Subcontracting and Economic - Indian Institute of Public Administration

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The Advantages of Subcontracting Flexibility Relating to the Demand Uncertainty and Business Strategy Today, many industries may face demand uncertainty due to cyclical and seasonal fluctuation. In such situations, a large firm may use outsourcing to expand its capacity without increasing its permanent and regular employment level and infrastructure. Here farming out is preferred to in-house activity, since in-house production increases the permanent costs even during recession. The small peripheral firms are used as the buffer stock. In most cases, the relationships between the parent firm and the ancillaries are not equal. So the parent firm can easily transfer the burden of the market fluctuation to its peripheral firms by delaying payment or by refusing to take delivery of the goods or by postponing inspection of the material. Moreover, the workers of the unorganised sector are less unionised and have lower bargaining power compared to the large firms’ workforce. So during the recession period, it is easier to lay them off rather than the permanent employees of the nuclear firm. This type of subcontracting is used in the Indian garment and electrical industries. Transaction Cost According to Coase and Williamson, one important concern of the firm is to design the production process in such a way that transaction cost is minimised. The transaction cost is the cost relating to the transactional environment, which includes relation-specific assets and cost due to poor labour relations, etc. There are also other types of transaction costs. If the transaction cost related to inhouse production is very high, then subcontracting can act as a device to reduce the high transaction costs (Kimura, 2001). Usually infant industries, facing high contracting costs, prefer the vertically integrated production process, but once the industry matures and the products are standardised, the firm would like the outsourcing relation. Long Ter erm Relation on the Basis of Game Theory Approach The subcontracting relationship can be explained by using the game theoretic approach. It can be shown that a longterm co-operative relation between a principal firm and subcontractors can be developed on the basis of the repeated game theory and reputation facet. So a successful farming-out relation can be formed if there is repeated interaction between principal firms and peripheral units in the long run (Kimura, 2001). Information Approach The theoretical foundation of the outsourcing relation can also be found in the economics of information approach. This approach is based on the contract theory, particularly the principal-agent model in which long-term relationships work for fostering efficient risk sharing arrangements under incomplete information (Kimura, 2001). The information approach describes the logic of saving monitoring costs, which partially explains why subcontracting is chosen instead of purchasing in the spot market. Network Approach The network approach advocates that the subcontracting relation is an intermediate organisation in which the market principal coexists. Under a particular economic environment, an outsourcing relationship with an efficient combination of competition and co-ordination is formed (Kimura, 2001). The network approach suggests that subcontracting, rather than vertical integration, is chosen when upstream production requires specialised technology or uses a particular productive factor such as specialised machines or unskilled labour in the secondary labour market. 7
Subcontracting And Economic Reforms In India With Special Reference To Agro-based Industries In India State Policy Sometimes different government policies encourage subcontracting relationships. In the case of the Indian economy, an outsourcing relationship can take full advantage of the dual state policies. There are two types of policies affecting the development of the farming-out relationship. One of them is the positive measure of promoting small-scale industries through product reservations, concessional credit for fixed and working capital and fiscal incentives. A large number of products are reserved exclusively for smallscale producers and large business units are not allowed to enter into those product lines. The small-scale sector is not subject to capacity licensing. Exemption from payment of excise tax has been the most attractive fiscal incentive for small firms. The value of this incentive scheme is found to be very high, as rates of duty vary from 15 percent to 105 percent. The second strategy is the protective measure to restrict the growth of large business units. The MRTP Act (Monopolies and Restrictive Trade Practices Act), and FERA (Foreign Exchange Regulation Act) put restrictions on the expansion of large firms. The second policy forces the large firms with frozen capacities to outsource additional output. The first policy facilitates outsourcing by creating a small-scale sector capable of producing numerous intermediate and final products with simple technology. Small firms usually obtain the technology from their customer firms and equipment suppliers. So a subcontracting relationship gives them an opportunity to acquire technical skills and managerial capabilities (Ramaswamy, 1999). 8
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Page 6 and 7: 2 What is Subcontracting? Subcontra
Page 8 and 9: Different Forms of Subcontracting a
Page 12 and 13: 5 The Disadvantages of a Subcontrac
Page 14 and 15: The Disadvantages of a Subcontracti
Page 16 and 17: Agro-Based Industries in India and
Page 18 and 19: A Theoretical Model of Subcontracti
Page 20 and 21: 8 Formulation of a Contract Law for
Page 22 and 23: 10 Alternative Remedy Measures Expe
Page 24 and 25: Damages in Case of Subcontracting o
Page 26 and 27: References Banerjee, N. 1988. ‘Sm

Subcontracting and Economic - Indian Institute of Public Administration

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