2.3 Governance of Economic Transactions Flashcards Preview

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Flashcards in 2.3 Governance of Economic Transactions Deck (13):

Why, according to Coase not all the economic transactions are arranged through markets?

Why are neither all economic transactions regulated through hierarchies?

Why do firms exist and what limits the size of the firm?

Disadvantages: Market

  • The operation of the market costs something and forming a firm and allowing some authority to direct resources, saves some marketing costs. It is always possible to revert to the market if it fails.
  • As a firm gets larger there may be decreasing returns to the entrepreneur function as the costs of organising additional transactions within the firm may rise.
  • Transactions increase: fails to place the factors of production in the uses where their value is greatest and fails to make the best use of the factors of production. The supply of one or more of the factors of production may rise, because the “other advantages” of a small firm may be greater than those of a large firm.
  • The first two would be labeled diminishing return of management.
  • The equation of diminishing returns the costs of carrying certain transaction out within the firm may be greater than
  • carrying them out in the open market. 

Disadvantage: Hierarchy

Firms address transaction activities ex post contract: vertical integration to economise on inspection costs due to uncertainty and bounded rationality (incomplete contracting):

- members of the same organisation more difficult to appropriate benefit from opportunistic behaviour

- internal organisation easier controlled
- internal organisation advantageous to resolve disputes 

• Firm-specific property rights for each member of the firm, need to analyse property rights/incentives and interests of individuals in firm

• „Impossible to intervene selectively“ 

Why do firms exist:

  • Main reason: there is a cost of using the price mechanism, especially discovering what the relative prices are. Additionally, costs of negotiating and concluding a separate contract for each exchange transactions must be taken into account. If the costs of making an exchange are greater than the gains, the exchange would not take place. 


What limits their size:

  • A firm becomes larger as additional transactions are organised by the entrepreneur and becomes smaller as he abandons the organisation of such transactions.
  • A firm will expand until the costs of organising and extra transaction within the firm become equal to the costs of carrying out the same transaction by means of exchange on the open market or the costs of organising in another firm. 


What is the discriminating alignment hypothesis and how does it relate to the approach of comparative economic organization?

Alignment hypothesis is a transaction, which in their attributes, are aligned with governance structures, which differ in their costs and competencies, in discriminating (mainly, transaction-cost-economizing) way. According to which transactions, which differ in their attributes, are aligned with governance structures, which differ in their cost and competence, so as to effect an economizing result. On the other hand economic organization with its generic forms i.e. market, hybrid, and hierarchy are distinguished by different coordinating and control mechanisms and by their different abilities to adapt to disturbances. In addition each generic form is supported and defined by distinct contract law. Moreover the cost effective choice of organization form is shown to vary systematically with attributes of transactions. Thus discriminating alignment hypothesis relates to economic organization in that both focuses on the governance structures (markets, hybrids and hierarchy) and economizing transaction costs.  


According to Williamson, the discriminating alignment hypothesis is this: 

1. If some transactions are simple and others complex, then the attributes of transactions that are responsible for these differences must be named and their ramifications worked out. →names asset specificity, uncertainty, and frequency as three of the critical dimensions for describing transactions.

2. If the comparative efficacy of different modes of governance (market, hierarchy, hybrid) differ, then the critical attributes that describe alternative modes of governance need to be named and viable modes need to be worked out. Relevant dimensions include intensive intensity, administrative control, and contract law regime.

3. A predictive theory of economic organisation resides in the hypothesis that transactions, which differ in their attributes, are aligned with governance structures, which differ in their costs and competencies, so as to effect a (mainly) transaction costs economising result.


Which attributes of transactions influence transaction costs of different governance structures how and why?

Define these attributes.

Please, also illustrate your argument with examples.

1. Asset Specificity:

Transaction-specific assets are non-redeployable physical and human investments that are specialised and unique to a task (Williamson).

  • Value of the asset in the first best allocation minus the value of the asset in the second best allocation divided by the value of the asset in the first best allocation

Examples: the production of a certain component may require investment in specialised equipment, the distribution of a certain product may necessitate unique physical facilities, or the delivery of a certain service may be predicated on the existence of an uncommon set of professional know-how and skills. 

2. Uncertainty:

Source of disturbances to which adaptation is required. Uncertainty is the situation which involves imperfect and / or unknown information. A state of having limited knowledge where it is impossible to exactly describe the existing state, a future outcome, or more than one possible outcome. 

  • Arises in partially observable and/or stochastic environments, as well as due to ignorance and/or indolence.

Example: Unavoidable in Environmental Impact Assessments, EIAs: involve situations in which the full set of possible options and impacts for a particular project might not be known; no certainty about the magnitude of impacts; assumptions are not easily verifiable. 

