Make and Buy II

17 December 2006 at 11:34 pm Peter G. Klein Leave a comment

| Peter Klein |

We discussed earlier an emerging literature on dual sourcing or “make-and-buy” decisions. Why do firms simultaneously make a particular input and buy some quantity of this input on the open market? The CCSM featured another paper on this topic, Ranjay Gulati and Phanish Puranam’s “Complementarity and Constraints: Why Firms Both Make and Buy the Same Thing.” (Neither author could make it to Copenhagen, unfortunately, but Tobias Kretschmer gave a fine presentation on their behalf.) The paper presents a simple model in which firms choose plural sourcing because of external complementarities (to mitigate opportunistic behavior from an external supplier or to benchmark the supplier’s performance), capital constraints (that prevent the firm from internalizing all purchases of the input), exit costs (that prevent the firm from outsourcing as much as it would like), and other factors.

A general implication is that theories of optimal or first-best modes of organization may have limited explanatory power in a world of high transaction costs. Seemingly inefficient governance structures may be second-best solutions to capital constraints, regulatory barriers, bargaining problems, and other frictions. Understanding these constraints, and the processes of experimentation, learning, and adaptation that work around them, should be high on the organization theorist’s agenda.