Short-term gain, long-term pain? The long-run implications of outsourcing for organisational innovation and productivity

The paper examines the relationship between organisational innovation, the introduction of new internet-based ICTs, de-verticalisation, and the rapid growth in business service outsourcing over the last decade. In order to examine this issue, a model of organisational innovation is developed. In this model, the goal of managers is to identify an organisational design that more effectively integrates all the administrative activities of the firm. As part of the process of innovation, the managers can choose to carry out an administrative activity in-house or to outsource that activity. Key factors influencing this decision are the relative information costs of organising activities internally and the information costs associated with setting up and maintaining interfaces with external suppliers. The framework is examined within the context of a novel model of organisational innovation. Simulations conducted on this model enabled us to consider the short- and long-run impacts of outsourcing on administration overheads and on long-term productivity growth. An interesting finding is that managers of a firm can become locked into a low productivity growth trajectory, associated with the outsourcing of activities, if they are myopic and learn through their own actions. They perceive outsourcing to cut overhead costs in the short-run (as expected), and so engage in further outsourcing thereafter. This is to the detriment of long-run productivity gains (system economies) generated though organisational innovation. This occurs because the potential for organisational innovation is reduced when modular components are outsourced, placing them beyond the control of the firm’s management. The findings accord with the empirical data, and provide a salutary warning to managers and policy-makers about the potential long-term implications of outsourcing