Thursday, July 30, 2009

6.2. Assumptions of Transaction Cost Economics

Transaction cost economists start from assumptions that are different from some of the more established approaches. True, taken separately, most of these assumptions have been around for a long time. It is, however, the merit of transaction cost economists to have synthesised them into a coherent theory. Three assumptions are of particular importance: (1) bounded rationality; (2) opportunistic behaviour, and (3) asset specificity. We shortly want to deal with every assumption in turn.

(1) Bounded rationality; this assumption means that actors are not assumed to be completely rational anymore but only limitedly so. Starting from boundedly rational individuals would make the assumption of actors who try to maximise utility in every instance a shaky one. Nobel-laureate Herbert Simon (1955) therefore proposed to assume that actors behave in a “satisficing” manner. Actors form expectations concerning the level of utility they hope to secure. As long as they factually secure that level, they do not have any incentives to change their behaviour. Only if the utility level aspired for is not reached anymore do they start to search for modified behaviour with the aim of reaching their old level of utility again. One consequence of bounded rationality is that contracts will not cover every possible contingency that could arise. They will, in other words, remain incomplete. This means that situations can arise that are not fully anticipated in contracts and the contracts do thus not specify the consequences of these situations completely, either. In such situations, general structures that can be used to settle conflicts are needed.

(2) Opportunistic behaviour; this assumption means that actors who can make themselves better off to the detriment of others should generally be expected to do so. If no institutional safeguards are available making opportunistic behaviour unattractive, then many potentially welfare-enhancing transactions will not take place.

(3) Asset specificity; this assumption means that some assets can only be used for very specific purposes. Opportunistic behaviour in combination with asset specificity can, e.g., become relevant if a good with specific characteristics needs to be produced before it can be sold. Ex ante, the buyer has every incentive to point at his ability and willingness to pay. Once the good is produced – and the second-best way to use this specific product is worth a lot less than the first-best – the buyer can be expected to ask for a reduction in price.

Economic institutions now serve the purpose of reducing transaction costs. Depending on the relevance of the assumptions just spelt out and on a number of factors to be spelt out in a minute, different “governance structures” (Williamson) are optimal in order to cope with the specific circumstances of the situation. Anything from a classic spot market transaction to a hierarchical firm can be a governance structure. It is important to note that governance structures can be conceptualised as a continuum with the two forms just mentioned as their most extreme points. In between, a large number of hybrid forms such a long-term contracts, franchising agreements, etc., are conceivable.

Before the introduction of transaction cost into economics, the existence of firms could not be convincingly explained. If one assumes market transactions to be executable without any costs, it is unclear why any transactions should not be executed via the market. Hierarchies, firms, however, are a way to ensure transactions not through voluntary consent but through command. Setting up and running organisational structures is certainly connected with positive costs and in the absence of transaction costs it is unclear why they should be incurred. As soon as transaction
costs are introduced, this whole picture changes dramatically. A shorthand for defining transaction costs is to call them the “costs of using markets” (Coase 1937). As soon as transaction costs and organisation costs are taken into consideration, predictions concerning the (optimal) size of firms can be generated: a firm will grow until the marginal revenue of integrating yet another activity is equivalent to the marginal costs that have to be incurred in order to integrate that activity. Formulated differently: the expansion of a firm will stop as soon as the transaction cost savings from integration are less than the additional organisation costs to be incurred.

The central hypothesis of transaction cost economics is that the specific characteristics of the relevant transactions determine the optimal governance structure. Williamson analyses the effects of three characteristics, namely of (1) asset specificity, (2) the degree of uncertainty, and (3) the frequency with which the relevant transactions are expected to take place. These three can be considered as independent variables, the optimal governance structure is the dependent variable to be explained with the independent ones. Simply put: we would expect governance structures to be more integrated, the more specific the assets used in some business relationship, the more important the role of uncertainty, and the more frequently transactions are expected to occur.

This is a static description concerning the optimal size of the firm. Changes in transaction as well as in organisation costs can be one factor leading to changes in optimal firm size. Reductions in organisation costs would, ceteris paribus, increase optimal firm size, reductions in transaction costs would, again ceteris paribus, decrease optimal firm size. In the early years of transaction cost economics, there was indeed the simple dichotomy between “Markets and Hierarchies” (Williamson 1975). In the meantime, representatives of this approach tend to think of these two forms of organisation as the extreme points of a continuous line, which allows for a multitude of so-called “hybrid” contractual agreements. They allow to explain the rationale of franchising, joint ventures, long-term contracts, etc., which were traditionally met with much scepticism by competition authorities.

With regard to the new industrial organisation, we observed that its representatives have produced exciting theories but that the empirical tests were somewhat lagging behind. This judgment cannot be made with regard to transaction cost economics. Although measuring concepts such as asset specificity or uncertainty with any degree of reliability seems no mean feat, it has been done successfully. Most empirical studies measuring asset specificity have relied upon Williamson’s (1985, 95f.) proposal to distinguish four kinds of it, namely (1) site specificity (costs ofgeographical relocation are great), (2) physical asset specificity (relationshipspecific equipment), (3) human asset specificity (learning-by-doing, especially in teams comprising various stages of the production process), and (4) dedicated assets (investments that are incurred due to one specific transaction with one specific customer). When estimating the effects of asset specificity on governance structures, one thus needs ways to measure one (or more) of these four kinds. Physical proximity of contracting firms has been used as a proxy for site specificity (e.g., by Joskow 1985, 1987, 1990 and Spiller 1985) and R&D expenditure as a proxy for physical asset specificity. With regard to both human asset specificity and dedicated assets, survey data have been used.

Instead of describing the empirical evidence in any detail here, we refer the reader to the survey of empirical studies by Shelanski and Klein (1999) and quote an early paper by Joskow (1991, 81) who observes that the empirical literature testing hypotheses based on transaction cost economics “is in much better shape than much of the empirical work in industrial organisation generally.”

Nevertheless, one empirical study dealing with alternative explanations for vertical mergers is too much to the point not to be cited. Spiller (1985) compared the predictive qualities of transaction cost economics with those of the market power paradigm of the Harvard approach. The latter predicts that the benefits of a merger increase in the degree of (supplier) market concentration, while transaction cost economics predicts that they increase in the degree of asset specificity. Gains from mergers are here operationalised according to the unexpected gains in the firm’s stock market prices at the announcement of the merger. Spiller finds that gains from mergers are smaller the greater the distance between the merging firms, i.e., the lower site specificity, whereas the industry concentration has no significant effect. This can be interpreted as evidence that the power of transaction cost economics in predicting mergers is higher than that of the more traditional structure-conductperformance paradigm.