Outsourcing & Economics: Lessons for better outsourcing from Nobel Prize-winners

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.

Economic thinkers have 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 tell us fundamental truths about outsourcing.

Business is a Math Problem

Ronald Coase shed light on a concept known as transaction cost analysis.

He advocated that it was not enough to include only production and transportation costs as the main costs of doing business; businesses needed to also consider the cost of entering into and executing contracts as well. This boils down to a mathematical exercise, and his breakthrough thinking was even given a mathematical name, the Coase Theorem.

It seems obvious now but Coase’s inclusion of contracting and contracting costs into the mix of a firm’s organizational structure and accounting resulted in a Nobel Prize in Economics in 1991 and created the conditions for outsourcing to become a normal, major part of a firm’s strategy.

Lesson #1: When outsourcing, think about the TOTAL COST – not just the price/budget of the work that is being outsourced. Making decisions solely on the price and scope of work and not on the total costs result in a myopic and inaccurate view.

Playing Nice is Good for Everyone

In the movie A Beautiful Mind the mathematician John F. Nash, as played by Russell Crowe, has a revelatory moment in a campus watering hole as he and his mates ponder the best ways to produce optimum results as they consider how to approach a beautiful blonde and her friends.

Nash’s moment of inspiration and clarity was that Adam Smith’s principle that the “best result comes from everyone in a group doing what’s best for themselves” was incomplete and needed revision: The best result comes from everyone in a group doing what’s best for themselves … and the group.

Nash’s pursuit and proof of that conclusion led to the Nash Equilibrium. He demonstrated that companies that work together will discover that the sum of the parts improve when combined effectively than if they work at cross-purposes.

Nash received a Nobel Prize in 1994, 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 (aka win-win) games for more than 50 years to show that playing nice is indeed good for you. Since Nash’s Nobel Prize – there have been seven more Nobel Prizes awarded to Game Theorists.

Lesson #2: Game theory development was crucial to the concept of reaching win-win solutions and outcomes in outsourcing contracts. It is just as important today.

Brains Trump Brawn

More than 50 years ago Robert Solow showed that technology was the real driver of economic growth.

Solow’s growth model premise, first presented in a 1956 article, was that without “technological progress” growth rates for capital, labor and total production would all be about the same. In fact, he found that about four-fifths of the growth in U.S. output per worker was attributable to technological progress. In short, brains matter more than brawn if you want to spur economic growth. Solow won the Nobel Prize in 1987.

Lesson #3: Most outsourcing agreements are transaction-based, meaning that a service provider gets paid for each activity – whether it’s a rear-end in a seat to answer a call, two hands for packaging, or fingers for filing. This approach focuses on brawn, not brains. If economic growth is achieved through “technical change” then companies that outsource should focus their efforts around paying suppliers for their innovative brainpower and not their brawn.

Not Playing Nice Can Really, Really Cost You

Oliver E. Williamson, professor emeritus of business, economics and law at the University of California, Berkeley, is taking transaction cost analysis to a new level that he calls ‘transaction cost economics’ (TCE).

He applied TCE directly to outsourcing and the supply chain in an April 2008 article in the Journal of Supply Chain Management (“Outsourcing: Transaction Cost Economics and Supply Chain Management“). Williamson warned about potential “maladaptations” in the contract process that can develop if companies don’t think cooperatively about “unanticipated disturbances” in order to preserve contract continuity.
His analysis of the three styles of contracting — muscular, benign and credible — is particularly insightful. He says, “Muscular buyers not only use their suppliers, but they often ‘use up’ their suppliers and discard them. The muscular approach to outsourcing of goods and services is myopic and inefficient.”

Oliver Williamson shared the 2009 Nobel Prize with Elinor Ostrom, who received recognition for her work on how user associations can effectively manage common property.

Lesson #4: Companies should think cooperatively – because switching costs of vendors is very expensive. If the basic strategy is to “bid and transition” you are probably losing at the TCE game. And for all those companies that have pitbull procurement professionals still on their staff – it is not only old school it’s “myopic and inefficient.” If you aren’t convinced of this by game theory, Williamson’s work is a tipping point on why not playing nice can really, really cost you.

Outsourcing is here is to stay

Thanks to the big thinkers, outsourcing is now an intrinsic part of the business landscape. It has been popularized in recent years by the New York Times columnist Thomas Friedman.

Friedman’s big bestseller, The World is Flat: A Brief History of the Twenty-First Century stresses the importance of technology and outsourcing as major elements of the global economic structure.

The book describes 10 “flatteners” that have leveled the global playing field. The rise of outsourcing and related activities such as off-shoring and supply chain networks figures prominently on his list. The ease of offshoring today – if done correctly! – allows a company to locate manufacturing and other processes to a foreign locale to take advantage of less-costly labor and operations.

So yes, outsourcing is here to stay and the world is getting flatter all the time. But there is a better way that takes outsourcing an important step beyond management guru Peter Drucker’s famous advice in 2004: “Do what you do best, and outsource the rest.”

That step is: Do it right, do it collaboratively – because simply deciding to outsource is just the beginning; failure to follow the economic teachings related to outsourcing will not maximize results.

For a primer on how to do outsourcing right, pick up a copy of Vested Outsourcing: Five Rules that will Transform Outsourcing.

We’ve come a long way thanks to thought leaders such as Coase, Nash, Solow and Williamson. The outsourcing phenomenon is really just getting started. It is poised to achieve new levels of sophistication and efficiency, especially if it becomes a collaborative, win-win exercise that benefits everyone.

Kate Vitasek

References/Links:

Robert M. Solow Prize Lecture, December 8, 1987
http://nobelprize.org/nobel_prizes/economics/laureates/1987/solow-lecture.html

Ronald H. Coase Prize Lecture, Dec. 9, 1991:
http://nobelprize.org/nobel_prizes/economics/laureates/1991/coase-lecture.html

1994 Nobel Prize Laureates: Nash, Selten, Harsanyi
http://nobelprize.org/nobel_prizes/economics/laureates/1994/press.html

2009 Nobel Prize Laureates: Williamson, Ostrom
http://nobelprize.org/nobel_prizes/economics/laureates/2009/press.html

Oliver Williamson:
Prize Lecture (video) – http://nobelprize.org/nobel_prizes/economics/laureates/2009/williamson-lecture.html
Slides: http://nobelprize.org/nobel_prizes/economics/laureates/2009/williamson-lecture-slides.pdf“Outsourcing: Transaction Cost Economics and Supply Chain Management,” Journal of Supply Chain Management, Volume 44, Issue 2 (p 5-16)
http://www3.interscience.wiley.com/cgi-bin/fulltext/119422182/PDFSTART?CRETRY=1&SRETRY=0

Thomas L. Friedman, The World is Flat: A Brief History of the Twenty-First Century 2005 ISBN 0-374-29288-4

Vested Outsourcing: http://www.vestedoutsourcing.com/
eBook: http://www.VestedOutsourcing.com/pdfs/Vested_Outsourcing_eBook.pdf

University of Tennessee Center for Executive Education http://www.thecenter.utk.edu

Supply Chain Visions: www.scvisions.com

Bar scene from “A Beautiful Mind”: http://www.youtube.com/watch?v=l0ywiYboCLk

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