Publication: RAND Journal of Economics
Publication Date: 22-MAR-07
Delivery: Immediate Online Access
Author: Baccara, Mariagiovanna

Article Excerpt
I analyze the R&D investment of firms that decide between outsourcing and in-house production when information leakage is present (contractors learn clients' technology and can diffuse it to competitors) in a general equilibrium model. Information leakage tends to concentrate the outsourcing market: despite the fact that the original market is competitive, when a market for information arises, it is monopolistic. If contractors do not have control of the information, the market splits into a set of high-tech firms that never outsource and a set of low-tech firms that always outsource. The equilibrium structure captures several features observable in the management consulting industry.

1. Introduction

* This is an era in which R&D development has emerged as one of the firm's most valuable assets. As a consequence, protecting the secrecy of R&D information is a crucial concern in industrial organization. (1) While close monitoring and career concerns can help mitigate the leakage of information caused by its own employees, a firm is particularly vulnerable to this problem when it interacts with the external world, and in particular when outsiders collaborate in the production process. (2)

On the other hand, a vast literature documents how increasing specialization and economies of scale induce firms to rely on outsourcing for an expanding number of productive activities, including even temporary workers. (3) When a firm hires an external contractor, information sharing is often a necessity, and even when it is not, the close relationship with a contractor can result in involuntary information leakage. Thus, external contractors may end up aggregating information from the pool of their clients, and as a result, other firms may have an incentive to hire the same contractors to have access to that information.

This article aims to explore the role of contractors as information intermediaries and the tradeoff between hiring efficient contractors and protecting R&D information from expropriation. In particular, I study the implications of this tradeoff on R&D investment, the information diffusion in an industry, and the size and structure of the outsourcing market. Because the value of the information acquired by contractors depends on the strategic choices of all their clients, this article tackles these questions using a general equilibrium approach. This allows deriving the market value of information and studying the characteristics of the downstream market for information that can endogenously arise in equilibrium.

I develop a model in which firms invest in cost-cutting technology and operate in a monopolistic competitive market. The production of each firm's good includes two stages: the first stage of production consists of a fixed task. Such task can be performed either in-house or by a specialized contractor, and it is the same for all firms. The "task" represents any stage of production that can, in principle, be outsourced, including legal advice, IT, banking, accounting, inputs manufacturing, and so on. The contractor is selected among the ones that populate a perfectly competitive outsourcing market. If a firm hires a contractor, the contractor learns the technology developed by the firm. The second stage of production can only be completed in-house, and its (variable) cost is determined by the technology available to each firm.

Once a contractor learns a technology, and before the second stage of production takes place, the technology may "leak" to competing firms. The information leakage can occur in two fundamental ways: first, a contractor may not have perfect control of the information that he learns. This lack of control determines an unintentional spill of information to a fixed measure of other firms. Second, each contractor can post a price for the information he knows and sell it to other firms.

The (exogenous) magnitude of the spill measures the ability of contractors to protect and market the information they have. Sometimes they may not have the expertise to understand and sell information on the market. Other times, geographical concentration (e.g., firms in Silicon Valley) or high employee turnover (e.g., management consulting firms) could cause a contractor not to be able to fully control the information flows coming from his firm. (4) A more sophisticated contractor may take measures to protect the value of the information and limit the spill to some degree. A contractor has perfect control of the information when he does not generate any involuntary spill. In this model, the magnitude of the information spill affects the demand for information and the size of the market that the contractors face as information sellers.

I study the equilibria of this model as the magnitude of the information spill varies. First, if a contractor has some degree of control over the information, there always exists a unique equilibrium in which a market for information arises. Quite strikingly, despite the fact that the outsourcing market is perfectly competitive, the market for information in equilibrium is always monopolistic. The intuition of this result is very general and robust. Consider the problem of a firm that invested in R&D. This firm also has to decide whether to hire a contractor and, in case it does, it has to select a contractor from the ones that populate the outsourcing market. In making these decisions, the firm has to consider the impact of its choice on the market for information that will arise downstream. In particular, the firm always has an incentive to distort such a market by keeping it as concentrated as possible. This is because, when the degree of competition in the market for information increases, the price for information decreases. Thus, more firms buy information on the market, and the information leakage increases. On the other hand, a more concentrated market for information guarantees a higher price for information and more limited leakage to the rest of the market. Then information leakage concerns have the tendency to concentrate the outsourcing market with respect to situations and industries in which information leakage is not present. (5)

When contractors face the financial constraint of posting a nonnegative price for the task, the ex ante competition to become the information monopolist does not dissipate the surplus from the market for information. Thus, the contractor who becomes the information monopolist appropriates all the market's surplus of information.

If the contractors have full control over the information, I show that there cannot be a market for information in equilibrium. In this case, firms know that if they do not invest in technology a monopolistic contractor will be their only source to learn cost-cutting technology in the future. If contractors cannot ex ante commit to a price for information, the information monopolist always prices it to extract all the information surplus. If this is the case, firms always prefer to invest in the technology themselves rather than wait to be charged a high price by the information monopolist. As a result, with full information control, there is only one equilibrium in which all firms invest in technology and outsource, and there is no market for information. (6)

Finally, I analyze the case in which contractors have no control over the information they learn. In this case, a market for information cannot arise, and I identify necessary and sufficient conditions for the existence of a unique equilibrium in which the market splits into a positive measure of firms outsourcing and not investing in technology and a positive measure of firms that have a high technology level but perform the task in-house. (7)

I compare the equilibrium investment and the diffusion of the technology under different degrees of contractors' information control. I show that the technology level reached in the market decreases as the degree of control over the information of the contractors increases. However, the measure of firms that adopt the technology increases with the degree of information control. From that, I derive some welfare implications of the model.

