Outsource or Not: A Serious Misreading of Coase

Yves here. I too am a big fan of Corey Robin, so I have mixed feelings about putting up this post. But to suggest that outsourcing is dealmaking is really off the mark, independent of the misreading of Coase.

As we’ve said repeatedly, outsourcing often amounts simply to a transfer from direct laborers of various sorts to managers, particularly when the outsourcing is done to a firm that has lower average wage costs by virtue of having significant operations in lower-wage locations. Or they could act as body shops for H1-B workers. We’ve had many insiders tell us the economic case for outsourcing was weak even before you factored in the greater risks.

And the risks are large, including the loss of flexibility and control, loss of know-how, greater inventory risks.

The reason I separately object to calling out-sourcing “deal-making” is it implies getting a few people in a room and agreeing to key points, and then having the minions paper it up. Outsourcing deals are the antithesis of that. You are entering into a long-term relationship with a third party which is taking over a portion of your operation. Outsourcing deals typically take six months simply to define what needs to be in the agreement. Prospective vendors are given an initial vetting, then have to submit details responses to RFP. The finalists go through further in-depth due diligence and negotiation of key terms. The process typically takes 18 months and can go longer.

By Peter Dorman, an economist and a professor at Evergreen State College whose writing and speaking focuses on carbon policy, child labor and the global financial crisis. Originally published at EconoSpeak

Corey Robin is very insightful about a lot of things. I think his take on conservatism, that the thread running through it is opposition to attempts to demolish pre-existing hierarchies, explains ideological twists and turns that would otherwise remain mysterious. Don’t take this post as an expression of anti-Robinism.

But CR seriously misreads economic texts that abut political theory. I felt this way about his analysis of Hayek, which simply ignores the centrality of his lifelong revulsion at Vienna-school-style positivism, with its echoes in a certain style of economic formalism. (Yeah, Hayek bought into a lot of the elitism of the right, but so did nearly every other conservative; that’s not what made him consequential.) And now he gives us a terrible interpretation of Coase.

According to CR, “Coase divides the economic world into two modes of action: deal-making, which happens between firms, and giving orders, which happens within firms.” He then goes on to paint Trump as an über-Coasian, at least in his own self-presentation, since these are the only types of action he recognizes. I won’t dispute the portrait of Trump, but Coase? Not a chance.

Coase is proposing a theory of the make-or-buy decision which faces every firm. (This is the case even for firms in a socialist economy, assuming they can transact in some way with other enterprises.) What goods does a firm produce internally, and what do they acquire from the outside? Do you hire your own accountant, or do you buy the services of some accounting firm? Does Toyota make its own seat cushions for its cars, or does it get them from a supplier (or group of suppliers)?

Coase assumes that going out onto the market is always best, in the sense that someone out there can do it better and cheaper than you can (or at least no worse and more expensive)—this is the market creed, with competition and all that—so there must be some other consideration at work. He says the missing ingredient is transaction costs: sometimes the cost of negotiating and enforcing a contract, which is what “buy” implies for inter-firm business, is so great as to negate the intrinsic benefits of using the market. The reason firms exist and have the boundaries they have (the result of a myriad make-or-buy choices), according to Coase, is the variegated presence of transaction costs.

(Oliver Williamson goes one step further and identifies the most crucial such cost as that of ensuring that one’s counterparty doesn’t lie, cheat, steal or hold you hostage to exploit your reliance. CR might take note that the Williamson interpretation of the authoritarianism of the firm is essentially the same as Marx’s, except that Williamson thinks the boss is the repository of virtue.)

What makes CR’s reading of Coase so strange is that, in a Coasian world, “deals”, understood as singular, complex transactions that absorb immense effort in negotiation and enforcement, should be rare. Only a failure of competition, due for instance to barriers thrown up by a regime of intellectual property rights, would put firms in a situation in which they had to submit to deal-making rather than internal production. Businesses, if they followed Coase’s formula, would shun deals to the maximum possible extent.

