Transactions cost economics
Transactions cost economics
Firm v market, transactions cost economics (TCE), make-or-buy dilemma, vertical boundaries of the firm, vertical chain.
Firms are important when contracts are incomplete, and firms make large specific investments. Firms are complex, a nexus of contracts where management take the view that vertical integration is useful for assuring input supply in an uncertain world. However coordination can be a problem in vertical chains yet management need to obtain economies of scale and size in production in order to be profitable. A critical task for management is to define the boundaries of the firm by determining what to make and what to buy.
Transaction Cost Economics and Vertical Boundaries of a Firm
The conditions under which businesses are being done are dramatically changing, with the continuous infrastructure improvement marked by communications, transportation and technologies, as well as revolutionizing the environment of business operations and stakeholders of business institutions as well as the interactions with suppliers, competitors, customers and other stakeholders (Williamson, 2002). Therefore, given the above changes in infrastructure, vertical integration turns out to be a logical option for firms due to the tremendous increase in market size and the demand of product thereby allowing high-volume production. Hence, with the continuous telecommunications technologies and production advancements, one of the most significant firm’s strategic decisions is defining their boundaries under the circumstances which they consider using market rather than using internal organization in coordinating exchange (Milgrom & Roberts, 1992).
This essay provides a keen examination of the key characteristics of Transaction Cost Economics (TCE), as well as analyzing the role that co-ordination plays in a vertical chain with the use of the issue tree. The essay has two parts where the first part starts by describing the TCE followed by the reviewing of the assumptions and the role of TCE. The second part provides a discussion of the role played by co-ordination in a vertical chain while the final part provides a conclusion of the essay.
The key characteristics of transaction cost
Milgrom & Roberts (1992) defines transaction cost economics as the search, bargain, monitoring, enforcing as well as other cost not in direct relation to production of both services and goods. The use of the principle of TCE has been extensive and managers utilize it to determine the goods and services’ which are needed in a production process for make-or-buy decisions. Williamson (1981) states the assumptions of TCE as bounder rationality which referring to the rate as well as storage limits on the individual’s capacities for retrieving, storing and processing information without errors.
However, the key characteristics of TCE would be discussed in terms of relationship specific assets, as well as the concept of fundamental transformation of rent, hold-up and quasi-rent (Milgrom & Roberts, 1992). Moreover, relationship specific assets are a set of investments or assets which are made towards supporting a given transaction particularly for improving efficiency of the given transaction whose redeployment to another transaction is not possible without incurring cost or affecting the asset productivity. Besanko, Dranove, Shanley & Schaefer (2010) described the key characteristics of CTE as well as the relationship specific asset which takes four forms discussed below:
1. Site specificity: These investments in assets can be referred to as the located side-by -side with the aim of taking advantage of efficiency in processing while making it economical to transport as well as minimizing inventory cost. Willamson (1981) provides an example of location of this as successive stations in check-by-jowl relation to each other in the attempts of economizing of the transportation and inventory expenses.
2. Physical Asset Specificity: Assets that are particularly tailored to a specific transaction in both physical properties and engineering. Willamson (1981) gives an example of a situation whereby specialized or unique resources are needed in a component.
3. Dedicated Assets: this is a situation whereby an investment is not necessarily profitable, in equipment and plant induced by a contract or promise of a buyer.
4. Human Asset Specificity: a set of know-how, skills as well as information acquired by a group of workers or workers who have valuable significance inside a particular transaction relationship compared to when it is outside of it. Milgrom & Roberts (1992) states that, this is likely to occur through a process of learning or by doing. Moreover, Besanko, Dranove, Shanley & Schaefer (2010) brings the fundamental transformation associated concepts of assets specific relationship as rent, holdup and quasi-rent problems.
The vertical boundaries of a firm and the role of coordination
Generally, the flow of goods occurs along a vertical chain, that is, from the component parts and raw materials to manufacturing through distribution and finally retailing. Williamson (2002) observed that, in making decisions on firm boundaries, managers and entrepreneurs weigh the internal production benefits against the risks and costs of using markets. For instance, in the oil and gas industry, the vertical chain of petroleum products is from crude oil which is the raw material being explored and produced, to storage and/or transportation through vessels and pipelines to a refineries for processing to various other petroleum products such as diesel, petrol, aviation fuel and other associated products. This also involves later storage and distribution of the finished petroleum products to various channels for retailing.
Irrespective of the position of a firm along the vertical chain, it has to define boundaries of the firm as well as the firm as a pool of experience, abilities and knowledge in addition to undertaking stages in which the application of the existing capabilities occur. In the attempts to resolve the associated make-or-buy decisions, there must be a comparison of the benefits as well as cost of using the market compared to performing the activities in house by the firm. Besanko, Dranove, Shanley & Schaefer (2010) reiterates that a firm uses the market mainly due to the fact that the market firm are in most cases very efficient because of the exploitation of the learning curve and economics of scale as well as eliminating bureaucracy, and vertical integration of a firm makes links with products in adjacent stages that are within the value chain as well as internalizing exchanges taking place in open market. Milgrom & Roberts (1992) states the cost incurred as a result of the use of the market as well as the reasons which makes the firm to embrace vertical integration such as the poor coordination cost between the vertical chain steps, asymmetric information and transaction cost.
Coordination is the management of the business activities dependencies (Besanko, Dranove, Shanley & Schaefer, 2010), and thereby make it a core aspect of the market utilization within the vertical chain. This implies that in coordination a set of two or more actors are involved in performing economic activities or exchanges in order to ensure goals are achieved within the vertical chain (Williamson, 2002). Using the issue tree in Figure 5.4 pp144 Besanko as guide for the critical role played by coordination in the vertical chain and how firms make or buy decision; the use of the market firm as well as vertically integration are very essential. Therefore, this implies that coordination arises in using the market, and the following of the issue tree would be achieved in using the market.
In this essay there has been identification of the key characteristics of TCE in terms of its relation asset specific as well as evaluating the assumptions of bounder opportunism and rationality. The discussion of the vertical chain as well as the essential role that coordination plays, have also been discussed in the essay.
Besanko, D., Dranove, D., Shanley, M. & Schaefer, S. (2010). Economics of strategy, 5th ed. Hoboken, NJ: John Wiley& Sons.
Milgrom, P., & Roberts, J. (1992). Economics, Organization and Management. Englewood Cliffs, NJ: Prentice-Hall.
Williamson, O. E. (1981). The Economics of Organization: The Transaction Cost Approach. The American Journal of Sociology, 87(3), 548-577.
Williamson, O. E. (2002). The Theory of the Firm as Governance Structure: From Choice to Contract. Journal of Economic Perspectives, 16(3), 171-195.