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On the Cost-vs-Quality Tradeoff in Make-or-Buy Decisions

The make-or-buy decision is analyzed in a simple two-task principal-agent model. There is a cost-saving/quality tradeoff in effort provision. The principal faces a dichotomous choice between weak ("make") and strong ("buy") cost-saving incentives for the agent; the dichotomy is due to an incomplete-contracting limitation necessitating that one party be residual claimant. Choosing "buy" rather than "make" leads to higher cost-saving effort and -- in a plausible "main case" -- to lower quality effort; this in spite of stronger direct quality-provision incentives in the former case.

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Paper provided by Lund University, Department of Economics in its series Working Papers with number 2010:2.

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Length: 19 pages
Date of creation: 26 Mar 2010
Date of revision:
Handle: RePEc:hhs:lunewp:2010_002
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Department of Economics, School of Economics and Management, Lund University, Box 7082, S-220 07 Lund,Sweden

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  1. Atif Mian, 2008. "Incentives in Markets, Firms, and Governments," Journal of Law, Economics and Organization, Oxford University Press, vol. 24(2), pages 273-306, October.
  2. Steven Tadelis, 2002. "Complexity, Flexibility, and the Make-or-Buy Decision," American Economic Review, American Economic Association, vol. 92(2), pages 433-437, May.
  3. Bajari, Patrick & Tadelis, Steven, 2001. "Incentives versus Transaction Costs: A Theory of Procurement Contracts," RAND Journal of Economics, The RAND Corporation, vol. 32(3), pages 387-407, Autumn.
  4. Domberger, Simon & Jensen, Paul, 1997. "Contracting Out by the Public Sector: Theory, Evidence, Prospects," Oxford Review of Economic Policy, Oxford University Press, vol. 13(4), pages 67-78, Winter.
  5. Oliver Hart & Andrei Shleifer & Robert W. Vishny, 1997. "The Proper Scope of Government: Theory and an Application to Prisons," The Quarterly Journal of Economics, Oxford University Press, vol. 112(4), pages 1127-1161.
  6. Gibbons, Robert, 2005. "Four forma(lizable) theories of the firm?," Journal of Economic Behavior & Organization, Elsevier, vol. 58(2), pages 200-245, October.
  7. Lindqvist, Erik, 2008. "Will Privatization Reduce Costs?," Working Paper Series 736, Research Institute of Industrial Economics.
  8. Andersson Fredrik, 2011. "Make-or-Buy Decisions and the Manipulability of Performance Measures," The B.E. Journal of Theoretical Economics, De Gruyter, vol. 11(1), pages 1-30, December.
  9. Giacomo Corneo & Rafael Rob, . "Working in Public and Private Firms," Penn CARESS Working Papers 7942b6b570793de0891a05acb, Penn Economics Department.
  10. Baker, George P, 1992. "Incentive Contracts and Performance Measurement," Journal of Political Economy, University of Chicago Press, vol. 100(3), pages 598-614, June.
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