Economic Foundation of Strategy – Transaction Cost Theory
Fall 2011
Contractual Commitments, Bargaining Power, and
Governance Inseparability:
Incorporating History into Transaction Cost Theory
Argyres & Liebeskind (1999)AMR, 24(1): 49-63
Presented by Pei-Li Yu, Qing Yang
Sept. 1st, 2011
Abstract
The authors argue that the following conditions
made by a firm can limit its ability to
differentiate or change its governance
arrangement in the future--- a condition they
term governance inseparability.
1.prior contractual commitments
2. changes in bargaining power between a firm
and its exchange partners
Motivation
TCE theory: An individual transaction is the unit of analysis for
predicting organizational form(Williamson, 1985)
What’s a contract: (the function)
TCE Theory:
To enforce exchange(s) = (contractual commitment)
To deter the opportunism
Long-term contracts (replace short-term’s)save the TC
It is as a governance mechanism!
3
Motivation -2
However, the authors think:
1.Focusing on the characteristics of isolated transactions can be insufficient to
explain the scope of the firm:
Reasons: New transaction linked inseparably with the governance of other transactions
costly or infeasible together(governance inseparability)
constrain a firm’s governance option in two ways:
(1) switching (same type of transactions)
(2) governance differentiation (use an existing governance arrangement for a new
transaction)
help to explain the limits to firm scope(too costly to internalize a given transaction)
2. To extend TCE theory: by incorporating two factors that serve to produce
governance inseparability:
–Contractual commitments (past history)
–Changes in bargaining power (employees, suppliers or customers)
They are costly!
4
Main Argument
Organizations in general, and firms in particular,
will demonstrate “weak-form path dependency”;
therefore, transaction costs can be only “limited
efficient”, due to the constraint imposed by
governance inseparability.
Refer to: Liebowitz&Margolis(1995)
Weaker form of path dependence(first- and second-degree): they
are commonplace, and they offer little in the way of an objection
to the neoclassical paradigm.
Key concepts
Governance Inseparability
A condition in which a firm’s past governance
choices significantly influence the range and
types of governance mechanisms that it can
adopt in future periods.
Key concepts
-2
• Governance Switching:
A firm cannot efficiently enter into a
governance arrangement of Type Y in future
periods for a particular transaction because it
already has a governance arrangement of Type
X in place with another party for that
transaction.
Key concepts -3
• Governance Differentiation:
A firm is obligated to enter into a governance arrangement of
Type X with one party because it already has a governance
arrangement of Type X in place with another party.
• Contractual Commitment:
An agreement between two or more parties that is binding
on those parties, to the degree that to renege on the agreement
will be costly.
• Bargaining Power:
The ability of one party to a contract to be able to influence the
terms and conditions of that contract or subsequent contracts in
its own favor.
Theory
1. Contractual Commitments
*Governance
Switching
-
-
Governance Inseparability
*formal contracts(union wage agreement)
*informal or nonlegally contracts
(self-bonding; social contracts)
-
2. Changes in Bargaining Power
*Governance
Differentiation
-
Contractual Commitments and Constraints on
Governance Switching:
Same type of transaction
Firm A
Transaction
Governance Arrangement X
(future)
Cases and Examples:
Franchising agreements(Coca-Cola)
Governance Arrangement Y
Contractual Commitments and Constraints on
Governance Differentiation
New transactions
(internal) Transaction 1
Firm A
Governance
Arrangement X
(internal) Transaction 2
Existing governance arrangement
Governance
Arrangement Y
Cases and Examples:
credible commitments to New venture units
(internal) Transaction 3
Bargaining Power and Constraints on Governance
Switching
B
S
Contract
The governance options for S
for some of its transactions
are constrained
Buyer B increase its bargaining
power over Seller S.
 prevent S from forward
integrating into its own business,
forcing S to continue to sell across
markets rather than to integrate
vertically.
◇Unionized labor uses its bargaining power to restrict outsourcing (UAW: United Auto
Workers).
