Transaction cost economics and its uses in marketing

Transaction cost economics and its uses in marketingOliver Williamson &Tarek GhaniReceived:6June 2011/Accepted:10June 2011/Published online:15July 2011#Academy of Marketing Science 2011Abstract Scholarship at the intersection of transaction cost economics (TCE)and marketing has enjoyed an impressive record of growth over the past three decades,and the future promises more of the same.Following Erin Anderson ’s perceptive uses of TCE in her 1982dissertation,the field of marketing has made many constructive uses of and contributions to TCE,where the latter include broadening the reach of TCE,posing important challenges,and identifying opportunities still to be addressed.Given this history,we advance the proposition that the relation between TCE and marketing has been and should be a two-way street.In considering the scope for future research,we give special attention to issues of asymmetric costs,the dynamics of governance,and disequilibrium contracting.We also discuss the four precepts of pragmatic methodol-ogy,with special emphasis on prediction and empirical testing.The Appendix provides added perspective on the evolving “science of organization ”of which TCE is a part.Keywords Marketing .Transaction cost .Empirical testing .Economizing .Microanalytics .Public policy toward businessWe responded to the invitation to contribute a “thought piece ”to the 40th anniversary issue of the Journal ofAcademy of Marketing Science (hereafter JAMS)with alacrity.After all,transaction cost economics and JAMS have grown up together.Although the concept of transaction cost and the effort to operationalize it (transaction cost economics)are closely related,they should nevertheless be distinguished.The concept of transaction cost was advanced by Ronald Coase in his pathbreaking paper on “The Nature of the Firm ”(1937)to repair a serious lapse in microeconomics —namely,the distribution of economic activity as between firm and market was taken as given,when instead such a fundamental condition should be derived.This lapse was mainly ignored by the economics profession until Coase (1960)and Kenneth Arrow (1969)pushed the logic of zero transaction costs to completion to reveal that both market failures and vertical integration would vanish —because the parties to such trans-actions would always costlessly bargain to an efficient result.That was preposterous,yet it takes a theory to beat a theory (Kuhn 1970).Williamson ’s 1971paper on “The Vertical Integration of Production:Market Failure Consid-erations ”was an effort to breathe operational content into positive transaction costs in the context of vertical integration and,as such,was an early effort to implement transaction cost economics (TCE).The first issue of JAMS would appear 2years later in 1973.By the early 1980s,these two would be working together —with the under-standing that within marketing it was more appropriate and/or judicious to refer to TCE as transaction cost analysis,or TCA.1Forty years later a constructive relation between the two is alive and well.1We see merit in this distinction but refer to TCE throughout.In fact,although TCA is mainly based on TCE reasoning,it also appeals to agency theory.For some purposes,TCE and agency theory are complementary constructions.O.Williamson :T.GhaniHaas School of Business,University of California,Berkeley,Berkeley,CA 94720–1900,USA T.Ghanie-mail:tarek_ghani@ O.Williamson (*)Business,Economics and Law,Berkeley,CA,USAe-mail:owilliam@J.of the Acad.Mark.Sci.(2012)40:74–85DOI 10.1007/s11747-011-0268-zThis thought piece is organized in four parts.We begin with a digression in which Williamson recalls early uses of TCE by Erin Anderson to examine issues of central importance to marketing.The second section discusses the uses of TCE reasoning and analysis in the years since and advances the proposition that the relation between TCE and marketing should be a two-way street.The third section discusses pragmatic methodology and related issues.The final section and an appendix on the progression of TCE conclude the paper.A digressionThis section briefly discusses Erin Anderson’s early recognition that TCE had ramifications for marketing research in the1980s and beyond.I first met Erin when she joined the faculty of the Marketing Department at the Wharton School in the fall of 1981.2Erin had been a student of both Barton Weiss(in marketing)and William Ouchi(in organization theory) when she did her PhD work at UCLA.Bill was an organization theorist with an early interest in transaction cost economics3and urged Erin to include TCE within her toolkit.Weiss even more strongly encouraged her to bring transaction cost economics to bear on marketing issues(A. Gatignon and H.Gatignon2010,p.232)in her dissertation.I never asked Erin if either Bill or Bart encouraged her to participate in the Industrial Organization Workshop at Penn, but she showed up at the first IO Workshop in the fall of 1981.She immediately caught my attention and that of other workshop participants(including Sanford Grossman, Henry Hansmann,Pablo Spiller,and Michael Riordan)by “asking