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Economic Foundations

of Strategy

Chapter 2: Transaction

Costs Theory

Joe Mahoney

University of Illinoisat Urbana-Champaign


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Transaction Costs Theory:

Arrow (1974): The Limits of Organization

Coase (1988): The Firm, the Market and theLaw

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 theclaims of individual self-fulfillment and

those of social conscience and action.


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Arrow (1974)


There are profound (economic and ethical)difficulties with the price system.

The idealization of freedom though the market

ignores that this freedom can be, to a largenumber of people, very limited in scope.

Valuable though it is in certain realms, the

price system cannot be made the completearbiter of social life.

The price system does not, in any way,

prescribe a just distribution of income.


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Arrow (1974)


Organizations are means of achieving the benefits ofcollective action in situations where there are severemarket frictions:

Moral hazard (hidden action);

Ex post opportunistic behavior

Adverse selection (hidden information);

Ex ante opportunistic behavior

Idiosyncratic assets

Uncertainty and the inabilityto insure some risks;


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Coase (1988)

The Firm, the Market and the Law

In the absence of transaction costs, marketsand hierarchies would be equivalent interms of allocative efficiency (Coase, 1937).

In the absence of transaction costs, liabilityrules would be equivalent in terms ofallocative efficiency (Coase, 1960).

In a world of positive transaction costs, thechoice of markets and hierarchies (and thechoice of liability rules) matter for

economic 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)


A comparative assessment of the economic efficiency ofalternative governance modes;

Organizational boundary issues are approached in an

interdisciplinary way where law, property rights theory,business history, and organization theory are usefullybrought together; and

The theory is applied to product markets, labormarkets, capital markets and value- chain analysis.


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Williamson (1975)


Following Coase (1937) and Simon (1947),hierarchy usually implies a superior-subordinate relationship;

The employment relationship iscommonly associated with voluntarysubordination.

The benefits and costs of the firm (e.g., vertical

integration) are well articulated.


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12/22Managerial Eco. - Rutgers University 6-13

Opt imal Input Procurement

Substantial

specialized

investmentsrelative to

contracting costs?

Spot ExchangeNo

Complex contracting

environment relative to

costs of integration?

Yes

Vertical

Integration

Yes

Contract

No


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Williamson (1975)


Benefits of Vertical Integration:

Eliminates preemptive claims onprofits between separate firms;

Cooperation can be achieved better in an adaptivesequential manner with more refined rewards;

Internal auditing has superior features to externalauditing (e.g., railroad cartels); and

More likely to achieve convergent expectations

within the firm via the development of a codingsystem within the firm.


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Williamson (1975)


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 (bounded rationality problem)

Deliberate distortion (an opportunism problem)


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Williamson (1975)


Multi-divisional Organization

R&D

HR

Finance

Production

Mktg/Sales

Division A

R&D

HR

Finance

Production

Mktg/Sales

Division B

R&D

HR

Finance

Production

Mktg/Sales

Division C

Corporate

Headquarters


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Williamson (1975)


Multi-divisional Organization

Responsibilities for operating divisions are assignedto (essentially self-contained) operating units;

The general office is mainly concerned with strategicdecisions, rather than tactical decisions;

Divisions are monitored and economic incentivesare provided;

Cash flow is allocated to high-yield uses.

R&D

HR

Finance

Production

Mktg/Sales

Division A

R&D

HR

Finance

Production

Mktg/Sales

Division B

R&D

HR

Finance

Production

Mktg/Sales

Division C

Corporate

Headquarters


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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)


Physical Asset Specificity:

E.g., specialized tools

Human Capital Specificity:E.g., firm-specific knowledge

Site Specificity: E.g., the co-location ofan electric plant and a coal mine


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Williamson (1985)


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 receivecredible commitments.

Key Idea: MUTUAL sunk cost commitment


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Williamson (1996)


Remediableness Criterion:

Relevant comparisons are with feasiblealternatives 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.

i i (1996)


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Williamson (1996)


Discrete Structural Alternatives:

Firms employ different means than markets employ;

Discrete contract law differences serve to defineeach generic form of governance; and

The implicit contract law of internal

organization is forbearance.

Hierarchy is its own court ofultimate appeal.


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Williamson (1996)


Calculative trust is a contradiction in terms:

To craft credible commitments (through the use of

economic bonds, economic hostages, informationdisclosure rules, specialized dispute settlementmechanisms) is to create functional substitutes fortrust.

It is redundant at best and can bemisleading to use the term trust todescribe commercial exchange forwhich investments in mutual economichostages have been made.

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