Economics of Organization Chapter 2: Transaction Costs Theory

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Economics of Organization Chapter 2
Transaction Costs Theory

• Joe Mahoney
• University of Illinois at Urbana-Champaign

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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

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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.

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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.

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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
• Moral hazard (hidden action)
• Ex post opportunistic behavior
• Adverse selection (hidden information)
• Ex ante opportunistic behavior
• Idiosyncratic assets

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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.

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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

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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.

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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.

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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 a hold-up
  problem.

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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.

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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)

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Williamson (1975)
Markets and Hierarchies

• Multi-divisional Organization

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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.

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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.

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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

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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

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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.

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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.

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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.