Transaction Cost Theory
Transaction Cost Theory
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.
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
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.
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).
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.
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
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.
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.
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.
References
Anderson, E. (1985), “The salesperson as outside agent or employee: a transaction cost
analysis,” Marketing Science, Vol. 4, Summer, pp. 234-54.
Anderson, E. and Coughlan, A.T. (1987), “International market entry and expansion vis
independent or integrated channels of distribution,” Journal of Marketing, Vol. 51,
January, pp. 71-82.
■
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.