Environmental Uncertainty
Bounded Rationality
Opportunism Small Numbers
Risk Specific Assets
Figure 3.8 Sources of Transaction Costs
Managerial Implications
Resource Dependence Theory
1. To maintain an adequate supply of scarce resources, study each resource transaction individually to decide how to manage it.
2. Study the benefits and costs associated with an interorganizational strategy before using it. 3. To maximize the organization’s freedom of action, always prefer an informal to a formal linkage
mechanism. Use a more formal mechanism only when the uncertainty of the situation warrants it. 4. When entering into strategic alliances with other organizations, be careful to identify the purpose of
the alliance and future problems that might arise between organizations, to decide whether an informal or a formal linkage mechanism is most appropriate. Once again, choose an informal rather than a formal alliance whenever possible.
5. Use transaction cost theory (see later) to identify the benefits and costs associated with the use of different linkage mechanisms to manage particular interdependencies.
organizations attempt to gain control of resources and minimize their dependence on other organizations. According to transaction cost theory, the goal of the organization is to minimize the costs of exchanging resources in the environment and the costs of man- aging exchanges inside the organization.45Every dollar or hour of a manager’s time spent in negotiating or monitoring exchanges with other organizations, or with managers inside one organization, is a dollar or hour that is not being used to create value. Organizations try to minimize transaction costs and bureaucratic costs because they siphon off produc- tive capacity. Organizations try to find mechanisms that make interorganizational trans- actions relatively more efficient.
Health care provides a dramatic example of just how large transaction costs can be and why reducing them is so important. It is estimated that over 40% of the U.S. health- care budget is spent handling exchanges (such as bills and insurance claims) between doctors, hospitals, the government, insurance companies, and other parties.46Clearly, any improvements that reduce transaction costs would result in a major saving of resources. The desire to reduce transaction costs was the impetus for the formation of health main- tenance organizations (HMOs) and other networks of health-care providers. HMO providers agree to reduce their costs in return for a more certain flow of patients, among other things. This trade-off reduces the uncertainty they experience.
Sources of Transaction Costs
Transaction costs result from a combination of human and environmental factors.47(See
Figure 3.8.)
ENVIRONMENTAL UNCERTAINTY AND BOUNDED RATIONALITY The environment is char- acterized by considerable uncertainty and complexity. People, however, have only a limited ability to process information and to understand the environment surrounding them.48
Specific assets Investments—in skills, machinery, knowledge, and information—that create value in one particular exchange relationship but have no value in any other exchange relationship.
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Because of this limited ability, or bounded rationality, the higher the level of uncertainty in an environment, the greater the difficulty of managing transactions between organizations.
Suppose Organization A wants to license a technology developed by Organization B. The two organizations could sign a contract. Considerable uncertainty, however, would surround this contract. For example, Organization B might want to find new ways of using the technology to make new products for itself. Given bounded rationality, it would be difficult and prohibitively expensive to try to write a contract that not only protected Organization B, which developed the technology, but also spelled out how the two organ- izations might jointly share in the future benefits from the technology. In this situation, the developing company (Organization B) might prefer to proceed alone and not ex- change resources with Organization A, even though it knows it could create more value by engaging in the exchange. Thus, because of bounded rationality and the high transac- tion costs of drawing up a contract, potential value that could have been created is lost. Environmental uncertainty may make the cost of negotiating, monitoring, and governing agreements so high that organizations resort to more formal linkage mechanisms—such as strategic alliances, minority ownership, or even mergers—to lower transaction costs. OPPORTUNISM AND SMALL NUMBERS Most people and organizations behave honestly and reputably most of the time, but some always behave opportunistically—that is, they cheat or otherwise attempt to exploit other forces or stakeholders in the environment.49 For
example, an organization contracts for component parts of a particular quality. To reduce costs and save money, the supplier deliberately substitutes inferior materials but bills for the more expensive, higher-quality parts. Individuals, too, act opportunistically: Managers pad their expense reports or exploit customers by manufacturing inferior products.
When an organization is dependent on one supplier or on a small number of trading partners, the potential for opportunism is great. The organization has no choice but to transact business with the supplier, and the supplier, knowing this, might choose to supply inferior inputs to reduce costs and increase profit.
When the prospect for opportunism is high because of the small number of suppliers to which an organization can go for resources, the organization has to expend resources to negotiate, monitor, and enforce agreements with its suppliers to protect itself. For ex- ample, the U.S. government spends billions of dollars a year to protect itself from being exploited by defense contractors such as Boeing and General Dynamics, which have been known to take advantage of their ability to exploit the government because they have so few competitors for defense-related work.
RISK AND SPECIFIC ASSETS Specific assets are investments—in skills, machinery, knowledge, and information—that create value in one particular exchange relationship but have no value in any other exchange relationship. A company that invests $100 million in a machine that makes microchips for IBM machines has only made a very specific investment in a very specific asset. An organization’s decision to invest money to develop specific assets for a specific relationship with another organization in its environment involves a high level of risk. Once the investment is made, the organization is locked into it. If the other party tries to exploit the relationship by saying, for example, “We will not buy your product unless you sell it to us for $10 less per unit than you’re charging now,” the organization is in a very difficult situation. This tactic is akin to blackmail.
An organization that sees any prospect of being trapped or blackmailed will judge the investment in specific assets to be too risky. The transaction costs associated with the investment become too high, and value that could have been created is lost.50
Transaction Costs and Linkage Mechanisms
Organizations base their choice of interorganizational linkage mechanisms on the level of transaction costs involved in an exchange relationship. Transaction costs are low when these conditions exist:
1. Organizations are exchanging nonspecific goods and services. 2. Uncertainty is low.