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Introduction

Transaction Cost Economics (TCE) is most associated with the economist Oliver Williamson^[1] who built on the theories of Nobel economist Ronald Coase to explain the structure of firms – in particular the formation of the modern corporation^[2] . Coase’s earlier seminal work^[3] was particularly interesting in its departure from classical economics in its attempt to explain the reasons why firms (or organisations) exist. From a classical economics perspective because the market is assumed to be efficient it is always ‘best’ at providing goods and services – this is because those firms that can produce the goods or services most efficiently are already doing so. Accordingly there is no scope for a firm to produce internally as it is always cheaper to hire or procure externally what it requires. What this implies is there is no reason to internalise any goods and services production – it is always cheaper to buy from the market.

Thus from this viewpoint a firm can produce nothing internally and therefore cannot come into existence. Coase’s contribution was to set down a framework to explain the formation of companies based on the observation that markets were not in fact perfectly efficient or costless – there always existed costs (contracting, procurement etc.) in arranging commerce that added to the direct cost of the goods. What this meant was that entrepreneurs could avoid these ‘transaction costs’ of the market by producing internally under hierarchical governance and a boundary of a firm could be conjectured to occur at the point where equilibrium was established between the costs of internal production and true market cost. The process of creating a firm in this model would involve initially those products or services that ‘saved’ the most in transaction cost by internal management and further goods added until the diminishing returns over the market approached zero.

Williamson^[1] builds on Coase’s earlier work on transaction costs and rests on a specification of the variables that inform the decision whether or not to ‘make or buy’ and behavioural assumptions that mediate (contextualise) the decision making process. It is important to note that all of Williamson work can comfortably sit within the classical framework – for example the profit motive is assumed. Where Williamson focuses our attention is more clearly on the role of economic actors - in a classical model the assumption is that managers act to maximise profits whilst under a transaction cost model they act to minimise cost. This perspective links TCE very closely to the resource based theory of the firm and acts to provide a rationale for decision making on the make or buy decision around peripheral non core resources.

Transaction Cost Economics

Transaction cost economics as formulated by Williamson rests on two behavioural assumptions: Bounded Rationality and Opportunism, and three principles of organisational design: Asset Specificity, Externality and Hierarchical Decomposition (ref).

The Behavioural Assumptions

Bounded Rationality

Bounded rationality was a term that came from Herbert Simon first coined in 'models of man'^[4] in his work on decision-making. Simon, who won a Nobel Prize for his work in 1978, coined the phrase 'bounded rationality' to describe the limited extent to which we make logical decisions in organizations. Instead of maximising and finding the best solution to a problem, we typically satisfice and settle for the solution with which we can make do. This arises because whilst decision-makers in organisations are intentionally rational they experience real limits in their cognitive ability in the formulation and solving of problems (receiving, encoding and transmitting ) as well as the processing of information. In terms of real world issues such as contracting or searching for vendors in an Outsource the process is constrained by this effect. Furthermore, the is compounded by the fact that we have access to only imperfect information – for one thing we do not know how competitors will react to our decisions. What this means is that whilst we may wish to take into account all of the relevant issues before making a decision – we cannot do so in a complete way – and thus all decisions from this perspective form some sort of compromise (and ‘incomplete contracting is the best that can be achieved’).

Opportunism

Opportunism extends the concepts of the normal self-interest of economic actors to allow for their acting in a self-interested way ‘with guile’ in Williamson’s terms. In certain circumstances one party may see an opportunity to exploit a situation at the expense of the other. To some extent no pejorative sense of harm for self-interest can be construed from these statements as it is to be expected that managers working for different companies and having differing objectives for themselves (or for their organisation) will seek advantage from their perspective. Where there is a problem in managing these phenomena is to understand they occur on occasion and that differing perspectives are to be expected from collaborating parties.

These two assumptions underpin the rest of Williamson’s exposition but it is important to note that whilst they inform the context within which the decision-making process takes place they say nothing about the structuring of organisations for this we consider the variables of TCE in the next section.

Principles of Organisational Design

Asset Specificity is the transactional ‘dimension of special interest’ and is the most important element in the theory and is described Williamson in terms of the three attributes: Frequency, Risk and Asset Specificity.

