Economic Foundations of Strategy Chapter 2: Transaction Costs Theory Joe Mahoney University of Illinois at Urbana-Champaign

Transaction Costs Theory: Arrow (1974): The Limits of Organization Coase (1988): The Firm, the Market and the Law Williamson (1975): Markets and Hierarchies Williamson (1985): The Economic Institutions of Capitalism Williamson (1996): The Mechanisms of Governance

Arrow (1974) The Limits of Organization “If I am not for myself then who is for me? And if I am not for others, then who am I? And if not now, when?” There is a tension we all feel between the claims of individual self-fulfillment and those of social conscience and action.

Arrow (1974) The Limits of Organization There are profound (economic and ethical) difficulties with the price system. Valuable though it is in certain realms, the price system cannot be made the complete arbiter of social life. The price system does not, in any way, prescribe a just distribution of income.

Arrow (1974) The Limits of Organization Organizations are means of achieving the benefits of collective action in situations where there are severe market frictions: Uncertainty and the inability to insure some risks (leading to incomplete markets); Moral hazard (hidden action); Ex post opportunistic behavior Adverse selection (hidden information); Ex ante opportunistic behavior Idiosyncratic assets

Coase (1988) The Firm, the Market and the Law In the absence of transaction costs, markets and hierarchies would be equivalent in terms of allocative efficiency (Coase, 1937). In the absence of transaction costs, liability rules would be equivalent in terms of allocative efficiency (Coase, 1960). In a world of positive transaction costs, the choice of markets and hierarchies (and the choice of liability rules) matter for efficiency.

Williamson (1975) Markets and Hierarchies A systematic study of market frictions: Incomplete markets due to uncertainty Insurance problems Employment relations Vertical integration Capital markets Increasing returns and sunk costs Indivisibilities Information asymmetries Public goods Lack of definition of property rights Externalities with positive transaction costs

Williamson (1975) Markets and Hierarchies A comparative assessment of the economic efficiency of alternative governance modes; Organizational boundary issues are approached in an interdisciplinary way where law, property rights theory, business history, and organization theory are usefully brought together; and The theory is applied to product markets, labor markets, capital markets and value- chain analysis.

Williamson (1975) Markets and Hierarchies Following Coase (1937) and Simon (1947), hierarchy usually implies a superior-subordinate relationship; The “employment relationship” is commonly associated with voluntary subordination. The benefits and costs of the firm (e.g., vertical integration) are well articulated.

Williamson (1975) Markets and Hierarchies Due to uncertainty and bounded rationality, contracts are necessarily incomplete. Incomplete contracts are a problem when some people act with opportunistic behavior and there is small-numbers bargaining in the presence of asset specificity, which can lead to an economic hold-up problem.

Williamson (1975) Markets and Hierarchies Benefits of Vertical Integration: Eliminates preemptive claims on profits between separate firms; Cooperation can be achieved better in an adaptive sequential manner with more refined rewards; Internal auditing has superior features to external auditing (e.g., railroad cartels); and More likely to achieve convergent expectations within the firm via the development of a coding system within the firm.

Williamson (1975) Markets and Hierarchies Costs of Vertical Integration: Internal Procurement Bias A norm of reciprocity easily develops Internal Expansion Bias and Persistence Partly a mechanism for reducing conflicts Communication Distortion Serial reproduction loss (a bounded rationality problem) Deliberate distortion (an opportunism problem)

Williamson (1975) Markets and Hierarchies Multi-divisional Organization

Williamson (1975) Markets and Hierarchies Multi-divisional Organization Responsibilities for operating divisions are assigned to (essentially self-contained) operating units; The general office is mainly concerned with strategic decisions, rather than tactical decisions; Divisions are monitored and economic incentives are provided; Cash flow is allocated to high-yield uses.

Williamson (1985) Economic Institutions of Capitalism More precisely identifies asset specificity as the key concept for potential contractual hazards: Asset specificity implies small-numbers, but Small-numbers does not imply asset specificity (e.g., a contestable market). Emphasizes the concept of “fundamental transformation.”

Williamson (1985) Economic Institutions of Capitalism Site Specificity: E.g., the co-location of an electric plant and a coal mine Physical Asset Specificity: E.g., specialized tools Human Capital Specificity: E.g., firm-specific knowledge

Williamson (1985) Economic Institutions of Capitalism Economic “hostages” involve asset specificity; They are an important component of self-enforcing agreements; They have both ex ante (screening) and ex post (bonding) effects; and The wise manager should both give and receive credible commitments. Key Idea: MUTUAL sunk cost commitment

Williamson (1996) The Mechanisms of Governance Remediableness Criterion: Relevant comparisons are with feasible alternatives all of which are flawed. Claims of (path dependency arguments of) inefficiency (Arthur, 1994) that can be recognized only after the fact and/or cannot be implemented with net gains have no operational importance.

Williamson (1996) The Mechanisms of Governance Discrete Structural Alternatives: Firms employ different means than markets employ; Discrete contract law differences serve to define each generic form of governance; and The implicit contract law of internal organization is forbearance. Hierarchy is its own court of ultimate appeal.

Williamson (1996) The Mechanisms of Governance “Calculative trust” is a contradiction in terms: To craft credible commitments (through the use of economic bonds, economic hostages, information disclosure rules, specialized dispute settlement mechanisms) is to create functional substitutes for trust. It is redundant at best and can be misleading to use the term “trust” to describe commercial exchange for which investments in mutual economic hostages have been made.