“Outsourcing and Market Thickness: The Case of U.S. Credit Unions”

This paper examines the role of market size as a determinant of market transaction costs using microdata on the IT outsourcing of U.S. credit unions. Taking advantage of cross-vendor variation of client information, we distinguish the effects of two explanations on an observed positive relationship between outsourcing and market thickness: (1) market transaction costs are lower in thicker markets, and (2) economies of scale in an vendor's production make outsourcing more attractive in thicker markets. We construct an estimation strategy based on a model of a coalitional game, in which a trade-off between market transaction costs and scale economy determines credit unions' equilibrium outsourcing decisions. To measure market thickness, we exploit the variation of credit union size and location, which characterize their IT requirements and are determined mostly at the time of their openings. Our estimation results show that, even after controlling for the effect of scale economies, a sizable effect of market thickness remains to explain credit unions' outsourcing decisions, indicating a significant role that market thickness plays in reducing transaction costs. In particular, apart from the effects of scale economies, an an increase in market thickness in terms of credit union size by one standard deviation raises the credit union's outsourcing probability by 16 percentage points (from 30% to 46%) on average.