2 Transaction Cost Economics

This chapter explains the Transaction Cost Theory developed by Oliver Williamson (1979, 1991, 2002). This theory argues that there are three important governance structures that are the blueprints for how to organise business activities: (1) Markets, (2) Long-term Contracts, and (3) Hierarchical Organisations. I will deal with these three blueprints in turn and explain the role of transaction costs in deciding which blueprint is optimal for different circumstances. Similar to the story of the mine, these three blueprints are a useful simplification of real world phenomena and not all real world examples will be easy to categorise. However, that does not mean that transaction cost economics has no practical applications because in the chapter I will use the theory to explain the role of strategic management accounting.

Blueprints of Governance

In this section, I explain the three blueprints ^[1] for governing economic transactions in the Transaction Cost Economics framework: Markets, Long-Term Contracts, and Hierarchical Organisations. We will see that these blueprints are idealised and simplified versions of real world phenomena. Just like the story in the first chapter, they help us to focus on what is important by simplifying reality.

Markets

The role of markets

The market is a meeting place for buyers and suppliers where buyers exchange money for a product or service from the supplier. In this market, suppliers sell at a given unit price and the buyers pay this unit price. For each buyer, the identity of the supplier is not important. They are merely interested in the product and the price they have to pay. This is the ideal market from any introduction to economics course and it has a number of interesting characteristics.

First, a market is adaptive to disturbances or changes in the economic environment. If the consumer demand for the goods of the buyers goes up and they need more materials from their suppliers, those materials becomes more valuable. Buyers will (have to) pay a higher unit price to their suppliers. Thus, the unit price that buyers pay and suppliers receive, responds to changes in the consumers’ preferences. In general, all relevant information about the economic environment will be captured in the price of the product. As a result an ideal market can be seen as an information generating machine. The market price gathers all the demand and supply related information. That also means that buyers and suppliers do not need to invest in information technology such as performance measurement. They can just follow the price to know all the relevant information that is in the market.

Second, an ideal market also provides incentives to the buyer and suppliers. The market is unforgiving in the sense that if a supplier wants to ask a higher price no buyer will be willing to pay that price. If buyers want to pay a lower price, no supplier will be willing to sell. That means that both buyers and suppliers have an incentive to be efficient. If they are inefficient, they are not able to generate a profit at the market price. Again, this means that the buyers do not have to worry about monitoring the suppliers and there is no role for performance measurement. Buyers will only buy a product or service that they need and they only care about the price they are paying.

Transaction Costs in Markets

We see in practice that firms use extensive contracts with their suppliers and with their employees. They set standards, have rule books, try to measure the quality of the work delivered, and the efficiency of work practices. This is because real markets are not perfect markets and these imperfections give rise to transaction costs, which are the costs of ensuring that the market functions.

The story of the mine already reveals some transaction costs in imperfect markets. Not every potential miner has the time to investigate the new land. Some miners might not have the necessary information to value the mine. The landowner might not know how to reach all miners who are interested in exploiting the mine. These types of information and search costs are common transaction costs in markets and they give rise to the need for formal contracts with clauses that reward good performance and penalise delays and bad performance.

Another potential problem in the story of the mine is that the landowner and the miner might need to make initial investments together before they can decide whether they want to respectively buy or sell the mine. For instance, the miner will want to independently investigate how valuable the iron ore and they will hire geologists to assess the mine. The landowner will have to invest in background checks on all potential bidders to make sure that they can actually pay for the mine. The problem is that both parties need to coordinate on these initial investments. If the landowner does not do background checks, the miners will not feel confident that the landowner actually wants to sell the land and they do not want to face the costs of hiring a geologist. If the miners do not invest in a geologist, the landowner does not feel confident that the miners actually want to buy the land and they do not want to invest in background checks. The transaction costs associated with solving these coordination problems are unimaginatively called coordination costs.

A typical solution in markets is that there is third party who is trusted by both parties who will assure that both parties are genuinely interested in the transaction: the buyers can be trusted to pay and the sellers can be trusted to deliver the goods. Exchanges and banks play this role in financial markets and traders pay the exchange or the bank fees for their services. These are transaction costs to solve the coordination problem. In business-to-business markets, companies rely a lot on reputation concerns. An organisation that wants to survive long term cannot be known in the industry for not paying their suppliers or for not delivering goods and services to their customers. The transaction cost is that sometimes you will not get paid as a supplier or you will not get your goods as a customers because the counter party does not care about their reputation because they plan on disappearing with all your money to a subtropical island.

