Walden, Eric A., "Intellectual Property Rights And Cannibalization In Information Technology Outsourcing Contracts, MIS Quarterly,
Vol. 29, No. 4, December 2005, pp. 699-720.
Walden/Intellectual Property Rights
RESEARCH ARTICLE
INTELLECTUAL PROPERTY RIGHTS AND
CANNIBALIZATION IN INFORMATION
TECHNOLOGY OUTSOURCING
CONTRACTS1
By: Eric A. Walden
Information Sciences and Quantitative
Sciences
Jerry Rawls College of Business
Administration
Texas Tech University
Box 42101
Lubbock, TX 79409
U.S.A.
ewalden@ba.ttu.edu
is determined. This model is then modified to
account for the possibility of cannibalization of the
client’s benefit when multiple others are allowed
use of the software. The results show that the
best contractual structure depends strongly on the
environment.
Keywords: Contracts, outsourcing, economic
models, interorganizational relationships
Introduction
Abstract
This paper examines the question of how intellectual property rights in the software created during
information technology outsourcing relationships
should be divided. This paper expands on the
property rights approach developed by Grossman,
Hart, and Moore by recognizing that, with respect
to software, it is possible to separate excludability
rights from usability rights. These rights are
modeled and the contractually optimal distribution
1
V. Sambamurthy was the accepting senior editor for this
paper. Sandra Slaughter was the associate editor.
Natalia Levina served as a reviewer. The other
reviewers chose to remain anonymous.
Outsourcing is one of the most important issues in
information technology today. It has evolved from
a sporadic business practice into one that is
reshaping our entire global economy. Economic
approaches to understanding outsourcing have
focused largely on ownership of physical property
(Bakos and Nault 1997; Brynjolfsson 1994;
Grossman and Hart 1986; Hart and Moore 1988).
However, software is not physical property but
rather intellectual property, and as such it is not
constrained by the same physical or legal rules as
physical property. Thus, as software becomes an
ever-increasing proportion of information technology, it is necessary to update IT outsourcing
theory to consider the different types of ownership
that software allows.
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Walden/Intellectual Property Rights
Software creation is an inevitable outcome of
many IT outsourcing relationships. This is trivially
true for software sourcing deals, but it is also true
for other outsourcing relationships, such as facilities management, integration, or implementation.
In the normal course of maintaining an information
system, old code is replaced with more efficient
code, filters and adaptors are written to connect
different systems, and new functionality is introduced to solve business problems. The scope of
this paper is the intellectual property rights associated with all of the various software created
during the relationship.
The property rights literature (Hart and Moore
1990; Maskin and Tirole 1999a) provides a starting
point for building a theory of software as intellectual property. However, software does not follow
the same physical laws as does the physical
property that has been previously studied. In particular, the use of software by one entity does not
physically preclude the use of that same software
by other entities. Therefore, to understand how to
assign intellectual property rights in software
created during an outsourcing relationship, it is
necessary to modify property rights theory, in order
to create intellectual property rights theory.
This work undertakes that task. First, it recognizes
that software gives way to ownership structures
which are fundamentally different than those of
physical property. Second, the intellectual property rights in software in an outsourcing relationship are modeled. Third, implications for the
optimal distribution of software intellectual property
rights in a variety of different possible environments are elucidated, including the consequences
of cannibalization.
This paper makes several important contributions.
Most importantly, it creates a theoretical basis for
the future study of intellectual property in IT. This
grants both practitioners and researchers a
starting point for the formulation of intellectual
property issues, rather than forcing them to rely on
physical property theory as a basis for a nonphysical thing. This work also provides some
ready-made solutions for empirical testing by
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MIS Quarterly Vol. 29 No. 4/December 2005
academics and the formulation of intellectual
property contracts by practitioners.
This paper follows Whang (1992) in observing
real-world contracts to inform my theory building.
Three contracts were procured from a private
source in order to serve as a guide for the
development of a realistic model. This work finds,
as did Whang, that, “while this is a small set of
cases, there is a substantial amount of commonality among these contracts and they merit
consideration, even if they are not comprehensive”
(1992, p. 309).
Specifically, the contracts
assigned two different property rights: the right to
use and the right to exclude others from using. In
the traditional property rights literature, these two
rights are inexorably joined because if one entity
uses a particular physical asset, others are automatically excluded from using that same asset.
However, with respect to software, these two rights
can be (and apparently are) separated and
assigned independently.
Managers must decide how to allocate property
rights between the parties to the contract.
Software is nonphysical and, thus, the range of
possible allocations is not bounded by the same
constraints that bound the ownership of physical
property. This paper shows that the optimal allocation of intellectual property rights depends on
three things: the ability of each firm to enhance
the internal usefulness of the intellectual property,
the ability of each firm to enhance the external
marketability of the intellectual property, and the
loss of competitive advantage arising from widescale distribution of the intellectual property.
The rest of the paper proceeds as follows. In the
next section, the literature on contracting for IT
and the property rights literature are reviewed.
Next, the property rights literature is extended to
account for intellectual property’s ability to separate usability and excludability rights. Following
that, propositions explaining some of the circumstances under which each of the intellectual
property right allocations are optimal are
developed. Finally, a discussion of the contribution, limitations, and directions for future research
is presented.
Walden/Intellectual Property Rights
Literature Review
To understand how intellectual property rights are
managed in IT outsourcing, it is necessary to
establish some definitions. In outsourcing, two
firms engage in a relationship. The relationship is
the set of all possible situations and actions the
two firms can face. The firms draft a contract to
define the parameters of the relationship. A contract is made up of sections, which address a specific aspect of the relationship (transfer of employees, for example). Each of the sections can
be thought of as being complete or incomplete.
A complete contract specifies all the actions that
each party would take in response to every
possible state of the world. This is an idealized
concept of a contract, but in reality it may have
value only where most of the important states of
the world, and important actions, can be specified.
However, in a long-term pervasive relationship,
such as that addressed in the contracts of this
study, completeness is an unrealistic goal.
Incomplete contracts are contracts that focus on
offering alternative ways to deal with aspects of
the relationship that are not easily addressable by
simply specifying all possible contingencies. For
example, an incomplete contract may specify
meetings (Ang and Beath 1993; Stinchcombe
1985) or ownership (Bakos and Brynjolfsson
1993a; Grossman and Hart 1986) to deal with
situations where appropriate actions cannot be
specified ex ante. While there is explicit recognition that no contracts are, in reality, complete,
there is lively debate on the extent to which
complete contract theory offers valuable insights
(see Hart and Moore 1999; Maskin and Tirole
1999a; Tirole 1999). In practice, actual contracts
contain both complete and incomplete sections.
Ownership is an alternative mechanism put into a
contract to help address the incompleteness of the
contract, with respect to some aspect of the relationship. This work follows the Grossman–Hart–
Moore definition of ownership: “all the rights
except those specifically mentioned in the contract” (Grossman and Hart 1986, p. 692). This is
an important point. Neither Grossman–Hart–
Moore nor this work claim that there are not parts
of the contract that are complete. Rather, Grossman, Hart, and Moore assert that, after all the
cost-effective clauses are written into a contract,
there are still important aspects of the relationship
that have not been defined. Thus, the contract
grants ownership of an asset to allow the
remaining states of the world and corresponding
actions concerning that asset to become the
responsibility of one of the parties.
