Contracting Structures for Custom Software Development : The Impacts of Efficient Investments and Imperfect Knowledge on Internal Development and Outsourcing

Custom software development projects have special information attributes that have challenged managers for many years; they are associated with information asymmetries regarding user valuation and developer costs, relationship- specific investments, and a resulting likelihood of externalities for the user or the developer from the other party's investment. Furthermore, in the custom project, market prices for software are not helpful in solving either the valuation or the cost problems. In this paper we analyze the unique nature of the software development agreements that can be reached between the user and the developer, with the goal of better understanding the factors relevant to the outsourcing decision. For internal development, we identify a new mechanism that achieves the first-best system whenever the project has positive expected net value, while achieving ex ante budget balance. In contrast, the optimal mechanism for an outsourcer will not in general yield the first-best system, so that when an internal developer and outsourcer have the same cost functions, internal development definitely yields larger net value. Numerical experiments indicate that this difference in net values can be very large, as much as an 100% increase of internal development over outsourcing. We also explain why the efficient levels of investment can be achieved only when there are no externalities, and show that the presence of externalities results in underinvestment. Since using an external developer will typically yield a system that is not first-best, inefficient investments result with or without externalties. Numerical experiments indicate that uncertainty about system value is not a significant factor in choosing between internal development and outsourcing. However, uncertainty about the developers costs is highly significant, with greater uncertainty making outsourcing less attractive