1. Economics of Strategy The Costs of Market Exchange: Transactions Costs

2. Transactions Costs the costs of negotiating, monitoring, and consummating a contractual arrangement

3. Arms-length market transactions –a transaction in which autonomous parties exchange goods or services with no formal, agreement that the relationship will extend into the future –governed by contract law –disputes are typically litigated

4. Contracts define the conditions of exchange are critical to a system of private property rights involve at least two parties who usually fulfill the contract in sequential steps represent an observable, rational interaction between two or more parties

5. Complete Contracts map out every possible contingency and prescribe the rights and responsibilities of each party under each possible contingency are fully enforceable don’t exist

6. Incomplete Contracts do not map out all contingencies, rights, and responsibilities are the norm the degree of completeness is a function of marginal costs and marginal benefits of identifying, assessing and monitoring compliance with the contract

7. What prevents complete contracting? Bounded Rationality Difficulties in specifying performance ex ante Difficulties in measuring performance ex post Asymmetric Information

8. Bounded Rationality limits in our ability to collect, assimilate, process, and act upon information we are neither omniscient nor capable of perfect foresight

9. Difficulties in specifying performance ex ante difficulty in foreseeing all contingencies costs of calculating foreseen contingencies unforeseen circumstances imprecision of language; especially in legal code –“preponderance of the evidence” –“with reasonable certainty”

10. Difficulties in measuring performance ex post Who measures the performance? How is performance measured?

11. Asymmetric Information where one party has more complete information than another

12. Asymmetric Information Hidden Information –when one party knows something which the other party does not Hidden Action –when one party cannot observe or verify or measure contract performance

13. Contract Law assists in contracting by providing enforceable norms across contracts

14. Contract Law is written in a sufficiently broad way as to not be a perfect substitute for complete contracting –“reasonable”, “in good faith”, “with due diligence” is costly due to litigation –direct costs of litigation –litigation damages relationships –in the case of firms these relationships were initially instituted and consummated because each firm was better off

15. Beyond Contract Law Relationship-Specific Investments Quasi-rents The Holdup Problem

16. Relationship-Specific Investments (RSIs) asset investment which is tied to a specific transaction and has characteristics which hinder the costless redeployment of the asset to other customers or other uses RSIs create interdependency among the contracting parties these types of assets set up a “fundamental transformation” in the relationship between upstream and downstream firms

17. Fundamental Transformation upstream firms and downstream firms form symbiotic relationships upstream firms that hold a specific asset may engage in “buy-in” pricing –lowball price to create the relationship and then take advantage of being the sole supplier of inputs downstream firms typically have some, often high, monopsony leverage these factors create distrust

18. Forms of Asset Specificity Site Specificity Physical Asset Specificity Dedicated Assets Human Asset Specificity

19. Site Specificity assets are built in the same geographic proximity in order to facilitate exchange and/or reduce costs –reduced transportation costs –temporal coordination of upstream inputs to downstream purchasers

20. Physical Asset Specificity specialized machinery unique to one downstream firm or even to one specific transaction –physical or engineering properties which are customized for one particular customer or transaction

21. Dedicated Assets assets which are the direct result of the needs of a particular upstream buyer –they are customized for one particular customer or transaction

22. Human Asset Specificity specific human capital among workers which is comprised of firm-specific knowledge –skills, training, technical expertise –firm culture for managers this firm-specific knowledge has more value within the existing employment relationship than it has in the open market

23. Bargaining with Asset Specificity Rent - the difference between the revenues the seller actually receives and the minimum amount of revenue that it must receive to make it worthwhile to enter the relationship ex ante. Rents are also known as economic profit.

24. Bargaining with Asset Specificity Quasi-Rents - the difference between the revenue the seller actually receives and what it must receive to be induced to not exit the relationship ex post. –Quasi-rents occur when a relationship-specific investment leads to: contract renegotiations which directly benefit one party at the expense of another opportunistic action by one party, that the other party cannot prevent because of incomplete contracting or being locked into a symbiotic relationship

25. The Case of Dr. Smith rents and quasi-rents

26. The Holdup Problem opportunistic behavior by one party to a contract to exploit the other party’s vulnerability due to a relationship specific investment (rsi) this raises the costs of transactions of market transactions in four ways –Contract Negotiations/Renegotiations –Distrust –Investments to improve ex post bargaining positions –Reduced RSI investment generally

27. Contract Negotiations/ Renegotiations when either side sees the possibility of holdup ex ante the initial contracting will more complex and expensive any renegotiations directly raise transactions costs –direct costs of renegotiating contracts –particularly critical where temporal coordination is important

28. Investments to improve ex post bargaining position Making alternative contracts with other suppliers in case of holdup –leads to increased transaction costs –leads to the potential for over- investment/excess capacity –where the alternative supplier is used, parceling up production may not allow any one supplier to achieve full economies of scale

29. Distrust Raises transactions costs –contracts must become more complete which costs more –impedes opportunities for sharing information or ideas which could increase quality or reduce costs

30. Reduced Investment in RSIs Relationship specific investments will become less attractive Efficiencies which could be gained through RSIs will be lost Induces vertical integration where market exchange would be more efficient

31. Transactions Costs and Vertical Integration Differences in Governance Repeated Relationships Organizational Influences

32. Differences in Governance the ability to handle disputes through administrative mechanisms rather than the courts –more flexible and less costly –typically less antagonistic –the party making judgment presumably has better information concerning the details of the disagreement the ramifications of alternative outcomes for both the involved parties and the firm

33. Repeated Relationships Vertical Integration assures the benefits of repeated relationships –stability –dramatically reduces the potential for hold-up problems

34. Organizational Influences Membership in the firm requires affirmation and support of firm goals The ability of corporate culture to influence behavior