The question immediately arises as to why contracting parties would cover some contingencies
directly, but leave others to be handled by alternative mechanisms, particularly when the alternative
mechanisms frequently result in a less-than- optimal solution. One reason is the cost of writing a
contract. Simply stated, if the expected cost of
writing a contract clause exceeds its value, then
the clause should be omitted (Battigalli and Maggi
2000). Another frequently cited reason is the
bounded rationality of the contract writers (Williamson 1985). Segal (1999) offers a rigorous model
of this situation, in which increasing the complexity
of the environment leads to a preference for incomplete contracts. Others simply cite the fact
that real-world contracts are never observed to be
fully contingent (Masten 2000). The important
point is that there is ample theoretical and empirical evidence to support the claim that contract
writers leave contracts incomplete with respect to
subsets of the relationship. Moreover, specific to
this work, the observed contracts were incomplete
with respect to software assets and the incompleteness was resolved with ownership. Therefore, the property rights approach seems to be a
reasonable base upon which to build additional
theory.
The property rights approach (Grossman and Hart
1986; Hart and Moore 1990) is an extension of
transaction cost economics (Coase 1937; Williamson 1975, 1985) and, as such, is aimed at
explaining the boundaries of the firm. The property rights approach posits that two firms create
value by working together. More value is created
if the firms cooperate than if they act indepen-
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dently, creating a quasi-rent.2 The property rights
approach follows transaction cost economics in
recognizing that this quasi-rent cannot be entirely
divided by an ex ante contract. Thus, the property
rights approach is also known as incomplete
contract theory, although that is a bit of a misnomer, since many contracting theories recognize
the inability of firms to write complete contracts
(Hart 1995; Hart and Holmstrom 1987; Maskin and
Tirole 1999b; Masten 2000).
The Grossman–Hart–Moore calculus assumes
that investment and output are observable, but not
verifiable. The former avoids some stochastic
elements, making the model more tractable and
distinguishing it from agency theory. The latter
simply means that the courts cannot verify the
investment and, hence, it cannot be contracted
upon.
Therefore, contracts contain clauses
describing property rights rather than detailing the
investments that should be made in creating those
assets. This assumption has received considerable attention (Hart and Moore 1999; Maskin and
Tirole 1999b; Segal 1999; Tirole 1999).
One argument in support of this assumption is that
the set of states of the world are too complex to
specify ex ante. However, through the life of the
contract, the range of potential states becomes
smaller as events unfold, so that the participants
can observe and make informed decisions after
the contract is signed (Grossman and Hart 1986;
Hart and Moore 1988; Segal 1999). Another argument is that verification is costly (Hart 1995; Hart
and Moore 1999). This is persuasive, considering
that lawsuits can take years (or decades) to
resolve and cost millions of dollars. Yet another
argument (Hart 1995; Hart and Moore 1988), is
that there is no legal provision to prevent renegotiation, and in the absence of such a provision
verifiability is moot. Finally, specific to this paper,
each of the contracts examined did, in fact, specify
ownership of intellectual property rather than
define the nature of the investments to be made.
2
A quasi-rent is income above opportunity cost. In this
case, the quasi-rent is the difference between the value
created by working together and the value created by
acting independently.
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MIS Quarterly Vol. 29 No. 4/December 2005
The existence of a quasi-rent leads to inefficiencies as each firm recognizes that it may not
get the full benefit of its investment. The property
rights approach specifies that the firms will engage
in ex post bargaining to split the surplus, where the
bargaining position and, hence, the bargaining
outcome are functions of ownership. If a physical
asset is solely owned by one firm, then that firm
will reap 100 percent of the return on any investments made in the asset and, hence, will invest at
an optimal level. If a physical asset is jointly
owned, each firm anticipates the fact that it will
have to share the value generated by its investment, and each firm underinvests. Simply stated,
the problem is that each firm pays 100 percent of
its own investment, but receives only half of the
value of that investment.
The property rights approach proposes ownership
as the solution to this problem. When firms
bargain over the quasi-rent attributable to an
asset, the owner of the asset will receive the entire
value. Creating value with an asset requires the
owner’s consent, and the owner can charge the full
value created for his consent. The essential
prescription of the property rights approach is that
the firm whose investment in an asset creates the
most value should be the owner of that asset. This
result occurs because the owner will make greater
investments in the asset.
The property rights approach has been applied in
prior IT literature to help explain the impact of
information technology on the size of firms. The
proposition is that certain information is inalienable
from the human agents that produce it and, thus,
ownership is predetermined (Brynjolfsson 1994).
This basic idea helps explain why, even when IT
significantly reduces coordination costs, firm size
may not change. That is to say, in spite of the fact
that IT offers a technical solution to outsourcing, in
general, it does not change the incentive structure
resulting from ownership and, thus, has little actual
effect on the level of outsourcing.
Building on this idea, IT literature has shown that
ownership considerations may also lead to firms
using a smaller number of suppliers in order to
give each supplier greater ownership and, hence,
Walden/Intellectual Property Rights
greater incentive to invest (Bakos and Brynjolfsson
1993b). Carried to its logical conclusion, this
stream of research has shown that in the presence
of indispensable agents (an agent with inalienable
assets that are necessary for value), the formation
of coalitions is the optimal response (Bakos and
Nault 1997).
This makes a case for less
outsourcing in the face of IT, rather than more.
An important thread to pick out in prior IT literature
concerning the property rights approach is that of
restricted ownership. Generally, the underlying
assumption is inalienability of information assets,
which restricts ownership to a specific firm or
agent. While there are certainly information assets
that are inalienable, this work investigates the
opposite issue. Rather than considering restrictions on ownership, this work considers IT-induced
extensions to ownership.
This is an important point and it bears additional
consideration. The practice of IT is solving
business problems with technology, and prior
literature has certainly demonstrated a business
problem. As Brynjolfsson observes, “merely
embodying information in a tradable form can
‘create’ a great deal of value even without increasing the stock of knowledge” (1994 p. 1652).
This task of embodying information in a tradable
form is an important business problem, which is at
the core of advances in object-oriented paradigms.
Thus, IT practice has spent considerable time and
effort in implementing technological solutions that
enable—force, in fact—new ownership structures
for software. It is time for theory to catch up with
these advances and consider the impacts of these
enhanced ownership structures in the context of
the property rights approach.
in the property rights literature. Ownership in all
applications of the property rights model, to date,
means the ability to exclude other parties from the
value generated by an asset. Grossman and Hart
(1986, p. 694) cite an Oliver Wendell Holmes’
definition of property rights, which concludes with
the sentence: “The owner is allowed to exclude
all, and is accountable to no one but him.” The
essence of ownership in the property rights literature is that the owner has veto power over value
creation. When it comes time to derive value from
an asset, the owner of the asset must give his
approval, or no value may be created.
There are two possible ownership structures under
this definition. One firm may be the sole owner of
the asset, in which case it derives sole value from
the asset. Another possibility is that both firms
jointly own the asset, so that each has veto power
over value creation. In this case, each firm has
equal bargaining power, and the value is assumed
to be split equally between them. While this leads
to a parsimonious model, it is far too simple a view
of ownership.
Legal ownership is richer than simple veto power,
in that it is a complex bundle of rights.3 Complex
combinations of rights can be given in a contract to
offer a much greater range of incentives. Grossman and Hart (1986, p. 692) recognize this bundle
of rights issue when they state “ownership is the
purchase of these residual rights of control.”4
However, in the interest of parsimony, all of these
rights are lumped together into a single construct
called ownership.
The spirit of economic inquiry is to begin with the
simplest possible model at the expense of overly
3
Theory Development
United States Code Annotated, Title 17, “Subject Matter
and Scope of Copyright,” §106, 2002.
