A Commitment-Based Explanation for the Evolution of Outsourcing

Abstract

We examine outsourcing decisions when the buyer/client is faced with a commitment problem in addition to the vendor’s moral hazard problem. While the production action is outsourced to the vendor, the design action can either be performed in-house or outsourced. The production and intervention actions are not contractible. If the vendor chooses the undesirable production action the client can help the vendor out with a costly intervention action. As such, the vendor may benefit by choosing an undesirable production action and having the client help him out with the intervention action. This leads to a potential client’s commitment problem in addition to the vendor’s moral hazard problem. We show that starting from the vendor’s moral hazard problem being more severe than the client’s commitment problem, improvements in production technology help to improve the client’s profit only up to a point; after which the client’s commitment problem becomes more severe, the client’s profit decreases. To mitigate the commitment problem the client can outsource the design action as well. This leads to situations where even though more tasks are outsourced, the unit price for the vendor may not increase to cover the direct costs of the added responsibility.