The core problem with CR is that he doesn’t see that, for Coase, a “deal” is a very different creature from a routine market transaction, and this difference is what the whole theory is about.

Incidentally, there are many problems with Coase’s formulation. Here are the two I believe to be the most important: (1) Coase assumes a unitary entrepreneur who owns the firm, profits from its success, and is the fountainhead for the entire order-issuing apparatus. This is the case for many small and medium-sized enterprises but fundamentally false for most of the corporate world. To some extent, the transaction cost theory can be tweaked to adapt to the corporate economy, but in the process it loses much of its explanatory power. (2) Coase focuses on what I regard as a secondary aspect of the existence (why do firms exist?) and boundary (make or buy) problems. Transaction cost factors are real but pale in importance beside the role played by the presence or absence of interaction effects between activities. Firms exist in the first place because they bundle activities that would have little value (and would therefore not be undertaken) separately. Or, if you prefer formalism, they exist to internalize nonconvexities. This is equally an explanation for make-or-buy choices.

Coase’s analysis was compelling for economists because it reconciled nonmarket organization (the internal coordination of firms) with the assumption of the efficiency properties of a competitive market. The much stronger argument based on nonconvexities is a harder sell because it also calls into question the premise of market efficiency.

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  1. vlade

    I hate outsouring, since most people who talk about it know zilch about how it actually works.

    Outsourcing manufacturing is not really outsourcing per se, it’s just deciding what you want to do where. It has been done for years, and can be done in a relatively straightforward way because the manufacturing can be (usually) very well defined and very well tested too. Japanese are really good at this, and work to develope really deep partnerships, to the extent that I hate to call it “outsourcing” which indicates “plug-and-play” bit, which even this really isn’t.

    Outsourcing services (where I put SW development as well), on the other hand, is extremely hard, and majority of it fails to deliver anything. I did not see what I’d call a sucessfull services outsourcing yet – although I did see a few cases where it became a long-term partnerships that worked, as long as everything was done on a long-term basis.

    The take-away? Partnerships works, “plug-and-play” outsourcing doesn’t.

    1. PlutoniumKun

      I think a lot depends on the sector. Back in the 1990’s I worked for a construction project management company which tried, on a very large series of contracts, to introduce partnership based contracts for construction rather than traditional ‘lowest cost on a bill of quantities’ model. The idea was to encourage the contractors to come up with their own ways to save costs and do the works more efficiently, with the benefits being shared equally between client and contractor. After about two years of intensive negotiations, the idea was dropped. The primary issue was cultural – the client, project managers and contractors just couldn’t get their heads around what was required, everyone just felt more comfortable with the traditional way, despite all the well known flaws.

      I think a good comparison can be seen in the world of retail. The traditional model in the Anglo world is of a retailer who sees their role as drilling down the costs by constantly pressurising supplier to reduce costs. But in Germany and other countries the traditional relationships are more partnership based, where the retailers develop long term deals with suppliers, which might involve the retailer helping small contractors invest in plant, etc. Its noticeable I think that some of the most successful retailers in last few years, such as Aldi (both of them) and Lidl in groceries, or Inditex from Spain, tend to follow more of a partnership model (although the ‘on the ground’ reality may be more complex).

      1. vlad

        I agree it’s a sector thing – but while the “here’s a spec, come back with the cheapest price” model works (at least to some extent) in manufacturing (or construction), it fails misserably in services (which is the gist of what was my too long a post about – it’s just outsourcing is a red rag for me ;) ).

        Partnership model is the only one I know of that works well in both worlds

      2. visitor

        But in Germany and other countries the traditional relationships are more partnership based

        Perhaps in some countries besides Germany, but I can assure you this is definitely not the case in France, where “drilling down the costs by constantly pressuring suppliers” is the norm (they have plenty of fancy techniques to achieve that, for instance something called “marges arrières”).