4
Ownership
The crux of the basic property rights model is the
idea that ownership provides incentives. Thus, it
is important to clarify what is meant by ownership
As a reviewer points out, it is important to note that
where contracting is easy, one would expect complete
contingent contracts that simply rewarded the vendor
based on action. The Grossman–Hart–Moore model
recognizes that some things are easy to contract on and
only considers the part of the relationship where things
are difficult to contract. Hence, the concept of residual
rights, rather than total rights.
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restrictive assumptions and then to build knowledge by relaxing those assumptions. This is precisely what is done here. This paper relaxes the
assumption that the bundle of property rights is a
whole, thereby enhancing and providing a deeper
understanding of the concept of property rights.
Moreover, the set of rights associated with an
asset depends on the nature of the asset. For
example, the set of rights attachable to a piece of
land will be different from those attached to an
employee, which will in turn be different from those
attached to software. Explicit recognition of this
allows for the construction of a richer theoretical
framework for property rights—one that generates
useable recommendations for practice and provides a basis for empirical investigation. This work
seeks to extend the theoretical implications of the
property rights literature by recognizing and
incorporating a richer set of property rights into the
basic model.
New Types of IT-Enabled
Property Rights
Property rights can create value in two ways. The
first, usability, allows the owner to actually deploy
the asset to generate profit. This is sometimes
called communal rights (Alchian and Demsetz
1973). The second, excludability, allows the
owner to charge for access to the asset. This
distinction is not informative in the case of physical
or even human capital assets because their finite
nature necessarily means that productive use of
an asset by one firm results in its exclusion from
another firm. An individual employed for the benefit of firm 2 for one year is not employed for the
benefit of firm 1 during that same year. A machine
being used by firm 1 cannot be used by firm 2.
There are obvious time-sharing options, but
because physical and human capital are finite,
there always exists a limit to their use.
Software, however, has no such restrictions
(Kauffman and Walden 2001; Shapiro and Varian
1999). Two or more firms can simultaneously, and
to full extent, use the same software at the same
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MIS Quarterly Vol. 29 No. 4/December 2005
time. Thus, this distinction between ownership as
productive use and ownership as excludability
becomes important when dealing with software.
This work investigates outsourcing of software
assets and is most applicable to software development. It can be applied to a varying degree to
other types of outsourcing depending on how
much of the outsourcing relationship is concerned
with intellectual rather than physical property.
Clearly, software allows for very different ownership characteristics than physical assets. While
ownership and possession are often linked for
physical assets, as far as software is concerned,
possession is a meaningless term. In fact, virtually
all ownership characteristics of software are purely
conceptual and defined by law, rather than by
physics. Thus, to use the property rights literature
for software requires considerable reconceptualization of the idea of ownership. (This is not only a
problem in economics and IT, but also an ongoing
issue in the field of law.5)
The nonphysical restrictions of software allow
ownership to be changed in two ways. First,
excludability and usability may be separated. This
means that a firm may be given the right to use an
information asset without also being given the right
to exclude others from its use. This does not apply
to physical assets because by using the asset, one
necessarily excludes others from its use. This is
relevant to even a very large physical asset that it
would seem multiple agents could simultaneously
use, such as a lake. If one is granted usability,
one may pump out all of the water or dump in toxic
chemicals, in effect excluding anyone else from
using it. Thus, if one agent has given away the
right of usability, his ability to exercise the right of
excludability is seriously impaired, because the
value to the remaining agents depends on how the
agent that has usability rights uses the asset. This
arises directly out of the physical law that a body
cannot occupy two different places at the same
5
For a primer on this see the Congressional Budget
Office’s August 2004 publication “Copyright Issues in
Digital Media,” available online at http://www.cbo.gov/
showdoc.cfm?index=5738.
Walden/Intellectual Property Rights
time.6 Thus, by using a physical asset, an agent
effectively builds a “fence” around the physical
object, thereby excluding others. However, the
information embodied in software can occupy
multiple places at the same time.
The second enhancement is the consideration of
multiple replications of the same right. This allows
for identical and independent ownership to go to
multiple firms. One implication of this is that it no
longer makes sense to simplify the models to
include only two firms, as typical property rights
models do. The model must be expanded to
recognize that excludability still has value to one
firm even if another firm has usability rights. The
idea of independent ownership means that multiple
firms can have property rights without having to
share the benefits, as discussed below.
The Model
Following the Grossman–Hart–Moore calculus
(Grossman and Hart 1986; Hart 1995; Hart and
Moore 1988, 1990), let us consider a relationship
between a risk-neutral client and vendor. In the
initial period, they write a contract that describes
the ownership structures and a transfer price p
from client to vendor. The parties use the transfer
payment to achieve a cooperative bargaining solution that maximizes joint surplus. The ownership
structure that maximizes joint surplus is guaranteed by allowing the party that is better off under
that ownership structure to pay the other party
some amount to compensate it for loss of
ownership.
Hart and Moore say that the contract “specifies the
conditions of trade” (1988, p. 757). They allow
either one or zero units to be traded, which means
that the client will either gain use of the item produced or will not. In this case, the asset of desire
is the software created in the relationship, and thus
trade is not an appropriate term. A trade implies
taking something from one party and giving it to
another. While this is certainly a restriction on
physical assets, it is not a restriction for information assets. It is not necessary for the vendor to
give up use of the item for the client to also have
use of the item. Thus this work explicitly recognizes that the contract defines the terms of use
rather than the terms of trade.
After the contract is signed, the client (c) and
vendor (v) learn about the state of the world and
make investments (i) in the software assets, ic and
iv. The idea of learning the state of the world can
be made more concrete by thinking about it as the
knowledge revelation that occurs between the time
a project is begun and the time it is completed. As
this knowledge is revealed, the client and vendor
make investments in improving the assets. This
work follows the Grossman–Hart–Moore model in
assuming that investments and outputs are
observable, but not verifiable.
Several types of benefit are generated by investments. Grossman, Hart, and Moore assume that
the only value generated is a gain from trade.
However, as this work is concerned with gains
from use, it is necessary to consider more potential
sources of gain. This work considers gain to the
client from use, Uc, gain to the vendor from use,
Uv, and gain from potential resale, S. Grossman,
Hart, and Moore were able to ignore the latter two
gains by assuming that the highest value use of
the asset was with the client, and that only one
entity could use the asset. However, if multiple
entities can simultaneously use the asset, then
each value must be considered independently.
For tractability, all of the potential value from the
resale market is lumped together into one value, S.
One important consideration is that resale may be
easily verifiable, and hence, contractible.7 Certainly, some aspects of resale are verifiable and by
the Grossman–Hart–Moore calculus are excluded
from consideration. However, there are situations
in which resale is imperfectly verifiable. Often,
resale is difficult to verify because resale is done at
the object level rather than the system level. That
is to say, the vendor redeploys some of the objects
to achieve speed and scale, but these objects are
6
This may not be true for quantum particles, but,
thankfully, contracts are not generally written at the
quantum level.
7
I thank an anonymous reviewer for pointing this out.
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deployed with other objects. This makes it difficult
to sort out each object’s contribution to value.
Furthermore, resale is difficult to verify in software
development because there are often a number of
complementary products that go along with software sales, such as maintenance, upgrades, and
integration. On the other hand, systems may be
designed with commercialization in mind
(DiRomualdo and Gurbaxani 1998), in which case
verifiability would be built into the contract. A promising direction for future research is an examination the boundaries of verifiability of resale. However, for the purposes of this paper, we assume
that there are some aspects to resale that are
unverifiable.
