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Transaction Cost Theory

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Transaction Cost Theory

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An executive summary

for managers and Hybrid governance: the role of


executive readers can be
found at the end of this transaction costs, production
article
costs and strategic considerations
Daniel C. Bello, Shirish P. Dant and Ritu Lohtia

In rapidly changing markets, firms face extremely short cycles to develop


and market their products and services. The need for rapid action challenges
a firm’s ability to champion the entire process of product development and
marketing by itself. As a result, companies are increasingly using hybrid
governance strategies such as strategic alliances, partnerships, and joint
ventures to manage their development and marketing tasks. The extreme
popularity of these hybrid governance strategies in the last 10-15 years bears
testimony to their ability to facilitate faster development and more effective
marketing. The adoption of a hybrid strategy, however, is not always suitable
for a firm; vertical integration or market contracting might be more
appropriate for a firm under certain conditions. Unfortunately, the theories
available to practitioners tend to offer ambiguous prescriptions for
addressing these governance or institutional form decisions. What is the best
way for a company to govern and manage its transactions? Should a
company rely on its own competences to develop, manufacture, and market
its products; should the company outsource the performance of these tasks to
independent contractors; or should the company use a combination of these
strategies? Further, what factors favor each of these governance strategies,
and under what conditions are each of these strategies most appropriate for a
firm? To clarify the theoretical prescriptions available to practitioners, this
paper proposes a framework for addressing these governance questions.
Manner of task All firms perform a wide variety of tasks. Each task can be performed
performance entirely by economic units within the firm, entirely by economic units
outside the firm, or jointly by economic units within and outside the firm.
The manner in which the performance of a specific task is organized and
allocated by a firm describes the governance structure for that task. If the
firm performs the task within its boundaries through bureaucratic control
and coordination, the governance structure being utilized is a “hierarchy.”
If the task is performed outside the firm through market coordination and
outsourcing, the governance structure being utilized is a “market.” If the task
is performed jointly by economic units within the boundaries of and
economic units outside the firm, the governance structure being utilized is a
“hybrid” (Williamson, 1991). Since a firm generally performs multiple tasks,
it can utilize distinct governance structures for the performance of different
tasks. For example, an OEM might perform the assembling task entirely
within its boundaries, purchase all components from outside vendors, and
perform all distribution jointly with a network of intermediaries. The
determination of these efficient boundaries of specific tasks firms perform is
the primary focus of the application of transaction cost analysis to the study
of organizations (Williamson, 1985).
Transaction cost analysis Transaction cost analysis is the dominant theoretical framework employed in
literature to model variations in governance structures. In this paper we
argue that the case for the importance of transaction costs is overstated, and
that observed patterns of firms’ governance structures suggest that firms also

118 JOURNAL OF BUSINESS & INDUSTRIAL MARKETING, VOL. 12 NO. 2 1997, pp. 118-133 © MCB UNIVERSITY PRESS, 0855-8624
account for production costs and strategic considerations to determine
efficient boundaries. In the following sections we begin by illustrating that
transaction costs are not always primary. Next we discuss the factors that
impact production costs and transaction costs, and review certain strategic
considerations that impact the choice of governance mode for a task. Finally,
guidance is offered to practitioners responsible for governance decisions by
illustrating the interaction of production costs, transaction costs, and
strategic considerations. Through a managerially-oriented contingency
approach (Figure 1), the complex interplay among the forces that lead to
governance formation is described and illustrated with corporate examples.

Critique of the primacy of transaction costs


Governance structure Transaction cost analysis (TCA) provides efficiency-based guidelines to
determine which governance structure would be appropriate for which type
of task, and tries to align a governance structure with transactions required
for the performance of the task. Accordingly the governance structure
utilized by a firm should be one that minimizes the sum of the cost of
performing the task within the boundaries of the firm and the cost of
managing the transaction if the task was performed outside of the firm’s
boundaries. Thus TCA recognizes that while transaction cost economizing is
important, such economizing does not proceed regardless of production cost
ramifications. It also notes that the analysis of transaction costs should be
located within a larger economizing framework, and the resultant trade-offs
between transaction and production costs should be considered (Williamson,
1975, 1985).
Though Williamson recognizes this trade-off, his thesis, nonetheless, retains
the primacy of transaction costs – the alignment of governance structure
with transactions is done in a “mainly transaction-cost-economizing way”
(Williamson, 1991, p. 277). The consideration of transaction costs is primary
when asset specificity is high, as is the case in most of Williamson’s
applications. Extending the primacy of transaction costs to marketing
applications is problematic, however.
Application of TCA There are several problems with the manner in which TCA has been applied
to guide marketing decisions. First, a number of applications (Heide and
John, 1992; Noordewier, John and Nevin, 1990) utilize the firm as the unit of
analysis, and conceive governance structures at too high a level of
aggregation. While in some cases firms as a whole might be integrated or
deintegrated, most governance decisions are made at the functional level (e.g.
R&D, distribution, advertising, etc.) because transaction and production costs
are incurred at this level. The extent of integration within a firm can vary
considerably from one task to another. For instance, the firm could integrate
R&D and advertising, and deintegrate distribution. The second, and perhaps
the more critical, problem pertains to the nature of asset specificity. When
assets are highly specific, transaction costs become extremely high and
transaction cost economizing becomes the dominant concern in designing
governance structures. Real-world firms, however, need to produce and
manage business functions that require assets whose specificity is low to
moderate. High asset specificity, with zero salvage value, is an exception.
Under moderate to low specificity antecedents other than transaction costs
and production costs influence governance decisions. Here strategic concerns
override efficiency (minimization of transaction or production costs)
concerns in determining functional integration/ deintegration. Most
applications of TCA to marketing (Heide and John 1990, 1992; Noordewier

