This paper examines the impact of intellectual property rights (IPR) enforcement on multinationals' choice of input suppliers and industry profits in a host economy. The framework consists of suppliers with heterogeneous capabilities who must engage in a relation‐specific investment to customize intermediate inputs upon a transfer payment by final producers. An outsourcing contract with better technologically endowed suppliers requires a lower transfer and generates a higher surplus. Stronger IPR enforcement leads firms to self‐select into better quality suppliers on average by reducing their outside option. Weak legal institutions instead make it possible for a larger range of suppliers, including the less capable ones, to form partnerships by granting them a larger outside option. A better IPR environment is more likely to harm lagging countries where the technology distribution is characterized by less capable suppliers.