3. Frequency:

frequency of transaction, if a transaction is done more frequently TCs will be lower with a long­term contract or vertical integration, depending on the other attributes, organization of transaction influences TCs, obviously lower if less organization needed




Transactions which differ in their attributes, such as asset specificity, uncertainty, incomplete knowledge and information asymmetry, are aligned with governance structures that differ in their costs and competencies.

Hierarchical structures are useful when there is an asymmetric relationship regarding the transaction.

Hybrids are chosen when there are some asset specificity investments and where there is much uncertainty concerning the transaction in relation to input/output and transformation method of production.

Classical market structures are useful when property rights are well defined but costs of information gathering and finding transaction partners vary according to market place. 


What is asset specificity (Faktorspezifität )? Provide examples for the different types. Illustrate with an example why asset specificity questions the effectiveness of market transactions.

There are four types of specific investments.

  • Site Specificity: Buyer and seller are in a cheek and jowl relation, reflecting ex ante decisions to minimise inventory and transportation expense.

Example: coal mine and coal burning facility. Specialisation by proximity.

  • Physical Asset Specificity: One or both parties make investments in equipment and machinery that involve design characteristics specific to the transaction and with low alternative uses.

Example: die for stamping out specific metal shapes.

  • Human Capital Specificity: Consequence of learning-by-doing, investment, transfer of skills specific to a particular relationship.

Example: arise from firm specific training or learning by doing

  • Dedicated Assets: General investment for the prospect of selling a significant amount of a product to a particular customer. If the contract is terminated the supplier has considerable excess supply; sold at distress prices.

Example: to carve out a specific piece of metal for a specific product that is not used by competitors.


  • (Brand Name Capital )


Which type of uncertainty is P-A theory most concerned about? How is Economic governance theory different in that regard?

P-A theory is most concerned about opportunist behavior (Pre-contractual opportunism and Post-contractual opportunism with contract partners)

In governance theory also uncertainties concerning the contract partners occur: 

  • Primary Uncertainty: Uncertainty concerning the future state of (exogenous) nature.

The most important type of uncertainty is the primary uncertainty, because that people have to forecast future wants. For example, the decision on which product will be released on the market is an entirely impersonal prediction of the wants and needs of the customer. 

  • Secondary Uncertainty: Uncertainty concerning the behaviour of the contracting partner that is due to communication problems between actors (not strategic/non opportunistic). 
  • Behavioural Uncertainty: Uncertainty concerning the behaviour of contracting partners that is due to strategic/ opportunistic behaviour. 



Provide examples of highly asset specific transactions (for both parties) and not at all asset specific transactions in a scenario of high uncertainty and in a scenario of low uncertainty (four examples total). Assume that frequency of transactions is high.



not in m&m 


Which type of governance structure would Williamson’s economic governance theory prescribe for highly uncertain, infrequent and highly asset specific transactions? Why? (Explain why for each of the transaction attributes).

Unified Governance (“vertical integration”) or Hierachy: high specificity; low to high frequency

  • The hybrid is a compromise mode that is located between hierarchy on all three attributes and works well in autonomous and coordinated adaptation reposts.
  • The viability is dependent on the efficacy of credible commitments (e.g. penalties for premature termination, information disclosure and verification mechanisms, specialised dispute settlement etc.) the cost effectiveness of which varies with the attributes of transactions.
  • Contract as framework, which is more elastic and promotes cooperative adaptation.
  • If the adaptive limits of a hybrid are exceeded, transactions are organised as hierarchies. The implicit contract law in hierarchy is forbearance. Forbearance law authenticates hierarchy by supporting its main purpose, namely, timely responsiveness to consequential disturbances for which coordinated adaptations are needed.

Trilateral Governance : mixed to high specificity; low frequency 

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Which type of governance structure would Williamson’s economic governance theory prescribe for frequent and somewhat asset specific transactions? Why? (Explain why for each of the transaction attributes; assume that uncertainty is low).

Bilateral Governance (“relational contract”):

• Mixed specificity; high frequency

• Absence of state support parties have no choice but to do their best to create their own bilateral or group mechanisms to support otherwise problematic exchange.

• Most disputes are resolved by avoidance, self-help etc. In many cases the participants can devise more satisfactory solutions than professionals, that are constrained to apply general rules with limited knowledge of the dispute. 


Bilateral governance (relational contract)

  • Example: Gym contract MCFit, 


Which type of governance structure Williamson’s economic governance theory would prescribe not asset specific transactions in a context of low uncertainty of transactions? Why? (Explain why for each of the transaction attributes; assume frequency is high).

Market governance (classical contract).

