1. Transaction Cost Economics and the Boundaries of the Firm
Peter G. Klein
Contracting and Organizations Research Institute
Division of Applied Social Sciences
University of Missouri, USA
June 2006

2. A little about me Education Positions
BA, economics, Univ. of North Carolina, 1988
PhD, economics, Univ. of California at Berkeley, 1995
Positions
Academic appointments at University of Georgia (1995–2002), CBS (2001), University of Missouri (2002–)
Senior Economist at Council of Economic Advisers, 2000–01
Associate Director of the Contracting and Organizations Research Institute (cori.missouri.edu)
Co-blogger at organizationsandmarkets.wordpress.com

3. A little about me (cont.)
Research interests
Entrepreneurship
Corporate diversification, internal capital markets, and relatedness
Economics of innovation
Institutions and economic development
Courses
PhD: economics of institutions and organizations, industrial economics
MBA: business economics
Undergraduate: managerial economics, economics of networks, law and economics, microeconomic theory

4. Transaction cost economics: background
“Transaction costs” and “transaction cost economics” (TCE)
Operationalizing Coase
Existence: team production, moral hazard, monitoring costs (Alchian and Demsetz, 1972)
Internal organization: agency costs and incentive contracts (Jensen and Meckling, 1976; Holmstrom, 1979)
Boundaries: economizing on transaction costs (Williamson, 1975, 1979, 1985; Klein, Crawford, and Alchian, 1978)
What exactly is TCE?
Narrow view: asset-specificity explanation for vertical integration (distinctions between KCA, Williamson, and GHM relatively insignificant)
Broad view: grand, unified theory of economic organization

5. A theory of everything?
“Any problem that can be posed directly or indirectly as a contracting problem is usefully investigated in transaction cost economizing terms” (Williamson, 1985, p. 41).

6. Williamson’s unique brand of TCE
TCE’s founder and best-known representative
Charismatic and influential leader
Influential book-length treatments
Markets and Hierarchies, 1975
The Economic Institutions of Capitalism, 1985
The Mechanisms of Governance, 1996
Idiosyncratic terminology
Loyal and devoted students
Odd position in the scholarly community
Describes his work as “a melding of the extremes of abstract economic theory and soft social science.”
Frequent target of Pfeffer, Ghoshal, and other critics
Students – a small number, however
Accused of cult-like tendencies!
Oliver E. Williamson (1932–)

7. Key Williamsonian terms and concepts
Bounded rationality: behavior that is “intendedly rational, but only limitedly so” (Simon , 1957)
Opportunism: “self-interest seeking with guile”
The transaction as the unit of analysis
Asset specificity: extent to which assets can be redeployed to alternative users and uses
The fundamental transformation: change from thick markets at contract selection stage to bilateral dependency at contract execution and renewal stages
The discriminating alignment hypothesis
Note emphasis on behavior and process

8. Ex-ante versus ex-post analysis
TCE as the “governance approach” to the science of contract

9. Vertical integration: TCE’s “paradigm problem”
The stages of production (diagram)
Historical trends
Merger wave of 1920s: public utilities, banking, food processing, chemicals, mining
Current debates on outsourcing
Benefits of contracting out
Comparative advantage
Specialization, trade, and the division of labor
Thick markets for inputs (productive and allocative efficiency)

10. The stages of production

11. Explanations for vertical coordination
Market-power explanations
Eliminating double marginalization
Facilitating price discrimination
Creating entry barriers
Economic efficiency explanations
Eliminating free riding
Reducing supply uncertainty
Stigler’s (1951) life-cycle explanation
TCE: the dominant explanation today

12. The basic TCE model Characteristics of transactions
Asset specificity
Physical
Site
Human
Temporal
Dedicated assets
Brand-name capital
Uncertainty
Frequency
“Potential for “maladaptation”

13. Asset specificity and holdup
Klein, Crawford, and Alchian (1978)
First to explicitly describe the “holdup problem”
Popularized the notion of “quasi-rents”
Economic rent: payments to a factor of production beyond that necessary to attract that factor to that activity (e.g., pro athletes who play for the love of the game)
Quasi-rent (Marshall): payments to a factor of production beyond that necessary to keep that factor from leaving (excess of value over salvage value); generally greater than economic rents (see diagram)
Main point: specialized assets generate a stream of quasi-rents, since they aren't easily redeployable; once specialized assets are in place, trading partners will try to expropriate part of those quasi-rents

