Inter-organisational Relations: Transaction costs economics, bureaucracies & management control

Question 1

Market efficiency (defined by Pareto)

Answer 1

• we can transact with relatively low fees
• a market participant’s (agent’s) utility can only be enhanced by making the principal worse off –can only make one participant efficient by making the other one worse off -1 can take advantage of the other

Question 2

Market inefficiency (defined by Pareto)

Answer 2

• a market participant (agent) can enhance its utility without affecting the principal’s utility

Question 3

Why do firms actually exist?

Why are some activities directed by market forces and others by firms?

Answer 3

• Coase - The Nature of the Firm (1937)
• put it down to transaction costs
• he relaxed the problematic of perfect certainty (neoclassical assumptions) –back then economic principles were predicated on the basis of perfect certainty – there were no frictions between participants tempting to transact with the market
• he said people have rational preferences with different expectations
• he was able to differentiate 5 different types of TC
• firms exists because these types of TC make it so difficult and preclusive that it’s very difficult for firms to engage in market based transactions – boundary of firm shifts and size of firm enlarges because we can’t transact with the external market – so then do in house.
• potential option of mitigating TC – if hard to mitigate TC then more likely to engage in house

Question 4

What are the 5 different types of TC’s proposed by Coase?

Answer 4

(1) discovering relevant prices for inter-organisational exchanges (there’s not always a price that exists in the market, sometimes we can’t go the outsourcer – cause it doesn’t exists)
(2) effort involved in the negotiation
(3) writing enforceable contracts
(4) re-negotiations – coming to the end of a contract and environment changing
(5) possibility of ‘lock-in’ via specific assets: giving us knowledge, information.. when the contract ends - losing all of this

Question 5

How relevant are TC’s? TODAY compared to 1937

Answer 5

• firms exist to avoid some of the costs of using the price mechanism
• by extension, what determines the boundary of the firm (or size?) are TC
• the greater the TC, the wider the boundary of the firm is and we maintain most of the activities in house
• whilst that was sufficient in 1937
• there is however a third option – HYBRIDS
• Power Company in Zambia – the challenge: they wish to reform the public sector in Africa – insuring we have participants that come to that part for the world – wish to transform the economy. Limited resources – go large people like EDF get them to invest in the Company – but political uncertainties, lack of experience in Africa.
• Should it do itself? Or partner with EDF?
• TCs in this arrangement:
• (1) Non-competitive supply environment: small numbers problem - only EDF available to support them
• Potential for opportunism
• Information asymmetry – no free exchange of information between the participants
• Bounded rationality – limitations of the human mind: human mind can only deal with a certain subset of information –understand both sides Buy or Make
• (2) Customizing idiosyncratic public sector offerings – electricity is complex, how to manage that
• (3) Under-developed institutions in Africa compared to EDF energy in France – contracts, legally binding arrangements difficult
• (4) Imperfect information exchange between principals/agents (governments, consumers and commerce)
• (5) Potential for significant opportunism – potential to be held hostage in those arrangements
• E.g. 5 years arrangement – African company given up knowledge etc. to the market + dependent on EDF for their assets, EDF might not be interested in partnering again.
• Market efficiency: potential of EDF of taking advantage of all resources offered by African Company

Question 6

How does the governance for TC look somewhat different with respect to services?

Answer 6

• between 1980 and 2014, we produce much less - change in market dynamics – rise in service types of economies - patterns of consumption has changed
• value of outsourcing (contemporary term) – a huge transformation in how organisations chose this decision: many organisations are now pursuing the buy option
• Key enablers – Moores Law: Gordon Moore; Intel co-founder: predicted that in the 1970’s (still true today) the capacity of a transistors would roughly double every 18 months – take advantage of that technology –AI, cloud based… innovative models
• Coase – choices were relatively limited between make or buy but now we are way more connected/could obviously export and import but when it came to business services usually just in one geographic location
• Rise in technology

Question 7

Moore’s law

Answer 7

Gordon Moore; Intel co-founder: predicted that in the 1970’s (still true today) the capacity of a transistors would roughly double every 18 months and the cost would 1/2 – take advantage of that technology –AI, cloud based… innovative models

