Jonathan D. Wareham wareham@acm.org

 Transaction Cost Economics
 Virtual Companies & formation of firm boundaries
Markets
Networks
Firms
Agents
 Economic Theory : Boundary of the firm

Sun Microsystems, Inc.



Sun Microsystems, a leading maker of computer workstations, concentrates on hardware and software design, where it distinguished itself from competitors, and outsources nearly everything else in its value chain
It relies so heavily on external manufacturers and distributors that its own employees never touch one of its top selling products
After a vendor assembles the machine, another contract supplier delivers it to the customer

"...the majority of the activities of the firm are contracted or outsourced."
This allows the firm to focus on its strategic, core processes ( core competencies )

Dispersed management
Dispersed employees
Dispersed customers
Dispersed partners
Dispersed suppliers

 In 1958 the Harvard Business Revenue predicted that computers would lead to a greater concentration of power in
American business because they would allow bosses to keep better track of information within large firms. Eventually, it predicted that the economy would be dominated by a few giants. In 1967 economist J.K. Galbraith argued that new technology would inevitably lead to increasing dominance by big corporations immune to market forces.
 These predictions have turned out wrong: the average size of firms has shrunk and competition has decreased since
1960’s. Recent research suggests that the economy is beginning a transition from large, vertically integrated enterprises to organizational forms that draw on resources of small, independent specialists suppliers. For example, in a study of 549 large firms, increased use of IT has found to be associated with substantial decreases in firm size and diversification.




Procure inputs in the least cost manner
Costs
Provide incentives for workers to put forth effort
$100
80
Failure to accomplish this results in a point like A
0
A
B
$10
C(Q)
Output

 Spot Exchange
 When the buyer and seller of an input meet, exchange, and then go their separate ways.
 Contracts
 A legal document that creates an extended relationship between a buyer and a seller.
 Vertical Integration
 When a firm shuns other suppliers and chooses to produce an input internally.

Knight (1921) Why don’t we have one big firm?
possibility of monopoly rents motivates continuous and unlimited expansion of firms, But we do not always see it.
There must be offsetting mechanisms.

Why do we have firms?
there must be some cost in using the price mechanism.
• Price discovery/search costs
• Contract negotiation
• Long term stability of supply sources
(uncertainty)
Ergo, operation of the market costs something, and by forming and organization and letting some authority to allocate resources, some costs are saved

 Transactions vary in nature and dimension, and will align themselves with the governance mechanisms which manages these transactions most efficiently.
 Size of firm increases until additional rent gained by bringing transaction in house is superceded by cost of bringing it in. That is, it has to be more costly on the market
 Coase theorem: Efficiency determines organizational structure

 Price determination
 Details of transaction
 Disclose existence of buyers and sellers to execute transactions
 Search prices or quality control
 Compiling and transferring information

 Specificity
 Frequency
 Duration
 Complexity
 Uncertainty
 Difficulty of measuring performance
 Connectedness

 Investments made to allow two parties to exchange but has little or no value outside of the exchange relationship
 Site specificity
 Physical-asset specificity
 Dedicated assets
 Human capital
 Lead to higher transaction costs and the problem of “hold-up”

No
Substantial specialized investments relative to contracting costs?
Yes
Spot Exchange
Contract
No
Complex contracting environment relative to costs of integration?
Yes
Vertical
Integration

 Internal: cost of communication and coordination “reduced returns to management”
 External: Costs of using market
 Balance:
 Internal
 External
 Economies of scale - keep firms at given size,

 Price determination
 Details of transaction
 Disclose existence of buyers and sellers to execute transactions
 Search prices or quality control
 Compiling and transferring information

 Specificity
 Frequency
 Duration
 Complexity
 Uncertainty
 Difficulty of measuring performance
 Connectedness

 Investments made to allow two parties to exchange but has little or no value outside of the exchange relationship
 Site specificity
 Physical-asset specificity
 Dedicated assets
 Human capital
 Lead to higher transaction costs and the problem of “hold-up”

No
Substantial specialized investments relative to contracting costs?
Yes
Spot Exchange
Contract
No
Complex contracting environment relative to costs of integration?
Yes
Vertical
Integration

Frequency
Occasional
Recurrent
Non specific
Purchasing
Standard
Equipment
Investment Characteristics
Mixed
Purchasing
Customized
Equipment
Idiosyncratic
Constructing a Plant
Purchasing
Standard
Material
Purchasing
Customized
Material
Site-Specific
Transfer of
Intermediate Product
Across Successive
Stages

Frequency
Occasional
Recurrent
Non specific
Investment Characteristics
Mixed Idiosyncratic
Trilateral Governance
(Neoclassical Contracting)
Market
Governance
(Classical
Contracting)
Bilateral
Governance
Unified
Governance
(Relational Contracting)

Frequency
Occasional
Standard
Standard Equipment
Machinery, PCs, Automobiles
Markets
Once off negotiated transaction
Frequent
Specificity
Medium
Customized Equipment
Machinery requiring some custom config.
Company to company negotiation
Semi-complex contracts
High
Constructing a plant
Turn-key projects
Company to company negotiation
Very complex contracts/government regulation
Standard Raw Material
Sugar, RAM chips, Steel
Markets
Contracts short to medium term
I year supplier: price based on index
Customized Material
Raw mat. with special process unique to customer
Value adding processes as specific site production processes within one or several factories within same location/proximity
Joint ventures, transfer of equity
Long-term binding contracts with significant investment
Hierarchies
Internal integration/ vertical conglomerate