good questions.”4I made a point of introducing myself to Erin after her third consecutive week of attendance.Not only did Erin become a regular attendee with many perceptive good questions,but Erin also made workshop presentations and began publishing articles that featured TCE.Her article on“The Salesperson as Outside Agent or Employee:A Transaction Cost Analysis”(1985)is the first marketing article to put TCE to work.I moved to Yale in1983and Erin joined the INSEAD faculty in1994,but we had professional and holiday correspondence in the interim.Then another lucky thing happened:a European conference on“Transaction Cost Economics and Beyond”was being organized,and I was asked to participate.I inquired about the other participants and ascertained that many were skeptics of transaction cost economics.I therefore recommended that additional schol-ars be invited—to include Erin Anderson,Keith Crocker, Paul Joskow,Scott Masten,Claude Menard,and Margherita Turvani.The conference organizers agreed,and the confer-ence was held in1994.The conference featured spirited discussions between the skeptics and the supporters of TCE.Indeed,during much of the conference we were often at a“he says/she says”impasse.Yet there was a difference.The difference was not that one side was more eloquent or made more clever oral arguments than the other.To the contrary,a neutral observer would have concluded that it was a draw in oral argument respects. The difference was that,in addition to the oral argument, one side had a predictive theory for which the data were corroborative,whereas the other side was empty handed in this respect.As will be discussed in the third section, the cutting edge for separating the sheep from the goats resides in the fourth precept of pragmatic methodology: derive refutable implications and submit these to empir-ical testing.It is undisputed that TCE made headway within economics,the contiguous social sciences,and the business schools because it had ramifications for such a broad range of phenomena to which the data are corroborative.5I was especially gratified when Erin informed me when I visited INSEAD a decade later that the timing of the1994 conference could not have been better:it inspired her to re-engage TCE in her teaching and research with even greater confidence and energy.History records that hers was an exceptionally successful career.6Everyone who knew her—family,friends,students,colleagues—mourned her untime-ly death from cancer in2007.2Because Tarek Ghani did not have the pleasure of meeting Erin Anderson,the use of the first person singular pronoun in this section refers to Williamson.3Ouchi wrote a very favorable book review of Markets and Hierarchies(1975)for the Administrative Science Quarterly(1977). He and I had many occasions to share ideas in the years since.4Kenneth Arrow related to me that the reason he remembered me as one of his students is that I“asked good questions”in a course that I took from him when I was an MBA student at Stanford.Arrow further observed that asking good questions is how he came to the attention of his teachers when he was a PhD student at Columbia.5Empirical tests of transactions cost economics numbered over900in 2006and have been broadly corroborative(Macher and Richman 2008).Indeed,“despite what almost30years ago may have appeared to be insurmountable obstacles to acquiring the relevant data[which are often primary data of a microanalytic kind],today transaction cost economics stands on a remarkably broad empirical foundation”(Geyskens et al.2006,p.531).There is no gainsaying that transaction cost economics has been much more influential because of the empirical work that it has engendered(Whinston2001).6Erin Anderson“published43scholarly articles as well as six book chapters on transaction costs in action,and was nominated in ISI’s top 0.5%most cited scholars in business and economics in2003”(A. Gatignon and H.Gatignon2010,p.232).Constructive usesScholarship at the intersection of transaction cost economics and marketing has enjoyed an impressive record of growth in the three decades following the completion of Erin Anderson’s dissertation(1982).As Macher and Richman(2008)observe in their review of approximately900articles testing TCE theory,marketing places second only to industrial organization economics in generating new business-related empirical TCE research. Among the uses of TCE in marketing are vertical integration, foreign market entry,industrial purchasing,distribution channel management,and sales force control and compensa-tion.7Marketing has also been at the forefront of efforts to test TCE’s antecedents and implications.The main value of TCE theory to marketing scholars has been in providing a constructive framework for analyzing contractual exchange,with testable implications that have proven empirically robust across a wide range of applica-tions.More generally,the field of marketing has broadened the reach of TCE,posed important challenges,and identified opportunities still to be addressed.Indeed, marketing and TCE scholars have much to gain from a more regular,two-way research dialogue.In this spirit of