Question 8

Relevance of TCs today

Answer 8

• Business services have become value webs
• Make or buy decision - It has the biggest effect in business services
• This is why it’s so relevant today as it did in 1937… because service rise / more potential of buy markets

Question 9

Definition of TC

Answer 9

Coase (1937)
• developed TCE to explain the boundaries of the firm in terms of the optimal choice between market and hierarchical provision. In turn, this is based on the T-O between ‘production’ and so called ‘information’ (transaction) costs
• explains the boundary of the firm in terms of the optimal choice between ‘bureaucracies’ (the make option defined by Coase) and ‘markets’
• Coase (1937) farther of TC: relaxed (problematic) neo-classical assumptions of perfect certainty
• Allowed for the possibility of incomplete contracting and enforcement
• Almost complete reverse of agency assumptions, under TCE, transactions are executed by innately ‘imperfect human beings’ (Spekle, 2001)
• The possibility of opportunism (seek to maximize their own utility first and foremost), bounded rationality to make a complex a decision

Question 10

Isomorphic pressures - on organisations to change

Answer 10

• ‘all organisations exists in an institutional environment’ – (Scott 1987) therefore we have to consistently evaluate the make or buy decision
• (DiMaggio and Powell 1983) – define 3 different types of pressures
• (1) Coercive – formal or informal pressures exerted by one organisation on another – HQ often provides coercive on business units – coercive change from HQ and business partners – the ability of them to coerce and influence the business to make changes – Power of the NUS, Government bodies… or Trump against outsourcing in US: coercive change
• (2) Normative – value & professional norms on organisations…’homogenization of management practice’ – the consulting environment, professional networks, universities…
• (3) Mimetic – promotion of good, best practice, leading to imitation – pressure to adapt or conform to a better practice practices – benchmarking as a tool is a memetic change
• Is it based to make internally or externally where we are consistently pressured to change?

Question 11

The effects of isomorphic pressures

Answer 11

• TCE assumes that organisations develop their practices & systems to achieve a higher level of conformity in surrounding institutional environments. How?
• These pressures to change can lead to conformity in an industry – pressure to be left behind/if you are not following the heard you will be left behind in the industry
• Isomorphic pressures lead to conformity in the industry –high value activities such as management control
• Professional reasons (institutions) to try and legitimize (and induce) continued practice – outsourcing becomes the norm
• Management control systems can reflect mimicry – what we are attempting to do is the copy of others
• Institutional environments are characterized by homogeneity - things just become standard

Question 12

Sources of TC

Answer 12

• Jones, 2006
• bounded rationality
• opportunism
• relation specific assets (asset specificity)

Question 13

Describe bounded rationality

Answer 13

• Provided by Simon (1957) – a behavioral construct relating to limited information processing capacity of the human mind – limited by the info we have
• We all have cognitive information related to our mind
• Function of attention dedicated to a problem & eliciting relevant information
• As decision complexity rises, bounded rationality exacerbates
• Outsourcing MA activities – more complex… greatly simplified choices available leaving information off the table

Question 14

Effects of bounded rationality

Answer 14

• bounded rationality occurring in 3 keys stages

(1) contact phase – limiting opportunities for competitive positioning & research for appropriate contractors – BBC wanting to outsource MA at that stage there weren’t any alternative, create their own market – a lot of TC at start / outsourcing MA today – because a developed market TC would be minimized
(2) contract phase – being informationally bound, humans cannot foresee / incorporate contingencies into ex-ante (def: based on forecasts rather than actual results) arrangement – if you can’t foresee potential risk/contingencies 5 years down the line hard to make them into any control system/into a contract today – with AI etc. /can live without the contract –turn to social exchanges –trust, reputation maybe. So much complex information going into it… for a contract… go back and rely on trust etc. World of Coase only contract to work with.
(3) control phase – limited ability to monitor post-contractual performance.

