Outsourcing Decisions and Managerial Incentives*

Abstract

ABSTRACT An agency model is presented in which outsourcing strictly dominates in‐house production. We argue that firms outsource in order to improve managerial incentives. Conditions are established under which the firm is strictly better off with outsourcing. The benefit of outsourcing, however, is constrained by the trade‐off between the incremental coordination costs of outsourcing and the improved incentive structure. The optimal contract is also shown to be a function of whether or not the firm is publicly held. For a publicly held firm, the contract is constant. For a privately held supplier, the contract is likely to be of a cost‐sharing type. These findings offer preliminary incentive explanations for commonly observed outsourcing practices.

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