13. Transaction Costs Flashcards
Simon’s parallelism (1991, “Organization and Markets”)
Suppose that a mythical visitor from Mars approaches the Earth from space, equipped with a telescope that reveals social structures. The firms reveal themselves, say, as solid green areas with faint interior contours marking out divisions and departments. Market transactions show as red lines connecting firms, forming a network in the spaces between them. As our visitor looked more carefully at the scene beneath, it might see one of the green masses divide, as a firm divested itself of one of its divisions. Or it might see one green object gobble up another. No matter whether our visitor approached the United States or the Soviet Union, urban China or the European Community, the greater part of the space below it would be within the green areas, for almost all of the inhabitants would be employees, hence inside the firm boundaries. Organizations would be the dominant feature of the landscape. A message sent back home, describing the scene, would speak of “large green areas interconnected by red lines.” It would not likely speak of “a network of red lines connecting green spots.”
Simon’s parallelism (1991, “Organization and Markets”)
Suppose that a mythical visitor from Mars approaches the Earth from space, equipped with a telescope that reveals social structures. The firms reveal themselves, say, as solid green areas with faint interior contours marking out divisions and departments. Market transactions show as red lines connecting firms, forming a network in the spaces between them. As our visitor looked more carefully at the scene beneath, it might see one of the green masses divide, as a firm divested itself of one of its divisions. Or it might see one green object gobble up another. No matter whether our visitor approached the United States or the Soviet Union, urban China or the European Community, the greater part of the space below it would be within the green areas, for almost all of the inhabitants would be employees, hence inside the firm boundaries. Organizations would be the dominant feature of the landscape. A message sent back home, describing the scene, would speak of “large green areas interconnected by red lines.” It would not likely speak of “a network of red lines connecting green spots.”
TCE perspective (Coase 1937, Williamson 1975, 1981)
In the neoclassical vision of markets, the exchange of goods in the market is without frictions or costs. If markets are perfectly competitive, the economic system reach Pareto optimal allocations.
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The Transaction Cost Economics (TCE) doubts the existence of these “perfect” markets: transactions are not instantaneous, the use of markets is costly: time & money to search for sellers & buyers, negotiate exchange terms, write contracts, enforce deals.
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In many circumstances, market is not the best economic organization to govern a transaction and alternative governance structures can be preferred.
The 3 pillars of the TCE
- Bounded rationality
- Opportunism
- Relationship-Specific Investments
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Without these three conditions the market works efficiently, otherwise the use of the market implies substantial costs
Bounded rationality (Herbert Simon, 1957)
“Boundedly rational agents experience limits in formulating and solving complex problems and in processing (receiving, storing, retrieving, transmitting) information“ (Herbert Simon, 1957, “A Behavioral Model of Rational Choice” in Models of Man, Social and Rational: Mathematical Essays on Rational Human Behavior in a Social Setting. New York: Wiley).
“Does bounded rationality mean that people (and therefore their actions) are irrational? Not at all. People making choices are intendedly rational. They want to make rational decisions, but they cannot always do so” (Bryan D. Jones, Bounded Rationality, Annu. Rev. Polit. Sci. 1999. 2:297–321).
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In decision making, rationality of individuals is limited by:
(a) the information they have: the economic agent does not know perfectly the present state of the nature and he is not able to forecast all the possible states of nature on which he will finds himself after a decision (substantial limit caused by environmental uncertainty).
(b) the cognitive limitations of their minds: even if it is possible to know the present and forecast all the possible future states of nature, there is not an algorithm that enables to find optimal solutions in a reasonable time. There is a “cognitive” and “time” problem (procedural limit).
–> Agents rely on heuristics and approximations for their behavior.
In the TCE perspective the bounded rationality implies two important facts.
In the TCE perspective the bounded rationality implies two important facts.
If 2 or more parties want to regulate a transaction by a contract:
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- It is very difficult to include in the contract all possible details of interest for the object of the contract: they can not include every likely (and less likely) circumstance in the present and in the relevant future that is of interest.
- Even if this could be possible, the parties are not able (or it would be too costly) to negotiate everyone of these single details. And if this could be possible (but it is not), details should be written down.
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–> Contracts are incomplete:
the parties of a contract have and can exert a certain degree of discretion over the fulfillment of contractual clauses.
Opportunism
(Some) Economic agents:
Pursue selfishly their own utility and interest even if this is detrimental to the utility or interest of someone else.
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Note:
- Not all economic agents are opportunists, but it is enough that some of them behave opportunistically in order to incur in additional costs of transaction.
- Ex-ante it is not possible to distinguish between opportunistic and not opportunistic economic agents
- Opportunistic behaviors can appear during the writing of the contract and also after (Post-Contractual Opportunism).