        Then there is the case of retailers that even have their own production plants (it is the case for the two largest general retailers in Switzerland, for instance, which produce a large part of their offering in the food department themselves).

    2. Larry

      My firm offers outsourcing services related to intellectual property. For medium sized IP firms, we offer a way to get deeper access to research materials and just as important, offload liability risk with our larger insurance policy. That’s just one example of successful outsourcing, but I’m sure others can think of more examples.

      1. vlade

        I’d have to look at what exactly you do, but I suspect you offer more of a product than outsourcing. As in, you’re not intimately tied in with the internal processes of your clients.

        Perhaps the first thing to do would be to define a boundary between outsourcing and normal customer/supplier relationship, which, admittedly, I didn’t define.

        Say, for me outsourcing is where you take something where an area with institutional knowledge specific to your organization exists, and you try to get someone to do it. Note that this is not necessarily directly business related – you may have say accounts run in a particular way (for whatever reasons), and if you try to oursource it, you’d run into massive problems. Yet, for tons of other people, having an external accountant is the norm.

      2. Larry Y

        Maybe more consulting than outsourcing? I guess medium sized firms don’t have enough (work or career) to offer specialists to keep them in house.

        On the other hand, I work at a large tech company, so we do patent stuff in house. I have talked a bit with the patent lawyers, and they like working there (salaried vs. billing hours).

  2. Jesper

    I’ve seen a couple of BPOs, Business Process Outsourcing deals.

    The key for success of BPO in the short term is to define the process – document every step of the process of having something done and then introduce control-functions to ensure that the process is being followed. Possibly also develop some tools in supporting the process.
    If the process is understood and documented well – so well that rare/expensive skill is no longer needed to follow the process – then it is possible to look for the lowest possible cost employee to follow the process.

    As far as I can tell the most common mistake in BPO deals is that the process being outsourced isn’t understood well. The documentation tends to be extensive but if the understanding is lacking then the process might be providing different results than wished for. Key Performance Indicators (KPIs) are introduced and then the gaming of the KPIs is begun….
    Even if the initial process was understood well and documented well then the next problem is that due to distance (provider to client) there might be difficulties in adapting the process to changing circumstances.

    And yes, there are similarities in BPOs and automation. Understanding of the process is key, without understanding of the process then the end result is usually bad. The key to learning and understanding is often humility and humility is often (in my experience) lacking in executives, senior management and project managers involved in BPO deals and/or efficiency projects.

    Automation in the Too Big bank Nordea:
    Time will tell if it is a success for Nordea and if other big banks will follow suit and cut 13% of their workforce.

    1. vlade

      See, you put it right on “the process is not understood well”. My point is, in many companies it’s questionable whether the process can even be ever understood well, unless you have significant in-company knowledge, which makes outsourcing a key risk, even in absence of anything else.

    2. ejf

      Yup,you got it – Business Process Outsourcing. I’ve seen the ill-understood processes ruined when, e.g., software development was transferred to India. I saw this starting in 2000 up til the present day. Yankee management LOVED the idea of cheap labor, but never got back the software it originally intended and designed.
      It was the culture: Yankees are software cowboys – able to change project as needed; Indians loved the process of development. The Indians sounded good but never go the job done.

      1. visitor

        In the 1990s, I was quite impressed that the first company to reach a CMM level 5 was from India (a subsidiary from IBM, if I remember correctly) — and thereafter seeing Indian software firms achieving ISO 9000/CMM compliance before large Western corporations.

        Later, I worked in several projects that were partly outsourced/externalized to India (the usual suspects like HCL or Wipro), and I understood. Personnel turnover in Indian firms is sky high. As soon as software engineers finish taking part in a project, they jot the reference on their CV, and rush to find another project, in a different area, to extend their skill set, beef up their CV and improve their chances of a higher salary in the IT market. Remaining in one domain area, with one set of technologies, is not considered a good thing for advancement in the Indian IT market, or when trying to get directly hired by a Western firm. They often have to support an extended family that paid for their computer science studies, so fast career moves are really important for them.

