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Economics is the study of human interactions involving trade. In addition to the costs of production and distribution, every trade has associated with it the costs of the trade itself: of locating trading partners, of negotiating the terms of the trade and adapting those terms as economic conditions change, of monitoring and enforcing the terms of the trade, and so forth. These costs are called transaction costs, and traders’ attempts to limit them explain why many economic, political, and social institutions have evolved the way they have.
Transaction cost economists seek to understand how transaction costs influence the design and evolution of the institutions used to coordinate economic relationships. Friedrich Hayek (1945) has written of the “marvel” of the spontaneous coordination of the market in a world of flux and change: It aggregates and makes efficient use of information no one person could ever know, it is flexible and capable of responding quickly to changing economic conditions, and it avoids undue concentrations of economic and political power (p. 527). But there is an alternative to market coordination: hierarchical coordination, defined as coordination through deliberate choices made by managers or central planners. All modern economic institutions embody varying degrees of these alternative coordination mechanisms.
Though most modern economies rely heavily on market coordination, it is easy to find hierarchical coordination in even the most market-oriented economies: Significant portions of our private sectors are composed of vertically integrated firms, firms in which internal flows of physical materials are coordinated by orders from superiors rather than by independent responses to price signals. Further, families, schools, religious groups, social organizations, nonprofit organizations, and governments all engage in economic activities, and all are coordinated through non-market means.
Examples of questions undergraduates can (and have) address using the tools of transaction cost economics include the following: Have the rules guiding trades on eBay changed over time, and if so, have they changed in a manner consistent with the principles of transaction cost economics? Are the rules guiding trades on massively multiplayer online role-playing games consistent with the principles of transaction cost economics? Are there patterns to which services particular universities own and operate themselves and which they contract out? (Who operates your bookstore? Your dining hall? Your library?) Are there patterns to which services hotels provide themselves and which they contract out? Restaurants? Minor-league baseball teams? When services are contracted out, how are the contracts structured? Why do tattoo artists frequently rent space in shops owned by others but always own their own tattoo machines? Are the relationships and patterns of asset ownership found between tattoo artists and the shops from which they rent space similar to those between hairdressers and beauty shops? Mechanics and garages? Doctors and hospitals? Are the similarities and differences consistent with the predictions made by transaction cost theory?
Transaction cost economics is particularly well suited for study by undergraduates. First, it is one of the few economic subdisciplines whose key concepts are better expressed in words than equations. This means that students can read almost its entire corpus—from its classic works to its cutting edge—without the need for mathematics any more advanced than that required for their introductory economics course. If they read the key works in chronological order, they can watch the economic frontier expand before their eyes, enabling them to understand the often halting process of economic inquiry in a manner unattainable through reading textbooks and later works written with the benefit of hindsight and reflection. Second, many students find transaction cost economics interesting because its study crosses disciplinary boundaries, relaxes assumptions, and explores subjects frequently left unaddressed in other economics courses. Thus, it challenges their views of what economics is, what it is not, and how it relates to other disciplines. Third, the tools and techniques of transaction cost economics are easily applied to real-world situations about which students have firsthand knowledge and interest. This makes it relatively straightforward for them to conduct research projects testing its fundamental propositions.
This research paper provides an introduction to transaction cost economics, with a focus on the classic works in the field. The first section lays the theoretical foundation, describing its origins, defining its key concepts, and deriving its central testable hypothesis. After discussing and illustrating its archetypical application, the make-or-buy decision, this section concludes with a discussion of the broad array of institutional arrangements that lie between spot markets and vertical integration. The second section applies the theory laid out in the first section and examines the empirical evidence supporting it. The focus of the second section is on early applications that highlight the key concepts and principles laid out in the first section and on early tests of the theory that exemplify approaches from which students writing term papers may draw inspiration. Much of the interest in transaction cost economics is policy driven. The third section examines these policy implications. The fourth section summarizes the key points made in the rest of the research paper and suggests directions for future research. This research paper closes with suggestions for further reading.
Transaction Cost Theory
Ronald Coase’s (1937) “The Nature of the Firm” is the key work in transaction cost economics. It is a remarkable treatise for many reasons, not the least of which is that it was conceived when its author was just 21 years of age (Coase, 1988a). Coase became interested in the questions of vertical and lateral integration while studying for his bachelor of commerce degree at the London School of Economics. Why, he wondered, if the invisible hand of the price system was as wonderful as his professors made it out to be, did firms intentionally replace the spontaneous coordination of the market with the deliberate coordination of the manager? Coase spent the academic year 1931-1932 exploring this intriguing question in a series of visits to U.S. businesses and industrial plants—the happy coincidence of the necessity for an additional year of study after completing the courses required for his degree with his receipt of a scholarship that allowed for travel abroad (Coase, 1988a).
