The Effect of Learning on the Make/Buy Decision

ABSTRACT

Economists, management scientists, and organizational theorists all recognize that the decision to make or buy product components and the resulting impact on industrial organization is of paramount importance to firms. The major theories put forward to explain sourcing decisions include transaction economics, channel power, appropriability, and scale economies. However, these theories do not account for how learning interacts with product design over time and do not explain many interesting empirical observations concerning outsourcing behavior. By including the effects of learning over time on both component production and the integration of components into complete products, we propose an engineering-based model of sourcing that can illuminate these unexplained observations, as well as provide an alternative explanation for much of what other theories predict. The model also makes several important new predictions. In particular, the model predicts that some sourcing decisions that improve a firm's short-run cost position can have a long-run cost penalty. This can create a path-dependent outsourcing trap in which a firm can find itself unable to recover from a regime of low profit and high outsourcing once an initial outsourcing decision is taken. The model also describes why and under what conditions partial outsourcing may dominate both complete insourcing and complete outsourcing. For example, our results suggest that high discount rates and product modularity lead to higher fractions of outsourcing. A final important result is that, if there is no cost-discounting, the long-run optimal outsourcing fraction increases monotonically with the speed of technological change; under cost-discounting, however, this result can actually reverse in slowly changing industries, creating a curvilinear relationship between outsourcing and technological change.