14. Perfect competition, shutdown, and quasi-rents

15. franchises, joint ventures
The basic TCE model
Characteristics of transactions
Asset specificity
Physical
Site
Human
Temporal
Dedicated assets
Brand-name capital
Governance structures
Uncertainty
Frequency
“hybrids”: contracts,
franchises, joint ventures
spot markets
fully integrated firms

16. Discriminating alignment: one independent variable

17. Discriminating alignment: two independent variables

18. Note on hierarchy The firm as a nexus of contracts
Complete versus incomplete contracts
Hierarchy and authority
Coase: fiat
Hart: ownership and residual rights of control
Williamson: mutual forbearance

19. Applications: the framework
Williamson’s “simple contracting schema”
Market
Market with hazard
Contracts
Hierarchy
Note on prices

20. Applications to vertical contractual relationships
Vertical integration
Backwards into manufacturing
Forwards into marketing and distribution
Vertical restrains (resale price maintenance, territorial restrictions)
Price discrimination
Labor-market contracting
Finance

21. Horizontal and conglomerate boundaries
Horizontal integration: little TCE work in this area
Williamson (1975, 1981) offers an internal-capital-markets explanation for conglomerate diversification, though not closely connected with TCE
More on this in a subsequent lecture…

22. The (new) property rights approach
Major contributions: Grossman and Hart (1986), Hart and Moore (1990), Hart (1995)
Simply a formalization of Williamson?
Similarities to TCE
Incomplete contracting
Asset specificity
Key differences
Emphasis on ex-ante incentive alignment (assumes perfect knowledge and costless bargaining, which “annihilates” governance problems (Williamson)
Purports to explain the costs of integration better than TCE – i.e., in GHM, there’s still underinvestment in specific assets after integration
Holds that the direction of integration matters
Gibbons: a different tradition than the “rent-seeking” tradition of Klein, Crawford, and Alchian (1978) and Williamson

23. Other formal approaches
Bajari and Tadelis (2001), Tadelis (2002): more in the spirit of TCE
Approach: formal model of ex post adjustments under incomplete contracting
Basic model
Completeness and complexity chosen simultaneously (and inversely)
Ownership gives contracting party the right to modify the project design ex post
Benefits (to buyer) of integration (internal procurement): can request changes to maximize own benefit ex post
Costs of integration: weaker incentives for seller ∙
Result: internal procurement an increasing function of complexity

24. Other formal approaches III
Baker, Gibbons, and Murphy (QJE, 2002)
Part of Gibbons’s “relational adaptation” group, along with Simon (1951) and Williamson (1975)
Key innovation: adding a new dimension for characterizing organizational form
Buy
Make
One-time
spot outsourcing
spot employment
Recurring
relational outsourcing
relational employment

25. Other formal approaches III
Baker, Gibbons, and Murphy (QJE, 2002) (cont.)
Main proposition: asset ownership (in the sense of GHM) affects parties’ temptations to renege on a relational contract.
Model
Upstream party produces a component, transferred to downstream party.
Downstream party wants to encourage high effort; makes a non-contractible promise to pay a bonus for high effort (setup for a repeated game).
Integration increases the downstream party's incentive to renege on the promise (under non-integration, if the downstream party reneges, the upstream party can sell the good to an alternative user).
Non-integration increases the upstream party's incentive to increase the value to the alternative user, increasing her bargaining position should the downstream party renege.  Tradeoff between integration and non-integration

26. Summary and conclusions
Of the three Coasian questions about the firm – existence, boundaries, and internal organization – boundaries has received the most attention by economists.
Williamson’s TCE the best-known, but not the only, economic approach to vertical boundaries.
Among academic economists, GHM is probably more popular today; TCE is only “quasi-mainstream.”
Besides the theoretical work described here, there is a large empirical literature on boundaries (to be discussed later).