1. Transaction Cost Economics
Lecture 6
4UZE402 Economics of Business Organizations

2. Outline Introduction to transaction cost economics
Behavioural assumptions
Dimensions of transactions
Organizational forms
Hybrid forms

3. Introduction
Transaction
Markets Organization ?
Cost minimization

4. Behavioural assumptions
Bounded rationality
Bounded rationality will
pose a problem only in
environments that are
characterized by uncertainty/complexity.
Opportunism
It is difficult or impossible to distinguish ex ante honest people from dishonest people.

5. Behavioural assumptions
HUMAN
FACTORS
ENVIRONMENTAL FACTORS
Bounded
rationality
Uncertainty/
complexity
Opportunism
Small
numbers

6. Dimensions of transactions
Transaction costs for a particular transaction depend on the critical dimensions of that transaction:
Asset specificity
Uncertainty/complexity
Frequency

7. Asset Specificity No local newspaper in town Appropria.
Opportunistic behaviour
LONG-TERM CONTRACT?
Transaction-specific asset
Financial guarantee
Mrs. Q
Mr. F
FC = $3500 per day
VC = $1500 per day

8. Uncertainty/complexity and Frequency
The higher uncertainty/complexity is the higher transaction costs due to bounded rationality.
Frequency
Setting up an organisation involves fixed costs. The costs can be covered only by high frequency transactions

9. Dimensions of transactions
High degree of asset specificity
High degree of uncertainty/ complexity
High frequency
Extremely high costs of market transaction
Transaction will be realized within organizations

10. Organizational forms
Fundamental assumption in transaction cost economics:
There is always competition between organizational forms and in the long run only the most efficient organizational form will survive.

11. Organizational forms Peer group no boss mutual adjustment Advantages:
Economies of scale
Information gathering
Risk-bearing advantages
Associational gains
Limitations:
Shirking

12. Organizational forms Simple hierarchy there is a boss
direct supevision
Advantages over peer group
Economies of communication
Economies of decision-making
Monitoring

13. Multistage Hierarchies
U-form enterprise
Chief Manager
Sales
Manager
Production
Logistics
Accounting
Personnel,
etc
department
information
Decisions, coordination

14. Multistage hierarchies
U-form enterprise
There are at least two layers of managers
Disadvantages of U-form:
Cumulative control loss
Corruption of the strategic decision-making process

15. Multistage hierarchies
M-from enterprise
Chief Manager
Sales
Manager A
Production
Logistics
Accounting
Personnel,
etc
Sales D. A
Prod. D A
Log. D A
Manager 2
Sales D. B
Prod. D B
Log. D B
Senior Manager
Product A
Product B

16. Multistage hierarchies
M-form enterprise is divided at the top level into several quasi-autonomous operating divisions, usually along product lines.
Main characteristics:
The divisions operate as quasi-firms
The corporate staff performs both advisory and auditing functions
The general office is principally concerned with strategic decisions
M-form enterprise economizes on bounded rationality and on opportunism

17. Hybrid forms
Long-term relations between buyers and suppliers (long-term contracts):
Long-term contract legal protection
Long-term benefits are much higher than short-term ones
Reputation
Involvement of the buyer
Common goals

18. Hybrid forms: Joint Venture
Business requires resources from both companies
It is difficult or impossible to trade these resources
Acquisition and/or merger requires lots of resources, which are not available

19. Hybrid Forms
Business groups - a group of legally independent firms, which are bound together by one or more formal or informal ties.
Formal ties: joint shareholding, interlocking directorates, cross-guarantees of bank loans, internal trading.
Informal ties: family ties, belonging of managers to the same social or ethnic group
E.g. Samsung (Korea), Tata Group (India)

20. Hybrid Forms Franchising
Provide services that have to be ‘produced’ locally while the customer is present;
Large advantages in developing and maintaining a ‘business formula’ and a brand name;
Reasons for franchising:
Resource scarcity thesis
Administrative efficiency thesis
Inefficient risk-bearing
Free riding be a franchisee
Appropriability of quasi-rents

21. Hybrid forms Franchising Problem Hierarchy Franchising
Independent companies
Shirking
Yes No
Inefficient risk-bearing
Free-riding on brand name

22. Glossary
Bounded rationality – the capacity of human beings to formulate and solve complex problems is limited.
Opportunism – an attempt to exploit a situation to one’s own advantage.
An asset is transaction specific if it cannot be redeployed to an alternative use without a significant reduction in the value of the asset.
Peer group – a group of people working together without hierarchy.
Simple hierarchy – a group of workers with a boss.

23. Glossary
Cumulative control loss – the corporate board loses control of day-to-day operations as the number of management increases
Franchise contract – an entrepreneur (franchisee) have a contract with a company (franchisor) giving him a right to operate under the name of this company.

24. Reading
Douma S., Schreuder H. (2002) Economic Approaches to Organizations. Prentice Hall. Ch. 8