Banking on the Theory of the Firm.

The other day, the undercover economist Tim Harford passed along Michael Munger’s lucid essay on the theory of the firm.

Then one day, in one firm, one manager, perhaps on a whim, outsources the computer services or janitorial services or the legal advice. Not to India or Ireland but simply to another company across town or across country. The boss signs a contract, after taking bids from several companies that provide similar services. These companies are forced by the scolding winds of market competition to provide excellent service at low cost. By looking at the different prices in the bids offered in this competition, the boss learns something. He learns how much the service costs to provide. And he learns how much money he saves by laying off the employees who used to provide the service in-house.

It’s hard to fire employees, particularly since most employees are smart enough to work hard enough to get acceptable performance reviews. The boss also has a hard time motivating the in-house staff, because watching each employee is expensive and tiresome. But it’s easy to fire contracted employees, because you just sign a new contract with a competitor. Why not let the market system do your motivation work? Let’s suppose that our outsourcing boss sees the company’s profits rise dramatically, and the stock price goes up 18% in six months. Life is good, for the boss.

Munger continues on to explain his thoughts on why too-little outsourcing will burden a firm with detrimental production costs and why too-much outsourcing will burden a firm with transactional costs that surpass cost savings from market pricing. In the Banking industry, any process that we outsource to an external service provider must fit into the firm’s operational risk framework because of the strict data privacy regulations that our firms face. An oversight by the risk management department’s auditing of the service provider, poses regulatory, legal, and reputation risks for the firm. This risk can be mitigated by paying a premium for service providers that are known for handling sensitive data and have a favorable working relationship with other risk management departments. But, it’s ultimately up to the firm’s policy makers to decide how much of that risk they are willing to take.

.info: economist