The costs of organization Masten, Meehan and Snyder (1991) Journal of Law, Economics, & Organization Presented by Hyeonsuh Lee

Overview Previous studies focused on examining factors that aggravate the hazards of market exchange. Internal organization cost as a limitation to be treated prior to integration. Why? Difficult to observe characteristics and organizational form. Difficult to measure transaction costs. Therefore, it is impossible to distinguish whether observed patterns of organization are resulted from the market transaction costs or from costs incurred organizing production internally. Explicitly examines the role of internal organization costs in integration decisions. Identify ways of overcoming the difficulties inhibiting direct tests of transaction-cost arguments.

Conceptual issues A tautological formulation Reduced-form analysis -- Difficult to observe and measure -- Selection problem Reduced-form analysis Estimate organizational form as a function of observable characteristics (e.g. asset specificity, level of uncertainty). The resulting model is qualitative choice estimation techniques such as probit and logit (stage 1) Hypotheses regarding organizational form can be based on the signs and relative magnitudes of the coefficients. Limitation β – α > 0  Integrate However, this finding can’t refute the underlying hypotheses that both coefficients are non-negative. Integration might be caused from the high cost of organization cost.

Conceptual issues Direct tests – stronger test of the theory! Only cost data for one of the institutions is required. Consistent estimates of the coefficients of equations (2) and (3) could be obtained using either maximum likelihood or two-stage methods. Advantages over reduced-form analysis Censored regression techniques yield dollar estimates of the costs of organization. Can identify the magnitude of individual coefficients in the cost equations and therefore permits tests of hypotheses regarding the costs of organizing under each institution.

Comparative assessment Whether and to what extent variations in internal rather than market organization costs are responsible for observed variations in organizational form? Demand a greater share of management’s limited attention Transaction specificities and uncertainty and complexity tend to aggravate organization problems both between and within firms, but the differential effects consistently favor integration. (allows firm adaptation) Transactions that are similar to ones in which the firm is already engaged are more likely to be integrated.  facilitates monitoring and supervision

Context: Naval Shipbuilding Determinants of organization costs in naval shipbuilding High degrees of human asset specificity (specialized design of military vessels) Physical assets are less relationship specific – tend to be mobile Involves organizing and coordinating a variety of relatively low-technology, labor-intensive activities associated with the physical fabrication and assembly of the final product. Timing and coordination are critical (temporal specificity) – The unique design and location aspects of construction projects, limit the ability to hold inventories of work in progress.

Hypotheses

Empirical methods Data: sample of tasks and components from the make-or-buy program of a large, naval shipbuilder. Survey design. They collected data on organization costs to permit estimation of structural cost equation. Costs of internal organization: the number of hours devoted by management to planning, directing, and supervising a particular component or process times the average hourly management wage rate. Two-stage procedure 1st stage Probit model The selection decision regarding whether to organize the process internally or to subcontract the work. Structural equations of the model Estimate internal organization costs to correct for selectivity using an index constructed from the first-stage results. Estimates of the coefficients in the (unobserved) external organization-cost equation are inferred from the parameters of the probit and internal organization cost estimates. 2nd stage

Results Comparison results of the full model Non-monotonic relationship Supports the proposition that variations in both market and internal organization costs influence the organization of economic activity. Results are consistent with hypotheses regarding (i) the potential for holdups in market transactions fostered by temporal and human asset specificities, and (ii) the costs of managing dissimilar, and hence, unfamiliar activities within the firm.

Results Log specifications Data on internal organization costs permit us to estimate both the structural organization-cost equations and dollar costs of organization. Confirm the predictions of the theory and the findings of the first-stage selection estimation with regard to the effects of temporal specificity and the similarity of transactions. Scheduling concerns raise the probability of integration by increasing the hazards of market exchange, while similarity fosters integration through its effects on internal organization costs. Complexity also exhibits a non-monotonic on administrative cost. Correlation between human asset specificity and the integration found in the first stage is a consequence of a decrease in internal organization costs rather than the increase in the costs of market exchange the theory predicts.

Discussion Can we locate “hybrid” governance form according to the suggested methods? Results from reduced-form analysis of Williamson (1991) Market Hybrid Hierarchy

Discussion Implication of this study – e.g., Does information technology increase market transactions? (Clemons, Reddi, and Row, 1993) The “move to the middle” hypothesis – a move to more outsourcing but with reduced set of stable partnerships.