Vendor's strategic investments under IT outsourcing competition

Abstract

Organizations today outsource many of their requirements to external information technology (IT) vendor firms, and these service providers invest upfront in capacity to win such contracts. We study a scenario where two upstream vendors compete by strategically investing in specific IT infrastructure (or capacity) to fulfill a client firm’s IT service requirement and also, serve their respective other potential third-party clients. We formulate a simultaneous game situation where the vendors simultaneously make IT capacity investment decisions under uncertainty about their final unit variable costs. The vendors have two potential sources of demand (one of which is the client firm), but both are uncertain. The client firm also faces uncertain demand, but it reserves some capacity in advance from one of these two competing vendors through a bidding process and sources the rest from short-term contracts after the demand is realized. The client firm announces total requirements to be sourced from the bidding process, after which the vendor makes the IT investment decisions. Our analysis reveals that, as client firm’s mean demand increases, the reservation amount increases and vendors’ capacity investment increases. We find at the low range of mean demand that, with the increase in demand variability, client firm’s reserved amount and the vendor’s investments increase. However, at the high range of mean demand, we find that the increase in demand variability decreases client firm’s reserved amount and vendor’s investments. We also find that a lucrative third-party client market for vendors leads to an increase in their IT capacity investments but reduces the client firm’s requirements to be sourced through bidding competition.