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Transaction Cost Economics

Transaction Cost Economics. Gun- woong Lee March 2 , 2012. Agenda . Transaction Cost Economics Theoretical Background of TCE History of TCE Key Properties of TCE TCE in the IS Domain Application of Economic Theories in IS TCE Application Limitations of TCE. Why do firms exist? .

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Transaction Cost Economics

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  1. Transaction Cost Economics Gun-woong Lee March 2, 2012

  2. Agenda • Transaction Cost Economics • Theoretical Background of TCE • History of TCE • Key Properties of TCE • TCE in the IS Domain • Application of Economic Theories in IS • TCE Application • Limitations of TCE

  3. Why do firms exist? • Individual vs. Firm • Adam Smith: “Team production yields more than the sum of individual productions” • QTotal > (qGun+qYen+qIrfan+qJeremyr+qReza+qMike) • Firm: A legal structure that provides the organizational basis for team production • Firm vs. Market • Why do firms exist as a separate entity from the market? • Coase (1937): “Cost of employing the price mechanism determines firm/market boundary” • Firm: A set of transactions coordinated by authority instead of by the market

  4. Economic Theories of the Firm • Classical Economics • Classical economic theories focused on Industry-level analysis and tried to understand markets alone (invisible hand) • Neoclassical Theory of the Firm • Firm as a production function (black box) (Labor & capital -> goods & service) • Manager purses owner’s objectives (a profit maximizer) • No incentives problems within the firm • Strong Assumptions • Perfect information • People have rational preferences among outcomes. • A production function People act independently on the basis of full information.

  5. Economic Theories of the Firm • Classical Economics • Classical economic theories focused on Industry-level analysis and tried to understand markets alone (invisible hand) • Neoclassical Theory of the Firm • Firm as a production function (black box) (Labor & capital -> goods & service) • Manager purses owner’s objectives (a profit maximizer) • No incentives problems within the firm • Strong Assumptions • Perfect information • People have rational preferences among outcomes. • A production function People act independently on the basis of full information. • Issues not Addressed • Organization of production within a firm • Resolution of conflicts of interest • Boundaries of the firm

  6. Economic Theories of the Firm • Principal Agent Approach • Asymmetric Information • Incentives and possible conflicts of interest • Optimal structure of firm firm derives from a comprehensive contract • Transaction Cost Approach • Try to address questions about • Why firms exist in the first place? • How firms define their boundaries? • How firms ought to govern operations? • Market imperfections create firms • Market mechanism is not cost-free and It involves transaction costs • Time & money to search for partners and to negotiate exchange term

  7. Economic Theories of the Firm • Principal Agent Approach • Asymmetric Information • Incentives and possible conflicts of interest • Optimal structure of firm firm derives from a comprehensive contract • Problems with this view • Organizational structure does not matter. • Incentive contract within firms and between firms are formally identical. • Transaction Cost Approach • Try to address questions about • Why firms exist in the first place? • How firms define their boundaries? • Market imperfections create firms • Market mechanism is not cost-free and It involves transaction costs • Time & money to search for partners and to negotiate exchange term

  8. History of TCE • Initiated by Coase, 1937 • If firms exist, this must have an economic meaning! • Why do firms exist? • They are cost-saving organizations in comparison with markets! • Firms exist because activities might be produced internally with inferior costs. • Make or Buy ? (The boundaries of the firm) • Firms emerge if (production costs + TC) < Market prices • Firm expansion halts if (internal TC) > Market prices • BUT Coase did not consider any deeper explanation on the motive why firms are cost-saving organizations.

  9. History of TCE • Defined by Williamson, 1971 • “Transaction are aligned with organizational form in a s transaction cost minimizing way.” • Governance form: Hierarchy, Market, and Hybrid. • “The basic assumptions in neoclassical economic theory (rational actors, perfect information, homogenous goods) fail to hold!” • Behavioral Assumptions of Human behavior • Bounded rationality and opportunism • Features of Transactions • Asset specificity, Uncertainty, and Frequency

  10. Key Behavioral Assumptions • Bounded Rationality • Utility-maximizing transactors are constrained by cognitive limits on their capacities to process information efficiently. • Transaction parties can never write completely detailed agreements. • Contrast to neoclassical perfect information assumption • Opportunism • Self-interest could induce strategic behavior by transactors to lie to cheat or mislead their exchange partners.

