The Role of Investment in Innovation on Asset Ownership in IT Outsourcing

We develop an economic model that relaxes assumptions in Property Rights Theory to allow for investment in innovation that can benefit both client and vendor in an IT outsourcing relationship. Our model offers an explanation for the empirically observed heterogeneity in asset ownership structure. We find that optimal ownership structure can vary due to the different incentives of the client and vendor and differences in the available set of investment opportunities. We show that scenarios exist where the client and vendor agree on the ownership structure and others where they disagree. When investment in innovation enables new services and features then the client should retain ownership of the assets and when it leads to cost savings then the vendor should own the assets. The client and vendor disagree on the asset ownership structure when the investment opportunities yield similar levels of benefits to both vendor and client. In this case neither party wants to own the assets. When there are multiple investment opportunities, both client and vendor prefer to own the assets. We find that allowing renegotiation leads to different ownership preferences. In the absence of renegotiation, the client and vendor agree on the ownership structure in most cases, however when renegotiation is allowed, they always disagree on the ownership structure. We find that allowing renegotiation leads to greater investment in innovation but also causes more gaming between the parties with ex post surplus extraction and more free-riding.