1. Transactions Costs Inside the black box Certain products require teamwork – either to be produced at all or to be produced efficiently Markets are not free – the market is a powerful co-ordinating device but there are a range of transactions costs associated with it

2. Transactions Costs Coase (1937) – transactions incur contracting costs Trading on spot markets Long-term contracts Internalizing the transaction within the firm Choice should be made dependent on which of these minimises transactions costs

3. Characteristics of Transactions Costs Frequency Infrequent transactions – spot markets Frequent transactions – long-term contract with single supplier or internalization? Timeliness/reliability JIT or inventory? Timeliness – long-term contract Timeliness & Reliability - internalization

4. Characteristics of Transactions Costs Complexity Occurs when the transaction involves a significant degree of private information e.g. difficulty in measuring quantity and/or quality Supplying party has incentive to engage in post-contract opportunism If transactions are complex, frequent but with a relatively short period of time before quality is revealed – long- term contracting If period of time is long integration may be preferred

5. Characteristics of Transactions Costs Asset Specificity Buyer-specific investments and sunk costs Positive sunk costs mean that the supplier may only be prepared to make the investment if a long-term contract is offered Ex-post opportunism may occur External supply may therefore be a problem and the input will not be outsourced but produced internally

6. Categories of Asset Specificity Site or locational specificity – process has to be located close to other assets – coal mine and electricity generating station (Joskow) Type specificity – plant & machinery that can only be used in a particular firm Human asset specificity – individuals may have knowledge/skills which are not easily transferable

7. Asset Specificity – An Example Fisher Body supplied car bodies to General Motors (market transaction) GM wanted Fisher to invest in a new dedicated plant adjacent to one of GMs assembly plants Planned reductions in: Transport costs Cost Inventory

8. Asset Specificity – An Example Fisher refused – they were afraid of ex-post opportunism in the form of pressure to reduce prices GM eventually acquired Fisher This strategy to reduce transactions costs was: Internalization Vertical Integration In-sourcing

9. Coasian Transactions Costs Search and information acquisition costs In markets buyers need to search for best prices, quality, availability. Sellers have to decide which prices to set – market research, monitoring competitors – and may need to invest in advertising. In organizations information is gathered at lower levels and passed up the hierarchy, then decisions are made and passed back down.

10. Coasian Transactions Costs Bargaining and negotiating costs – can be long and costly e.g. wage negotiations Contracting costs – both for new contracts and the termination of existing ones Policing and enforcement costs – the need for costly monitoring

11. Agency-based Transactions Costs Hidden information – pre-contract opportunism can cause mutually beneficial transactions to fail Hidden action – post-contract opportunism can cause inefficient outcomes when the actions of one (or more) of the parties is not observable

12. Transactions Cost Minimisation Taking the technology of production as given the organization should be structured to minimise transactions costs Market transactions may be attractive but firms exist to reduce transactions costs by: Reducing the number of transactions Reducing the overall cost per transaction

13. Cost Minimisation by Reducing the Number of Contracts All Coasian transactions costs increase with the number of parties involved The firm as a nexus of contracts Bilateral and Multiparty contracts 6 workers & 3 products Firm negotiates 6+3=9 contracts Market would require 6x3=16 contracts

14. Cost Minimisation via Implicit or Incomplete Contracting Internalization reduces the costs in drawing up, monitoring and enforcing explicit contracts which are required for market transactions Spot contracts Sequential Spot Contacts State-Contingent Contracts & Bounded Rationality

15. Cost Minimisation via Implicit or Incomplete Contracting Most contracts within firms are incomplete – this makes them easier to write but more difficult to enforce – the employment contract Implicit contracts are unwritten – extremely difficult to enforce - promotion

16. Caveats on Transactions Costs Theory Economies of scale – the volume of input required by a firm may be too small for the firm to produce it internally – utilities Competitiveness of External Market Competitive=Out-sourcing Non-Competitive=In-sourcing Interdependencies between Transactions & Technologies – JIT technology & efficiency of contracting