◇Franchising (Meineke Mufflers Dealers Association; Naugles, Inc.: unable to
open a new franchise close to an existing one since the increases in franchisees’
bargaining power)
Bargaining Power on Governance Differentiation
◇Three major US long-distance trucking firms (Yellow Corp., Consolidated, and
Roadway); US airline industry.: union( or pilots) bargaining power prevented a
firm from carrying out a change in organization that it was seeking.
Is Governance Inseparability Avoidable?
• The answer is NO.
Reasons:
Contractual Commitments:
1. Firms cannot exist efficiently without commitments
2. Contractual commitments are necessary for a firm to earn economic rents.
Changes in Bargaining Power:
1. Due to the large number of interrelated factors that affect the relative power of
contracting parties, changes in bargaining power are difficult to foresee.
2. These changes may occur very gradually over long periods of time so that their
future importance is difficult to perceive.
Some Implications of Governance Inseparability
• Use of Alternative Governance Mechanisms
-1
B
S
Contract 1
But, the
meaning?
Contract
2
2a: older firms tend to be more
encumbered with past
commitments;  market
contracting?
2b: with internal parties
outsource activities limited(for that
not involve firm-specific goods or
assets!
(hierarchical mechanisms?)
Some Implications of Governance Inseparability
• Use of Alternative Governance Mechanisms
-2
The examples:
Germany and France, accord greater bargaining power to
labor unions that do other country.
Some Implications of Governance Inseparability
-2
Limit to Firm Scope
P5. Optimal scope of a firm under
different level of uncertainty:
internationalization may be highly
inefficient (switching，differentiation)
P4. A third answer to Coase’s(1937) main concerns the limits to the size and the
scope of a firm. <<(1) firm size   incentives(within firms) (Williamson,
1985);(2)firms, precisely because they are organized as hierarchies, promulgate
influence activities by managers incur costs that markets avoid>>
Governance Inseparability:
Implications
1. Contractual Commitments
*formal contracts(union wage agreement)
*informal or nonlegally contracts
(self-bonding; social contracts)
+
*Governance
Differentiation
+
-
*Governance
Switching
-
Governance Inseparability
-
2. Changes in Bargaining Power
*identical transactions in
different way (p1)
*market contracting(p2)
*hierarchical mechanisms:
labor union (p3)
*costly internalizing (p4)
*reduce the vertical and
horizontal scope of
firm(p5)
-
Some Implications of Governance Inseparability
-2
Competition and Industry Evolution:
◆competition: lock-in results is from contractual
commitments
△Organizational inertia
◆Industry Evolution: (Population ecologists v.s.
Evolutionary economists): a moderated view of inertia; organizations
will be inert according to the degree that the contractual commitments they entered
into in earlier periods constrain their subsequent governance options
△ weak-form path dependency(history matters): howwever, histroy is
important only because the sequence of events determines current
values(Liebowitz&Margolis, 1995)
We submit:
Q1. The main rationale of this article: most firms will become constrained over
time by their existing arrangements in place, which will limit both their scope and
their strategic flexibility
◇TCE: (long-term) contract makes both firms adapted effectively (Williamson, 1985)
◇ Social Views: e.g. Social mechanism: social norms(Joshi & Arnold, 1997;
Clan(Ouchi, 1980); mutual trust (Dyer & Chu, 2003;Hedlund, 1994) can help both
firms adaptive better
Q2: Any new transaction in which a firm may seek to engage may become linked
inseparably with the governance of other transactions in which the firm is already
engaged.
◇The example (proof)??? Firm might govern the contracts based on prior
experience (history..etc)(governance inseparability), but any individual contact can
be signed independently.  the characteristic of the transactions v.s. governance
inseparability  relevance, but…
Q3: firms may be constrained in their choice of governance mechanisms by past
governance mechanisms
◇contradictory; organization learns (by doing)
Q4: historical constraints???
◇ Increasing relationship duration development better mutual understanding
(Schreiner et al., 2009)
Thank you for your listening!