JOURNAL OF BUSINESS & INDUSTRIAL MARKETING, VOL. 12 NO. 2 1997 119


et al., 1990) uphold the primacy of transaction costs as they speciously
assume the extent and importance of asset specificity.
Importance of The dominant importance of transaction costs in a firm’s efforts to design
transaction costs appropriate governance structures is questionable. Since transaction costs
minimization leads a firm to internalize transactions by adopting integrated
governance structures, we would observe more real-world firms with such
structures if transaction costs were in fact salient. Normative implications for
designing governance structures thus should not be driven by analyzing
transaction costs alone; the analysis of production costs, and strategic
considerations should be incorporated as well.
The increasing importance of production costs and strategic considerations
in structuring governance modes and make/buy decisions is illustrated in
two recent examples. Prompted largely by strategic and production cost
considerations, the big three US automobile manufacturers now routinely
conduct joint primary research, and have recently filed for joint patents
(Suris, 1993). These manufacturers perceive the need for meeting the threat
of international competition as strategically far more important than the
competition and rivalry between themselves. Besides, these manufacturers
no longer have the resources required individually to “produce” primary
research. It is interesting that these companies engage in cooperative
research in spite of the high transaction costs associated with such joint
actions. Since joint ownership of research output increases the risk of
opportunism, companies minimizing transaction costs alone would not
engage in such cooperative research. Clearly their cooperation is motivated
by strategic and production cost considerations.
Manufacturing The high costs of internal production and strategic considerations also
partnerships account for the large number of manufacturing partnerships recently
established in the microprocessor industry. Most of these partnerships are
driven primarily by the need for faster product development and to share the
astronomical costs of introducing new microprocessor chips, factors that
affect production costs (McWilliams and Gross, 1993). Here too strategic
considerations play an important role in determining who the strategic ally
should be. For instance, Digital Equipment Corporation’s (DEC) decision to
have a manufacturing partnership with Mitsubishi Electric was guided in
part to capitalize on the latter’s name and industrial status to prove the
potential of chips designed by DEC. Thus, for companies in the
microprocessor industry too, it appears that their need to minimize
transaction costs is less critical than these strategic and production cost
considerations.
In the next section we illustrate the factors that impact production costs.
This is followed by factors that impact transaction costs and strategic
considerations.

Production cost theory


Production cost for a particular task/function is the cost of performing that
task, and is borne by the firm performing it. Though general production
theory stresses economies of scale, several factors affect production costs,
including:
(a) resource requirements;
(b) scale effects; and
(c) buyer experience.

120 JOURNAL OF BUSINESS & INDUSTRIAL MARKETING, VOL. 12 NO. 2 1997


Resource requirements
Resource requirements refer to the magnitude of resources (capital, technical
know-how, and human) needed to perform a task. Tasks requiring substantial
capital investments and/or highly sophisticated and expensive technologies
have high production costs associated with them. Large resource
requirements for a task raise entry-barriers for a firm considering performing
that task since the firm would have to acquire the relevant capital,
technological, and human resources. Conceivably, thus, tasks whose
performance requires relatively smaller magnitudes of resources, and
consequently have few associated entry-barriers, would be performed by a
large number of firms. Conversely, tasks requiring large resources would be
performed by the few firms that can overcome the associated barriers.
Risk considerations Entry-barriers for tasks requiring substantial commitment of resources are
also raised due to considerations of risk of failure and risk of inflexibility.
While any firm performing a high-resource-requirement task would
experience risk, the problem is more acute for those firms performing the
task for self consumption. A firm that internally allocates performance of a
task for self consumption experiences more risk because it is applying
substantial resources in ventures whose output serves its own needs alone.
If a firm builds a factory for its own use, to meet its own requirements, it is
more susceptible to losses from the inability to utilize installed capacity
when its own output needs decline, and meeting own requirements when its
own needs increase. This makes the dedicated factory a risky venture unless
the firm is able to diversify into the output market.
External vendors, on the other hand, are able to diversify their risk easily by
pooling the demand curves of multiple clients. These vendors maintain a
portfolio of clients, so that volume losses due to decline in needs of one
client might be offset by needs of another client. External vendors,
consequently, confront lower costs for performing a task since they do not
need to incorporate a risk premium in their costs structure that is reflected in
transfer prices charged by internal suppliers:
P1a: Tasks with large resource requirements have higher production costs
associated with them.