Question 15

Describe opportunism and its effects

Answer 15

• Relates to incomplete or distorted information, especially to calculated efforts to mislead, distort, disguise, obfuscate or otherwise confuse (Williamson, 1986) –take advantage of opportunities/consequences in certain environment.
• inadequate supply of alternatives so potential of one player to take advantage of bounded rationality and information asymmetry
• Zesco lack of information– EDF potential to take advantage of bounded rationality of Zesco – key risk in those transactions
• Many not necessarily breach an agreement, but takes advantage of bounded rationality
• Allows for ‘hold-ups’ in behalf of transacting party
• Distort other behavior/information – trying to confuse another player in the market place – so market efficiency
• Especially prevalent – small number problems (small number of participant in market EDF) likely to take advantage of opportunism – because of lack of alternative supplies
• Effects: diminishing trust / consistently re-negotiate a transaction (which we are trying to minimize) create TC itself

Question 16

Describe relation specific assets (asset specificity)

Answer 16

• Relates to the customization of assets to a particular transaction in an inter-organisational relationship:
• If you have to customize an asset to that exchange relationship it becomes very specific to that transaction
• If EDF energy chose to work with Zesco in Zambia then of course the assets have been made for Zesco, can’t share with other participants in the market
• If you as a potential outsourcer, bring an investments specific to a client (Zesco) what are the risks involved. End of contract – 0 value elsewhere.
• The ability to deploy those assets diminishes
• Potential sources: site/location (share sites), physical in nature e.g. ASP systems, human (often what we see is high value decision in R&D, if we are going to outsource take the best people along with them, specific investments (e.g. R& D – very little value elsewhere), brand name capital (can go with the outsources too)

Question 17

Effects of asset specificity

Answer 17

‘The buyer’s position is strengthened the greater the number of alternative sources of supply, the less the TCs involved in switching to another supplier, and the greater his share of the vendor’s total sales’ (Thorelli, 1986) –
• (1) customization precludes asset sharing / redeployment, at least without high costs
• (2) creates barriers to entry – strengthen EDF position (with their knowledge)
• (3) potential of lock in – potential of opportunism – held hostage

Question 18

How well do TCE principles explain payroll outsourcing

Answer 18

• Active market: choice and low switching costs – 1000000 of options available – even if held hostage… can switch quite quickly. Low BR – not complex, few phone calls. Low small number + opportunism. Specificity – very low in payroll. Sources of transaction very low – make it difficult to explain why do it internally. Little impact on trust. Don’t need to over invest in contact stage or control.
• Opportunity costs of not outsourcing > TC of exchange
• However… why are more strategically important activities (MA, finance accounting) increasingly transferred to the market in markets characterized by high levels of TC (i.e. in a failing market)?
• Still being outsources in failing markets…

Question 19

Locating TCs in the transactions (MA and finance accounting)

Answer 19

Article (Nicholson et al. 2006)
• Contact phase – UK to India – issue about time and space, telecoms infrastructures add complexity
• Contract phase – challenges in political institutions, regulatory frameworks, disputes, corruption, offshore instability, technological issues…. HUGE POTENTIAL RISK IN EXTEDING WORK TO INDIA

Question 20

Nature of the inter-organisational exchanges

Answer 20

• Different types of outsourcing – HYBRID outsourcing – encompasses both make and buy (Coase, 1937) BUT the joint negotiations of TCs mitigating strategies not introduced by Coase

• Spekle 2001 – By focusing only on the client’s perspective, existing theory failed to acknowledge that the control in a hybrid arrangement are likely to be determined jointly by both vendor and client and may be subject to periodic renegotiation –draft and define their own arrangements – not held to a contract – own types of arrangements, talking about TC in those relationships
• The pressures on organisations – reevaluate the boundaries, with the rise of AI
• There could be opportunity cost in not engaging in this technology – we could be left behind in terms of competitiveness – embrace this new world even if it is frightening in terms of TCs
• Embrace TCs and create our own market
• Perspective into the future – TCEs provides us with a framework to evaluate risks…
• Endless conferences about the future, but don’t actually know what the future looks like
• OPI (vendor) clients have to standardize their in house accounting to fit OPI’s ERP (enterprise resource planning), so clients bear the brunt of asset specificity – potential of BR: forced to standardize – knowledge of OPI system, never used before / potential of opportunism: learn from their system – creates TCs

Question 21

How to control some of these risks? Control exchanges

Answer 21

• Accounting and Finance outsourcing uses a range of control practices not restricted to a single archetype (consistent with Langfield Smith 2003)
• Difficult to say they use a certain type of system
• Diagnostic (machine) – codification, norms and rules, monitoring supervision penalties, rewards
• Interactive (Exploratory) – let’s just learn together, social pressure, info sharing, ethical behaviour, codes of conduct / embrace unknown future with AI for e.g. and learn
• Boundary – info sharing, ethics, personal conduct, external audit

