Winner of Nobel Prize in Economics On Outsourcing and Supply Chain

Oliver Williamson, a Professor Emeritus at the University of California Berkley and co-recipient of the 2009 Nobel Prize in Economics, published a paper in April 2008 titled “Outsourcing: Transaction Cost Management and Supply Chain Management” in the Journal of Supply Chain Management. Williamson’s area of expertise is transaction cost economics. The paper is far more focused on theory than practice, and is not an easy read by any means. However, there are a few nuggets of wisdom that may interest managers who procure third party logistics (3PL) services. 

Williamson’s research looks at the differences between buying something in the spot market (e.g., procuring a truck to ship something from Detroit to Chicago), outsourcing to a lead logistics provider, and operating an activity in house (e.g., operating a private fleet).  Each type of transaction has its strengths and weaknesses, but Williamson focuses mostly on outsourcing arrangements. 

Outsourcing arrangements rely on contracts, but “all complex contracts are incomplete,” writes Williamson, “[thus] order-preserving mechanisms are devised that enable the parties to preserve cooperation during contract execution.” The framework devised should be “highly adjustable” in that it creates mechanisms “to deal with unanticipated disturbances as they arise, the effect of which is to facilitate adaptation [and] preserve continuity.”

Williamson highlights three main ways in which outsourcing agreements are negotiated and governed. One way, which he refers to as the “muscular” approach, assumes that the buyer, often a large company, deals with smaller suppliers in a preemptory manner. “Muscular buyers not only use their suppliers, but they often ‘use up’ their suppliers and discard them,” Williamson states. “The muscular buyer simply tells suppliers ‘These are the specifications for the good or service to be provided. Give me your best price.’” However, this approach is less effective for services that require high levels of expertise. “Power is a trap,” writes Williamson, and this approach is “myopic and inefficient.” 

Another approach is the “benign approach” where the buyer assumes the supplier will always act in good faith. Obviously, this is naïve. 

The best approach assumes that “cooperative adaptation” is needed. Both parties need to “look ahead, uncover potential hazards,” and then work out mechanisms to deal with those hazards and factor those back into the design of the contract. “Credible commitments are thus introduced to effect hazard mitigation.”

In contract negotiations, three kinds of situations can exist: those where both parties unambiguously perceive to have the purpose of improving the bargain; I win, you lose types of proposals; and “those for which there is asymmetric knowledge of the consequences,” where one party proposes “a contractual refinement the prospective gains from which are skewed in its favor, yet represents otherwise, while the other party is unable to ascertain the true ramifications.”   

If both parties think that a long term relationship is in their interest, negotiators should not be, as the saying goes, “a penny wise and a pound foolish.” Instead of never leaving money on the table, a better approach is to always leave money on the table. Neither party should feel that the other party is acting in bad faith by using ploys to gain unfair advantage.    

Sure, certain economic concepts work in theory, but do they work in practice? After slogging through this article, which admittedly was not written for practitioners, my reaction is that cooperative adaptation is an interesting idea, but how do you put it into effect?

This will be a good question to discuss at our upcoming seminar on “Performance-based Outsourcing: Maximizing the Value of 3PL-Customer Relationships” (February 9-11 in Orlando, FL). It’s not too late to register. Visit the website for the latest agenda and registration details.