Scale of operations
The scale of operations in general permits realization of lower average
production costs. This is because large-scale production permits
specialization of labor, managers, and technology. It also permits economies
in buying and selling (Harvey, 1983).
Specialization of As a firm’s volume grows, it can divide work into many separate tasks. Each
managers worker may then specialize in relatively few tasks. Ford’s large volume
production, for example, enables workers to concentrate on only a few tasks
at a time at which they become proficient thus reducing costs. The same
applies for the specialization of managers. Increased output also allows
specialists to be fully employed, further reducing costs. A firm with larger
output can also use more efficient equipment and technology that would not
be economical for a small producer. Larger volumes also permit the
introduction of various types of automation devices, which tend to reduce
the unit cost of production.
Economies can also be realized in buying raw materials and selling the
finished product. Favorable terms may be granted to a firm placing a bulk
order for materials because such an order is of more value to the producer of

JOURNAL OF BUSINESS & INDUSTRIAL MARKETING, VOL. 12 NO. 2 1997 121


those materials. Often a firm’s staff is not being worked to capacity and so
more goods can be sold at little extra cost.
Production costs Costs associated with performance of most tasks are subject to the above
economies of scale which erects a lower bound on the scale of operations
below which production is no longer efficient. External vendors operate
above minimum efficient scale by distributing their fixed costs over a large
number of buyers. This advantage is generally not available to a firm
considering internal production for self consumption unless the firm’s own
requirements are large enough to afford realization of scale economies:
P1b: For scale sensitive functions increase in volume will decrease
average production costs.

Experience effect
Experience effect refers to the decline in a firm’s cost of performing a task
with cumulative experience. As a firm gains experience at performing a task
it learns how to do it better. For example, workers learn short cuts and
become more adept at a job as they repeat it, the flow of material is
improved, procurement costs are cut, and so on (Kotler, 1991). This results
in a reduction of average costs as experience is accumulated.
Experience can also be shared across different tasks that involve similar
kinds of activities. For example, the costs of producing a product line
modification can be substantially lowered if the modified product requires
the same production or distribution activity. Experience effects can impact
the ease with which other firms can perform a task. Consider a firm that
decides to perform a task/function for the first time. Even if this firm realizes
economies of scale, its initial production costs are likely to be greater than
those of experienced vendors. However, over time, as the firm continues to
produce, and accumulates volume, it might be able to overcome the
production cost advantage of other vendors due to experience curve effects.
Lack of experience, thus, increases a firm’s production costs:
P1c: For experience curve sensitive functions increase in expertise will
decrease average production costs.
In summary, significant resource requirements, scale effects, and buyer
experience all impact production costs. The following section details the
factors affecting transaction costs.

Transaction cost theory


Interorganizational In recurrent interorganizational exchange relationships transaction costs are
exchange relationships generally defined as the costs of writing, monitoring, and enforcing
contracts. Operationally these are the costs of running a market-based
system, or the costs associated with the allocation of tasks to external
agencies (Arrow, 1969; John, 1984). According to Williamson’s transaction
cost framework (Williamson, 1981), transaction costs arise due to:
(a) transaction specific investments;
(b) environmental uncertainty; and
(c) internal uncertainty.
Recent research by Walker and Weber (1984), and Walker and Poppo (1991)
suggests that transaction costs are affected by (d) market competition, as well.

Transaction specific investments


Transaction specific investments are investments in those assets that have
been tailored for a particular transaction and cannot be easily transferred.

122 JOURNAL OF BUSINESS & INDUSTRIAL MARKETING, VOL. 12 NO. 2 1997


Such investments raise safeguarding problems as they can be used for
opportunistic exploitation.
Bargaining situations Consider the organization of a transaction between two parties, General
Motors (GM) and its parts supplier, where the parts supplier is the party
making investments in assets specific to GM (investments in proprietary
component design to meet GM’s specific needs), and GM is the party
receiving these investments. These specific assets give the parts supplier an
ex-post advantage over other firms GM could potentially transact with. Since
the supplier has invested in assets specialized toward GM, it reduces
competitive pressures on itself for subsequent transactions. A small numbers
bargaining situation is thus created where no third party can provide to GM
the same level of performance output as the parts supplier. This reduces the
likely impact of GM’s threat of replacement of the parts supplier (Anderson
and Coughlan, 1987), and creates safeguarding problems for GM, and raises
GM’s transaction costs.
Transaction-specific investments also create safeguarding problems for the
party making the investments. In the above example, GM can behave
opportunistically by threatening to terminate its relationship with the parts
supplier. Since the parts supplier has invested in assets specific to GM, it
stands to lose in the event of termination. Provided competition among firms
to get GM’s business is sufficient to make GM’s threat of replacement to the
parts supplier credible, these specific assets become a source of ex-ante
disadvantage for the parts supplier, and raise its transaction costs. Thus
transaction-specific investments raise transaction costs by creating
safeguarding problems for each party:
P2a: Transaction specific investments increase transaction costs.

