Organizations are transforming their relationships with their business partners. For example, instead of playing off dozens or even hundreds of competing suppliers against each other, many firms are finding it more profitable to work closely with only a small number of "partners". While these firms generally increase their amount of outsourcing, by focusing on a small number of partners they create value networks that are often referred to as "value-added-partnerships", "virtual organizations" or "modular corporations". In this work we explore some causes and consequences of this transformation. We apply the economic theory of incomplete contracts to study the optimal number of business partners, with particular attention to the role of information technology. Surprisingly, we find that organizations will often maximize profits by limiting their options and reducing their own bargaining power. This may seem paradoxical in an age of cheap communications costs and aggressive competition. However, unlike earlier studies that focused on coordination costs, we focus on the critical importance of providing incentives for business partners. Our results spring from the need to make it worthwhile for business partners to invest in "non-contractibles" like innovation, responsiveness and information sharing. Such incentives will be stronger when the number of competing partners is small. The findings of the theoretical models appear to be consistent with observations from empirical research which highlight the key role of information technology in enabling this transformation.
Copyright © 1996 by Yannis Bakos and Erik Brynjolfsson