Transcript Economic Foundations of Strategy Chapter 2: Transaction Costs Theory Joe Mahoney University of Illinois at Urbana-Champaign.

Economic Foundations
of Strategy
Chapter 2: Transaction
Costs Theory
Joe Mahoney
University of Illinois
at Urbana-Champaign
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
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 selffulfillment and those of social
conscience and action.
Arrow (1974)
The Limits of Organization
 There are profound (economic and
ethical) difficulties with the price system.
 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.
Arrow (1974)
The Limits of Organization
 Organizations are means of achieving the benefits of
collective action in situations where there are severe
market frictions:
• Uncertainty and the inability to insure some risks
(leading to incomplete markets);
• Moral hazard (hidden action);
• Ex post opportunistic behavior
• Adverse selection (hidden information);
• Ex ante opportunistic behavior
• Idiosyncratic assets
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
efficiency.
Williamson (1975)
Markets and Hierarchies
 A systematic study of market frictions:
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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
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.
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.
Williamson (1975)
Markets and Hierarchies
 Due to uncertainty and bounded
rationality, contracts are necessarily
incomplete.
 Incomplete contracts are a problem
when some people act with opportunistic
behavior and there is small-numbers
bargaining in the presence of asset
specificity, which can lead to an
economic hold-up problem.
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.
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 (a bounded rationality
problem)
• Deliberate distortion (an opportunism problem)
Williamson (1975)
Markets and Hierarchies
 Multi-divisional Organization
Corporate
Headquarters
Division A
Division B
Division C
R&D
R&D
R&D
HR
HR
HR
Finance
Finance
Finance
Production
Production
Production
Mktg/Sales
Mktg/Sales
Mktg/Sales
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.
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.”
Williamson (1985) Economic
Institutions of Capitalism
 Site Specificity: E.g., the co-location of an
electric plant and a coal mine
 Physical Asset Specificity: E.g., specialized
tools
 Human Capital Specificity: E.g., firm-specific
knowledge
Williamson (1985) Economic
Institutions of Capitalism
 Economic “hostages” involve asset specificity;
 They are an important component of selfenforcing 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
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.
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.
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.