ECON 356 - Outline Nine
The Theory of the Firm: The Literature and Transaction Cost Economics
It basically began with Ronald H. Coase: The Nature of the Firm (1937) in Economica.
"A firm undertakes those activities which are cheaper to organize internally rather than acquiring them from the marketplace."
Transactions Costs are important: Costs to using the market.
A "set of contracts" theory emerges - arguing that a firm is simply a set of contracts but internally organized.
Two means (modes) of organizing resources into an output:
1) Market contract mode: each specialist owns his own tools (there is no separate capitalist who owns the means of production)
(relationship between independent contractors -- no employees)
2. Internal organization mode: tools and machinery owned by the functionally distinct owner or owners.
(relationship would be employee, not contractor)
Gets fuzzy - some see the employee relationship as a contract relationship, for example.
Why do we observe one mode and not the other - or more generally, when should we expect to observe one mode and when the other (what is it in the structure of transacting that makes one form less costly than the other?
Coase on Transaction Costs: "The main reason why it is profitable to establish a firm would seem to be that there is a cost of using the price mechanism. The most obvious cost of 'organising' production through the price mechanism is that of discovering what the relevant prices are. . . . The costs of negotiation and concluding a separate contract for each exchange transaction which takes place must also be taken into account." (my emphasis) -
So he is talking about not having perfect information about prices.
Dahlman breaks down the transaction costs into three categories:
1. Search and information
2. Bargaining and decision
3. Policing and enforcement
So, "It is true that contracts are not eliminated when there is a firm but they are greatly reduced." - and therefore, so are transaction costs.
Coase on Uncertainty: "The question of uncertainty is one which is often considered to be very relevant to the study of the equilibrium of the firm. It seems improbable that a firm would emerge without the existence of uncertainty." (my emphasis)
This is because transaction costs (with the exception of time - which always exists) would not exist without uncertainty.
Coase on the Entrepreneur: "A firm, therefore, consists of the system of relationships which comes into existence when the direction of resources is dependent on an entrepreneur."
That is, instead of the price system (although -- the entrepreneur is guided by the price system to some extent as well).
So to sum it up:
Uncertainty → Transaction Costs → Entrepreneur → Action of bypassing transaction costs by internalizing (ownership of tools of production) → The Firm
After Coase - different economists tried to either disagree with Coase (offer another theory as to why firms exist) or build upon Coase. Let's look at some of the more famous:
1. Stigler ("The Division of Labor is Limited by the Extent of the Market"): Basically Stigler tried to provide more explanations as to why we would see more vertical integration or not.
a. Vertical integration:
b. Horizontal integration:
c. Conglomerate diversification:
Stigler's theory: he picks up off of Adam Smith's theory that division and specialization of labor is limited by the size of the market. So he predicts:
a. In growing markets - vertical disintegration
b. In large markets - vertical disintegration
Basically, when a market is growing -- and has grown large enough -- it justifies division and specialization of labor and functions of the firm will spin off on their own.
We don't always see this. It depends upon the industry. For example, when the rate of growth is really fast (say in a high tech field), then firms might actually integrate because that's the only way they can get the technology they need -- since it's changing so fast.
c. When a firm has rival functions - vertical disintegration - To quote Stigler, "The greater the rate of output of one function (input), the higher the cost of a given rate of output of the other processes." Management is an example - harder to coordinate as the firm produces more inputs.
When a firm has complementary functions - vertical integration - Example from Stigler - making steel, also supply scrap.
2. Alchian and Demsetz ("Production, Information Costs and Economic Organization"): They offer a different theory of why firms exist.
Team production is more efficient (transaction costs go down).
But the problem with team production is that it becomes difficult if not impossible to identify individual marginal products of labor.
Therefore -- people will have an incentive to shirk in a team (all benefits from shirking goes to the shirker but the costs are spread among the team).
Therefore - need a central monitor to make sure that people don't shirk.