It is cheaper to integrate a very asset specific department in the firm. It is more expensive to invest into a hierarchy (firm) as a government structure but benefits regarding hold-up problem. High asset specifity leads to vertical integration (hierarchy). 


What does simultaneous adaptation refer to in the study of governance structures? And independent adaptation? To which governance structures are each associate? Use an example for each type of adaptation.

Adaptation is the central problem of economic organization, of which two kinds are distinguished

- “Independent or autonomous adaptation” in the market in response to price signals

- and “Simultaneous or cooperative adaptation” in the firm with the support of fiat (sanção, ordem). A high-performance system will align transactions with governance structures in relation to their adaptive needs. Both investment and contracting are implicated. Efficiency is the product of adaptive capacities. 


When are firms more advantageous than markets according to Williamson’s economic governance theory?

Why are not all economic transaction organized through firms according to the same theory?

Firms enjoy advantages over markets in cooperative adaptation respects - it being the case under property rights theory that all ownership configurations costlessly adapt in the contract implementation interval. Firm and market are regarded as “alternative methods of coordinating production”.

  • Because added bureaucratic costs accrue upon taking a transaction out of the market and organising it internally, it is the organisation of last resort. That is, try markets, try hybrids and have recourse to the firm only if all else fails.
  • However, a unified firm comes in as higher degrees of asset specificity and added uncertainty pose greater needs for cooperative adaptation.
  • Vertical Integration has the advantage of being simpler, because a variety of complications that arise between firms and workers or firms and consumers (e.g. disparities of information, differential access to legal and technical expertise, differential capacity to bear the risk etc.) are of lesser importance in transactions between firms, where the specialisation of labour within a and between functions is extensive.
  • Markets and hierarchies differ in kinds, in that each possesses distinctive strengths and weaknesses, where hierarchy enjoys the advantage for managing cooperative adaptations and the market for autonomous adaptations.



Describe and define the governance structures of markets, and hierarchies. Provide examples of each. Describe advantages and disadvantages of each.


Definition: “Social arrangement concerning repeated exchange among a majority of exchanging partners; network of relational contracts providing for competition, and exchange (sellers and buyers)”

Description: Market use of the price system to communicate information, whence “how little the individual participants need to know to be able to take the right action.” Market is described as an organizational alternative.

  • Market governance structures transfer property rights
  • Specialisation in exchange of property rights through mechanisms that require the mutual consent of parties involved (freedom of contract)/ coordinate decentralised decisions through the price system.
  • Markets depend on institutions that shape them. Require institutional support, e.g. Property rights, court systems.
  • Different stock exchanges/ diamond exchange, role of personal relations > differences in price determination (posted or negotiated)
  • Agents collect information about the characteristics of goods and services through the price system 


Definition: Transactions based on employment contract; “centrally coordinated networks of corporate members“(Firms). Bilateral dependency introduces an opportunity to realize gains through hierarchy.

Description: Incentive intensity is less, administrative controls are more numerous and discretionary and internal dispute resolution supplants court ordering. Adaptation is taken to be the main purpose, where the requisite mix of autonomous adaptations and coordinated adaptations vary among transactions. Specifically, the need for coordinated adaptations builds up as asset specificity deepens. 

Advantages of hierarchical relationship:

  1. Flexibility allocating human resources/ address uncertainty
  2. Improve decision making/ „division of cognitive labour“ 
  3. Communication coordinated by entrepreneur may be gain
  4. Settle disputes without time and costs of arbitration
  5. Internal auditing more effective than external control
  6. Cooperation also in firms: „willingness of agents to pool resources; scale economies (information; risk bearing; ...) 


  1. non-replicability of market incentives in firm
  2. How distribute residual claims among residual claimants,
  3. loss of information along hierarchy
  4. collective decision making hampering command; incentives to collude/ develop side payments;
  5. high cost of processing information/ communication/ control 


What are hybrids? Provide examples. Why do you think hybrids may be more efficient than markets and hierarchies?

Hybrid modes: forms of long-term contracting, reciprocal trading, franchising, more elastic than markets and more legalistic than hierarchies 

Example: A farmer has a long term contract, with a supermarket to sell apples but still is independent and can do business with other parties, depend in this transaction other examples are cooperatives or franchise (subway) 


  • increased market share,
  • transfer of competencies,
  • access to scarce resources 


  • uncertain about uncoordinated transactions/ transaction cost problems emerge (bounded rationality/ incomplete information); Share resources / coordinate decisions in order to create rents/ may also be source of conflict
  • Contracts incomplete/ How to minimize renegotiations?
  • Role of prices in hybrids in disciplining replaced by mix of competition and cooperation