Outsourcing, Firm Innovation, and Industry Dynamics in the Production of Semiconductors

I build a dynamic oligopoly model of firm innovation to isolate the equilibrium effects of outsourcing. Firms enter the industry each period and choose whether to produce in proprietary fabrication facilities or outsource production to lower marginal costs. Incumbent firms strategically invest to stochastically improve product quality and firm profits. I estimate the model using data from the semiconductor industry where outsourcing firms account for approximately one-third of revenue. The estimated model demonstrates that outsourcing increased entry (extensive margin) by relaxing the financial constraints for small firms but decreased research effort of incumbent, vertically-integrated firms (intensive margin). Global supply chains reduced marginal costs, increasing firm R&D and entry. Consumer welfare falls early in the transition path but outsourcing is ultimately beneficial for consumers indicating that effective government policy requires a long-run perspective.