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Transaction Cost Economics and the Boundaries of the Firm
Peter G. Klein
Contracting and Organizations Research InstituteDivision of Applied Social SciencesUniversity of Missouri, USA
June 2006
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 (1995–
2002), CBS (2001), University of Missouri (2002–)
Senior Economist at Council of Economic Advisers, 2000–01
Associate Director of the Contracting and Organizations Research Institute (cori.missouri.edu)
Co-blogger at organizationsandmarkets.wordpress.com
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
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
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).
Williamson’s unique brand of TCE
TCE’s 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 criticsOliver E. Williamson (1932–)
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
Ex-ante versus ex-post analysis
TCE as the “governance approach” to the science of
contract
Vertical integration: TCE’s “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)
The stages of production
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 Stigler’s (1951) life-cycle explanation TCE: the dominant explanation today
The basic TCE model
Characteristics of transactions Asset specificity
Physical Site Human Temporal Dedicated assets Brand-name capital
Uncertainty Frequency
“Potential for “maladaptation”
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
Perfect competition, shutdown, and quasi-rents
p3
p2
p1
quasi-rent
rent
The basic TCE model
Characteristics of transactions Asset specificity
Physical Site Human Temporal Dedicated assets Brand-name capital
Governance structures
spot markets fully integrated firms“hybrids”: contracts,
franchises, joint ventures
Uncertainty Frequency
Discriminating alignment: one independent variable
Discriminating alignment: two independent variables
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
Applications: the framework
Williamson’s “simple contracting schema”
= 0
0
0
= 0
A
B
C ̂
{
D
Market
Market with hazard
Contracts
Hierarchy
Note on prices
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
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…
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,
there’s 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
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
Other formal approaches III
Baker, Gibbons, and Murphy (QJE, 2002) Part of Gibbons’s “relational adaptation” group, along
with Simon (1951) and Williamson (1975) Key innovation: adding a new dimension for
characterizing organizational form
Buy Make
One-time spot outsourcing spot employment
Recurring relational outsourcingrelational
employment
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
Summary and conclusions
Of the three Coasian questions about the firm – existence, boundaries, and internal organization – boundaries has received the most attention by economists.
Williamson’s 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).