Outsourcing and Agency Costs

The Times reports that the exploding outsourcing industry in India has run into two sorts of problems: (1) domestic political instability resulting from a federal system; and (2) duty of care problems resulting in data breaches. The two articles, fronted together, remind me that I’ve not yet had a chance to plug George Geis’ provocative article on Business Outsourcing and the Agency Cost Problem. From his abstract:

Why has business outsourcing increased so rapidly over the past decade? The question is important for corporate law scholars because it raises foundational issues underlying the theory of the firm. Indeed, the decision to pool resources under centralized control presents a fundamental tension between the benefits of scale and the dangers of unchecked managerial discretion. The location of a firm’s borders – and thus the extent of outsourcing – can be viewed as an equilibrium of these competing effects.

The conventional explanation for the rise in business outsourcing is that falling interaction costs have changed this balance by opening new markets where firms can source economic inputs for less. This Article offers a second account, however, for the outsourcing phenomenon – one that is rooted in agency theory. Like many other economic relationships, outsourcing projects generate agency risk because a vendor makes decisions that affect the wealth of the outsourcing firm.

This Article argues that business outsourcing has thrived in recent years not only because globalization has unlocked inexpensive production markets, but also because it is becoming easier for firms to monitor and prevent the agency costs of outsourcing. Drawing upon a detailed analysis of outsourcing contracts, it explores several strategies to minimize agency costs – shedding new light on the structure and terms of a typical outsourcing project. It then contends that the same forces that are opening new markets are also making it economical for firms to mitigate outsourcing agency risk. Taken together, this work adds another important, but previously neglected, context for understanding the essential tradeoffs that arise when economic ownership is divorced from control.

It is a terrific paper, I think, which might lead some folks to new applications of AC theory. One question I have concerns the role of consultants as norm entrepreneurs, and as developers of strategies to monitor outsourced agents. (If, indeed, outsourced firms ought to be thought of as agents). It is also interesting to think about agency costs and remedies in transnational contracts. If, as the Times reports, Bangalore will shut down today, which jurisdiction’s contract law on force majuere will shadow the resulting dispute?

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