interdisciplinary exchange,we briefly review in this section the principal means by which TCE has informed marketing and the major themes through which marketing has in turn informed TCE.Given that several excellent overviews of the marketing-TCE literature already exist(e.g., A. Gatignon and H.Gatignon2010;John and Reve2010; Rindfleisch and Heide1997),our intention is not to provide a comprehensive survey of past and current research,but rather to draw out recurrent themes,highlight novel insights,and clarify ambiguities.TCE informs marketingTCE differs from the neoclassical lens of choice,which places its primary emphasis on prices and output,supply and demand,by examining economic organization through the lens of contract/governance and taking the transaction to be the basic unit of analysis.TCE joins Coase(1937, 1960),in his insistence that the standard assumption of zero transaction costs needs to give way to express provision for positive transaction costs,and John mons,in his pronouncement that“The ultimate unit of activity…must contain in itself the three principles of conflict,mutuality and order.This unit is a transaction”(1932,p.4).Not only does TCE take the transaction to be the unit of analysis,but TCE also interprets governance as the means by which to infuse order,thereby to mitigate conflict and realize mutual gains from trade(both interfirm and intrafirm).Transaction cost economics took shape by progressively operationaliz-ing this agenda.8As described by Williamson(2010),the key moves in TCE are:(1)to examine economic organization through the lens of contract/governance;(2)to identify the key attributes of human actors(bounded rationality and oppor-tunism)that bear on the efficacy of contracting;(3)to name the key attributes of transactions to which contractual complications accrue,especially asset specificity(which gives rise to bilateral dependency)and disturbances (especially outliers,for which the stakes are great);(4)to take adaptation to be the main problem of economic organization,of which autonomous and coordinated types of adaptation are distinguished;(5)to name the key attributes that describe alternative modes of governance (with special emphasis on the syndromes of attributes that define markets and hierarchies);and(6)to advance the discriminating alignment hypothesis—wherein transactions, which differ in their attributes,are aligned with governance structures,which differ in their cost and competence,so as to effect a transaction cost economizing outcome.The basic regularities are these:if asset specificity is low,autonomous adaptation to changes in relative prices in the market (simple market exchange)will be efficient.As,however, asset specificity builds up and a condition of bilateral dependency develops,consequential disturbances pose interfirm contracting hazards for which hierarchy affords relief.As John and Reve(2010)observe,TCE has come to occupy a significant place in mainstream marketing strategy.As a variant upon TCE,the authors note that S-A-M governance structures—whereby parties to a transac-tion devise Safeguards thereby to promote Adaptations to changing circumstances for activities that lack verifiable outcome Measures—“constitute the workhorse model of channel mode choice in contemporary textbooks”(p.250).9 This consensus builds upon the work of Anderson’s dissertation(1982),which provided compelling early evidence for the role of behavioral uncertainty and specific investments in sales force management by electronics firms, and the related marketing research that followed(e.g. Anderson1985,1988a;Carson2000;Heide1987;John7See Rindfleisch and Heide(1997,p.30)for a detailed list of references corresponding to each of these five categories.8Other early contributors include Victor Goldberg(1976);Klein et al.(1978);Klein and Leffler(1981);Monteverde and Teece(1982); Scott Masten(1984);Masten and Crocker(1985);Anderson and Schmittlein(1984);Paul Joskow(1985,1987);and Grossman and Hart(1986)9It is noteworthy how closely S-A-M processes replicate the “Commons Triple”of conflict,mutuality,and order.For one example of a marketing textbook that makes productive use of TCE,see Coughlan et al.(2006),particularly chapters8,9,and13.and Weitz1988;Noordweier1986).10This branch of the marketing literature is focused mainly on the human capital dimensions of asset specificity and as such makes a distinctive contribution to the empirical study of TCE.While the most widely known applications of TCE in marketing deal with the classic question of governance mode and related issues of vertical integration,a number of sub-literatures have also developed that apply TCE to interpret other novel marketing phenomena,test the robustness of TCE’s predictions,or examine TCE’s bound-ary conditions.John and Reve(2010)review novel applications of TCE to marketing puzzles,such as incentivizing sales staff to focus on house brands over national brands(Anderson and Robertson1995),the co-branding of component-provider logos with certain prod-ucts and services(Ghosh and John2009),and the granting of royalty-free licenses for so-called“clone products”in the electronics