Long-Term Contracts

The Role of Long-Term Contracts

The second blueprint is a long-term contract where two or more different economic parties decide to work together for an extended period of time. In practice, these long-term contracts can take the form of joint ventures, alliances, purchasing agreements, strategic partnerships and many more. The crucial part for our purpose is that both parties remain independent organisations and they plan to interact with each other for an extended period of time.

The critical part of a contract is that it specifies rewards for when the parties completely adhere to their responsibilities and it contains penalties for when the parties do not fulfil their duties. A supply contract typically contains penalties for late delivery and the buyer will need to pay interest on any late payments.

The ability of contracts to specify the parties’ responsibilities creates the opportunity to solve the coordination problems that emerge in markets. The contract can specify which initial actions a buyer and supplier need to take. For instance a supplier of industrial machines will have to invest in a new production technology to produce the customised machines that a new customer wants. Their customer will need to share information about their production process so that the supplier knows what the customer needs. The advantage of the long-term contract is that the buyer and supplier can rely on the contract to be sure that the other party will fulfil their part of the deal. They can write the contract in such a way that the supplier is incentivised to invest in the new technology and the buyer is incentivised to share the information. After signing the contract, either party can be assured that the other will do their part. Specifically, the supplier does not have to fear that they will invest in a costly technology and that the customer will not share the necessary information to do the job. Furthermore, the long-term contract also covers multiple transactions for an extended period of time. This also gives the suppliers more assurance that the customer will reward them for the initial investment in new production technology.

Another type of clause in long-term contracts are stipulations on how the parties will address conflicts when they inevitably arrive. In a long-term contract the parties interact with each other for an extended period and they cannot predict all possible problems that will arise. If both parties agree on how to deal with problems, there is no problem. However, if both parties disagree, they need a mechanism to resolve this conflict. The contract will specify when they can resort to mediation by a third party, renegotiation of the contract, or to the legal system. Conflict resolution in a long-term contract makes sure that the buyer and supplier can adapt the working relationship if the environment or requirements of the task change.

Transaction Costs in Long-Term Contracts and the Role of Performance Measures

The transaction costs of long-term contracts consists of two categories. The first costs are the costs associated with the contract itself and the second ones are the costs of a breakdown in the relation. The first category are obvious contract costs such as lawyers involved in negotiating the contract, the opportunity cost of the time it takes to negotiate the contract, and the information and measures that are needed to determine whether the parties should be rewarded or penalised.

The last example is our first encounter with performance measurement. In the transaction cost view, performance measurement is important because it allows the parties to write a contract that solves the coordination problem. In this view, performance measurement is subject to a cost-benefit analysis. The costs are the time, money, and effort involved in collecting the measures. The benefits are that the measures allow the parties to work together while being assured that the other parties will make the necessary and agreed upon investments in the joint project. This allows the parties to organise economic transactions that would not be possible in the ideal market because of coordination problems.

The second category of transaction costs in the long-term contract are the costs of conflict resolution. In the ideal market, there are no costs of conflict because the only transaction that happens in the ideal market is that the buyer and seller exchange money for goods or services and this is where the relation ends. In the long-term contract, the buyers and supplier keep interacting with each other. They have been able to overcome the coordination problem together and therefore cannot just go to a different partner. They are to some extent dependent on each other. This creates the risk that when the economic environment, such as customer demands or the cost of energy, changes the benefits of working together might change. For instance, the supplier of industrial machines might have to adapt the machine they delivered to new specification by their customer, so that the customer can respond to changing demands from their customers. In some cases, the contract will specify which party is responsible for upgrading the machines and at what cost to the supplier. It is also possible that the changes in the environment were not predicted at the time the contract was signed and the parties need to renegotiate parts of the contract with all the costs that entails. In the most extreme case, the parties will disagree who is responsible for making adjustments or how to continue the relation. They might end up in a legal battle with all the legal costs involved.

The role of performance measurement and collecting information from the environment is to lower the possibility that the changes in the environment are not foreseen in the contract or at least that they do not come as a surprise to the parties. So, another advantage of a good performance measurement and information system is that they help the parties in the long-term contract predict changes that can lead to a conflict in the relation. It gives the parties time to adapt to changes in the environment. Nevertheless, certain economic activities are too unpredictable and require too much coordination and cannot be dealt with efficiently in a long-term contract. For these type of transactions, we need the third blueprint, organisations.

Organisations

The Role of Hierarchical Organisations

Hierarchical organisations are formed to react quickly to changes in the environment when mutual investments are needed and need to be coordinated. In an organisation the buyer and supplier are no longer two different entities. They become one organisation which can take many legal forms but most of the time we will think of them as for-profit corporations. In fact, in an organisation there will often be more than two parties, not just a buyer and a supplier. An organisation has multiple divisions or departments who all need to work together. If a manufacturing firm needs to produce different products in response to changing customer demands, the marketing division needs to collect information on what customers want, the production division needs to adjust the manufacturing process, the purchasing department need to search for new suppliers, and the HR team needs to hire new specialists. The advantage that organisations have is that these actions are coordinated.

