Nobel Prize Winners Provide Insight on Outsourcing, Contract Work

The Nobel Prize in economics seldom has practical applications for workforce management. Yet this year’s prize, awarded in October to Oliver Williamson and Elinor Ostrom, recognizes research that provides insights into such workforce issues as employee contracts, bonuses and outsourcing.

Williamson, a professor at the Haas School of Business at the University of California, Berkeley, and Ostrom, an economist at Indiana University, were praised for studying the way economic decisions are made outside markets.

Ostrom, the first woman to win the prize, focused on how natural resources are shared, and ultimately better managed, among various groups rather than by a central government or through complete privatization.

Williamson’s research shows that companies, not markets, are sometimes better equipped to handle business transactions that are tailored to a company’s needs.

While that may appear obvious, Williamson’s research showed how, why and when that is so, particularly when employers look to contract for services outside the firm.

“A very important part of Oliver Williamson’s contributions [was] precisely about how to think about the cost and benefits of outsourcing and contracting decisions,” says Steven Tadelis, a professor at the Haas School of Business.

Williamson illustrated that a special economic and legal relationship exists between employers and employees, and it can be lost when a company outsources its work.

While many management professionals intuitively understand that employees can’t be easily replaced by contract workers, most economists viewed work as a financial transaction, not as a “system embedded in law and authority,” says Witold Henisz, a professor of management at the University of Pennsylvania’s Wharton School.

“There is a range of discretion you have as a manager that you don’t have over an external consultant,” says Henisz, who was a student of Williamson’s.

It’s particularly important with highly specialized tasks that require a dedicated investment of skill and money, which often can be more effectively completed internally than by buying those services in the market, says David R. Henderson, a research fellow at the Hoover Institution and an economics professor at the Naval Postgraduate School in Monterey, California.

Williamson’s research helps explain why companies that have outsourced complex, unique business processes have run into cost overruns that lead them to bring the functions back in-house.

Firms have little bargaining power to get outsourcing partners to make changes without having to pay more.

A recent example is Boeing’s costly, overdue production of its 787 Dreamliner, much of which had been outsourced.

Boeing recently decided it needed more control over the complex production process. It canceled contracts and acquired some of the companies that were making the jet’s parts.

“I need to be very sure I can specify what I need in advance and wouldn’t have to ask for changes later” to make outsourcing contracts cost-effective, Tadelis says.

A contract employee is like an outsourcing company, and the same thinking can be applied to how companies use bonuses and other incentives, Tadelis adds.

Like contracts, firms should negotiate bonuses based on the complexity of the work.

For example, a company could pay a worker a bonus for simply completing a complex project. For projects that are much simpler, firms could pay bonuses based on getting the job done within a certain amount of time and under a certain cost.

“The type of incentive depends on the complexity of the work,” Tadelis says.

Williamson’s work has many applications beyond economics, Tadelis says.

“Fortunately this Nobel Prize will spur a lot more interest in it.”

—Jeremy Smerd

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