Technological change and the make-or-buy decision

The make-or-buy decision is one of the most studied in the literature on firms. A new working paper, Technological Change and the Make-or-Buy Decision by Ann P. Bartel, Saul Lach and Nachum Sicherman, looks at the effects of technological change on the make-or-buy decision.

The abstract reads,

A central decision faced by firms is whether to make intermediate components internally or to buy them from specialized producers. We argue that firms producing products for which rapid technological change is characteristic will benefit from outsourcing to avoid the risk of not recouping their sunk cost investments when new production technologies appear. This risk is exacerbated when firms produce for low volume internal use, and is mitigated for those firms which sell to larger markets. Hence, products characterized by higher rates of technological change will be more likely to be produced by mass specialized firms to which other firms outsource production. Using a 1990-2002 panel data set on Spanish firms and an exogenous proxy for technological change, we provide causal evidence that technological change increases the likelihood of outsourcing.

Dick Langlois, at the Organizations and Markets blog, argues that the basic story on the effects of technological change is,

[...] when markets are thin and market-supporting institutions weak, technological change, especially systemic change, leads to increased vertical integration, since in such an environment centralized ownership and control may reduce “dynamic” transaction costs; but when markets are thick and market-supporting institutions well developed, technological change leads to vertical disintegration, since in that environment the benefits of specialization and the division of labor outweigh the (now relatively smaller) transaction costs of contracting.

The division of labour is limited by the extent of the market and if you are producing only for your own firm then the "market" is very limited and if technological change makes sunk costs investments worthless then you pay a heavy price. A firm which specialises in producing the good has a greater market for its output and thus can more easily re coup any sunk investments which reduces the dangers of technological change.