FROM TRANSACTION COST ECONOMICS TO ORGANIZATION THEORY A REVIEW OF THE LITERATURE
Douglas Nanka-Bruce Departament d’Economia de l’Empresa, 08193 Bellaterra, Barcelona - Spain. Email:
[email protected]
Abstract Transaction Cost Economics (TCE) has evolved from two complementary fields of New Institutional Economics (NIE) and New Economics of Organization. TCE was pioneered by Oliver Williamson and strives to push beyond the theory of the firm as a production function to an organization with a governance structure. The objective of this paper is to review the literature on some works that have been constructed from a TCE perspective to appreciate the usefulness of positive transaction costs in analyzing organizational efficiency, effectiveness and efficacy. Some empirical applications of TCE in business and non-business related field are reviewed to appreciate the importance of this framework in helping to understand how organizations seek to engage in optimal decision-making.
Key words: Transaction Cost Economics, New Institutional Economics, Organizational Economics
March, 2004
Table of Contents 1. Problem statement and objectives 2. Introduction and basic concepts 2.1 Transaction and transaction cost explanation 2.2 Types of transaction costs 2.2.1 Market transaction costs 2.2.2 Managerial transaction costs 2.2.3 Political transaction costs 3. Theoretical framework 3.1 Governance structures 3.1.1 Markets 3.1.2 Hierarchy 3.1.3 Hybrid governance forms 3.2 Conditions under which firms supplant the market 3.2.1 Frequency of transactions 3.2.2 Asset specificity 3.2.3 Transactions under uncertainty 3.2.4 Transaction costs and market failure 3.3 Long-term contracts 3.4 Property rights and the nexus of contracts approach 4. Empirical applications of TCE 4.1 Marketing 4.2 Finance 4.3 Organization theory 4.4 Accounting 4.5 International business 4.6 Strategy 4.7 Non-business areas 5. Deficiencies of transaction cost economics 6. Conclusion 7. Bibliography
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1. Problem Statement and Objectives There has been a proliferation of immense literature on the choice of organizational forms from a transaction theory perspective since Williamson (1975) rejuvenated the earlier works by Coase (1937) where the underlying argument is based on efficiency. Performance measures of organizational efficiency have also been analyzed from a resource-based perspective (see for example Wernefelt, 1984; Barney, 1986) and even from a real options perspective. Transaction Cost Economics (TCE) has evolved from two complementary fields of New Institutional Economics (NIE) and New Economics of Organization (Williamson, 1998) and strives to push beyond the theory of the firm as a production function to an organization with a governance structure.
In the classic integration of Great Northern Ore properties into United States Steel, the issue was not to increase the market power of the steel of the latter as had hitherto been believed (from shifting Cournot competition to ex post monopolization) but was an example of acquiring a relationship-specific investment for efficiency gains through a reduction in transaction costs (Mullin & Mullin, 1997). The choice of contractual governance structure was done albeit at the expense of extensive bargaining with its concomitant transaction costs which however was justified in the long-term because the potential for moral hazards had been eschewed to a greater extent. This costs of transaction is missed in the neo-classical approach.
The motive behind the acquisition has been empirically proven by the authors to have been done for an efficient governance structure designed to overcome the problem of ex post opportunism that typically [arose] in contracts involving significant relationship-specific investments and not because of vertical foreclosure considerations (Mulin & Mullin, 1997:96). Transaction costs economics is therefore an efficient theoretical lens to analyze organizations and this is what the paper aims to bring out to the fore.
The basic insight of TCE is to recognize that in a world of positive transaction costs (and that transactions are also costly), exchange agreements must be governed, and that, contingent on the transactions to be organized, some forms of governance are better than others. It evolves whenever there is a contrast between two individuals or
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organizations and since contracts form a core of marketing, it is thus an important aspect to be given its due attention.
The objective of this paper is therefore to review the literature on some works that have been constructed from a TCE perspective to appreciate the usefulness of positive transaction costs in analyzing organizational efficiency, effectiveness and efficacy. Some empirical applications of TCE in business and non-business related field will also be discussed to really appreciate the importance of this framework in helping to understand how organizations seek to engage in optimal decision-making.
2. Introduction and Basic Concepts New institutional economics from which TCE takes its root was founded with figures like John Commons, Wesley Mitchell and Thorstein Veblen but their approach has been described as largely descriptive, with a historical perspective and not based on theoretical foundations. TCE is concerned with how contractual relations are governed. Governance depends on the institutional environment, and the attributes of the relevant economic actors, and assumes that humans are rationally bounded in behavior and thus outcomes will only be second best (Simon, 1961)1. TCE additionally assumes the actors to be opportunistic and are self-interest seeking with guile (Williamson, 1993:114). Williamson suggests that bounded rationality and opportunism have been subscribed from Organizational Theory (OT).
2.1 Transaction and Transaction Cost Explanation TCE provides a systematic application of comparative statics, making equilibrium appear inevitable under conditions that assure the achievement of minimum transaction costs (Slater & Spencer, 2000:74). A transaction occurs when a good or service is transferred across a technologically separable interface. One stage of activity terminates and another one begins (Williamson, 1985:1) or a transaction is said to take place when a good or service passes a technological barrier (Gazendam &
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Bounded rationality leads to incomplete contracts and contractual safeguards are inadequate to combat opportunistic behavior, potential for hold-ups, monitoring and coordinating problems leading to additional administrative costs to streamline these problems.
