Transactions costs and their link

to institutions
Emerging markets
Jakob Arnoldi
Fall 2019
 Learning goals
• Understand transaction costs and their three
main components.
• Understand the links between transaction
costs and institutions.
 Transaction costs economics

• Economic theory explaining organizations’

(firms’) role in the economy.
• Link with institutional theory.
– Transaction costs as a function of institutional
efficiency.
• Relevant for analysis of any (type of)
organization’s choice to outsource or integrate.
 Central theme
• Make or buy decisions.

• But also other themes that are central to this

course:
– Institutional efficiency in reducing TCs.
– Bounded rationality and problems related to intra
firm coordination.
– Opportunistic behavior and corporate governance
problems (agency costs/problems).
CC BY 3.0,
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Coase on the boundaries of the firm

Coase intended to discover

”…why a firm emerges at all in a specialised exchange economy…” “why is
there any organisation?” and he mentioned some of disadvantages - or
costs – of using the price mechanism. One of the reasons to use the
alternative - the organization - is the existence of uncertainty.
And
“…a firm will tend to expand until the costs of organising an extra
transaction within the firm become equal to the costs of carrying out the
same transaction by means of an exchange on the open market …”

(Coase, R.: The Nature of the Firm, Economica, Vol. 4, Issue 16, pp. 386–405, 1937)
 Transaction Cost Theory: The Transaction
• The transaction:
”…a good or service is transferred across a
technologically separable interface. One stage
of activity terminates and another begins”
(Williamson, 1985, p. 1)
 Or the longer version…
• A transaction occurs when a good or service is transferred
across a technologically separable interface. One stage of
activity terminates and an- other begins. With a well-working
interface, as with a well-working machine, these transfers
occur smoothly. In mechanical systems we look for frictions:
do the gears mesh, are the parts lubricated, is there needless
slippage or other loss of energy? The economic counterpart of
friction is transaction cost: do the parties to the exchange
operate harmoniously, or are there frequent
misunderstandings and conflicts that lead to delays,
breakdowns, and other malfunctions? (Williamson 1981, p.
552)
 Transaction Cost Theory
Transaction costs:

“Transaction cost analysis supplants the usual preoccupation with

technology and steady-state production (or distribution) expenses
with an examination of the comparative cost of planning,
adapting, and monitoring task completion under alternative
governance structures” (Williamson 1985, p. 2)

The theory is based on these behavioral assumptions:

- Bounded rationality: “intendedly rational but only limited so”
(Simon 1961)
- Opportunism: “self-interest seeking with guile” (Williamson, 1985)

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 The two main modes of governance/coordination of
transactions

Transaction Transaction inside a firm =

between two firms Hierarchical governance
= Market governance

A B A B
 Basic proposition
• The mode of governance chosen will be the
most efficient one.
• Efficient = mode with lowest transaction
costs.
• Thus: Boundaries of the firm will be at the
point where the cost of hierarchical
governance exceeds the cost of market
governance
 Example
A bicycle manufacturer:
Think of the various stages in the production
process (value chain) of bicycles, starting with
the raw materials and ending with the finished
bike.
– Is it likely that the whole production process is
done within a single firm?
– What determines the boundaries in the process?
 Governance types
Governance structures
(Coase 1937, Macneil, 1974/78, Williamson, 1991)

1.Market (classic contract law)

– The identity of the parties is irrelevant
– No dependency on each other
– The ideal transaction in the perfect market
– The contract is a clear agreement on clear performance
– Classical contract law stress formal arguments (if disputes should appear)
2.Hybrid (neoclassical contract law)
– More elastic contracting mechanism
– Ex.: “joint and equal responsibilities of each party..”
3.Hierarchy (forbearance)
– Most elastic contracting mechanism
– “Hierarchy is its own court”
 Governance Structures

Transaction Transaction inside a firm

between two firms = Hierarchical governance
= Market governance
Hybrid mode:
Transaction between
interdependent firms

AA B A B A B
 Contractual instruments:

Market governance Hybrid Hierarchical governance

(Classical contract law) (Neoclassical) -”fiat”,
- ”forbearance”
- ”hierarchy is its own court”

AA B A B A B
 Markets and hierarchies
• Form of governance type a question of
transaction costs involved.
• Transaction costs :
– Frequency.
– Uncertainty.
– Asset specificity.
• (And opportunism and bounded rationality - but these
appear in various ways in the three just mentioned)
 Frequency
• The Achilles's heel of transaction costs theory
but ( at least according to Williamson):
• The more regular (no disturbances) and
repeated (volume) the transaction the more
hierarchy is favored as it then becomes easier to
recover initial investments.
But be careful, frequency also used To signify frequency of
disturbances. In that case hybrid modes of governance becomes
costly and even market governance may become costly as
uncertainty will increase. Finally there are also economists that
argue that frequent transactions between partners will make them
less likely to behave opportunistically as they both see the benefit
of maintaining good relations.
 Asset specificity
Interdependencies between buyer and seller or
the specific investment needed.
• Site (production location).
• Human resources (specialized know-how and
labor).
• Physical assets (production facilities).
• And also dedicated assets, time specific assets,
procedure specific assets.
 Task:
• Please construct an imaginary example of a
buyer-seller relationship that involves as many
kinds of asset specificity as possible.
 Uncertainty
• Opportunism (self-interest with guile).
• Information asymmetry.
• Bounded rationality.
 Contractual instruments:

Market governance Hybrid Hierarchical governance

(Classical contract law) (Neoclassical) -”fiat”,
- ”forbearance”
- ”hierarchy is its own court”

AA B A B A B
The contract (1): Classical contract law

(Example)
“Buyer,…, seller…, goods, delivery.., price..”
“Buyer agrees to pay for the goods in full upon
receipt…”

Buyer Seller

- Standard contract (impersonal)

- ”…monetized in extreme degree”
- Written formal terms most important (strict legalistic)
The contract (2): Neoclassical contract law

(Example)
“…An adjusted base coal price that differs from market
price by more than ten percent (10%) shall constitute a
hardship”
“.. equal responsibility of both Parties to act promptly and
in good faith…”
“If the Parties cannot reach agreement within sixty (60)
days the matter shall be submitted to arbitration”

Buyer Seller

- Elastic – consider relevant disturbances (“hardships”)

- Consider the parties’ responsibility in adaptation
- Rather arbitration (third party decision) than court
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at definere topteksten
 Instead of summation: How is transaction cost theory
relevant for emerging markets?

• Costs of market governance hinge on

institutional efficiency.
• Therefore institutional voids= transaction
costs.
• We may even call the transaction costs
occurring in markets for institutional costs.

Transaction Cost theory generally predicts that the boundaries of firms extend
further in emerging markets then developed dittos.
 But also a problem:
Undersocialized markets and over-socialized
hierarchies.
– Organizations are not as solely coordinated
through fiat as Williamson claims. Managers use
coalitions and networks to escape hierarchical
control
– Markets are not only depending on formal
institutions but on personal trust through social
networks.
 quiz
when you read the following statement
“Markets are not only depending on formal institutions but on
personal trust generated through social networks.”
you think of: