Scandinavian Working Papers in Economics

Working Papers,
Lund University, Department of Economics

No 2010:2: On the Cost-vs-Quality Tradeoff in Make-or-Buy Decisions

Fredrik Andersson ()
Additional contact information
Fredrik Andersson: Department of Economics, Lund University, Postal: Department of Economics, School of Economics and Management, Lund University, Box 7082, S-220 07 Lund, Sweden

Abstract: 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.

Keywords: make-or-buy decision; manipulation; outsourcing

JEL-codes: D23; L24; L25

19 pages, March 26, 2010

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