Why Buy from Outside Rather than Make Within Your Firm?

In the world, many firms are subcontracting out activities that in past decades they would have had employees do. Why is that?

One of the modern economic theories which we use at Mobus Creative Negotiating is transaction cost economics by Nobel-Prize-winning economist John Williamson. He developed and expanded the work of Ronald Coase from the 1930s. The basic question they ask is: Why do companies buy anything on the market instead of making all their inputs themselves? Or asking the same question in another way, why do firms exist: Why don’t people just buy everything on the market, rather than buying a bundle of services from a firm?

Their theory says: companies weigh the “transaction cost” of using the market compared to the bureaucratic costs of doing things in-house. When external transaction costs are less than the company’s internal bureaucratic costs, the company uses outside services – think of how many firms have turned to outside cleaning companies, outside security providers, etc. However, if the bureaucratic costs are less than the external transaction costs, then the company does things in-house.

Sounds obvious when put this way, but the theory has a lot of ramifications that help us understand the dynamics of negotiating, especially of relationship-building. In the modern economy, companies are likely to often reconsider whether to do things in-house or contract them out, which is exactly what this theory predicts. Williamson has a lot of insights into the factors that go into the decision. Most of his work is highly technical; even his simplified explanation, http://www.economics-ejournal.org/economics/discussionpapers/2007-3/file, is pretty complex.

Transaction cost economics goes a long way to explaining why in the modern economy, more and more companies enter into long-term strategic partnerships with other firms, rather than trying to do those activities themselves (or just buying up the firm providing them with the key inputs). Modern negotiating has become more complex precisely because of the proliferation of these long-term strategic partnerships. What distinguishes Mobus Creative Negotiating is that we teach both how to bargain for a low price in a simple purchase AND how to get the most out of a long-term strategic partnership.