Environmental uncertainty
Contingency prediction Environmental uncertainty refers to the complex, little known, and turbulent
nature of the environment within which an organization functions.
Environmental uncertainty raises problems in predicting future contingencies
that can confront an exchange relationship. If such contingencies cannot be
accurately predicted, they undermine the firm’s ability to write efficient
contingent contracts. When substantial specific assets are involved, a “hold
up” potential is created by an opportunistic partner when a contractually
unaccounted for contingency arises (Williamson, 1985). Under conditions of
low to moderate asset specificity, the effects of potential hold-ups are
significantly less, and consequently, lower transaction costs are incurred:
P2b: Environmental uncertainty, in the presence of transaction specific
investments, increases transaction costs.

Internal uncertainty
Internal uncertainty refers to the difficulty in ascertaining adherence and
conformity to contracted agreements when the performance of a task is
allocated externally. Also known as the problem of hidden action (Arrow,
1985), it represents the difficulty in monitoring the behaviors of the external
agency to which the task has been allocated, and in measuring and evaluating
its outputs. First, monitoring difficulty is problematic because it raises the
potential for an opportunistic partner to shirk contractually assigned
responsibilities. It should be noted that even if a firm has experience with the
allocated task, which conceivably makes monitoring inputs feasible (Walker
and Weber, 1984), costs associated with such input metering over any
significant period can be inordinately high (Williamson, 1981).

JOURNAL OF BUSINESS & INDUSTRIAL MARKETING, VOL. 12 NO. 2 1997 123


Internal uncertainty Second, evaluation difficulties complicate attempts to write contracts that
provide compatible incentives to both parties (Anderson, 1985; Jensen and
Meckling, 1976). The problem is exacerbated because quality of outputs
generated by the external agency cannot be easily assessed due to problems
in adequately specifying evaluation criteria, and other evaluation difficulties
experienced by the allocating party:
P2c: Tasks subject to high internal uncertainty (i.e. when monitoring inputs
and evaluating outputs are difficult) incur high transaction costs.

Market competition
Market competition refers to the competition among a firm’s current and
potential vendors to contract with it. In unconcentrated markets the sources
of supply are distributed over a number of suppliers, and thus there is a
viable replacement threat to incumbent suppliers. This threat of replacement
can restrain suppliers’ opportunistic tendencies which, in turn, reduce the
contracting firm’s transaction costs (Walker and Poppo, 1991; Walker and
Weber, 1984).
It would seem that competitiveness in supplier markets will curb
opportunistic behavior only under conditions of low asset specificity, since,
as explained earlier, high asset specificity would give rise to ex-post small
numbers bargaining situation in favor of the incumbent supplier. However,
competition in the supplier market checks the incumbent supplier’s behavior
even when high asset specificity is involved since it raises the incumbent’s
ex-ante risk of replacement. Consequently, we propose that, irrespective of
the level of asset specificity, increases in supplier market competition will
reduce transaction costs for the buyer:
P2d: Tasks that lack market competition incur high transaction costs.
Thus, transaction specific investments, environmental uncertainty, internal
uncertainty, and market competition all impact a task’s transaction costs. In
the following sections we present a discussion on strategic considerations.

Considerations from strategic theory


Competitive positioning As shown in the preceding sections, several factors impact a firm’s
transaction and production costs. Transaction cost theory, driven by
efficiency considerations, posits that firms will transact by the mode that
minimizes the sum of transaction and production costs. However, the
selection of a governance mode is also affected by strategic considerations.
For example, in an effort to improve competitive positioning relative to
rivals, a firm might transact by a mode that involves higher transaction costs
(Kogut, 1988); alternatively, to enhance competitive positioning, a firm may
rely on a governance mode with substantial accompanying production costs.
The following strategic factors influence the attractiveness and selection of a
governance mechanism.

Speed of development
Speed of development refers to the need for rapid market action in response
to environmental conditions. With product life cycles shrinking, technologies
changing rapidly, and intense competition, organizations are striving to get
products to market quicker. Coping with change requires faster response time
on the part of the organization. In-house production of tasks can involve
substantial time delays as resources are developed internally; as a result
vertically integrated organizations can be slow to respond to competitive
changes facing them. Deintegrated or partially integrated governance modes

124 JOURNAL OF BUSINESS & INDUSTRIAL MARKETING, VOL. 12 NO. 2 1997


reduce acquisition time for resources, and seem to permit firms to gain faster
access to technologies and markets (Powell, 1987). Thus firms that need to
undertake rapid market actions, and cannot delay their actions until their
internal resources have been developed, may allocate the performance of their
tasks to deintegrated governance modes.

