Institutional Choice and the Organization of Production: The Make-or-Buy Decision

Abstract

Having selected an end-product line, a producer must decide which in the stream of intermediate products and processes successively combining to form his eventual output to administer himself and which to delegate to outside suppliers, along with the terms under which any external procurements would take place. The transaction-cost literature has provided a number of insights into the factors likely to affect the outcome of such decisions (e.g., see Williamson [1975, 1979]; and Klein, Crawford and Alchian [1978]). But because of the mainly verbal arguments adopted by these authors, some questions have remained regarding the generality and validity of their hypotheses. This paper employs some simple but plausible assumptions about the incidence of bargaining and contracting costs to model this series of procurement decisions - sometimes referred to as a firm's make-or-buy program - as part of a producer's overall optimization problem. In addition to identifying conditions under which the transaction-cost arguments can be expected to hold, the model permits investigation of a number of interactions and relationships not readily amenable to verbal analysis. For example, the degree to which specialized investments are adopted to support production is often a matter of discretion to the parties involved: the hazards of exchange that arise in the presence of such investments may induce the parties to choose more standardized designs or to invest less than would otherwise be optimal. Whereas earlier arguments have taken the extent of asset specificity as given, this analysis determines the level of investment in transaction-specific assets under each organizational arrangement endogenously. The model also permits an investigation of the factors affecting the choice of contract length governing external * I would like to thank Keith Crocker, Charles Holt, Jr., Roger Sherman and the participants at the Microeconomics Workshop at the University of Virginia for their helpful comments. The contributions of Oliver Williamson, Jeffrey Perloff, Tom Ross and Michael Waldman during the earlier stages of this research are also gratefully acknowledged. Support for this research was received from the Center for the Study of Organizational Innovation and from Sloan and National Science Foundation grants

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