Coase (1988a) first laid out his answer to his question in a letter written in October 1932, describing a lecture he had just given at the Dundee School of Economics and Commerce (p. 4). Following reflection on what he had observed and discussed with plant managers, Coase noted that there were costs to using the price system, costs we now know as transaction costs. Coase reasoned that firms emerge when the transaction costs associated with coordinating particular exchanges using markets exceeded those of coordinating the same exchanges using managers. In the absence of transaction costs, Coase (1988c) wrote, “The firm has no purpose” (p. 34).
Coase published his explanation in 1937. As he was to write in 1972, for close to 35 years, “The Nature of the Firm” was “much cited and little used” (Coase, 1988b, p. 23). One explanation may be that Coase’s observation that vertically integrated firms exist because the advantages of replacing the costs of market exchange with those of command and control is fundamentally tautological: Any and every substitution of one means for organizing economic activity for another can be explained as the outcome of a desire to reduce transaction costs. Because Coase’s theory was not fleshed out enough to predict in advance which exchanges would be the most likely candidates for vertical integration, it explained both everything and nothing (Fischer, 1977, p. 322; Williamson, 1979, p. 233).
Oliver Williamson was one of the first to recognize that Coase’s fundamental insight represented the beginning of a research agenda, not the end. Beginning in the early 1970s, Williamson, his students, and others who have been inspired by his and Coase’s work have produced a flourishing body of research that has grown into a rich and powerful set of intellectual tools, tools amenable to those hallmarks of science, prediction, and test. Especially important have been the works that formed the basis of Williamson’s Markets and Hierarchies: Analysis and Antitrust Implications (1975), The Economic Institutions of Capitalism (1985), and The Mechanisms of Governance (1996).
One of the more frustrating aspects of taking up a new subject is learning its jargon. Six concepts central to transaction cost economics are transaction, transaction cost, governance structure, bounded rationality, opportunism, and asset specificity.
Transaction. Trade requires transactions, that is, transfers of goods or services across “technologically separable interface[s]” (Williamson, 1981, p. 552). Note that while trade between businesses, individuals and businesses, governments and businesses, and so forth necessarily results in transactions, transfers of goods or services across technologically separable interfaces are almost certainly at least as common within businesses, families, social organizations, and governments. Thus, just as the transfer of a six-pack of beer from your local convenience store’s shelves to your refrigerator represents a transaction, so does the transfer of aluminum cans from a brewer’s aluminum-can-manufacturing operations to its brewing operations.
Transaction cost. Transactions have costs associated with them: locating trading partners, negotiating the terms of trade, writing explicit contracts prior to the commencement of trade, monitoring compliance with the contracts and enforcing them as trade progresses, adapting the terms of trade to address changing circumstances, and observing, quantifying, and processing the information required to do all of the above. It is noteworthy that these transaction costs differ from those economists ordinarily emphasize— production costs—in that it is assumed “the former can be varied by a change in the mode of resource allocation, while the latter depend only on technology and tastes” (Arrow, 1969, p. 60).
Governance structure. What Arrow referred to as “mode[s] of resource allocation” (1969, p. 60) are now called governance structures. The term was coined by Williamson in his 1979 paper, “Transaction-Cost Economics: The Governance of Contractual Relations.” Governance structures are examples of institutions, defined as sets of laws, rules, customs, and norms that guide human behavior (North, 1994). Thomas Palay (1984) provided an unusually clear definition of the term, writing that “governance structure” is “a shorthand expression for the institutional framework in which contracts are initiated, negotiated, monitored, adapted, enforced, and terminated” (p. 265). Examples of governance structures include spot markets (your purchase of gasoline at a convenience store while driving to spring break) and vertical integration (an oil company’s production of the crude oil it will later refine into gasoline). Although the reasons different governance structures generate different transaction costs will be dealt with in greater detail later, in defining the rules of the game (customers are required to pay in advance for the gas they pump, and convenience stores are required to maintain accurate meters on their gas pumps), well-designed governance structures create incentives for transactors to cooperate with each other.
Bounded rationality. As a step toward understanding why the choice of governance structure matters, one must abandon the fiction of the all-knowing economic man. Transaction cost economists assume that economic decision makers are subject to bounded rationality; that is, while their actions are “intendedly rational,” cognitive limitations render them “only limitedly so” (Simon, 1957, p. xxiv).
The cognitive limitations that give rise to bounded rationality come in many forms. First and foremost, we live in an incredibly complex and ever-changing world. Even if we could fully comprehend all those parts of the world critical to the economic decisions we face, what we know today may no longer be relevant when we wake up in a new world tomorrow. Worse, what we will need to know tomorrow may well be unknowable today. Governance structures differ both in regard to the amount and depth of the information individuals need and in their ability to adapt to changing information. Remember what Hayek (1945) found marvelous about the governance structure we call the market: its ability to aggregate and make efficient use of information no one person could ever know, including its ability to aggregate and make efficient use of new information.
