Economics and Organisation Theory
A brief introduction to what i am studying. Please avoid reading if you were trying to enjoy your holiday.
Throughout the study of organisation theory, economics played little part of it until Oliver Williamson came up with some theories involving transaction cost. Organisation theory is the study of how organisation structure itself, how it comes about, its existence and its demise. For this part of the theorem (among many others), economics tried to explain the perennial question of "why firms exist?"
Ronald Coase, more famous for his Coase-Theorem in microeconomics (studied last year), used his point of view as an economist to offer an explanation for the existence of firms. Markets offer mechanisams to ensure an optimal efficient allocation of resources between buyers and sellers, a process of negotiation which only stops at the effecient point actually. Firms, however, applied different principles of allocation, directed by a management hierarchy. The management decided what was required and goes into the supply market in search of the lowest cost supplier. Based on coase theroem then, institution of firm should not have arisen since allocation is by hierachy and not by market.
Oliver Williamson then skips along the playground and offered his share of explanation.
Williamson explained that a transaction occurs when "a good or service is transferred across a technologically separable interface" (Williamson, 1994). He furthered identified three different types of governance structures - market, hybrid and hierarchy structures. Market structure is one where the nature of competition is perfect and goods and services are exchanged at their production costs (i.e. a dream). However, transaction (as correctly identified by Williamson), is not cost-less and hence the varying level of transaction cost leads to the different governance structure. Note that the firm is fluid in structural nature, in the sense that the firm may move from market structure to hybrid and then back to market or hierarchy structure depending on the environment.
Transaction costs arises due to three main reasons - boundedly rationality, opportunism and asset specificity.
People are boundedly rational and hence face incomplete information which under normal circumstances pose no immediate problems. However, in a highly complex and uncertain transaction, the incomplete information affects the cost. To specify contractual specifications, plenty of negotiation (ex ante bargaining for that before the contract is signed) and hence effort is needed, increasing the cost of both parties. Ironically, this undermines the key characteristics of market contracting which are speed and flexibility.
Opportunism occurs "when a person acts to deceive or cheat the other" and is controlled by market machanisms where there are large numbers of buyers or sellers. People learn from their experience and will not engage (duhz) with a person who continually cheats (except for certain fools). However, when the market is characterised by small numbers, the opportunist is harder to control since the buyer is dependent on the seller. Thus the buyer is risking opportunism when entering a market of small numbers and seeks to bind the seller to a transaction (by means of a legal contract) which further introduces cost to the transaction.
Asset specificity increases the transaction cost. In certain cases, the buyer requires something specific in nature from the seller which cannot be used for any other purposes. The seller risks providing the specific goods or services as they have no use should the buyer takes the business elsewhere. To reconcile their interest, the two parties engages in detailed contracts for the supply of the otherwise useless asset. Once again, transaction costs increase.
Hybrid governance involves "creation of long-term contractual relationships between buyers and sellers", which inherently seeks to inhibit opportunism and enhance co-operation. Inter-firm networks, "systems of relations between groups of firms that go beyond simple market exchanges and enable organisations to enter into long term relational contracting without the fear of suffering opportunism", are developed as a result.
In a inter-firm network, the co-operation discourage opportunism and encourage the investment in specific assets. Furthermore, it avoids the creation of hierarchy which allows for the retaining of some market incentives and flexibility. However, this only works when the firms in question no longer feel threatened by opportunism.
Although networks appears to be an improved efficiency over markets and hierarchies, this economising view underplays the significance of institutional factors such as duties of responsibilities and trust towards other. For example, firms in Japan operate on basis of trust and forms networks without contracting while in Germany and Denmark, well recognised legal and reputaional factors act to inhibit opportunism instead of contracts. Thus hybrid structures can vary in their form, depending on their institutional environment. As conditions changes, hybrids may move back to markets (long-term contracting too expensive to sustain) or move into hierarchies in order to take ownership of the other members (when opportunism resurfaces).
Hierarchies enable the reduction of all types of transaction costs as they are brought inside the firm and subjected to management's control and monitoring. Several advanatges arises due to this form of governance structure. First, as mentioned, transaction costs are reduced. Secondly, hierarchies enable easy coordination across transaction boundaries inn complex and interdependent production processes. Thirdly, hierarchies are better at handling risk and uncertainty in the market.
Due to the huge size of the structure, hierarchies are traditionally slower to response to the market. Also, they lack high-powered incentives to force the structure to be more efficient. In order to counteract this, Williamson provided a justification by borrowing Sloan's theory on M-form and suggested that the divisions within the structure can be managed according to targets, resources and investments go to units with high profit growth and those failing to meet the targets are wounded up.
In addition, the principal-agent problem bugs the hierachy structure as the ownership is separated from the control. Managers, who are not under complete supervision of the owners, may act in the interest of growth and stability rather than increasing the wealth of shareholders. To curb the problem, there have been managerial compensation schemes such as performance-related pay or stock options to align the interests of the managers and the owners. Furthermore, in view of possible takeover or acquisition by other firms (which will inevitably lead to the loss of managerial positions), they managers are forced to improve efficiency and firm value.
