Wednesday, July 8, 2009

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).
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.


Ken Houghton said...

"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."

Take a close look at GE.

Eleanor said...

This is interesting. Years ago a friend with relatives in the garment industry told me that high end clothing was union made -- it was then -- because the New York designers wanted to work with shops close by that they could visit and personally control the quality.

Eleanor said...

But more interesting is -- the market does not work inside companies, but there may be offsetting advantages. I have been making lists of places the market does not work/is not used. It's obviously far more important in capitalism than in previous societies, but there are still huge areas where it does not work -- and where if it worked, society would probably fall apart.

juan said...


right, by internalizing trade, transnational firms transform trade into transfer, a negation of trade even though this is not indicated by nation-centered accounting practices. probably a third of world trade is not-trade.

boeing's problems may have less to do with 'lean mean global assembly lines' and subcontractors than an underestimation of design and engineering complexity. See

paul said...

70 years after Coase, economists still almost uniformly act as if the information and other costs associated with almost all transactions were zero. Then you get ad hoc stuff like attempts to understand the "irrationality" of economic actors.

Myrtle Blackwood said...

"Boeing Co. agreed to acquire manufacturing operations from one of its key suppliers [Controlled by the Carlyle Group] "

The Carlyle Group eh? It's Washington DC based. The world's biggest private equity group. (1,300 investors in 71 countries). Founded by David Rubenstein (former policy advisor to Jimmy Carter and 'legalised bribery' corporate lobbyist) and stephel L Norris (a a former tax whiz for Marriott...Rubenstein was the one with the connections).

Carlyle is a business allegedly founded on a tax scheme in 1987 "that has grown up to be what its own marketing literature once called "a vast interlocking global network.""

Apart from Carlyle benefitting from the loss of a billion dollars worth of tax revenuw to the Government, US State pension funds pour money into Carlyle and the corporations benefits hugely from huge amounts of public money fed into the military industrial complex.

George Bush Sr is a senior adviser to this corporation (he gets min. $80,000 for each speech he makes on behalf of Carlyle). Bush Jr also has significant links. Carlyle's board of directors is "stocked with high level Republican policy makers" (many of whom would probably sit on the boards of dozens of other major transnational corporations). Carlyles "cast of characters includes some of the most famous and powerful men in the world. "

Carlyle has deep connections to the Saudi royal family. (Carlyle has a major stake in a company that trains and manages the Saudi National Guard and the Saudi air force).

"the scandal here is not what's illegal but what's legal."