Transcript TRANSACTION COST THEORY

TRANSACTION COST THEORY
Ronald Coase (1937) posed two Nobel-prize puzzles :
• Why do any firms emerge in a market economy?
• Why not just One Big Firm for whole economy?
Neoclassical economics treats the firm as a production
function that efficiently transforms land, labor & capital
inputs into goods & services. Competitive markets
coordinate buyer-seller exchanges via price signals.
Coase argued that market mechanism not cost-free, but involves
transaction costs: time & money to search for sellers & buyers,
negotiate exchange terms, write contracts, inspect results, enforce deals
Firms will emerge if an “economizing” organization can
reduce its production + transaction costs < market prices
Firm expansion halts when intra-org’l TC > market prices
The Costs of Transacting
Transaction: The transfer of a good/service across
“technologically separable interface” (locational boundary)
EX: Machine-scoring of multiple-choice exams
Reserve reading materials
Transaction costs of making, enforcing agreements
EX: How much to conduct your one-time social
survey?
Transactions are embedded within social, political, legal
institutional environments that affect transaction costs.
These “rules of the game” affect property, production,
distribution, and exchange relations among economic actors
EX: EPA regulations about lead pollution emissions
Transaction cost theory seeks to explain variations in forms of
governance of economic exchanges
Forms of Governance
Oliver Williamson (1975, 1981) identified three
fundamental forms of transaction governance
and the conditions when they’re likely to occur:
Market: Autonomous parties’ exchanges are
governed by prices in supply-demand equilibrium
Hierarchy: (Formal org) Transactions among parties occur under
a unified owner, who settles disputes by administrative fiat
Hybrid: “Long-term contractual relations that preserve [parties’]
autonomy, but provide added transaction-specific safeguards as
compared with the market.”
EX: United Way and social service agencies
Strategic alliances; agricultural cooperatives
Networks of small-medium suppliers and manufacturers
Behavioral Assumptions
Transaction parties can never write completely detailed agreements
covering all possible future contingencies (“incomplete contracting”)
Williamson assumed transactors’ abilities & motives involve:
Bounded rationality: Utility-maximizing, intendedly rational
transactors are constrained by cognitive limits on their capacities to
process information efficiently (contrast to neoclassical perfect info)
Opportunism: “Self-interest with guile” could
induce strategic behavior by transactors to lie to,
cheat, confuse, mislead their exchange partners
EX: Used car salesmen; political candidates;
your prelim study group?
Nicolo Machiavelli
Even when opportunism risks are low, orgs must still
safeguard against possibly severe damages from an
opportunistic partner (worst case scenario)
Three Transaction Dimensions
Transactions have three key dimensions that determine
how their costs affect governance choice
• Uncertainty about environments, other actors
EX: Floods delay factory supplier’s just-in-time deliveries
• Frequency of exchanges; one-off or recurrent?
• Asset specificity: investments lacking alternative uses except
at loss of productive value; asset specificities can be human skills,
geographical sites, brand names, dedicated machinery
EX: You buy a unique readings packet for this course
Chip supplier builds factory to Dell’s computer specs
Transaction Economizing → Governance
Williamson’s key claim: Variations in exchange governance
forms result from efforts to economize on transaction costs
His three transaction costs dimensions align efficiently with
transactors’ choices among the three ideal forms of governance:
Market
Hybrid
Hierarchy
Uncertainty
LOW
MIDDLE
HIGH
Frequency
LOW
MIDDLE
HIGH
Asset
Specificity
LOW
MIDDLE
HIGH
Make-or-Buy?
Transaction cost theory examines the conditions under which
organizations chose to internalize some functions (hierarchy) or
to purchase them on the market (e.g., relational subcontracting)
EX When should a firm or agency train its own employees, hire external
vendor (college or commercial), or create a jointly staffed program?
• Are employee job skill requirements
changing rapidly & unpredictably?
• How often must newly hired or promoted
workers be (re)trained?
• Would org’s own training staff have to
invest heavily in asset-specific facilities,
such as simulation labs?