        The consequence is that Indian IT firms in charge of the outsourced projects/products just cannot rely upon the implicit knowledge within the heads of their employees. In a sense, they cannot afford to have “key personnel”, experienced people who know important, undocumented aspects of a piece of software and can be queried to clear up things — all employees must be interchangeable. Hence the strict reliance on well-documented processes.

        1. Jesper

          all employees must be interchangeable

          To expand on that I’d say that interchangeable employees have limited or no bargaining power leading to it being easier to keep salaries low. What is left for the interchangeable employee to do to increase earnings? Yep, change jobs leading to more focus on making employees interchangeable….
          The game (war) between the company and its employees escalates. Power is everything and all CEOs know that you don’t get paid what you’re worth – you’re paid what you negotiate. Maintaining power is worth the cost of churn.

  3. Thuto

    Pity the “build or buy” decision calculus has been perverted beyond what the firm needs as inputs into its final market ready products, but is increasingly being used as a defensive move by big companies to kill off competition from smaller firms via knock off products or “acqui-hiring” of talent.

  4. Thuto

    Aqui-hiring aka acquiring the smaller firm, pretending to integrate its product into the big company’s product line, starving the product of resources to slowly kill it off, then pulling the plug citing “dissapointing sales and take up in the market” to protect big company’s market share…

    1. Thuto

      Then redeploying the acqui-hired “talent” (I.e. founders of the acquired firm) to work on the next generation of big company’s products (except now they do so in a bureaucratic, red tape laden maze of “corporate innovation management” processes).

  5. Dan

    Outsourcing your core competencies or your competitive advantage – that’s the real beauty of outsourcing! What could go wrong?

    1. WobblyTelomeres

      I thought one would outsource the core competitive disadvantages. That is, a smaller firm would outsource (buy) when they could not competitively create a subassembly/subcomponent because the sourcing firm had successfully achieved superior economies of scale (EoS) . This is why multiple automobile manufacturers purchase their subcomponents (say, coils or sparkplugs or bearings) from a supplier instead of manufacturing them in-house as the supplier achieves superior EoS by supplying the entire industry.

      Even commenter Larry’s above example (“offload liability risk with our larger insurance policy”) is an EoS advantage/disadvantage, no?

      Problems occur when one side of the dance is dominated by one or two very large players (think WalMart or Takata) or political will (defined here as $) is involved.

      OTOH, I’m prolly just extremely naive.

      1. sgt_doom

        Naïve? No, you sound unholy ignorant, chum!

        When Corporate America started offshoring R&D, scientist jobs, engineering jobs, programming jobs, medical jobs, legal jobs, etc., etc., etc. beginning in the late 1970s, but exploding under Jack Welch at GE in 1984-1985 [and I was offered a position helping in the process — so nobody dare contradict me] it simply exacerbates those offshored manufacturing jobs, for without them in the past, too many American inventors would never have come to fruition — this of course requires some knowledge of the history of technology.

        The one absolute in human nature and human commerce: the greater the inequality, the lower the innovation — IN EVERYTHING, IN EVERY AREA!

        In other words, the greatest innovation in America (and everywhere else throughout history) took place when this nation was at its lowest in inequality indices and closest to socialism: the 1950s to 1960s and early 1970s — and almost everything has simply been incremental since then.

        As Leonardo da Vinci once remarked:

        Realize that everything connects to everything else.

        1. WobblyTelomeres

          In other words, the greatest innovation in America (and everywhere else throughout history) took place when this nation was at its lowest in inequality indices and closest to socialism: the 1950s to 1960s and early 1970s

          I disagree with this statement and would ask you to provide specific references for such a sweeping claim.

          and almost everything has simply been incremental since then.

          And would argue, with diagrams on a chalkboard if necessary, that all human knowledge is incremental. At least, that which requires more than simple immediate sensory perception.

