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Name Sankha Chatterjee Student number 8293666 Assignment Reference GA_ME/May12/1

Classical economic theory always viewed the market as the most efficient co-coordinator of the economic transactions. Ronald Coase (1937) however challenged the traditional view on the market competitiveness by introducing the theory of Transaction Cost Economics (TCE) that strives to answer the question - how is it determined that a vertical chain activity will be performed by the market or the firm. A vertical chain consists of all the activities that are performed in the production of a good or service. The central issue of TCE theory is whether a transaction is more efficiently performed within a firm (vertical integration) or outside it, by autonomous contractors (market). I will analyse vertical boundaries of my firm Secure Meters Limited by evaluating the make or buy decision of the value chain activities. We are a leading manufacturer of electronic energy meters and Smart Meters for monitoring and managing electric and gas consumption in domestic and industrial applications. There is a nexus of contracts in Secure Meters between its employees, suppliers and customers which leads to agency relationships and extensive coordination.

The operating problem of TCE theory was resolved by Williamson in his book Markets and Hierarchies, where he based TCE on two behavioral assumptions - bounded rationality (individuals behave rationally bounded by the limited information they have access to) and opportunistic behavior (possibility of parties in a bilateral relation resorting to self-interest). Asymmetric information leads to opportunism, the less informed side strives to find more information that leads to transaction costs. In Williamsons view, if agents are trust worthy, comprehensive contracting can be achieved. However opportunism leads to costly contractual breakdowns as they adversely affect ex ante investment incentives and the efficiency of ex post performance. Hence, many organisations spend considerable amount of money towards professional fees on specialised organisations for their advice while drawing up complex, high-value contracts to protect themselves from unforeseen risks and often this cost is a significant proportion of the overall contract value. Williamson also talked about various dimensions of transactions in terms of - asset specificity, uncertainty and frequency. Asset specificity arises when an investment has been specialised for a particular transaction. Assets that are highly specific are likely to have almost zero other usage. Hence the imminent desire to protect the investment and alleviate risk of asset specificity pushes the TC so high that the firm loses its price competitiveness in the market. For example, many car ancillary companies set up their manufacturing facilities around a large car manufacturer with an aim to cater to it. Their products are meant for that car manufacturer only, which means these companies face a major hold up risk. Organisations try to neutralise the uncertainty as much as possible by attaching a price to it which also adds to the transaction 1

Name Sankha Chatterjee Student number 8293666 Assignment Reference GA_ME/May12/1 cost. Another important dimension of transaction cost is environmental variability and behavioural uncertainty (Rindfleisch and Heide, 1997); as uncertainty increases so does the transaction cost of governance. Frequency of transactions is another important element of TCE; one off transactions does not result into higher transaction costs. However, very frequent transactions increase the monitoring and management cost and firms preference, therefore, is to make rather than buy.

The transaction costs cannot be easily determined when the boundaries of a firm are not clearly defined. The vertical boundaries of a firm define the activities that the firm itself performs as opposed to purchase from independent firms in the market. There are costs and benefits associated with both making and buying which the firm needs to optimise. In order to achieve that, organisation sometimes can adopt an optimal strategy and take a position anywhere in between the make or buy continuum. Intermediate solutions such as strategic alliances and joint ventures may also be feasible for minimising production costs. Key issues in determining how much to vertically integrate are to make use of the least cost production process (technical efficiency) and the degree of exchange of goods and services in the value chain to minimize coordination, agency and transaction costs (agency efficiency). Optimal vertical integration aims to minimise the sum of technical and agency efficiencies. The case for buy is to exploit economies of scale and technical expertise of the market firms as they may have achieved over a period of time while doing the same activity for many firms on a larger scale. A decision to make could be made in order to avoid high transaction cost because of the costs imposed by poor coordination within the market firms, lack of trust amongst the stakeholders to share valuable information and double marginalisation effect within the supply-chain network.