Frequency

Frequency refers to the occurrence of the economic transaction – whether crudely recurrent or occasional. In principle when a transaction is frequent and of low specificity then it is likely that the market will offer scale and scope benefits – and outsourcing is favoured for example. For example, if we consider the setting up of an internal consultant O&M department (much as Philips Consumer Electronics did in the eighties and nineties) in such a case unless the service is used frequently then it can offer little advantage over the market where consultancies whose core competence the service is offer scale and scope at a price that compares well to the permanent structure cost that an internal department would cost.

Risk

Uncertainty is interesting as it is clearly difficult to foresee all the eventualities that might occur over the term of the contract for example particularly when complex relationships have to be controlled. Highly specific assets cannot be sourced without loss of productivity or strict control of service delivered after contract closure. In such circumstances writing (ex ante cost) and policing a contract can be very expensive and ex post (projected) costs can easily exceed internal costs – this is one of the ‘hidden costs’ of outsourcing that is discussed later. Aspects of specificity also add complexity to the process. Specific services tailored to a customer increases asset specificity that locks in both client and vendor (see below) – a commitment is needed to recover costs in developing the service that extends the time needed for vendors to recoup the costs. However in attempting to reduce the risk introduced by the specification of service by increasing the term introduces its own risk due to the long term nature of the contract and the uncertainty of the future development of the business or of the service demanded.

Uncertainty causes the above problems in part due to the contextual influence of bounded rationality and information asymmetries. We cannot foresee all the problems per se and it is rare for total disclosure within a bargaining situation as in the case of a contract discussion. What this implies is that often contracting takes place against a backdrop of quite some uncertainty and without proper governance in place can imprint the whole partnership with hidden problems and conflict for future managers to resolve.

Asset specificity

Asset specificity is particularly important. As assets (production equipment, knowledge, patents or buildings) become more specialised they become less transferable to another provider or to the market. Economies of scale can be more easily organised internally. This process of specialisation of assets (through learning or use) leads to the situation where the asset cannot be used outside of the specific use by the client or user of the service. The process of specialisation and learning increases specificity and in outsourcing for example, occurs quite naturally as the vendor ‘learns’ to provide the service to the required standard and tailors technology and service delivery to the individual client’s needs. As a corollary to this high specificity of an outsource service acquired over time acts to prevent client switching and locks in the vendor to providing a specialised service. The vendor providing a specialised service means scale and scope effects (from spreading generic frequent services across multiple clients) are lost and cost pressures mean that ceteris paribus service transaction cost approaches the internal cost that the client could have expected by internal provision. Thus if a vendor is prevented from offering scale and scope by a specialisation process what is left is labour arbitrage from which cost savings and margin have to be derived. In practice it seems that partnerships in this mode tend towards a bilateral exchange model driven by mutual asset specificity – although a more instrumental conflict situation can also occur^[a].

Externality

Relationship between asset specificity and the ratio of market to hierarchical transaction cost. As specificity rises so the balance moves in favour of providing the product or service in-house.^{[See Endnotes for further on this]}

The externality principle is mainly concerned with the issue of forward integration and is very important in the consideration of forward integration into distribution. Asset specificity is about the transformation from large number bidding situations to small numbers risk for example when we deal with incumbent vendors – the process of specialisation and increased specificity and is concerned with backward and lateral integration.

In Williamson’s view integration is driven by asset specificity and risk considerations. Transaction costs (ex ante and ex post) are balanced against production costs in house. If transaction costs rise as asset specificity rises then integration is favoured. Technology forces can foster integration as it is easier to integrate technology inside a boundary rather than across boundaries (companies or organisations) – this issue is well known in merging companies for example often the technology is a major barrier. As technology becomes more standardised and/or flexible then costs of integrating across boundaries falls and we would expect an integrated supply chain model. There is however a hidden problem of tacit technology competence to deal with as technology competence accumulates over time which implies high (hidden) specificity and increased risk – which should be accounted for in an assessment of whether certain technologies over time should be placed from the market. However in principle flexible (industry standard or generic IT technologies) could actually act to reduce the integration cost. From this view integration could be seen not as a technology issue per se but as a balance of the costs between procurement and making a product or service. If a technology can be separated out from an organisation conceptually then from a classical perspective there is no compelling reason to integrate (internally) and the decision is driven purely by cost considerations^[b].