  11. Governance Structure • Hierarchy: interaction within the firms • Coordination by command and contracts • Market: Interaction between the firms • Coordination through prices and contracts • Hybrids (Network): include governance elements form both markets and hierarchies • Subsets of markets: Joint venture& alliance shared service organizations

  12. Transaction Costs • Human factors • Bounded rationality: Human are unlikely to have the abilities or resources to consider every state-contingent outcome associated with a transaction that might arise. • Opportunism: Human will act to further their own self-interests • Environmental factors • Asset Specificity: How specific is the product or service you are buying • ‘Highly specific assets give rise to a condition of bilateral dependency’ (Williamson, 1979) • Physical, site, Human, Temporal, Dedicated assets, or Brand-name capital • Frequency: How often does the transactions occur • Uncertainty: Internal, external, and behavior uncertainty

  13. Limitations of TCE • Transaction costs are not direct observable, so empirical work must be indirect. • Production costs paly no direct role in the explanation. • TCE assumes that production costs are given and do not differ across governance modes. • Ambiguous term “Transaction costs” • Transaction costs: costs of negotiating, monitoring or enforcing contracts for goods and services in the sphere of markets or exchange • Monitoring costs: costs of monitoring or enforcing contracts within a firm

  14. Recent Application of Economic Theory in IT Research (Bakos and Kemerer, 1992) • Information Economics • Assess the values of IS • Production Economics (look inside the IT blackbox) • Study the characteristics of IT production and cost functions • Economic Models of Organizational performance • Measure the organizational benefits resulting from IT investments • Industrial Organizations • Study business behavior and its implications for firm conduct and market structure (e.g., Network externalities, Switching cost, and so on.) • Institutional Economics • Study the comparative costs of alternative economic institution • Transaction cost theory and Agent theory • Macroeconomic Studies for Productivity • Study the impact of IT on productivity and on industrial structure form using economic data

  15. Five Characteristics of Electronic Marketplaces (Bakos,1991) • Predictions based on microeconomic theories • Low Searching Costs • Network Externalities • Significant Switching Costs • Substantial Economies of Scale and Scope • Uncertainty (Information asymmetry)

  16. Electronic Markets and Electronic Hierarchies • Theorizing by Analogy • Allow a theorist to reuse elements form past theory • Bring it into a new context that that has its own features • Role of IT in Firms • Electronic communication effect (the same amount in less time) • Electronic brokerage effect (improved matching of buyers and seller) • Electronic integration effect(tightened process coupling) • Shift from Hierarchies toward Markets • Technology would create a force to push against hierarchical transactions and toward market transaction by firms.

  17. EMH in Customer Loan Origination Systems • Existing Theory Testing and Validation • New theory building by falsifying existing theory • Properties of Home Mortgage Loans • Low asset specificity • Low coordination and low search cost • CLOs would provide an opportunity for an electronic market to arise. • BUT, the most successful is best characterized by electronic hierarchy • Why doesn't the EMH predict well for CLOs? • Was it a matter of how long it would take to observe the impact of IT that the EMH predicted? • Was there some fundamental problems with the EMH? • Complexity of the transaction • Frequency of transaction • Relation of good/service supplier and system supplier

  18. Limitations of TCE in the IS domain • Overemphasis on Communication and Brokerage effects • Firms have downsized and now “make” less and outsource more, but do no with many suppliers (market-ripe relationship), but rather with few suppliers in tightly-knit “network (hybrid) relationships. • The emphasis is “integration” as opposed to “brokerage” or “Communication” • Failure to Emphasize supply-chain relationships • EMPs takes dyadic sales transactions as the basic unit of analysis. • Many sales transactions take place in the context of pretexting relationships between buyers and sellers. • Failure to Address Power Issues • Powerful suppliers like Wal-Mart can mandate use of EDI to partners.

  19. Conclusion • TCE has created new insights in identifying the existence of firms and firms’ boundaries. • TCE will continue to be applicable to various industrial and academic setting. • TCE has provided IS studies a theoretical lens for understanding how technology changes firms’ governance structures. • TCE is still developing • New interpretation and intuition for the firms enabled by new technology will be required.

  20. Conclusion • TCE has created new insights in identifying the existence of firms and firms’ boundaries. • TCE will continue to be applicable to various industrial and academic setting. • TCE has provided IS studies a theoretical lens for understanding how technology changes firms’ governance structures. • TCE is still developing • New interpretation and intuition for the firms enabled by new technology will be required.

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