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Jorna, 2002:2). This barrier determines the delimitations of activity phases. TCE focuses on the transactions between the delimited phases and not on the actual phases. TCE focuses on optimizing transaction costs and is thus an optimization theory.2 Commons also describe transactions as the alienation and acquisition between individuals of the rights of future ownership of physical things (1934:58 quoted in Furubotn & Richter, 2000:41-42).
Transaction costs can be fixed or variable and this is an important consideration in the type of governance structure that will be preferred. Transaction costs within the firm may include coordination and organizational costs. Outside the firm, it includes contracting costs and contract fulfilment costs among firms. More rents are achieved by optimizing the expected revenues on costs. The assumption here is that firms would try to optimize rents but are uncertain of success (Gazendam & Jorna, 2002).
Transaction costs include the costs of resources utilized for the creation, maintenance, use, change, and so on of institutions and organizations (Furobotn & Richter, 2000:40). When applied to property and contract rights, it includes the costs of defining and measuring resources or claims, and the costs of utilizing and enforcing the specified rights. It can also be applied to the transfer of property and contract rights including informational costs, negotiation and enforcement costs between two legal entities or individuals (Furubotn & Richter, 2000).
TCE is used in the analysis of whether to make or buy a product or service as well as how to organize the resulting choice, and many other questions of organizing also. The antecedent of TCE was a seminal paper entitled The Nature of the Firm by Coase3 (1937) and was subsequently developed especially by Williamson (19754, 1985) although Commons (1924) had already discussed the concept.
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See also section 4 on property rights as an optimization theory. … firms arise voluntarily because they represent a more efficient method of organizing production. 4 Williamson argues that contracting problems are posed because of bounded rationality: When, however, transactions are conducted under conditions of uncertainty/complexity, in which event it is very costly, perhaps impossible, to describe the complete decision tree, the bounded rationality constraint is binding and an assessment of alternative organizational modes, in efficiency respects, becomes necessary (1975:23). Hence the problem of uncertainty/complexity is inessential: Given unbounded rationality, contingent claims contracting goes through, whatever the degree of complexity to be dealt with (1975:22). 3
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Boerner and Macher (2001) elaborate on three main factors that underlie positive transaction costs. The first factor is that individuals are limited in their cognitive ability to plan ahead. Despite putting up appreciable efforts in dealing with the complexity and unpredictability of the world, they lack the knowledge, foresight and skill to accurately predict and plan for all the various contingencies that may arise.
The second issue is that assuming perfect planning is possible, it is difficult for contracting parties to negotiate these plans due to the associated complexities in developing a common mode of understanding in describing actions and states of the world5 with which the parties have little prior experience (Hart, 1995 quoted in Boener & Macher, 2001). The third assumption is that parties could plan and negotiate for a complete contingent contract. This is always not the case since there are communication problems for an uninformed third party to reasonably enforce them.
The third factor is that because contracts are incomplete, there are the concomitant occurrence of opportunism due to the fact that humans are selectively rational and would seek to maximize the appropriation of surplus rents. Favorable institutional arrangements are therefore selected to safeguard against such opportunistic behavior and in doing so, minimize the costs of the transactions involved. Such resulting governance structures employed by organizations to safeguard against these contracting hazards vary in discrete structural ways with reference to their adaptive performance by reasons of differences in incentive intensity, administrative controls and contract law regime (Williamson, 1991 quoted in Borner & Macher, 2001:4).
2.2 Types of Transaction Costs Furubotn and Richter (2000) elaborate on three different types of transaction costs, which are; market, managerial and political transaction costs. They still go on to identify variable and fixed transaction costs in all the three types but liken transaction activities as a transaction function in line with production function from neoclassical economics. 5
State of the world is defined as assigning values to all the uncertain variables which are relevant to the economy….and comprises a complete list of all these variables (King 1977:128 quoted in Williamson 1985:28n)
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2.2.1 Market transaction costs Transaction costs in this category comprise mostly of information and bargaining costs. Information costs is necessarily high because of asymmetries and uncertainties of information and the cost associated with searching for interested parties, negotiating and drawing up contracts as well as enforcing these contracts. Furubotn and Richter (2000) broadly classify these costs under search and information costs, bargaining and decision costs, and supervision and enforcement costs.
2.2.2 Managerial transaction costs These are primarily the costs associated with drawing up labor contracts between firms and their employees once the initial costs associated with the market for seeking employees have been concluded. Furubotn and Richter (2000) have identified two types. The first type is the costs of setting up, maintaining and changing organizational designs and are usually fixed costs. The second type is of two types which are all associated with the costs of running the organization. The costs of information associated with decision making, monitoring and measuring performance make up the first of this type. The costs associated with the physical transfer of goods from one technological phase to the other makes up the second category of variable costs in managerial transaction costs.
2.2.3 Political transaction costs Political transaction costs have been a third type identified but this is not so important to the use of transaction costs as a form of organizational theory and as such brief mention will be made of it. Usually it is assumed for granted that market and managerial transaction costs can only work well when the political system is functioning adequately. They are the costs of supplying public goods for collective interest. These costs are: the costs of setting up, maintaining and changing a system’s formal and informal political organization, and the costs of running a polity (Furubotn & Richter, 2000:47-49).