          1. Yves Smith Post author

            Read Marianna Mazzucat’s The Entrepreneurial State.

            During that period, Bell Labs and Xerox Parc were huge drivers of innovation in the private sector. They were starved into triviality starting in the 1980s thanks to the rise of the myth that companies exist to maximize shareholder wealth.

            1. WobblyTelomeres

              I understand. But, science hasn’t stopped!!! LIGO, Oak Ridge’s Titan, James Webb Space Telescope, the Human Genome Project, Large Hadron Collider, National Ignition Facility, CHREC (the little corner of the science world I worked with).

              I agree. The grant dance sucks. However, it has always sucked. Pleasing the court sucks. From Euler’s wiki page:

              The Academy’s benefactress, Catherine I, who had continued the progressive policies of her late husband, died on the day of Euler’s arrival. The Russian nobility then gained power upon the ascension of the twelve-year-old Peter II. The nobility were suspicious of the academy’s foreign scientists, and thus cut funding and caused other difficulties for Euler and his colleagues.

              Sound familiar? I would argue, using myself as a prime example, that those that think science and its contribution to the expansion of the sphere of human knowledge has stopped are simply obsolete.

    2. sgt_doom

      Thanks, Dan! Most of the comments here today are simply beneath commenting on, therefore your most sarcastic and cogent comments sums it up!

      I should be flabbergasted by them, but I have frankly given up!

      Recommended Reading (to the clueless, not Dan!):

      Sold Out by Michelle Malkin

      Outsourcing America by Ron Hira

      Take This Job and Ship It by Byron Dorgan

  6. Wade Riddick

    I agree. This completely misreads Coase.

    But the guy correcting our misreading of Coase is also misreading Coase.

    If Coase were here – still working out of the law school – he’d start with the legal argument for the firm. Fims maximize profits to the partners and minimize liabilities. Coase would then invoke his own work on negative externalities to explain outsourcing.

    Adhering to labor laws, laws against rent-seeking (e.g. anti-trust), environmental protections – even the tax code itself – they are all liabilities. If the managers want to pocket more money without, you know, actually being any good at this “business” stuff, then they have to wiggle out from under their legal obligations as American citizens bound by American law. These are the “barriers” driving outsourcing.

    Outsourcing is merely a different way to pollute the common good. The lack of a transnational legal framework isn’t a bug; it’s the feature. It’s why this occurs in the first place. Domestically, Bill Black would call this “regulatory capture.” This is merely a different means of escape.

    Once the thieves start noticing that they’re being robbed too (usually of their intellectual property but sometimes just through simple policing), then they start getting all upset too and demanding trade treaties (which, conventiently, coincidentally, enshrine the same domestic regime of regulatory capture with these investor-state dispute settlement committees made up of corporate flacks).

    And if you want to understand how bad at “business” stuff these guys are, just look at the Ayn Rand acolyte who took over Sears and ran it into the ground by, among other atrocities, having employees compete with one another like they were out there cold and naked in the marketplace on their own instead of, you know, teammates working to advance the common goals of the firm employing them.

    In the words of the immortal bard, “Doh!”

  7. ape

    Skips the issues of kick-backs. Outsourcing — any external deal — creates a huge space for your employees to get kickbacks for directing business, especially if you’re crossing international boundaries.

    If I was a VP, and could liquidate the assets I’m responsible for and get a cut of the deal by redirecting that business outside of the audited internal zone, I’d have to be stupid to not outsource — stupid, or incredibly honest.

    Kinda like outsource R&D costs by using startups.

  8. Peter Dorman

    I didn’t deal directly with outsourcing as a strategy of exploitation in the OP, since I wanted to keep it simple, but of course that’s a major aspect. Coase, or any believer in market efficiency for that matter, would argue that the low wages or margins outsourcing is intended to take advantage of simply reflect the underlying economic facts. Cheap labor is abundant relative to demand; low-margin firms are commodity producers where there is ready entrance and exit and therefore low commitment costs of capital. That’s an article of faith. The real world experience described here and elsewhere points in other directions, however.

