Transaction Costs Economics

Introduction

The conditions of doing businesses change dramatically for the past century and especially for the past 30 years. With the continuous improvement of the infrastructure marked by transportation, communications and technologies, as well as changing role played by the government and the financial markets, firms found new ways and equipped with new abilities to control their operations and interact with suppliers, customers, competitors and other stakeholders.

Given the above infrastructure changes, vertical integration became a logical option for firms as the demand of product and market size increased tremendously which allowed the high-volume production since the early 90s. With the continuous advancement of the production and telecommunications technologies, it comes to a stage whereby market became a viable substitution of organisation as the exchange coordinator. Hence, one of the most important strategic decisions of firms is to define their boundaries and under what circumstances should they consider using market instead of internal organisation to coordinate exchange.

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This essay is to try to describe the key characteristics of Transactions Costs Economics (hereafter TEC) and with real life examples given as how it affects the decision of using market vs. organisation. Also, by quoting the example of Sony (battery), Apple (iPod) and firm that I am working with, we can see how firms define their vertical boundaries and what is the role played by coordination in a vertical chain. TEC One of the principle contributors to the study of TEC is Oliver E. Williamson.

While Williamson drew on the earlier work done by Ronald Coase regarding the concept of transactions costs, he further advanced it and had developed the Transaction Costs Analysis (TCA) theory in the 1970s and the 1980s. In the neo-classical approach of economics study, firm is treated as a “black box”, and internal workings of which were not considered to be important. TEC, however, argued differently. It tried to explain why firms exist and why they existed in a particular form of structure and the extent to which it will integrate vertically, given the existence of transaction costs.

Transaction costs can be aroused from:

• researching potential suppliers
• collecting information on prices
• negotiating contracts
• monitoring the supplier’s input
• legal costs incurred should the supplier breach contractual negotiations

Another key characteristic of TEC is its underlying assumptions, namely bounded rationality and opportunism. Bounded rationality refers to the fact that people are bounded by the limits of their own knowledge and memories. People may also be bounded in their rationality when they are overloaded with information which is beyond their processing abilities.

Opportunism refers to the possibilities that people might try to maximize their own benefit by lying about their true intentions or chances that people might exploit another party by taking advantage of unforeseen situations. It is worthwhile to mention that while TEC had tried to modify the assumptions under neo-classical decision theory by adding the deceitful human behaviour element in TCA, the core assumption of profit maximisation is still maintained. One of the key methods to maximize profit is to minimize costs.

By assuming that management and the owners of the firms are rational, they must compare the cost of internal co-ordination, which includes the cost of internal production and the cost of governance, to the cost of using the markets, which includes external production cost and transactions costs. In essence, management is considering the “Make or Buy” decision when they do the cost comparison exercise. With the assumptions highlighted above, TEC then attempts to explain why a firm will integrate vertically by specifying three attributes that are used to characterize any transactions s, i. e. Frequency, Uncertainty and Asset Specificity.

TEC argues that these attributes will determine whether transaction costs will be lowest in an organization or in a market. For frequency, it refers to the situation whereby firm will seldom integrate vertically if the services rendered or goods produced are rarely used. For uncertainty, it may be rooted from bounded rationality described above and from a situation whereby different parties involved had asymmetric information of the exchange. High uncertainty would generally lead to vertical integration, given the savings in transaction costs outweigh the costs incurred for vertical integration.

For asset specificity, arguably it could be the most distinctive element in the TEC theory. As investment in relationship-specific asset that cannot be redeployed to another transaction without incurring extra cost or sacrifice in the productivity of the asset, it would lock the parties into the relationship to some degree. The level of specificity will increase if an asset has little value in alternative use. With the existence of this attribute, transaction costs may increase so much that it may push potential firm away from using market.

In turn, firm will internalize the exchange by vertically integrating the firm that provided/offered the specific assets. With the notion of the investment in relationship-specific asset, it transforms the relationship between trading partners whereby parties which made investment in relationship-specific assets, the relationship changes from a “large numbers” bargaining situation to a “small numbers” bargaining situation. This situation is described by Oliver Williamson as the fundamental transformation.

It gives raise to two important theoretical concepts, i. e. Quasi-Rents and the problem of Holdup. Both of these concepts affect the costs of arm’s-length market exchange and in turn affect the “Make or Buy” decision. Once a firm invests in a relationship-specific asset, it generates positive quasi-rent. The other party in the exchange may know this extra profit and will push for getting a share of it by holding up its trading partner. It can be done by renegotiating the terms of the exchange, or event breaching the contracts when they are incomplete.