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3. Theoretical Framework Under this section, the theoretical underpinnings of transaction cost economics that determine the mode of governance structure elected will be discussed as well as the conditions when one form of governance mode is preferred to the other, making use of some of the basic concepts that have been discussed in section 2 above.
3.1 Governance Structures The study of governance makes provision for spontaneous and intentional organizational forms (Williamson, 1996b). Complex organizational modes are suitable for organizations with complicated and complex transactions which invites many contractual hazards, whereas simple modes of governance suffice for simple transactions. Of course, using a simple governance mode is inappropriate for complex transactions since contracts will not work effectively and using a complex structure for simple transactions is economically unjustifiable.
TCE colludes to the fact that adaptation is the main issue in economics of organizations, hence matching organizational governance of high requirements for coordination for cost effectiveness and organizational efficiency (Leiblein, 2003). Williamson concedes that TCE is extensively influenced by concepts and empirical underpinnings from organizational theory (1993:108). TCE takes the position of adaptation being the central issue with economic organizations, considers the importance of both autonomous and cooperative kinds of organizational forms and their corresponding hybrids, and argues that market, hybrid and hierarchy differs in their adaptation to autonomous and cooperative forms (Williamson, 1998). TCE acknowledges the use of both types for efficiency within the firm due to their competence abilities to flexibly adapt to both as when required (Williamson, 1998).
3.1.1 Markets Organizations modelled on market exchanges rely on prices to signal opportunities to exploit new opportunities in the changing marketplace by adapting autonomous governance forms. Increasing nature of specific investments leads to a coordinated form of adaptation. The movement from market to hierarchy entails trading off high6
powered incentives and autonomous adaptive properties for the added safeguards and centralized coordinating properties of internal organization (Boerner & Macher, 2001). Governance through the markets can be distinguished from firms by the level of incentive intensity, administrative controls, adaptive mechanism and contractual laws (Williamson 1998).
Transaction cost theory (TCT) also implicitly assumes that market transactions are of a lower cost and more efficient than hierarchical governance due to scale economies, specialization, administrative costs and incentives. Contract laws are also well developed in firms than in the markets ( Boerner & Macher, 2001). But because contracts are incomplete, market transactions may incur added costs to annul its technical efficiencies leading to the firm becoming a cheaper alternative (Leiblein, 2003). Markets may be a
better mode of governance for smaller firms because the advantages that the firm can achieve is only possible when it is relatively large. These advantages are discussed in the section below where markets will still be considered as comparisons between the two governance modes are best made together.
3.1.2 Hierarchy Hierarchy is the asymmetric and incompletely defined authority of one actor to direct the activities of another within certain bounds. However hierarchy is an intrusion on individual liberty that can only interfere with efficiency (Miller, 1992: 16, 27). It is a way of organizing human activities in the context of business transactions as opposed to the market, negotiated contracts and democracy. Hierarchy as already discussed leads to scale economies because overhead costs can be achieved for larger organizations. Hence hierarchy is more convenient for larger organizations because transactions tend to be positively associated with organizational size.
Hierarchical governance forms provide weaker incentives for performance than market contracts because of promotion of teamwork (Leiblein, 2003). Firms are more flexible to a broader set of administrative control systems than market contracts. Williamson (1998) sees core technology as the basic tenet of the TCE approach to the boundary of the firm in which integration is easily done without problems be it forward or backward mechanisms.
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Hierarchy replaces market better when investments and strategic decisions have to be ably coordinated as well as more efficient organization of labor. TCE subscribes to the choice of the debt-equity mix where debt is organized more through market mechanisms and equity through hierarchy as a result of the series of contractual choices that firms are subjected to (Williamson, 1998).
3.1.3 Hybrid governance forms Hybrid governance is what exists before the organization is fully integrated on one side and also overlaps with the market exchange at the other extreme. Hybrid forms have been argued to have most of the advantages of hierarchical governance while being flexible and responsive to market exchanges (Zupan, 1989; Kaufman & Lafontaine, 1994; Minkler & Park, 1994; Dyer, 1996; Menard, 1996; Heide et al, 1998; Kashlak et al, 1998; Bercovitz, 1999; Brickley, 1999). Advantages of the market which are decentralization and competition are overwhelmed by the advantages of the firm which include scale and scope economies and coordination. The hybrid mode gives rise to cospecialization and the combination of the positive aspects of hierarchy and market modes. Albeit, contractual incompleteness and opportunism do make the hybrid form susceptible to ex post enforcing difficulties and appropriate contingent measures should be enacted to minimize the unpleasant effects.
Empirical work has been conducted in the aspect of hybrid organizations which takes the advantages of both hierarchy and markets. These include relational contracting (Palay, 1984), bilateral governance (Heide & John, 1990), and joint ventures (Klein et al, 1990). Oxley (1999) combined all the above hybrid organizational forms in his empirical study. Further empirical studies are considered in section 4.
3.2 Conditions Under Which Firms Supplant the Market Williamson concurs that the three most important elements pertaining to the study of transactions are; the frequency of transaction recurrence, the condition of asset specificity and the level of uncertainty the transaction is exposed to. These elements are now considered below. 8
3.2.1 Frequency of Transactions The basic unit of analysis in the TCE theory is the transaction and the different aspects to which transactions differ are identified and analyzed (Williamson, 1996b). An important assumption underlying transaction cost economics is that important dimensions along which transactions differ can be identified and measured, qualitatively if not quantitatively (Boerner & Macher, 2001).
