A firm seeks to achieve its production goals with cost minimizing inputs. In certain cases, purchasing corporate and professional services through vendors, as opposed to insourcing, is the cost-minimizing option. Cited reasons for procurement of services may be gains from specialization, economies of scale, lower available labor costs, etc. It should be noted that cost minimzation does not infer choosing the lowest quality inputs $-$ it is understood that relatively lower quality inputs yield less return for production goals. The firm sets its production goals and finds the cost minimal inputs to reach them; this may result in the firm choosing the highest quality inputs, lowest quality inputs, or a mixture of many differing quality inputs.
Formalize using Cobb-Douglass production function:
$min \quad C = p_1 x_1 + p_2 x_2 + ... + p_n x_n \quad s.t. \quad q = f(x) = x_1^{a_1} x_2^{a_2} ... x_n^{a_n}$
Where $C$ represents total cost of production, $x$ is a vector of inputs, $p$ is a vector of input prices, and $q$ is the production level.
I assume that the firm discussed below is capable of negotiating for service prices. In turn, there are obstacles to negotiating the most favorable contracts for external services, most of which arise from service provider rent-seeking behavior. I give a broad overview of three economic challenges below.
Say that external providers of a service charge a slightly lower price than it would cost a firm to insource the service. How does the firm determine its willingness to pay for the service? If the firm has no information on the cost function of a service provider (how much it costs a provider to supply the service), the firm would be willing to take any price below the cost to insource.
There are very important implications to this asymmetry of information $-$ it creates the possibility of monopoly pricing or price collusion between service providers. Despite the service providers charging a slightly lower price than it would cost to insource, due to specialization and economies of scale, it may cost the service providers far less than the price they quote to the firm. This would afford the service providers excess profits, and working under the assumption that the service providers would only shut down if their marginal cost is greater than their price per service unit, it is certainly not cost minimizing for the firm.
How does the firm find the cost functions of the respective service providers? There may be industry experts that have information on the costs incurred by the service providers or financial data on their operations. For publicly-owned service providers, the Compustat or EDGAR datasets would provide high-level financial data. With the providers' cost information in hand, the firm is now capable of negotiating for cost minimal pricing.
If there are significant barriers to entry into the service's market, negotiation will be made difficult. It may be worthwhile for the firm to share the service provider's cost function with other buyers to coordinate a collective purchasing strategy.
Price discrimination occurs when a service provider charges a firm greater than the equilibrium price, because they know the firm has a higher willingness to pay for the service. In this context, price discrimination is particularly common for large firms with low accountability for expense reduction. To guard against price discrimination, it is important for firms to be aware of service providers' cost functions and to negotiate accordingly.
Moral hazard occurs when a service provider has little incentive to work in the best interest of the firm, after the contract has been signed. Moral hazard is commonly found when it is difficult to estimate the service's effect on the firm's production goals. If the firm is unable to accurately assess the returns from the service, the provider has a lesser incentive to supply its service to the best of its ability. To avoid this, firms must estimate the causal impact of the service on their production goals; potential methods to do this are instrumental variable or difference in differences estimation.
These challenges are only a portion of the potential obstacles to cost minimization in the context of purchasing corporate and professional services. More can be found in Bernheim and Whinston's Microeconomics. I look forward to learning more about this field and finding solutions for barriers to expense reduction.