Information systems outsourcing projects as a double moral hazard problem

In the past two decades many organizations have turned to other organizations to satisfy their information systems needs. Information systems outsourcing arrangements cover the spectrum from agreements involving the delivery of all information services to those providing specific services such as systems development, communications management, desktop computing provision and maintenance, and so on. In this paper we model information systems outsourcing arrangements as a non‐cooperative game with two players: a company and an outsourcing vendor. The game between the two players has an inherent double moral hazard problem as the success of the information system outsourcing project depends on the actions of both players, which are costly for them and are not directly contractible. Both parties make their decisions taking into account the effects that these decisions have on the other player's actions. In our analysis, we compare the solution obtained without a moral hazard problem (the first‐best solution) to the one obtained under a double moral hazard setting (the second‐best solution). We demonstrate some results based on the assumption that increases in the productivity of the vendor lead to increases in the productivity of the company. Further we establish that outsourcing contracts should provide no separate payment for failure to the outsourcing vendor although effectively many of them do. We also provide a sharing rule for providing appropriate incentives for the vendor and examine the dynamics associated with this sharing rule. Finally, we further provide for the characterization of response functions and the ensuing Nash solution including the optimal outsourcing fee. This allows for the nuanced consideration of the degree of interaction between the effort of one party and the productivity of the effort of the other party. This particular interaction has not been explored formally in the extant research literature.