The organisation will set-up formal responsibilities and duties to make sure that all necessary actions are taken. Typically, a small group of people, top management, is responsible to ensure that everyone in the organisation fulfils their responsibility. Top management can unilaterally decide to assign duties to different employees, to invest in new technology, or to focus on new customers. They do no need to rewrite a long-term contract to change the course of the organisation. This gives the organisation the flexibility to quickly adapt to changes in the environment.

Organisations have a second function to deal with changes in the environment. Top management can easily resolve conflicts at will in the organisation. If two divisions do not agree on how the organisation should react to changes in the environment, top management can simply tell them what to do. There is no need for time wasting negotiations between the divisions or expensive court cases.

Unfortunately, this flexibility in organisations comes at a cost. All divisions in the organisation know that they are stuck with each other. Together they are creating value by being able to act together in response to changes. That means that no division can be easily replaced and as a result they need to be forgiving of each other when one of them makes a mistake. While markets are unforgiving because every supplier or buyer can easily be replaced, organisations are forgiving. Thus, incentives to perform well are lower in organisations because a division is more likely to not be punished because the other divisions of the organisation need it. To make sure that the divisions work in the best interest of the firm, top management will have to design incentive systems. In transaction cost economics, the role of incentives in organisations is to take over one of the role of prices in markets: motivating the parties involved in the transaction.

Transaction Costs in Hierarchical Organisations

The transaction costs in organisations are the most directly observable costs that we have dealt with so far. The first category of costs are the costs of setting up a bureaucratic system of role descriptions, duties, and budget allocation. These are the costs involved in making sure that top management’s decisions are carried out all throughout the firm. In this category, we will also find a role for cost accounting and measurement of key performance indicators or balanced scorecards. All these tools provide information to top management and allow them to make better decisions. The specific costs can be the cost of collecting data, managing databases, or the cost of the Human Resources department.

The second category of costs are the costs involved in designing rewards and penalty schemes to motivate the divisions and not let them rely on being forgiven for mistakes. The costs involved in these incentive schemes are the same costs of information collection but also the cost that employees will want to be compensated for the risk that their compensation depends on factors beyond their control. I will discuss these last costs further in the chapter on incentives.

The fundamental insight of transaction cost economics is that there is a cost-benefit trade-off for strategic management accounting tools. There is a cost in setting up accounting systems which needs to be weight against the benefits of coordinating different divisions. If the costs are too high to manage the different divisions, the different divisions in the organisation might be better off splitting up and operating as separate entities.

Overview and How To Apply Transaction Cost Economics

The important insight of transaction cost theory is that market, contracts and hierarchical bureaucracies are efficient for different economic transactions. Hierarchical organisations are better at coordinating activities and investments that benefit the organisation as a whole and resolving conflicts within the organisation. The disadvantage of organisations is that they cannot rely solely on market prices to provide information and incentives. Organisations need performance measurement and accounting systems to replace the information and incentives of prices. These systems have their own costs which have to be weighted against the costs of better coordination and better conflict resolution.

As we will see going forward, the role of performance measurement and evaluation systems is to provide information on the environment, the performance of different divisions, and provide incentives, just like ideal markets do. Firms will often outsource some activities to suppliers because they believe that the market is better at evaluating and incentivizing the supplier or they believe it is better to outsource certain activities with a long-term contract. Nevertheless, firms also keep a lot of activities within the firm and strategic management accounting plays an role in coordinating those activities and motivating the divisions.

As we will see further on, transaction cost economics does not capture all important factors to understand the role of strategic management accounting tools. Just like the story of land owner and the mine, transaction cost economics provides a useful, simplified model to help us think about the role of management accounting tools in organisations. I deliberately used blueprints to refer to the different ways of managing economic transactions in transaction cost economics because they should be seen as incomplete representations of real world markets, contracts, and organisations. Real relations between businesses, between employees and employers, or between divisions within a firm might show some elements of each blueprint but often one blueprint will dominate. What will be important for us is that we should be able to realise the transaction costs of managing the relation and that we can compare the benefits of blueprints to their potential costs.

In order to better understand those costs and benefits, in the next section, I turn my attention to two factors that drive the cost-benefit trade-off that favours one blueprint over an other.

