The outsourcing conundrum: Misappropriation of intellectual property in supply chains

In an outsourcing arrangement, the principal must weigh the potential savings in manufacturing cost against the risk of intellectual property (IP) misappropriation by suppliers. While formal legal measures for protecting IP exist in many countries, they are by no means perfect. We consider a market‐based approach where the supplier can sell the acquired IP to a third party imitator or can become an imitator if the imitation‐cost is not large. We identify economic‐equilibrium scenarios that discourage excessive misappropriation of IP. We find that IP sell/purchase transactions can happen only if the market potential has a moderate value. It can also motivate the supplier to become imitator. A large market, while attractive to the imitator, causes the principal not to outsource. In a small market, on the other hand, the imitator is unable to compete especially with a high‐quality imitation. Interestingly, we also find that the combined sales of the principal and imitator decreases, if the imitator increases IP purchase. We establish that the principal can benefit from partial outsourcing implying that a proportion of the components are outsourced, if the market potential is large.