Competitive positioning
Market power Competitive positioning refers to the market power of one firm relative to its
competitors. While control over decisions is not desirable per se, to those
firms which seek to increase their market power vertical integration affords a
powerful mechanism of doing so. A firm that internalizes its sources of
supply increases its market power relative to other firms. For example, one
of the reasons Exxon is more powerful relative to other oil companies is
because it owns extensive oil fields that guarantee it a steady supply of
crude. While other oil companies are subject to the vagaries of international
crude suppliers, Exxon’s profitability is seldom affected to the same extent
by crude price fluctuations. Similarly, a manufacturer that integrates into
distribution by acquiring a network of independent distributors can enhance
its competitive positioning and market power by denying competitors access
to the acquired distribution network. This raises entry barriers for
prospective competitors too. Moreover, if the primary competitors in a
market have integrated distribution channels, the firm might also decide to
establish integrated distribution channels to signal its competitors and
customers that it too is serious about serving the market, and is willing to
commit resources to do so (Anderson and Coughlan, 1987). Since market
power is enhanced in vertical integration, firms seeking to enhance it will
choose vertically integrated governance modes.
It can also be reasoned that a firm can improve its competitive positioning
by choosing a partially integrated governance mechanism to:
(a) convert competitors into allies;
(b) weaken competitor’s position (Kogut, 1988); or
(c) enter a new market through partnerships.
Joint ventures In concentrated markets, where intensive competitor retaliation usually
follows new firm entry, a less conspicuous market entry can be facilitated
through a less integrated governance mode like a joint venture (Hennart,
1991). The proposal by British Airways to spend $750 million to buy a 44
percent stake in USAir is an example of using a partially integrated
governance mode to help improve competitive position in an industry that is
dominated by a few large carriers who have survived deregulation. However,
since this would have strengthened USAir, competing US airlines were
lobbying to prevent the alliance.

Other strategic considerations


Though the analysis of transaction and production costs, and evaluation of
strategic considerations is paramount in choosing a governance mode,
additional firm-specific factors may hinder or facilitate this choice. Factors
like specific product characteristics, firm’s size and its access to resources
are not expressly included in the economizing framework, but should be
considered to determine the appropriate governance structure.
For example, the effects of product characteristics on the choice of governance
mechanism is highlighted by McGuire and Staelin (1983) and Anderson and
Coughlan (1987). The greater the attractiveness of the product line to a firm,

JOURNAL OF BUSINESS & INDUSTRIAL MARKETING, VOL. 12 NO. 2 1997 125


the more likely it is to choose an integrated mode to purchase components and
raw materials needed for production, or to market it downstream. Similarly,
firms are more likely to distribute highly differentiated product lines through
integrated channels to capitalize on their brand value.
The above discussion suggests that in addition to costs, a firm should
consider strategic issues to help determine the appropriate choice of
governance mode. The next section illustrates the impact of the interaction
of production costs, transaction costs, and strategic issues on governance
modes.

Practitioner implications: interactions among costs and strategy


The article so far has stressed the impact of individual factors on transaction
costs and production costs. According to Williamson (1985), the most
efficient choice of governance mode is one that will help minimize the sum of
production and transaction costs. Governance decisions, however, are not
devoid of strategic content. In the following paragraphs we illustrate how
governance decisions should be based on the combined impact of transaction
and production costs, and strategic considerations. We first present a
discussion of the choice of governance mode for a combination of low,
moderate, and high transaction costs and low and high production costs.
Figure 1 illustrates the choice of governance mode based on the combination
of production costs and transaction costs when strategic considerations are
low. Next, we introduce strategic issues and using an industry example
suggest how the choice of governance mode may change when the
simultaneous impact of transaction costs, production costs and strategic
issues is considered.

Low production costs, low transaction costs, and strategic considerations


Integrate or deintegrate? The first situation being examined is one where transaction costs and
production costs are both low. Since the cost of producing the function are
low (due to small resource requirements, prior experience, etc.) the firm may
choose to integrate or deintegrate the function. Moreover, since the costs of
managing the function, if it was performed by an external firm, are also low
(due to low asset specificity, market competition, etc.), efficiency
considerations provide few guidelines for organizing the function. This
situation is illustrated in cell I of Figure 1.
A company like Whirlpool has low production costs and low transaction
costs for the task of manufacturing commodity fasteners (nuts and bolts)
used in its end-product washers and driers. This would imply a decision to
either make or buy the fasteners. Whirlpool has the ability to make cheaply
these component parts for its washers and dryers. Furthermore, since no
specialized assets are required to produce these commodity parts, transaction
costs for Whirlpool are also low. Under these circumstances, Whirlpool
should be able to buy the components from multiple suppliers through spot
market transactions. However, if the nuts and bolts are critical to the
functioning of its production line (a strategic concern), Whirlpool may be
inclined to develop a close relationship with one supplier to ensure that the
components are available on time. Indeed, Whirlpool has formed a
partnership with a fastener vendor since nuts and bolts are critical to its
production process:
P3a: When production costs are low and transaction costs are low firms
will either perform the task in-house or allocate it to external vendors.