* An example: management consulting firms. While the question addressed in this article applies to a wide range of outsourcing activities, it can be related in an interesting way to the case of the management consulting industry.

In the model, contractors learn R&D information as a byproduct of the main activity (or task) for which they are hired. If a contractor understands the market value of the information and has the capabilities to market it, he could try to sell it to other firms.

Historically, several very successful management consulting firms originated as small consulting practices within a firm specializing in professional services such as accounting, auditing, tax filing, or engineering.

McKinsey & Co. originated from James O. McKinsey & Co., a firm specializing in accounting and management engineering, and its successive merger with Scovell, Wellington & Co., another accounting firm. The first years of the partnership were characterized by a heated debate on the decision to keep the accounting and the consulting practices separate or under the same roof. (See Bhide (1996).) Other major accountancy firms offered consultancy-type advice to their clients on a small scale, and from the 1980s onward they expanded these kinds of services. (8) This suggests that the transition from professional service to consulting may have occurred to capitalize on the expertise these professionals developed working in close contact with their clients.

Even the current management-consulting industry fits the model quite well. It is very difficult to define the products that are traded in this industry. They are sometimes identified with organizational ideas, other times with the necessity to validate some unpopular decisions, such as personnel reduction, and so on. (9) However, products that management consultants explicitly market and sell are the so-called "best practices." Best practices are benchmarks that are usually formulated by aggregating the information consultants gather from the pool of their clients on a given common issue. (10) As McKenna (2001, p. 152) puts it: "Management consultants have primarily functioned as disseminators of organizational ideas." In the words of sociologists Di Maggio and Powell (1983, p. 44), "Large organizations choose from a relatively small set of major consulting firms which, like Johnny Appleseed, spread a few organizational models throughout the land." (11)

Suppose that a firm with good technology related to a given function decides to hire a management consultant for some reason (e.g., to acquire a best practice related to some other function, a better organization, to validate some personnel reduction, etc.). Once the management consultants are hired, they typically send a team to work at the client's headquarters for a period of time that ranges from some months to years. During its stay, this team has access to a large portion of the firm's private information. So it is natural that the firm may be worried that the technology it holds becomes part of some other best practice sold to a competitor in the future. (12)

Because of its high labor turnover, a management-consulting company typically does not have perfect control of the information it aggregates. (13) Thus, the model this industry seems to match is one of imperfect control of information. This is the case under which a market for information arises in equilibrium and consultants appropriate the surplus of this market in the long run.

Finally, the results of the article predict that a monopoly is the only possible equilibrium outcome when a market for information arises. Such result (or, more generally, the intuition that information leakage concerns tend to concentrate the consulting market) is consistent with the observation that, among many accounting or auditing firms, only a few made the transition to successful consulting firms. Moreover, the management-consulting industry is characterized by high market concentration and high growth of a few market leaders. In particular, in 2001 McKinsey had 40.6% of the market share and, in the late 1990s, it experienced a growth of 20% annually. Moreover, McKinsey and its largest competitor, Booz, Allen, & Hamilton, together held almost 60% of the market in 2001. (14)

* Related literature. After Coase (1937) originally identified the "make-or-buy" decisions as the element that defines the boundaries of a firm and Williamson (1985) more recently reexplored Coase's fundamental intuition, a vast literature started to analyze such decisions both in individual and in general industry equilibrium settings. Very influential work on this issue has been carried out by Klein, Crawford, and Alchian (1978), Grossman and Hart (1986), and Hart and Moore (1990), and it has focused mainly on what is known as the "hold-up problem" arising from relation-specific investments and incomplete contracts. However, as Holmstrom and Roberts (1998) have pointed out in a recent article, explaining the boundaries of the firm only in terms of the hold-up problem and asset specificity seems a too narrow view for a very general issue. The aim of this article is to introduce a new possible perspective for "make-or-buy" decisions, which is based on informational concerns.

My approach is close to Grossman and Helpman (2002, 2005). This is because, rather than taking a decision-theoretic approach in which the industry environment is given, I consider a general equilibrium model that allows studying the interdependence among firms and sectors. Between those two articles, Grossman and Helpman (2002) is the closest to this one because it focuses on firms' make-or-buy decisions. (15) However, in that article, the fundamental tradeoff the firms face when they make such a decision is substantially different from the one I consider here. Namely, rather than facing an informational concern that may erode the return of their investment in R&D, the firms face the choice of high governance costs from being vertically integrated or search costs to find a more specialized and lower cost partner. In addition, because of incomplete contracts and the specialized investment required, specialized partners face a potential hold-up problem. Similar to this article, Grossman and Helpman (2002) characterize the conditions under which we observe vertical integration, pervasive outsourcing, or coexistence of the two on a market. However, in this article, I also relate these events to information diffusion in the industry through the presence of the market for information.

Jovanovic and MacDonald (1994) analyze the evolution of a competitive industry in which firms reduce costs by innovating or imitating their rivals' technologies. In the steady state, they find that the diffusion of the technology from the investing firms to the imitating ones leads to a low level of investment. This effect is present in this article as well. However, I focus on endogenizing the mechanism through which the information spreads and on the role of contractors as information intermediaries. (16)

Another article that analyzes the issue of property information flows in the firm-to-firm service markets is Demski et al. (1999). However, their focus is on the internal organization of the service-providing firm and the problem of designing incentives to discourage employees from leaking information. I abstract from the contractors' internal...



NOTE: All illustrations and photos have been removed from this article.



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