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The Make-Buy Decision

Standard textbook microeconomics does not tell us anything about whether industrial firms have direct control over all production (vertical integration) or why they seek vertical disintegration through subcontracting (outsourcing). The former is the do-it-yourself ‘make’ decision, and the latter, the ‘buy’ decision.

A neo-Marxian economist with a historical sense of capitalism, such as Andre Friedman, has thrown light as follows on this missing topic in the mainstream curriculum.
To begin with, in general, the extent of vertical integration or its reverse subcontracting/outsourcing option is affected by scale economies. In traditional industries based on the system of batch production of low technology, ‘discrete’ products with limited or without any technical economies of scale and subject to fast changing demand, social division of labour and specialisation through subcontracting has been by and large the form of production organisation. In modern industries where the final assembly and the production of certain critical parts (especially those involving firm specific, proprietary technology) are subject to scale economies. One would expect their internalisation by a large firm at least at their respective ‘minimum efficient scale of production’ so that there would be no incompatibility between final assembly and parts-making. Since not all the items/operations can be internally produced at their respective efficient scales of production, it is very reasonable to expect the tendency to purchase and subcontract out certain standardised and non-standardised items respectively. The outsourcing/subcontracting relationship thus emerges and sustains itself on the hope that the firms which supply the components and processes supply a number of firms, and so achieve economies of scale, which their customers would not achieve if they did not buy out.

If a fully integrated firm wishes to expand its output in response to a spurt in demand, then costs will rise quickly because it would take longer to expand its capacity or enter afresh into subcontracting arrangements. If it wishes to reduce its output consequent upon a fall in demand, then costs do not fall quickly because of increased overheads and decreased flexibility in dealing with labour. Moreover, if it is entirely dependent on all its supplies from within its operations, then any disruption in supplies will result in large revenue loss than when it is also dependent on outside, multiple sourcing.

Thus, given the costs of vertical integration, large firms would tend to economise fixed capital and concentrate investments in core production processes and critical parts where up-to-date technology is crucial to survive or win domestic/foreign competitive onslaughts, and then buy out standardised and non-standardised items from outside parties—large and small—through purchasing and subcontracting arrangements respectively.

The central point here is that there are supply and demand factors that determine the discretionary power of the top-managements of larger firms to choose between the two alternatives: direct control over all production on the assumption that demand will be stable or flexibility through subcontracting on the assumption that supply of intermediate items and final product demand will be unstable in future.

Since it is very important for top-managements to form some view of the likely stability or instability of demand in future as also of the likely smoothness of flow of parts, components and subassemblies from existing suppliers and from their in-house facilities and since it is extremely difficult to estimate these intangible factors, we find in reality firms choosing very different mixes of control and flexibility. This also explains in part why there could be differences in the extent of subcontracting relations between firms or why firms (even if they are similarly sized) alter the relative importance of subcontracting relations over time.

With the onset of microelectronics and flexible automation (embodying greater and greater artificial intelligence), much can be said on both sides. Computerised manufacturing permits efficient verticalization at one place. However, it also permits centralised control over decentralised production. Since it erodes economies of large-scale, it also permits the main or lead companies to offload production process fully or partly to smaller companies equipped with computerised production methods. As such, we can say that subcontracting relations may persist after all in so far as larger firms can flexibly automate their core processes and maintain market as also extra-market links with flexibly automated small firms.

Larger firms derive their discretionary power from their outsourcing relations with smaller firms in a number of ways. They can overcome their capacity or space constraints through subcontracting. Most frequently, they can reduce their overall fixed and variable costs through subcontracting and purchasing and thereby reduce the rates of capacity utilisation at which they can break-even. If the factory cost (i.e. prime cost plus factory overhead) is less than the procurement price for the same quality and if future demands are significant, large firms may find it better to make rather than buy, ceteris paribus. Large firms can also resolve the problem of high prime and transport costs arising from a particular disadvantageous geographical location by subcontracting the whole production in the final markets or nearer to areas of market growth.

Frequently, firms find it economic to subcontract to outside parties possessing special knowledge, equipment or a patented process than to procure special equipments and knowledge to train personnel in order to handle the work or license the process. Large firms can achieve risk-spreading via subcontracting; they can spread the costs of constant retooling, rejuvenation and innovation in the context of technological change and short product life-cycles. Further, outsourcing can be used as a stop-gap arrangement so as to modernise present facilities or set up new lines and get rid of the old lines of production. Thus, since modernisation process can set in along with the phasing out of the erstwhile lines and methods, subcontracting is an eminent way of achieving the Schumpeterian creative destruction.