The problem though -- who will monitor the monitor? The market -- make the monitor the owner of the tools, assets, etc. and he or she will have an incentive to make sure people don't shirk (even themselves)!
So we have internalization again -- ownership of the means of production by a central party - but for a different reason -- monitoring!
3. Cyert and March; Simon (A Behavioral Theory of the Firm): How do managers behave within the firm and how does it evolve over time because of this behavior.
For example, does a manger "maximize profit" or "maximize sales" or "maximize his/her own utility"? How risk averse are managers, etc.?
4. Klein, Crawford and Alchian ("Vertical Integration, Appropriable Rents, and the Competitive Contracting Process") and Williamson (Transaction Costs Economics): Basically they offer further explanations for why we might see vertical integration. So they are extending Coase, not so much disagreeing with him. This has been extended considerably and has become pretty important in microeconomics and the theory of the firm. So we will spend some time on it.
Transaction Cost Economics - Mostly Williamson (see your reading)
According to transaction cost economics, how we study economic organization (how resources are organized into outputs) depends upon two important behavioral assumptions:
1. Humans are subject to "bounded rationality" -
2. Humans are given to opportunism -
Also - important, if not the most critical dimension for describing transactions is the condition of
3. Asset specificity:
Given all three , we should: "organize transactions so as to economize on bounded rationality while simultaneously safeguarding them against the hazards of opportunism."
In other words -- try to decrease uncertainty regarding contingent events about what others might do -- by decreasing the incentive or likelihood of opportunism.
So assume we want to produce something and we need an input in order to do it. We have three options:
1) short term contract - buy the input in the spot market
2) long term contract - engage in a long term arrangement
3) make the input ourselves - vertical integration
Which one do we do? This will depend upon our circumstances. Are there specific assets involved, for example. If there are specific assets -- opportunism becomes a real possibility and we will have to think about that when we make our decision about our input.
So let's specify clearly what specific assets are. There are four types (as per Williamson):
1) Site specificity: the buyer and seller are right next to each other due to inventory and transportation costs. Once sited, the assets in place are highly immobile.
2) Physical asset specificity: when one or both parties make investments in equipment and machinery that involves design characteristics specific to the transaction and which have lower values in alternative uses.
3) Human asset specificity: investment in relationship-specific human capital that often arise through a learning-by-doing process.
4) Dedicated assets: general investments by a supplier that would not otherwise be made for the prospects of selling a significant amount to a particular customer. If the contract were terminated prematurely it would leave the supplier with significant excess capacity.
When there is a specific asset -- there is more of an incentive for opportunism.
Examples:
So let's get back to our input decision. What we should do, according to transaction cost economics, depends upon our circumstances. So let's look at four different scenarios (change our assumptions in each one) and see what the theory says will happen.
Scenario (or assumption) one: Let's assume that we do not have bounded rationality -- therefore we know beforehand all of the possible contingent situations that could arise once we make the contract. Given that -- "a comprehensive bargain is struck at the outset" and all contingencies are described in the contract. We will call this planning -- since we are simply planning out the future in our contract.
Scenario (or assumption) two: Now we have bounded rationality and specific assets, but there is no opportunism (that is everyone is "nice" and will never take advantage of anyone else - his word can be trusted). Given that -- "Thus although gaps will appear in these contracts, because of bounded rationality, these can be covered by recourse to a self enforcing general clause." For example -- if anything happens that changes the circumstances of this contract that hurts either party, the parties will agree to change the contract at that time such that both parties are again getting a fair deal. Basically, this is the world of promise -- since we simply promise to enforce the contract and do the right thing if something comes up we didn't foresee.
Scenario (or assumption) three: Now we assume that we have both bounded rationality and opportunism, but no specific assets. In this case, "parties to such contracts have no continuing interests in the identity of each other." There is no reason to trade with one person over another except that they offer a better deal. This can be described as competition. Fraud is assumed to be taken care of by the courts.