Second, even if we could know everything there is to know about those parts of the world most important to us—past, present, and future—we would still be hampered by our ability to make sense of what we know. Herbert Simon (1972) emphasized the difficulties faced by people who must process large amounts of information. Consider, Simon (1972) suggested, writing out a decision tree for a chess game and then using this tree to decide which moves to take. Although doing so would reveal the optimal move in any given situation, no one, not even a grand master, could construct and make efficacious use of such a tree. Instead, chess players husband their limited cognitive resources by relying on relatively simple strategies that they know from experience will guide them to favorable— though not necessarily optimal—outcomes (pp. 165-171). Similarly, governance structures differ with regard to their demands on economic actors’ ability to process information; assigning activities to alternative governance structures in a transaction-cost-economizing way requires strict attention to the differences in cognitive demands alternative governance structures make.
John McManus (1975), Douglass North (1981), and Yoram Barzel (1982) emphasize yet another cognitive limitation with implications for institutional design: the difficulty, and at times impossibility, of quantifying the information needed to make, monitor, and enforce agreements. Barzel and Roy Kenney and Benjamin Klein (1983) offer the diamond sights arranged by the DeBeers group, in which dealers are offered mixed lots of presorted diamonds on a take it or leave it basis, as an example of an economic institution that has evolved to reduce the costs incurred when cognitively limited human beings must quantify information.
Opportunism. Opportunism is self-interest taken to its limit. To be opportunistic is to act in ways that combine “self-interest seeking with guile” (Williamson, 1975, p. 26). As Williamson (1985) wrote, “This includes but is scarcely limited to more blatant forms, such as lying, stealing, and cheating. Opportunism more often involves subtle forms of deceit.” These subtle forms include, “the incomplete or distorted disclosure of information, especially calculated efforts to mislead, distort, disguise, obfuscate, or otherwise confuse” (p. 47). Recognition of our proclivity for opportunism deepens our understanding as to why the choice of governance structure matters. Just as the assignment of activities to alternative governance structures requires strict attention to the differences in cognitive demands alternative structures make, so too does the assignment require strict attention to the abilities of alternative governance structures to discourage opportunism.
Asset specificity. Some transactions require investments in durable (i.e., long-lived) assets that have little or no value except in support of the transaction for which the investment has been made. For example, auto racks—the railcars railroads use to transport finished automobiles—are useful only for transporting automobiles and are built in custom configurations to carry specific models produced by specific manufacturers (Palay, 1984, p. 269). Williamson (1979) used the term idiosyncratic transaction to refer to transactions supported by transaction-specific assets; a number of synonyms are used to describe the investments themselves, including idiosyncratic investments (and assets) and transaction-specific investments (and assets).
There are many sources of asset specificity. Investments in auto racks exemplify the term physical asset specificity: They represent an investment in physical capital in a custom configuration with little value in any but the transaction for which they are designed. Investments in transaction-specific human capital (e.g., the value of the time a mechanical engineer spends mastering the technical details of products unique to his or her employer and of value to no one else) represent the term human asset specificity. Other sources include site specificity (e.g., an investment in physical capital located at a specific site that is costly to relocate and has little value except when located in close proximity to the transaction it supports), dedicated asset specificity (e.g., an investment in physical capital that increases capacity that is not needed except in support of the transaction it was made to support), and brand-name capital specificity (e.g., an investment developing, promoting, and maintaining the goodwill associated with a specific branded good or service).
Two important points about transaction-specific investments cannot be overemphasized. First, the investments of interest are indeed transaction specific. Consider the investment in time and money a student makes learning to be a mechanical engineer. This investment is specific in the sense that it trains the student to be a mechanical engineer, but it is not transaction specific because there are many alternative transactions requiring general mechanical engineering skills. Second, transaction-specific investments are not made for the sake of making transaction-specific investments but because they stimulate final sales or reduce production costs (Williamson, 1981, p. 558). Thus, it may make sense to make transaction-specific investments in dies designed to stamp uniquely appealing auto bodies because doing so stimulates sales or to make transaction-specific investments in custom auto racks because doing so reduces the cost of transporting automobiles from the manufacturer to the dealer, but it would not make sense to do so in the absence of benefits like these.
A Testable Hypothesis
The central testable hypothesis of transaction cost economics has come to be known as the discriminating alignment hypothesis. It rests on three propositions:
Proposition 1: The transaction costs associated with particular transactions depend on the governance structures within which the transactions take place. This is a restatement of Arrow’s (1969) observation that transaction costs “can be varied by a change in the mode of resource allocation” (p. 60). The reasons for believing this proposition will be discussed in greater detail later, but remember that governance structures can be viewed as defining the rules of the game, and as James Buchanan (1975) had so often argued, changing the rules of the game can change outcomes—including the transaction costs associated with the play of the game.
