Contracting Out, Or Boeing Bites Itself on the Butt

Boeing is having a great deal of difficulty in constructing its new airplane. These problems remind me of the work of Ronald Coase.

In 1991, Coase won the misnamed Nobel Prize for economics, largely on the basis of two articles. In one of these, Coase explored the nature of the firm, “distinguishing mark” of which is the “the suppression of the price mechanism.”

Coase, Ronald. 1937. “The Nature of the Firm.” Economica, 4: 386-405, p. 389.

To some, at first glance, such words might suggest a radical Marxist ideology — “suppressing the price system”. In fact, Coase saw something that earlier economists had overlooked. Business transactions between firms are based on prices, but, within a business orders and procedures generally determine how things are done, not prices.

At the same time, a business can theoretically contract out virtually everything it does. A major corporation could consist of a telephone, an Internet connection, and a bank account. It could rent its office and make contracts with employees on a daily basis. It could pay other companies to produce and market its goods.

No major company has ever gone that far because of the difficulty of specifying everything it needed in contracts. Yet, in the new age of neoliberal worship of markets some corporations have actually made great strides toward creating a totally market-driven business. A few corporations have even taken to using prices within the firm in an effort to make each division accountable.

Subcontracting can have different kinds of motives. Some firms may subcontract because another firm is more efficient in performing a task. Of course, subcontracting with sweatshops in low-wage countries has become all too common. Others may do so in order to avoid responsibility, such as an otherwise “reputable” corporation that subcontracts out janitorial work to a company that pays minimum (or even subminimum) wages.  In this way, the company can still present itself as an upstanding “citizen” — never having a clue about the fate of its janitors. Other unionized firms may openly subcontract just to avoid paying union wages.

Now back to Boeing. For years, Boeing has increasingly subcontracted out work. In part, the objective was to provide jobs in countries that purchased its planes, but avoiding unionized labor was a major motive for much of the subcontracting.

Now, the subcontracting is coming back to bite Boeing. The specifications for airplane parts leave little tolerance for error, yet the quality of some of the work was substandard or late. So now Boeing is forced to purchase some of the subcontractors instead of their products.

Sanders, Peter. 2009. “Boeing Sets Deal to Buy a Dreamliner Plant: Company to Pay Vought Aircraft $580 Million, Forgive Cash Advances for Work on 787.” Wall Street Journal (8 July).
http://online.wsj.com/article/SB124696971307105465.html#mod=todays_us_marketplace

“Boeing Co. agreed to acquire manufacturing operations from one of its key suppliers [Controlled by the Carlyle Group] on the delayed 787 Dreamliner aircraft at a cost of $1 billion. The purchase of a plant in North Charleston, S.C., from Vought Aircraft Industries would mark the second time Boeing has taken over a key part of the Dreamliner’s supply chain.”

Now back to Coase. His idea was that firms chose to avoid the price system, at least in part, because of the difficulty of framing requirements in terms of a formal contract. Perhaps, the management of Boeing might consider reading Coase.

One other part of Coase’ analysis was the idea transactions costs — the time and expense of working out deals or specifying the requirements of purchased products or services. Contracts are terribly difficult to write in a way that they spell out all contingencies in advance. Economists refer to this as the principal-agent problem.

One other problem with contracting out: sometimes such arrangements require more than a contract. Parties may shut down or build new factories depending upon which side of the contract they sign. Should economic conditions change, readjustment can be costly. Workers must relocate or remain unemployed [which explains why there is an association between home ownership and unemployment]. Companies may be left with the challenge of restarting production or with finding alternative uses for empty factories.

For example, when oil prices spiked, some companies found that increasing transportation costs wiped out the expected savings from contracting out production in far-off lands. For this reason, some the business press is suggesting that Mexican maquiladoras are now becoming more attractive than Chinese sweatshops.

5 comments so far

  1. […] More: Contracting Out, Or Boeing Bites Itself on the Butt […]

  2. […] Contracting Out, Or Boeing Bites Itself on the Butt « unsettling … By mperelman The purchase of a plant in North Charleston, S.C., from Vought Aircraft Industries would mark the second time Boeing has taken over a key part of the Dreamliner's supply chain.” Now back to Coase. His idea was that firms chose to avoid … unsettling economics – https://michaelperelman.wordpress.com/ […]

  3. David on

    On this line I’ve heard market advocates say that when firms become too big and unwieldy they are substituted by smaller, more agile firms. Of course this is rarely seen in practice, in particular when the task to be accomplished by the firm is of very high complexity. For instance it would be practically impossible to do what Intel does with anything significantly smaller than Intel, and the tasks require a level of integration that make it impractical to split the operation very much.

  4. […] Contracting Out, Or Boeing Bites Itself on the Butt « unsettling economics […]

  5. Laurent GUERBY on

    David, Intel does subcontract, eg with TSMC:

    http://www.anandtech.com/cpuchipsets/showdoc.aspx?i=3522

    In the silicon industry there are many “fabless” players. Now of course latest silicon tech fabs are costing billions, but the trend seem to mutualize them.


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