Economic Foundations of Strategy Chapter 2: Transaction Costs Theory

1. Economic Foundations of StrategyChapter 2: Transaction Costs Theory Joe Mahoney University of Illinois at Urbana-Champaign

2. Transaction Costs Theory: • Arrow (1974): The Limits of Organization • Coase (1988): The Firm, the Market and the Law • Williamson (1975): Markets and Hierarchies • Williamson (1985): The Economic Institutions of Capitalism • Williamson (1996): The Mechanisms of Governance

3. Arrow (1974) The Limits of Organization • “If I am not for myself then who is for me? And if I am not for others, then who am I? And if not now, when?” • There is a tension we all feel between the claims of individual self-fulfillment and those of social conscience and action.

4. Arrow (1974) The Limits of Organization • There are profound (economic and ethical) difficulties with the price system. • The idealization of freedom though the market ignores that this freedom can be, to a large number of people, very limited in scope. • Valuable though it is in certain realms, the price system cannot be made the complete arbiter of social life. • The price system does not, in any way, prescribe a just distribution of income.

5. Arrow (1974) The Limits of Organization • Organizations are means of achieving the benefits of collective action in situations where there are severe market frictions: • Moral hazard (hidden action); • Ex post opportunistic behavior • Adverse selection (hidden information); • Ex ante opportunistic behavior • Idiosyncratic assets • Uncertainty and the inability to insure some risks;

6. Coase (1988) The Firm, the Market and the Law • In the absence of transaction costs, markets and hierarchies would be equivalent in terms of allocative efficiency (Coase, 1937). • In the absence of transaction costs, liability rules would be equivalent in terms of allocative efficiency (Coase, 1960). • In a world of positive transaction costs, the choice of markets and hierarchies (and the choice of liability rules) matter for economic efficiency.

7. Williamson (1975) Markets and Hierarchies • A systematic study of market frictions: • Incomplete markets due to uncertainty • Insurance problems • Employment relations • Vertical integration • Capital markets • Increasing returns and sunk costs • Indivisibilities • Information asymmetries • Public goods • Lack of definition of property rights • Externalities with positive transaction costs

8. Williamson (1975) Markets and Hierarchies • A comparative assessment of the economic efficiency of alternative governance modes; • Organizational boundary issues are approached in an interdisciplinary way where law, property rights theory, business history, and organization theory are usefully brought together; and • The theory is applied to product markets, labor markets, capital markets and value- chain analysis.

9. Williamson (1975) Markets and Hierarchies • Following Coase (1937) and Simon (1947), hierarchy usually implies a superior-subordinate relationship; • The “employment relationship” is commonly associated with voluntary subordination. • The benefits and costs of the firm (e.g., vertical integration) are well articulated.

11. Williamson (1975) Markets and Hierarchies • Due to uncertainty and boundedrationality, contracts are necessarily incomplete. • Incomplete contracts are a problem when some people act with opportunisticbehavior and there is small-numbers bargaining in the presence of assetspecificity, which can lead to an economic hold-up problem.

13. Williamson (1975) Markets and Hierarchies • Benefits of Vertical Integration: • Eliminates preemptive claims on profits between separate firms; • Cooperation can be achieved better in an adaptive sequential manner with more refined rewards; • Internal auditing has superior features to external auditing (e.g., railroad cartels); and • More likely to achieve convergent expectations within the firm via the development of a coding system within the firm.

14. Williamson (1975) Markets and Hierarchies • Costs of Vertical Integration: • Internal Procurement Bias • A norm of reciprocity easily develops • Internal Expansion Bias and Persistence • Partly a mechanism for reducing conflicts • Communication Distortion • Serial reproduction loss (bounded rationality problem) • Deliberate distortion (an opportunism problem)

15. Williamson (1975) Markets and Hierarchies • Multi-divisional Organization

16. Williamson (1975) Markets and Hierarchies • Multi-divisional Organization • Responsibilities for operating divisions are assigned to (essentially self-contained) operating units; • The general office is mainly concerned with strategic decisions, rather than tactical decisions; • Divisions are monitored and economic incentives are provided; • Cash flow is allocated to high-yield uses.

17. Williamson (1985) Economic Institutions of Capitalism • More precisely identifies asset specificity as the key concept for potential contractual hazards: • Asset specificity implies small-numbers, but • Small-numbers does not imply asset specificity (e.g., a contestable market). • Emphasizes the concept of “fundamental transformation.”

18. Williamson (1985) Economic Institutions of Capitalism • Physical Asset Specificity: E.g., specialized tools • Human Capital Specificity: E.g., firm-specific knowledge • Site Specificity: E.g., the co-location of an electric plant and a coal mine

19. Williamson (1985) Economic Institutions of Capitalism • Economic “hostages” involve asset specificity; • They are an important component of self-enforcing agreements; • They have both ex ante (screening) and ex post (bonding) effects; and • The wise manager should both give and receive credible commitments. • Key Idea: MUTUAL sunk cost commitment

20. Williamson (1996) The Mechanisms of Governance • Remediableness Criterion: • Relevant comparisons are with feasible alternatives all of which are flawed. • Claims of (path dependency arguments of) inefficiency (Arthur, 1994) that can be recognized only after the fact and/or cannot be implemented with net gains have no operational importance.

21. Williamson (1996) The Mechanisms of Governance • Discrete Structural Alternatives: • Firms employ different means than markets employ; • Discrete contract law differences serve to define each generic form of governance; and • The implicit contract law of internal organization is forbearance. • Hierarchy is its own court of ultimate appeal.

22. Williamson (1996) The Mechanisms of Governance • “Calculative trust” is a contradiction in terms: • To craft credible commitments (through the use of economic bonds, economic hostages, information disclosure rules, specialized dispute settlement mechanisms) is to create functional substitutes for trust. • It is redundant at best and can be misleading to use the term “trust” to describe commercial exchange for which investments in mutual economic hostages have been made.