Proposition 2: Transactions tend to be matched to alternative governance structures in ways that reduce the sum of production and transaction costs. The matching may be due to conscious choice or it may be the outcome of evolutionary processes (e.g., survival in a competitive world). This proposition is a restatement of Coase’s (1937) seminal insight that vertically integrated firms exist because of the advantages of replacing the costs of market exchange with those of managerial coordination.
As noted earlier, however, Proposition 2 is, by itself, tautological: Any and every substitution of one governance structure for another can be explained as the outcome of a desire to reduce transaction costs. Williamson in “The Vertical Integration of Production: Market Failure Considerations” (1971) and “Transaction-Cost Economics: The Governance of Contractual Relations” (1979), and Benjamin Klein, Robert Crawford, and Armen Alchian in “Vertical Integration, Appropriable Rents, and the Competitive Contracting Process” (1978) broke the tautological nature of Coase’s argument with proposition three:
Proposition 3: Alternative governance structures differ in their abilities to economize on particular types of transaction costs; likewise, exchanges differ in their proclivity to generate particular types of transaction costs. This proposition implies that researchers should, after identifying the appropriate characteristics of exchanges and of governance structures, be able to predict ex ante which types of exchanges will be matched to which types of governance structures. The ability to do so allows Coase’s proposition to be tested.
The Archetypical Application: The Make-or-Buy Decision
The classic application of transaction cost economics is to the make-or-buy decision: Should a firm make an input itself, or should it buy it from an outside vendor? The discriminating alignment hypothesis suggests a three-step approach. First, assess the production and transaction-cost-reducing advantages and disadvantages of the competing governance structures. Second, identify the critical dimensions with respect to which transactions differ from each other in their proclivity to generate particular types of costs. Third, choose the governance structure whose cost-reducing advantages and disadvantages are the best match to the types of transaction costs the transaction in question is likely to generate.
Consider as Williamson did (1979, p. 245) the potential advantages to a firm of buying the input from an outside vendor. Looking first at the transaction costs, if the market for the input is competitive, the interaction of demand and supply will determine the terms of trade, present and future. This reduces the transaction costs associated with negotiating the initial terms and adapting them to changing economic conditions. The existence of alternative buyers and sellers, should either party try to take advantage of the other, encourages both to do what they have agreed to do. This reduces the transaction costs associated with enforcing the terms of trade. Finally, larger firms are more difficult to manage than smaller firms because of the difficulties bureaucracies have preserving the high-powered incentives provided by markets (Williamson, 1985, chap. 6). All else equal, by choosing to buy rather than to make, the firm will be a little smaller and easier to manage.
There are two reasons buying the input from an outside vendor may lead to lower production costs. First, if by meeting the needs of multiple customers, an outside vendor can achieve greater economies of scale, the vendor’s production costs will fall, a cost savings that in a competitive market will be passed on to the vendor’s customers. Second, if demand fluctuates over time, by combining production for customers whose demand for the input is less than perfectly correlated, the vendor can reduce the variability in his or her production runs in the same way an investor holding a diverse portfolio can reduce the variability in his or her returns. This too lowers production costs.
Given the many advantages of buying from outside vendors, why would a firm ever want to make the input itself? Like markets, hierarchies have their own distinctive strengths and weaknesses. With vertical integration, both sides to the transaction become part of a common team. This encourages the pursuit of a single goal—the success of the team—rather than the opportunistic pursuit of the separate goals of the parties on either side of the transaction. Further, when conflict arises, higher-level managers have access to financial, market, and technical information that can help settle disputes in ways they do not when negotiating with independent suppliers or customers. Finally, if a higher-level manager’s access to lower-level information is not by itself sufficient to settle a dispute, the higher-level manager can simply declare the terms on which the dispute will be resolved. Such management by fiat is in general a more effective and less costly means of conflict resolution than third-party arbitration or litigation.
By reducing the incentives for opportunistic behavior and by increasing the options for dispute resolution, vertical integration can be especially attractive for transactions that require frequent adaptations to changing economic conditions and in which competition from rival traders cannot be relied on to discourage opportunistic behavior. Rather than write an initial contract spelling out the terms of trade for every future contingency (the better to avoid opportunistic renegotiation of the terms of trade as the future becomes the present), the vertically integrated firm can replace extensive contingent contracting and its demands on the transactors’ limited cognitive powers with adaptive, sequential decision making.
Against these strengths, the weaknesses of vertical integration must be weighed. First, by vertically integrating, the firm gives up the potential production cost savings available to an input supplier meeting the needs of multiple customers. Second, as already discussed, vertically integrated firms are larger firms, and all else equal, larger firms are more difficult (read more expensive) to manage than smaller firms.