Question 22

Imagination and Apple

Answer 22

• Shares in Imagination Technologies plunged more than 60 per cent after Apple, its biggest customer, said that it would no longer use the UK chip designer’s technology in new products.
• Imagination’s graphics chip is a key component in Apple’s mobile devices, such as the iPhone and iPad, helping to make it a rare British success story in the hardware sector.
• Apple accounts for roughly half of Imagination’s annual revenues, and is one of its largest shareholders with a 9.5 per cent stake in the company.
• However, Imagination’s London-listed shares plummeted after Apple notified the company that it had been working on a separate, independent graphics design for its own products

Question 23

Big pharma and biotech

Answer 23

• Biotech can easily get overshadowed by its larger and more profit-generating cousin, big pharma. However, the symbiosis between the two sectors has never been greater.
• e.g. UK-listedPureTech Health working with Novartis - biopharmaceutical company. Last month it announced a licensing and equity agreement with the Swiss drugmaker, initially to focus on diseases related to immunosenescence, an age-related decline in immune function.

Question 24

The problem of partnerships

Answer 24

• Potential of opportunism and to be held hostage in these partnerships –difficult to think about an effective relationship to mitigate these risks. Information asymmetry is high –virgin territory.
• Biothech and pharmaceutical companies –small number problems/potential for opportunism.
• This is what happened to Imagination –dependencies of Imagination on Apple.

Question 25

Driver of change: make or buy to hybrids

Answer 25

• (1) globalisation (short run of product life cycles/moving into maturity stage much quicker, new entrants eroding MS + much more innovative products) / difficulty maintaining in-house expertise across all elements of the value chain -organisations are being largely pushed to manage that value chain (core competencies make choice about what is core and not –the other move to market)/ much more opportunity to compete or collaborate for competitive advantage
• (2) technological complexity – few can be at the forefront of technology in all arenas
• (3) barriers to entry - Ford and Toyota partnered together to produce battery cars – giants investing in R&D… why would you want to enter? Porter’s 5 forces – these types of arranges create barriers to entry

Question 26

Coase (1937)- why do firms exist?

Answer 26

Firms exist to mitigate the risks in TC

Question 27

Product life cycle

Answer 27

introduction, growth, maturity, decline

Question 28

Porter 5 forces

Answer 28

threat of new entry, bargaining power of suppliers, bargaining power of buyers, threat of substitutes, rivalry among existing competitors

Question 29

Implications on control theory

Answer 29

• Does change MC frameworks
• Challenge conventional notions of resource management & control
• The very boundary of the firm, resources and its environment are constantly subject to change
• For MA – there are changes on demand in the accounting professions on regarded to performance management – how do we draft contracts with hybrids?
• Contract phase – can choose something different to a contract / and manage relationships without contract

Question 30

The role of exploratory controls? Spekle (2001)

Answer 30

• Approaching the market with an exploratory mind-set
• These activities which were typically precluded form market-based previously because of TC can now be explored through exploratory mechanisms – to so put contracts to the side (idiosyncratic, less frequent activities)
• Emphasized general commitment or the sketching of ‘broad confines’ of expectations, not necessarily performance (as opposed to drafting everything through a contract/because if there is information asymmetry… limited capacity precludes us for defining a perfect contract)
• We need to explore alternatives

Question 31

Key difference 1937 – and currently

Answer 31

HYBRID

Question 32

Market-based pattern

Answer 32

(1) Transaction characteristics
- low asset specificity
- high repetition
- measurability of output
- short or medium term contract
(2) Transaction environment
- many potential market participants
- market price contains all relevant information
- social embeddedness not prevalent
(3) Party characteristics
- low switching costs
- information asymmetries in contracts
- low opportunism

Question 33

Bureaucracy based pattern

Answer 33

(1) Transaction characteristics
- medium to high asset specificity
- protected by contractual rules
- low / medium repetition
- medium or long term term contract
(2) Transaction environment
- more certainty around future contingencies
- medium/high level of market risk
(3) Party characteristics
- idiosyncratic activities requiring knowledge and info not easily available or controllable in the external market

