Business Intelligence

On The Cost-Vs-Quality Tradeoff In Make-Or-Buy Decisions

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Executive Summary

The make-or-buy decision is analyzed in a simple two-task principal-agent model. There is a cost-saving/quality tradeoff in effort provision. The principal faces a dichotomous choice between weak ("Make") and strong ("Buy") cost-saving incentives for the agent; the dichotomy is due to an incomplete-contracting limitation necessitating that one party be residual claimant. Choosing "Buy" rather than "Make" leads to higher cost-saving effort and - in a plausible "Main case" - to lower quality effort; this in spite of stronger direct quality-provision incentives in the former case.

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