TRANSACTION COST THEORY

1. TRANSACTION COST THEORY • Ronald Coase (1937) posed two Nobel-prize puzzles : • Why do any firms emerge in a market economy? • Why not just One Big Firm for whole economy? Neoclassical economics treats the firm as a production function that efficiently transforms land, labor & capital inputs into goods & services. Competitive markets coordinate buyer-seller exchanges via price signals. Coase argued that market mechanism not cost-free, but involves transaction costs: time & money to search for sellers & buyers, negotiate exchange terms, write contracts, inspect results, enforce deals Firms will emerge if an “economizing” organization can reduce its production + transaction costs < market prices Firm expansion halts when intra-org’l TC > market prices

2. The Costs of Transacting • Transaction: The transfer of a good/service across “technologically separable interface” (locational boundary) • EX: Machine-scoring of multiple-choice exams • Reserve reading materials • Transaction costs of making, enforcing agreements • EX: How much to conduct your one-time social survey? Transactions are embedded within social, political, legal institutional environments that affect transaction costs. These “rules of the game” affect property, production, distribution, and exchange relations among economic actors EX: EPA regulations about lead pollution emissions Transaction cost theory seeks to explain variations in forms of governance of economic exchanges

3. Forms of Governance Oliver Williamson (1975, 1981) identified three fundamental forms of transaction governance and the conditions when they’re likely to occur: Market: Autonomous parties’ exchanges are governed by prices in supply-demand equilibrium Hierarchy: (Formal org) Transactions among parties occur under a unified owner, who settles disputes by administrative fiat Hybrid: “Long-term contractual relations that preserve [parties’] autonomy, but provide added transaction-specific safeguards as compared with the market.” EX: United Way and social service agencies Strategic alliances; agricultural cooperatives Networks of small-medium suppliers and manufacturers

4. Behavioral Assumptions Transaction parties can never write completely detailed agreements covering all possible future contingencies (“incomplete contracting”) Williamson assumed transactors’ abilities & motives involve: Bounded rationality: Utility-maximizing, intendedly rational transactors are constrained by cognitive limits on their capacities to process information efficiently (contrast to neoclassical perfect info) Opportunism: “Self-interest with guile” could induce strategic behavior by transactors to lie to, cheat, confuse, mislead their exchange partners EX: Used car salesmen; political candidates; your prelim study group? Even when opportunism risks are low, orgs must still safeguard against possibly severe damages from an opportunistic partner (worst case scenario) Nicolo Machiavelli

5. Three Transaction Dimensions Transactions have three key dimensions that determine how their costs affect governance choice • Uncertainty about environments, other actors EX: Floods delay factory supplier’s just-in-time deliveries • Frequency of exchanges; one-off or recurrent? • Asset specificity: investments lacking alternative uses except at loss of productive value; asset specificities can be human skills, geographical sites, brand names, dedicated machinery EX: You buy a unique readings packet for this course Chip supplier builds factory to Dell’s computer specs

6. Transaction Economizing → Governance Williamson’s key claim: Variations in exchange governance forms result from efforts to economize on transaction costs His three transaction costs dimensions align efficiently with transactors’ choices among the three ideal forms of governance:

7. Make-or-Buy? Transaction cost theory examines the conditions under which organizations chose to internalize some functions (hierarchy) or to purchase them on the market (e.g., relational subcontracting) EX When should a firm or agency train its own employees, hire external vendor (college or commercial), or create a jointly staffed program? • Are employee job skill requirements changing rapidly & unpredictably? • How often must newly hired or promoted workers be (re)trained? • Would org’s own training staff have to invest heavily in asset-specific facilities, such as simulation labs? • Is org’s own training staff more knowledgeable than external trainers about firm-specific and tacit skills needed by employees? • Are external vendors competent, reliable & cost efficient?

8. More TC Applications TC theory can be applied to explain diverse org’l phenomena: • Difficulties in establishing micro-credit lending associations • Unionization drive successes or failures • Creation of “company towns” for miners, loggers • Diffusion of conglomerate, M-form corporate structures • Mergers-acquisitions vs. technology transfers among alliance partners • Quarrels over which members own a defunct rock band’s name • (Pink Floyd, Yes, Flying Burrito Brothers) (Cameron & Collins 1997) • Band names are asset-specific capital for re-releases of oldies that fans will buy • Reincarnated inferior group seeks undeserved “rents” from the reputations earned by their more talented predecessors

9. TC Theory Critiques TC theory’s heavy emphasis on potentially opportunism by employees & partners is an unwarrantedly pessimistic view of human nature (but, economics is “the dismal science”) Is TC as a normative prescription for org’l best-practices? • Moral dimensions of organizational behavior could reduce or replace need to make and enforce formal contractual safeguards against opportunistic risks of deceit and self-interested, guileful actions • Trust among individuals & between organizations is an alternative basis for lowering transaction costs • Learning effectiveness increases with transactors’ beliefs in an information source’s competence and goodwill • Self-actualization motives (work- and org-commitments) orient participants towards collective performances • Empowerment to make work decisions gives participants a stake in achieving better performance outcomes

10. PRINCIPAL-AGENT THEORY Principal-agent theory shares TC concepts of uncertainty, opportunism, externalization, cost-efficiency calculations Principal pays Agent to perform service in exchange for fee EX: Hollywood & sports agents negotiate contracts for stars Board pays CEO megabuck$ to boost share prices Trustees hire President to raise U’s academic prestige • Information asymmetry: How does Principal know if Agent is competent and working on behalf of P’s interests? (If P had necessary knowledge and skills, A would be unnecessary) • Agency costs: Principal’s search, monitoring, bonding costs to hire and supervise Agent (vs P doing the job herself) • Opportunism (moral hazard): Risk-averse Agent tempted to deceive & shirk duties; pocket fee but not deliver the best deal

11. Performance Incentives Monitoring Agent’s skills & activities is difficult, so Principal could use pay-for-performance incentives to encourage A’s risk-taking and make A more accountable in looking out for P’s interests EX: Make A’s compen$ation contingent on actual outcomes CEO bonus, stock options depend on annual share prices Teacher’s salary gains tied to her student’s test scores Problem: Org’s performance affected by many factors beyond agent’s control (fickle consumers, govt regs, bad weather) In high uncertainty, tying compensation to performance may actually induce a risk-averse CEO to take timid, less-risky actions in effort to avoid a major loss to personal fortune Major corporate CEO pay-performance effect very weak: only $3.25 per $1,000 change in shareholder wealth = 1 week’s pay ($9,600 in 1980s) This amount judged “small for an occupation in which incentive pay is expected to play an important role” (Jensen & Murphy 1990:227)

12. References Cameron, Samuel and Alan Collins. 1997. “Transaction Costs and Partnerships: The Case of Rock Bands.” Journal of Economic Behavior and Organization 32:171-183. Coase, Ronald H. 1937. “The Nature of the Firm.” Economica 4:386-405. Reprinted pp. 33-55 in R.H. Coase. 1988. The Firm, the Market, and the Law. Chicago: University of Chicago Press. Jensen, Michael C. and Kevin J. Murphy. 1990. “Performance Pay and Top-Management Incentives.” Journal of Political Economy 98:225-264. Williamson, Oliver E. 1975. Markets and Hierarchies: Analysis and Antitrust Implications. New York: Free Press. Williamson, Oliver E. 1981. “The Economics of Organization: The Transaction Cost Approach.” American Journal of Sociology 87:548-577.