SUBCONTRACTING VERSUS CAPACITY EXPANSION AND THE IMPACT ON PRICING OFSERVICES

The strategic trade-offs between acquiring new capacity and subcontrac ting (or leasing) capacity are explored for service environments chara cterized by rapid technological improvement or highly seasonal demand. Reflecting the focus on service-sector organizations, it is assumed t hat demand cannot be met from inventory. Furthermore, the critical imp act that subcontracting has on a firm's competitive pricing policy is examined. The analysis presented is of particular relevance for firms in price-competitive industries such as telecommunications, informatio n services, or health care, because subcontracting capacity represents an alternative to acquiring costly new capacity which may soon become obsolete or unnecessary. It is shown that the optimal price charged i s based on the higher of the two operating costs incurred (internal un it cost or unit cost of subcontracting). It is also shown that as a co nsequence of subcontracting to maximize profit, the optimal price char ged is never reduced and may increase. (C) 1994 John Wiley & Sons, Inc .