In the second period, after investments ic and iv are
made and the values of Uc, Uv, and S are realized,
the client and vendor costlessly renegotiate a contract dividing these values. The total pie then is
π total = Uc (ic , iv ) + Uv (ic , iv ) + S(ic , iv ) − ic − iv (1)
where the cost of investment is normalized to the
level of investment and Uc, Uv, and S are twice
differentiable, increasing, positive, concave
functions.
The innovation in equation (1) is that, because the
asset under consideration is an information asset,
all the relevant entities can conceivably use the
asset simultaneously. In the Grossman–Hart–
Moore model, only one entity could benefit from
use of the asset. Also, note that investments are
considered to be general, in that they create value
for all the entities involved.
As in the Grossman–Hart–Moore calculus, the
payoff to each party in the second period depends
on each party’s bargaining power in the second
period renegotiation, which, in turn, depends upon
the rights contracted for during the first period.
This work allows for two separate property rights:
excludability and usability. These cannot be
separated for physical assets, but may be for
information assets.
Excludability is the right to engage the legal
apparatus of the nation to force other entities to
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MIS Quarterly Vol. 29 No. 4/December 2005
cease use of the asset (or to compensate the
property right owner for damages). With the right
of excludability comes the choice of exercising that
right. In other words, the ability to sell. An entity
with excludability rights can contract with other
entities not to exercise those rights. In this case,
the excluder sells its promise not to exclude. An
entity can choose not to exclude itself. Where
both parties have excludability rights, this work
follows Grossman–Hart–Moore in assuming that
Nash bargaining takes place, giving each party
one-half of the payoff from excludability rights.
Thus, if both parties have excludability rights, then
generating outside value from the asset requires
approval of both parties, who then bargain over the
surplus and receive one-half of that value.
Usability takes precedence over excludability, in
that it allows the property right owner to disengage
the nation’s legal apparatus. Usability is a promise
that no one can exercise excludability. Usability
allows the owner to take any private actions with
the asset that he desires. However, usability does
not allow the right of sale. Those with usability
rights cannot offer any threat to stop others from
using, and hence cannot sell a promise not to
exclude. For example, the author has usability
rights on the word processing software used to
write this paper. I can write what I want, but I
cannot resell, because I cannot credibly threaten
anyone else’s use of the software. No one will pay
me not to engage the legal apparatus of the
nation, because I have no rights to engage that
legal apparatus.
Each party’s property rights are an ordered pair of
rights (Re, Ru), where Re denotes excludability
rights and can take values E and N, corresponding
to the presence or absence of excludability rights.
Ru denotes usability rights and can take values U
and N, corresponding to the presence or absence
of those rights. Usability rights allow the owner to
maintain all of the value from the owner’s use. In
general, excludability rights allow the owner to
garner some share of the value of resale S of the
software. The payoffs to different ownership combinations are listed in Table 1. The investment
levels are suppressed, because the client always
pays ic and the vendor always pays iv. Likewise,
Walden/Intellectual Property Rights
Table 1. Payoffs to Second Period Game as a Function of Ownership (Client’s Payoff
is on Top)
Vendor
(E,U)
(E,N)
(N,U)
(N,N)
(E,U)
(E,N)
(N,U)
(N,N)
Uc + ½S
½Uc + ½S
Uc
½Uc
Uv + ½S
½Uc + Uv + ½S
Uv + S
½Uc + Uv + S
Uc + ½Uv + ½S
½Uc + ½Uv + ½S
Uc
½Uc
½Uv + ½S
½Uc + ½Uv + ½S
Uv + S
½Uc + Uv + S
Uc + S
Uc + S
Uc
0
Uv
Uv
Uv
Uv
Uc + ½Uv + S
Uc + ½Uv + S
Uc
0
½Uv
½Uv
0
0
the transfer payment p is also suppressed
because the client always pays p and the vendor
always gains p. The derivation of this table is
discussed in the appendix.8
Rather than discuss 16 ownership structures, the
table is simplified to rule out some irrational combinations. In addition, the symmetry of the table is
used to avoid discussions that are identical but for
a change in subscripts.
First, notice that the four ownership structures in
the bottom right of the table are not rational
choices. They are not rational, in the Pareto optimal sense, because other ownership structures
exist which make at least one of the parties better
off without making the other worse off. For
example, [(N,U), (N,U)] can be improved upon by
granting excludability to both of the parties [(E,U),
(E,U)], because each will get what they would
under [(N,U), (N,U)] plus one-half S, which is
positive.
Second, notice that [(E,U), (N,U)] and [(E,N),
(N,U)] have identical payoffs. The only role ownership plays is in determining payoffs. Hence,
[(E,U), (N,U)] and [(E,N), (N,U)] have no relevant
differences. For simplicity, assume that (E,U) will
be chosen over (E,N) if the payoffs are identical.
8
The appendix for this paper is located at http://misq.org/
archivist/vol/no29/issue4/WaldenAppendix.pdf.
This also eliminates [(E,N), (N,N)], [(N,U), (E,N)],
and [(N,N), (E,N)].
This leaves the leftmost column and the topmost
row, which are symmetrical, and the [(E,N), (E,N)]
ownership structure. Because the leftmost column
is symmetrical to the topmost row, only the
topmost row will be discussed. This yields five
ownership structures and associated payoffs, as
described in Table 2. The transfer price and
investment levels are included for completeness.
First Best
It is clear from (1) that the first best level of
investment is the level of investment that solves
∂U c (ic , iv ) ∂U v (ic , iv ) ∂S (ic , iv )
= 1 (2)
+
+
∂i c
∂ic
∂i c
and
∂U c (ic , iv ) ∂U v (ic , iv ) ∂S (ic , iv )
= 1 (3)
+
+
∂i v
∂iv
∂i v
In this first best situation, both the client and
vendor equate their marginal contribution to profit
to the marginal cost of investment. However, this
first best will not be achieved, because under no
proposed ownership structure do the two firms
face a payoff that yields these two first-order
conditions (see appendix). Thus, a second best
solution must be found.
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Table 2. Reduced Payoffs From Different Ownership Structures
Ownership Structure
[(client rights),(vendor rights)]
Client Payoff
Vendor Payoff
[(E,U), (E,U)]
Uc + ½S – p – ic
Uv + ½S + p – iv
[(E,N), (E,U)]
½Uc + ½S – p – ic
½Uc + Uv + ½S + p – iv
[(N,U), (E,U)]
Uc – p – ic
Uv + S + p – iv
[(N,N), (E,U)]
½Uc – p – ic
½Uc + Uv + S + p – iv
[(E,N), (E,N)]
½Uc + ½Uv + ½S – p – ic
½Uc + ½Uv + ½S + p – iv
Second Best
The contracting parties’ problem is to choose the
ownership structure that maximizes the joint
return. This means choosing the ownership structure that maximizes (1) subject to the constraint
that the chosen level of investment is the solution
to the first-order conditions detailed in the appendix. Thus, investment is a function of ownership structure and joint surplus is a function of
investment.
In general, the optimal ownership structure depends on how each party’s investment creates
value, and none of the structures under consideration dominate any others. Thus, to evaluate the
benefits of different structures, it is necessary to
make meaningful assumptions about the effects of
investments.
Let the term is primarily sensitive to mean that the
level of a value source, V 0 { Uc, Uv, S }, is sensitive (primarily) to one type of investment, ik, in the
sense that MV/Mij = g(MV/Mik), where j, k 0 {client,
vendor}, j … k, and g is arbitrarily small. This
means that only one entity’s investments bring
about any meaningful change in value and the
other entity’s investments have an arbitrarily small
effect.
