Transcation Cost Theory Flashcards
What are TC
They are the costs associated with economic exchange.
Internal vs. External
They help to explain and predict the boundaries of the firm. They help managers to decide which activities to perform in-house and which services to get from external markets.
Internal vs. External TC
External
- Searching a firm to contract with
- Negotiating, monitoring and enforcing the contract
Internal
- Recruiting and retaining employees
- Salaries and benefits
- Setting up shop floor
- Provide office space and computers
- Incentivizing employees
Ways to organize economic transactions
Transactions between firms:
Markets - individuals are guided by market prices and make independent decisions to buy and sell goods
Transactions within a firm:
Hierarchies - Transactions among parties occur under a unified owner, who settles disputes by administrative control
When to vertically integrate
When TC - inhouse < TC - market
- Own production of the inputs
- Own distribution channels
When firms are more efficient than the market, vertically integrate.
TC Theory - Behavioral Assumptions
One can never write completely detailed agreements covering all possible future contingencies - incomplete contracting. One is exposed to
Bounded rationality: Utility maximizing, intendedly rational actors are constrained by cognitive limits to progress information.
Opportunism: Self-interest with guile - could induce counterpart to cheat, confuse, etc.
TC Theory - Characteristics Transactions
- Uncertainty - about environments, about actors
- Frequency - of exchanges, one-off or recurrent
- Asset specificity
Asset Specificity
Unique assets with high opportunity cost. They have significantly more value in their intended use than in their next-best use.
- Site specificity - Co-location requirements
- Physical specificity - Unique physical & engineering properties
- Human asset specificity - Investments made in human capital
Appropriability
This means the appropriability of knowledge and determines the risk of knowledge leakage. Even with vertical integration, this could be an issue.
TC Theory - Costs
Cost of markets:
- Search costs
- Negotiation costs
- Costs of contracting
- Enforcing and monitoring contracts
- Smaller number bargaining and dependence
- Cost of opportunistic behavior
Cost of hierarchies:
- Administrative and organizing costs
- Costs of monitoring and creating incentives
- Cost of opportunistic behavior
The context and characteristics of the transaction determine which governance mechanism is relatively cheaper and thereby the scope of the firm.
Benefits and risk of Vertical Integration
Benefits:
- Lower costs
- Control over quality
- Facilitates scheduling and planning
- Facilitates investments in specialized assets
- Secures critical supplies and distribution channels
- Offset/ limit bargaining power of buyers and suppliers
Risks
- Increase in costs
- Reduction in quality
- Reduction in flexibility (demand fluctuations, changes in tech, BUT could conducive system-wide flexibility)
- lack of incentives for businesses to operate in most efficient way
Benefits and risks of outsourcing
Benefits:
- Focus on core capabilities and where you can create value
- Increased flexibility
- Easier to get rid of partners when they are external than vertically integrated suppliers or distributors
Risk:
- Reputation risk
- Contract enforceability might be an issue, could create competitor
- Hold up the situation in case supplier has high bargaining power
Tapered integration
As an alternative to vertical integration
- Backward Integration& relying on others for supplies
- Forward Integration & relying on others for distribution
Corporate Strategy: Implementation and Coordination & Boundaries of the firm and ownership
Integration: Organization and Coordination to create synergies
When not full ownership is necessary the TCT helps to determine the best governance (Alliance - JV - Contract - Long term relationships with trust)
YouTube Videos
In Slides two nice videos - Session 7 Slide 63
