Nobel Prize winner's theory shows where Boeing went wrong with its 787

Is competition in a free market always the best way? That idea certainly contributed to our current financial catastrophe. But one of yesterday's Nobel Prize winners for economics, Oliver Williamson, was lauded for his work suggesting that the free market isn't always the most efficient way to allocate resources. For instance, sometimes it's better for a company to do things itself, rather than turn to outsourcing.

If Williamson had been asked about it, he would likely have predicted the failure of Boeing's (BA) approach to developing its 787 Dreamliner, which now has an 850-order backlog due to production delays. As Williamson acolyte and Berkeley professor, Steve Tadelis, told the Wall Street Journal, Williamson's theories would have predicted problems because Boeing shifted too much responsibility to the free market when it decided to outsource 60 percent of the 787's design and development to suppliers (as I wrote in my book, You Can't Order Change).

Williamson argues that in an oligopoly -- an industry, such as aircraft manufacturing, where a handful of firms control the business -- it's far more efficient to coordinate activities that are performed inside the firm, rather than outside it. This is why some firms backward-integrate, or acquire their suppliers. Tadelis says that because Boeing had less control over its 787 supply line, it couldn't adapt flexibly and quickly to the changes in the complex 787 program, according to the Journal.

The reason Boeing cited for unwittingly defying Williamson's Nobel-winning logic is that it did not want to take on the $10 billion risk of developing a new aircraft. Boeing incorrectly wagered that it could shift the capital, design and manufacturing risk onto the 787's suppliers and that the costs of coordinating those suppliers would be manageable.

With six delays in its production schedule, lost orders, billions in charges and still unsolved technical problems, it's clear that Boeing miscalculated about how manageable those coordination costs would be. Whether Boeing has done enough to "in-source" production to take advantage of Williamson's insights remains to be seen.

Peter Cohan is amanagement consultant, Babson professor and author of eight books including, You Can't Order Change. Follow him on Twitter. He has no financial interest in the securities mentioned.

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