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Better selection or efficient contracting?

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By comparing two service outsourcing processes – competitive bidding and negotiation – this study shows the contingencies under which one outsourcing process dominates another. We study the selection and contracting process in which one client without sufficient in-house capabilities seeks to outsource the service needs to one service vendor selected from two ex-ante identical vendors. We show that competitive bidding yields good selection but contract inefficiency; in contrast, the negotiation process enables outsourcing firms to achieve perfect efficiency but results in poor vendor selection. Hence the outsourcing process involves a fundamental trade-off: one cannot simultaneously maximize the chance of selecting the best vendor and the efficiency of contracting with the selected vendor. We show that competitive bidding dominates the negotiation process in most feasible conditions. However, when vendor selection becomes less risky and more costly, the negotiation process can yield a higher expected payoff for the outsourcer (client) than an optimal competitive bidding process. This study also highlights the implications of payment schemes. We show that in the negotiation process, a performance menu that involves multiple payment schemes enables the client to achieve perfect contract efficiency, whereas in a competitive bidding process, adding an additional payment scheme increases the client's expected payoff by increasing the competition between vendors.

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