We use an economic learning model to examine how knowledge parameters characterizing a sourcing relationship between a vendor and a client interact with production costs and coordination costs to affect the business value of alternative outsourcing strategies. This information is then used to determine a firm's optimal rate of information technology (IT) outsourcing. We find that the optimal outsourcing rate is dependent on the ability of the outsourcing client to acquire production knowledge from its outsourcing vendor and to retain its internal coordination knowledge despite losses of fundamental production skills due to outsourcing. Specifically, when the client is unable to acquire sufficient production knowledge from the external vendor, the client's optimal outsourcing decision is to engage in either one of two extreme strategies--total insourcing or total outsourcing--depending on the rate at which the client's coordination knowledge depreciates. On the other hand, when the client is able to acquire a substantial amount of production knowledge from the external vendor, the firm's optimal decision is to outsource only a portion of its IT services, where the proportion depends on the rate at which the client's coordination knowledge depreciates.
We use a duopoly model of quality--price competition between a software innovator and an imitator to determine the socially optimal software patent policy and to assess the social welfare implications of alternative patent policies. We find that the optimal patent policy is to grant patent protection for the entire life of the innovative software product (i.e., set infinite patent length) and to set the novelty and nonobviousness requirement for attaining a patent (i.e., patent height) and the scope of patent protection (i.e., patent width) such that both the innovator and imitator produce higher-quality products than they would in the free market. This policy not only maximizes social welfare but also makes the innovator, imitator, and consumers better off than in the free market. However, counter to intuition, we find that firms exhibit lower research and development intensity under the socially optimal patent policy than they do under free market competition. While highly stylized, the model offers a useful framework within which researchers and regulators can think about the economic trade-offs among three patent policy parameters (length, height, and width) simultaneously.
In this paper, we present an economic learning model that helps to formalize the complex relationships among an offshoring firm's knowledge levels, production costs, and coordination costs. Specifically, we model a domestic firm's use of a selective offshore strategy (i.e., offshoring only a portion of its information technology activities) to exploit, through IT investments or contractual provisions, the foreign vendor's large, scale-driven repository of production knowledge. We illustrate the conditions under which knowledge transfers during offshoring may reduce a domestic firm's in-house production costs, leading to total cost savings in both the short term and the long term. Alternatively, when knowledge transfers are not sufficiently large, some short-lived offshoring projects may generate substantial cost savings to the domestic firm; however, long-lived offshoring projects may cause a disruption in the knowledge supply chain, resulting in substantial losses in the later stages of the project. A firm that fails to realize the costs associated with such a disruption soon enough in the project life may find itself locked into a disadvantageous offshoring agreement without any recourse. However, a domestic firm may be able to overcome a disruption in its knowledge supply chain by exploiting the learning-by-doing production knowledge generated by the foreign vendor's economies of scale. The managerial implications derived from our learning model may help guide firms as they consider the impacts of offshore contracts and knowledge management investments on firm knowledge, production costs, and coordination costs.
We use an economic model to formalize the complex relationships among IT investments, intermediate performance measures (e.g., product quality and output levels), and economic performance (e.g., productivity, profits, and consumer surplus). We demonstrate that a profit-maximizing monopolist invests in IT (modeled as changes in parametric characteristics of the firm) to design a better-quality product and charge a higher price. While this profit-maximizing adjustment generates more consumer surplus, it also increases production costs in a way that adversely affects productivity. In contrast, a simple model extension shows that when a firm is unwilling or unable to improve product quality, then IT investments result in suboptimal improvements in profits, an increase in consumer surplus, and an increase in productivity. Together, these models highlight the way in which product quality moderates the relationship between IT investments and economic performance. We also demonstrate that these relationships are robust to the socially optimal case in which a social planner chooses price and quality to maximize social welfare. In addition, we demonstrate that the results of the monopoly model hold when considering the design and development of products offered free of charge (e.g., free online content), but that provide indirect benefits to the firm (e.g., more advertising revenues).