Transaction frequency has not received much attention in the literature like uncertainty and asset specificity. Williamson (1985) asserts that the frequency of transactions brings the market inside the firm because of the high costs of carrying this outside. It has also been argued that scale economies are associated with internal mode of carrying frequent transactions but empirical research has not been able to fully support this assertion. This may account for the fact that work in this field has not received much attention. Empirical studies such as that of Anderson and Schmittlein (1984), Anderson (1985) and Maltz (1993 & 1994) have not shown any positive correlation with governance mode and transaction frequency. In other studies where transactions are made one-stop and recurrent, a significant relationship has been observed (John & Weiss, 1988; Klein et al, 1990). This therefore is an area of further research.
3.2.2 Asset specificity Williamson (1975:10) writes that the firm offers superior control over opportunism – the internal incentives and control machinery is much more extensive and refined than that which obtains in market exchanges – which implies that when asset specificity is important, the firm will be preferred to market exchanges.
According to Williamson (1996a), there are six types of asset specificity namely: the site, physical asset, human asset, dedicated asset, brand name capital (referring to reputation) and temporality. The site specificity is when the investments are located on the same site to reduce inventory and production costs. Dedicated asset is when the actors have invested too much into this specific investment in order to maximize value for the customer as for example in Just-In-Time production. Temporal or spatial asset
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refers to investments made to facilitate the timely response or coordination of human assets (Leiblein, 2003).
Human asset is a very important specific asset that is developed by the actor in the working relationship with an organization and together with physical assets that are coinvested specialized assets used in adding value to a customer’s product requirements are very essential in sustaining competitive advantage by firms in their industry of operation. Unforeseeable contingencies that affects market contracts include technological and political uncertainties. These hazards are more pronounced when contracts involve the use of specific assets. Market failure is therefore more likely in situations where high levels of asset specificity and uncertainties prevail (Williamson, 1996a).
Barthelemy and Quélin asserts that TCE is too loose in explaining asset specificity and thus distinguish between three types: core specificity, transactional specificity and relational specificity. Core specificity is investment in activities that contribute to competitive advantage. Transactional specificity relates to the employees and equipments that help to achieve core specificity. Relational specificity refers to specific assets that are developed in the duration of a relationship (2002). They argue that though there is a link between transaction specificity and contractual complexity, there is no evidence of opportunism found in the link between core specificity and contract complexity. They thus hypothesize that core ( also transactional and relational) specificity is (are) positively related to contractual complexity.
Several empirical studies have been conducted within the framework of asset specificity. Joskow (1985, 1987 & 1990) has concentrated on site specificity (physical proximity) as a factor in transactional costs. Masten et al (1991) have conducted studies on spatial (temporal) specificity and Masten (1984) looks at asset specificity associated with complex products. Work on inter-firm co-specialization has been done by Dyer (1996). Specificity of working relationship has been studied by Anderson (1985), and that due to communication by Monteverde (1995). Human capital specificity has also been delved with by Monteverde and Teece (1982a & b). Interesting to note also are such works by Hamilton (1999) which deals with specificity of wives and their nuclear families and use of pre-marriage contracts, and a study by 10
Cameron and Collins (1997) on the specificity of individual rock band members to assessment of the music quality.
Asset specificity leads to bilateral contracts to be made by firms. Bargaining, which is a result of sharing surplus quasi-rents leads contracting parties attempting to appropriate the most rents generated from the relationship6. Generally, the studies tend to support that asset specificity in combination with some other transactional issues determine vertical integration to a greater extent7.
3.2.3 Transactions under uncertainty Slater and Spencer (2000) emphasizes the role of uncertainty as a core assumption of TCE and thinks it has been subsumed by the roles of opportunism and bounded rationality8. He lends credence to the fact that Coase didn’t distinguish between risk and uncertainty, while Williamson had placed too much emphasis on Simon’s bounded rationality concept. This had led Williamson9 to create difficulties in distinguishing uncertainty from complexity.
Empirical treatment of the role of uncertainty in TCE has also received the due attention. Uncertainty as used in transactions refer to ex post changes in the market exchanges that were not anticipated hitherto in the contracts. Such varied work have been carried out by Anderson (1985), Heide and John (1990) and Noordewier et al (1990). Heide and John carried out an empirical analysis of demand under uncertainty. Uncertainty of suppliers has also received some study by Walker and Webb (1987). Uncertainty under technological conditions has received attention by various researchers including Walker and Weber (1984), and Balakrishnan and Wernerfelt (1986).
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See section 3.5 for more on property rights theoretical framework. Section 4 deals with more empirical work on asset specificity and vertical integration. 8 Williamson has acknowledged the incompleteness of using bounded rationality (intentionally limited rationality) and has introduced another concept he calls far-sightedness. He argues that contracts are farsighted and incomplete in what he refers to the economic approach (1996a). Agents can thus adapt capacities to learn to look ahead, perceive problems and fold them back into the present. Williamson’s approach has been criticized in Slater and Spencer (2000). 9 Slater and Spencer (2000) also criticize Williamson’s (1985) attempt to distinguish between complexity and uncertainty by attributing opportunism as the creation of uncertainty and behavioral uncertainty as one which leads to complexity. 7
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Anderson (1985), Heide and John (1990), and Stump and Heide (1996) focuses their studies on behaviorial uncertainty and how firms evaluated their partners based on some decision-making criteria. Harrigan (1986) and Klein (1989) have studied how asset specificity and uncertainty are combined in the make or buy decision of organizations.
