13 baker et al 1997 present a formal analysis of the

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13 Baker et al. (1997) present a formal analysis of the choice between external and internal procurement,
82 Journal of Economic Perspectives / 300e se26 Mp 82 Tuesday Oct 03 02:43 PM LP–JEP se26 would presumably bring severe future penalties. As importantly, the amount of future 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—and frequent redesigns allow them to punish and reward performance on an on-going basis. In this sense, supplier relationships in Japan are potentially less , not more, locked in than in the traditional U.S. model, where at the corresponding point in the 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 reduces the costs of monitoring and increases the frequency of transacting, both of which strengthen 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 for significant 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 each supplier, 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 also details of technology, operations and costs. The automakers also assist the suppliers in improving productivity and lowering costs: technical support engineers are a major part of the automakers’ purchasing staff, and they spend significant amounts of time at the suppliers’ facilities. All this in turn means that potential information asymmetries are reduced, which presumably facilitates both performance evalua- tion and the pricing negotiations. 14 Perhaps the major problem in the system may be that the automakers are inherently too powerful and thus face too great a temptation to misbehave oppor- tunistically. Indeed, many Japanese observers of the system have interpreted it in terms of the automakers’ exploitation of their power. One counterbalance to this power asymmetry is the supplier association, which facilitates communication among the suppliers and ensures that if the auto company exploits its power over one, all will know and its reputation will be damaged generally. This raises the cost of misbehavior. In this regard, the fact that Toyota itself organized an association of the leading suppliers for its Kentucky assembly plant is noteworthy (Milgrom and Roberts, 1993).

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