Session 8: The Boundaries of the Firm I: Transaction Cost Economics

Question 1

Observable vs verifiable information

Answer 1

Sensible incomplete contracts are based only on information which is observable as well as verifiable. Observable information which is not verifiable is left out of a sensible incomplete contract

Question 2

The size of a firm

Answer 2

The size of a firm: According to Coase, the size of a firm is determined by the point where the marginal cost of transacting in the market equals the marginal cost of additional mistakes and more administrative rigidity in the company

Question 3

Transaction costs

Answer 3

Costs of bargaining, designing contracts, monitoring, dispute resolution, etc.

• Narrow sense: The time and effort necessary to establish a transaction or exchange
• Broad sense: The means required in negotiating the contracts, the time needed to enforce contracts and the costs involved with taking precautionary measures (what this section is geared towards)

The incompleteness of contracts results in various transaction costs, which are expressed in co-ordination and motivation problems.

Question 4

Assumptions in transaction costs economics

Answer 4

1. People are bounded rational.
2. People are not always trustworthy / honest, but opportunistic.
3. Transactions differ with respect to how frequently they take place; the uncertainty that surrounds them; and the degree of asset specificity they involve.
4. Different contractual, organizational arrangements (i.e., «governance structures») necessary for handling different transactions

Question 5

Asset specificity

Answer 5

When the investment has a higher value inside the specific relationship than outside it. Such investments are called sunk investments, because part of the costs is sunk into the relationship, i.e. cannot be recovered elsewhere

Five types of specific investments
1. Site-specific: Ex-ante decisions to minimize inventory and transportation expenses. It is however costly to move them once they have been made (e.g., the construction of a harbor)
2. Human asset specificity: Knowledge which is valuable for specific work. Arises learning by doing fashion
3. Dedicated assets: Derive their value from the prospect of selling a significant amount of product to a specific customer
4. Physical asset specificity: The design of specific tools required to product a component of, for example, a computer chip or car
5. Brand name: Improves the image of a product and thus value of the product. However, the investment of building a brand is hard to recoup
6. Time specificity: (Introduced later): When “timely responsiveness” is necessary, and this creates dependence

Question 6

Quasi surplus

Answer 6

Indicates the size of the possible contractual problems. Quasi-surplus is defined as the value of an investment in its current use minus the value of the investment in its best alternative use. It equals the revenue minus the recoverable costs

Surplus vs. quasi-surplus: The difference between surplus and quasi-surplus is the sunk cost. The quasi-surplus is always at least as large as the surplus. Quasi-surplus emerges when specific investments are done

Question 7

Hold-up problem

Answer 7

Renegotiating the contract by the downstream party. The party which has made the relation-specific investments finds itself in a disadvantageous position, because the other party has various possibilities of reducing the price of the contract. E.g., threats to break up the relationship
* Not necessarily inefficient. The only effect of hold-up is redistribution of the quasi-surplus

Conclusion: Investing will generate -10, while not investing will yield 0, and therefore, the inventor will not invest (0,0 is equilibrium). This is a dramatic example of transaction costs

(See picture in notes)

Question 8

Governance structure

Answer 8

The choice of governance structure is driven by minimizing transaction costs (production costs can be ignored)
* The transaction is the unit of analysis
* Governance structure is chosen depending on the characteristics of the transaction (the frequency with which a transaction occurs, the degree of asset specificity and the degree of uncertainty that surrounds the transaction)

Assumptions: The behavioral assumptions are opportunism and limited rationality

Question 9

Choice of governance structure

Answer 9

As a function of asset specificity and uncertainty

(Low AS, low uncertainty): Market
(Low AS, high uncertainty): Market
(High AS, low uncertainty): Long-term contract
(High AS, High uncertainty): Hierarchy

Question 10

Vertical integration and long-term contract

Answer 10

Vertical integration: An example of a governance structure. Removes the fear of and prevents the hold-up problems and therefore results in valuable investments. In a situation with high asset specificity, long-term contracts and vertical integration remain as possible efficient forms of governance

Long-term contract: The governance structure that will be chosen (over vertical integration) in a market with limited uncertainty, because having a good reputation is important in such markets
* Bad behavior (violating contracts) is undesirable in stable markets (low uncertainty) because many other parties will find out about it. Bad behavior is more undesirable when reputation plays an important role in relationships

Question 11

Problems of vertical integration

Answer 11

Specialization: Outside suppliers often perform a task better than the firm can.

Incompatibility: 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.”