    For an interesting take on outsourcing and inter-firm rent extraction, see Eileen Appelbaum—either her article “Domestic Outsourcing, Rent Seeking, and Increasing Inequality” in the Review of Radical Political Economics (published a few months ago online behind a paywall) or “What’s Behind the Increase in Inequality?” for the Center for Economic and Policy Research.

    1. Jeremy Grimm

      I puzzled through this post trying to figure out what it was arguing. Getting down to the next to last paragraph I encountered:

      “Firms exist in the first place because they bundle activities that would have little value (and would therefore not be undertaken) separately. Or, if you prefer formalism, they exist to internalize nonconvexities. This is equally an explanation for make-or-buy choices.”

      I’m no student of Coase’s writings — so I guess “internalize nonconvexities” must mean something in Neoliberal-speak but in plain English it sounds like pure nonsense.

      I haven’t read any Corey Robin so I had to rely on the sources I could find on the web and the links at Angry Bear. The more I read the more puzzled I became as to why this post by Peter Dorman was posted here at NakedCapitalism.

      Dorman points to “A terrible interpretation of Coase” which at Angry Bear linked to a Corey Robin passage titled “Forty Years of The Firm: Trump and the Coasian Grotesque.” So I went there and searched for one passage which seemed to offend Dorman “According to CR, ‘Coase divides the economic world into two modes of action: deal-making, which happens between firms, and giving orders, which happens within firms.’ ”

      I didn’t see that passage anywhere at the “Forty Years of The Firm …” reference but I did see a passage something like that:
      “Trump is a Coasian grotesque. Making deals and giving orders: that’s all he knows how to do. Except that he doesn’t. As we’re seeing, he’s really bad at both.”

      From there Dorman launches into a discussion of outsourcing and Coase’s theory of the firm.

      Why should we care about Coase’s theory of the firm? I haven’t read it but what Dorman describes of it makes as much sense to me as the sentence from Dorman’s conclusion which I quoted at the start of my comment.

      Scanning through Corey Robin’s lengthy discussion of Hayek at the Nation — linked to from the Angry Bear copy of Dorman’s post right above the link to the Corey Robin ‘Coase’ link … was much more interesting given Corey Robins characterization of the elitism and anti-democratic content of Hayek’s writings and particularly interesting where Corey Robins identified the close ties between the elderly Hayek and Chile’s Augusto Pinochet.

      1. Jeremy Grimm

        After sleeping on it and putting Corey Robin’s Coase passage in context with the few other of his writings I read or scanned — I don’t think Corey Robin was saying anything about Coase. Considering what I read of his opinions of Hayek and Trump I tend to think he was just making fun of Coase and Trump.

        As for misreading Coase’s theory of the firm and relating it to outsourcing — completely separate from Corey Robin — I have to ask why I should give any regard to Coase’s theory of the firm. He adheres to a theory of the Market that elaborates the wonders of a Market never seen in reality and which bears little relation to real world structures and organizations sometimes called markets — especially by hopeful economists of various leanings who like Coase want to craft odd fantasies about them. Why should I care about theories of the firm from a guy who can so deftly make externalities go away by invocation of the magical wonders of this same fantasy Market he believes in. Should I be awed that he can rationalize outsourcing while completely ignoring the very real and hardly “creative” destructions of our social, political and economic fabric which outsourcing so deftly accomplished. In any case reading Coase — when I have made the attempts — is an effort which has always proven distasteful and remarkably repulsive.

  9. Normal

    …loss of know-how…

    This is the most unappreciated factor in outsourcing. American companies have taught the Chinese to make Printed Circuit Boards, Integrated Circuits, Engines, on and on. The American companies got a transient benefit and then were put out of business by their own suppliers.

    If they wanted to return to US manufacturing it would be very difficult.

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