 Internal: cost of communication and coordination “reduced returns to management”
 External: Costs of using market
 Balance:
 Internal
 External
 Economies of scale - keep firms at given size

 You are a principal in a high tech start-up with
70m in funding and a rapidly growing customer base. Your business model has been tested in several pilot markets and the board has given the green light to scale up from 2 to 10 markets. This will make significant scalability demands of your
IT function that, up to now, you have grown internally. At a management meeting the chairman - in a deep, serious tone – commands:
“it’s your call
(insert your name here)
. What do you recommend?“

 Use the tools provided by TCE to evaluate the following alternatives:
1.
Full outsourcing
2.
Partial outsourcing (specify what functions)
3.
Internal integration

1.
Specificity
2.
Frequency
3.
Duration
4.
Complexity
5.
Uncertainty
6.
Performance measurement
7.
Connectedness
8.
Search Costs
9.
Price Determination
10.
Quality Monitoring

Markets
Hierarchies
Production
Costs
Low
High
Coordination
Costs
High
Low

Hierarchy
Market
Asset specificity

eBusiness

eBusiness

Bird’s eye coordination
Centralized
Decision
Information
Costs
Agency
Costs
Decentralized
Local information
Where combined costs (Int CC) are minimized

Hierarchical Coordination
Agency Monitoring costs
Costs Bonding costs
Residual loss Internal
Coordination
Costs Decision Information processing costs
Information Communication
Costs Documentation
Opportunity costs due to poor information

External
Coordination
Costs
Market Coordination
Search costs
Transportation costs
Operational Inventory holding costs
Communication costs
Costs of writing contracts
Costs of enforcing contracts
Contractual

Transaction
Costs
Total Cost
Optimal Firm
Size
Internal
Coordination &
Operations
Costs

Definition of Outsourcing
Outsourcing = purchase
...of an externally produced good or service
...that was previously internally produced

Definition of Outsourcing
Out
In

IBM
Computer
Associates
Outsourcers: Who?
AT&T
Lotus
Compaq
MCI
Peachtree
Software
Bell
South

Factors Favoring Outsourcing




Need for organizations to focus on their strategic assets or core competencies
Realization of greater economies (lower costs)
Need for greater flexibility and expertise in workforce
Bandwagon effect

Factors Favoring Outsourcing
 Managers can and should make use of two kinds of arguments in their case for (or against) outsourcing
(bandwagon reasoning is not a defensible managerial decision!)



Need for organizations to focus on their strategic assets or core competencies
Realization of greater economies (lower costs)
Need for greater flexibility and expertise in workforce

Factors Favoring Outsourcing
 Outsourcing makes available to the organization the value-added specialized knowledge that the outsourcer-agent brings to the transaction Specialization of Labor

Factors Favoring Outsourcing
 Bandwagon effect
"Everyone else is doing it and we'll look like we are not with it if we don't too."
(...in academese,
mimetic or imitative behavior)

Factors Against Outsourcing





Loss of strategic assets
Do not realize greater economies
(actually higher costs!)
Lose "loyal" workforce
Cannot readily access or utilize increased systems expertise
Loss of one's own sense of mission in the bandwagon

Factors Against Outsourcing
 Loss of strategic assets
Certain Web applications represents the ability of the firm to lead the industry and thereby to change the structure of the industry; should that strategic asset be traded away or lost control of?

Factors Against Outsourcing
 Higher costs result
Vendors argue that they can recapture scale, but if the contract overly favors the outsourcer, the organization may pay more than if the function were insourced
Also, transaction costs need to be subtracted from production cost advantages lest estimates be unrealistic

Given a positive financial assessment:
Is the Web system or service being considered.....
No
A Core
Competency/
Strategic Asset?
Yes
Consider Inhouse Bids vs.
Outsourcer Bids
Most Likely to
Outsource
Retain In-house
If Outsource,
Legal
Protections
Critical
Yes No
Does Firm Have Internal Expertise?

 A tale of 2 companies….

 Sell 50,000 computers with only 4 days of inventory
 Keep few suppliers very close
 30 suppliers 75% of materials
 When order is made, signal is sent to supplier, 90 minutes later, supplies are delivered to Dell.
 “We sell what we have, we don´t sell what we don´t have”

 Have as few suppliers as possible
 In real time, communicate your inventory levels and replenishment needs to them
 Order from suppliers only when you receive demand from customers.

VARS
Manufacturers
Wholesalers/Distributors
End Users

 Avoiding the Risks…
 Assets & Inventory
 Accounts receivable
 Use technology to bring benefits of vertical coordination to the network

 Darling of stock market.
 First Virtual company
 No inventory, no warehouses
 But what happened…..

 Bringing vertical coordination to the network… but how?

Hierarchy
Market
Asset specificity

 Your firm is considering outsourcing its IT function. Use Transaction Cost
Economics to help you evaluate this decision.
 What important factors are not addressed in a Transaction cost perspective ?