Thus, in answering the question, should we make or should we buy? the firm must weigh the distinctive strengths and weakness of vertical integration against the distinctive strengths and weakness of market procurement. Ordinarily, we would expect the weight of the comparisons to favor market procurement (Williamson, 1979). Note, however, that the advantages of market procurement hinge on the related assumptions that the market for the input is competitive and that the outside vendor can realize cost savings by meeting the combined needs of multiple customers. To the extent that these conditions are not met, the advantages of buying over making decrease, the disadvantages increase, and alternatives to market contracting begin to look more attractive. An important reason these conditions may not be met is that the transaction in question is supported by transaction-specific investments.
It is time to turn to the second step of the discriminating alignment hypothesis: What are the critical dimensions with respect to which transactions differ from each other? Williamson (1979) identified three transaction characteristics that in combination make vertical integration more likely: the frequency with which a transaction recurs, the degree of uncertainty associated with the transaction, and the specificity of the assets supporting the transaction.
Frequency matters for several reasons, one of which is that greater frequency implies that the extra costs associated with creating more complex governance structures can be spread over a greater number of transactions. This reduces the marginal cost of bringing the transaction under the direct control of the firm’s managers, which, when combined with uncertainty and asset specificity, makes vertical integration more likely.
Uncertainty is important because it makes contracting over markets more complex and increases the likelihood that both sides of a transaction will find it in their interest to renegotiate the transaction’s terms as economic conditions change. As an example of both uncertainty and the incentives firms have to adapt their contracts as conditions change, consider the relationship between a commercial aircraft manufacturer designing a new plane and the vendor from which it buys engines. An airliner’s engines are among its most important components. Many aspects of the design and performance of the new design will depend on the specific characteristics of the engines used, engines that are designed in tandem with the new plane so that both can take advantage of the most recent technological advances. Because the technology used is so new, however, the actual characteristics of the engines—including the cost to produce them—may not be known with certainty until the engine is in production. The fate of both the aircraft manufacturer and its engine vendor can be tied to their willingness to renegotiate the terms of their relationship as technological and market conditions unfold. This example is based on the experiences of the Boeing Company and the Lockheed Aircraft Manufacturing Company and the difficulties they experienced bringing the Boeing 747 and the Lockheed L-1011 to market; Lockheed’s struggles brought it to the brink of bankruptcy. Boeing is today experiencing similar troubles bringing their 787 Dreamliner to market, due in part to the uncertainties associated with building the first large commercial airliner whose wings and fuselage are constructed out of fibers held together with epoxies rather than aluminum held together with fasteners.
It is worth noting that the importance of uncertainty in the make-or-buy decision is directly related to bounded rationality: If not for their cognitive limitations, traders should, at least in theory, be able to write contracts specifying the terms of trade under every possible future state of the world. Given their cognitive limits, however, both the expense and the ultimate impossibility of conceiving and enumerating all possible future states of the world prevent them from doing this. One alternative is to write contracts that are intentionally incomplete, then adapt them to the conditions that emerge as the future becomes the present. However, in the presence of the third transaction characteristic that makes vertical integration more likely—asset specificity—incomplete contracting opens the door to opportunistic behavior.
Asset specificity can lead to contracting problems because investments in transaction-specific assets lock the parties to transactions into bilateral (i.e., one-to-one) relationships in which each party is dependent on the other and competitive forces cannot be depended on to quickly, easily, and impartially determine the terms of trade. Because of this dependency and lack of competition, an environment ripe for opportunistic gamesmanship is created each time the terms of trade are renegotiated: If the first party owns the transaction-specific asset, the second party can threaten to withdraw from the relationship if the first refuses to renegotiate the terms in the second’s favor. The gamesmanship and the transacting problems it can lead to have become known as the hold-up problem.
Klein et al. (1978) were the first to describe the hold-up problem in detail, introducing the concept of the appropriable quasi rent to do so. An appropriable quasi rent is the difference between the net revenue ownership of an asset generates for its owner when deployed in support of its current transaction at the current terms of trade and the net revenue it generates when deployed in support of its next best alternative transaction. In the absence of asset specificity, the appropriable quasi rent is zero: If the first party refuses to renegotiate and the second party withdraws from the relationship, the first can redeploy his or her assets with a third party at the original terms of trade and no loss in net revenue. At the other extreme, if the asset owned by the first party is uniquely suited to the transaction with the second party, there will be no third party to which the first can turn, and the entire difference between the net revenue at the current terms of trade and the salvage value of the asset is potentially in play.
Note that even in cases in which markets are competitive before investments in transaction-specific assets are made, after the investment, the parties are locked into the noncompetitive bilateral relationship that can lead to the hold-up problem. This shift from a competitive to a non-competitive situation after the specific investments are made is called the fundamental transformation. When answering the make-or-buy question, firms must consider the possibility that the fundamental transformation will occur, and if so, whether they can devise a nonmarket governance structure that will encourage cooperative behavior without placing unrealistic demands on their limited cognitive capacities and forcing them to give up the production cost savings associated with market provision.
