Transaction Cost Economics and the Boundaries of the Firm

1. Transaction Cost Economics and the Boundaries of the Firm Peter G. Klein Contracting and Organizations Research Institute Division of Applied Social Sciences University of Missouri, USA June 2006

2. A little about me • Education • BA, economics, Univ. of North Carolina, 1988 • PhD, economics, Univ. of California at Berkeley, 1995 • Positions • Academic appointments at University of Georgia (1995–2002), CBS (2001), University of Missouri (2002–) • Senior Economist at Council of Economic Advisers, 2000–01 • Associate Director of the Contracting and Organizations Research Institute (cori.missouri.edu) • Co-blogger at organizationsandmarkets.wordpress.com

3. A little about me (cont.) • Research interests • Entrepreneurship • Corporate diversification, internal capital markets, and relatedness • Economics of innovation • Institutions and economic development • Courses • PhD: economics of institutions and organizations, industrial economics • MBA: business economics • Undergraduate: managerial economics, economics of networks, law and economics, microeconomic theory

4. Transaction cost economics: background • “Transaction costs” and “transaction cost economics” (TCE) • Operationalizing Coase • Existence: team production, moral hazard, monitoring costs (Alchian and Demsetz, 1972) • Internal organization: agency costs and incentive contracts (Jensen and Meckling, 1976; Holmstrom, 1979) • Boundaries: economizing on transaction costs (Williamson, 1975, 1979, 1985; Klein, Crawford, and Alchian, 1978) • What exactly is TCE? • Narrow view: asset-specificity explanation for vertical integration (distinctions between KCA, Williamson, and GHM relatively insignificant) • Broad view: grand, unified theory of economic organization

5. A theory of everything? “Any problem that can be posed directly or indirectly as a contracting problem is usefully investigated in transaction cost economizing terms” (Williamson, 1985, p.41).

6. Williamson’s unique brand of TCE • TCE’s founder and best-known representative • Charismatic and influential leader • Influential book-length treatments • Markets and Hierarchies, 1975 • The Economic Institutions of Capitalism, 1985 • The Mechanisms of Governance, 1996 • Idiosyncratic terminology • Loyal and devoted students • Odd position in the scholarly community Describes his work as “a melding of the extremes of abstract economic theory and soft social science.” Frequent target of Pfeffer, Ghoshal, and other critics Oliver E. Williamson (1932–)

7. Key Williamsonian terms and concepts • Bounded rationality: behavior that is “intendedly rational, but only limitedly so” (Simon , 1957) • Opportunism: “self-interest seeking with guile” • The transaction as the unit of analysis • Asset specificity: extent to which assets can be redeployed to alternative users and uses • The fundamental transformation: change from thick markets at contract selection stage to bilateral dependency at contract execution and renewal stages • The discriminating alignment hypothesis Note emphasis on behavior and process

8. Ex-ante versus ex-post analysis TCE as the “governance approach” to the science of contract

9. Vertical integration: TCE’s “paradigm problem” • The stages of production (diagram) • Historical trends • Merger wave of 1920s: public utilities, banking, food processing, chemicals, mining • Current debates on outsourcing • Benefits of contracting out • Comparative advantage • Specialization, trade, and the division of labor • Thick markets for inputs (productive and allocative efficiency)

10. The stages of production

11. Explanations for vertical coordination • Market-power explanations • Eliminating double marginalization • Facilitating price discrimination • Creating entry barriers • Economic efficiency explanations • Eliminating free riding • Reducing supply uncertainty • Stigler’s (1951) life-cycle explanation • TCE: the dominant explanation today

12. The basic TCE model • Characteristics of transactions • Asset specificity • Physical • Site • Human • Temporal • Dedicated assets • Brand-name capital • Uncertainty • Frequency • “Potential for “maladaptation”