Question 34

Factors inhibiting inter-organisational re-design

Answer 34

Leibeinstein (1966) ‘X-inefficiency’
• Why some organisations (public sector particularly) locked in inefficiency inherently – wouldn’t consider make or buy
• Labour contracts are incomplete – University - contract of an academic – broad expectations
• Production function aren’t completely specified/understood– hospitals, how can you think of specific contract for doctors
• Not all factors of production are fully marketed, known or accessible
• Penrose (1959) – these factors hinder the efficient transfer of excess resources

Question 35

Joint ventures risks

Answer 35

• Joint Venture
• Share unique competencies
• Pharmaceuticals
• Innovative arrangements –managed without a contract
• Additional risks: control risks – legal fall back in there is no contract, enforcement of contracts –different regulatory –bounded rationality – India and UK – which one do you rely on if there is contract failure
• Information Asymmetry: control systems cannot be universal –they are customised to that particular arrangements – potential for IA - control phase
• Small numbers problem – have to sometimes create own market – BBC first to want financing activities outsourced
• Bounded rationality – large information – takes time to set up JV – additional costs in contact phase –create market with very limited information
• How to manage this? Traditionally manage itself
• Now rely on TRUST, we can now support that trust

Question 36

How can you mitigate these risks of setting up a joint venture?

Answer 36

TRUST

Question 37

Entering the Chinese market and BMW

Answer 37

• Access this lucrative market place/Market isn’t mature yet in china
• Nature of relationship – ‘exchange hostages’ – 1 partner gives up something and also the other in the view to build on trust
• Profit, loss and risk are shared to the contribution of registered capital of the JV partners
• 50% BMW Brilliance Automotive Ltd. -subsidiary of BMW in Shenyang
• For China - sharing knowledge and process knowledge transfer
• Training employees and engineers - keen to learn in China/engineer needs to be the same in Germany and China / supervisors in Shen
• Products are not to be marketed in competition to the JV products

Question 38

Exchange hostages

Answer 38

‘exchange hostages’ – 1 partner gives up something and also the other in the view to build on trust
BMW

Question 39

Virtual Networked Organisations

Answer 39

• Virtual in nature - didn’t exist in Coase world in 1937
• TCs preclusive in these arrangements – benefit is we can take away all that capital intensity from the BS
• Sweating assets
• Coca Cola – recipe and brand – striped down assets into Coca Cola enterprises but don’t technically own these enterprises in terms of equity
• Coca Cola enterprises – preclusive contracts –e effective control can’t make coke for other companies
• Supportive through technology – minimize TCs – Skype / WhatsApp : contact stage
• What’s the glue that these organisations together form a control perspective & what might classical TCE prescribe for governing such relations?
• Don’t rely on contact – social and trust and relationships very important – in these arrangements - OC of not engaging in this can be higher in TC of trying to – you’ll be left behind – the next Kodak

Question 40

3 types of controls (Dekker, 2004)

Answer 40

Outcome controls
Behavioral controls
Social Controls

Question 41

Outcome controls

Answer 41

Ex-ante
Goal setting
Incentives/rewards

Ex-post
Performance monitoring and rewarding

Question 42

Behavioral controls

Answer 42

Ex-ante
Structural specifications: planning, procedures, rules/regulations

Ex-post
Behavior monitoring and rewarding

Question 43

Social controls

Answer 43

Ex-ante 
Partner selection
Trust (goodwill/capability)
Interaction 
Reputation
Social networks

Ex-post 
Trust building
Risk taking
Joint DM and problem solving
Partner development

Question 44

Traditional TC VS Social

Answer 44

Dekker (2004)
• How can we control these types of arrangements?
• TCEs – outcome control very little about behavioral (part from we are inherently opportunistic)
• Exclusion on social mechanisms
• Containing TC in working with external participants
• Incentive for Ernst Young to partner with BBC – create new market – BBC manage cost based much more effectively
• Social controls: selecting a partner based on reputations/trust/interaction between existing payers/social networks
• Ex – post after we have embarked on arrangement – trust building, risk taking (encouraging to make mistakes)/joint decision making and problem solving and partner development

