In this paper, we argue that capabilities serve as shift parameters that result in a change in the critical value of asset specificity at which firms switch from in-sourcing to outsourcing. Capabilities have two effects: they result in a change in firm production costs and in firm governance costs relative to the market. As a result, the frontier at which market governance gives way to firm governance shifts. Three factors that produce such shifts are the value, rarity, and inimitability of capabilities employed in firm processes. Considered as shift parameters, the effect of capabilities integrates seamlessly into transaction costs reasoning and is not a competing view of firm governance. We demonstrate these arguments empirically using a sample of 180 information systems sourcing decisions. Copyright © 2013 John Wiley & Sons, Ltd.