Production Cost, Transaction Cost, and Outsourcing Strategy: A Game Theoretic Analysis

Abstract

This paper presents a game theoretic analysis of the impact of both production and transaction costs on the single-or-multiple source purchasing decision. Both dyadic interactions involving a buyer and a seller, and triadic interactions involving a buyer and two suppliers, are examined to gain a more precise understanding of how small number interactions might influence transaction cost. We show that transaction cost is maximized when a buyer follows a single source strategy and learning specificity is present. Only if a buyer follows a multiple source strategy that splits the supply contract in such a way as to equalize the effects of learning specificity across the suppliers, will transaction cost be maximized and will a buyer be able to appropriate the efficiency gains achieved by its suppliers. Production and transaction costs interact to influence governance decisions. The equilibrium is such that a single (multiple) source strategy is optimal when efficiency gains due to the economies of scale are large (small), but those due to learning specificity are small (large). When both the effects of economies of scale and learning specificity are large, internalization is the optimal strategy.