Transaction Cost Economics and the Boundaries of the Firm

1
Transaction Cost Economics and the Boundaries of
the Firm

• Peter G. Klein
• Contracting and Organizations Research Institute
• Division of Applied Social Sciences
• University of Missouri, USA
• June 2006

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A little about me

• Education
• BA, economics, Univ. of North Carolina, 1988
• PhD, economics, Univ. of California at Berkeley,
  1995

• Positions
• Academic appointments at University of Georgia
  (19952002), CBS (2001), University of Missouri
  (2002)

• Senior Economist at Council of Economic Advisers,
  200001
• Associate Director of the Contracting and
  Organizations Research Institute
  (cori.missouri.edu)

• Co-blogger at organizationsandmarkets.wordpress.co
  m

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A little about me (cont.)

• Research interests
• Entrepreneurship
• Corporate diversification, internal capital
  markets, and relatedness
• Economics of innovation
• Institutions and economic development
• Courses
• PhD economics of institutions and organizations,
  industrial economics
• MBA business economics
• Undergraduate managerial economics, economics of
  networks, law and economics, microeconomic theory

4
Transaction cost economics background

• Transaction costs and transaction cost
  economics (TCE)
• Operationalizing Coase
• Existence team production, moral hazard,
  monitoring costs (Alchian and Demsetz, 1972)
• Internal organization agency costs and incentive
  contracts (Jensen and Meckling, 1976 Holmstrom,
  1979)
• Boundaries economizing on transaction costs
  (Williamson, 1975, 1979, 1985 Klein, Crawford,
  and Alchian, 1978)
• What exactly is TCE?
• Narrow view asset-specificity explanation for
  vertical integration (distinctions between KCA,
  Williamson, and GHM relatively insignificant)
• Broad view grand, unified theory of economic
  organization

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A theory of everything?

• Any problem that can be posed directly or
  indirectly as a contracting problem is usefully
  investigated in transaction cost economizing
  terms (Williamson, 1985, p. 41).

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Williamsons unique brand of TCE

• TCEs founder and best-known representative
• Charismatic and influential leader
• Influential book-length treatments
• Markets and Hierarchies, 1975
• The Economic Institutions of Capitalism, 1985
• The Mechanisms of Governance, 1996
• Idiosyncratic terminology
• Loyal and devoted students
• Odd position in the scholarly community
• Describes his work as a melding of the extremes
  of abstract economic theory and soft social
  science.
• Frequent target of Pfeffer, Ghoshal, and other
  critics

Oliver E. Williamson (1932)
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Key Williamsonian terms and concepts

• Bounded rationality behavior that is intendedly
  rational, but only limitedly so (Simon , 1957)
• Opportunism self-interest seeking with guile
• The transaction as the unit of analysis
• Asset specificity extent to which assets can be
  redeployed to alternative users and uses
• The fundamental transformation change from thick
  markets at contract selection stage to bilateral
  dependency at contract execution and renewal
  stages
• The discriminating alignment hypothesis
• Note emphasis on behavior and process

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Ex-ante versus ex-post analysis
TCE as the governance approach to the science
of contract
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Vertical integration TCEs paradigm problem

• The stages of production (diagram)
• Historical trends
• Merger wave of 1920s public utilities, banking,
  food processing, chemicals, mining
• Current debates on outsourcing

• Benefits of contracting out
• Comparative advantage
• Specialization, trade, and the division of labor
• Thick markets for inputs (productive and
  allocative efficiency)

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The stages of production
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Explanations for vertical coordination

• Market-power explanations
• Eliminating double marginalization
• Facilitating price discrimination
• Creating entry barriers
• Economic efficiency explanations
• Eliminating free riding
• Reducing supply uncertainty
• Stiglers (1951) life-cycle explanation
• TCE the dominant explanation today

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The basic TCE model

• Characteristics of transactions
• Asset specificity
• Physical
• Site
• Human
• Temporal
• Dedicated assets
• Brand-name capital
• Uncertainty
• Frequency
• Potential for maladaptation

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Asset specificity and holdup

