Name:	Elaine Baker
Student number:	115927
Course:	MSc Political Economy of Development
Module:	Political Economy of Institutions
Lecturer:	Dr Mustaq Khan
Due date:	23 March 2001
Word count:	4663
Question:	Define transaction costs.  Compare and contrast the transaction cost approach to explaining firm structure with neo-Marxian approaches which identify power and conflict as key determinants of firm structure.

Introduction

The first section of this essay sets out the concepts of transaction costs, firms and markets which are used in the analysis of firm structure and economic organisation.  The next sections apply these concepts to the analysis firstly to the internal organisation of firms and secondly to the degree of integration, scale and scope of firms.  The final section looks at functionalist vs. neo-Marxian methods of analysis.  It concludes that while transaction cost concepts are useful, a functionalist use of these concepts neglects the important illumination Marxian and neo-Marxian analysis can contribute to the analysis of economic organisation.

Concepts in the analysis of transaction costs 
Transaction costs

In a hypothetical economy where everyone produced for their own consumption, there would be no transaction costs.  Specialisation requires co-operation through mechanisms such as firms or markets (Alchian and Demsetz, 1972).  Transaction costs are the time, effort and risk involved in specialising and therefore co-ordinating economic activity in an economic system.  They include the work involved in obtaining information about other people’s demands, the risk involved in producing something without being sure of its end exchange value, the organisational effort in co-ordinating different work roles within a structure such as a firm, and the administration involved in drawing up agreements and contracts, monitoring them and enforcing them.

Increasing specialisation and therefore a more complex economic system entails greater transaction costs.  In the most industrialised countries, work for the majority of people involves running the economic system rather than producing a consumer good or service.  For example, the goods-transport and retail sectors, the communications services used by businesses, and the sections of firms devoted to accounting, marketing, management, human resources and information technology are involved neither in directly producing a physical good, nor in directly performing a consumer service, but in organising the efforts of producers so they are more effective, organising that the results of those efforts reach those that demand them, and bearing the risk that producer supply will not match consumer demand.

The Firm

The form of the economic system comprises many different types of economic relationships and institutions.  A commonly used concept in analysing the economic system is the firm.  A firm can be thought of as a group of people who implicitly or explicitly agree to work in the same chain together on an on-going basis according to a special set of rules (a contract), rather than according to the default set of rules determined by a wider market/state.  By working in the same chain, I mean that their work contributes somewhere in the process from the production to the final use of the same consumer good or service.  People within a firm form employment contracts with the firm, and the firm forms contracts with other firms and people.  In this way, the firm can be thought of as a contracting node or hub (Jensen and Meckling, 1976).

The Market

People can interact within a firm as above, or they can interact in the market.  The theoretical extreme of a market transaction is a situation where people have no long-term transaction relationships.  People have the option of changing who they buy work from or sell work to easily.  People lose nothing by changing – i.e. they do not incur penalties for breaking a long term contract, and they must either be easily able to change to different work of a similar value, or there must be other people available who will sell or buy their original work for the same price.  

In reality, however, a market transaction means that the default set of rules and conventions of a society govern the transaction.  While two individuals may have no long-term economic relationship as individuals, they do have a long-term relationship through being members of the same society.

Contracts and transaction costs – negotiation, information, risk

Transaction risk is one form of transaction cost.  Transaction risk arises because of the inability to fully specify contracts.  For example, a firm would have no transaction risk if it could carry out a consumer order relying on guaranteed supplies or pre-decided compensation from all its suppliers.  However, consumers cannot decide everything they will wish to consume well in advance.  In addition, it is impossible to design a contract which specifies what the supply and compensation rights and responsibilities of each actor are in each conceivable circumstance.  This is called bounded rationality.  

The more fully specified a contract, the more negotiation and information transaction costs involved.  The less specific it is, the more transaction risk involved.  This transaction risk consists of the potential for costly disputes, and for the necessity of adaptations which would not originally have been agreed to.   The potential to force others into actions they would not originally have agreed to, due to the occurrence of unforeseen circumstances, is called opportunism.  (Williamson, 1985, Ch.1)

For example, a worker may agree to learn the skills an employer needs in exchange for a higher wage, but what is to happen if the skills the employer requires change, may not be specified in the contract.  If the required skills change the employer may be opportunistic and not increase the wage.  The worker has already learnt the skills but may not have done so if s/he had known beforehand that the wage would not increase. 
 
