Outsourcing decisions and managerial incentives

An agency model is presented in which outsourcing strictly dominates in-hou se production. We argue that firms outsource in order to improve managerial incentives. Conditions are established under which the firm is strictly be tter off with outsourcing. The benefit of outsourcing, however, is constrai ned by the trade-off between the incremental coordination costs of outsourc ing and the improved incentive structure. The optimal contract is also show n to be a function of whether or not the firm is publicly held. For a publi cly held firm, the contract is constant. For a privately held supplier, the contract is likely to be of a cost-sharing type. These findings offer prel iminary incentive explanations for commonly observed outsourcing practices.