3.2.4 Transaction costs and market failure Market failure is as a result of inefficient resource allocation. It exists when any of the built-in-assumptions of welfare economics – competitive markets, private goods, and costless information – are not met (Miller, 1992:20). Market contracting becomes inefficient when high costs are incurred for negotiating, monitoring and enforcing contracts. Three factors that cause market failure are – information asymmetries, monopoly power and externalities. Information asymmetry leads to unverifiable information which makes market contracts difficult to carry out.
Externalities have also been realized as a source of market failure. Since several actors are responsible for making a product, shirking by some concerned actors might lead to extensive monitoring – the absence of which might lead to inefficient utilization of resources. In the words of Miller, externalities provide opportunities for individual shirking and can make it especially costly to reach a satisfactory contract for the efforts of any one member or all members of such a team production technology (1992:17). Externality costs tend to be positively associated with increasing information asymmetries. Nash equilibrium of collective efforts tend to become Pareto suboptimal.
Another reason for market failure is when there are only a few players who control the market mechanism. The actors become price setters because of inefficient underallocation of resources to the produced goods. Monopoly power creates incentives that makes rational actors commit to suboptimal outcomes by increasing prices which backfires because consumers react by limiting their purchasing power. Monopoly power also tends to be positively associated with specialization when there are only a
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few players. Specialized team production has the potential for efficiency gains but it also has the ability to create market failure.
As a result of market failure, Williamson proposed three alternatives by which internalization of contracts could be carried out by the firm; these are a one-stop contract, a series of short-term contracts and vertical integration (1971 quoted in Furubotn & Richter, 2000).
3.3 Long-term Contracts A firm’s efficiency advantages is greatest when long-term contracts are negotiated. Long-term contracts are preferable unless the negotiation and enforcement costs of separate short-term market contracts are low (Slater & Spencer, 2000). Long-term contracts however have more contractual problems. Gaps, omissions, and vagueness are necessary aspects of firm contracts; how these contracts are enforced depends on the "conscious control" or "visible hand" (Chandler, 1977 quoted in Slater & Spencer, 2000). Coase (1937) calls this enforcement as the entrepreneur-co-ordinator role.
In terms of long-term contracting, there has also been a very significant interest with studies from contracts between private firms and power utilities in France (Saussier, 2000) to inter-temporal incentives in firms (Libecap & Smith, 1999). Long-term contracts tend to subside the contractual incompleteness problem because of the repeated game logic which reduces the propensity to renege on contracts. When future events can be adequately predicted that are generally agreed upon by contracting parties, contingent contracts are introduced to serve as guidelines for subsequent contractual adjustments.
Under conditions where it is difficult to check conformity to the contractual obligations, mechanisms are instituted for ex post adaptation through rewards and punishments flexible enough in changing conditions. When it is still very difficult to monitor a relational contract which is very specific to a firm, vertical integration to take over the management of the absorbed firm serves as the final panacea.
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The difficulty associated is that future contingencies cannot always be anticipated (Medema, 1992), appropriate adaptation mechanisms will not be known before hand for contingencies until they are witnessed and, there are resulting conflicting claims due to ambiguous changes in the states of the world (Williamson, 1979 quoted in Medema 1992:301).
3.4 Property Rights and the Nexus of Contracts Approach Used in conjunction with transaction costs as a theory of organization is property rights which entails bargaining and who has the right to a property. Property rights will therefore be given treatment as well.10 Property rights are assigned to individuals based on the assumption of the principle of private ownership and that sanctioned ownership rights are transferable by consent in accordance with the principle of freedom of contract (Furubotn & Richter, 2000:71). The individual has the right to use, change some aspects or transfer the rights to another individual (or legal entity) as desired. The ownership rights and competition from the market however determines how the rights are transferred to another party and whether leasing or outright ownership is preferable. Changing constraints of which transaction costs play a significant role lead to the best optimization model that can best be suited for the particular state of the world.
In this view, appropriation of rent profit is inefficient because it diverts control and ownership towards self interested actors whose motivation is reduced by free riders (Alchian & Demsetz, 1972; Jensen & Meckling, 1979). Participation may, however, raise productivity if workers are better equipped to motivate and monitor each other than supervision from management, or if they can provide technical information to management that would otherwise be too costly or time consuming to obtain. Whatever the true relationship between employee sharing, participation and productivity, this study is hindered by a lack of information regarding the extent of co-determination within the firms.
It is not always necessary to take the market inside the firm to achieve optimum outcomes. Sometimes non-hierarchical contracts specifying the necessary actions to be
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For an exhaustive treatment of property rights see for example Furubotn and Richter (2000).
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undertaken by the relevant parties and sharing of quasi-rents can be effectively construed to create harmonized efficiency outcomes. This is applicable in hybrid organizations which sometimes are more efficient than the hierarchical constructs. Property rights significantly reduce transaction costs since there is a third party that is authorized through the courts (or sometimes by arbitration) to enforce the contracts when they are broken. The problem however is the transparency of the information needed as perceived by the enforcing party, since asymmetric information tends to blur the inputs for decision making (and hence the reason why courts only prosecute accused persons or legal entities - beyond reasonable doubts).
