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L04 - Transactions Costs and Their Link

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L04 - Transactions Costs and Their Link

Uploaded by

marie.m.brandt
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Transactions costs and their link

to institutions
Emerging markets
Jakob Arnoldi
Fall 2022
Learning goals
• Understand transaction costs and their three
main components.
• Understand the links between transaction
costs and institutions.
Transaction costs economics

• Economic theory explaining organizations’ (firms’) role in


the economy.
• Link with institutional theory.
– Institutional efficiency reducing transaction costs.
• Relevant for analysis of any (type of) organization’s choice
to outsource or integrate.
• Also high relevance in regard to internationalization
strategy (also generally/not only in EMs), specifically
decisions about entry mode (equity or non-equity modes,
etc.)
Central themes relevant for this course
• Make or buy decisions.
– Internalisation
• Vertical integration/diversification.
• Business groups.
• Entry modes.

• But also other themes that are central to this course:


– Institutional efficiency in reducing TCs.
– Bounded rationality and problems related to intra firm
coordination.
– Opportunistic behavior and corporate governance problems
(agency costs/problems).
Coase on the boundaries of the firm

Coase intended to discover


”…why a firm emerges at all in a specialised exchange economy…” “why
is there any organisation?” and he mentioned some of disadvantages -
or costs – of using the price mechanism. One of the reasons to use the
alternative - the organization - is the existence of uncertainty.
And
“…a firm will tend to expand until the costs of organising an extra
transaction within the firm become equal to the costs of carrying out
the same transaction by means of an exchange on the open market …”

(Coase, R.: The Nature of the Firm, Economica, Vol. 4, Issue 16, pp. 386–405, 1937)
Transaction Cost Theory: The Transaction
• The transaction:
”…a good or service is transferred across a
technologically separable interface. One stage
of activity terminates and another begins”
(Williamson, 1985, p. 1)
Or the longer version…
• A transaction occurs when a good or service is transferred
across a technologically separable interface. One stage of
activity terminates and an- other begins. With a well-working
interface, as with a well-working machine, these transfers occur
smoothly. In mechanical systems we look for frictions: do the
gears mesh, are the parts lubricated, is there needless slippage
or other loss of energy? The economic counterpart of friction is
transaction cost: do the parties to the exchange operate
harmoniously, or are there frequent misunderstandings and
conflicts that lead to delays, breakdowns, and other
malfunctions? (Williamson 1981, p. 552)
Transaction costs are the costs of servicing, maintaining and lubricating so that friction
is minimized.
Stages in bicycle production (not complete)
Metal mining Plastic production
Rubber plantation

Aluminium
Rubber production

Frames Bicycle components


Tire production

R&D
Painting Assembly
Distribution

Retail sales
Marketing
Which stages will be covered by a single
firm?
This hinges on costs of coordinating the transactions, for example:
• Cost of reducing opportunistic behaviour;
• cost of reducing misunderstandings/sharing knowledge due to
bounded rationality;
• cost of ensuring quality;
• risks of investing in resources needed for transactions;
• etc.
1: Extent of such coordination problems are ultimately related to
degree of uncertainty, frequency of transactions, and asset
specificity.
2. Two ways of reducing the problems: contractual and hierarchical
coordination.
Basic proposition
• The mode of governance chosen will be the
most efficient one.
• Efficient = mode with lowest transaction
costs.
• Thus: Boundaries of the firm will be at the
point where the cost of hierarchical
governance exceeds the cost of market
governance
The two main modes of governance/coordination of
transactions

Transaction
Transaction inside a firm =
between two firms Hierarchical
governance (using fiat)
= Market governance (using contracts)

A B A B
There are in fact three…
Governance structures
(Coase 1937, Macneil, 1974/78, Williamson, 1991)

1. Market (classic contract law)


– The identity of the parties is irrelevant
– No dependency on each other
– The ideal transaction in the perfect market
– The contract is a clear agreement on clear performance
– Classical contract law stress formal arguments (if disputes should appear)
2. Hybrid (neoclassical contract law)
– More elastic contracting mechanism
– Ex.: “joint and equal responsibilities of each party..”
3. Hierarchy (fiat and forbearance)
– Most elastic contracting mechanism
– “Hierarchy is its own court”
Contractual instruments:

Market governance Hybrid Hierarchical governance


(Classical contract law) (Neoclassical) -”fiat”,

- ”forbearance”

- ”hierarchy is its own court”

AA B A B A B
Assumptions behind TCE

The theory is based on two behavioral


assumptions:
- Bounded rationality: “intendedly rational
but only limited so” (Simon 1961)
- Opportunism: “self-interest seeking with
guile” (Williamson, 1985)

Dias 14
Three underlying factors determining TCs

• Transaction costs :
– Frequency.
– Uncertainty.
– Asset specificity.

(opportunism and bounded rationality appear in


various guises in the three just mentioned)
Frequency
• The Achilles's heel of transaction costs theory but (at
least according to Williamson):
• The more regular (no disturbances) and repeated the
transactions the more attractive hierarchical
governance becomes even if each transaction requires
a lot of coordination (is asset specific or uncertain).

But be careful, frequency also used to signify frequency of


disturbances. In that case hybrid modes of governance becomes
costly and even market governance may become costly as
uncertainty will increase. Finally there are also economists that
argue that frequent transactions between partners will make them
less likely to behave opportunistically as they both see the benefit
of maintaining good relations.
Asset specificity
Specific investments needed for making a transaction which in turn
create interdependencies between seller and buyer.
• Site (specific production location needed).
• Human resources (specialized know-how and labor needed).
• Physical assets (specific production facilities needed).
• Temporal specific assets (quick and coordinated deliveries
needed).
• Dedicated asset specificity (physical assets that are not specific
yet of a volume or scale which create dependencies).
• Brand asset specificity (transactions will impacts on reputation of
transactor).
• Procedure specific assets (specific service procedures need).
Uncertainty
• Opportunism (self-interest with guile).
• Information asymmetry.

Yes, it is all about institutions.


The role of institutions
• How does institutions affect transaction costs?
• Do institutions affect uncertainty, asset
specificity or both?
• Do institutions affect contractual coordination,
hierarchical coordination, or both?

There is a bit of ambiguity on the questions


Internalisation knowing TCE

Institutional uncertainty (voids) creates an


impetus for relying on hierarchical coordination.
Or:
Institutional uncertainty (voids) increases costs
of market transactions, making hierarchical ditto
relatively more attractive.
What does more hierarchy entail:
• More vertical integration (and thus
diversification).
• More business groups (conglomerates).
• More wholly owned subsidiaries as entry
mode.
Summation
• Transaction costs are costs of moving between
stages in the production process.
• Such moves requires coordination or governance
(which is costly).
• Two types of coordination: Contractual and
hierarchical.
• Institutions reduce costs of coordination (but more
contractual coordination than hierarchical).
• EM firms therefore tend to rely more on hierarchical
coordination.

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