Facilitating Specialized Investments
Sometimes firms have to invest in specialized assets in order to do business with another enterprise.26 A specialized asset is one whose value is contingent upon a particular relationship persisting. For example, imagine Ford of Europe has developed a new, high-performance, high-quality, and uniquely designed fuel injection system. The increased fuel efficiency will help sell Ford cars. Ford must decide whether to make the system in-house or to contract out the manufacturing to an independent supplier. Manufacturing these uniquely designed systems requires investments in equipment that can be used only for this purpose; it cannot be used to make fuel injection systems for any other automaker. Thus, investment in this equipment constitutes an investment in specialized assets. When, as in this situation, one firm must invest in specialized assets to supply another, mutual dependency is created. In such circumstances, each party might fear the other will abuse the relationship by seeking more favorable terms.
An asset designed to perform a specific task, whose value is significantly reduced in its next-best use.
ANOTHER PERSPECTIVE Made in America: Trend Against Outsourcing Brings Jobs Back from China
The United States may be on the verge of bringing back manufacturing jobs from China. Outsourcing manufacturing to China is not as cheap as it used to be. Many companies, especially in the auto and furniture industries, moved plants overseas once China opened its doors to free trade and foreign investment in the last few decades. Labor was cheaper for American companies—less than $1 per hour according to the BCG report. Today, labor costs in China have risen dramatically, and shipping and fuel costs have skyrocketed. As China’s economy has expanded, and China has built new factories all across the country, the demand for workers has risen. As a result, wages are up as new companies compete to hire the best workers. Experts note the fears that United States manufacturing is in decline are overstated and that the United States is still a manufacturing giant. In 2010, China provided 19.8 percent of global manufacturing value added. The U.S. accounted for a marginally less 19.4 percent, which, according to Boston Consulting, was “a share that has declined only slightly over the past three decades.”
To appreciate this, let us first examine this situation from the perspective of an independent supplier who has been asked by Ford to make this investment. The supplier might reason that once it has made the investment, it will become dependent on Ford for business because Ford is the only possible customer for the output of this equipment. The supplier perceives this as putting Ford in a strong bargaining position and worries that once the specialized investment has been made, Ford might use this to squeeze down prices for the systems. Given this risk, the supplier declines to make the investment in specialized equipment.
Now take the position of Ford. Ford might reason that if it contracts out production of these systems to an independent supplier, it might become too dependent on that supplier for a vital input. Because specialized equipment is required to produce the fuel injection systems, Ford cannot easily switch its orders to other suppliers who lack that equipment. (It would face high switching costs.) Ford perceives this as increasing the bargaining power of the supplier and worries that the supplier might use its bargaining strength to demand higher prices.
Thus, the mutual dependency that outsourcing would create makes Ford nervous and scares away potential suppliers. The problem here is lack of trust. Neither party completely trusts the other to play fair. Consequently, Ford might reason that the only safe way to get the new fuel injection systems is to manufacture them itself. It may be unable to persuade any independent supplier to manufacture them. Thus, Ford decides to make rather than buy.
In general, we can predict that when substantial investments in specialized assets are required to manufacture a component, the firm will prefer to make the component internally rather than contract it out to a supplier. Substantial empirical evidence supports this prediction.