The ownership or renting of property or inputs does not consider transaction costs in the neo-classical theory (Samuelson, 1957 quoted in Furubotn & Richter, 2000). The implicit assumption is that deviation from required behavior can be identified and dealt without incurring costs. We however have the knowledge of hindsight to know how important transaction costs play in owning or renting some factors of production. Property rights lead to economic outcomes in a world of positive transaction costs, information asymmetries and uncertainty. When actors are made owners of properties, the high costs of monitoring are reduced since the actor seeking his selfish interest will use the inputs judiciously as well than if it was a common pool which demanded collective interests.
Vertical integration stems from the metering problems associated with components of the value chain and is opted to reduce costs of production, protect proprietary knowledge and avoid contractual problems with suppliers. It is one of the major applications of TCE or contractual approach as a theory of the firm. Firms integrate as an aspect of its boundary’s efficiencies (Foss11, 1993). William has looked at the theory of the firm from asset specificity perspective while Alchian and Demsetz (1972) used the moral hazard approach and the high cost of monitoring in team production whereby incentives had to be structured to curtail opportunism. They used information asymmetries and opportunism to derive their explanation of the firm through overcoming the moral hazard problem. This is achieved through monitoring via the
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Based on his analysis of Coase’s 1937 seminal article on the nature of the firm.
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structuring of incentives and the best ways to handle the metering problems for the firm’s efficiency.
Property rights approach or how rents have to be appropriated has also been studied by Grossman and Hart (1986) using the underlying assumptions of bounded rationality, asset specificity and opportunism and the high cost of bargaining. They conclude that the transaction costs and rent appropriation tussle though of importance are not the sole reasons for vertical integration but the collective agreement to efficiently implement incentives that allocated residual rights ownership when contracts are incomplete. Grossman and Hart followed the Williamsonian perspective. In another work by Jensen and Meckling (1979), they followed the nexus of contracts approach of Alchian and Demsetz to come out with similar conclusions as Grossman and Hart’s – which is minimizing production and transaction costs for organizational efficiency.
4. Empirical Applications of TCE The economic and business fields have seen an explosion of empirical work using TCT framework as for example vertical integration and long-term contracting. Is asset specificity the critical reason why firms decide to own their products and services? Is this why some upstream (or downstream) relational contracts are acquired by relevant firms? Monteverde and Teece (1982a), Anderson and Schmittlein (1984), Masten (1984) and Joskow (1985) have all carried out empirical studies to help solve this canonical topic.
Schilling and Steensma combined the transaction cost theory approach (in opportunistic environments), the resource based theory (for sustained competitive advantage) and the options theory approach (for managerial flexibility in uncertain markets) to come out with a structural model for the paths taken by technological firms and found an insignificant relationship between uniqueness of a technology, technological dynamism, and commercial uncertainty (2002).
Leiblein and Miller have also used the transaction cost (TC), resource based view (RBV) and real options (RO) theories to analyze 469 make-or-buy decisions involving 117 semiconductor firms and conclude that the decisions involving the governance of 16
production activities are influenced by transaction and firm specific activities (2003). The model they proposed is shown in figure 1.
Like the assertion of Conner and Prahalad (1996), transaction cost theory has been seen as a complement to the other theories of the firm to fully explain how organizations work. It is a useful tool that needs to be understood and exploited by all forms of organizations in making efficient and rational choices in the management of their supply chain and customer satisfaction.
In another empirical study Levy used the Industrial File of Standard and Poor’s Compustat tapes and industry level data from Census of Manufacturers reports together with CRSP tapes pulled over time to support the implications of the transaction cost approach to vertical integration in the manufacturing sector. Detailed consideration of transaction costs at separate stages however were not covered (Levy, 1985).
Rabinovich et al (2003) also evaluates the supply chain transaction efficiency effects from consumers who purchase CDs online. They develop and test empirically, a framework that looks at the role online sales have in establishing transactionefficiency levels in product exchanges involving retailers, at different stages of the supply chain, and consumers. The theoretical framework however integrates the transaction-cost theory with other literature from internet economics, interorganizational information systems, and supply chain management.
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Figure 1 A model of vertical integration decisions incorporating transaction-and-firm level attributes
TCE Approach
RBV Approach
RO Approach
Source: Leiblein and Miller, 2003
4.1 Marketing Most of the literature on TCE has been in the field of organization theory (OT). The use of TCE in marketing is only surpassed in OT (Boener & Macher, 2001). This is particularly realistic judging the contractual nature of a firm and its distributors or when a firm is staging an entry into foreign markets. Typically, firms integrate backwards into supplies, but in the marketing literature, forward integration into distribution has been empirically researched using TCE as a stand alone framework or in conjunction with other types. Anderson and Schmittlein (1984), Anderson (1985), John and Weitz (1988), Weiss and Anderson (1992), and Murray and Kotabe (1999) also support the argument of integration when assets are specific and behavior about distributors is uncertain. Similarly, in foreign market entry, TCE has also been used extensively whereby the specificity of the asset and behavioral uncertainty [(and not environmental uncertainty) leading to high monitoring costs] encourages channel integration. Works carried out include that of Anderson and Coughan (1987), Klein et al (1990), Eramilli and Rao (1993), and Klein and Roth (1993). Other works that look at the governance mode of foreign market entry existing between the firm and distribution channels from exporting to staging a greenfield entry have been analyzed with the TCE framework. In using intermediate organizational structures,
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Fein and Anderson (1997) looked at the impact on the restriction of brand names and geographic limitations to assess the organizational governance mode.