WHO the hell is interested in the above. I'm more than willing to pass you my book and notes after my exams. =|
Throughout the study of organisation theory, economics played little part of it until Oliver Williamson came up with some theories involving transaction cost. Organisation theory is the study of how organisation structure itself, how it comes about, its existence and its demise. For this part of the theorem (among many others), economics tried to explain the perennial question of "why firms exist?"
Ronald Coase, more famous for his Coase-Theorem in microeconomics (studied last year), used his point of view as an economist to offer an explanation for the existence of firms. Markets offer mechanisams to ensure an optimal efficient allocation of resources between buyers and sellers, a process of negotiation which only stops at the effecient point actually. Firms, however, applied different principles of allocation, directed by a management hierarchy. The management decided what was required and goes into the supply market in search of the lowest cost supplier. Based on coase theroem then, institution of firm should not have arisen since allocation is by hierachy and not by market.
Oliver Williamson then skips along the playground and offered his share of explanation.
Williamson explained that a transaction occurs when "a good or service is transferred across a technologically separable interface" (Williamson, 1994). He furthered identified three different types of governance structures - market, hybrid and hierarchy structures. Market structure is one where the nature of competition is perfect and goods and services are exchanged at their production costs (i.e. a dream). However, transaction (as correctly identified by Williamson), is not cost-less and hence the varying level of transaction cost leads to the different governance structure. Note that the firm is fluid in structural nature, in the sense that the firm may move from market structure to hybrid and then back to market or hierarchy structure depending on the environment.
Transaction costs arises due to three main reasons - boundedly rationality, opportunism and asset specificity.
People are boundedly rational and hence face incomplete information which under normal circumstances pose no immediate problems. However, in a highly complex and uncertain transaction, the incomplete information affects the cost. To specify contractual specifications, plenty of negotiation (ex ante bargaining for that before the contract is signed) and hence effort is needed, increasing the cost of both parties. Ironically, this undermines the key characteristics of market contracting which are speed and flexibility.
Opportunism occurs "when a person acts to deceive or cheat the other" and is controlled by market machanisms where there are large numbers of buyers or sellers. People learn from their experience and will not engage (duhz) with a person who continually cheats (except for certain fools). However, when the market is characterised by small numbers, the opportunist is harder to control since the buyer is dependent on the seller. Thus the buyer is risking opportunism when entering a market of small numbers and seeks to bind the seller to a transaction (by means of a legal contract) which further introduces cost to the transaction.
Asset specificity increases the transaction cost. In certain cases, the buyer requires something specific in nature from the seller which cannot be used for any other purposes. The seller risks providing the specific goods or services as they have no use should the buyer takes the business elsewhere. To reconcile their interest, the two parties engages in detailed contracts for the supply of the otherwise useless asset. Once again, transaction costs increase.
Hybrid governance involves "creation of long-term contractual relationships between buyers and sellers", which inherently seeks to inhibit opportunism and enhance co-operation. Inter-firm networks, "systems of relations between groups of firms that go beyond simple market exchanges and enable organisations to enter into long term relational contracting without the fear of suffering opportunism", are developed as a result.
In a inter-firm network, the co-operation discourage opportunism and encourage the investment in specific assets. Furthermore, it avoids the creation of hierarchy which allows for the retaining of some market incentives and flexibility. However, this only works when the firms in question no longer feel threatened by opportunism.
Although networks appears to be an improved efficiency over markets and hierarchies, this economising view underplays the significance of institutional factors such as duties of responsibilities and trust towards other. For example, firms in Japan operate on basis of trust and forms networks without contracting while in Germany and Denmark, well recognised legal and reputaional factors act to inhibit opportunism instead of contracts. Thus hybrid structures can vary in their form, depending on their institutional environment. As conditions changes, hybrids may move back to markets (long-term contracting too expensive to sustain) or move into hierarchies in order to take ownership of the other members (when opportunism resurfaces).
Hierarchies enable the reduction of all types of transaction costs as they are brought inside the firm and subjected to management's control and monitoring. Several advanatges arises due to this form of governance structure. First, as mentioned, transaction costs are reduced. Secondly, hierarchies enable easy coordination across transaction boundaries inn complex and interdependent production processes. Thirdly, hierarchies are better at handling risk and uncertainty in the market.
Due to the huge size of the structure, hierarchies are traditionally slower to response to the market. Also, they lack high-powered incentives to force the structure to be more efficient. In order to counteract this, Williamson provided a justification by borrowing Sloan's theory on M-form and suggested that the divisions within the structure can be managed according to targets, resources and investments go to units with high profit growth and those failing to meet the targets are wounded up.
In addition, the principal-agent problem bugs the hierachy structure as the ownership is separated from the control. Managers, who are not under complete supervision of the owners, may act in the interest of growth and stability rather than increasing the wealth of shareholders. To curb the problem, there have been managerial compensation schemes such as performance-related pay or stock options to align the interests of the managers and the owners. Furthermore, in view of possible takeover or acquisition by other firms (which will inevitably lead to the loss of managerial positions), they managers are forced to improve efficiency and firm value.
WHO the hell is interested in the above. I'm more than willing to pass you my book and notes after my exams. =|
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