industry(Dutta1990).A recurrent theme in all of these cases is that the action resides in the microanalytics of transactions and governance structures.Numerous other studies have subjected TCE’s predictions to empirical scrutiny in the marketing context.Rindfleisch and Heide’s detailed survey(Rindfleisch and Heide1997)finds broad support across45empirical studies for TCE’s conceptual emphasis on safeguarding specific assets,adapting to environmental uncertainty,and the firm’s decision to invest in performance measurement technologies.11The last point concerning performance measures receives attention both within firms,in the case of employee monitoring costs where human capital is a specific asset,and between firms, when trading partners seek independent qualifications of each other’s capabilities(e.g.,Heide and John1990).These authors also propose extensions to or improvements upon TCE,some of which are addressed below.Among other marketing issues to which TCE speaks but, evidently,has not been fully persuasive are the issue of “trust”and the explication of hybrid modes of contracting (where these two are related).TCE expressly takes exception with the propensity among sociologists and some economists to treat calculated risk as a manifestation of “trust”in commercial transactions.Calculated risks are precisely what the term implies:take the risk if the expected net gains are positive but not ing trust and calculated risk interchangeably introduces avoidable confu-sion by introducing problems of two kinds.First,use of the word trust serves often to suspend hard-headed analysis by inviting ex post rationalizations(as discussed in Williamson (1996a,pp.256–267)).Second,expansive use of the word trust commonly obfuscates the mutual gains from trade that are often realized by introducing credible commitments, thereby mitigating contractual hazards.Specifically,TCE interprets the hybrid mode of gover-nance as a means to mitigate the contractual hazards that would accrue to market exchange(by reason of asset specificity and uncertainty)without incurring the added bureaucratic costs and loss of incentive intensity that arise under hierarchy.The mechanisms through which hybrid contracting works include penalties for breach of contract, better information disclosure and verification,and private ordering dispute settlement mechanisms that promote continuity rather than rely on the adversarial process to award financial damages in the courts(Williamson1983, 1991).To repeat,such hazards are mitigated(but not eliminated)in a cost-effective way.Hybrids,so construed, are vital to effective marketing relationships(especially in intermediate product markets,but they have application to final goods and services as well).Appealing to trust draws attention away from hard-headed contracting—with the result that our understanding of efficient trade is sacrificed in the process.Marketing informs TCEAs A.Gatignon and H.Gatignon(2010,p.241)observe, Erin Anderson’s academic career began shortly after TCE’s development,and she played an instrumental role in providing the theory with empirical grounding.Crucially, Anderson also provided a roadmap for how other scholars could apply TCE in new research areas:look for novel applications,take testable hypotheses to the data,and extend the robustness of results.As a result of her disciplined research and that of many scholars who followed,the research frontiers in marketing—and TCE more generally—rest on a stronger and more diversified foundation.Marketing scholars have not only advanced several new research themes which warrant attention from TCE economists,including asymmetric costs and dynamic governance,but they are also well positioned to contribute to nascent efforts to develop and estimate structural TCE models.What,for example,is the cost to firm performance associated with making the“wrong”choice in the make-or-buy decision,and how does it relate to the underlying conditions of asset specificity and uncertainty in the contractual exchange?John and Reve(2010,pp.250–251)address this question,citing the findings of Rao (2009)that firms that mistakenly choose high-powered incentives for compensating their sales force suffer a larger penalty than firms that mistakenly choose low-powered10Interestingly,many of the early uses of TCE in marketing weredone by PhD students working on their dissertations.Some have been heard to say(with a wink)that TCE is“young people’s economics.”11The performance evaluation problem,as framed by Rindfleisch andHeide(1997,p.45),“arises when a firm whose decision-makers are limited by bounded rationality has difficulty assessing the contractual compliance of its exchange partners.”incentives.Also,Anderson(1988b)shows that wrong choices in high uncertainty regimes carry a significant penalty,while wrong choices in low uncertainty regimes may not.Rao’s(2009)conjecture that hierarchies provide insurance against costly mistakes is intriguing and warrants further research.Marketing scholars have also been active in expanding TCE’s theory horizons.The dynamics of governance is one area where marketing scholars have sought to push