4.2 Finance TCE has received attention in this field within two main streams of established research (Boerner & Macher, 2002). The role of using governance structure to diversify away risk is one stream of study and the debt-equity financing mode is the other. The use of governance structures to diversify away risk in banks has been studied by Woodward (1998). Villalonga and McGahan (2001) studying acquisitions and alliances used TCE to determine if the governance structure by financial markets depended on transaction differences. An event study covering the period 1990-2000 in 9000 deals by Fortune 100 companies indicated variability of governance modes reflective on individual firm’s contractual contingencies. Studies on debt to equity financing choice have also been varied. Debt financing is preferred when asset specificity is low (or when market uncertainty is low – Ottoo, 2002) and equity financing is preferred when there is high asset specificity (Williamson, 1985). This hypothesis has been positively tested by Balakrishnan and Fox (1993). Other empirical tests on debt-equity financing using the TCE framework have been done by Bjuggren (1995), Bergh and Lawless (1998), Perry and Robertson (1998) and Erridge et al (1999).
4.3 Organization theory This is the area where the most empirical constructs have been undertaken and the most relevant to addressing this topic. It has been used singly as a theoretical framework or as a complement to other theories of organization. TCE as already been highlighted is an optimization theory based on efficiency analysis and outcomes. Several articles are worth mentioning here. Hughes et al (1997) worked on organizational change from a NIE perspective [TCE and institutional theory] and find that regulatory policy interventions affect the contracting practices of the Welsh National Health Services. They think that mimesis (imitating to achieve outcomes in
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line with what has been set out as performance indicators) is more practiced than organizational efficiency.12
Zaheer and Venkatraman (1995) use TCE and institutional theory to establish the role of trust and normative pressure in exchange relationships. Their results support the mode of hierarchy choice for asset specificity when commanding trust is critical in the organizational process. Gulati and Singh (1998) also use TCE framework in strategic alliances and conclude that the frequency of transactions are positively associated with contractual alliances and indicate that for transactions that don’t experience trust of the relevant parties, a joint venture is more likely to regulate opportunistic tendencies.
Some other researchers have acknowledged the complementarity of TCE to other organizational theories. Schilling and Steensma (2002) have pursued this direction in technological sourcing arrangements by firms in conditions such as commercial uncertainty and technological dynamism. Other empical studies conducted in the field of organization theory have been summarized in table 1 below.
12
See Taylor and Taylor (2003) for similar discussions on mimetic isomorphism in the Australian institutions of higher learning though they use another framework of productivity analysis i.e. the Xefficiency approach.
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Table 1 Some Empirical Researches using TCE in Organization Theory Researcher(s), Date
Framework
Area(s) of Analysis
Arrighetti et al, 1997
Transactional features & social
Contractual alliances
norms Zaheer et al, 1998
-do-
-do-
Pilling et al, 1994
Relational exchange theory
-do-
Heide & John, 1990,1992
-do-
-do-
Park & Ruso, 1996
TCE & organization ecology
Joint venture failure
Osborn & Baughn, 1990
-do-
Inter-firm alliances
Silverman et al, 1997
-do-
Mortality rate of large motor carriers in the US
Freeland, 1996
TCT & organization theory (OT)
M-form organization
Hill, 1988
-do-
-do-
DeBruin & Dupuis, 1999
-do-
Analysis of networks
Eccles & White, 1988
-do-
Examination of authority
Adapted from Boener and Macher, 2001
4.4 Accounting With regards to organization theory and marketing, not too much work has been carried out in the field of accounting using the TCE framework (Boerner & Macher, 2001). TCE is used in accounting to address the relation between organizational costs and financial performance. Accounting policies and contacting behavior has been given empirical testing applying the TCE framework and some notable works have been compiled in table 2 below. These results are in conformity with Williamson’s opportunism and contractual incompleteness assumptions.
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Table 2 Some Empirical Researches using TCE in Accounting Researcher(s), Date
Framework
Area(s) of Analysis
Mohrman, 1992, 1996
Separtion of corporate ownership and
Debt covenant hypothesis
control Warfield et al, 1995
-do-
-do-
Adapted from Boener and Macher, 2001
4.5 International Business The international business arena is especially a field where TCE can and is being used by firms to organize strategic entries into new countries. Evidence has shown that political, socio-cultural and firm-specific factors all influence the choice of governance mode. Some empirical works that have been undertaken have been summarized in table 3 below.
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Table 3 Some Empirical Researches using TCE in International Business Researcher(s), Date
Framework
Area(s) of Analysis
Gatignon & Anderson, 1988
Choice of governance mode
Manufacturing operations of US
based on political, socio-cultural
multinationals’ foreign
and transactional factors
subsidiaries
-do-
Ownership structure of foreign
Hu & Chen, 1993
partners in joint ventures with Chinese companies Comes-Casseres, 1989
-do-
Foreign entry market decisions
Cooke, 1997
-do-
-do-
Murtha, 1993
-do-
-do-
Henisz, 1998
Political risk calculation and
-do-
transactional level factors i.e. asset specificity Henisz & Zelner, 2001
-do-
-do-
Delios & Henisz, 2000
-do-
-do-
Adapted from Boener and Macher, 2001
4.6 Strategy Strategy fits all the areas of business in the broader sense, but there have been studies that have been carried out at the strategic level relating to decision-making that is worth mentioning. TCE has been applied to strategy in relationship-specific investments and organization forms (Boerner & Macher, 2001). Table 4 summarizes some of the important studies that have carried out in this field.
