Second Sourcing and the Incentives for R & D Investment

Second sourcing is a frequently suggested policy in defense procurement, under which the procurer leaves open an option of replacing an initial developer for an alternative supplier in the full scale production stage. This paper studies the incentives for R&D investment and the welfare performance of second sourcing relative to sole sourcing (under which the procurer commits not to replace the developer). The key feature of the model is that the investment undertaken in the development stage serves to augment the informational superiority of the developer about the production process, and leads to an increase in the information rents accruing to the developer. The resulting tendency for overinvestment, this paper shows, can be correctively discouraged by the use of second sourcing. Also, a comparative static analysis suggests that second sourcing is likely to be valuable when the investment is sufficiently specific and when the procurer can commit to discriminatory competition in the selection of the full-scale producer.