Abstract
This paper presents a novel explanation of the decision by a firm to make an input within the firm rather than to out-source the production to another firm. Due to the limited attention of the manager/entrepreneur, time spent overseeing production in-house has an opportunity cost: the neglect of potential new products/markets. Outsourcing production economizes on attention, but writing and negotiating contracts also has an opportunity cost: the neglect of current operations. This paper derives the endogenous transaction costs of writing a contract with another party and shows that positive transaction costs are not sufficient for the optimal internalization of transactions. However, positive net transaction costs results in the optimal decision to produce the input internally. In addition, although there are larger firm sizes of higher value than obtainable under the optimal policy, the optimal policy maximizes the social value of each individual transaction.
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