The Cost of Organization Scott E. Masten; James W. Meehan, Jr.; Edward A. Snyder Journal of Law, Economics, & Organization, Vol. 7, No. 1. (Spring, 1991), pp. 1-25

Interorganizational Costs Internal organization costs play a role in decision to integrate. Due to issues in direct measurement of transaction costs, reduced-form relationships between observed and organizational forms can be used. These indirect tests can’t distinguish between changes in cost due to market transaction or from the cost incurred due to organizing

Estimation of Transaction costs Main Hypothesis of TCE Transactors min transaction costs Io if Go < Gm I* Im if Gm ≥ Go Such costs are difficult to observe and measure directly Selection problem: organization costs cannot be directly observed for organizational forms not chosen. Best case: cost of institution chosen directly compared to cost of alternative institution is not possible. Institutions minimize transaction cost; easy to claim difficult to measure

Reduced form analysis Reduced form analysis Direct Tests To address issue of direct measurement above, the observable characteristics were related to the incidence of transaction costs Base hypotheses on the sign of estimated parameters of linear model of the costs Gm and Go , and their relative magnitude; rather than the costs themselves. Linear model of the costs, relate the exogenous variables of the organization. Direct Tests Firms chose lower cost organization alternative and we could observe the transaction cost incurred under the institution adopted. To test integration decision, we need to know the selection process and data that captures the transaction cost. Application of switching regression techniques could provide estimates for both costs Gm and Go Use of censored regression model, reduces the burden of data.

Transaction Cost Differentials Perquisite to apply censored regression technique is the need to distinguish the cost of internal and market exchange and then relate the incidents of each to the attributes of transaction. Not easy!!! Contracts not explicit in internal organization Little attention has been paid to the factors that effect the level of these costs. Exception: Ronald Coase : Understanding “the effect of activities in which the firm is already engaged on the cost of undertaking additional activities” is essential to explain why particular operation are organized within specific firms. Internal organization costs are higher for differentiated (by location or characteristics) transaction cost for which there is uncertainty. Higher levels of uncertainty and complexity on an average leads to larger probability of integration. However similarity in transaction, could not effect costs of market exchange since Transactors care about the final outcomes and not the production process In addition to familiarity of transactors with each other’s techniques making it easy to detect opportunistic behavior , does not imply successful enforcement. Similar transactions are integrated.

Data: Naval Ship Building Difference in construction and manufacturing operations influence the circumstances that give rise to opportunism and determine the level of organization cost. Temporal specificity: Despite skills and assets necessary to perform task is fairly common, difficulty of identifying and arranging to have alternate supplier on short notice creates a holdup. In addition to four specificity described by Williamson : asst, human, site and dedicated assets

Hypothesis Shipbuilding like other construction operation, mainly involves organizing and coordinating a variety of low technology and labor intensive activity involved in assembly of final product. Hypothesis: the internal organization costs will be smaller and thus the likelihood of integration greater, the more labor intensive and less engineering intensive the production process.

Estimation Results: Make or Buy Decisions

Estimation Results: Costs of Organization

Findings Supports some standard transaction cost arguments. Temporal specificity can be major determinant of organizational form in some settings Integration becomes more likely in the presence of relationship-specific human capital and for at least very complex components. Effects of physical asset specificity on both organization costs and integration vary across specifications of the equations. The probit estimations indicate that the particular firm we studied is less likely to integrate engineering-intensive activities and more likely to internalize labor-intensive ones.

Implications of the findings While transaction-cost theory has emphasized the ways in which attributes of the transaction influence costs of market or contractual exchange (for which the probit results are supportive), the independent variables in our estimations, with the exception of SCHEDULE, have their principal influence on the costs of internal organization. This both illustrates the hazards of testing transaction-cost hypotheses using reduced- form equations and argues that greater attention should be paid to the determinants of internal organization costs as Ronald Coase has long contended. The findings regarding the effects of engineering effort on the integration decision raise questions about the interpretation of this variable in previous studies. The costs of dealing across a market interface, and hence the incentive to integrate, rise the greater the potential for holdups in a given transaction The evidence indicates that variations in the level of internal organization costs also play an important role in integration decisions.

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