Managerial Economics: Assignment

Topics: Transaction cost, Contract, Theory of the firm Pages: 7 (2069 words) Published: October 26, 2011
In this paper we shall focus first on the key characteristics of TCE (transactions cost economics) giving a theoretical introduction of its concepts.
We will then analyze the vertical boundaries of Ross & C, the company I currently work for, and we will see how they evolved during the years. The discussion will concern the “to buy or to make” dilemma applied to the real case of the sales force. We will in fact show the transition from the sale force as outside agents (to buy) to the sale force as direct employee (to make) showing how the change of the environment can influence the modus operandi of a company.

Key characteristics of Transactions Costs Economics (TCE)
Transactions costs economics (TCE) theory, introduced by R. Coese in 1937 and later developed by Williamson, is concerned with understanding when it’s preferable to perform a process within the company (vertical integration) or on the contrary when it is convenient going to the market.

According to Williamson (1979) “the three critical dimensions for characterizing transactions are (1) uncertainty, (2) the frequency with which transactions recur, and (3) the degree to which durable transaction-specific investments are incurred.”

The consequent transaction costs are normally generated by researching potential suppliers, comparing the cost of the supplier and negotiating contracts. Further, costs will come from monitoring the performance and, in some cases, from legal costs due to contractual breaches.

The effectiveness of contracts hence depends on the completeness of the contract and the available body of contract law (Besanko – 2010) In the real world most of the contracts are imperfect due to the impossibility to map every possible contingency. The main factors that prevent complete contracting are: (1)bound rationality

(2)difficulties measuring performance
(3)asymmetric information,

Firstly, bound rationality considers the limited capacity of individuals of keeping under control all the contingencies that could incur in a transaction. Such uncertainty can arise either due to lack or excess of information. Secondly, difficulty measuring performance concerns the fact that in certain cases the measure of the performance is not easy and unique. This problem can lead to confusion into each party’s rights and responsibilities. Lastly, asymmetric information refers to the case when one party has more or better information than the other having then the possibility to alter or disguise the result of an activity to its best advantage.

However, in taking the final decision, we should keep in mind also other two factors: the (4) relationship-specific assets and (5) holdup problems.

A relationship-specific asset is an investment made to support a given transaction (Besanko – 2010). The suppliers with relationship-specific asset generally have qualified capacities to conduct the transaction and, due to this specific ability hard to substitute, can become opportunistic or unadoptable with the firms.

Asset specificity can be identified in:
(1) Site specificity. Site specificity occurs when investments in productive assets are made in close physical proximity to each other in order to reduce inventory, transportation, and sometimes processing costs. (2) Physical Asset specificity. Equipment and machinery specific to a particular customer or are specialized to use an input of a particular supplier. For instance, the giant presses for stamping out automobile body parts are specific to the automobile manufacturer. (3) Dedicated Assets. Dedicated assets by an input supplier are investments in general capital to meet the demand of a specific buyer, for example the military defence equipment. (4) Human-Asset Specificity. Human-asset specificity refers to the accumulation of knowledge and expertise that is specific to one organization as the design engineers who have developed special skills in designing a particular type of automotive....
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