The Economics of Outsourcing
Lessons from Nobel Prize-winning economists on better outsourcing
By Kate Vitasek, Karl Manrodt, and Bill DiBenedetto
Today, important questions should be answered in order for businesses to achieve long-term success through outsourcing. What drives the decision to outsource? More importantly, how can businesses outsource properly?
One might be surprised that much of the evolution of modern outsourcing can be tied to the study of economics. In fact, economic research stretching for more than 80 years is woven into the fabric of modern outsourcing. The big thinkers focused on growth theory, transaction costs, game theory, property rights, deregulation, and the nature of the firm. At least six Nobel Prizes have been awarded to economists that have something to teach us about outsourcing.
Understanding the impact of the history of economics on modern outsourcing also poses another question: what does this mean for the average practitioner in charge of outsourcing today? It means that the theories, lessons, and wisdom of the brilliant economists can serve as validation and guideposts for outsourcing in the real world.
We examine some of the best-known economists and how their findings can be applied to modern outsourcing. We’ve taken the essence of their work and distilled it into a simpler version that can help you the next time you find yourself trying to develop your outsourcing strategy or structuring a deal.
Understanding the impact of the history of economics on modern outsourcing also poses another question: what does this mean for the average practitioner in charge of outsourcing today? It means that the theories, lessons, and wisdom of the brilliant economists can serve as validation and guideposts for outsourcing in the real world.
We examine some of the best-known economists and how their findings can be applied to modern outsourcing. We’ve taken the essence of their work and distilled it into a simpler version that can help you the next time you find yourself trying to develop your outsourcing strategy or structuring a deal.
Ronald Coase’s Coase Theorem: Business is a Math Problem
The groundbreaking work of Ronald Coase, which stretched back to the 1930s, shed light on a concept known as transaction-cost economics. He advocated that it was not enough to include only production and transportation costs as the main expenses of doing business; businesses needed to also consider the cost of entering into and executing contracts. This boils down to a mathematical analysis, and his breakthrough thinking was even given a mathematical name—the Coase theorem.
That all seems obvious today, but Coase’s inclusion of contracting and contracting costs into the mix of a firm’s organizational structure and accounting helped him win the Nobel Prize in Economics in 1991 and created the conditions for outsourcing to become a normal and major part of a firm’s strategy. Coase was probably scratching his head laughing at companies who rushed to offshore in the late 1990s only to find that the $1 they saved in manufacturing was offset by other costs.
Lesson for outsourcing firms: Think about the total cost and not just the price/budget of the work that is being outsourced. Making decisions solely on the price of the work scope only leads to a myopic and highly inaccurate view.
John Nash’s Game Theory: Playing Nice is Good for Everyone
Is it a wild stretch to move from the Coase theorem to the famed bar scene in the movie A Beautiful Mind? Possibly, but not for a useless purpose.
In the movie, the mathematician John F. Nash, as played by Russell Crowe, has a revelatory moment in a campus watering hole as he and his mates debate on the best ways to produce optimum results in approaching a beautiful blonde and her friends. Examining Adam Smith’s principle that “the best result comes from everyone in a group doing what’s best for themselves,” Nash declared this incomplete and needs revision. According to him, the best result comes from everyone in a group doing what’s best not just for themselves but the whole group as well.
Nash’s pursuit and proof of his conclusion led to what is called the Nash equilibrium. He demonstrated that companies working together will discover that the sum of the parts can be better when combined effectively than when working at cross purposes.
He went on to win a Nobel Prize in 1994 for his work and the related work of John C. Harsanyi and Reinhard Selten whom he shared his prize with. Their contribution spurred an entire branch of economics now known as game theory or behavioral economics.
Game theorists have been studying the economics of playing non-zero sum games also known as win-win games for more than 50 years to show that playing nice is indeed more beneficial. Since Nash bagged the Nobel Prize, seven more have been awarded to game theorists.
Lesson for outsourcing firms: It’s pretty easy to observe the seminal importance of game-theory development in reaching equilibrium or win-win solutions and outcomes in outsourcing contracts.
Robert Solow’s Technical Change: Brains are Better than Brawn
More than 50 years ago, Robert Solow showed that technology was the real driver of economic growth, proven by his growth model first presented in a 1956 article. His premise: without technological progress, growth rates for capital, labor, and total production would all be about the same. In fact, he found out that around four-fifths of the growth in US output per worker was attributable to technological progress. In short, brains matter more than brawn to boost economic growth.
This study earned Solow a Nobel Prize in 1987.
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