Outsourcing of innovation

This paper looks at the outsourcing of research and development (R&D) activities. We consider cost reducing R&D and allow manufacturing firms to decide whether to outsource the project to research subcontractors or carry out the research in-house. We use a principal-agent framework and consider fixed and revenue-sharing contracts. We solve for the optimal contract under these constraints. We find that allowing for revenue-sharing contracts increases the chance of outsourcing and improves economic efficiency. However, the principal may still find it optimal to choose a contract that allows the leakage to occur—a second-best outcome when leakage cannot be monitored or verified. Stronger protection of trade secrets can induce more R&D outsourcing without inhibiting technology diffusion and increase economic efficiency, as long as it does not significantly lengthen the product cycle. We have benefitted from comments from Andy Daughety, Bob Becker, Rick Bond, Kenneth Chan, Kenji Fujiwara, Shingo Ishiguro, Ron Jones, Seiichi Katayama, Pravin Krishna, Stephanie Lau, Jennifer Reinganum, Koji Shimomura, Eden Yu, two anonymous referees, an editor, and seminar participants at Arizona State, Indiana, Kobe, Osaka, Purdue, Michigan State, UC-Irvine, Vanderbilt, the American Economic Association Meeting in Philadelphia, the Midwest Economic Theory and International Trade Meetings at Indianapolis, the Public Economic Theory Conference in Beijing (China), the WTO and Globalization Conference at Hitotsubashi (Japan), the ETSG meeting in Nottingham (UK), and the CES-IFO Conference in Munich (Germany). We also thank Marketa Sonkova for research assistance. Financial support by the Research Grants Council of Hong Kong SAR, China (Project No. CityU1476/05H) and the Department of Economics and Finance of City University of Hong Kong is acknowledged. The usual disclaimer applies.