Contracts may be explicit or implicit relationships.  For example, conventions may come to prevail between firms or individuals who repeatedly transact with one another.  They may gain by having an ongoing relationship thereby reducing risk and information transaction costs, or through greater quality thereby reducing monitoring transaction costs.  However, the implicit nature of conventions may allow opportunism when circumstances change (Williamson, 1985, Ch.3).  

Conventions or implicit contracts on a society wide level, together with explicit society wide contracts such as laws and institutions, determine the default set of rules commonly referred to as the market.  Different markets may be governed by different conventions, laws and institutions.  The market is not a single state of affairs with “natural” laws, but a particular manifestation of a society wide contract arrived at through historical processes and affected by coercive power.

Asset specificity

Long term contracts between firms and employees are not the only type of long term contract. Williamson analyses this using the concept of asset-specificity.  This is where assets (e.g. equipment or skills) are only valuable in a producing a specific output, or as part of a specific chain, and cannot be easily transferred into other economic activities.  A firm which invests in specific assets is taking a risk that other parts of the chain will continue to function, and there will continue to be a market for the end product.  This risk is a transaction cost, i.e. a cost involved in working in a chain involving other people who may act opportunistically.

For example, firm A can decide to invest in specific assets, taking the risk that if conditions change its investment will no longer be as valuable.  Alternatively, firm A can decide to pay firm B to engage in the part of production involving the specific asset, and so firm A can exit or change quickly without losing an investment.  Firm B now bears the risk that firm A may decide to switch to another supplier, as well as the risk that final demand will change and firm A will exit.  

Firm B may not engage in the activity due to this risk of opportunism – the risk that firm A will decrease the price it pays or switch to another supplier after firm B has made the investment.  Firm A can agree to decrease firm B’s risk by engaging in a credible long-term contract with it.

In the case of long term contracts, the lines between firms are blurred.  Are firm A and firm B still separate firms?  Combined, they are a larger group of people working together in special non-society-wide long term contracts, which fits with the above definition of a firm, although those contracts may be organised around two entities with which employment contracts are made, suggesting two firms (Klein, Crawford and Alchian, 1987). Williamson (1985, Ch.3) points out that there is a spectrum from market to firm including franchises, joint ventures and other forms of long term contract.

Organisation within the firm

Work roles within a firm can be divided into three types – management, specific asset providers / risk bearers, and other non-specific input providers.  Those who provide specific assets are bearing a risk, as they are producing an asset which is much less valuable if the venture is not profitable.  They include the owners of specific capital and labourers with specific skills.  Non-specific input providers include owners of capital which can easily be transferred to other uses without losing value, and labourers who can easily transfer their skills to equally valuable employment.  Managers are those who co-ordinate, monitor, gather information and make decisions about production and transactions, and usually require firm specific skills to do this.

It is difficult for the providers of these different inputs to buy and sell their services from each other through market transactions.  In many cases, the output is not separable; that is, output is dependent on the inputs of members of a team in complex ways (Alchian and Demsetz, 1972).  The information transaction costs of procuring these services through the market every day, and the transaction risk costs involved in a crucial input becoming suddenly unavailable mean that long term employment contracts (transaction costs within the firm) can be less cost than transaction costs through the market.  Managers may not be able to sell management services as this involves selling knowledge, which is problematic as the quality of knowledge cannot be ascertained before it is bought (Knight, 1921).

Ownership of the residual

Fully specified long-term contracts are impossible due to bounded rationality.  Therefore, if this work is to be combined in a long-term contact, the question arises as to who is to own the residual, i.e., what is left over after other parties have been paid a contracted amount.  This person is in effect the greatest risk bearer, as the degree of success of the venture affects his/her pay-off more than it affects the others.  This person also has the greatest incentive to ensure a venture is profitable.  This raises conflicts between the desire to spread risk by having ownership by a large number of people, and the efficiency effects of having concentrated ownership in order to avoid collective action problems in monitoring (Stiglitz, 1974). Monitoring involves ensuring and verifying that inputs and rewards are being assigned according to the contract, and that the residual is being maximised (Alchian and Demsetz, 1972).

Barzel (1982) explains why capital owners own the residual by arguing that a system is more efficient if those who have the greatest degree of influence over the outcome are also the residual owners of the gain or loss.  This means that those with greater influence over the outcome are monitoring those with less influence over the outcome, rather than the other way around.  The most influential parts of the chain do not need much monitoring, as they have strong incentives, while shirking resulting from less-than-perfect monitoring of the less influential parts will have less of a detrimental effect.  Therefore the transaction costs involved (monitoring plus shirking) are less.  

