The Make-or-Buy Decision: Lessons from Empirical Studies
Abstract
The “transaction cost” theory of the firm introduced by Coase (1937) has become
a standard framework for the study of institutional arrangements. The Coasian
framework helps explain not only the existence of the firm, but also its size and
scope. Why, in Coase's (1937, pp. 393-94) words, “does the entrepreneur not
organize one less transaction or one more?” Some firms are highly integrated:
IBM, for example, produces many of its components and software and maintains
its own sales force for mainframe computers. Others are much more specialized:
Dell Computer outsources virtually all its hardware and software components,
selling directly to end users through its catalog and website, while the shoe
company Reebok owns no manufacturing plants, relying on outside suppliers to
make its products. U.S. manufacturing and service companies are increasingly
contracting with specialized information technology firms for their computing
and data warehousing needs, spending $7.2 billion on outsourced computer
operations in 1990. Standard and Poor's estimates total worldwide outsourcing
for 2003 at $170 billion.1
Why do some firms choose a vertically integrated structure, while others
specialize in one stage of production and outsource the remaining stages to
other firms? In other words, should a firm make its own inputs, should it buy
them on the spot market, or should it maintain an ongoing relationship with
a particular supplier? Traditionally, economists viewed vertical integration or
vertical control as an attempt to earn monopoly rents by gaining control of
input markets or distribution channels. The transaction cost approach, by contrast,
emphasizes that vertical coordination can be an efficient means of protecting
relationship-specific investments or mitigating other potential conflicts
under incomplete contracting. As transaction cost economics was developed
in the 1970s and 1980s, a stream of empirical literature emerged explaining
the “make-or-buy decision” using transaction cost reasoning. (The traditional
approach has generated relatively few empirical applications beyond analyses
of particular antitrust cases.) This chapter surveys the empirical literature on vertical boundaries, focusing on the transaction cost approach and emphasizing
the most important results, while highlighting the challenges that
remain.
Citation
Handbook of New Institutional Economics (Springer, 2005), pp. 435-64.