The role of cash on the outsourcing decision

This paper investigates the effect of cash on a firm’s choice between vertical integration and outsourcing. We model the production decision in a Principal-Agent framework, and show that what motivates the choice of outsourcing are the firms’ cost differentials in effort and the benefit provided by the supplier’s effort alone. This latter benefit is linked with greater probabilities of reaching high production values in good states of nature. Suppliers use cash as a strategic instrument to collect the surplus from outsourcing, and their wealth constraint or limited liability ensures them more attractive compensation schemes.N/