However, it may be the case for technological reasons that the less influential input providers of the chain are more costly to monitor, increasing the case for these to have ownership and therefore greater incentives.

Even if it is the case that it is more efficient for the most influential input providers to own the residual, this does not necessarily imply that the capital provider should be the residual owner.  Firstly, the most influential inputs may not be specific asset inputs.   Specific asset providers have a good deal of influence over the outcome.  By withdrawing the quantity of their work or assets, they can disrupt the chain, whereas if non-specific asset providers withdraw, they can be more easily replaced.  However, the quality of specific asset provision may not necessarily be more influential than the quality of other inputs.  Secondly, specific asset providers are not necessarily capital providers – they may be specifically skilled workers.  

Therefore the relative efficiency of a organisation where the capital provider claims the residual cannot be assessed without reference to the particular technology, specific and non-specific assets, importance of quality, and monitoring possibilities of a particular production process.  All of these factors are in turn influenced by the wider context within which a firm operates.

Different firm structures

In a classical capitalist firm, there is a small group who provides capital, manages and claims the residual.  They have high incentives to monitor and manage well, as the value of their specific assets and the amount of residual they claim depend on their success.  However, drawbacks include a high concentration of control and wealth, the fact that those with the best management skills may not be those who can provide capital, and the high concentration of risk.

In a corporation structure, specific assets are owned by shareholders, who are also the residual owners.  Day to day monitoring is done by managers, while shareholders monitor the managers (Alchian and Demsetz, 1972).  This combines concentration of responsibility on a few managers who can build up firm specific knowledge, with spreading the risk among many shareholders.  However, if there are many shareholders, each one has a low incentive to closely monitor the managers.  The degree of equity in this structure depends on the spread of share ownership.  A wide spread of workers may have pension funds or bank savings, with pension funds or banks owning shares.  This creates a system with workers monitoring pension fund/bank monitoring firm managers monitoring workers.  The state may also monitor pension funds or banks through regulation.  This sort of system has large information and monitoring transaction costs, but relatively low risk-of-shirking transaction costs.
 
Shared ownership of the residual (profit-sharing) among workers is often perceived as equitable and creating direct incentives for workers thereby requiring less monitoring. The wide spread of the residual can mean the incentives are low and shirking is high (Alchian and Demsetz, 1972).  However, Liebenstein (1982) highlights that the prisoners’ dilemma of shirking may be overcome through conventions in a repeated game.  If it is possible for workers to mutually monitor while they work, a convention with a trigger mechanism can emerge, whereby they all continue to not shirk so long as others do not shirk.  However, this is not as feasible in a risky environment where conventions and work patterns must continually change.

There can also be profit sharing among workers who hire and monitor a manager who then monitors them to their gain, by preventing shirking. Jensen and Meckling (1976) argue that “asking to be monitored” has gains, as this increases the amount earned more than the gain from shirking.  

Profit sharing among workers also presents the problem that those who can provide labour may not be able to contribute capital.  Johnson and Whyte (1977) present the case of a worker-run enterprise which borrows money to buy specific assets, and shares profits.  However, the lender of money is taking the risk of default, especially if this is a limited liability venture or the workers have no funds to contribute themselves as collateral.  If the lender is to take the negative risk of default without the positive risk of excess profits, it will demand a higher interest rate than if it was the owner and residual claimant.  This may make this firm structure more difficult to initiate, but not necessarily less efficient.

Williamson (1985, Ch.9) puts forward six possible types of firm organisation – putting-out where a co-ordinator owns inventories and contracts work out to “cottage” industries; federated – where each worker in a chain buys and sells from the next but there are penalties for letting buffer stocks fall too low, communal where each person has access to equipment for each part of the chain for a certain time and brings inventories along, peer groups where every worker rotates doing each type of work and gets an equal share of overall output, inside contracting (like a corporation) where owners contract with managers who contract with employees and authority relation (like a classical capitalist firm) where the capital owner employs workers.  He then classifies them as good or bad based on product flow, allocation of skills and incentive characteristics.  He uses this to crudely conclude that an authority relation is most efficient.  However, this analysis is flawed, as his rankings on different grounds are very disputable and not independent of wider conventions and economic systems. 