Let the term depends equally on mean that the
level of a value source, V 0 { Uc, Uv, S }, is determined equally by each entity, in the sense that V =
f(ic) + f(iv), where f is an increasing, concave,
twice-differentiable positive function. Because
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MIS Quarterly Vol. 29 No. 4/December 2005
both entities have the same f, the investments by
each have the same impact.
Let the term similar sensitivity mean that for any
two value sources, V, W 0 { Uc, Uv, S } and any
two types of investment, j, k 0 {client, vendor},
MV/Mij = (1 + g)MW/Mik, where g is arbitrarily small.
This simply means that the level of each value
source changes in a similar manner.
Let the term return to investment falls off more
rapidly mean that for any two value sources, V, W
0 { Uc, Uv, S } and any two types of investment, j,
k 0 {client, vendor}, if M2V/Mij2 > M2W/Mik2, then the
return to ij in V falls off more rapidly than the return
to ik in W. This literally refers to the curvature of
the value function. If one value function has
greater curvature, then the impact of investment
on value creation falls off rapidly relative to a
function with less curvature.
Define a source of value, V, as being relatively
more sensitive to an investment type, ij, than value
source, W, if MV/Mij > MW/Mij + q, for all ij, where q is
arbitrarily large. This means that for any given
value of ij, the marginal benefit of investing in V is
much greater than the marginal benefit for
investing in W.
Define a source of value V to be sensitive over a
wide range to a type of investment, ij, if M2V/Mij2 =
g(MV/Mij), where g is arbitrarily small. This simply
means that the rate of change of the first derivative
is small relative to the size of the derivative. Thus,
the impact of investment, ij, is consistent over a
large range of values.
Walden/Intellectual Property Rights
Given these definitions, each of the ownership
structures can be evaluated. The conditions presented are not exhaustive, but they are representative of real situations. Other sufficient conditions
exist that may make one ownership structure
preferred to others. All proofs are located in the
appendix.
Proposition 1: When [(E,U), (E,U)] IS
Second Best. If Uc is primarily sensitive
to ic, Uv is primarily sensitive to iv, S
depends equally on ic and iv, and the
sensitivity of Uc to ic is similar to the
sensitivity of Uv to iv, then [(E,U), (E,U)]
ownership is the second best (i.e., it is at
least as good as any other ownership
structure, but fails to be optimal).
This is an intuitive ownership structure where each
party gains the full value of their internal benefit
and the parties share the external benefit equally.
This works if the internal benefit to each party is
unilaterally determined by the party in question.
However, these conditions are not what one would
expect in a typical outsourcing arrangement. In
typical outsourcing, the client’s benefit depends on
the vendor’s investment as much, or more, than it
depends on the client’s. Outsourcing is usually
done to take advantage of the relative superiority
of the vendor.
There are arrangements where this type of
contract would work well. This sort of equality
contract would tend to work well in joint research
and development projects (Jap 2001). Arrangements that are created more for developing a
sellable product than for internal use would be well
served by such a contract. Thus, it is not surprising that the contracts viewed for this work do
not exhibit this ownership structure.
Proposition 2: When [(E,N), (E,U)] Is
Second Best. If Uv is primarily sensitive
to iv, Uc depends equally on ic and iv, S
depends equally on ic and iv, the sensitivity Uc with respect to ic is similar to
the sensitivity Uc with respect to iv, and Uv
is sensitive over a wide range to iv, then
[(E,N), (E,U)] ownership is the second
best.
It is easy to imagine a situation where a technically
competent vendor desires to enter a new business
domain about which it knows very little. The
vendor can then partner with a client that has a
great deal of in-depth business knowledge in the
domain. The combination of technical proficiency
and in-depth business knowledge can then
produce valuable software that the client itself can
use, but that also has good resale potential. A
variation on this would be a situation in which the
vendor’s benefit was very small, but the client
required the vendor’s help, and the software being
designed had significant resale value.
Proposition 3: When [(N,U), (E,U)] IS
Second Best. If Uc is primarily sensitive
to ic, and both Uv and S are primarily
sensitive to iv then [(N,U), (E,U)]
ownership is the second best.
These conditions suggest that value creation is
largely independent so that investment by the
client creates value for the client and investment
by the vendor creates value for the vendor. Under
such circumstances, it is not clear why either party
would desire to form a relationship rather than
produce independently.
This concern could be addressed if Uc = fc(ic) + [giv
+ q], where g is small, q is a large constant, and
the term in brackets is the effect of the vendor’s
investment. In this case, the vendor has a set of
standardized, high-value investments that it makes
but, after making those standard investments,
additional vendor investment has negligible impact
on value creation.
This seems like a reasonable perspective on
typical outsourcing arrangements. The vendor has
some set of general best practices that it brings to
the relationship, which create real value. However, all the specific fine-tuning depends on the
client’s efforts to adapt the software to its particular
processes (or its processes to the software).
Proposition 4: When [(N,N), (E,U)] Is
Second Best. If all sources of value
depend primarily on the vendor’s iv, then
[(N,N), (E,U)] ownership is the second
best.
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If the vendor is particularly competent, and the
client is not, then this may be a very realistic
scenario. In such a case, it makes sense to give
all of the rights solely to the vendor. However, this
leaves the client exposed and allows the vendor to
appropriate some of the value the client may gain
from the use of the software.
This ownership structure also makes sense when
a vendor hires a domain expert for advice.10 In
such a case, the arbitrary labels client and vendor
are misleading, because the vendor is paying the
client for services. However, the model is flexible
enough to account for this situation, which is
common in practice.
At first glance one would not expect a client to ever
agree to such a contract. However, upon reflection, it seems that clients do sometimes agree to
such a contract, and rationally so. Clients frequently outsource software development because
of a sense of internal frustration. These clients do
not feel that they can effectively manage software
development. They recognize that they need software to handle a function, but they also recognize
that they lack the expertise, in-house, to build the
software. If these types of clients are prudent,
they will grant all of the rights to the vendor in
order to maximize vendor investment, then seek a
transfer price, p, that enables them to gain the
benefits of the system up-front. In other words,
they negotiate a negative p. In essence, they sell
the vendor the right to take advantage of them in
the future for current gains.
In sum, this ownership structure can make sense
even though it reduces incentive for client investment. It makes sense because it allows a client to
gain some up-front payment that compensates the
client for future appropriation by the vendor.
However, it probably also causes other difficulties
beyond the scope of this analysis (Singh and
Walden 2003). Nonetheless it should be recognized and explored.
This may seem like a purely academic logic
exercise, but evidence suggests that it is not.
Cash infusions from outsourcing vendors to clients
are common (Lacity and Hirschheim 1993). The
Outsourcing Institute reports that one of the top 10
reasons for outsourcing is, in fact, to gain a cash
infusion.9 In many full sourcing agreements, the
vendor will purchase all of the client’s hardware
and leases for more than market price. It is
common for vendors to give clients low interest
loans (Lacity and Hirschheim 1993). This suggests that the transfer price agreed upon in the
original contract is, in fact, negative, with the
vendor actually paying the client. Of course, this
payment is then recouped in later periods (Singh
and Walden 2003). Clients frequently cite rising
prices in the later years of the contract as a major
cause of friction (Barthelemy 2001).
