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2. Theoretical background
Outsourcing is the handover of an activity to an external supplier; it is an alternative to internal production. It was first described by Coase [6] who outlined many of the avenues subsequently explored by researchers in transaction costs and incomplete contracts theories. The essence of the argument is that using a market is not frictionless. When buying a service or a product, one incurs costs. If these costs become too high, relying on self-production is more appropriate.
Transaction costs theory has two underlying assumptions:bounded rationality and opportunism. Bounded rationality is the inability of the human mind to find or process all the information about a transaction; therefore, it is conducted with a certain level of uncertainty. Opportunism is more than the simple defense of one’s interest or value maximization; it
is self interest seeking with guile [41]. The combination of these assumptions results in information asymmetry. When parties do not have the same information,they will not share the information they possess,because they wish to use it strategically. In order to strike a better deal, sellers will hide negative characteristics of their products, and buyers will not reveal how much they are prepared to pay. Since both parties know that the other is opportunistic, each will engage in information seeking activities, for example having a product tested before buying it, or asking for warranties and safeguards to protect themselves from potentially false allegations from the other party. All these actions generate transaction costs.
The factors determining the importance of transaction costs are grouped into three broad categories: (1)the specificity of the assets required for performing the transaction, (2) the uncertainty surrounding the transaction, and (3) the origin of the critical investments associated with the transaction and their alignment with the allocation of residual rights.
2.1. Asset specificity
The nature of assets varies.They can be machinery required to manufacture a product, knowledge needed to perform a service, or even appropriate location convenient for dealing with the other party. While some assets are common, others are dedicated to a particular use and are said to be specific. The degree of
specificity can be measured by the difference between the cost of the asset and the value of its second best use[40]. For example, money is not specific. One thousand dollars might be needed for a given transaction but should the transaction not be completed, the
U$ 1000 could be used for another transaction with no loss in value. Here, asset specificity is null. At the other extreme, knowledge is often a specific asset:
in acquiring knowledge, one makes an irreversible investment (one cannot ‘‘unlearn’’ and recuperate the time spent). If the knowledge becomes obsolete, it is a lost investment. Similarly, if the knowledge was unique to one trading partner and the relationship terminated, the investment is lost.
Outsourcing is the handover of an activity to an external supplier; it is an alternative to internal production. It was first described by Coase [6] who outlined many of the avenues subsequently explored by researchers in transaction costs and incomplete contracts theories. The essence of the argument is that using a market is not frictionless. When buying a service or a product, one incurs costs. If these costs become too high, relying on self-production is more appropriate.
Transaction costs theory has two underlying assumptions:bounded rationality and opportunism. Bounded rationality is the inability of the human mind to find or process all the information about a transaction; therefore, it is conducted with a certain level of uncertainty. Opportunism is more than the simple defense of one’s interest or value maximization; it
is self interest seeking with guile [41]. The combination of these assumptions results in information asymmetry. When parties do not have the same information,they will not share the information they possess,because they wish to use it strategically. In order to strike a better deal, sellers will hide negative characteristics of their products, and buyers will not reveal how much they are prepared to pay. Since both parties know that the other is opportunistic, each will engage in information seeking activities, for example having a product tested before buying it, or asking for warranties and safeguards to protect themselves from potentially false allegations from the other party. All these actions generate transaction costs.
The factors determining the importance of transaction costs are grouped into three broad categories: (1)the specificity of the assets required for performing the transaction, (2) the uncertainty surrounding the transaction, and (3) the origin of the critical investments associated with the transaction and their alignment with the allocation of residual rights.
2.1. Asset specificity
The nature of assets varies.They can be machinery required to manufacture a product, knowledge needed to perform a service, or even appropriate location convenient for dealing with the other party. While some assets are common, others are dedicated to a particular use and are said to be specific. The degree of
specificity can be measured by the difference between the cost of the asset and the value of its second best use[40]. For example, money is not specific. One thousand dollars might be needed for a given transaction but should the transaction not be completed, the
U$ 1000 could be used for another transaction with no loss in value. Here, asset specificity is null. At the other extreme, knowledge is often a specific asset:
in acquiring knowledge, one makes an irreversible investment (one cannot ‘‘unlearn’’ and recuperate the time spent). If the knowledge becomes obsolete, it is a lost investment. Similarly, if the knowledge was unique to one trading partner and the relationship terminated, the investment is lost.
Investments in specific assets lead to transaction
costs. A party investing in a specific asset will seek a
promise from the other party before actually making
the investment. Failure to secure such a promisewould
put the first party in a vulnerable position, since the
other party could renege on the agreement by asking
for a lower price, for instance. Indeed, accepting a
lower price, even if it would make the transaction
unprofitable, would be better than losing the specific
investment. The investing party could end up paying
a quasi-rent to the other party [30]. Generally, the
promises take the form of long-term contracts, bonds,
and volume guarantees, which enable the investing
party to recoup its investment without risk [39].
Implementing all these promises creates transaction
costs. As asset specificity increases and contract pro-
tection clauses become more numerous and complex,
they become increasingly costly to implement. When
these costs are too high, it would be more appropriate
to conduct the transaction in-house.
costs. A party investing in a specific asset will seek a
promise from the other party before actually making
the investment. Failure to secure such a promisewould
put the first party in a vulnerable position, since the
other party could renege on the agreement by asking
for a lower price, for instance. Indeed, accepting a
lower price, even if it would make the transaction
unprofitable, would be better than losing the specific
investment. The investing party could end up paying
a quasi-rent to the other party [30]. Generally, the
promises take the form of long-term contracts, bonds,
and volume guarantees, which enable the investing
party to recoup its investment without risk [39].
Implementing all these promises creates transaction
costs. As asset specificity increases and contract pro-
tection clauses become more numerous and complex,
they become increasingly costly to implement. When
these costs are too high, it would be more appropriate
to conduct the transaction in-house.