Economic incentives are not the only forces working within a firm.  For example, Williamson (1985) sees promotion as a tool whereby, as workers build up firm-specific skills, they can bargain for larger wages, as their leaving would costs the firm more.  However, promotion, authority relations and degrees of control, the degree of challenge, and opportunities for learning and developing interests are also very important aspects of the desirability of different work roles.  These factors are affected by wider social roles and opportunities.

Degree of firm integration

Internal economies of scale (greater efficiency due to a firm doing more of an activity) and economies of scope (greater efficiency due to doing a wider range of activities) are concepts commonly used in analysing the degree of firm integration.  Transaction costs are a way of looking at the factors that lie behind, or create, these economies of scale and scope.

If transactions are internal to a firm, the risk bearer / residual owner can better affect the risk outcome, by taking part in monitoring other parts of the chain.  However, the costs of internally organising and managing a larger amount of activities may be higher, due to the need to gathering information, monitoring and setting up decision making procedures which allocate resources efficiently – roles which otherwise would be performed by a market price (Coase, 1937).  Asset specificity increases the costs of transactions through the market by increasing risk and/or through the costs of setting up and monitoring long-term contracts.

Factors other than asset specificity also affect the efficiency of different firm structures.  Spatial dispersion and mobility of factors of production, and the capacity for communication between those in different parts of a firm have important effects on information, monitoring and transport transaction costs.  Technology may mean that production processes and assets have multiple uses, giving rise to economies of scope.  The social and regulatory environment can make certain firm structures more efficient; for example a firm’s location may affect its ability to transfer price or evade tax.  The timing of transaction links in a chain may be more important in chains involving perishable goods or goods with high storage opportunity costs, giving rise to economies in combining production with distribution and marketing in one firm (Williamson, 1985, Ch.4).

In some cases, there are firms whose whole business is in transaction-work.  For example, there are firms wholly devoted to recruitment, accounting, legal services for businesses, market research or business information technology.  They sell their services to other firms through the market.  In other cases, firms combine production of a good (production work) with in-house recruitment, management, marketing, distribution and even retail (transaction work).  In yet other cases a firm may do transaction work in some chains (transporting goods, providing communications services for businesses or providing information services for businesses) and also produce services for consumers (providing transport, information and communication services which consumers demand for the services’ own sake).

Therefore firms incur transaction costs in two ways.  They may incur internal transaction costs in the sense that they employ people to manage, market, account, form and monitor contracts, and they take risks that they will make a loss due to changes in the market.  They may incur external transaction costs in that they spend money on business services, and they pay others to take risks through shareholder dividends and loan interest payments.

The size of the firm is the set of activities that are co-ordinated inside the firm as opposed to through a market.  The size of firms affects the types of transaction-work that take place, and therefore the types and degrees of transaction costs borne by the firm and by others in society.  The concept of “efficiency” is used to denote that means the lowest possible transaction costs for the whole of society are achieved.

However, the degree of transaction costs external to the firm are determined by the economic characteristics of the wider market/state as well as by wider social and technological factors.   Therefore, a firm structure that minimises internal transaction costs in one context may not be efficient in another.  A firm may not always bear its external transaction costs; therefore a structure that is efficient in itself may not be efficient for society.

Functionalism vs. Neo-Marxian analysis

An economic system comprises such characteristics as the internal structures of firms, competition structure, the geography of production and distribution, the degree of specialisation, the rules and conventions of the market and the public institutions which regulate or take part in production and transactions.

Functionalism

Functionalism is the view that the most efficient economic systems emerge in a "natural” way.  It is based on evolutionary principles – those of random variation and natural selection.  Random variation takes place through experimentation with different forms of economic organisation.  Natural selection occurs through firms whose size and scope are least efficient making less profit and therefore being taken over or deciding to change.  Alchian and Demsetz (1972) argue that the capitalist system  (where workers are paid and the surplus or residual left over goes to the owner of capital) has emerged because it is more efficient, i.e., capitalist firms took over less efficient firm types.  Functionalism also attempts to explain myriad observed institutions, such as dispute settlement procedures and courts, property rights systems, patterns of division of labour and different forms of contracts, solely on the basis that they exist, therefore they serve an efficiency function (see Williamson, 1985, Ch.1).

This view rests on the assumption that a firm's survival is determined only by efficiency and is independent of the wider social and technological system.  For example, society may preserve an inefficient form of organisation due to its effects on the relative power and influence of different groups, on income distribution, on family structures or on the social and political aspects of peoples' geographical location.  If society was an individual decision-maker, it could in some sense "rationally choose" a less efficient system for these reasons.

