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Economic Foundations
of Strategy
Chapter 2: Transaction
Costs Theory
Joe Mahoney
University of Illinoisat Urbana-Champaign
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Transaction Costs Theory:
Arrow (1974): The Limits of Organization
Coase (1988): The Firm, the Market and theLaw
Williamson (1975): Markets and Hierarchies
Williamson (1985):The Economic Institutions of Capitalism
Williamson (1996):
The Mechanisms of Governance
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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 theclaims of individual self-fulfillment and
those of social conscience and action.
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Arrow (1974)
The Limits of Organization
There are profound (economic and ethical)difficulties with the price system.
The idealization of freedom though the market
ignores that this freedom can be, to a largenumber of people, very limited in scope.
Valuable though it is in certain realms, the
price system cannot be made the completearbiter of social life.
The price system does not, in any way,
prescribe a just distribution of income.
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Arrow (1974)
The Limits of Organization
Organizations are means of achieving the benefits ofcollective action in situations where there are severemarket frictions:
Moral hazard (hidden action);
Ex post opportunistic behavior
Adverse selection (hidden information);
Ex ante opportunistic behavior
Idiosyncratic assets
Uncertainty and the inabilityto insure some risks;
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Coase (1988)
The Firm, the Market and the Law
In the absence of transaction costs, marketsand hierarchies would be equivalent interms of allocative efficiency (Coase, 1937).
In the absence of transaction costs, liabilityrules would be equivalent in terms ofallocative efficiency (Coase, 1960).
In a world of positive transaction costs, thechoice of markets and hierarchies (and thechoice of liability rules) matter for
economic efficiency.
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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
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Williamson (1975)
Markets and Hierarchies
A comparative assessment of the economic efficiency ofalternative governance modes;
Organizational boundary issues are approached in an
interdisciplinary way where law, property rights theory,business history, and organization theory are usefullybrought together; and
The theory is applied to product markets, labormarkets, capital markets and value- chain analysis.
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Williamson (1975)
Markets and Hierarchies
Following Coase (1937) and Simon (1947),hierarchy usually implies a superior-subordinate relationship;
The employment relationship iscommonly associated with voluntarysubordination.
The benefits and costs of the firm (e.g., vertical
integration) are well articulated.
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Opt imal Input Procurement
Substantial
specialized
investmentsrelative to
contracting costs?
Spot ExchangeNo
Complex contracting
environment relative to
costs of integration?
Yes
Vertical
Integration
Yes
Contract
No
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Williamson (1975)
Markets and Hierarchies
Benefits of Vertical Integration:
Eliminates preemptive claims onprofits between separate firms;
Cooperation can be achieved better in an adaptivesequential manner with more refined rewards;
Internal auditing has superior features to externalauditing (e.g., railroad cartels); and
More likely to achieve convergent expectations
within the firm via the development of a codingsystem within the firm.
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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 (bounded rationality problem)
Deliberate distortion (an opportunism problem)
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Williamson (1975)
Markets and Hierarchies
Multi-divisional Organization
R&D
HR
Finance
Production
Mktg/Sales
Division A
R&D
HR
Finance
Production
Mktg/Sales
Division B
R&D
HR
Finance
Production
Mktg/Sales
Division C
Corporate
Headquarters
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Williamson (1975)
Markets and Hierarchies
Multi-divisional Organization
Responsibilities for operating divisions are assignedto (essentially self-contained) operating units;
The general office is mainly concerned with strategicdecisions, rather than tactical decisions;
Divisions are monitored and economic incentivesare provided;
Cash flow is allocated to high-yield uses.
R&D
HR
Finance
Production
Mktg/Sales
Division A
R&D
HR
Finance
Production
Mktg/Sales
Division B
R&D
HR
Finance
Production
Mktg/Sales
Division C
Corporate
Headquarters
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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.
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Williamson (1985)
Economic Institutions of Capitalism
Physical Asset Specificity:
E.g., specialized tools
Human Capital Specificity:E.g., firm-specific knowledge
Site Specificity: E.g., the co-location ofan electric plant and a coal mine
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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 receivecredible commitments.
Key Idea: MUTUAL sunk cost commitment
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Williamson (1996)
The Mechanisms of Governance
Remediableness Criterion:
Relevant comparisons are with feasiblealternatives 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.
i i (1996)
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Williamson (1996)
The Mechanisms of Governance
Discrete Structural Alternatives:
Firms employ different means than markets employ;
Discrete contract law differences serve to defineeach generic form of governance; and
The implicit contract law of internal
organization is forbearance.
Hierarchy is its own court ofultimate appeal.
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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, informationdisclosure rules, specialized dispute settlementmechanisms) is to create functional substitutes fortrust.
It is redundant at best and can bemisleading to use the term trust todescribe commercial exchange forwhich investments in mutual economichostages have been made.