Transaction Cost Economics Lecture 6 4UZE402 Economics of Business Organizations

Outline Introduction to transaction cost economics Behavioural assumptions Dimensions of transactions Organizational forms Hybrid forms

Introduction Transaction Markets Organization ? Cost minimization

Behavioural assumptions Bounded rationality Bounded rationality will pose a problem only in environments that are characterized by uncertainty/complexity. Opportunism It is difficult or impossible to distinguish ex ante honest people from dishonest people.

Behavioural assumptions HUMAN FACTORS ENVIRONMENTAL FACTORS Bounded rationality Uncertainty/ complexity Opportunism Small numbers

Dimensions of transactions Transaction costs for a particular transaction depend on the critical dimensions of that transaction: Asset specificity Uncertainty/complexity Frequency

Asset Specificity No local newspaper in town Appropria. Opportunistic behaviour LONG-TERM CONTRACT? Transaction-specific asset Financial guarantee Mrs. Q Mr. F FC = $3500 per day VC = $1500 per day

Uncertainty/complexity and Frequency The higher uncertainty/complexity is the higher transaction costs due to bounded rationality. Frequency Setting up an organisation involves fixed costs. The costs can be covered only by high frequency transactions

Dimensions of transactions High degree of asset specificity High degree of uncertainty/ complexity High frequency Extremely high costs of market transaction Transaction will be realized within organizations

Organizational forms Fundamental assumption in transaction cost economics: There is always competition between organizational forms and in the long run only the most efficient organizational form will survive.

Organizational forms Peer group no boss mutual adjustment Advantages: Economies of scale Information gathering Risk-bearing advantages Associational gains Limitations: Shirking

Organizational forms Simple hierarchy there is a boss direct supevision Advantages over peer group Economies of communication Economies of decision-making Monitoring

Multistage Hierarchies U-form enterprise Chief Manager Sales Manager Production Logistics Accounting Personnel, etc department information Decisions, coordination

Multistage hierarchies U-form enterprise There are at least two layers of managers Disadvantages of U-form: Cumulative control loss Corruption of the strategic decision-making process

Multistage hierarchies M-from enterprise Chief Manager Sales Manager A Production Logistics Accounting Personnel, etc Sales D. A Prod. D A Log. D A Manager 2 Sales D. B Prod. D B Log. D B Senior Manager Product A Product B

Multistage hierarchies M-form enterprise is divided at the top level into several quasi-autonomous operating divisions, usually along product lines. Main characteristics: The divisions operate as quasi-firms The corporate staff performs both advisory and auditing functions The general office is principally concerned with strategic decisions M-form enterprise economizes on bounded rationality and on opportunism

Hybrid forms Long-term relations between buyers and suppliers (long-term contracts): Long-term contract legal protection Long-term benefits are much higher than short-term ones Reputation Involvement of the buyer Common goals

Hybrid forms: Joint Venture Business requires resources from both companies It is difficult or impossible to trade these resources Acquisition and/or merger requires lots of resources, which are not available

Hybrid Forms Business groups - a group of legally independent firms, which are bound together by one or more formal or informal ties. Formal ties: joint shareholding, interlocking directorates, cross-guarantees of bank loans, internal trading. Informal ties: family ties, belonging of managers to the same social or ethnic group E.g. Samsung (Korea), Tata Group (India)

Hybrid Forms Franchising Provide services that have to be ‘produced’ locally while the customer is present; Large advantages in developing and maintaining a ‘business formula’ and a brand name; Reasons for franchising: Resource scarcity thesis Administrative efficiency thesis Inefficient risk-bearing Free riding be a franchisee Appropriability of quasi-rents

Hybrid forms Franchising Problem Hierarchy Franchising Independent companies Shirking Yes No Inefficient risk-bearing Free-riding on brand name

Glossary Bounded rationality – the capacity of human beings to formulate and solve complex problems is limited. Opportunism – an attempt to exploit a situation to one’s own advantage. An asset is transaction specific if it cannot be redeployed to an alternative use without a significant reduction in the value of the asset. Peer group – a group of people working together without hierarchy. Simple hierarchy – a group of workers with a boss.

Glossary Cumulative control loss – the corporate board loses control of day-to-day operations as the number of management increases Franchise contract – an entrepreneur (franchisee) have a contract with a company (franchisor) giving him a right to operate under the name of this company.

Reading Douma S., Schreuder H. (2002) Economic Approaches to Organizations. Prentice Hall. Ch. 8