The Drivers of Costs and Benefits

Asset Specificity

As I explained above, both markets and organisations ^[2] can adapt quickly to changes in the environment. You might ask yourself what the difference is between the blueprints if they essentially do the same thing well. The difference between markets and organisations is in how they need to respond to changes.

Organisations rely on asset-specific investments which are investments that are only valuable for a specific transaction. For instance a supplier can invest in a technology to improve the quality of the products they produce. If all their current and potential customers are willing to pay more for the improved quality, the technology is general and not specific. The market will reward suppliers who invest in this technology. However, if the improved quality of the products is only relevant for one or two customers, the investment is specific to the relation that supplier has with those customers. There are two reasons why the supplier might not be willing to invest in the technology. The first one is that the supplier needs to invest in the technology before they reap the benefits from higher sales. If the higher sales do not materialise, they are just left with additional costs. The second and related issue is that the customers can not always assess the quality of the product before they use it. If this is the case, they will not be prepared to pay a higher price for the product and thus, the supplier will not want to invest in the technology.

I can make this more concrete with another simple story which we will build on in the following chapters. Imagine that one supplier can make shiny white computers and one buyer can build shops that make shiny white computers look more attractive to consumers ^[3]. If the suppliers sells their white computers to another buyer with another shop, their investment in the production technology for white computers is useless. If the buyer purchases regular grey computers, their investments in lighting for white computer are useless. Based on the price in the competitive market the supplier has no incentive to make the investment in the production technology for white computers. Therefore the buyer has no incentive to invest in lighting for white computer. As I have explained before, it will be beneficial for the supplier and the buyer to write a contract that makes sure that they both invest or they can form a single organisation where top management directs both parties to make the investment.

Uncertainty

The role of uncertainty and unpredictable changes in customer demands or technology has permeated the discussion of transaction cost economics in this chapter. At the end of the chapter, I will clarify some of the more subtle differences I have glossed over. The most obvious place where uncertainty has popped up is that I have defined the benefits of the blueprints in terms of how quickly they can respond to changes in the environment. If the environment never changes and is not expected to change, there is no uncertainty at all.

Uncertainty also showed up as a measurement problem. Top management in an organisation is uncertain about its environment and needs to collect information to decide what the best combination of actions and investments is for the divisions of the firm. Buyers are uncertain about the quality of products delivered and suppliers are uncertain whether a buyer will pay a higher price. In a lot of these cases, we can transform the problem to a risk-benefit trade-off. For instance, the buyer might not be sure about the quality of the product but they can decide that it might still be worth the risk to buy a product. Top management might not be sure that customers want a new product but they can decide it is worth the risk to launch a new product because of the potential sales. One important feature of this type of risk is that it can be minimised by having better measurement systems. Thus, there is a role for performance measurement and information systems to minimise the risk.

The last type of uncertainty is fundamental unpredictability. Some events cannot be predicted and therefor cannot be put as a condition in a long-term contract. In an organisation, unpredictable events lead to conflicts and mistakes. In a fundamentally unpredictable environment, the value of conflict resolution and integration of different perspectives in decision making will be crucial. On the other hand, unpredictability can also break markets if buyers are no longer be assured that suppliers will deliver the goods and services and sellers are not longer sure that buyers will pay. All blueprints can deal with a moderate level of unpredictability but the common view is that organisations at least have the processes in place to deal with completely unexpected events in the form of a group of top managers that can take decisions in the best interest of the firm as a whole.

Summary of the Drivers

The drivers are the factors that determine which of the blueprints is best at adapting to changing environments. Since the focus on this book is on strategic management accounting tools, we are primarily concerned with organisations. This blueprint is best at coordinating a bundle of specific investments that are only valuable within the organisation in an unpredictable environment. In transaction economics, organisations are somewhat of a paradox in that they on the one hand are resilient to change because their value comes from this bundle of investments where all investments are necessary. On the other hand, when necessary they can change quickly because only a handful of top managers need to agree to make the change happen. From a transaction cost economics point of view, the key role of strategic management accounting is to coordinate the bundle of investments and to provide top managers with information on how to adapt to a changing environment.

References

Williamson, O. E. (1979). Transaction-Cost Economics: The Governance of Contractual Relations. The Journal of Law and Economics, 22(2), 233. https://doi.org/10.1086/466942

Williamson, O. E. (1991). Comparative economic organization: The analysis of discrete structural alternatives. Administrative Science Quarterly, 36(2), 269–296. https://doi.org/10.2307/2393356

Williamson, O. E. (2002). The Theory of the Firm as Governance Structure: From Choice to Contract. Journal of Economic Perspectives, 16(3), 171–195. https://doi.org/10.1257/089533002760278776