This paper develops a series of two-stage duopoly models of quality-price competition and a series of monopoly models of quality-price choice in order to examine the impact of information technology (IT) investments on firm profit, firm productivity, and consumer welfare. We solve the duopoly and monopoly models for four cost functions, where each function makes a different assumption about the form of the marginal cost of production. These models are used to conduct a two-by-four comparison [(monopoly, duopoly) x (four cost functions)] of the impact of IT investments on economic performance. The analysis reveals that together market structure and cost structure play a critical role in determining the form of the relationship between IT investment and economic measures. Specifically, moving from monopoly to duopoly and moving from zero marginal cost to marginal cost as a function of quality increase the number of economic measures for which the directional effects of IT investment are ambiguous, or depend on model parameter values.
For over a decade, empirical studies in the information technology (IT) value literature have examined the impact of technology investments on various measures of performance. However, the results of these studies, especially those examining the contribution of IT to productivity, have been mixed. One reason for these mixed empirical findings may be that these studies have not effectively accounted for the impact of technology investments that increase production efficiency and improve product quality on firm productivity. In particular, it is commonly assumed that such investments should lead to gains in both profits and productivity. However, using a closed-form analytical model we challenge this underlying assumption and demonstrate that investments in certain efficiency-enhancing technologies may be expected to decrease the productivity of profit-maximizing firms. More specifically, we demonstrate that investments in technologies that reduce the firm's fixed overhead costs do not affect the firm's product quality and pricing decisions but do increase profits and improve productivity. In addition, we demonstrate that investments in technologies that reduce the variable costs of designing, developing, and manufacturing a product encourage the firm to improve product quality and to charge a higher price. Although this adjustment helps the firm to capture higher profits, we show that it will also increase total production costs and will, under a range of conditions, decrease firm productivity. Finally, we show that the direction of firm productivity following such investments depends upon the relationship between the fixed costs of the firm and the size of the market.
Advances in genetic testing and data mining technologies have increased the availability of genetic information to insurance companies and insureds (applicants and policy holders) in the individual health insurance market (IHIM). Regulators, concerned that insurance companies will use this information to discriminate against applicants who have a genetic risk factor but who are still healthy, have implemented genetic privacy legislation in at least 18 states. However, in previous work we have demonstrated that such legislation will have unintended consequences--it will reduce consumer participation in the market without making those remaining better off. This paper identifies a mechanism, a pure bundling strategy, that insurance companies may implement in this regulatory environment to restore (or maximize) consumer participation in the market and to discourage such discrimination among insureds. This problem is examined through System Dynamics, a simulation-based modeling technique. The results will have significant implications for policy designs implemented by insurance companies, and for legislation implemented by industry regulators, and therefore, for the insurability of the individuals that rely on this market for health insurance coverage.
This paper addresses the cost imposed on an insurance market when individual applicants possess an information advantage over the insurers; in short, we examine the social cost of private information. When consumers differ significantly in terms of their riskiness, and their insurance companies cannot, or are not permitted to assess these differences, insurance companies will attempt to charge all consumers the same premiums for equivalent coverage; unless mechanisms can be designed to allow consumers to signal accurately and credibly their private assessments of their own riskiness, low-risk consumers will consider that they are being overcharged and many will drop out of the market. These consumers, who wish to buy insurance--albeit at a lower price--but who are not now insured, represent a loss of social welfare. As information asymmetries increase, more consumers determine that they are being overcharged, increasing the loss of social welfare. This paper addresses minimizing the loss of social welfare, or maximizing the extent to which the population is insured, in the presence of extremely different consumer risk profiles by examining plausible pricing and policy designs, in order to assess which design minimizes decreases in consumer participation in the insurance market. While unable to make selections among information regimes, which entail a wide range of complex and subjective social choices, the paper does make clear comparisons of alternative designs within each information regime.
Recent experience suggests that many reengineering efforts fail, and that they fail for reasons unrelated to the technical ability of organizations to implement information systems. Our research suggests that the two principal reasons for failure are functionality risk and political risk: respectively, the organization's inability to understand its uncertain future strategic needs, and its inability to make painful and difficult changes in response to these future strategic needs. Recent research in the organizational change literature suggests that these risks are the result of conflict among the organization's current strategy, its espoused degree of change, the actually accepted and generally smaller degree of change, and the generally larger degree of change that would be in some sense optimal. Moreover, the conflicts among these may be unperceived or undiscussable within the organization, exacerbating the risks. We summarize in a few testable hypotheses our experience with managing the risks of reengineering, and use a small set of representative case studies to examine these hypotheses informally.