Economic Foundations of Strategy - Transaction Cost Theory

1. Economic Foundation of Strategy – Transaction Cost Theory Fall 2011 Contractual Commitments, Bargaining Power, and Governance Inseparability:Incorporating History into Transaction Cost Theory Argyres & Liebeskind (1999)AMR, 24(1): 49-63 Presented by Pei-Li Yu, Qing Yang Sept. 1st, 2011

2. Abstract The authors argue that the following conditions made by a firm can limit its ability to differentiate or change its governance arrangement in the future--- a condition they term governance inseparability. • prior contractual commitments 2. changes in bargaining power between a firm and its exchange partners

3. Motivation TCE theory: An individual transaction is the unit of analysis for predicting organizational form(Williamson, 1985) What’s a contract: (the function) TCE Theory: • To enforce exchange(s) = (contractual commitment) • To deter the opportunism • Long-term contracts (replace short-term’s)save the TC It is as a governance mechanism! What’s wrong with AN INDIVIDUAL TRANSACTION ? 3

4. Motivation-2 However, the authors think: Focusing on the characteristics of isolated transactions can be insufficient to explain the scope of the firm: Reasons: New transaction linked inseparably with the governance of other transactions costly or infeasible together(governance inseparability) constrain a firm’s governance option in two ways: (1) switching (same type of transactions) (2) governance differentiation (use an existing governance arrangement for a new transaction) help to explain the limits to firm scope(too costly to internalize a given transaction) 2. To extend TCE theory: by incorporating two factors that serve to produce governance inseparability: Contractual commitments (past history) Changes in bargaining power (employees, suppliers or customers) They are costly! Linked inseparably? What’s wrong with the current(past) experience? 4

5. Main Argument Organizations in general, and firms in particular, will demonstrate “weak-form path dependency”; therefore, transaction costs can be only “limited efficient”, due to the constraint imposed by governance inseparability. What’s a weak-form path dependency??? Refer to: Liebowitz&Margolis(1995) Weaker form of path dependence(first- and second-degree): they are commonplace, and they offer little in the way of an objection to the neoclassical paradigm.

6. Key concepts Governance Inseparability A condition in which a firm’s past governance choicessignificantly influence the range and types of governance mechanisms that it can adopt in future periods.

7. Key concepts -2 • Governance Switching: A firm cannot efficiently enter into a governance arrangement of Type Yin future periods for a particular transaction because it already has a governance arrangement of Type X in place with another party for that transaction.

8. Key concepts -3 • Governance Differentiation: A firm is obligated to enter into a governance arrangement of Type X with one party because it already has a governance arrangement of Type X in place with another party. • Contractual Commitment: An agreement between two or more parties that is binding on those parties, to the degree that to renege on the agreement will be costly. • Bargaining Power: The ability of one party to a contract to be able to influence the terms and conditions of that contract or subsequent contracts in its own favor.

9. Theory *Governance Switching Governance Inseparability 1. Contractual Commitments *formal contracts(union wage agreement) *informal or nonlegally contracts (self-bonding; social contracts) 2. Changes in Bargaining Power - - - *Governance Differentiation -

10. Firm A Governance Arrangement X Transaction Governance Arrangement Y Contractual Commitments and Constraints on Governance Switching: Same type of transaction (future) Cases and Examples: Franchising agreements(Coca-Cola)

11. Firm A Governance Arrangement X Governance Arrangement Y New transactions Contractual Commitments and Constraints on Governance Differentiation (internal) Transaction 1 (internal) Transaction 2 Existing governance arrangement (internal) Transaction 3 Cases and Examples: credible commitments to New venture units

12. Bargaining Power and Constraints on Governance Switching The governance options for S for some of its transactions are constrained ◇Unionized labor uses its bargaining power to restrict outsourcing (UAW: United Auto Workers). ◇Franchising (Meineke Mufflers Dealers Association; Naugles, Inc.: unable to open a new franchise close to an existing one since the increases in franchisees’ bargaining power) Buyer B increase its bargaining power over Seller S.  prevent S from forward integrating into its own business, forcing S to continue to sell across markets rather than to integrate vertically. B S Contract Bargaining Power on Governance Differentiation ◇Three major US long-distance trucking firms (Yellow Corp., Consolidated, and Roadway); US airline industry.: union( or pilots) bargaining power prevented a firm from carrying out a change in organization that it was seeking.