The real challenge may be to achieve the benefits of the market, while safeguarding transactions with a high degree of asset specificity → hybrid forms, e.g., alliances, long-term contractual arrangements

Question 12

Frequency of the transactions

Answer 12

Formulated in terms of level of asset specificity and the frequency with which transaction costs occur

(Low frequency, Low AS): Market transaction/”market governance
(Low frequency, Medium AS): Contract/”Trilateral governance”
(Low frequency, High AS): Firm organization/”Unified governance”
(High frequency, Low AS): Market transaction/”market governance)
(High frequency, Medium AS): Contract/”Bilateral governance”
(High frequency, High AS): Firm organization/”Unified governance)

(see picture in notes)

• Unilateral governance structure: One party has the power, e.g., vertical integration
• Bilateral governance structure: Both parties are independent and have comparable power, e.g., long-term contracts

Question 13

Efficiency and governance structure

Answer 13

(See picture in notes)

If the degree of specificity of investments is low kϵ[0,k_1 ], then the governance structure market had the lowest costs M(k)
For high level asset specificity, the hierarchy has the lowest governance costs H(k)
A hybrid governance structure is chosen to minimize the governance costs when the level of asset specificity is at an intermediate level i.e., kϵ[k_1,k_2 ] (e.g., franchises, joint ventures, etc.)

Question 14

Other considerations in choosing organizational structure

Answer 14

Measurement approach: In the measurement approach, the governance structure with the lowest measurement costs (the costs of measuring costs and benefits) is chosen

The role of risk: Another ingredient in the choice of governance structure is the degree of risk aversion. This may argue against vertical integration, because becoming the owner entails carrying a lot of risk. This is unattractive for a risk averse agent

Bargaining problem: Three kinds of bargaining problem:
1. Co-ordination problem: This argues for bringing the transaction inside the organization, because co-ordination is an important task of management
2. Collection of information: A lot of time is spent on determining the costs and benefits of a project, because it is known that proposals are submitted by self-interested or opportunistic individuals
3. Asymmetric information: Regarding the reservation prices of the involved parties. This offers possibilities for the misinterpretation of preferences, where exchange may not occur even though it is attractive for everybody

Market exchange is efficient when there are no bargaining costs, regardless of the frequency of the transactions, the degree of uncertainty and the level of asset specificity

Question 15

WILLIAMSON (1991): Focus of the paper

Answer 15

To identify and explicate the key differences that distinguish three generic forms of economic organization, market, hybrid, and hierarchy. The three generic forms are distinguished by different coordinating and control mechanisms and by different abilities to adapt to disturbances.

Question 16

WILLIAMSON (1991): Dimensionalizing governance:

Answer 16

Transactions and governance: Transactions, which differ in their attributes, are aligned with governance structures, which differ in their costs and competencies, in a discriminating way.

Adaptation: “Economic problems arise always and only in consequence of change”
* Adaptation A: (A) denotes autonomy; Neoclassical ideal in which consumers and producers respond independently to parametric price changes so as to maximize their utility and profits, respectively.
* Adaptation C: Bilateral dependency introduces an opportunity to realize gains through hierarchy. As compared with the market, the use of formal organization to orchestrate coordinated adaptation to unanticipated disturbances enjoys adaptive advantages as the condition of bilateral dependency progressively builds up

Markets and hierarchies: Markets and hierarchies are polar modes. As indicated at the outset, however, a major purpose of this paper is to locate hybrid modes in relation to these polar modes.

Hybrid modes: The hybrid mode displays intermediate values in all four features.
* It preserves ownership autonomy, which elicits strong incentives and encourages adaptation to type A disturbances (those to which one party can respond efficiently without consulting the other).
* Because there is bilateral dependency, however, long-term contracts are supported by added contractual safeguards and administrative apparatus (information disclosure, dispute-settlement machinery). These facilitate adaptations of type C but come at the cost of incentive attenuation.

Question 17

WILLIAMSON (1991): Advantage of hierarchy over hybrid

Answer 17

With respect to bilateral adaptation, internal contracts can be more incomplete. More importantly, adaptations to consequential disturbances are less costly within firms because
1. Proposals to adapt require less documentation
2. Resolving internal disputes by fiat rather than arbitration saves resources and facilitates timely adaptation
3. Information that is deeply impacted can more easily be accessed and more accurately assessed
4. Internal dispute resolution enjoys the support of informal organization
5. Internal organization has access to additional incentive instruments-including especially career reward and joint profit sharing-that promote a team orientation.

Question 18

WILLIAMSON (1991): Conclusions

Answer 18

(1) The economic problem of society is described as that of adaptation, of which autonomous and coordinated kinds are distinguished.
(2) Each generic form of governance is shown to rest on a distinctive form of contract law, of which the contract law of forbearance, which applies to internal organization and supports fiat, is especially noteworthy.
(3) The hybrid form of organization is not a loose amalgam of market and hierarchy but possesses its own disciplined rationale.
(4) More generally, the logic of each generic form of governance (market, hybrid, and hierarchy) is revealed by the dimensionalization and explication of governance herein developed.
(5) The obviously related but hitherto disjunct stages of institutional economics (the institutional environment and the institutions of governance) are joined by interpreting the institutional environment as a locus of shift parameters, changes in which parameters induce shifts in the comparative costs of governance.