Transaction Cost Economics

1. Transaction Cost Economics Gun-woong Lee March 2, 2012

2. Agenda • Transaction Cost Economics • Theoretical Background of TCE • History of TCE • Key Properties of TCE • TCE in the IS Domain • Application of Economic Theories in IS • TCE Application • Limitations of TCE

3. Why do firms exist? • Individual vs. Firm • Adam Smith: “Team production yields more than the sum of individual productions” • QTotal > (qGun+qYen+qIrfan+qJeremyr+qReza+qMike) • Firm: A legal structure that provides the organizational basis for team production • Firm vs. Market • Why do firms exist as a separate entity from the market? • Coase (1937): “Cost of employing the price mechanism determines firm/market boundary” • Firm: A set of transactions coordinated by authority instead of by the market

4. Economic Theories of the Firm • Classical Economics • Classical economic theories focused on Industry-level analysis and tried to understand markets alone (invisible hand) • Neoclassical Theory of the Firm • Firm as a production function (black box) (Labor & capital -> goods & service) • Manager purses owner’s objectives (a profit maximizer) • No incentives problems within the firm • Strong Assumptions • Perfect information • People have rational preferences among outcomes. • A production function People act independently on the basis of full information.

5. Economic Theories of the Firm • Classical Economics • Classical economic theories focused on Industry-level analysis and tried to understand markets alone (invisible hand) • Neoclassical Theory of the Firm • Firm as a production function (black box) (Labor & capital -> goods & service) • Manager purses owner’s objectives (a profit maximizer) • No incentives problems within the firm • Strong Assumptions • Perfect information • People have rational preferences among outcomes. • A production function People act independently on the basis of full information. • Issues not Addressed • Organization of production within a firm • Resolution of conflicts of interest • Boundaries of the firm

6. Economic Theories of the Firm • Principal Agent Approach • Asymmetric Information • Incentives and possible conflicts of interest • Optimal structure of firm firm derives from a comprehensive contract • Transaction Cost Approach • Try to address questions about • Why firms exist in the first place? • How firms define their boundaries? • How firms ought to govern operations? • Market imperfections create firms • Market mechanism is not cost-free and It involves transaction costs • Time & money to search for partners and to negotiate exchange term

7. Economic Theories of the Firm • Principal Agent Approach • Asymmetric Information • Incentives and possible conflicts of interest • Optimal structure of firm firm derives from a comprehensive contract • Problems with this view • Organizational structure does not matter. • Incentive contract within firms and between firms are formally identical. • Transaction Cost Approach • Try to address questions about • Why firms exist in the first place? • How firms define their boundaries? • Market imperfections create firms • Market mechanism is not cost-free and It involves transaction costs • Time & money to search for partners and to negotiate exchange term

8. History of TCE • Initiated by Coase, 1937 • If firms exist, this must have an economic meaning! • Why do firms exist? • They are cost-saving organizations in comparison with markets! • Firms exist because activities might be produced internally with inferior costs. • Make or Buy ? (The boundaries of the firm) • Firms emerge if (production costs + TC) < Market prices • Firm expansion halts if (internal TC) > Market prices • BUT Coase did not consider any deeper explanation on the motive why firms are cost-saving organizations.

9. History of TCE • Defined by Williamson, 1971 • “Transaction are aligned with organizational form in a s transaction cost minimizing way.” • Governance form: Hierarchy, Market, and Hybrid. • “The basic assumptions in neoclassical economic theory (rational actors, perfect information, homogenous goods) fail to hold!” • Behavioral Assumptions of Human behavior • Bounded rationality and opportunism • Features of Transactions • Asset specificity, Uncertainty, and Frequency

10. Key Behavioral Assumptions • Bounded Rationality • Utility-maximizing transactors are constrained by cognitive limits on their capacities to process information efficiently. • Transaction parties can never write completely detailed agreements. • Contrast to neoclassical perfect information assumption • Opportunism • Self-interest could induce strategic behavior by transactors to lie to cheat or mislead their exchange partners.

