Arnold Kling

Make or Buy?

Arnold Kling, Great Questions of Economics
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In his New York Times column today, Hal Varian looks at one of the most fascinating issues about the information revolution. How will it affect the firm's choice between internal and external suppliers?.

Many gurus, such as the authors of Unleashing the Killer App, argue that large companies should be outsourcing heavily in order to take advantage of the Internet. However, Varian points out,

The real issue confronting a company trying to decide if some unit will be inside or spun off is what incentives the spinoff will have. If you spin off something critical to your business, you leave yourself open to extortion down the road. An internal monopoly supplier may be sluggish and inefficient, but its incentives are at least party aligned with the rest of the organization. An external monopoly can be much worse.

The example that occurs to the reader is the decision by IBM to outsource the development of the operating system for its personal computer in the early 1980's. It created an "external monopoly" for a start-up called Microsoft.

My opinion is that many organizations are erring on the side of trying to perform too many functions internally.

  • Doctors' offices perform far too many adminstrative services, as I argued here.
  • Financial institutions could take better advantage of external information technology services, as I argued here.
  • Schools, law firms, and many small- and mid-sized companies could use external suppliers to meet all of their information technology needs. Instead, these organizations struggle to manage information technology staff that is underqualified and undependable.

I think that what goes on in these cases is that the bosses are risk-averse, and they fear a loss of control if they switch from internal suppliers. In fact, the internal suppliers sometimes go to great lengths to reinforce this fear.

Discussion Question. The head of information technology services within an organization would appear to have an incentive to argue against outsourcing IT. What can the organization do to arrive at an objective but informed decision?

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