As economists explore the causes of the current worldwide recession, they are expressing a growing recognition that free markets are not always as efficient as many assumed them to be. In particular, they do not appear to be able to properly price systemic risk: the second- and third-order effects of decisions by a number of financial players, each apparently operating rationally, which can combine to cause a complex interrelated financial system to collapse.
The same forces can lead a number of manufacturing companies — each independently making apparently rational decisions to outsource certain segments of their operations — to ravage their industrial commons: the valuable infrastructure of suppliers and skills that underpins them. The supposed savings they expect to generate from such activities are based on costs that often do not properly reflect the damage they are causing.
A related situation where free market prices understate the true cost of a transaction occurs when decisions turn out to be either uninsurable or irreversible. Most decisions to buy or sell a financial asset (e.g. a stock, bond, collateralized debt obligation (CDO), or credit default swap) are made with the implicit assumption that one can either insure against possible losses from such decisions or unwind them (with acceptable penalties) at some later date. But insurers, deluged by an unforeseen surge in claims and possibly faced with similar losses, may not be able to honor their contracts. And even apparently reversible financial decisions may turn out not to be so after all — as when the failure of a major player causes a market suddenly to collapse, as did those for CDOs and others in the fall of 2008.
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Decisions to outsource something to a foreign company rather than do it oneself have these same potential weaknesses if they result in decimating both the internal and the communal skills and capabilities that are key to a company’s ongoing competitiveness. Collectively, they also can undermine the competitiveness of the network of back-up suppliers (their “insurers,” in effect) that were counted on to step in if a major supplier failed to meet its commitments. And the loss of such capabilities is hard to reverse in that they can take a very long time to regenerate and then usually only if other companies participate in the rebuilding process.
A company’s competitive advantage is rooted in things it can do (e.g. design, make, distribute, or market) that its competitors cannot do as well, if at all. As the number of these core capabilities decreases, the company’s competitive vulnerability to those that are able to master the same capabilities goes up. American manufacturing companies’ preoccupation with outsourcing an ever-increasing portion of their operations has had the effect of teaching an armada of hungry potential competitors first how to master, then how to surpass their capabilities. All the while the lower costs they have achieved by outsourcing products and services have deluded them into thinking they are improving their profitability. In actuality, they are simply cashing out their intellectual assets. Again, an ideological belief in the supposed transparency and efficiency of free markets has led them to the brink of disaster.
Robert H. Hayes
Philip Caldwell Professor of Business Administration, emeritus
Harvard Business School