Relationship-Specific Investments
Investments that are specific to the relationship between the parties and to the nature of the counterparts
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Examples (among the myriad possible).
- A supplier working for FIAT Chrysler has to buy ad-hoc machines for specializing itself in the production of a car-component that can be sold to FIAT Chrysler only.
- A supplier locates the plant close to one single specific customer firm in order to facilitate just-in-time processes, but there are no other firms in the surroundings to whom the good can be sold.
- A firm acquires a software and trains its employees for its usage, while this type software is sold and its usage taught only by a specific software house.
- I am invited to hold lectures in the small island of Neverland, if I accept I have to translate all my slides and learn how to speak Neverlandish.
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The 3 most important types of relationship-specific investments:
The 3 most important types of relationship-specific investments:
- Physical asset specificity refers to assets whose (physical or engineering) properties are specifically tailored to a particular transaction (e.g. supplier-buyer relationship along the supply chain).
- Site specificity refers to assets that are located side-by-side to economize on transportation (e.g. for high transportation costs) or inventory costs or to take advantage of processing efficiencies.
- Human asset specificity refers to situations where some of the managers/employees of the firms engaged in the transaction may have to acquire relationship-specific skills, know-how and information.
The 3 most important types of relationship-specific investments:
The 3 most important types of relationship-specific investments:
- Physical asset specificity refers to assets whose (physical or engineering) properties are specifically tailored to a particular transaction (e.g. supplier-buyer relationship along the supply chain).
- Site specificity refers to assets that are located side-by-side to economize on transportation (e.g. for high transportation costs) or inventory costs or to take advantage of processing efficiencies.
- Human asset specificity refers to situations where some of the managers/employees of the firms engaged in the transaction may have to acquire relationship-specific skills, know-how and information.
The 3 most important types of relationship-specific investments:
The 3 most important types of relationship-specific investments:
- Physical asset specificity refers to assets whose (physical or engineering) properties are specifically tailored to a particular transaction (e.g. supplier-buyer relationship along the supply chain).
- Site specificity refers to assets that are located side-by-side to economize on transportation (e.g. for high transportation costs) or inventory costs or to take advantage of processing efficiencies.
- Human asset specificity refers to situations where some of the managers/employees of the firms engaged in the transaction may have to acquire relationship-specific skills, know-how and information.
Relationship-Specific Investments
The relation-specific part of the investment (red area) is not recognized outside the relationship (non-redeployable inv.)
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The more this red area is large the more a firm would be reluctant to exit from the relationship (once entered)
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The more asymmetric these red areas are between parties, the more the firm facing low relationship-specific investment may “exploit” the firm facing high relationship-specific investment
Example on rent, quasi-rent and the hold upproblem
Suppose your company contemplates building a factory to produce cup holders for Ford automobiles. The factory can make up to 1 million holders per year at an average variable cost of C dollars per unit.
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The construction of your factory is financed with a mortgage from a bank that requires an annual payment of I dollars. The loan payment of I dollars thus represents your (annualized) cost of investment in this plant. I is an unavoidable cost: You have to make your payment even if you do not do business with Ford.
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You will design and build the factory specifically to produce cup holders for Ford. Total cost of making 1 million cup holders is thus:
I + 1,000,000C dollars per year.
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Of course your expectation is that Ford will purchase your holders at a profitable price (you will make non negative extra-profits out of this business).
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But suppose that you also want to consider outside options (i.e. Market). The “market price” you can expect to get from selling your cup holders is Pm.
Suppose that:
Pm > C.
Variable profits (without considering fixed cost I): 1,000,000(Pm - C) > 0
But that the annual investment cost I > 1,000,000(Pm - C).
See slides for cont
Transaction Cost Economics approach
Given that markets are not always perfect and their use may entail substantial costs the main aim of the TCE perspective is to individuate for each transaction the best governance structure possible.
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3 alternatives:
- Market which may present costs (related to the use of contracts).
- Hierarchy (transactions are internalized and carried out inside the firm, costs arise from the administrative bureaucracy that internalize and monitor the exchanges).
- Hybrid forms (e.g. non equity alliances, equity alliances, joint ventures).
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The efficient solution to govern a transaction may change over time, in a sort of Darwinian selection process, where only the best option (in that particular time) survives. Note that from this perspective, firm may be seen as an efficient response to a market failure.
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The famous Fisher Body-GM case study is emblematic of this dynamics.
Classification of transactions (Williamson 1986)
2 determinants:
1) Relation-specific investment needed for carrying out the transactions
2) Frequency of transactions
An increase in uncertainty of transactions (which may affect the degree of incompleteness of contracts) is likely to lead to less hybrid forms