Lastly, large firms can gain in numerous ways as captured by the elastic category, flexibility, which outweigh the organisational dilemmas and difficulties of subcontracting. Multiple sources of supply guarantee timely procurement to meet delivery schedules. They also apply competitive pressure on the subcontractors. In the context of demand instability, especially in recessionary and depressed times, the burden of adjustments can be shifted to subcontractors. Furthermore, subcontracting can effectively debilitate the bargaining strength of unionised labour. Large firms could at the most concede organised labour wage increases only against commitments on productivity. Thus, outsourcing gives firms flexibility in redefining their wage strategy and over their responses to the spectre of militant unionism.

The geographical dispersal of subcontractors no doubt increases transport costs but in the calculus of some firms, this may well be offset by the industrial peace attained due to such fragmentation of work and workforce, so much so that flexibility is the most important criterion for many firms in their ‘make-buy’ decision.

The adjustment costs of changes effected at the main or lead firms are usually passed on to the subcontractors much to the latter’s disadvantage and even collapse, especially in recessionary times. As such, subcontracting relationship, although apparently appears to be based on mutual interests, is largely unsymbiotic as far as the subcontractors are concerned. There are unequal power relations between firms, and the relationship is ultimately beneficial to larger firms–like most marriages between males and females are ultimately skewed in favour of the former in patriarchal and patrilineal societies.

Andrew Friedman had rightly attacked mainstream microeconomics as reflected in standard textbooks on the grounds that it has almost abstracted from the middle ground between arms’ length transactions and vertical integration—where firms on either side of a market cooperate via subcontracting, long-term contracts, leases, technical (patent license) agreements, etc., and that it has covered just the middle ground between competition and horizontal integration (through combination/merger or takeover) where firms in the same business restrict competition through price agreements and market sharing.

However, the modified neoclassical school has addressed itself, albeit belatedly, to the ‘black box’ of the middle ground between arms’ length transactions and vertical integration. In this thinking, subcontracting occurs in the middle ground between vertical integration (that reflects complete internalization or manifestation of complete market failure as far as the ability of the market to coordinate inter-firm transactions) on the one hand, and arms’ length transactions reflecting ‘pure’ market transactions (i.e. anonymous buyers and sellers exchanging goods in discrete transactions at price determined in perfectly competitive markets) on the other. The middle ground reflects extra-market, direct linkages or relationships established by firms in complementary activities. And this is treated as a manifestation of ‘partial market failure’ in so far as the establishment of a direct linkage is the means of achieving coordination of inter-firm transactions in the real world of imperfections involving (a) differential technical characteristics of the products to be exchanged; (b) existence of firms exercising significant market power; (c) unpredictable future; (d) lack of all the information and knowledge (including technology) that the firms need and hence the need for exchange of information through negotiations, etc. This middle ground of direct linkages is also referred to as the world of ‘vertical inter-firm linkages’, or ‘vertical quasi-integration’.

This middle ground which constitutes fairly large part of the real, imperfect business world has no doubt costly costs of contracting, so to speak. These are known as transaction costs—the tangible and intangible costs of non-optimal administrative/bureaucratic decision making, discovering prices, search and negotiations to be undertaken, inspections to be made, arrangements to be made to settle disputes, etc. The central point is that despite there being these costs in the extra-market methods of inter-firm coordination, they (the extra-market methods) are nonetheless preferred to relying on the fictionalized ‘pure’ market mechanism—the only method of coordination normally worshipped and analysed by liberal and conservative neoclassical economists.

The lack of appropriate and efficient legal and other formal and informal institutional arrangements (‘rules of the game’) required to settle the disputes arising out of possible conflicts between firms depending on the extra-market exchange relations, constitutes a significant transaction cost. And the source of inter-firm conflicts in this connection can be fundamentally attributed to the tendency of the dominant, larger parent firms’ opportunistic behaviour to become parasitic, if unchecked, especially when large firms become ‘vulnerable dinosaurs’ in the face of intense competition.

Now, here is some homework for you. Explore how the New Institutional Economics of Nobel-laureates Ronald Coase and Oliver Williamson throws light, via the above modified neoclassical thinking, on this topic of make-buy decision, and if it is better than the neo-Marxian analysis of Andrew Friedman. Write an essay for this platform.

Annavajhula J.C. Bose, PhD Department of Economics, SRCC

References

Andrew Friedman. 1977. Industry and Labour. MacMillan. London. Annavajhula J.C. Bose. 2018. Exploring the Real World Industrial Organisation. Educreation Publishing. C.F. Pratten. 1971. Economies of Scale in Manufacturing Industry. CUP.
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