In view of the possible Holdup issue, the incentive for firms to invest in relationship-specific assets in the first place might be greatly reduced. Without the adequate supply of these assets, it might force the firm to make them by itself. Make Vs. Buy Cases Having the theoretical basis of the TEC theory described above, we can now see how the theory can be applied to the real life examples. The first example that I quote is the defect notebook batteries produced by Sony which resulted in recall in year 2006 and in 2008.

In the personal computer (PC) manufacturing industry, most of the players, such as Lenovo, Hewlett-Packard, Toshiba and Dell, have been using the market and they buy most of the component parts required to make their desktops and notebooks instead of making them by themselves. One of the standard components of notebook is its battery. All of these PC firms buy their batteries from the market and one of the major battery suppliers is Sony. These PC firms made this “Buy” decision as they found Sony has attached economics of scale in producing notebook batteries which their in-house unit could not attain.

Also notebook batteries are not relationship-specific assets and are not too difficult to coordinate in the production flows as it is a stand alone add-on that only required when the assembly of the notebook components is completed. So Timing and Sequence Fit are not a major coordination issue. In addition, leakage of private information is a non-issue as the raw materials of making battery cells are almost homogenous and relatively “low-tech” in the manufacturing process. Hence, these giant PC firms entered into contracts with Sony for the supply of their notebooks batteries.

In year 2006, dozen of consumers worldwide reported Sony batteries were overheating and a few minor burns. The overheating batteries were shipped with Lenovo, HP, Toshiba and Dell notebooks. It resulted in a 9. 6 million notebook recall in year 2006. In this case, all PC firms were following the standard make vs. buy decision process and tried to reduce their production costs by using the market. However, all of them had underestimated the transaction costs related to the use of the market mechanism.

With asymmetric information where Sony has more information that HP, Dell and other PC firms, it may subsequently use it opportunistically. The PC firms can reduce the problem by improving the quality control and contract terms of buying these batteries. However, it comes at a cost, transaction costs. While the compensations claims from these PC firms to Sony were not publicly disclosed, it certainly damaged the reputation of these PC firms and Sony. It also increased the costs of the contracts between them.

While public expected this recall would not happen again, in year 2008, about 35,000 Sony notebook batteries were recalled in US after several reports of fire. Apparently, all parties involved had not taken into the transaction costs factor seriously enough given the 2006 recall. Vertical Integration I would like to illustrate the vertical integration strategy by referring to production of iPod by Apple Inc. While Apple Inc. claimed itself as a firm that designs and manufactures consumer electronics and computer software products, essentially it uses the market specialists as the coordination.

It contracted out of all of its manufacturing functions and only kept the core design of its products in-house. Even its software was not entirely developed in-house. Steve Jobs, CEO of Apple Inc. , ordered a team of hardware designers within the firm to design the hardware of iPod in year 2000. When Apple first launched iPod in the market on October, 2001, it used the software developed by a company called PortalPlayer. Apple also contracted another company, Pixo, to help on the user interface design and implementation. It is Apple Inc. hich continuously refined the look and feel of the software as the development progress. Regarding manufacturing, it was out-sourced to Taiwan companies with factories located in Mainland China. Component parts that made up of iPod are supplied by different suppliers, such as Samsung for microcontroller and storage medium and Cirrus Logic for audio chip. Interestingly, while Apple Inc. decided not to have forward integration for the manufacturing of iPod, it actively pursed the downstream integration by establishing its own distribution and retailing channel.

It set up an online media store of iTunes Music Store on April 2003 and operates more than 250 retail stores in more than 9 countries. With the PC iTunes software that can access the iTunes Store and the special property right protection technology (Data Retention Management) that only allows iPod to play the contents (which include music, videos and games) purchased from the Store, the iPod, iTunes and on-line iTunes Store are well-coordinated in the downstream of the vertical chain.

It also increased greatly the sales and profitability of Apple Inc.. Another case that I can refer to is my firm that I am currently working with. It is big law firm. When we decide whether we would outsource our supporting functions, such as data management and IT support, we always consider the chance of leakage of our private (client’s) information, which is critical to our profession. It will have negative legal and reputational consequence if our clients’ information is leaked to outsiders.

As complete contracting is either infeasible or too costly, most of data management applications are developed in-house instead of buying from the market. Conclusion TEC is important as it represents one of the first and most influential attempts to develop an economic theory that look into the firm structure in a more serious manner. It is most often used to analyze vertical integration of firms. With the development of technologies and communications, transaction costs to use Market are reduced.

However, the example of Sony batteries recall case shows that firms might underestimate these costs. While more firms are downsizing their structure and contracted out their functions, they strategically integrate to the functions which can enhance their overall profitability. The setting up of iTunes Stores and selling of proprietary contents by Apple Inc. for iPod is a good example. With possible leakage of private information and the failure to have complete contract, professional services firm is more likely to use the internal resources for its data and IT management.

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