Question 45

Outcome controls

Answer 45

• Clarify mutual expectations & increased goal congruence (hence reduce BR)
• Non- financial indicators not just outcomes – far more motivating than contracts
• Look satisfaction
• Open book accounting initially associated with Japanese companies to reduce information asymmetries
• Accounting measures: define expected cost reductions, minimum order quantities (through service level agreements SLA)

Question 46

Behavioral controls

Answer 46

• Specify how parties should act and control specifications (boundary related) –shared belief
• E.g. policy documents, supply procedures, regular meetings, task groups, employment contract and training, quality plans
• Challenge – mitigate around some of these TCs

Question 47

Social controls

Answer 47

• Always relate to values norms and cultures in a particular society
• Cannot be explicitly designed – only influenced…
• What can be put into place?
• Setting a mandate to oversee
• Meeting and try and gain an understating of what the parties expect
• Marry the cultural values
• Capabilities audit – marrying both together – there should be a shared knowledge of capabilities
• Partner selection is key in the contact phase– prior experience to build trust cause existing relationship EY and BBC initial relationship enabled them to take on the finance work
• Looking for cultural matches not clashes
• Trust – ‘the expectations by one organisation in a relationship that the other(s) will behave in a predictable and acceptable way’ (Sako, 1992)
• Goodwill trust – the expectation one party will perform in the interests of the relationship, even if it is not in the interests of the other’s interests to do so. Safeguards against opportunism. We do them to build goodwill trust with stakeholders we work with
• Capability – expectations about competencies
• Relational – Builds up overtime – derived from repeated interactions / deliberate risk taking / joint interest and goals / human specificity / problem sharing
• Institution – based – legal forms, social norms & values can facilitate /sometimes undermine trust
• How might the relative importance of the three different forms of management control change over time?
• Difficult to look at outcome based mechanisms if we don’t know them initially
• Behavioral controls develop overtime unless relationships already exist
• Social controls are more important initially – we rely on the relationship that we have initially.

Question 48

Definition of trust

Answer 48

Trust – ‘the expectations by one organisation in a relationship that the other(s) will behave in a predictable and acceptable way’ (Sako, 1992)

Question 49

Is goodwill trust a substitute or complement for formal control mechanisms?

Answer 49

• Complementary view: additive

* Against - Inverse relationship – more trust less form of controls

Question 50

Hybrid organisational forms (the middle ground) between make or buy

Answer 50

• Characteristics – rapid change (technological, capabilities, practices…)
• Risk – high risk so think about dependencies
• Corporate histories to rely on EY and the BBC helps in contact phase
• Skills – tacit knowledge to fusion together

Question 51

How can we manage hybrid arrangements ?

Answer 51

• Classic contract – find the lowest cost contract
• But hybrids – searching for contractual ambiguity – once we’ve understood the notion of diversity
• Communication: searching for active ways of driving innovation
• Spreadsheets: oversee the contract – inhibit collaborative communications (obsession with Excel bad…/let go of control…)
• Outcomes slows down problem solving
• Look for dependencies between the players
• Loosen the traditional control mechanisms
• Where they have come from? Past history of innovation
• Logic of synthesis – Ford and Toyota what was their main aim – focus on why they formed the relationship
• Boland et al. – hybrids infused with path dependent histories – pre– existing relationships: therefore trust
• Hierarchical control mechanisms can be preclusive with hybrids
• How do we manage these?
• Control can be enhanced by reducing the number of formal controls
• Financial efficiency is found by doing financially inefficient things!
• Letting loose to the budget – not useful in hybrids to guide outcomes – much more important to tract number of patents in order to innovate
• Abandoning conventional control cultures can foster vibrant cultures to emerge overtimes
• INSTITUTIONS COME TOGETHER TO FACILITATE CHANGE
• …Developing IOR costs management practices
• …Sharing R&D
• …Co-locating employees –BBC didn’t make staff redundant shared with EY

Question 52

Concluding remarks - are TC’s still relevant in the three phases?

Answer 52

• Still relevant in the three phases? Contact/contract/control 3C’s (Nooteboom, 1993)
• Still potential for opportunism/BR/IA etc.
• TC still relevant, still exist
• It’s the way we mitigate them that’s changed
• social
• gone from prescriptive to audit tool
• But using to identify risk and opportunities