Sourcing With Unverifiable Performance Information

Firms often decide whether to purchase an input from an outside supplier or produce the input internally. For example, automobile and computer manufacturers routinely choose between subcontracting for component parts and producing them in-house. Similarly, large firms and government agencies must often decide whether to employ outside experts (e.g., law firms) or create internal staffs of experts. Among the many considerations that affect these "make-or-buy" sourcing decisions are the incentive issues that arise under the two modes of operation. We examine a setting where the decision to buy the input from an outside supplier gives rise to a two-sided moral hazard problem: the supplier's effort is unobservable, and the buyer receives private information about the quality of the input. Truthful reports from the buyer about product quality might be used to motivate the supplier to labor diligently, inducing stochastically higher quality from the buyer's perspective. However, the buyer may be tempted not to acknowledge high product quality when doing so contractually requires a higher payment to the supplier. The two-sided moral hazard problem we investigate is complicated by the absence of a third party who might manage the relationship between the buyer and supplier.