the envelope.A.Gatignon and H.Gatignon(2010,pp.240–241)provide a rich discussion of switching costs facing managers converting from one mode of governance to another,as well as a life-cycle approach to market relationships in which principal-agent relationships evolve over time.Switching costs offer one possible mechanism by which a governance decision becomes locked-in(Anderson and Gatignon1986;Guiltinan1974;Weiss and Anderson 1992),despite the possibility that changes in contracting conditions or the principal-agent relationship may lead alternative governance arrangements to be preferred(e.g., Jap and Anderson2007).Quantifying these switching costs, and exploring the gap between perceptions and realities,is worthy of more attention.Also,as TCE is further formalized(Tadelis and Williamson2011),dynamic gover-nance choices may provide a setting in which marketing scholars and TCE economists can collaborate,drawing upon a growing stable of dynamic contracting models(e.g., Bolton and Dewatripont2005,chap.9–10).Closely related to the questions of dynamic governance are the“disequilibrium contracting”issues that are posed by high velocity events,especially in conjunction with organizational and technological innovations.Real time responsiveness often trumps steady-state equilibrium con-siderations in such circumstances(Williamson1991).The simultaneous provision of high-powered incentives to the parties while avoiding the burdens of bureaucracy(Wil-liamson1985,chap.6)come to the fore,of which specialized financial structures(such as venture capital firms and leveraged buyouts)are examples(Williamson 2009).Marketing exigencies doubtless also arise for which disequilibrium contracting and organizational issues trump those that are pertinent to efficient alignment in more mature markets.These likewise warrant scrutiny.Familiar-ity with the equilibrium TCE setup nevertheless provides a baseline to inform the when and why and how of disequilibrium contracting—although not to the exclusion of other frameworks.As for future TCE empirical applications,Rindfleisch and Heide(1997)argue that“marketing’s rich tradition in construct measurement and survey research techniques have contributed to the operationalization and testing[of TCE]”(p.30).Interim developments in and uses of TCE notwithstanding,Rindfleisch et al.(2010)do not in the least regard this as a finished project and encourage motivated scholars to pursue challenging research opportunities. Perhaps,as John and Reve(2010)suggest,TCE marketing scholars will be among those next to address the empirical challenges of bounded rationality,or take the lead in formalizing and structurally estimating TCE models.If so, we hope they will find many willing research collaborators among our colleagues in the economics field.Indeed,as the marketing and strategy literatures make clear, still additional TCE challenges arise when issues are not posed de novo but as between pre-existing firms that have heterogeneous backgrounds.In that event,questions such as the following should be posed:“How should firm A—which has pre-existing strengths and weaknesses,core competencies and disabilities—organize X?”(Williamson1999,p.1103). TCE not only can be but has been and should be pushed to examine such circumstances by marketing research(John and Reve2010,p.283).Pragmatic methodologyBoth transaction cost economists and marketing specialists who have brought transaction cost analysis to bear on marketing issues(1)are interested in applied issues,(2) recognize that much of the relevant action resides in the microanalytics,(3)regard economizing on transaction costs to be important,and(4)believe that understanding complexity is a pluralist enterprise in which several focused lenses are usefully brought to bear.12Also,implicitly if not explicitly,many transaction cost economists and marketing scholars subscribe to the four precepts of pragmatic methodology.A sketchPragmatic methodology is herein discussed in a two-part way.The four precepts of pragmatic methodology are set out first.The transaction cost economics ramifications of the four precepts are then examined.13Describing himself as a native informant rather than as a certified methodologist,Robert Solow offers a“terse description of what one economist thinks he is doing”(2001,p.111)in the form of three precepts:keep it simple; get it right;make it plausible.Keeping it simple is accomplished by stripping away inessentials,thereby to 12Some marketing scholars are keen to move beyond the baseline setup and address new challenges.Others appear to believe that the basic model is unduly simple and/or over constraining.Although we applaud efforts to move beyond the basic setup,we believe that TCE is foundational and take the occasion here to set out the rudiments.13This discussion of pragmatic methodology is based on Williamson (2009,pp.145–157).focus on first order effects—the main case,as it were—after which qualifications,refinements,and extensions can be introduced.Getting it right entails working out the logic. And making it plausible means preserving contact with the phenomena and eschewing fanciful