Contracting Structures for Custom Software Development: The Impacts of Informational Rents and Uncer

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Contracting Structures for Custom Software
Development The Impacts of Informational Rents
and Uncertainty on Internal Development and
Outsourcing

• Eric T. G. Wang, Terry Barron, Abraham Seidmann
• Management Science / Vol. 43, No. 12, December
  1997

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outline

• abstract
• the model
• internal bargaining
• investment

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abstract

• custom software development projects
• information asymmetries
• user valuation and developer costs
• relationship-specific investments
• positive externalities for the user or the
  developer from the other partys investment

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• market prices for software are not helpful in
  solving either the valuation or the cost problems
• analyze the unique nature of the software
  development agreements that can be reached
  between the user and the developer

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• compare the value of using internal and external
  developers
• understanding the factors relevant to the
  outsourcing decision

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• when internal and external developers have
  identical cost functions
• internal development definitely yields the larger
  net value

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• the model is similar to the two-stage contracting
• emphasis on software development bargaining
  outcomes under
• informational asymmetries
• relation-specific investments
• investment externalities

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the model
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• events and timing

systems value is affected by a user investment ß
developer investment ? user private information q
feasible system specification
switch cost
relationship-specific investment requirements
analysis focus on a and ß are not contractible
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• at bargaining stage
• user gt value
• developer gt cost
• assume ? and ? are not correlated
• ?(?) will not change after learning ?(?)
• assume that there is only one potential outsourcer

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• central management
• internal develop
• budget balancer
• external develop
• has all bargaining power
• welfare weight

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• users investment will increase the systems
  value at a diminishing rate
• creates positive investment externalities and
  also increases the systems value
• developers investment will increase the systems
  value at a diminishing rate
• creates positive investment externalities and
  also decreases the systems cost

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internal bargaining

• a and ß has been made
• two-sided incomplete information
• user (developer) knows realized ?(?) but not
  realized ?(?)
• optimal truth-revelation machanism
• central management
• maximize V(q, ?) - C(q, ?)
• expect not to incur a budget deficit

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• let

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• the first-best software specification is

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• users expected payoff
• developers expected payoff

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• central managements problem is to set the
  software specifications, the users charges, and
  the developers payment
• maximize the systems net value

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• characterizes the set of incentive-compatible and
  individually rational mechanisms

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• compensate for the costs of investments so that
  the user and the developer are willing to
  participate at the beginning of the project

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• in order to induce the user and developer to
  reveal their private information
• some premium over expected cost is paid to the
  developer
• if the expected system net value is large enough
  to cover both the users and the developers
  informational rents
• central management can expect not to incur a
  budget deficit

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• the central management can expect to at least
  balance the budget while at the same time
  inducing truth revelation and achieving
  bargaining efficiency

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investment

• first consider the case where the specific
  investments create no externalities
• Vß0 and Ca0
• the efficient investments are

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• first-order conditions

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• theorem 2
• Given the efficient mechanism in period 2
  (development), the ex ante investments are also
  efficient regardless of whether the investments
  are contractible, provided that the investments
  create no externalities.

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• central managements beliefs are set at
• user can predict the resulting specification of
  the new system
• user knows her own optimal reporting strategy
  perfectly, she can predict the exact
  specification as a function of ?

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• at the outset, central management displays a
  mechanism (or a contract)
• instructs the user and the developer to make
  investments equal to a and ß

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• result shows that under-investment will not arise
  when the investments generate no positive
  externalities
• if the investments do generate positive
  externalities, under-investment occurs

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external bargaining

• users problem in period 2 for a realized ? can
  be formulated without loss of generality as

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• incentive compatible and individually rational
  payment

extra cost that the user has to pay the developer
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• optimal system specification for outsourcing

informational rent required for inducing
truth-revelation
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investment

• user offer a contract based on
• realized ?
• investment a
• beliefs developers investment
• letting denote the users optimal
  system specification given

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• with the developers beliefs about users
  investment fixed at
• developers optimal investment
• first condition

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• given beliefs about the developers investment
  
• users optimal investment
• first condition

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• equilibrium

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• if the value and cost of developing the system
  are the same for internal and outsourcing
• how the cost is evaluated
• internal
• no real resources have been transferred out
• outsourcing
• outsourcers profit margin
• real dollars that the organization has to pay

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numerical example

• k 1, s 2, t 1, t0 1

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Figure 3
Figure 5
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Figure 4
Figure 6
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managerial and research implication

• an internal developer can be expected to have a
  substantial advantage over an outsourcer
• rational firm will behave in just this way
• 186 projects from 5 firms
• 64 custom / insource
• 17 custom / outsource
• 11 package / insource
• 8 package / outsourced