IE 463 Lec 3. Firm and External Cooperation-1

TRANSACTION COST ECONOMICS (TCE) All exchange transactions encounter problems of information enforcement Transaction: dealing or trading with others Transaction costs: costs incurred during the process of buying or selling, on top of the price of whatever is changing hands; costs of managing relationships costs of performance evaluation costs related to safeguarding the exchange relationship adaptation costs etc.

costs mainly caused by opportunism economic costs production costs costs of transforming inputs into outputs,or direct production costs transaction costs costs of making exchange,or indirect production costs motivation costs costs of motivating specialized agents to align their interests, e.g. cost of cheating or opportunistic behavior agency cost among owners, managers, and debt holders coordination costs costs of coordinating the actions between specialized agents, e.g. cost of obtaining information cost of coordinating input in production cost of measurement costs mainly caused by opportunism costs mainly caused by bounded rationality

Agency cost: can arise when somebody (the principal) hires somebody else (the agent) to carry out a task and the interests of the agent conflict with the interests of the principal. One way to reduce agency costs is for the principal to monitor what the agent does to make sure it is what he has been hired to do. But this can be costly, too. Another way to lower agency costs, especially when monitoring is too expensive or too difficult, is to make the interests of the agent more like those of the principal. Asset: an economic resource belonging to a company or entity, an item owned by the company or entity; an asset has future economic benefit and is the result of past financial transaction.

TCE is concerned with the examination of the comparative costs of planning, adapting and monitoring task completion under alternative governance structures like, market firm (hierarchy) network etc. Question: “ Why are some transactions directed by managers inside firms or networks rather than in an open market ? “

ASSUMPTIONS of TCE Bounded Rationality can’t assimilate all the information at one’s disposal (limit to the amount of information one can hold) can’t accurately work out the consequences of the information obtained (limit to the amount of calculations one can understand) Opportunism can possibly act in a self-interested way “with guile”, not entirely honest and truthful about their intensions attempting to take advantage of unforseen circumstances that gives them the chance to exploit others

Potential opportunism of economic actors is central in TCE, hence TCE focuses on the organization of a transaction through the most efficient governance structure; one which minimizes the transaction costs associated with safeguarding against opportunistic behavior. If a firm chooses to conduct an activity through some form of collaboration, such a choice reflects the fact that the collaborative form is the transactionally efficient mode of organizing that activity.

VARIABLES OF TCE TCE uses three variables that are common to any transaction; Frequency A firm would not want to internalize the activity concerning a good or a service that is very rarely used (ie. will not integrate within the firm) . It is then better to use the services of another firm which has the competency for it. Uncertainty During the course of a transaction, it is difficult to forsee all the consequences, especially for long transaction times. When uncertainty is not low, the firm can choose to integrate inside or establish long-term partnerships with other firms in order to reduce uncertainty.

3. Asset Specificity Transactions involve assets that are only valuable in the context of a specific transaction. In that case, transaction costs will be reduced by integration, within the firm or amongst partners within a network structure Such assets normally have low alternative use values so that owners have a strong interest in continuing the transaction. Strong asset specificity is a reason for establishing long-term relationships, but because of bounded rationality and opportunism factors, it involves high risks. Other things being equal, when transactions involve highly specific assets, transaction costs are likely to be lower in hierarchies and networks than in markets.

SOURCES OF ASSET SPECIFICITY Site specificity When successive stages of production are located in close proximity, common ownership generally results. This occurs when assets are immobile or, the set-up or relocation costs are large. Once an asset is in place, owners of the asset may use that asset for a single purpose. 2. Physical asset specificity If the assests are mobile and their specificity is attributable to their physical features (specialized parts or components), market procurement of particular product might or might not be possible. If the seller has no other buyer for his particularized part/component then the seller’s assets have physical asset specificity.

Human asset specificity Specialization in a particular field may give rise to human asset specificity. Where an emloyee had developed special skills that are useful only to a particular employer, the employee has developed a degree of human asset specificity. degree of specificity contractual response non-specific semi-specific highly specific spot market long-term contracts vertical integration

Transaction costs are low when; organizations are exchanging nonspecific goods and services uncertainty is low there are many possible exchange partners Transaction costs are high when; organizations are exchanging specific goods and uncertainty is high the number of possible exchange partners is small According to TCE, organizations will adopt increasingly formal linkage mechanisms with their exchange partners as transaction costs increase (alliances etc.). But these mechanisms also carry bureaucratic costs within the organization.