• Is org’s own training staff more knowledgeable than external trainers
about firm-specific and tacit skills needed by employees?
• Are external vendors competent, reliable & cost efficient?
More TC Applications
TC theory can be applied to explain diverse org’l phenomena:
• Difficulties in establishing micro-credit lending associations
• Unionization drive successes or failures
• Creation of “company towns” for miners, loggers
• Diffusion of conglomerate, M-form corporate structures
• Mergers-acquisitions vs. technology transfers among alliance partners
• Quarrels over which members own a defunct rock band’s name
(Pink Floyd, Yes, Flying Burrito Brothers) (Cameron & Collins 1997)
• Band names are asset-specific capital for
re-releases of oldies that fans will buy
• Reincarnated inferior group seeks
undeserved “rents” from the reputations
earned by their more talented predecessors
TC Theory Critiques
TC theory’s heavy emphasis on potentially opportunism by
employees & partners is an unwarrantedly pessimistic view of
human nature (but, economics is “the dismal science”)
Is TC as a normative prescription for org’l best-practices?
• Moral dimensions of organizational behavior could reduce or replace
need to make and enforce formal contractual safeguards against
opportunistic risks of deceit and self-interested, guileful actions
• Trust among individuals & between organizations is an alternative
basis for lowering transaction costs
• Learning effectiveness increases with transactors’ beliefs in an
information source’s competence and goodwill
• Self-actualization motives (work- and org-commitments) orient
participants towards collective performances
• Empowerment to make work decisions gives participants a stake in
achieving better performance outcomes
PRINCIPAL-AGENT THEORY
Principal-agent theory shares TC concepts of uncertainty,
opportunism, externalization, cost-efficiency calculations
Principal pays Agent to perform service in exchange for fee
EX: Hollywood & sports agents negotiate contracts for stars
Board pays CEO megabuck$ to boost share prices
Trustees hire President to raise U’s academic prestige
• Information asymmetry: How does Principal know if Agent is
competent and working on behalf of P’s interests? (If P had
necessary knowledge and skills, A would be unnecessary)
• Agency costs: Principal’s search, monitoring, bonding costs to
hire and supervise Agent (vs P doing the job herself)
• Opportunism (moral hazard): Risk-averse Agent tempted to
deceive & shirk duties; pocket fee but not deliver the best deal
Performance Incentives
Monitoring Agent’s skills & activities is difficult, so Principal could
use pay-for-performance incentives to encourage A’s risk-taking
and make A more accountable in looking out for P’s interests
EX: Make A’s compen$ation contingent on actual outcomes
CEO bonus, stock options depend on annual share prices
Teacher’s salary gains tied to her student’s test scores
Problem: Org’s performance affected by many factors beyond
agent’s control (fickle consumers, govt regs, bad weather)
In high uncertainty, tying compensation to performance may
actually induce a risk-averse CEO to take timid, less-risky
actions in effort to avoid a major loss to personal fortune
Major corporate CEO pay-performance effect very weak: only $3.25 per
$1,000 change in shareholder wealth = 1 week’s pay ($9,600 in 1980s)
This amount judged “small for an occupation in which incentive pay is
expected to play an important role” (Jensen & Murphy 1990:227)
References
Cameron, Samuel and Alan Collins. 1997. “Transaction Costs and
Partnerships: The Case of Rock Bands.” Journal of Economic Behavior and
Organization 32:171-183.
Coase, Ronald H. 1937. “The Nature of the Firm.” Economica 4:386-405.
Reprinted pp. 33-55 in R.H. Coase. 1988. The Firm, the Market, and the
Law. Chicago: University of Chicago Press.
Jensen, Michael C. and Kevin J. Murphy. 1990. “Performance Pay and TopManagement Incentives.” Journal of Political Economy 98:225-264.
Williamson, Oliver E. 1975. Markets and Hierarchies: Analysis and
Antitrust Implications. New York: Free Press.
Williamson, Oliver E. 1981. “The Economics of Organization: The
Transaction Cost Approach.” American Journal of Sociology 87:548-577.