11. Governance Structure • Hierarchy: interaction within the firms • Coordination by command and contracts • Market: Interaction between the firms • Coordination through prices and contracts • Hybrids (Network): include governance elements form both markets and hierarchies • Subsets of markets: Joint venture& alliance shared service organizations

12. Transaction Costs • Human factors • Bounded rationality: Human are unlikely to have the abilities or resources to consider every state-contingent outcome associated with a transaction that might arise. • Opportunism: Human will act to further their own self-interests • Environmental factors • Asset Specificity: How specific is the product or service you are buying • ‘Highly specific assets give rise to a condition of bilateral dependency’ (Williamson, 1979) • Physical, site, Human, Temporal, Dedicated assets, or Brand-name capital • Frequency: How often does the transactions occur • Uncertainty: Internal, external, and behavior uncertainty

13. Limitations of TCE • Transaction costs are not direct observable, so empirical work must be indirect. • Production costs paly no direct role in the explanation. • TCE assumes that production costs are given and do not differ across governance modes. • Ambiguous term “Transaction costs” • Transaction costs: costs of negotiating, monitoring or enforcing contracts for goods and services in the sphere of markets or exchange • Monitoring costs: costs of monitoring or enforcing contracts within a firm

14. Recent Application of Economic Theory in IT Research (Bakos and Kemerer, 1992) • Information Economics • Assess the values of IS • Production Economics (look inside the IT blackbox) • Study the characteristics of IT production and cost functions • Economic Models of Organizational performance • Measure the organizational benefits resulting from IT investments • Industrial Organizations • Study business behavior and its implications for firm conduct and market structure (e.g., Network externalities, Switching cost, and so on.) • Institutional Economics • Study the comparative costs of alternative economic institution • Transaction cost theory and Agent theory • Macroeconomic Studies for Productivity • Study the impact of IT on productivity and on industrial structure form using economic data

15. Five Characteristics of Electronic Marketplaces (Bakos,1991) • Predictions based on microeconomic theories • Low Searching Costs • Network Externalities • Significant Switching Costs • Substantial Economies of Scale and Scope • Uncertainty (Information asymmetry)

16. Electronic Markets and Electronic Hierarchies • Theorizing by Analogy • Allow a theorist to reuse elements form past theory • Bring it into a new context that that has its own features • Role of IT in Firms • Electronic communication effect (the same amount in less time) • Electronic brokerage effect (improved matching of buyers and seller) • Electronic integration effect(tightened process coupling) • Shift from Hierarchies toward Markets • Technology would create a force to push against hierarchical transactions and toward market transaction by firms.

17. EMH in Customer Loan Origination Systems • Existing Theory Testing and Validation • New theory building by falsifying existing theory • Properties of Home Mortgage Loans • Low asset specificity • Low coordination and low search cost • CLOs would provide an opportunity for an electronic market to arise. • BUT, the most successful is best characterized by electronic hierarchy • Why doesn't the EMH predict well for CLOs? • Was it a matter of how long it would take to observe the impact of IT that the EMH predicted? • Was there some fundamental problems with the EMH? • Complexity of the transaction • Frequency of transaction • Relation of good/service supplier and system supplier

18. Limitations of TCE in the IS domain • Overemphasis on Communication and Brokerage effects • Firms have downsized and now “make” less and outsource more, but do no with many suppliers (market-ripe relationship), but rather with few suppliers in tightly-knit “network (hybrid) relationships. • The emphasis is “integration” as opposed to “brokerage” or “Communication” • Failure to Emphasize supply-chain relationships • EMPs takes dyadic sales transactions as the basic unit of analysis. • Many sales transactions take place in the context of pretexting relationships between buyers and sellers. • Failure to Address Power Issues • Powerful suppliers like Wal-Mart can mandate use of EDI to partners.

19. Conclusion • TCE has created new insights in identifying the existence of firms and firms’ boundaries. • TCE will continue to be applicable to various industrial and academic setting. • TCE has provided IS studies a theoretical lens for understanding how technology changes firms’ governance structures. • TCE is still developing • New interpretation and intuition for the firms enabled by new technology will be required.

20. Conclusion • TCE has created new insights in identifying the existence of firms and firms’ boundaries. • TCE will continue to be applicable to various industrial and academic setting. • TCE has provided IS studies a theoretical lens for understanding how technology changes firms’ governance structures. • TCE is still developing • New interpretation and intuition for the firms enabled by new technology will be required.