When deciding the firm strategy; locate and estimate the transaction costs of an exchange relationship estimate the transaction cost savings from using different linkage mechanisms estimate the bureaucratic costs of operating the linkage mechanism choose the strategy that gives the most transaction cost savings at the lowest bureaucratic costs. However, TCE is criticised for assuming that individuals usually behave opportunistically not paying sufficient attention to trust and market instruments that strengthen it 6 -

RESOURCE BASED VIEW (RBV) Basic Assumptions: Firms are unique bundles of resources and capabilities Competitive advantage derives from unique (not tradable and difficult to substitute) and inimitable resources and competencies, which allow to achieve a superior customer benefit Firm derives competitive advantage from unique (not tradable and difficult to substitute) resources and competencies.

Resources (Stocks) Activities (Flows) Resource Commitments Capability Development

TYPES OF RESOURCES Tangible Resources Relatively easy to identify, and include physical and financial assets used to create value for customers 1. Financial resources firm’s cash accounts firm’s capacity to raise equity firm’s borrowing capacity 2. Physical resources modern plant and facilities favorable manufacturing locations state-of-the-art machinery and equipment

3. Technological resources trade secrets innovative production processes patents, copyrights, trademarks 4. Organizational resources effective strategic planning processes excellent evaluation and control systems Intangible Resources Difficult for competitors (and the firm itself) to account for or imitate, typically embedded in unique routines and practices that have evolved over time 1. Human experience and capabilities of employees trust managerial skills firm-specific practices and procedures

2. Innovation and creativity technical and scientific skills innovation capacities 3. Reputation effective strategic planning processes excellent evaluation and control systems

Organizational Capabilities: outstanding customer service excellent product development capabilities innovativeness of products and services ability to hire, motivate, and retain human capital Routines: “... an executable capability for repeated performance in some context that has been learned by an organization in response to selective pressures” “… the decision rules which firms employ, both in terms of highly defined production techniques and extremely tacit strategic directions. These routines encompass most of what is regular and predictable about business behavior, and represent the genetic material of the firm in the evolutionary model. They are persistent within the firm, and heritable toward the future of the firm. They define not only how the firm operates now, but also how it will tend to operate in the future”

It is the input to a firm’s production process. Capability Resource It is the input to a firm’s production process. Capability It is the ability to exploit resources. They consist of a set of organization processes and routines that manage the interaction among the resources. A capability resides in a particular function i.e. it is functionally based. (“teams” of resources). Competence It is the cross-functional integration and coordination of capabilities and resources. capabilities competitive advantage competence resources

competencies resources capabilities tangible intangible structures processess systems

Core Competence It is a well-performed internal capability that is central, not peripheral, to a company’s strategy, competitiveness, and profitability. Core competence reflects a collective learning in the organization, especially how to coordinate diverse production skills and integrate multiple streams of technologies. Distinctive Competence It is a competitively valuable core competence that a company performs better than its rivals, something a company does especially well in comparison to its competitors.

DEVELOPING COMPETENCIES increasing Distictive competencies core competencies competencies difficulty value capabilities resources

EXAMPLES: DISTINCTIVE COMPETENCIES Toyota, Honda, Nissan Low-cost, high-quality manufacturing capability and short design-to-market cycles Intel Ability to design and manufacture ever more powerful microprocessors for PCs Motorola Defect-free manufacture (six-sigma quality) of cell phones

Cooperation is a strategic response to conditions of uncertainty and dependence: the primary goal of organizations is to maximize power organizations need to obtain resources and competencies from their environment for survival environment is uncertain few organizations are self-sufficient w.r.t. critical resources and competencies Therefore reliance on others for resources and competencies is unavoidable when resource flows are not under control, it causes uncertainty in firm’s decision making

However RBV, neglects cooperative relations when actors have no direct dependence (does not adequately adress the issues of networking) motivation and rationale for cooperation is restricted to gaining resources and power (but, org.s make strategic choices to join networks when the advantage of increased survival capacity outweighs the costs of maintaining relations)

