Lecture 8 - Transaction Cost Economics

Question 1

TCE: Behavioral assumptions

Answer 1

• Bounded rationality
• Opportunistic behavior

Question 2

TCE: Contracts

Answer 2

Incomplete
* High costs of writing a complex/complete contract
* Inability to anticipate all possible contingencies
* Different interpretations of the same contractual terms
* Some contractual terms may be unverifiable by an independent third party (e.g., a court)

Question 3

TCE: View of the firm

Answer 3

Nexus of incomplete contracts

Question 4

TCE: Governance structures

Answer 4

• Hierarchies (firms)
• Hybrids (franchise)
• Markets

Question 5

Factors influencing transactions

Answer 5

• Frequency
• Uncertainty
• Asset specificity

Question 6

Asset Specificity

Answer 6

1. Physical asset specificity
   o E.g., specific/specialized tools for production
2. Site-specific
   o Investment is costly to move once it has been made. E.g., steel production & oil drilling
3. Dedicated assets
   o Upon contract termination, excessive capacity
4. Brand names
   o Large investment which may be difficult to re-coup in alternative use
5. Human asset specificity
   o Valuable knowledge for specific tasks
6. Time specificity
   o When timely responsiveness is necessary, and this creates dependence

Question 7

Quasi-surplus / rent

Answer 7

• Quasi-surplus: the difference between the value of the asset in the current (best) use and its next best use
• Once specialized assets are in place, trading partners will try to expropriate part of those quasi-rents
• Occurs because specific assets aren’t easily re-deployable

Question 8

Hold-up problem

Answer 8

Ex ante reservation prices
U’s cost: $200 (part of the cost that is sunk: K)
Value to D: $240

Surplus
Surplus: value-costs=$240-$200=$40
Quasi-surplus: surplus+K=$40+K
quasi-surplus = value in best use ($240) minus value in the next best use ($200 – K)

Ex ante contract price and profits – K = $0
Bargaining power: 50:50
Ex-ante contract price: $220
U profit (revenue – investment): $220 - $200 = $20
D profit (value – cost): $240 - $220 = $20
I.e., both parties benefit from the transaction

Ex post reservation prices – K = $60
K = $60
U: Costs-Sunk costs=$200-$60=$140
D: Value=$240

Quasi-surplus
Quasi-surplus: surplus+K=$40+$60=$100

Contract price and profits if K = $60
Bargaining power: 50:50
Ex post contract price: $190
Profits:
U profit (revenue – investment): $190 - $200 = -10
D profit (value – cost): $240 - $190 = $50

Question 9

Ex post

Answer 9

Bargaining is now over the quasi-surplus
D will try to appropriate the quasi-surplus

Question 10

Consequences of the Hold-Up Problem

Answer 10

• Underinvestment (market failure)
• Contract negotiations become costly b/c need to protect yourself
• Distrust  more detailed contracts –> more costly
• Distrust –> less flow of information –> less efficient process

Question 11

Solution to the Hold-Up Problem

Answer 11

Choose another governance structure (than the market), which results in the efficient choice of investment (hierarchy or hybrid)

Low Asset Specificity: Markets
Medium Asset Specificity: Hybrids
High Asset Specificity: Hierarchies

Question 12

Advantages of buy option (markets)

Answer 12

• Outside suppliers often perform a task better than the firm can
• Competencies, capabilities may be too different for vertical integration to make sense
• Subject to market discipline; in-house units may be able to hide their inefficiencies behind overall corporate success
• Williamson: Vertical integration is the option of last resort
• So, the real challenge may be to achieve the benefits of the market, while safeguarding transactions with a high degree of asset specificity
  –> hybrid forms such as alliances, long-term contractual arrangements…