Proposition 5: When [(E,N), (E,N)] Is
Second Best. If the value from all
sources depends equally on ic and iv, the
return to ic with respect to Uc falls off
more rapidly than the return to iv with
respect to Uc, the return to iv with respect
to Uv falls off more rapidly than the return
to ic with respect to Uv, and Uc is relatively
more sensitive to iv than Uv is, then
[(E,N), (E,N)] ownership is the second
best.
This situation is likely to occur when the software
development is truly a partnership with the client
supplying business expertise and the vendor
supplying technical expertise. This represents the
ideal of development as a partnership with proper
incentives for both vendor and client. However,
such a partnership only makes sense if both
parties actually contribute equally.
Summary of Ownership Structures
Each of the ownership structures may be second
best in different situations. The conditions provided are not exhaustive, but do offer some indication of meaningful conditions that make each dif-
9
See http://www.outsourcing.com/content.asp?page=
01b/articles/intelligence/oi_top_ten_survey.html.
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MIS Quarterly Vol. 29 No. 4/December 2005
10
I thank an anonymous reviewer for this insight.
Walden/Intellectual Property Rights
ferent ownership structure superior to the others.
There are two important take-aways. First, this
work details sufficient conditions for each structure to be second best. This knowledge can guide
practitioner creation of contracts, and provides
testable hypotheses for future academic work.
Just as important is the fact that there are so many
nondominant ownership structures. There is a tendency to search for a globally best contract, with
relative disregard for the complexity of choices.
Some commentators suggest that outsourcing
should be a partnership, with each participant
working toward creating shared value. However,
as the analysis shows, this type of contract only
makes sense if the participants are equal partners.
In other situations, it may make sense to grant the
vendor considerable ownership if value is primarily
sensitive to vendor investment. In yet other situations, it makes sense to give each party the fruits
of their labor, and nothing else, but still form a
partnership. The point is, the ideal contract depends on how each party’s investments influence
value creation, and it is not likely that this will be
the same for every relationship. The ideal ownership structures as a function of the relational
environment are displayed in Table 3.
Cannibalization
Because software is intellectual, not physical,
property and can be sold to many agents simultaneously, cannibalization must also be considered. Cannibalization occurs when the vendor
uses or sells software that would generate more
value to the client if the client were the sole user
In such situations, the software that is developed
may have greater value to the client if only the
client has access to that software. This can be
operationalized in the model by making the client’s
value a negative function of resale value.11 In this
case, the joint benefit becomes
11
I thank an anonymous reviewer for pointing this out.
[
π total = U c ( i c , i v ) −δS ( i c , i v )
]
+ U v (i c , i v ) + S (ic , i v ) − i c − iv
(4)
The term in brackets is the client’s new benefit
function and cannibalization is assumed to enter
linearly. The coefficient * is assumed to be
positive.
It is clear that the potential benefit under cannibalization will be smaller than the benefit absent of
cannibalization because a negative term has been
added to the benefit function. This also means
that the benchmark of first best will be different, so
that the same levels of investment that were first
best without cannibalization will no longer be first
best. However, there are several other effects
which are less clear.
Proposition 6: The Effect of Cannibalization on Client Incentives. If the
net benefit to client use of the software is
[Uc(ic, ic) – *S(ic, ic)], then the client will
have reduced incentive to invest under
each of the five ownership structures.
This is an intuitive result, but is only made accurate because none of the five ownership structures
fully transfers the client’s usage benefit to the
vendor. Thus, the client will always incur some
level of cannibalization loss when it makes investments, which will lead to lower client investment.
The intuition is that the client does not want to
work very hard making software for its competitors.
Proposition 7: The Effect of Cannibalization on Vendor Incentives. If the
net benefit to client use of the software is
[Uc(ic, ic) – *S(ic, ic)], then the possibility of
vendor overinvestment occurs under
each of the five ownership structures.
This is a slightly less intuitive result that again
follows from the fact that the vendor cannot fully
internalize the client’s usage benefit. If the vendor
could appropriate the full value of the client’s
usage benefit, then it would fully consider the
cannibalization costs. However, because it cannot, the vendor can make some investment that
benefits the vendor but harms the client.
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Table 3. Summary of Ownership Structures
Ownership Structure
Conditions That Make the Ownership Structure Second Best
Ownership structure
[(E,U), (E,U)] allows both
parties to the contract full
use of the software, but
requires that they share
the proceeds from sales
to third parties.
This ownership structure works best when three conditions hold:
(1) The usefulness of the software to each party is determined primarily
by the investments of that party.
(2) The resale value of the software is determined equally by the
investments of each party.
(3) The ability of each party to generate usefulness for itself is
approximately the same.
Ownership structure
[(E,N), (E,U)] allows the
vendor to freely use the
software, but the client
must pay for its use, and
requires that they share
the proceeds from sales
to third parties.
This ownership structure works best when five conditions hold:
(1) The usefulness of the software to the vendor is determined
primarily by the investments of the vendor.
(2) The usefulness of the software to the client depends equally on the
vendor and client’s investments.
(3) The resale value of the software is determined equally by the
investments of each party.
(4) The ability of each party to generate usefulness for the client is
approximately the same.
(5) The ability of the vendor to generate usefulness for the vendor
persists over a wide range of possible investment levels (i.e.,
returns diminish slowly).
Ownership structure
[(N,U), (E,U)] allows both
the vendor and client free
use of the software, but
the vendor keeps all of
the proceeds from sales
to third parties.
This ownership structure works best when three conditions hold:
(1) The usefulness of the software to the client is determined primarily
by the investments of the client.
(2) The usefulness of the software to the vendor is determined
primarily by the investments of the vendor.
(3) The resale value of the software is determined primarily by the
investments of the vendor.
Ownership structure
[(N,N), (E,U)] allows the
vendor to freely use the
software and grants the
vendor all of the proceeds
from sales to third parties.
Moreover, the vendor and
client share the value of
the usefulness of the
software to the client.
This ownership structure works best when all sources of value creation
depend on the vendor’s investments.
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MIS Quarterly Vol. 29 No. 4/December 2005
Walden/Intellectual Property Rights
Table 3. Summary of Ownership Structures
Ownership Structure
Conditions That Make the Ownership Structure Second Best
Ownership structure
[(E,N), (E,N)] splits all
benefits equally between
the two parties.
This ownership structure works best when three conditions hold:
(1) The usefulness of the software to each party and the resale value
of the software is determined equally by the investments of each
party.
(2) The ability of the vendor to generate usefulness for the client
diminishes more quickly than the ability of the client to generate
usefulness for the client.
(3) The ability of the vendor to generate usefulness for the vendor
diminishes more quickly than the ability of the client to generate
usefulness for the vendor.
(4) The return to vendor investment in client usefulness is greater than
the return to vendor investment in vendor usefulness.
This is particularly problematic given that vendor
investment in resale is generally more important
than client investment. Vendors have the network,
the marketing channels, and the reputation to
resell useful software. Clients’ competencies
usually lie in other areas, namely, the sale of their
own products. Thus, it generally makes sense to
give excludability rights to the vendor. However, if
the vendor works too hard making the software
usable by the client’s competitors, the client may
derive little or no value from the software. This
can make the software a competitive necessity
rather than a competitive advantage (Hitt and Frei
1998).
The next proposition requires that MUc/Miv is arbitrarily large. This means that the value to the
client is highly sensitive to the vendor’s investment. Viewed another way, it means that the
vendor is very efficient at creating client value.
Presumably this is often the case, as an important
consideration of most outsourcing arrangements is
for the vendor to create value for the client.
Vendors who are not efficient at creating client
value will usually be passed over in favor of
vendors that are more efficient.