Scenario (or assumption) four: Now we have all three: bounded rationality, opportunism and specific assets. All three of our situations above won't work -- we must come up with ways of dealing with this situation. So we need to figure out how to "organize transactions so as to economize on bounded rationality while simultaneously safeguarding them against the hazards of opportunism." In other words -- different means of contracting (or not contracting) come about because of this situation. We call this private ordering. This is the situation that interests transaction costs economics. Firms come up with their own private solutions to contracting problems -- different business practices that have been seen in the past as being "inefficient" and even illegal are now seen as ways of dealing with contracting costs.
For example: exclusive dealings contracts -- I will agree to sell to you exclusively in a specific area if you agree to make investments in specific assets. Levi Jeans agreeing to sell to only one store in a mall in exchange for the store investing in promotion material specifically designed to sell Levi Jeans.
To sum up:
Planning - when we do not have bounded rationality.
Promise - when we do not have opportunism.
Competition - when we do not have asset specificity.
Private Ordering - when we have all three.
So let's get back to our original decision -- how do we obtain our input?
1) Short-term (spot) contract
2) Long-term contract
3) Vertical integration - make it ourselves
Let's assume we are faced with scenario four (we have all three -- bounded rationality, possible opportunism, and specific assets involved).
Will a short-term contract work? If we didn't have asset specificity, we could enter into a short-term (spot market) contract and basically we are just faced with finding the best deal in a competitive market.
We wouldn't have to worry about the fact that we have transaction-specific assets (the value of which is contingent upon us dealing with a specific party). But we do -- so this option will not do.
For example, let's say that the input that we need is specific to a machine that we already own. We need a very specific input produced -- or it will not work with our existing machine. Most likely the party we deal with will also have to invest in specific assets to produce our input. This involves a long term relationship with a particular party.
Will a long-term contract work? Maybe -- it depends -- as the costs of incomplete long-term contracts increase, and as the likelihood of opportunism increases, long-term contracts become less attractive and we might have to turn to our third option.
Will vertical integration be the best option? It transaction costs are high enough -- yes -- we make it ourselves!
So Williamson concludes that Transaction Cost Economics:
1. More micro-analytic than mainstream theories of the firm.
2. More self-conscious about behavioral assumptions (the entrepreneur does exist and we don't have perfect information)
3. Concerned with the importance of asset specificity
4. More reliant on comparative institutional analysis (comparing one contract or business practice to another)
5. Regards the firm as a governance structure (set of contracts) rather than a production function
6. Places greater weight on the ex-post institutions of contract -- with special emphasis on private ordering (as compared with court ordering).
Real World Case Example: The Fisher Body-GM Case
GM wanted Fisher brothers to produce their metal bodes (for cars).
But that would mean that Fisher brothers had to invest in specific machinery to make the specific bodies for GM (stamping machines and dies)
In 1919 they engaged in a long-term exclusive dealing contract. Since GM could potentially "hold up" Fisher brothers after the specific asset investment was made and either reducing their demand for the bodies or end the contract with them if the price was not adjusted downward.
The exclusive dealings clause in the contract required GM over a 10 year period to buy all their closed metal bodes from Fisher -- this limited the potential for GM to hold up Fisher.
But this created the potential for Fisher to hold up GM. Fisher could take advantage of the requirement that GM not purchase elsewhere by increasing the price or decreasing quality.
So pricing clause: Fisher's VC + 17.6% (designed to cover labor and transportation costs + anticipated capital costs - including opportunity cost of the capital or profit)
Also: most favored nation provision - price could not be greater than what they charged for similar bodies elsewhere.
So what happened?
What about a Self-Enforcing Range - (relying on reputation):
Another example: Alanson P. Minkler and Timothy A. Park, "Asset specificity and Vertical Integration in Franchising" in the Review of Industrial Organization, 2005.
"We employ measures of the proportion of company-owned outlets for the degree of integration and brand name capital for the degree of asset specificity. The results suggest that for the sampled firms the degree of asset specificity is positively related to the degree of vertical integration".
So the more brand name capital invested - the more vertically integrated the franchise operation was.