Summary of Transaction Cost Economics

The basic research question for Transaction Cost Economics (TCE) is "How firms decide their boundaries when the firms are views as a nexus of contracts? ".  The main idea is that transactions should be organized to safeguard the contingencies of the exchange. The process to safeguard the exchange has cost (transaction cost). There are three organizational forms of transaction cost economics: market, hybrid and hierarchy. Hierarchy has advantage over market, because it more efficient in governing complex transactions. (Williamson, 1998).

Transaction cost economics have three premises, which render a contract incomplete. The incomplete contract leads to opportunism, which a potential cost for the contractors. First, Human cognition has limitations. Therefore, individuals cannot foresee the future contingencies and potential opportunism and plan well. Second, two contracting parties cannot develop a completely common language of the state of the world and possible actions. Third, the third-party, who enforces the contract, can have a hard time in understanding the contract interpreted by both of the parties. (North,1990; Williamson, 1985)

Practically, transaction cost can be manipulated by measuring three different constructs. First, higher asset specificity means higher transaction cost.  Asset specificity refers to the transferability of assets to alternative uses (Williamson, 1985). Williamson (1985) identify three types of asset specificity: 1) site specificity 2) physical specificity 3) human asset specificity. Site specificity: the situation whereby successive production stages that are immobile in nature are located close to one another. It reduces inventory and transportation costs and can lower the costs of coordinating activities (Dyer, 1996). Physical asset specificity: transaction-specific capital investments (e.g. customized machinery) that tailor processes to particular exchange partners. Physical asset specificity has been found to allow for product differentiation and may improve quality by increasing product integrity or fit (Clark and Fujimoto, 1991). Human asset specificity refers to transaction-specific know-how accumulated by contractors through long-standing relationships. The more specialized a resources becomes, the lower its value is in alternative uses. Therefore, it is harder to switch partners. The contingent value of a specialized resource exposes its owner to a greater risk of opportunism than does a general resource ( Klein et al.,1978). Firms, who develop a specific assets will face the hold-up problem, where the suppliers can extract extra rents from the consumers with opportunism, because the specified assets are of little value out of given context. Second, appropriability refers to the contracting hazards when the valuable intellectual property of the firms is exposed to expropriation (Gualti & Singh, 1998; Oxley, 1997;Pisano,1990). When firms engage in a contract in the market, they may have to exchange their proprietary information and technology. The partner firms who get the expropriate valuable technology can compete with the original firms to extract the rent from the technology. Contracts cannot fully prevent the moral hazard (Shapiro & Varian, 1999). Therefore, firms would want to internalize their transactions. Third, when the outcomes are hard to observe, the contract hazard is high (Holmstrom, 1979).

There are four main critics for transaction cost economies. First, it ignores the role of differential capabilities in structuring economic organization (Richardson 1972). This point is further developed by Resource-based Theory and Knowledge-based Theory. 

Second, it excessively focused on the assumption of opportunism. For instance, Ghoshal and Moran (1996) claimed that opportunism is not exogenous. Once the situational sources of opportunism (rather than the dispositional source) are factored in, Williamson’s prescriptions for mitigating the hazards of opportunism within organizations are likely to enhance it. Therefore, Williamson’s approach becomes a “self-fulfilling prophecy” and it thus “bad for practice”.  

Third, it views organization as instrument controlling pathological behavior, but neglects the institutional role of organizations which is embedded in the social networks (Granovetter 1985). In those critics, firms are often portrayed in rosy terms as “mini-societies” (Freeland 2002) that provide “identity” (Kogut and Zander 1996), “higher-order organizing principles” (Kogut and Zander 1992), and trust relations (Ghoshal and Moran 1996) that, purportedly, “atomistic” markets cannot provide. Firms exist because and to the extent that they not only allow managers to lower the cost and to increase the effectiveness of economic activity, but also create and sustain a context in which collaborative entrepreneurial behavior can flourish. Research, developing in this vein, has incorporate institution theories and population ecology. Hughes et al. (1997) study the contracting practices in the Welsh National Health Services (NHS) are subject to both efficiency and political influences. Study about strategic alliances between firms show that trust and relational governance partly mitigate the transaction costs (Gualti and Singh, 1998). Park and Russo (1996) find that the dissolution of joint venture is influenced both by organizational age and efficiency. 

Fourth, the uncertainty is not theorized well. Weber, L., & Mayer, K. (2014) discuss that different contractors’ cognitive framing is the source of uncertainty in contracting. Different governance forms are chosen to allow different degree of communication to align the cognitive frameworks.  

By Kate Jue Wang 

References:

Ghoshal, S., & Moran, P. (1996). Bad for Practice : a Critique O F the Transaction Cost Theory. Academy of Management Review, 21(1), 13–47.

Macher, J. T., & Richman, B. D. (2008). Transaction Cost Economics: An Assessment of Empirical Research in the Social Sciences. Business and Politics, 10(1), 1–65.

Moran, P., & Ghoshal, S. (1996). Theories of Economic Organization : the case for realism and Balance. The Academy of Management Review, 21(1), 58–72.

Willamson, O. E. (1996). Economic Organization: The Case for Candor. Academy of Management Review, 21(1), 48–57. Retrieved from

Williamson, O. E. (1979). Transaction-cost economics: the governance of contractual relations. Journal of Law and Economics, 22(2), 233.

Williamson, O. E. (1991). Comparative Economic The Analysis Organization : Analysis of Discrete Structural Alternatives. Administrative Science Quarterly, 36(2), 269–296.

Williamson, O. E. (1999). Strategy research: Governance and competence perspectives. Strategic Management Journal, 20(12), 1087–1108

Weber, L., & Mayer, K. (2014). Transaction cost economics and the cognitive perspective: Investigating the sources and governance of interpretive uncertainty. Academy of Management Review, 39(3), 344–363.