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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
Contact details of provider: Postal: Department of Economics, School of Economics and Management, Lund University, Box 7082, S-220 07 Lund,Sweden
Phone: +46 +46 222 0000
Fax: +46 +46 2224613
Web page: http://www.nek.lu.se/en

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  1. 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.
  2. Hart, Oliver & Shleifer, Andrei & Vishny, Robert W, 1997. "The Proper Scope of Government: Theory and an Application to Prisons," The Quarterly Journal of Economics, MIT Press, vol. 112(4), pages 1127-61, November.
  3. Baker, George P, 1992. "Incentive Contracts and Performance Measurement," Journal of Political Economy, University of Chicago Press, vol. 100(3), pages 598-614, June.
  4. Giacomo Corneo & Rafael Rob, . "Working in Public and Private Firms," Penn CARESS Working Papers 7942b6b570793de0891a05acb, Penn Economics Department.
  5. 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.
  6. Steven Tadelis, 2002. "Complexity, Flexibility, and the Make-or-Buy Decision," American Economic Review, American Economic Association, vol. 92(2), pages 433-437, May.
  7. Lindqvist, Erik, 2007. "Will Privatization Reduce Costs?," SSE/EFI Working Paper Series in Economics and Finance 660, Stockholm School of Economics.
  8. Gibbons, Robert, 2005. "Four forma(lizable) theories of the firm?," Journal of Economic Behavior & Organization, Elsevier, vol. 58(2), pages 200-245, October.
  9. 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.
  10. Patrick Bajari & Steven Tadelis, 1999. "Incentives versus Transaction Costs: A Theory of Procurement Contracts," Working Papers 99029, Stanford University, Department of Economics.
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