Make-or-Buy in Software: The Boundaries of the Firm through Transaction Cost Economics

When large organizations are faced with the decision of whether to build software in-house or purchase the software from a vendor, they are faced with a common issue in economics: the make-or-buy decision. Ronald Coase's (1937) theory of the firm and Oliver Williamson's work in transaction cost economics provide a lens to understand these choices. The issue at hand is whether a firm can more efficiently utilize hierarchical control in-house or rely on outside providers.

In the modern digital economy, this decision plays out in many settings, including payroll systems, logistics platforms, and emobility software development where complex integrations and long term updates make the question especially relevant.

Asset Specificity: Industry Knowledge vs. Market Contracts

Williamson's primary contribution is about how asset specificity guides governance structures. In terms of software, that specificity can be categorized as the base of industry knowledge and custom integrations. For instance, a multinational utility company that requires grid management tools tailored to specific regulatory framework may need to ask itself: is it better to train developers in-house to create custom integrations from scratch considering how expensive it would be, or rely on a vendor that specializes in these verticals since they’ve already spread costs across many clients?

That said, once a firm has committed to a solution that is vendor-specific, it becomes very difficult to switch. This “lock-in” is characteristic of Williamson's bilateral dependency concept, which explains how both parties have the potential for detrimental opportunistic behaviors. Long term contracts with detailed intellectual property (IP) agreements and exit clauses can mitigate some of these opportunistic behaviors.

Coordination and Monitoring Expenses

With respect to the role of transaction costs, Coase argued that firms exist to minimize transaction costs in markets. But, there are also costs attached to coordinating in-house development: with project management , with team turnover, and there will always be the ongoing effort and costs of keeping skills up to date. 

Outsourcing to specialized vendors transfer these costs into service-level agreements (SLAs) and the vendor governance model. Vendors are expected to adhere to uptime, feature delivery and compliance with security, while firms are expected to monitor these standards through dashboards and audits. In its 2023 IT services report, Gartner reported that, 72% of enterprises are currently using formalized KPIs to monitor vendor performance, rather than mere informal oversight, a sign of a mature governance model.

Uncertainty and Frequency of Work

Transaction cost economics suggests that optimal boundary is a function of both the frequency of tasks, as well as its uncertainty. Generally, firms with repeat, but stable needs (for instance, a stable HR or finance software need), tend to purchase standardized solutions. Alternatively, where uncertainty is heightened, firms may choose increased flexibility in staffing.

Yet, today there are many third-party providers (TPPs) that contract embedded teams for the long-term; therein blurring the line between the traditional notions of outsourcing or internal employment. For example, enterprise clients could engage engineers belonging to a vendor for years. By taking this approach, the firm reduces the hiring risk with staffing and has the flexibility to deal with the consequences of demand fluctuations, and can still keep transaction costs lower instead of expanding the full time payroll blanket.

Relational Contracting and Performance Clauses

It is impossible to have complete contracts for software projects because of its nature to continuously evolve. Williamson described this as the problem of incomplete contracts. Therefore, a relational contracting model or an agreement based on trust, repeat interactions, and mechanisms for flexible adjustment is more important.

In practice, performance clauses are the central principles. Contracts often outline release schedules, bug fix lead times, and financial penalties for downtime. In mission-critical sectors such as aviation or healthcare, regulators sometimes mandate these performance guarantees, effectively normalizing the relational governance.

Economic Forces Leading to Trend

There are a set of macroeconomic forces that can explain why enterprises are buying more rather than making:

Increasing Complexity - Software stacks evolve quicker than companies can train internal people. For example, there is a steep learning curve to deploy and manage a cloud-native platform (the Kubernetes orchestration and scaling) or launching an AI model.

Labor Market Constraints - According to the World Economic Forum, there will be a talent shortage for qualified developers of 85 million people world-wide by 2030 and in-house hiring becomes increasingly expensive. 

Economies of Scale – Vendors providing the same service for multiple clients can share their development, compliance, and security costs across their client bases. A single banking institution could never cost-effectively replicate the same cyber defense infrastructure that an external vendor provides across fifty clients.

Implications for Firms and Markets

The shift to vendor-based long-term staffing opens the door to several implications:

• Re-defining Boundaries: The lines between "inside the organization" and "outside the organization" blur as vendors provide teams that feel internal but remain contract-based.

• Lock-In Risk: Asset specificity means firms must do their due diligence when designing contracts to avoid becoming overly dependent.

• Market Concentration: As big players dominate the niches, bargaining power moves away from individual companies, and long-term costs go up.

Conclusion

Transaction cost economics shows the make-or-buy decision in software is not about ideology, it’s about minimizing total costs of coordination, monitoring and opportunism. The rise of embedded vendor teams is a pragmatic rebalancing of firm boundaries: buying external capacity is often simpler and cheaper than scaling internal talent, especially in fast moving spaces like emobility software development.

For economics undergrads and grads, this is a real-life example of Coase’s insight: firms and markets are not rivals, they are adaptive structures whose boundaries change with technology, costs and institutional design.