Transaction cost economics. Ronald Coase set out his transaction cost theory of the firm in 1937, making it one of the first (neo-classical) attempts to define the firm theoretically in relation to the market.

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MANAGERIAL ECONOMICS

COURSE ASSESSMENT 1

PREPARED BY MS. KWOK NA, CLARA

STUDENT NUMBER: 8221037

ASSIGNMENT REFERENCE: ME/JULY11/1

BACKGROUND

According to , people begin to organize their production in firms when the  of coordinating production through the market exchange, given imperfect information, is greater than within the firm.   set out his  theory of the firm in 1937, making it one of the first () attempts to define the firm theoretically in relation to the market. One aspect of its 'neoclassicism' lies in presenting an explanation of the firm consistent with , rather than relying on . 

Transaction cost economics (TCE), and more specifically the version of TCE that has been developed by Oliver Williamson (1975, 1985, 1993b), has become an increasingly important anchor for the analysis of a wide range of strategic and organizational issues of considerable importance to firms.

Characteristics of TCE

Contracting problem

Although transaction cost economics maintains that all complex contracts are unavoidably incomplete by reason of bounded rationality, such incompleteness should not be confused with myopia. On the contrary, transaction cost economics maintains that intended rational economic agents are far-sighted – in that they will look ahead, perceive hazards, and fold these back into the contractual calculus.  That is an exercise in far-sighted contracting – according to which incomplete contracts are examined in their entirety.  

Asset specificity

For , the existence of firms derives from ‘asset specificity’ in production, where assets are specific to each other such that their value is much less in a second-best use.   This causes problems if the assets are owned by different firms (such as purchaser and supplier), because it will lead to protracted  concerning the , because both agents are likely to become locked into a position where they are no longer  with a (possibly large) number of agents in the entire market, and the incentives are no longer there to represent their positions honestly: large-numbers bargaining is transformed into small-number bargaining.

Holdup problem

If the transaction is a recurring or lengthy one, re-negotiation may be necessary as a continual power struggle takes place concerning the gains from trade, further increasing the . Moreover there are likely to be situations where a purchaser may require a particular, firm-specific investment of a supplier which would be profitable for both; but after the investment has been made it becomes a sunk cost and the purchaser can attempt to re-negotiate the contract such that the supplier may make a loss on the investment (this is the , which occurs when either party asymmetrically incurs substantial costs or benefits before being paid for or paying for them). In this kind of a situation, the most efficient way to overcome the continual conflict of interest between the two agents (or coalitions of agents) may be the removal of one of them from the equation by  or . Asset specificity can also apply to some extent to both physical and human capital, so that the hold-up problem can also occur with labor (e.g. labor can threaten a strike, because of the lack of good alternative ; but equally the firm can threaten to fire).

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Opportunism

Probably the best constraint on such opportunism is  (rather than the , because of the difficulty of , writing and enforcement of ). If a reputation for opportunism significantly damages an agent’s dealings in the future, this alters the  to be opportunistic.

Asymmetric information

Williamson sees the limit on the size of the firm as being given partly by costs of delegation (as a firm’s size increase its hierarchical bureaucracy does too), and the large firm’s increasing inability to replicate the high-powered incentives of the residual income of an owner-entrepreneur. This is partly because it is in the ...

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