Economics of Strategy The Costs of Market Exchange: Transactions Costs

1. Economics of StrategyThe Costs of Market Exchange:Transactions Costs

2. Transactions Costs • the costs of negotiating, monitoring, and consummating a contractual arrangement

3. Arms-length market transactions • a transaction in which autonomous parties exchange goods or services with no formal, agreement that the relationship will extend into the future • governed by contract law • disputes are typically litigated

4. Contracts • define the conditions of exchange • are critical to a system of private property rights • involve at least two parties who usually fulfill the contract in sequential steps • represent an observable, rational interaction between two or more parties

5. Complete Contracts • map out every possible contingency and prescribe the rights and responsibilities of each party under each possible contingency • are fully enforceable • don’t exist

6. Incomplete Contracts • do not map out all contingencies, rights, and responsibilities • are the norm • the degree of completeness is a function of marginal costs and marginal benefits of identifying, assessing and monitoring compliance with the contract

7. What prevents complete contracting? • Bounded Rationality • Difficulties in specifying performance ex ante • Difficulties in measuring performance ex post • Asymmetric Information

8. Bounded Rationality • limits in our ability to collect, assimilate, process, and act upon information • we are neither omniscient nor capable of perfect foresight

9. Difficulties in specifying performance ex ante • difficulty in foreseeing all contingencies • costs of calculating foreseen contingencies • unforeseen circumstances • imprecision of language; especially in legal code • “preponderance of the evidence” • “with reasonable certainty”

10. Difficulties in measuring performance ex post • Who measures the performance? • How is performance measured?

11. Asymmetric Information • where one party has more complete information than another

12. Asymmetric Information • Hidden Information • when one party knows something which the other party does not • Hidden Action • when one party cannot observe or verify or measure contract performance

13. Contract Law • assists in contracting by providing enforceable norms across contracts

14. Contract Law • is written in a sufficiently broad way as to not be a perfect substitute for complete contracting • “reasonable”, “in good faith”, “with due diligence” • is costly due to litigation • direct costs of litigation • litigation damages relationships • in the case of firms these relationships were initially instituted and consummated because each firm was better off

15. Beyond Contract Law • Relationship-Specific Investments • Quasi-rents • The Holdup Problem

16. Relationship-Specific Investments (RSIs) • asset investment which is tied to a specific transaction and has characteristics which hinder the costless redeployment of the asset to other customers or other uses • RSIs create interdependency among the contracting parties • these types of assets set up a “fundamental transformation” in the relationship between upstream and downstream firms

17. Fundamental Transformation • upstream firms and downstream firms form symbiotic relationships • upstream firms that hold a specific asset may engage in “buy-in” pricing • lowball price to create the relationship and then take advantage of being the sole supplier of inputs • downstream firms typically have some, often high, monopsony leverage • these factors create distrust

18. Forms of Asset Specificity • Site Specificity • Physical Asset Specificity • Dedicated Assets • Human Asset Specificity

19. Site Specificity • assets are built in the same geographic proximity in order to facilitate exchange and/or reduce costs • reduced transportation costs • temporal coordination of upstream inputs to downstream purchasers

20. Physical Asset Specificity • specialized machinery unique to one downstream firm or even to one specific transaction • physical or engineering properties which are customized for one particular customer or transaction

21. Dedicated Assets • assets which are the direct result of the needs of a particular upstream buyer • they are customized for one particular customer or transaction

22. Human Asset Specificity • specific human capital among workers which is comprised of firm-specific knowledge • skills, training, technical expertise • firm culture for managers • this firm-specific knowledge has more value within the existing employment relationship than it has in the open market

23. Bargaining with Asset Specificity • Rent - the difference between the revenues the seller actually receives and the minimum amount of revenue that it must receive to make it worthwhile to enter the relationship ex ante. • Rents are also known as economic profit.

24. Bargaining with Asset Specificity • Quasi-Rents - the difference between the revenue the seller actually receives and what it must receive to be induced to not exit the relationship ex post. • Quasi-rents occur when a relationship-specific investment leads to: • contract renegotiations which directly benefit one party at the expense of another • opportunistic action by one party, that the other party cannot prevent because of incomplete contracting or being locked into a symbiotic relationship

25. The Case of Dr. Smithrents and quasi-rents

26. The Holdup Problem • opportunistic behavior by one party to a contract to exploit the other party’s vulnerability due to a relationship specific investment (rsi) • this raises the costs of transactions of market transactions in four ways • Contract Negotiations/Renegotiations • Distrust • Investments to improve ex post bargaining positions • Reduced RSI investment generally

27. Contract Negotiations/ Renegotiations • when either side sees the possibility of holdup ex ante the initial contracting will more complex and expensive • any renegotiations directly raise transactions costs • direct costs of renegotiating contracts • particularly critical where temporal coordination is important

28. Investments to improve ex post bargaining position • Making alternative contracts with other suppliers in case of holdup • leads to increased transaction costs • leads to the potential for over-investment/excess capacity • where the alternative supplier is used, parceling up production may not allow any one supplier to achieve full economies of scale

29. Distrust • Raises transactions costs • contracts must become more complete which costs more • impedes opportunities for sharing information or ideas which could increase quality or reduce costs

30. Reduced Investment in RSIs • Relationship specific investments will become less attractive • Efficiencies which could be gained through RSIs will be lost • Induces vertical integration where market exchange would be more efficient

31. Transactions Costs and Vertical Integration • Differences in Governance • Repeated Relationships • Organizational Influences

32. Differences in Governance • the ability to handle disputes through administrative mechanisms rather than the courts • more flexible and less costly • typically less antagonistic • the party making judgment presumably has better information concerning • the details of the disagreement • the ramifications of alternative outcomes for both the involved parties and the firm

33. Repeated Relationships • Vertical Integration assures the benefits of repeated relationships • stability • dramatically reduces the potential for hold-up problems

34. Organizational Influences • Membership in the firm requires affirmation and support of firm goals • The ability of corporate culture to influence behavior