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Table 4 Some Empirical Researches using TCE in Strategy Researcher(s), Date
Framework
Area(s) of Analysis
Bensauo & Anderson, 1999
Firm’s motivation in undertaking
Supply relationships involving
relationship-specific investments
automakers in USA and Japan
– co specialization versus contractual hazards Bigelow, 2001
Relationship specific investments
Performance implications of of organization form
Silverman et al, 1997
-do-
-do-
Silverman, 1997
TCE and RBV
Corporate diversification
Teece, 1980
TCE – relational contracting
Spin-offs
Bethel & Liebeskind, 1998
TCE
Corporate diversification
Brouthers & Brouthers, 2000
-do-
-do-
Nickerson et al, 2000
TCE and Strategic positioning
Japanese international courier and package services industry
Nickerson & Vanden Bergh, 2001
TCE
Strategic decision-making
Argyres, 1996
-do-
-do-
Kim, 1999
-do-
-do-
Adapted from Boener and Macher, 2001
4.7 Non-Business Areas In the fields of public law and policy issues like antitrust and regulation (Boerner & Macher, 2001:28), TCE has also been extensively applied. Similar use of TCE can also be found in the health economics and policy - and agricultural economics and policy where several authors have carried out empirical studies using this framework alone or with other types. TCE has become both multidisciplinary and interdisciplinary as other theories are being used in conjuction to better explain empirical results (Boerner & Macher, 2001).
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5. Deficiencies of Transaction Cost Economics Some attacks have been carried out by Kogut and Zander (1992), Madhok (1996), and Ghoshal and Moran (1996) on TCE. These writers have attacked from a competence, knowledge and resource-based perspective. Writing under the title “Bad for Practice: A Critique of Transaction Cost Theory”, they argue that organizations possess unique advantages for governing certain kinds of economic activities which transaction cost theory fails to recognize. They therefore argue for Simon’s (1991) organizational economy to be used as an organizational template.
Williamson (1996c in Economic Organization: A Case for Candor) countered this critique that was directed at him by implying that depending on how one saw a problem and his personal biases, he could explain it in his own way to satisfy himself. Moran and Goshal (1996) again responded to Williamson’s (1996c) article with another article (Theories of Economic Organization: The Case for Realism and Balance) where they argue Williamson had not addressed the issues they had raised concerning the assumptions of Transaction Cost Theory. They argue that firms and markets shouldn’t be compared since they have very different internal logics that are not substitutable but complementary. Such has been the field, criticizing and been criticized.
For another example see Conner (1991) to the transaction cost approach who was also criticicized by Foss (1996) and then she had to come back to defend her stand (Conner & Prahalad, 1996). In fact, these contributions argue that TCE seems to subvert the important estimation of organizational flexibility. It also neglects the aspects of market positioning among many other requirements for competitive strategy, works with a narrow conceptualization of transaction costs that focuses on problems associated with asset specificity, uncertainty and frequency of transactions.
Conner and Prahalad also argue that opportunism that seems to be a cornerstone on TCE should be toned down since not all actors engaged in transactions are opportunistic (1996). Other sources of transaction costs are virtually not given due attention (Milgrom & Roberts, 1990; Holmström & Roberts, 1998). It also neglects learning and important cognitive issues (Kogut & Zander, 1992). The question then is whether TCE (and OE at large) has the potential to remedy these deficiencies.
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6. Conclusion This article has touched on most of the main underlying constructs of the transaction cost theoretical framework and some theoretical applications that spans over two decades in trying to offer salient explanations of how organizations exist and function for efficiency gains. It has also revealed that transaction cost economics have successfully been used with other theoretical frameworks to better explain organizational decision making especially in their choice to either contract services or products from the market exchanges, form a strategic alliance or joint venture or integrate activities into the firm.
Like the assertion of Conner and Prahalad (1996), transaction cost theory has been seen as a complement to the other theories of the firm to fully explain how organizations work. It is a useful tool that needs to be understood and exploited by all forms of organizations in making efficient and rational choices in the management of their supply chain and customer satisfaction.
We also have acknowledged in part that participation may, raise productivity if workers are better equipped to motivate and monitor each other than supervision from management, or if they can provide technical information to management that would otherwise be too costly or time consuming to obtain. Whatever the true relationship between employee sharing, participation and productivity, this study is hindered by a lack of information regarding the extent of co-determination within the firms.
Empirical studies such as that of Anderson and Schmittlein (1984), Anderson (1985) and Maltz (1993 & 1994) have not shown any positive correlation with governance mode and transaction frequency. In other studies where transactions are made one-stop and recurrent, a significant relationship has been observed (John & Weiss, 1988; Klein et al, 1990). This therefore is an area of further research.
The relation between complexity and uncertainty which have been used interchangeably is also an area where further research can help to better equip transaction cost theory as one that will stand the test of time. Researchers must still use the multi-disciplinary and interdisciplinary nature of transaction cost theory to other diverse fields of human endeavor where it has still not been used.
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