While knowledge-based theory points to the importance of IT knowledge in value creation in the context of IT outsourcing, we complement the theory by further developing the mechanism by which IT knowledge held by a services firm can translate into productivity gains for a client firm beyond those resulting from direct cost savings. Specifically, we focus on the spil lover effects of knowledge transfer that can occur when firms trade with one another. Indeed, numerous studies have identified trade as a channel through which knowledge is transmitted (Caselli and Coleman 2001; Coe and Helpman 1995). Firms receive spillover benefits when the firm that invests in knowledge creation, say through R&D, cannot appropriate the full benefits from its investments because some part of the benefits diffuses (without proportionate compensation) to non-investing firms.