126 JOURNAL OF BUSINESS & INDUSTRIAL MARKETING, VOL. 12 NO. 2 1997


Figure 1. Typology of governance structures

P3b: When production costs are low, transaction costs are low, and product
criticality is high, firms will choose a hybrid governance structure to
perform the task.

High production costs, low transaction costs, and strategic considerations


When production costs are substantially high relative to transaction costs,
the position taken by (pre-Williamsonian) functionalists (Baligh and
Richartz, 1967; Bucklin, 1970) appears to be that task performance be
allocated primarily according to the criteria of maximizing production cost
efficiency. Accordingly, task performance should be allocated to external
vendors if they can aggregate diverse demands (Williamson, 1985), or they
have a production cost advantage over buyers (Walker and Weber, 1984).
This situation is illustrated in Cell II of Figure 1.
Product criticality For a vendor of electronic components, the transaction of delivering
components to its OEM customers involves high production costs but low
transaction costs. This should suggest a decision to buy the delivery service.
However, in many cases the vendor partners with courier companies like
UPS due to “product criticality” to ensure fast, reliable delivery to the time-
sensitive OEM customers. Consider a situation where the vendor uses UPS
to transport emergency parts to an OEM. If the transportation function were
performed by the vendor, it would require high production costs (because of
the resources required, e.g. airplanes etc., the vendor’s limited ability to pool
demand, and inexperience in the transportation business). Further, since the
assets required to move packages are not transaction specific, i.e. they could
be used to transport other vendors’ packages, the transaction costs for the
vendor would be low. Under this situation, the functionalists would
recommend that the vendor buy the service from transportation providers
and maintain arm’s-length relationships with the couriers. However, driven
by the need to supply critical products to its OEM customers (strategic
issue), the vendor often uses only one transportation provider like UPS, and
builds a strategic alliance with it so as to ensure that the parts are always
delivered on schedule. Thus, whereas an arm’s-length transaction is

JOURNAL OF BUSINESS & INDUSTRIAL MARKETING, VOL. 12 NO. 2 1997 127


expected, given high production costs and low transaction costs surrounding
the transportation function, a strategic partnership prevails:
P4a: When production costs are high and transaction costs are low, firms
will allocate the task to external vendors.
P4b: When production costs are high, transaction costs are low, and task
criticality is high, firms will choose a hybrid governance structure to
perform the task.

Low production costs, moderate transaction costs, and strategic


considerations
Regulatory pressures When production costs are low and transaction costs are moderate, criteria
for task allocation are not clear. For example, for Toyota, the task of making
commodity auto parts involves low production costs but moderate
transaction costs since production of these parts requires moderately
specialized assets. This implies that Toyota should be better off making the
parts (see Cell III of Figure 1). However, Toyota regularly buys from US
vendors for image enhancement or to overcome regulatory pressures. Toyota
is probably at that point in the experience curve where there are diminishing
returns to scale and experience. Therefore, the additional resources required
to produce the component parts are not high. Furthermore, the production
costs for a component manufacturer are also probably low. In this situation
Toyota can either make or buy the parts. Since the criteria of production cost
efficiency provide ambiguous guidelines, the firm is likely to consider
transaction cost or strategic concerns to guide its allocation decision.
Consequently firms might have a slight preference for internal allocation,
but transaction cost considerations do not provide sufficient guidelines. Here
also the firm is likely to be guided by strategic considerations like image
enhancement (Lewis, 1990). To appeal to the US consumers or meet
regulatory requirements on domestic content, Toyota may choose to buy the
parts locally and promote the domestic content of the cars:
P5a: When production costs are low and transaction costs are moderate,
firms will perform the task in-house.
P5b: When production costs are low, transaction costs are moderate, and
regulatory/image concerns are high, firms will choose a hybrid
governance structure to perform the task.

High production costs, moderate transaction costs, and strategic


considerations
Hybrid governance Strategic considerations also explain why hybrid governance structures
structures prevail in situations characterized by high production costs and (a) moderate,
or (b) high transaction costs. In the first case consider the example of IBM
and Motorola jointly developing the PowerPC chip. For IBM, the task of
designing and manufacturing the next-generation chip (PowerPC) involves
high production costs and moderate transaction costs. This would suggest
that IBM should be equivocal to in-house or external designing and
manufacturing (see Cell IV of Figure 1). But IBM joint ventures with
Motorola to design and manufacture the chip in order to increase speed of
development.
Specialized assets The costs of chip development are astronomical for either partner
(McWilliams and Gross, 1993). Furthermore, specialized assets (human
training etc.) are required to produce the chip. However, since the assets may
be partially redeployable (since both firms operate in the computer
business), transaction costs for either may be moderate. Though production

128 JOURNAL OF BUSINESS & INDUSTRIAL MARKETING, VOL. 12 NO. 2 1997


cost analysis seems to suggest so, tasks may not be allocated externally since
they are associated with non-trivial transaction costs. Thus, complete
deintegration is inappropriate since problems associated with transaction
costs persist, even though such action may help lower production costs. At
the same time, given high production costs, internal allocation is inefficient
as well. Here strategic considerations seem to guide the decision. Driven by
the need for faster product development, IBM has formed a joint venture
with Motorola to develop the chip jointly:
P6a: When production costs are high and transaction costs are moderate,
firms either perform the task in-house or allocate the tasks to external
vendors.
P6b: When production costs are high, transaction costs are moderate, and
speed of development is critical, firms will choose hybrid governance
structures to perform the task.

