Week 3: make or buy
Article 1: Transaction Cost Economics as a Theory of the Firm,
Management, and Governance
1. Introduction
Transaction Cost Economics (TCE) is a theory of how business transactions are structured in
challenging decision environments.
• TCE is a theory of the firm: The fundamental objective in the early formulation of TCE in
particular was to understand the specifics of an individual transaction involving two
exchange partners and a transaction
• TCE is a theory of management in that it has much to say about the internal
organization of firms as well
• TCE is a theory of transaction: TCE is not only a theory of transactions, but it also
applies more generally to any situation where a contractual arrangement of some kind
is used to organize activities involving various stakeholders with only partially
overlapping objectives
2. The Special Case of Vertical Integration
Vertical integration here means changes in financial ownership in the value chain (e.g.,
Mahoney, 1992), such as a firm purchasing the assets of either its supplier (backward
integration) or its customer (forward integration).
Horizontal integration, where a firm buys the assets of a similar company, such as one of its
competitors.
3. The General Case of the Governance Decision
TCE starts at trying to specify how transactions differ. According to TCE, the three dimensions
that merit attention are frequency, uncertainty, and specificity. All three should be thought of
as characteristics of a contractual exchange relationship between two exchange parties; the
principal unit of analysis in TCE is indeed the individual transaction.
• Frequency refers to the volume of transactions between the two exchange parties.
Contractual relationships are always associated with a cost, and with larger volumes
(i.e., recurring transactions), costs of specialized governance structures can be justified,
for instance
, • Uncertainty refers to the contracting parties’ limited ability to predict environmental
changes and one another’s behavior under unforeseen circumstances. TCE works out of
the assumption that contracts are incomplete.
• Specificity refers to specialized investments made by one party, or both parties, to
enable the exchange. Specificity takes many different forms (Williamson, 1985): site
specificity (e.g., an electric plant), physical asset specificity (e.g., specialized tools), and
human asset specificity (e.g., firm-specific knowledge).
3.1 TCE and Stakeholder Management
• Trying to maximize shareholder value is typically unrealistic (because of bounded
rationality and uncertainty), but we could think of a good governance decision or a good
contract as one that at least increases shareholder value at a rate that is acceptable to
the investors and thus secures their continuing cooperation
• TCE is ultimately primarily interested in just one of the stakeholders, specifically, the
shareholder
• “the first and simplest lesson of transaction cost economics is that corporate
governance should be reserved for those who supply or finance specialized assets to the
firm”
• All relationships that involve negligible specificity should be governed by a contract,
because they are much more flexible than the more “heavy-duty” arrangements such as
awarding board seats.
Article 1: Transaction Cost Economics as a Theory of the Firm,
Management, and Governance
1. Introduction
Transaction Cost Economics (TCE) is a theory of how business transactions are structured in
challenging decision environments.
• TCE is a theory of the firm: The fundamental objective in the early formulation of TCE in
particular was to understand the specifics of an individual transaction involving two
exchange partners and a transaction
• TCE is a theory of management in that it has much to say about the internal
organization of firms as well
• TCE is a theory of transaction: TCE is not only a theory of transactions, but it also
applies more generally to any situation where a contractual arrangement of some kind
is used to organize activities involving various stakeholders with only partially
overlapping objectives
2. The Special Case of Vertical Integration
Vertical integration here means changes in financial ownership in the value chain (e.g.,
Mahoney, 1992), such as a firm purchasing the assets of either its supplier (backward
integration) or its customer (forward integration).
Horizontal integration, where a firm buys the assets of a similar company, such as one of its
competitors.
3. The General Case of the Governance Decision
TCE starts at trying to specify how transactions differ. According to TCE, the three dimensions
that merit attention are frequency, uncertainty, and specificity. All three should be thought of
as characteristics of a contractual exchange relationship between two exchange parties; the
principal unit of analysis in TCE is indeed the individual transaction.
• Frequency refers to the volume of transactions between the two exchange parties.
Contractual relationships are always associated with a cost, and with larger volumes
(i.e., recurring transactions), costs of specialized governance structures can be justified,
for instance
, • Uncertainty refers to the contracting parties’ limited ability to predict environmental
changes and one another’s behavior under unforeseen circumstances. TCE works out of
the assumption that contracts are incomplete.
• Specificity refers to specialized investments made by one party, or both parties, to
enable the exchange. Specificity takes many different forms (Williamson, 1985): site
specificity (e.g., an electric plant), physical asset specificity (e.g., specialized tools), and
human asset specificity (e.g., firm-specific knowledge).
3.1 TCE and Stakeholder Management
• Trying to maximize shareholder value is typically unrealistic (because of bounded
rationality and uncertainty), but we could think of a good governance decision or a good
contract as one that at least increases shareholder value at a rate that is acceptable to
the investors and thus secures their continuing cooperation
• TCE is ultimately primarily interested in just one of the stakeholders, specifically, the
shareholder
• “the first and simplest lesson of transaction cost economics is that corporate
governance should be reserved for those who supply or finance specialized assets to the
firm”
• All relationships that involve negligible specificity should be governed by a contract,
because they are much more flexible than the more “heavy-duty” arrangements such as
awarding board seats.
