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

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  • Eric T. G. Wang

    (Department of Information Management, School of Management, National Central University, Chung-Li, Taiwan 32054, Republic of China)

  • Terry Barron

    (ISOM Department, College of Business Administration, University of Toledo, Toledo, Ohio 43606)

  • Abraham Seidmann

    (William E. Simon Graduate School of Business Administration, University of Rochester, Rochester, New York 14627)

Abstract

Custom software development projects have special informational attributes that have challenged managers for many years: they are associated with information asymmetries regarding user valuation and developer costs, relationship-specific investments, and a resulting likelihood of positive externalities for the user or the developer from the other party's investment. Furthermore, in a custom project, market prices for software are not helpful in solving either the valuation or the cost problems. In this paper we analyze the unique nature of the software development agreements that can be reached between the user and the developer in such a setting. We compare the value of using internal and external developers, with the goal of better understanding the factors relevant to the outsourcing decision. For internal development, we derive a new mechanism that achieves the first-best system whenever the project has positive expected net value, while achieving ex ante budget balance. In contrast, the optimal mechanism for an external developer will not in general yield the first-best system. This implies that when internal and external developers have identical cost functions, internal development definitely yields the larger net value. More generally, this implies that an external developer must have considerable cost advantages over an internal developer in order to have the larger net value. Numerical results indicate that this difference in net values can be very large, as much as a 100% increase for internal development over external development. This is consistent with the strong bias in favor of internal custom development found in recent empirical studies. We also explain why the efficient levels of investment can be achieved only when there are no externalities, and we show that the presence of positive externalities results in underinvestment. Since using an external developer will typically yield a system that is not first-best, inefficient investments result with or without externalities. We present examples showing that uncertainty about system value is not a significant factor in choosing between internal and external development. However, uncertainty about the development costs is highly significant, with greater uncertainty making outsourcing less attractive.

Suggested Citation

  • Eric T. G. Wang & Terry Barron & Abraham Seidmann, 1997. "Contracting Structures for Custom Software Development: The Impacts of Informational Rents and Uncertainty on Internal Development and Outsourcing," Management Science, INFORMS, vol. 43(12), pages 1726-1744, December.
    • Handle: RePEc:inm:ormnsc:v:43:y:1997:i:12:p:1726-1744
    DOI: 10.1287/mnsc.43.12.1726
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    Citations

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    Cited by:

    1. Ejaz Ghani & William R. Kerr & Christopher Stanton, 2014. "Diasporas and Outsourcing: Evidence from oDesk and India," Management Science, INFORMS, vol. 60(7), pages 1677-1697, July.
    2. Qiu, Larry D., 2006. "A general equilibrium analysis of software development: Implications of copyright protection and contract enforcement," European Economic Review, Elsevier, vol. 50(7), pages 1661-1682, October.
    3. Kursad Asdemir & Nanda Kumar & Varghese S. Jacob, 2012. "Pricing Models for Online Advertising: CPM vs. CPC," Information Systems Research, INFORMS, vol. 23(3-part-1), pages 804-822, September.
    4. Elitzur, Ramy & Gavious, Arieh & Wensley, Anthony K.P., 2012. "Information systems outsourcing projects as a double moral hazard problem," Omega, Elsevier, vol. 40(3), pages 379-389.
    5. Tarun Jain & Jishnu Hazra, 2019. "“On-demand” pricing and capacity management in cloud computing," Journal of Revenue and Pricing Management, Palgrave Macmillan, vol. 18(3), pages 228-246, June.
    6. Chenglong Zhang & Nan Feng & Jianjian Chen & Dahui Li & Minqiang Li, 0. "Outsourcing Strategies for Information Security: Correlated Losses and Security Externalities," Information Systems Frontiers, Springer, vol. 0, pages 1-18.
    7. Dekker, Henri C., 2008. "Partner selection and governance design in interfirm relationships," Accounting, Organizations and Society, Elsevier, vol. 33(7-8), pages 915-941.
    8. Yuanyuan Chen & Anandhi Bharadwaj, 2009. "An Empirical Analysis of Contract Structures in IT Outsourcing," Information Systems Research, INFORMS, vol. 20(4), pages 484-506, December.
    9. Subrata Chakrabarty, 2009. "A Conceptual Model for Bidirectional Service, Information and Product Quality in an IS Outsourcing Collaboration Environment," Papers 0902.0188, arXiv.org.
    10. Shannon W. Anderson & Henri C. Dekker, 2005. "Management Control for Market Transactions: The Relation Between Transaction Characteristics, Incomplete Contract Design, and Subsequent Performance," Management Science, INFORMS, vol. 51(12), pages 1734-1752, December.
    11. Pun, Hubert & Sebastian Heese, H., 2014. "Outsourcing to suppliers with unknown capabilities," European Journal of Operational Research, Elsevier, vol. 234(1), pages 108-118.
    12. Nigel Wadeson, 1999. "Two-way Communication Costs and the Boundaries of the Firm," International Journal of the Economics of Business, Taylor & Francis Journals, vol. 6(3), pages 301-329.
    13. Debabrata Dey & Ming Fan & Conglei Zhang, 2010. "Design and Analysis of Contracts for Software Outsourcing," Information Systems Research, INFORMS, vol. 21(1), pages 93-114, March.
    14. Chul Ho Lee & Xianjun Geng & Srinivasan Raghunathan, 2013. "Contracting Information Security in the Presence of Double Moral Hazard," Information Systems Research, INFORMS, vol. 24(2), pages 295-311, June.
    15. Seung Hyun Kim & Tridas Mukhopadhyay, 2011. "Determining Optimal CRM Implementation Strategies," Information Systems Research, INFORMS, vol. 22(3), pages 624-639, September.
    16. Chenglong Zhang & Nan Feng & Jianjian Chen & Dahui Li & Minqiang Li, 2021. "Outsourcing Strategies for Information Security: Correlated Losses and Security Externalities," Information Systems Frontiers, Springer, vol. 23(3), pages 773-790, June.

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