Other aspects of the externality considerations are the management of risk – in particular the management of quality and effective delivery (and of service). Supply chain partners downstream in effect manage the service quality for the upstream manufacturers but have different objectives and manage service expectations across a wide range of other customers. As a result there is a risk of poor quality resulting that has to be managed by service level agreements and in some case strict monitoring. These transaction costs plus and cost resulting from brand degradation (brand risk) also have to be balanced against costs of internal provision. Which leads to a principle of organisation design laid down by Williamson: as demand requirements increase (quality, delivery schedules, customer satisfaction) then forward integration increases if not to full integration to franchising and captured provision (almost a subsidiary).

Hierarchical Decomposition

The final structuring principle is not so important to our discussion on outsourcing but is more applicable to the understanding of the general form of organisations and changes over time, the growth of conglomerates and the arrival of the ‘M’ form structure and accordingly will be treated briefly here.

Williamson contends that the ‘M’ form emerged driven by the need to minimise transaction costs. An ‘M’ form is a divisionalized structure with the legs of the ‘M’ representing autonomous divisions whilst the bar at the top represents a corporate layer across all the divisions. The idea is that corporate level transactions are normally concerned with low frequency activities such as press relations, legal and treasury, or shareholder relations for example, better consolidated and handled at a high level for all the divisions. Operating divisions on the other hand are concerned with frequent production and distribution types of transactions. Divisions face the market directly and in this model can focus on high frequency customer interaction whilst corporate generalists handle the longer term relational work. By such a division of responsibility transaction costs are minimised overall and the corporation tends to minimise cost.

Summary

Some of the principles laid down in TCE can be useful in understanding the evolution of the outsourcing market and they are summarised as shown below. One the left the framework is overlaid with the types of contractual relations implied by the recurrance and asset specificity requirement.

The value of market outsourcing reduces:

• As the human and physical resources become more specific,
• As service becomes specific to a particular customer,
• A service becomes less transferable outside of parties,
• Economies of scale move in direction of outsourcer,

The above principles can be summarised more simply in the form of a table shown below which shows the relationship between the principal dimensions of Williamson’s model: Asset specificity or investment characteristics against the frequency or recurrence of transactions.

End Notes

^{Further information on Externality}

Relationship between asset specificity and the ratio of market to hierarchical transaction cost. As specificity rises so the balance moves in favour of providing the product or service in-house.Economies of scale and scope favour a wider range of asset specificity under the market - highly specific assets can be procured due to scale effects. A more configured service, for example development, can be procured if the internal costs of setting up a specific department as well as the long term structural cost exceed that of a vendor who has all the configuration and processes in place. What this means is production and governance cost ‘push’ the asset specificity breakeven point to the right as shown in the diagram above and more specific goods and services become cheaper in the market. This helps us understand why bespoke services such as building or legal although uniquely created for an organisation never the less are procured more efficiently from the market – for example the set up and running costs for all but the largest companies of a legal practice would far exceed what the market could offer.

See also

Resource Based Theory

Notes

• ^aAfter a contract has been signed we move from having a large number of bidders and low specificity of service to small numbers transaction cost risk as the implicit knowledge gained by the (now) incumbent during specialisation locks out new suppliers and locks in the client. Exchange thus moves from large numbers bidding to small numbers during contract execution and market to bilateral contract relations.
• ^bIf we consider a mixed investment where there is some degree of asset specificity and accordingly a higher risk, this sort of situation calls for a more complex governance structure. We may see these types of investment in for example off shoring application development. In such cases there is the possibility of gravitating towards extremes such as standardising to reduce functionality (reduce specificity be more generic) or to move the development back in-house under hierarchical governance to manage risk.

References

1. ↑ ^{1.0 1.1} Williamson, O., E.,(1985) 'The Economic Institutions of Capitalism', Free Press New York
2. ↑ Williamson O., E., (1981),'The Modern Corporation: Origins, evolution, attributes', Journal of Economic Literature, 19 (Dec 1981) ^mercer1995
3. ↑ Coase, R., H.,(1952), 'The nature of the firm', Ecomica N.S., 4 (1937) Repr. IN Stigler G.,J., eds (1952), Readings in Price Theory, Homewood, Ill Irwin
4. ↑ Simon, H. (1957), 'A Behavioral Model of Rational Choice', IN Models of Man, Social and Rational: Mathematical Essays on Rational Human Behavior in a Social Setting, New York: Wiley

Bibliography

• ^ Williamson, E., O.,(1985) 'The Economic Institutions of Capitalism', Free Press New York
• ^ Mercer, D., (1995), 'Managing the External Environment - A Strategic Perspective', SAGE OU