Transaction Cost Theory
82 PART 1 • THE ORGANIZATION AND ITS ENVIRONMENT
In these environmental conditions, it is easy for organizations to negotiate and moni- tor interorganizational behavior. Thus, in a low-transaction-cost environment, organiza- tions can use relatively informal linkage mechanisms, such as reputation and unwritten, word-of-mouth contracts.
Transaction costs increase when these conditions exist:
1. Organizations begin to exchange more specific goods and services. 2. Uncertainty increases.
3. The number of possible exchange partners falls.
In this kind of environment, an organization will begin to feel it cannot afford to trust other organizations, and it will start to monitor and use more formal linkages, such as long-term contracts, to govern its exchanges. Contracts, however, cannot cover every situ- ation that might arise. If something unexpected happens, what will the other party to the exchange do? It has a perfect right to act in the way that most benefits itself, even though its actions are harmful to the other organization.
How does an organization act in a high-transaction-cost situation? According to transaction cost theory, an organization should choose a more formal linkage mechanism to manage exchanges as transaction costs increase. The more formal the mechanism used, the more control organizations have over each other’s behavior. Formal mechanisms in- clude strategic alliances (joint ventures), merger, and takeover, all of which internalize the transaction and its cost. In a joint venture, two organizations establish a third organi- zation to handle their joint transactions. Establishing a new entity that both organizations own equally reduces each organization’s incentives to cheat the other and provides in- centives for them to do things (e.g., invest in specific assets) that will create value for them both. With mergers, the same arguments hold because one organization now owns the other.
From a transaction cost perspective, the movement from less formal to more formal linkage mechanisms (see Figures 3.3, 3.4, and 3.7) occurs because of an organization’s need to reduce the transaction costs of its exchanges with other organizations. Formal mechanisms minimize the transaction costs associated with reducing uncertainty, oppor- tunism, and risk.
Bureaucratic Costs
If formal linkage mechanisms are such an efficient way to minimize the transaction costs of exchanges with the environment, why do organizations not use these mecha- nisms all the time? Why do they ever use an informal linkage mechanism such as a con- tract if a joint venture or a merger gives them better control of their environment? The answer is that bringing the transactions inside the organization minimizes but does not eliminate the costs of managing transactions.51Managers must still negotiate, monitor,
and govern exchanges between people inside the organization. Internal transaction costs are called bureaucratic costs to distinguish them from the transaction costs of ex- changes between organizations in the environment.52We saw in Chapter 2 how difficult
communication and integration between functions and divisions are. Now we see that integration and communication are not only difficult to achieve but cost money be- cause managers have to spend their time in meetings rather than creating value.53Thus
managing an organization’s structure is a complex and expensive problem that be- comes much more expensive and complex as the organization grows—as GM, Kodak, and IBM discovered.
Using Transaction Cost Theory to Choose an Interorganizational Strategy
Transaction cost theory can help managers choose an interorganizational strategy by en- abling them to weigh the savings in transaction costs achieved from using a particular linkage mechanism against the bureaucratic costs of operating the linkage mechanism.54 Because transaction cost theory brings into focus the costs associated with different link- age mechanisms to reduce uncertainty, it is able to make better predictions than is resource dependence theory about why and when a company will choose a certain
CHAPTER 3 • ORGANIZING IN A CHANGING GLOBAL ENVIRONMENT 83
interorganizational strategy. Managers deciding which strategy to pursue must take the following steps:
1. Locate the sources of transaction costs that may affect an exchange relationship and decide how high the transaction costs are likely to be.
2. Estimate the transaction cost savings from using different linkage mechanisms. 3. Estimate the bureaucratic costs of operating the linkage mechanism.
4. Choose the linkage mechanism that gives the most transaction cost savings at the lowest bureaucratic cost.
The experience of the Ekco Group of Nashua, New Hampshire, offers an interesting example of how a supplier can use a linkage mechanism to reduce transaction costs for cus- tomers to gain their support. Ekco makes a wide range of bakeware products, kitchen tools and equipment, household plastic products (such as laundry baskets), and pest-control de- vices.55It produces thousands of nonelectric consumer and office products that require no assembly and are replaced rather than repaired when they wear out. Ekco’s wide product range reflects the needs of retail customers like Walmart and Kmart, which are continually trying to reduce the transaction costs associated with obtaining products. Obtaining a wide range of products from one supplier reduces the transaction costs associated with building many supplier relationships. By offering a broad range of products that Kmart, Walmart, and others are interested in carrying, Ekco helps the retailers minimize the number of com- panies they must go to for the products they want to carry. In this way, Ekco is implicitly inviting customers to increase their links with Ekco.
To foster long-term commitment and trust with its customers, Ekco installed a state- of-the-art $4 million data-processing system (a specific asset) that allows it to provide a just-in-time inventory service to retailers who supply the company with data. This system simplifies retailers’ ordering and tracking of their inventory. By managing customers’ transactions at no cost to them, the system further reduces the retailers’ transaction costs with Ekco and strengthens their perception that it is a good company to do business with. Ekco’s attempt to develop informal linkage mechanisms with its customers paid off, and sales to its major customers increase every year.56Ekco and its customers jointly benefit from close personal ties, and there is no need for formal and expensive mechanisms to co- ordinate their interorganizational exchanges.
The implication of a transaction cost view is that a formal linkage mechanism should be used only when transaction costs are high enough to warrant it. An organization should take over and merge with its suppliers or distributors, for example, only if the sav- ing in transaction costs outweighs the costs of managing the new acquisition.57 Otherwise, like Ekco and its customers, the organization should rely on less formal mechanisms, such as strategic alliances and long-term contracts, to handle exchange rela- tionships. The relatively informal linkage mechanisms avoid the need for an organization to incur bureaucratic costs. Three linkage mechanisms that help organizations to avoid bureaucratic costs while still minimizing transaction costs are keiretsu, franchising, and outsourcing.
KEIRETSU The Japanese system of keiretsu can be seen as a mechanism for achieving the benefits of a formal linkage mechanism without incurring its costs.58The policy of owning a minority stake in its suppliers’ companies gives Toyota substantial control over the exchange relationship and allows it to avoid problems of opportunism and uncertainty with its suppliers. Toyota also avoids the bureaucratic costs of actually owning and managing its suppliers. Indeed, keiretsu was developed to provide the benefits of full ownership without the costs.
In contrast, until 2005, GM used to own more suppliers than any other car manufac- turer, and as a result it paid more for its inputs than the other car companies paid for theirs. These high costs arose because GM’s internal suppliers were in a protected situa- tion; GM was a captive buyer, so its supplying divisions had no incentive to be efficient and thus behave opportunistically.59
So what should GM do to reduce input costs? One course of action would be to divest its inefficient suppliers and then establish strategic alliances or long-term contracts