13. Is Governance Inseparability Avoidable? • The answer is NO. Reasons: Contractual Commitments: 1. Firms cannot exist efficiently without commitments 2. Contractual commitments are necessary for a firm to earn economic rents. Changes in Bargaining Power: 1. Due to the large number of interrelated factors that affect the relative power of contracting parties, changes in bargaining power are difficult to foresee. 2. These changes may occur very gradually over long periods of time so that their future importance is difficult to perceive.

14. Some Implications of Governance Inseparability • Use of Alternative Governance Mechanisms -1 B S But, the meaning? Contract 1 Contract 2 2a: older firms tend to be more encumbered with past commitments;  market contracting? 2b: with internal parties outsource activities limited(for that not involve firm-specific goods or assets! (hierarchical mechanisms?)

15. Some Implications of Governance Inseparability • Use of Alternative Governance Mechanisms -2 Case: BENq AND simens!!! The examples: GermanyandFrance, accord greater bargaining power to labor unions that do other country.

16. Some Implications of Governance Inseparability -2 Limit to Firm Scope P5. Optimal scope of a firm under different level of uncertainty: internationalization may be highly inefficient (switching，differentiation) P4. A third answer to Coase’s(1937) main concerns the limits to the size and the scope of a firm. <<(1) firm size   incentives(within firms) (Williamson, 1985);(2)firms, precisely because they are organized as hierarchies, promulgate influence activities by managers incur costs that markets avoid>>

17. Governance Inseparability: Implications - + - *Governance Switching Governance Inseparability 1. Contractual Commitments *formal contracts(union wage agreement) *informal or nonlegally contracts (self-bonding; social contracts) 2. Changes in Bargaining Power *identical transactions in different way (p1) *market contracting(p2) *hierarchical mechanisms: labor union (p3) *costly internalizing (p4) *reduce the vertical and horizontal scope of firm(p5) - - *Governance Differentiation + -

18. Some Implications of Governance Inseparability -2 Competition and Industry Evolution: ◆competition: lock-in results is from contractual commitments △Organizational inertia ◆Industry Evolution: (Population ecologists v.s. Evolutionary economists): a moderated view of inertia; organizations will be inert according to the degree that the contractual commitments they entered into in earlier periods constrain their subsequent governance options △ weak-form path dependency(history matters): howwever, histroy is important only because the sequence of events determines current values(Liebowitz&Margolis, 1995)

19. We submit: Q1. The main rationale of this article: most firms will become constrained over time by their existing arrangements in place, which will limit both their scope and their strategic flexibility ◇TCE: (long-term) contract makes both firms adapted effectively (Williamson, 1985) ◇ Social Views: e.g. Social mechanism: social norms(Joshi & Arnold, 1997; Clan(Ouchi, 1980); mutual trust (Dyer & Chu, 2003;Hedlund, 1994) can help both firms adaptive better Q2: Any new transaction in which a firm may seek to engage may become linked inseparably with the governance of other transactions in which the firm is already engaged. ◇The example (proof)??? Firm might govern the contracts based on prior experience (history..etc)(governance inseparability), but any individual contact can be signed independently.  the characteristic of the transactions v.s. governance inseparability  relevance, but… Q3: firms may be constrained in their choice of governance mechanisms by past governance mechanisms ◇contradictory; organization learns (by doing) Q4: historical constraints??? ◇ Increasing relationship duration development better mutual understanding (Schreiner et al., 2009)

20. Thank you for your listening!