13. Asset specificity and holdup • Klein, Crawford, and Alchian (1978) • First to explicitly describe the “holdup problem” • Popularized the notion of “quasi-rents” • Economic rent: payments to a factor of production beyond that necessary to attract that factor to that activity (e.g., pro athletes who play for the love of the game) • Quasi-rent (Marshall): payments to a factor of production beyond that necessary to keep that factor from leaving (excess of value over salvage value); generally greater than economic rents (see diagram) • Main point: specialized assets generate a stream of quasi-rents, since they aren't easily redeployable; once specialized assets are in place, trading partners will try to expropriate part of those quasi-rents

14. Perfect competition, shutdown, and quasi-rents rent p3 p2 p1 quasi-rent

15. The basic TCE model • Characteristics of transactions • Asset specificity • Physical • Site • Human • Temporal • Dedicated assets • Brand-name capital • Governance structures • Uncertainty • Frequency “hybrids”: contracts, franchises, joint ventures spot markets fully integrated firms

16. Discriminating alignment: one independent variable

17. Discriminating alignment: two independent variables

18. Note on hierarchy • The firm as a nexus of contracts • Complete versus incomplete contracts • Hierarchy and authority • Coase: fiat • Hart: ownership and residual rights of control • Williamson: mutual forbearance

19. Applications: the framework • Williamson’s “simple contracting schema” Market Market with hazard Contracts Hierarchy Note on prices

20. Applications to vertical contractual relationships • Vertical integration • Backwards into manufacturing • Forwards into marketing and distribution • Vertical restrains (resale price maintenance, territorial restrictions) • Price discrimination • Labor-market contracting • Finance

21. Horizontal and conglomerate boundaries • Horizontal integration: little TCE work in this area • Williamson (1975, 1981) offers an internal-capital-markets explanation for conglomerate diversification, though not closely connected with TCE • More on this in a subsequent lecture…

22. The (new) property rights approach • Major contributions: Grossman and Hart (1986), Hart and Moore (1990), Hart (1995) • Simply a formalization of Williamson? • Similarities to TCE • Incomplete contracting • Asset specificity • Key differences • Emphasis on ex-ante incentive alignment (assumes perfect knowledge and costless bargaining, which “annihilates” governance problems (Williamson) • Purports to explain the costs of integration better than TCE – i.e., in GHM, there’s still underinvestment in specific assets after integration • Holds that the direction of integration matters • Gibbons: a different tradition than the “rent-seeking” tradition of Klein, Crawford, and Alchian (1978) and Williamson

23. Other formal approaches • Bajari and Tadelis (2001), Tadelis (2002): more in the spirit of TCE • Approach: formal model of ex post adjustments under incomplete contracting • Basic model • Completeness and complexity chosen simultaneously (and inversely) • Ownership gives contracting party the right to modify the project design ex post • Benefits (to buyer) of integration (internal procurement): can request changes to maximize own benefit ex post • Costs of integration: weaker incentives for seller ∙ • Result: internal procurement an increasing function of complexity

24. Other formal approaches III • Baker, Gibbons, and Murphy (QJE, 2002) • Part of Gibbons’s “relational adaptation” group, along with Simon (1951) and Williamson (1975) • Key innovation: adding a new dimension for characterizing organizational form

25. Other formal approaches III • Baker, Gibbons, and Murphy (QJE, 2002) (cont.) • Main proposition: asset ownership (in the sense of GHM) affects parties’ temptations to renege on a relational contract. • Model • Upstream party produces a component, transferred to downstream party. • Downstream party wants to encourage high effort; makes a non-contractible promise to pay a bonus for high effort (setup for a repeated game). • Integration increases the downstream party's incentive to renege on the promise (under non-integration, if the downstream party reneges, the upstream party can sell the good to an alternative user). • Non-integration increases the upstream party's incentive to increase the value to the alternative user, increasing her bargaining position should the downstream party renege.  Tradeoff between integration and non-integration

26. Summary and conclusions • Of the three Coasian questions about the firm – existence, boundaries, and internal organization – boundaries has received the most attention by economists. • Williamson’s TCE the best-known, but not the only, economic approach to vertical boundaries. • Among academic economists, GHM is probably more popular today; TCE is only “quasi-mainstream.” • Besides the theoretical work described here, there is a large empirical literature on boundaries (to be discussed later).