6 pages 48 hours (A0109)

KEY ISSUES

Key Terms

 Bounded Rationality

 Opportunism

 Asset Specificity

 Uncertainty/Complexity

 Frequency

 The Fundamental

Transformation

 The Hold-up Problem

 Peer Groups

 Economies of

Communication

 U-Form

 M-Form

 Internal markets

 Clans

 Networks

 Franchising

 Virtual Corporation

Information & Organisational Design LUBS5002

Lecture 6 Markets and Hierarchies: a Transaction Cost Approach

INTRODUCTION

In this session we develop a detailed understanding of transaction cost economics and

relate it to the understanding of markets and hierarchies. Based largely on the work of Ronald

Coase and Oliver Williamson, transaction cost theory focuses on the specific nature of the

transaction and the key elements of a parties behaviour which influence how such transaction

are co-ordinated.

Much of the application of transaction cost economics to the understanding of the

organisational structure of firms comes down to the concepts of bounded rationality,

opportunism, firm size and complexity. Such concepts (and others) can be used to analyse the

efficiency and effectiveness of various types of organisational structure ranging from the most

simple hierarchies and peer groups to more complex hierarchies such as the Unitary-Form

and Multistage hierarchy.

While the comparison of markets and hierarchies is the focus of much of the session, we

also realise that new organisational structures are emerging as a consequence of the changing

marketplace. Recognising this we look at more modern and less rigid organisational forms

such as franchises and the virtual corporation.

For this session you will need to read chapters 8 and 14 of the textbook.

Further Reading:

Wiliamson O.E. ‘The Governance of Contractual Relations’, chapter 9 in Putterman and

Kroszner (eds.) The Economic Nature of the Firm, 2 nd

edition, CUP.

Paul Milgrom and John Roberts, ‘Bargaining costs, influence costs, and the organization of

economic activity’, chapter 12 in Putterman and Kroszner (eds.) The Economic Nature of the

Firm, 2 nd

edition, CUP.

OBJECTIVES

After completing this unit you should be able to:

1. Apply the concepts of transaction cost economics to the understanding of efficient organisational structure.

2. Realise the key factors which influence effective organisational structure

3. Understand that there is no optimal organisational structure rather it depends on the business environment in which they operate.

4. Begin to look at the effectiveness of newer hybrid forms of organisation.

Simple Hierarchies

Markets and

Hierarchies

Critical Dimensions of

the Transaction

Multistage Hierarchies

Bounded Rationality/

Opportunism

Clans and Hybrid forms

of Organisation

Organisational Markets

Information and

Organisational Design

Markets and Hierarchies

Objectives

 Apply the concepts of transaction cost economics to the understanding of efficient organisational structure.

 Realise the key factors which influence effective organisational structure

 Understand that there is no optimal organisational structure rather it depends on the business environment in which they operate.

 Begin to look at the effectiveness of newer hybrid forms of organisation.

Introduction

Example: Trevor Bayliss

Inventor-Wind-up Radio

Managers may have a good idea, and they may have previous experience and a proven ability to implement their idea.

However, actually organising the necessary resources may be too tall a task. In the language of economics, transaction costs may be very high.

Transaction Costs

Stems from pioneering work of Ronald Coase and Oliver Williamson.

The essence of Williamson’s work is built around two central behavioural assumptions:-

 bounded rationality

 opportunism

and the critical dimensions of the transaction

Transaction Cost Framework

Bounded Rationality

Developed by Herbert Simon (1951)

‘the limitations in human mental abilities that prevent people from foreseeing all possible contingencies and calculating their optimal behaviour. Bounded rationality may also include those limitations on human language that prevent perfect communication of those things that are known.’

Two costs of co-ordination Co-ordination costs – determining prices, costs of acquiring info on

quality, reliability and availability. Costs of bringing parties together

Motivation cost = costs of measuring performance, providing incentives and enforcing agreements.

In what instances will bounded rationality be prevalent?

-transactions involving high degree of uncertainty/complexity

Opportunism

‘self interest seeking with guile’ (Williamson)

Assumptions

 Not everyone displays opportunistic behaviour.

 Those who might act opportunistically do so sometimes and it is difficult or costly to tell ex ante when they do or do not.

Opportunism is a problem in small numbers exchange

Critical Dimensions of Transactions

 .the specificity of the investments required to conduct the transaction

 .the frequency with which similar transactions occur and the duration over which they are repeated

 .the complexity of the transaction and the uncertainty about what performance will be required

 .the difficulty of measuring performance in the transaction

 .the connectedness of the transaction to other transactions involving people.

The Fundamental Transformation

Once a relationship-specific investment has been made, the relationship changes from a “large numbers” to a “small numbers” bargaining situation; a fundamental transformation of the relationship has occurred.

Because the well being of the other firm is now inextricably linked to yours this permits opportunistic behaviour. This allows one party of the transaction to exploit the other parties vulnerability due to the relationship-specific assets. This “ransom” is called the hold-up problem.

Peer Groups and Simple Hierarchies

What advantages do simple hierarchies have over peer groups?

Peer groups more appropriate when the outcomes benefit from frequent interaction and group incentives, and when the costs of group co-ordination do not detract from group outcomes.

Organising by groups makes it difficult to monitor and control individual output. This is where simple hierarchies come in (Alchian and Demsetz).

Multistage Hierarchies

Importance of firm size

– problems of ‘departmentalisation’, co-ordination, control.

Bounded rationality leads to two problems in large, multi- product U-form firms: cumulative control loss and corruption of the strategic decision-making process.

M-form serves to economise both on bounded rationality and on opportunism because less information need be transferred and goal congruence is more easily achieved.

Markets and Hierarchies: Is That All?

Major focus of criticism is that while the comparison and choice between markets and organisations is correct, Williamson’s authoritarian view of the organisation is too limiting.

In this sense the work of Williamson and Ouchi (on clans) form subsets of Mintzbergs categorisations.

Also need to recognise that the distinction between markets and organisations is increasingly blurred.

‘Third Ways’ of Transacting: Clans

‘the socialisation of individuals through the development of behavioural norms’

These set of common values and beliefs come to govern how transactions are co-ordinated within organisations.

Culture controls the activities of employees on the basis of their attachment to the firm rather than on the basis of incentives and monitoring.

‘Third Ways’ of Transacting:

Networks

Based on Japanese manufacturers use of networks of independent contractors (Keiretsu). Typically involve much higher degree of collaboration between parties and the delegation of a more sophisticated set of responsibilities to the subcontractor.

Rely less on formal contractual arrangements, instead trust is developed through the long-term nature of these arrangements.

Hybrid Forms of Co-ordination

Contingency Theory - the best organisational structure for a firm depends on the specific circumstances it faces.

 Franchising

 Strategic Alliances and Joint Ventures

 The Virtual Corporation