Proposition 8: Ownership Structures
to Combat Cannibalization Problems.
If the cannibalization problem is defined
to be greater when the level of * necessary for vendor overinvestment is smaller
and MUc/Miv is arbitrarily large, then the
ownership structures can be ranked from
the largest cannibalization problem to the
smallest as [(E,U), (E,U)], [(N,U), (E,U)],
[(E,N), (E,N)], [(E,N), (E,U)], [(N,N),
(E,U)].
This proposition offers guidance as to when the
cannibalization problem will be more prevalent.
The actual level of the problem depends on the
level of *, but this proposition offers guidance on
when organizations should become concerned
about the problem.
There are two basic strategies suggested by this
proposition on how to handle the cannibalization
problem. First, the parties could sign a contract
that reduces the vendor’s share of the resale
benefit. This limits vendor investment by removing
the primary incentive. However, this solution is
likely to be unappealing in practice because it is
too blunt an instrument. If, as discussed above,
vendors are more competent at resale than clients,
then removing a significant share of the resale
value from them would tend to overcorrect the
problem, causing more harm than good.
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Table 4. Summary of Cannibalization Effects
Proposition
Implication
Proposition 6: The Effect of
Cannibalization on Client
Incentives
A client will always have reduced incentive to invest in software
created in an outsourcing relationship if the use of that software
by other firms will reduce the value to the client. This occurs
because even when a client has no intellectual property rights, it
can still appropriate some value from the relationship. However,
the value is less than if there is no cannibalization issue.
Proposition 7: The Effect of
Cannibalization on Vendor
Incentives
Vendors may invest more in software created in an outsourcing
relationship than is socially optimal. This occurs because the
vendor cannot internalize the client’s loss of competitive
advantage arising from cannibalization.
Proposition 8: Ownership
Structures to Combat
Cannibalization Problems
The more intellectual property rights the client possesses, the
larger the cannibalization problem. This occurs because the
vendor internalizes less of the client’s loss of competitive
advantage as the vendor surrenders intellectual property rights to
the client.
The second strategy is to give the vendor some
share of the client’s net usage benefit via ownership. Because the vendor can never fully internalize the client’s net usage benefit, this will
always fall short of aligning vendor incentives with
total benefit. However, it does result in a move in
the right direction. Since all five basic ownership
structures promote underinvestment in the
absence of cannibalization, in the presence of
cannibalization, the additional incentive given by
client absorption of some of the costs will temper
the potential for vendor overinvestment.
The optimal strategy depends on the level of
vendor overinvestment. If overinvestment is a real
problem (* is large), then removing some of the
resale rights from the vendor will have more of an
impact on the problem. If overinvestment is a
minor problem (* is moderate), then forcing the
vendor to internalize a portion of the client net
benefit will accomplish a finer tuning of investments. If there is no overinvestment (* is small),
then the strategies discussed in the prior section
will be appropriate with no changes.
Overall, the results show that, in the presence of
cannibalization, client incentives are reduced and
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MIS Quarterly Vol. 29 No. 4/December 2005
vendor incentives are increased relative to the new
first best.12 The relative increase in vendor incentives may lead to vendor overinvestment. Parties
to the contract can deal with this by removing a
vendor’s excludability rights or by removing a
client’s usability rights. These ideas are summarized in Table 4.
Discussion
This work has expanded the traditional property
rights approach to consider a variety of different
ownership structures made possible by the nonphysical nature of software. Specifically, the work
proposes, illustrates, and explains how software
permits a separation of usability and excludability.
12
Vendor incentives are actually reduced or unchanged
relative to the first best without cannibalization.
However, the optimal level of investment is reduced by
more than the vendor incentives are reduced. Thus, the
vendor will make investments that are a larger
percentage (perhaps even greater than 100 percent) of
the first best under cannibalization. In the absence of
cannibalization, the vendor’s investments are a smaller
percentage of the first best level of investment.
Walden/Intellectual Property Rights
This allows for one firm to hold unlimited usage
rights without requiring the other firm to surrender
any particular rights. Such a distinction requires
the property rights approach to recognize not only
the two firms explicitly involved in a relationship
but also all of the other firms implicitly in the market. This, in turn, leads to ownership structures,
such as copyleft,13 that would be nonsensical for
physical assets.
On a practical front, this work shows that the best
distribution of property rights depends on the
nature of the relationship between the two parties.
Thus, no single way to manage a relationship is
always better than any other way. The choice
between total outsourcing, partnership, incentives,
or any of the many ways to structure the relationship depends on the relative strengths and
weaknesses of the parties.
Another interesting finding is that all of the
contracts studied for motivation offered full usage
rights to clients, whereas theory suggests that a
client might want to be compensated ex ante
rather than to have property rights. One explanation of this is that negotiating power is as important
in the division of assets as value creation (Lerner
and Merges 1998). This line of reasoning suggests that firms will appropriate as many property
rights as possible, even if doing so reduces overall
surplus. Clients are certainly in a strong negotiating position prior to the signing of the contract,
and it is reasonable to believe that they use this
position to appropriate additional rights for
themselves.
This work also shows practitioners how the
possibility of cannibalization distorts the incentives
of the relationship, so that the vendor works hard
to make a technology that can be redeployed by
the client’s competitors.
Contribution
On a theoretical front, this work extends the
property rights approach (Bakos and Brynjolfsson
1993a; Bakos and Nault 1997; Brynjolfsson 1994;
Grossman and Hart 1986; Hart 1995; Hart and
Moore 1988, 1990) in order to make a number of
valuable contributions to IT literature. The thesis
of the work is that different types of assets have
different characteristics, which lead to different
potential bundles of property rights and call for
different methods of contracting for those rights.
Instead of the standard property rights model’s
physical assets, this work considers software
assets. The theory presented is based on the
actual text of real-world contracts, and takes into
account the different property rights that those
contracts exhibit.
13
Copyleft is the type of license that covers Linux. It
specifies that all agents have the right to do anything with
the software except exclude others from its use.
Finally, this work offers suggestions for what
intellectual property should be assigned in five
different situations, and how intellectual property
rights should be modified to account for cannibalization. This is extremely important to practitioners because they must actually formulate and
abide by outsourcing contracts.
Directions for Future Research
and Speculations
As with any intellectual undertaking, simply performing the process has raised new questions, and
this section speculates what some of the more
interesting questions and solutions might be.
Many of these speculations and questions
originated with reviewers.
Moral Hazard and Property Rights
One question that always arises in a research
context is, Why not some other model? Another
popular economic model for interorganizational
relationships is moral hazard (Bhattacharyya and
Lafontaine 1995). In moral hazard models, it is the
goal of the principle to choose a rule for sharing
the value of the output when the inputs are not
observable. A more recent popularization is a
multi-task model in which there are several outputs
and inputs that are more or less observable
(Holmstrom and Milgrom 1991).
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Moral hazard type models were not used in this
work, simply because the contract sections dealing
with intellectual property, and specifically software,
did not contain sharing rules. Rather, they contained clauses assigning ownership via software
licenses. Thus, a moral hazard model would not
offer an appropriate description of the contracts
observed. Both simple moral hazard and multitask problems can degenerate into ownership
institutions if the outputs are sufficiently unobservable. However, the choice of different ownership
institutions remains. Rather than deal with the
issues of uncertainty, this work focuses on the
issues of different ownership structures. Thus, this
work offers a parsimonious model of ownership
structures without making additional assumptions
about the relative uncertainty of outcomes.
Of course, unobservability raises questions about
the ability to act on ownership structures.
However, from a practical point of view, firms must
make some estimation of the value propositions of
outsourcing, including the value of intellectual
property. The property rights approach allows
firms to take a guess at the time the contract is
written and assign the appropriate ownership
structure. The moral hazard model would require
a guess to be made at the time the output
occurred, and then to compensate the parties
based on that guess. This would be particularly
problematic in practice because there would be
great incentives to guess wrong.
The guess problem is further complicated in the
moral hazard model because no actions are left to
the parties after the guess and, thus, there is no
mechanism to insure an accurate guess. Adverse
selection problems like those of Snir and Hitt
(2004) solve this by allowing for more value creation beyond the realization of the outcome. Some
such mechanisms could be added to a moral
hazard model to insure that the guesses were
honest. However, this would further complicate
the model and still not address the central question
of different ownership structures. The property
rights approach avoids this guessing problem by
forcing renegotiation, wherein each party can
credibly commit to refuse unreasonable guesses.
While the moral hazard framework is problematic
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for the intellectual property part of the contract, it
may be useful elsewhere. For example, one of the
contracts requires that the project manager be
compensated based upon the outcome of a user
satisfaction survey. Such a survey avoids the
guessing problem because the individual users
have no vested interest in lying.
Generalizability
This model is based on a small number of
contracts and, therefore, questions of generalizability arise. As noted in the beginning, there is a
great deal of commonality among these contracts,
so it is not unthinkable that other contracts by the
same vendor will be similar. In practice, contracts
are generally formulated from templates, so these
contracts are probably representative of an ideal
contract that forms the basis for a number of other
arrangements. Because the vendor is large, this
may include a significant fraction of all outsourcing
arrangements. Of course, this is not proof, but
rather it is speculation that should be validated
empirically. From a practical standpoint, that may
be extremely difficult, due to confidentially issues.
As Nobel laureate Ronald Coase laments, “The
main obstacle faced by researchers in industrial
organization is a lack of available data on contracts and the activities of firms” (1992, p. 719).
Many additional directions for future research
present themselves as a result of this analysis.
Generally, these can be categorized as operational
and economic. The operational research questions are touched on briefly in some of the analysis
above. For example, the impact of IT on the ability
to contract, measure, and monitor certainly will
prove to be an interesting and valuable avenue for
inquiry (Banker et al. 2000). Researchers should
not only develop an explanation of how IT may
allow firms to write better contracts, but also how
contracts can be written to take advantage of
some of the special properties of IT, such as
costless reproduction of software. Decision support for outsourcing contracts is also an avenue of
inquiry that would help firms utilize IT to generate
value. While it seems that none are more qualified
to develop such systems than the IT community,
Walden/Intellectual Property Rights
the legal nuances of contracting would require the
cooperation of legal scholars, paving the way for
more interdisciplinary research.
Another important operational research area
concerns itself with digital contracting. Some
authors have begun to examine this issue (Dasgupta and Dickinson 1998). There is no a priori
reason why contracts must be static documents.
Contracts could be dynamic intelligent systems
that constantly update their parameters in
response to changes in the external environment.
A digital contract could have the capabilities of
smoothing the impacts of business events by
tapping directly into the accounting, finance, and
operational systems of each firm.
Another direction for future research is to expand
the range of property rights considered. This work
focuses on two different types of ownership rights
defined in prior property rights literature (Alchian
and Demsetz 1973). However, there are clearly a
multitude of different property rights that exist in
reality.14 For example, each party could have the
right to grant usability rights, so that each party
could freely sell the property to others without
gaining the acceptance of the other party. Alternatively, the software could be created with
copyleft—the ability for anyone to use the software, but for no one to sell the software. Rights
could be assigned to allow one party to exclude
some certain group and the other party to exclude
some other group—like a protected territory. The
range of possible property rights is limited only by
the creativity of the contract writer. Further
exploration of other commonly appearing rights
would certainly be a welcome contribution, as
would devising hitherto unimagined rights that
generate greater welfare.
While this work has focused on property rights,
other methods of generating surplus in IT
outsourcing might also play a significant role.
These might include dependence balancing (Heide
and John 1988), reputation (Williamson 1985),
trust (Das and Teng 1998), and messaging (Tirole
14
I thank an anonymous reviewer for pointing this out.
1999). In all likelihood, no one theory can explain
all of the text in contracts, and future research
should address the degree to which different
theories explain contracts. More importantly,
future research should address the boundary
conditions that lead firms to choose one theory
over another.
Finally, this work focuses on a narrow section of
the contract concerned with the software assets.
It seems that, to some degree, the arguments put
forth apply to other types of intellectual property,
such as know-how, data, or trade secrets. The
fundamental difference between software and
physical assets is the ability for software to be
simultaneously and independently used in an
infinite number of locations, while physical assets
must occupy a single location at any given time.
This ability to be in use at multiple locations at the
same time is an attribute largely shared by all
intellectual property. For those types of intellectual
property that require a great deal of human interaction, the model would have to be modified to
account for two characteristics. First, transfer of
the intellectual property among humans may entail
significant costs. Second, humans are free-willed
entities rather than assets to be owned, and thus
their incentives must be taken into account.
However, the effort may be well worth it in order to
better understand knowledge management.
Bakos, Brynjolfsson, and Nault have examined
some of the human aspects of intellectual property
from a property rights viewpoint; however, they
constrained themselves to the traditional ownership structures (Bakos and Brynjolfsson 1993a;
Bakos and Nault 1997).
Conclusion
The property rights approach has a great deal to
offer to the understanding of software issues in IT
outsourcing contracts. The basic model proposes
that incentives lead to actions, which generate
value. While this has a great deal of face validity
and logical consistency, it is not easily actionable
because it is too general. However, when it is
recognized that different types of assets give rise
to different, fairly specific, bundles of property
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rights, one can begin to generate richer, actionable, and testable theory. Of particular importance
to the IT outsourcing context are intellectual property issues, such as software issues. Of course,
these intellectual property issues may also apply to
trade secrets and other knowledge assets.
Outsourcing will continue to grow in importance in
the coming years as firms seek new ways to
generate value. The contract is the defining document of these relationships. Understanding how it
is created and how it should be created offers a
remarkable opportunity for IT researchers and
practitioners to help firms become more successful. This work is a beginning step in aiding
development of a comprehensive theory of the
why and how of IT contracting, and it is hoped that
it inspires a generation of researchers to scrutinize
this question and continue the research.
Acknowledgments
The author would like to thank George John,
Donald Jones, James Burkman, Zhangxi Lin,
Param Vir Sidhu, three anonymous reviewers, and
the two editors for their valuable comments and
insights; Robert Kauffman and Alina Chircu for the
introduction to incomplete contract theory; and the
participants in the Texas Tech IS colloquium for
their input.
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About the Author
Eric Walden’s research interests focus on developing a greater understanding of information systems in the organizational context. This includes
issues within and among organizations. Eric tries
MIS Quarterly Vol. 29 No. 4/December 2005
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to combine strong theory from industrial organization in economics, with empirical validation
within an organizational context. It is his hope that
this focus will bridge a gap between pure analytic
economics issues and softer, real world organizational issues, making each more accessible to
the other and helping to develop real theory unique
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to the information systems literature. Eric received
his Ph.D. from the University of Minnesota, and is
currently an assistant professor at the Rawls
College of Business at Texas Tech University. His
prior research has appeared in Information Systems Research, The International Journal of
Electronic Commerce, and Electronic Markets.