Thursday, February 23, 2012

Risk of Opportunistic Behavior in Outsourcing model

In the last blog, we looked at how Outsourcing enables a diversification of risk for a supplier company amongst its customers. In the current blog we continue this discussion of supplier and consumer in the context of outsourcing but moving beyond the benefits and considering the case of an opportunistic behavior by the customer.

Many a time, when it comes to the decision of making it in-house or buying it from outside - we rush through our decisions. Is there a possible framework for these things? Yes there is definitely when you consider the whole process in economic terms - however that is not what we shall discuss here - In case someone might be interested in this, it is best to read the whole paper "Outsourcing: Practice in search of a Theory - by Prof Sourav Mukherji and Prof J Ramachandran". In this blog we focus on the possibility of an opportunistic behavior in an outsourcing transaction.

A specialized supplier would be more efficient at producing than the organization producing it in-house. The underlying premise is that there would be a strong binding contract that could be well enforced. However if there is lot of information asymmetry, uncertainty and almost no competition, the transactions might not get through pretty well. It is in these situations that the opportunistic behavior - "self seeking behavior with guile". This would also need to be factored in while drafting the contract.

In a supplier makes a "transaction specific investment" to meet the buyer's demand then the possibility of opportunistic behavior is higher. The supplier in such situations where he makes a transaction specific investment would ask for a price premium over the competitive rates to guard himself from the opportunistic behavior. 

So the next time you intend to look out at an investment that is transaction specific do look at the possibility of an opportunistic behavior and hedge yourself.

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