Low production costs, high transaction costs, and strategic considerations


Even though Williamson’s emphasis on transaction costs is justified in certain
situations (Gatignon and Anderson, 1988; Klein and Alchain, 1978;
Monteverde and Teece, 1982) and his arguments provide decision-making
guidelines when costs associated with external contracting are substantially
high relative to costs incurred in internal production, the most efficient choice
of governance mode may be different when strategic considerations prevail.
Uncertain demand Consider the case of Xerox. The task of designing a next-generation copier
for Xerox involves low production costs but high transaction costs. Having
been in the copier business Xerox operates on the low cost end of the
economies of scale curve (thus has low production costs). Further, since the
manufacture of copiers requires moderately specific investments and the
demand is uncertain, transaction costs are probably very high. Faced with
high transaction costs and low production costs, TCA would suggest that
Xerox should design the copiers in-house. (This situation is illustrated in
Cell V of Figure 1.) However, to pool complementary skills possessed by
Microsoft, a strategic concern, Xerox has chosen to develop the copier
jointly with Microsoft (Smart, 1993):
P7a: When production costs are low and transaction costs are high, firms
will choose to perform the task in-house.
P7b: When production costs are low and transaction costs are high, and
pooling of resources is necessary, firms will choose a hybrid
governance structure to perform the task.

High production costs, high transaction costs, and strategic considerations


Finally, situations accompanied by high transaction costs and high
production costs present a unique dilemma for firms. Consider a firm like
Siemens. For Siemens, the task of designing a next-generation chip involves
high production and high transaction costs. This would suggest that they
should be indifferent to the make vs. buy decision (see Cell VI of Figure 1).
However, Siemens’ joint ventures with IBM and Toshiba were made in order
to speed development and exploit complementary skills.
Resource pooling When deciding to invest in R&D for chip development, Siemens AG of
Germany is faced with extremely high development costs. Also the
specialized assets required, and the technological and demand uncertainty
facing Siemens increases its transaction costs. While high transaction costs
would suggest internal allocation of tasks, high production costs retard

JOURNAL OF BUSINESS & INDUSTRIAL MARKETING, VOL. 12 NO. 2 1997 129


incentives for full integration. Again, strategic issues may guide the
decision. Hybrid governance forms like joint ventures become more
attractive as they facilitate the pooling of complementary resources and
recognizing synergies that could lead to a stronger competitive position
(Lewis, 1990). Furthermore they insure rapid speed of development. For
these reasons, Siemens has developed a joint venture with IBM and Toshiba
of Japan (Browning, 1994):
P8a: When production costs are high and transaction costs are high, firms
will either perform the task in-house or allocate the task to external
vendors.
P8b: When production costs are high, transaction costs are high, and
exploiting complementary skills is necessary, firms will choose
hybrid governance structures to perform the task.

Conclusion
This paper emphasizes the importance of production costs and strategic
considerations in a firm’s make versus buy decisions. We have argued that
while the analysis of transaction costs is important in structuring governance
mechanisms to manage transactions between organizations, ramifications of
production costs and strategic considerations cannot be ignored. In fact the
economization of transaction costs alone does not explain the large number
of alliances and partnerships witnessed in industry today. If, as suggested by
transaction cost analysis, minimization of transaction costs alone was
sufficient to guide governance choice, more firms would be totally vertically
integrated in the current uncertain environment in which firms routinely
incur substantial transaction specific investments. The fact that, even under
these situations, a large number of firms prefer hybrid governance
mechanisms over vertical integration, and the fact that outsourcing to
independent contractors has become the new corporate mantra bears
testimony to the importance of an expanded economizing framework that
supplements the analysis of transaction costs with the analysis of production
costs and an evaluation of strategic considerations.
Optimal governance This research synthesizes the theoretical literature in marketing, strategy,
mode economics, and law which has dealt with the design of governance modes,
and shows that all factors considered in extant research can be categorized as
affecting one of the following: production costs, transaction costs, or
strategic considerations. Second, by synthesizing the literature this research
helps clarify for researchers and practitioners all the factors that need to be
considered before choosing a governance mode. Previous theoretical
research has focussed only on one or a few of these variables that impact this
choice. Third, this research refocuses scholarly attention on the importance
of considering production costs and strategic factors in choosing a
governance mode. With a few exceptions, most research has focussed
exclusively on factors affecting transactions costs. For a more rational
decision, the other two variables cannot be ignored. Market researchers and
practitioners should thus jointly evaluate production cost, transaction cost,
and strategic factors before deciding which governance mode is optimal.

