13Baker et al. (1997) present a formal analysis of the choice between external and internal procurement,
82Journal of Economic Perspectives/ 300e se26 Mp82Tuesday Oct 03 02:43 PMLP–JEPse26would presumably bring severe future penalties. As importantly, the amount offuture business awarded to a supplier is linked to ratings of supplier performance.The auto companies carefully monitor supplier behavior—including cost reduc-tions, quality levels and improvements, general cooperativeness, and so on—andfrequent redesigns allow them to punish and reward performance on an on-goingbasis. In this sense, supplier relationships in Japan are potentiallyless, not more,locked in than in the traditional U.S. model, where at the corresponding point inthe value chain, the supplier is typically an in-house division or department.Having a small number of suppliers is crucial to the Japanese system. It reducesthe costs of monitoring and increases the frequency of transacting, both of whichstrengthen the force of reputation. Also, the rents that are generated in the pro-duction process do not have to be shared too widely, providing the source forsignificant future rewards. This logic underlies the normal ‘‘two-supplier system’’used at Toyota. There is more than one supplier to permit comparative perfor-mance evaluation, to allow shifting of business as a reward or punishment, to pro-vide insurance against mishaps, and perhaps to limit the hold-up power of eachsupplier, but the number is not chosen to minimize hold-ups.The relationship is marked by rich information sharing, including both sched-ules of production plans necessary for just-in-time inventory management and alsodetails of technology, operations and costs. The automakers also assist the suppliersin improving productivity and lowering costs: technical support engineers are amajor part of the automakers’ purchasing staff, and they spend significant amountsof time at the suppliers’ facilities. All this in turn means that potential informationasymmetries are reduced, which presumably facilitates both performance evalua-tion and the pricing negotiations.14Perhaps the major problem in the system may be that the automakers areinherently too powerful and thus face too great a temptation to misbehave oppor-tunistically. Indeed, many Japanese observers of the system have interpreted it interms of the automakers’ exploitation of their power. One counterbalance to thispower asymmetry is the supplier association, which facilitates communicationamong the suppliers and ensures that if the auto company exploits its power overone, all will know and its reputation will be damaged generally. This raises the costof misbehavior. In this regard, the fact that Toyota itself organized an associationof the leading suppliers for its Kentucky assembly plant is noteworthy (Milgromand Roberts, 1993).