constructions.Solow observes with reference to the simplicity precept that“the very complexity of real life…[is what]makes simple models so necessary”(2001,p.111).Keeping it simple requires the student of complexity to prioritize:“Most phenomena are driven by a very few central forces. What a good theory does is to simplify,it pulls out the central forces and gets rid of the rest”(Friedman1997,p. 196).Central features and key regularities are uncovered by the application of a focused lens.Getting it right“includes translating economic concepts into accurate mathematics(or diagrams,or words)and making sure that further logical operations are correctly performed and verified”(Solow2001,p.112);plausible simple models of complex phenomena are expected to “make sense for reasonable or plausible values of the important parameters”(Solow2001,p.112).Also,because “not everything that is logically consistent is credulous”(Kreps1999,p.125),fanciful constructions that lose contact with the phenomena are suspect—especially if alternative and more realistic models yield refutable implications that are congruent with the data.This last brings us to a fourth precept:derive refutable implications to which the relevant(often microanalytic) data are brought to bear.Nicholas Georgescu-Roegen had a felicitous way of putting it:“The purpose of science in general is not prediction,but knowledge for its own sake,”yet prediction is“the touchstone of scientific knowledge”(1971,p.37).Indeed,most economists know in their bones that theories that are congruent with the data are more ton Friedman’s reflections on a lifetime of work are pertinent:“I believe in every area where I feel that I have had some influence it has occurred less because of the pure analysis than it has because of the empirical evidence that I have been able to organize.”14Inasmuch as the social sciences deal with exceptionally complex phenomena(Simon1957,p.89;Wilson1999,p. 183),“any direction you proceed in has a very high a priori probability of being wrong;so it is good if other people are exploring in other directions”(Simon1992,p.21). Accordingly,we are concerned with theories(plural)rather than a theory(singular).Also pertinent in this connection is that theories rarely appear full blown but undergo a natural progression—from informal to pre-formal,semi-formal, and fully formal stages of development—over which interval the relation between the theory and the evidence is interactive(Newell1990,p.14).Successive refinements and reformulations of a theory do not,however,go on indefinitely.Sooner or later the time comes for a reckoning when each would-be theory needs to stand up and be counted—by which we mean that each candidate theory should be examined with reference to the four precepts of pragmatic methodology,with special emphasis on the last.TCE’s responses to the four preceptsTransaction cost economics subscribes to this framework and advises other would-be theories of firm and market organization to do the same.The TCE response to the first precept—keep it simple—is to take economizing on transaction costs to be the main case.As discussed earlier, this is implemented by taking adaptation to be the main problem of organization,of which autonomous and coordi-nated adaptations are distinguished—where autonomous adaptations are accomplished in the market in response to changes in relative prices(and constitute the“marvel of the market”to which Hayek(1945)gave prominence),whereas coordinated adaptations are accomplished in a“conscious, deliberate,purposeful”way with the support of hierarchy (and constitute the“marvel of hierarchy”to which Barnard (1938)gave prominence).The transaction cost economics response to the precept “get it right”is to examine the economizing purposes of economic organization through the lens of contract,rather than rely entirely on the neoclassical lens of choice.As applied to the economics of organization,the lens of contract divides into two parts:ex ante incentive alignment and ex post governance.Of these two,transaction cost economics focuses predominantly on the ex post gover-nance of contractual relations,with emphasis on the mutual gains to be realized by looking ahead,identifying hazards, and crafting cost effective credible commitments—which, in the limit,entail taking transactions out of the market and organizing them hierarchically under unified owner-ship.The move from the lens of choice to the lens of contract is consequential.Whereas textbook economic theory treats the firm as a black box for transforming inputs into outputs according to the laws of technology, as a consequence of which organization is unimportant, TCE expressly holds otherwise.Not only is organization important,but operationalization is undertaken with the object of making organization susceptible to analysis.The governance of contractual relations prominently makes its appearance.Making it plausible poses unexamined tensions with both of the first two precepts.When plausibility collides with simplicity and mathematical tractability,what to do?14Personal communications from Milton Friedman to Oliver Williamson,February6,2006.。