Efficiency is not independent of distribution.  A system that is perfectly efficient in producing and distributing goods and services according to one distribution may not be efficient for another distribution.  For example, firms producing luxury goods for a small amount of people may require different structures and sizes to firms producing more basic goods for a wider distribution.

Even if a system that is favourable to most people in terms of both efficiency and the above characteristics potentially exists, this system may not emerge due to uncertainty about its effects, and the unwillingness of people to sacrifice the certainty of the status quo.

Even if the characteristics of a system were perfectly known, and that system was deemed preferable, losers from the change may block the change.  It may not be possible for winners to persuade them through offering some form of compensation as identifying the winners and losers in an objective way may not be possible, and the promise of compensation may not be credible ex post.

Changing technological and natural conditions may mean that the efficiency of a system in the past is no guide to the efficiency of the same system in the future. Social, technological and economic change are locked together in a path-dependent way.  This is like a situation of multiple equilibria, where any change in one of the social, technological or economic systems is not an improvement, but a change in all of them may be, and that large change may have uncertain effects and so people do not co-ordinate to effect it.  

These arguments apply in different ways to small scale economic organisation (e.g. within firms or industries) and large scale economic organisation (e.g. nationally or globally).  The efficiency and other characteristics of a given form of small-scale organisation may be very different depending on larger scale systems of which it is a part.  It is more probable that the most efficient small-scale types of organisation will emerge in a given large-scale system, than that the most efficient large-scale system will emerge.  This is because there is greater scope for "experimentation" and "natural selection" on a smaller scale.

Neo-Marxian analysis

Marx (1867) saw the efficiency and distribution characteristics of a system influencing relative power and class conflict, and thereby influencing institutional change into new systems.  The dynamic nature of economic systems is very important.  For example, what the residual claimant does with the residual or surplus is more important in a dynamic sense to how s/he got it.  Marx places people in classes based on whether or not they are residual claimants and looks at the incentives and opportunities they have to use the surplus to invest in capital, to consume it, to distribute it in exchange for political support, or to use it to build up coercive power thereby maintaining a given system.

Marglin (1974) and Edwards (1979) see distributive aspects of specialisation, of capitalism and of hierarchy within firms as the main reason for their emergence.  They propose that a high degree of specialisation is not more efficient, and that one person can divide his/her time into multiple types of work.  They also argue that hierarchy is not necessary for either specialisation or efficiency.  They explain the emergence of hierarchy and capitalism through it being in the interests of a particular group (those heading hierarchies or capitalists) who use a tactic of divide and rule.  This group promotes specialisation within a firm as this creates the need for a manager/co-ordinator/risk bearer/capital owner, and by filling these roles they acquire the ability to appropriate surplus.  Therefore it is in the interest of a capitalist class to create and perpetuate a capitalist system even if it is less efficient.  They may do this through appropriation of land and capital, so that workers are dependent on them for production.

Monopoly power as well as efficiency are important in explaining firm integration (Williamson, 1985, Ch.1).  Firms may merge in order to extend their market power into new markets (the leverage theory), or to extract more consumer surplus by bundling goods together (Posner, 1979).  Entry barriers may be erected using the coercive or state power.  Firms may act strategically by sinking large investments in order to create a credible threat of undercutting any potential competitors.

Because many forms of transaction costs, and therefore efficiency, are not measurable, functionalism as a way of explaining economic systems, i.e., measuring transaction costs through observing which forms of economic organisation survive, is tempting.  However, this can lead to a lack of attention to historical processes and the multiple characteristics of different economic systems.  Neo-Marxian forms of analysis can be complementary to transaction cost concepts in analysing economic organisation.

Conclusion

Transaction costs are a useful concept in analysing economic and firm organisation, and a considerable improvement on microeconomics which sees the firm as a black box.  Consideration of the costs of information, monitoring, risk, co-ordination and contracts using concepts of authority relations, residual/surplus, incentives, asset specificity, opportunism and bounded rationality can contribute much to an understanding of large and small economic organisations and economic relations.  However, using transaction costs to construct functionalist views of economic organisation neglects the importance of Marxian and neo-Marxian explanations and analysis.  The distribution and efficiency characteristics of economic organisation are bound together; and historical processes, economic geography, social and technological change, and coercive power are central to explaining the emergence of, and evaluating the results of, various forms of economic organisation.

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