Two final points before moving on to an illustration: First, transaction cost economics is an explicitly comparative institutional endeavor. Williamson (1975, p. 130) reminded us that all institutions have associated with them characteristic strengths and weaknesses. Finding that market procurement in a particular situation has hazards associated with it is not the same as finding that vertical integration is necessarily the superior alternative. The challenge for businesses (and the economists studying their decisions) is to match troublesome transactions to imperfect institutions in a discriminating way.
Second, the matching of transactions characterized by frequency, uncertainty, and asset specificity to more complex governance structures—up to and including vertical integration—rests on a crucial assumption. This assumption was first clearly and unambiguously stated by Klein et al. (1978), who wrote,
The crucial assumption underlying the analysis of this paper is that, as assets become more specific and more appropriable quasi-rents are created (and therefore the possible gains from opportunistic behavior increases), the costs of contracting will generally increase more than the costs of vertical integration. (p. 298)
Combined with Williamson’s (1979) insight that asset specificity alone is not sufficient to tilt the scales away from market contracting and that frequency and uncertainty are required to create the conditions in which asset specificity matters, it follows that the greater the degree to which frequency, uncertainty, and asset specificity are combined, the more likely it is that the answer to the question, should we make or should we buy? will be to make.
An Illustration: Adam Smith’s Pin Factory
The prevalence of opportunism combined with bounded rationality creates interesting problems for our political, economic, and social institutions to overcome. Consider, for example, the trading hazards faced by people working together to produce a simple product. In his Wealth of Nations, Adam Smith (1776/1974) described the manufacture of pins circa 1776:
One man draws out the wire, another straights it, a third cuts it, a fourth points it, a fifth grinds it at the top for receiving the head; to make the head requires three distinct operations; to put it on is a peculiar business, to whiten the pins is another; it is even a trade by itself to put them into the paper; and the important business of making a pin is, in this manner, divided into about eighteen distinct operations. (p. 110)
Imagine the problems faced by any two of Smith’s pin makers if the manufacture of pins is organized along entrepreneurial lines, that is, if the governance structure used to coordinate flows of semifinished pins rests on repeated market exchanges between independent entrepreneurs at each of the 18 separable stages in a pin’s manufacture. Because the pin makers are only boundedly rational, they will have difficulty foreseeing and then writing a contract covering all the possible contingencies over which disagreements could occur in the future. Because each has reason to suspect the other may on occasion be opportunistic, each will be concerned that his or her trading partner may on occasion try to take advantage of him or her. This means that neither can place complete faith in a contract that says, “I will always negotiate in good faith when unforeseen contingencies arise and always provide accurate and timely information.” Further, their physical proximity locks them into a bilateral trading situation; this reduces the role competitive forces can play in guaranteeing harmonious exchange. So they may look for alternatives to market organization, alternatives that realign the incentives they face to act at cross-purposes. In particular, they may choose to form a vertically integrated firm.
Note something important: By choosing a different governance structure, the formerly independent entrepreneurs have altered their incentives to cooperate with each other. That is, through careful manipulation of their trading environment, they have sought to make mutually desired outcomes (harmonious adaptation to changing circumstances) more likely. Doing so may well entail some costs: bias in information flows, additional information-processing costs, bureaucratic inertia, and so forth, but in an imperfect world, some transaction costs are unavoidable; the trick is to find that governance structure that economizes the transaction costs associated with a particular exchange. In Smith’s pin factory, this has been accomplished by (in Arrow’s, 1969, words), replacing “the costs of buying and selling on the market by the costs of intrafirm transfers” (p. 48).
Beyond the Make-or-Buy Decision: Governance as a Continuum
Although the make-or-buy decision may be both the original and the archetypical application of transaction cost economics, a moment’s reflection on the incredible diversity of trading arrangements in our economy leads to the conclusion that most of the action is neither in the sorts of spot markets that dominate principles of economics texts nor in vertical integration. From the beginning of the revival of interest in Coase’s work, transaction cost economists have devoted much of their attention to governance structures that lie between spot markets and vertical integration. Williamson (1979) identified four general types of governance structures, ranging from market governance (or classical contracting) at one end of a rough continuum to unified governance (or vertical integration) at the other. In between are trilateral governance (or neoclassical contracting) and bilateral governance (or relational contracting).
In trilateral governance, moderate to highly specific investments may be made—creating an incentive for the parties to work together because punishing opportunism by leaving a relationship is costly—but the transactions are so infrequent that the costs of creating a specialized governance structure exceed the benefits. In such cases, the parties to a transaction may rely on a third party to serve as an arbitrator to encourage cooperative behavior and settle disputes. Most construction projects, for example, are managed by a general contractor who hires, coordinates the actions, and settles disputes between the various subcontractors and between the client and the subcontractors.