The vertical chain includes activities directly associated with the processing and handling of materials from raw inputs to the finished product. This includes acquisition of raw materials, manufacturing, distribution and sale of finished goods and services. For example, the production-marketing chain consists of producers, assemblers or intermediaries, processors, wholesalers, retailers and consumers. It varies with the type of product and various other factors. For instance farmers selling vegetables at a farmers market is an example of a simple single-stage market structure. Processed meat, however, has to go through several stages i.e. producers, slaughterhouse, processors, wholesalers, retailers and finally consumers. Some firms cover just a small part of the chain and can be referred to as being vertically disintegrated, e.g. local convenient shop. Others span several links and are 2

Name Sankha Chatterjee Student number 8293666 Assignment Reference GA_ME/May12/1

vertically integrated e.g. construction companies and steel plants. Vertical coordination refers to all possible economic arrangements involved in transferring resources between economic stages. A firms decision to the extent of vertical coordination is based on a number of factors e.g. profit incentives, cost reduction and control incentives. The decisions made by firms at any level concerning supply and demand depend on the extent to which a firm has control over the supply and demand factors. Some firms prefer to merge with an upstream firm (backward integration) or a downstream firm (forward integration). Sometimes firms in subsequent stages may enter into an agreement regarding the production, supply and/or distribution of the products. Some firms follow a mixed governance structures (combining of different governance structures) to handle different aspects of their business. Over time, given the characteristics of a transaction and its surrounding organizational context, mixed governance structures may be altered to adjust to specific organizational needs (Boudreau et. al., 2007). Whether the organization does all the arrangements itself or uses the market depends on comparing the transactions costs of the market with the management costs of the organization. This helps to explain why some conglomerates are now reducing transaction cost either by unbundling, i.e. floating subsidiaries in the market or selling subsidiaries/non-core business to other companies or sometimes forming jointventures with other companies within the supply chain network. In conclusion, make or buy decisions involve estimating the costs and benefits of integration. The manager must assess if the market provides any alternative to vertical integration. If the answer is negative, then the firm must take on the task itself or set up a quasi-independent supplier through a joint venture or strategic alliance. If there are information, coordination or hold up problems the firm should determine whether these problems can be prevented through contract (buy) or internal governance (make). The firm also needs to determine if double marginalization is occurring and profits are suffering as a result. An example is Pepsicos control over its bottlers. PepsiCo was initially a syrup manufacturer purchasing ingredients (input materials) from the market and using external agencies for bottling and distribution of its products. Over a period of time Pepsico has been able to consolidate its distribution and marketing activities. Sophisticated advertising and promotion campaigns demanded national coordination and the cooperation of bottlers. For better coordination, Pepsi bought out many of the bottlers and control the majority of its bottlers operation. Eventually, Pepsico spun off the bottling group but retained de-facto control. It wont be out of context to mention that the transaction cost theory is not without criticism. Ghoshal and Moran (1996) were sceptical about the normative implications of 3

Name Sankha Chatterjee Student number 8293666 Assignment Reference GA_ME/May12/1

transaction cost theory because of its strongly self-fulfilling assumptions (e.g., opportunism can increase even when hierarchical controls are imposed). Some were critical about the reliance on opportunism and the neglect of differential capabilities (i.e., firm heterogeneity) and dynamics (Winter 1991; Langlois 1992; Kogut and Zander 1992) in TCE. Some scholars argue that differential capabilities give rise to different production costs, and that such cost differentials may crucially influence the make or buy decision. Thus, firms may internalise activities because they can carry out these activities in a more production (not transaction) cost-efficient way than other firms are capable of. Others contended that the existence of the firm can be explained in knowledge-based terms and without making use of the assumption of opportunism (Demsetz 1988; Kogut and Zander, 1992). They argue that firms can build capabilities and engage in learning efforts that markets cannot. However, in spite of such criticism, the TCE theory is sufficiently successful theoretically and empirically and plays an important role in explaining firms choice of its vertical boundaries and thus achieving optimum cost efficiency.