsource. If contractors have full information control, all firms invest in technology and outsource, and a market for information never arises. As the contractors’ degree of control on information increases, the equilibrium technology level decreases and the set of firms that adopt such technology increases. The structure of the equilibria of the model captures several features observable in the management consulting industry.