Bilateral governance is arguably the most interesting case. It occurs in situations that combine frequency with moderate amounts of uncertainty and asset specificity. It also occurs in cases that combine significant amounts of frequency, uncertainty, and asset specificity with significant production cost savings realized when the demands of multiple buyers are aggregated. In such situations, highly idiosyncratic long-term contractual, social, and cultural relationships may be crafted to ensure cooperative behavior. For example, bilateral governance structures often include contractual provisions—like the requirements that buyers pay for a minimum quantity of a good, service, or input even if they choose not to accept delivery of the entire minimum order (take-or-pay requirements)—that are hard to square with traditional economic models but make sense when viewed as means to align incentives and promote cooperative behavior in long-term relationships that might otherwise be problematic.
Applications and Evidence
A considerable body of evidence exists in support of transaction cost economics’ central testable hypothesis: As transaction frequency, uncertainty, and, especially, asset specificity increase (the independent variables), the governance structures used to support transactions become increasingly complex, moving out the governance continuum toward relational contracting and vertical integration (the dependent variable). This body of evidence, which includes case studies, econometric studies, and combinations of the two, overwhelmingly supports Williamson’s (1996) assertion that “transaction cost economics is an empirical success story” (p.55). “Indeed,” wrote Paul Joskow (2008), “it is hard to find many other areas in industrial organization where there is such an abundance of empirical work supporting a theory of the firm or market structure” (p. 16).
The empirical research on transaction cost economics has been summarized numerous times. Two works in particular stand out: “Empirical Research in Transaction Cost Economics: A Review and Assessment” (Shelanski & Klein, 1995) and “The Make-Or-Buy Decision: Lessons From Empirical Studies” (Klein, 2008). Rather than summarize these summaries, the focus of this section will be on a handful of case studies and empirical tests that highlight key concepts and exemplify approaches from which students writing term papers may draw inspiration.
Palay’s (1984) “Comparative Institutional Economics: The Governance of Rail Freight Contracting” has inspired many student papers. There are four reasons for this. First, Palay did an excellent job translating the often idiosyncratic language in which transaction cost theory was developed into language students can understand. Note Palay’s definition of governance structure and illustration of physical asset specificity from the theory section of this research paper. Second, he finds ways to break down the theory’s key concepts—many of which are both abstract and complex— into smaller, more understandable, measurable pieces. An example of this is his identification of five characteristics of governance structures (how agreements are enforced, how they are adjusted, the types of adjustments made, whether information necessary for long-term planning is exchanged, and whether information necessary for structural planning is exchanged), each of which can be evaluated on scales running from least to most complex (i.e., from what one would expect to see in a spot market to what one would expect to see in relational contracting). Third, the strategy Palay employed to test the relationship between asset specificity and governance—creating a series of tables, one for each of his five governance-structure characteristics, in which the columns represent increasing degrees of governance complexity, the rows represent increasing degrees to which transaction-specific investments have been made, and the numbers in the individual cells represent the number of transactions characterized by particular combinations of governance complexity and asset—is simple, intuitive, and does not require a course in economic statistics to apply: Look to see if the expected pattern between asset specificity and governance emerges (the greatest numbers of observations should form diagonals down the tables, with cells in the upper left, center, and lower right of each table most full). And fourth, collecting the raw data can be fun—it is done by conducting a series of interviews about specific transactions, asking questions that allow the interviewer to characterize each transaction in terms of governance-structure complexity and investments in transaction-specific investments, uncertainty, and frequency. Parents, employers, college administrators, and local business owners can all be interviewed, depending on the student’s research project.
One criticism some students have of the classic works in transaction cost economics is their focus on heavy industry: commercial aircraft producers and their subcontractors (Bell, 1982), rail freight contracting (Palay, 1984), natural gas producers and pipelines (Masten & Crocker, 1985), coal and electric utilities (Joskow, 1987), steel producers and source of iron ore (Mullin & Mullin, 1997), and so forth. There are good reasons for reading these works. The significance of Palay’s work was discussed above, and that of Joseph Mullin and Wallace Mullin’s will be discussed in the section of this research paper on policy implications. The extensive reliance on subcontracting in the production of commercial aircraft described by Bell reminds us that high frequency, uncertainty, and transaction-specific investment need not lead to vertical integration if the benefits of achieving economies of scale and smoothing production by aggregating less than perfectly correlated demand in different end markets are high. Scott Masten and Keith Crocker (1985) did a great job describing the sort of odd contractual provisions (take-or-pay requirements, in their case) that are difficult to explain when one views the world as a series of spot markets but are the hallmarks of relational contracting. Of the many virtues of Joskow’s (1987) article, one is that his discussions of site and physical asset specificity (mine mouth power plants built next to coal mines and power plants specially built to efficiently burn coal with the specific metallurgical properties of the coal unique to a colocated mine) help remind us that asset specificity is not chosen for its own sake but rather for its demand-enhancing or production-cost-reducing benefits. But are the only applications of transaction cost economics to heavy industry? Thankfully, the answer is no.