• Klein, Crawford, and Alchian (1978)
• First to explicitly describe the holdup problem
• Popularized the notion of quasi-rents
• Economic rent payments to a factor of production
  beyond that necessary to attract that factor to
  that activity (e.g., pro athletes who play for
  the love of the game)
• Quasi-rent (Marshall) payments to a factor of
  production beyond that necessary to keep that
  factor from leaving (excess of value over salvage
  value) generally greater than economic rents
  (see diagram)
• Main point specialized assets generate a stream
  of quasi-rents, since they aren't easily
  redeployable once specialized assets are in
  place, trading partners will try to expropriate
  part of those quasi-rents

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Perfect competition, shutdown, and quasi-rents
rent
p3 p2 p1
quasi-rent
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The basic TCE model

• Characteristics of transactions
• Asset specificity
• Physical
• Site
• Human
• Temporal
• Dedicated assets
• Brand-name capital
• Governance structures

• Uncertainty
• Frequency

hybrids contracts, franchises, joint ventures
spot markets
fully integrated firms
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Discriminating alignment one independent variable
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Discriminating alignment two independent
variables
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Note on hierarchy

• The firm as a nexus of contracts
• Complete versus incomplete contracts
• Hierarchy and authority
• Coase fiat
• Hart ownership and residual rights of control
• Williamson mutual forbearance

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Applications the framework

• Williamsons simple contracting schema

Market Market with hazard Contracts Hierarchy
Note on prices
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Applications to vertical contractual relationships

• Vertical integration
• Backwards into manufacturing
• Forwards into marketing and distribution
• Vertical restrains (resale price maintenance,
  territorial restrictions)
• Price discrimination
• Labor-market contracting
• Finance

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Horizontal and conglomerate boundaries

• Horizontal integration little TCE work in this
  area
• Williamson (1975, 1981) offers an
  internal-capital-markets explanation for
  conglomerate diversification, though not closely
  connected with TCE
• More on this in a subsequent lecture

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The (new) property rights approach

• Major contributions Grossman and Hart (1986),
  Hart and Moore (1990), Hart (1995)
• Simply a formalization of Williamson?
• Similarities to TCE
• Incomplete contracting
• Asset specificity
• Key differences
• Emphasis on ex-ante incentive alignment (assumes
  perfect knowledge and costless bargaining, which
  annihilates governance problems (Williamson)
• Purports to explain the costs of integration
  better than TCE i.e., in GHM, theres still
  underinvestment in specific assets after
  integration
• Holds that the direction of integration matters
• Gibbons a different tradition than the
  rent-seeking tradition of Klein, Crawford, and
  Alchian (1978) and Williamson

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Other formal approaches

• Bajari and Tadelis (2001), Tadelis (2002) more
  in the spirit of TCE
• Approach formal model of ex post adjustments
  under incomplete contracting
• Basic model
• Completeness and complexity chosen simultaneously
  (and inversely)
• Ownership gives contracting party the right to
  modify the project design ex post
• Benefits (to buyer) of integration (internal
  procurement) can request changes to maximize own
  benefit ex post
• Costs of integration weaker incentives for
  seller
• Result internal procurement an increasing
  function of complexity

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Other formal approaches III

• Baker, Gibbons, and Murphy (QJE, 2002)
• Part of Gibbonss relational adaptation group,
  along with Simon (1951) and Williamson (1975)
• Key innovation adding a new dimension for
  characterizing organizational form

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Other formal approaches III

• Baker, Gibbons, and Murphy (QJE, 2002) (cont.)
• Main proposition asset ownership (in the sense
  of GHM) affects parties temptations to renege on
  a relational contract.
• Model
• Upstream party produces a component, transferred
  to downstream party.
• Downstream party wants to encourage high effort
  makes a non-contractible promise to pay a bonus
  for high effort (setup for a repeated game).
• Integration increases the downstream party's
  incentive to renege on the promise (under
  non-integration, if the downstream party reneges,
  the upstream party can sell the good to an
  alternative user).
• Non-integration increases the upstream party's
  incentive to increase the value to the
  alternative user, increasing her bargaining
  position should the downstream party renege. ?
  Tradeoff between integration and non-integration

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Summary and conclusions

• Of the three Coasian questions about the firm
  existence, boundaries, and internal organization
  boundaries has received the most attention by
  economists.
• Williamsons TCE the best-known, but not the
  only, economic approach to vertical boundaries.
• Among academic economists, GHM is probably more
  popular today TCE is only quasi-mainstream.
• Besides the theoretical work described here,
  there is a large empirical literature on
  boundaries (to be discussed later).