Outsourcing and R&D Investment with Costly Patent Protection

We analyse decisions of firms on outsourcing of intermediate goods and R&D investment. If firms choose in-house production, a high profit discount is incurred due to the inefficiency of producing the intermediate goods, whereas if firms search for and outsource to specialists, the production costs decrease, but an imitation risk arises by specialists, who may become competitors in the final-good market. Accordingly, patents are used to mitigate this possibility, which are costly. We show that in outsourcing, all firms outsource to the same specialist to minimise the possibility of successful imitation in equilibrium. Moreover, firms still invest in R\&D activities and outsource their intermediate goods with some patent protection even though the selected specialist put effort into imitation.