Examples of applications and empirical tests of transaction cost economic outside heavy industry include academic tenure (McPherson & Winston, 1983), fiscal federalism (Bell, 1988, 1989), marketing and distribution in the carbonated beverage industry (Muris, Scheffman, & Spiller, 1992), franchising in the fast food industry (Kaufman & Lafontaine, 1994), and even marriage (Hamilton, 1999). Applications by students have added to the variety, as demonstrated by the list of term paper topics in the introductory section of this research paper.
The roots of the revival of interest in what we now call transaction cost economics were policy driven. Both Arrow (1969) and Williamson (1967) conducted research on government contracting in general and defense contracting in particular just as the revival was getting under way, exploring many of the same issues Williamson in particular would soon explore in greater depth in the context of commercial contracting. Just as an awareness of the issues raised by bounded rationality, opportunism, the fundamental transformation, and the potential for contractual provisions in long-term contracts that realign incentives in a way that promotes cooperative adaptations to changing economic conditions are important to businesses transacting with other businesses, they are important to governments transacting with businesses. The issues involved should play an important part in the ongoing and increasingly important debate over the future of the U.S. health care system. But historically, interest in the policy implications of transaction cost economics has been strongest in the area of antitrust.
Significant portions of two of the key early works on transaction cost economics, Williamson’s Markets and Hierarchies (1975) and his The Economic Institutions of Capitalism (1985), are devoted to the antitrust implications of transaction cost economics, and many of the key early papers were published in law journals. This is no coincidence. Before the advent of transaction cost analysis, the default assumption in the antitrust community was that odd contractual provisions, that is, provisions that differed much from what one might expect to see in a spot market, were suspicious. Transaction cost economics provided an alternative explanation: Rather than mechanisms for the enhancement and exploitation of market power, these odd contractual provisions promoted economic efficiency. Examples cited by Williamson (1985) in the first chapter of The Economic Institutions of Capitalism included “customer and territorial restrictions, tie-ins, block booking, franchising, vertical integration, and the like” (p. 19).
The motivation for much of the interest in transaction cost economics has thus been to distinguish between contractual provisions most likely used to enhance market power (which is illegal) and those most likely used to promote economic efficiency (which is not illegal, can be used as a defense in an antitrust case, and in general should be encouraged). Mullin and Mullin’s (1997) “United States Steel’s Acquisition of the Great Northern Ore Properties: Vertical Foreclosure of Efficient Contractual Governance?” provided an interesting illustration. Mullin and Mullin revisited a historic antitrust case, one in which U.S. Steel stood accused of vertical foreclosure (creating an illegal barrier to entry into a market by eliminating a potential rival’s access to a critical input) through their negotiation in 1906 of a long-term lease of ore properties owned by the Great Northern Railway. This relationship, called the Hill Ore Lease, is particularly interesting because its structural characteristics are consistent with both the market power and transaction-cost-reducing explanations for its existence. The two interpretations have different implications, however, for the postcontractual profits and stock prices of U.S. Steel’s largest customers at the turn of the last century—the railroads. Mullin and Mullin used ordinary least squares, the capital asset pricing model, and railroad stock prices to see with which interpretation returns on railroad stocks over the period the lease was in effect were consistent. Because these returns were abnormally high, Mullin and Mullin concluded that the primary effect of the lease was the promotion of economic efficiency, not market power.
Transaction cost economists believe that either through decision makers’ conscious choices or by doing what is necessary to survive in a competitive world, economic institutions evolve in ways that reduce the sum of production-plus-transaction costs. When the exchanges between the various technologically separable steps required to bring a good or service to market are simple, spot markets tend to do this best. However, as the exchanges become more complex, the transaction costs associated with the use of spot markets begin to rise, and alternatives to spot-market contracting become more appealing. One alternative is vertical integration. Just as spot markets have transaction costs associated with their use, however, so does vertical integration. For this reason, comparisons of the costs and benefits of the various institutional alternatives generally result in pairings of particular transactions to governance structures that lie between the extremes of spot-market contracting and vertical integration.
To test transaction cost theory, one must identify those factors that lead to greater transaction complexity. Theory predicts that complexity increases as the combination of transaction frequency, uncertainty, and the presence of transaction-specific investments increases, all else equal, including the production-cost benefits associated with capturing economies of scale and smoothing production by aggregating demand in less than perfectly correlated end markets. This theory has been tested using case studies, econometric studies, and combinations of the two. The overwhelming weight of the evidence is in support of transaction cost theory.
A number of important reminders emerge from these tests and applications, including the frequency with which real-world governance stops short of vertical integration and the consequent prevalence of relational contracting and its odd contractual provisions. These provisions have historically been viewed with suspicion by antitrust authorities. With the advent of transaction cost reasoning, they are seen in a new light—as means to reduce transaction costs and promote efficient adaptations to changing economic conditions rather than as mechanisms by which to exploit and enhance market power.
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