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(Daniel C. Bello is a Professor at Georgia State University, USA, Shirish P. Dant


works for the Gallup Organization in Princeton, New Jersey, USA, and Ritu Lohtia
is Assistant Professor at Georgia State University, USA.)


This summary has been Executive summary and implications for managers and
provided to allow executives
managers and executives
a rapid appreciation of Governance choice and business ideology
the content of this There exists a challenge for those who study business government to look
article. Those with a beyond the practical – how to create the most efficient corporate structure –
particular interest in the and consider the philosophical.
topic covered may then Government (in its widest sense) has exercised the thoughts of more great
read the article in toto to men and women than most topics. These thinkers looked at the “why” of
take advantage of the government as well as the “how”. They considered whether a particular
more comprehensive form was “right” rather than whether it was effective. (Although some like
description of the
Macchiavelli saw right and effective as essentially the same thing.)
research undertaken
and its results to get Writers about business have, in the main, focussed on the tangible measures
the full benefit of the of business success rather than ideological issues relating to business
material present organization. Bello, Dant and Lohtia continue in this tradition by focussing
on the question of using transaction cost theory to determine government
structures. Yet, in observing that managers don’t rely solely on this theory,
they lift the debate about corporate governance out of the detail of costs,
efficiencies and management effectiveness.
At the heart of Bello et al.’s contention is that belief the strategic
considerations other than transaction costs should inform decisions about
the definition of the institutional forms “...in which business activities are
conducted.” And, while strategy decisions do involve quantitative analysis,
they are equally determined by qualitative issues. Thus the “ideology” of the
firm’s directors must inform whether particular activities are owned, sub-
contracted or undertaken in partnership with third-parties.
Bello et al. comment that transaction costs alone do not “...explain the large
number of alliances and partnerships witnessed in industry today.” A
political scientist might argue that the penchant for strategic alliances
reflects prevailing business ideologies as much as practical benefits to the
businesses involved. If we believe that partnerships are “right” then we have
a predilection for that form of governance in the same way that a belief in
democracy would guide decisions about administrative structures and
policies in national government.
None of this denies Bello et al.’s assertion that production costs and
“strategic considerations” need assessment alongside transaction costs but
it does suggest that practitioners are closer to having it right than those who
slavishly follow one approach to “make or buy” decisions. We cannot know
whether – having made one or another decision about governance – that
decision is better than an alternative. We can only know whether it delivers
the business objectives we set.

132 JOURNAL OF BUSINESS & INDUSTRIAL MARKETING, VOL. 12 NO. 2 1997


Bello et al. concentrate on theoretical literature in marketing, strategy,
economics and law since those are the areas where the question of
“governance modes” is studied. This focus takes us to the issue of
practicality and effectiveness; it doesn’t answer the question of why
businesses opt for particular organizational structures. Nor does it address
the issue of whether a particular structure is “right” in ideological terms.
Practitioners reading this article should, however, ignore these concerns.
After all, your business strategies depend on a variety of factors peculiar to
your business and industry. What you need to do is assess the whole effect of
a particular organizational choice rather than look only at one or another
aspect. Transaction costs matter but only in combination with other costs
and your own belief about the sort of relationship needed with stakeholders.
Furthermore there will be conflicts within any analysis of options for
institutional design. You have to balance the interests of customers, staff,
suppliers and shareholders. And you need to consider the inevitable clash
between short-term sales and the sustenance of the business over the long-
term. Thus owning a process might save on transaction costs. It may even
reduce production costs. But in the long-run such a choice might undermine
your ability to respond to market change.
Bello et al. have opened up the debate about corporate governance and
“make and buy” decisions. Rather than focussing on one variable they show
how other factors impact these decisions. The debate must occur on two
levels: first to look at how government of business process links to
organizational culture, business ideology and the wider environment; second
to consider how to create the most effective institutions and structures for
individual businesses.
This debate needs both parts to provide practical managers with guidance.
It’s not enough to show via analytical methods how one approach or another
is “right.” Any theory needs the philosophical reassurance provided by a
business ideology. Currently partnerships, alliances and other “hybrid”
governance models dominate much of business thinking. We see long-term
benefits in such models of organization; not just tactical advantage.
However, the issue of power and control still remains and it could be that
less rigid forms of inter-business association will come to dominate.
Certainly those who write about the Hollywood or Silicon Valley “network”
approach to business development argue in favour of far more fluid
structures.
The prevailing business ideology will change. To what I’m not sure but it
will change. To understand that change when it occurs we need to examine
why, for example, democratic models of government succeed over the long
run while less open forms inevitably fail. We need to appreciate why
liberalism – despite the costs of openness – works better than a culture of
secrecy. And above all we need to think about why we are in business and
how that affects the decisions we make about running a firm.
(A précis of the article “Hybrid governance: the role of transaction costs,
production costs and strategic considerations.” Supplied by Simon Cooke for
MCB University Press.)

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