RESOURCE BASED APPROACH TO STRATEGY 4. Select a strategy which best exploits the firm's resources and capabilities relative to external opportunities. 3. Appraise the rent-generating potential of resources and capabilities in terms of, their potential of sustainable competitive advantage, and the appropriability of their returns  2. Identify the firm's capabilities: What can the firm do more effectively than its rivals? Identify the resources inputs to each capability, and the complexity of each capability. 1. Identify and classify the firm's resources. Appraise Strengths and weaknesses relative to competitors. Identify opportunities for better utilization of resources . Identify resource gaps, replenish, augment and upgrade. Modify strategy to develop new capabilities. Strategy Competitive Advantage Capabilities Resources

STRATEGIC MANAGEMENT THEORY (SMT) Firms enter into cooperative relationships with other firms; to acquire competencies that the firm lacks to learn how to operate in new markets to acquire resources to diversify into new business to capitalize on economies of scale to circumvate trade or foreign restrictions ... Strategic management involves both long-range thinking and adaptation to changing conditions. It concentrates on the development, manintanence and explotitation of strategic potentials. Firm derives competitive advantage from strategic fit with its external environment.

Porter’s Five Forces of Competition SUPPLIERS bargaining power of suppliers INDUSTRY COMPETITORS threat of substitutes threat of new entrants POTENTIAL ENTRANTS SUBSTITUTES Rivalry among existing firms bargaining power of buyers BUYERS Industry analysis to identify attractive industries for corporate strategy 7

Strategic Positioning: Superior performance comes from close linkages and correspondence from; distinctive value propositions (unique added value an organization offers customers through their operations; it describes how an organization will differentiate itself to customers) a carefully designed product-market focus (comprises the products a firm chooses to trade in and the customer segments it targets) a set of unique value activities (the things a firm does to deliver the value proposition to the target product-market segments; value system/chain)

Porter: A cooperative strategy might offer a mutually advantageous opportunity for firms to modify their market positions and increase market power. Strategic approach to inter-org. linkages: competitive advantage often is derived from linkages among activities alliances provide competitive benefits in improving firms’ strategic posture within the industry firms enter cooperative relationships in order to achieve expansion and growth as well as to secure efficiencies of the kind identified in transaction cost economies in SMT, networking is a competitive strategy which is used by managers to position their firms in a favorable environment

firm’s competitive advantage lies in its capacity to gain access to, and exploit, valued external resources and expertise through the network Network is regarded as an investment for future access to other firm’s internal assets. However STM is criticised for not considering socially organized relations as important

EFFICIENCY In the framework of the strategic business management the issue of organization’s efficiency is of primary importance. i. Previously, efficiency was perceived through the internal resources (technological, technical, informational, economic) and was based on comparing costs and results. In that case the process of strategic planning is about the functions of defining the organization’s targets interpreting the environment forming a strategy adjusting the organization to the needs of implementing the adopted strategy.

The "network" model gave rise to an altogether different approach to the problem of an effective management of an organization. Relationships move to the center of the strategic management. The cooperative dimension of strategy ensures its efficiency through a coordinated behavior of individuals within the system of interactions, relationship becomes the main focus in defining efficiency and setting the strategy thus, efficiency of organization’s strategy is based on its interactive behavior.

DEPENDENCE Linking of activities and exchange of resources among the network members are sources of dependence and power. These aspects are missing in the literature on marketing. For example, in the models of marketing buyers and sellers are free to choose and change business partners. It is assumed that suppliers and buyers can be always changed. However, dependence on external resources is important. As a result, in industrial marketing neither sellers nor buyers are free to pick and change partners and such steps are highly risky. The degree of dependence of a firm on the partner depends on, the partner’s resource collection and the partner’s monopoly (control) for such supplies.

Therefore, dependence is rather a characteristic of the structure of complementary activities and the distribution of the resources of ‘interacting firms’ than a characteristic of the buyer and the seller dependence is the basis for power relationships. As soon as interacting firms begin to appreciate interfirm relationships and not isolated transactions, coordination of the activities and cooperation of the firms across the network is achieved.