Economic Organization and Transaction Costs - Essay Example

Economic Organization and Transaction Costs Introduction In the field of economics, transaction costs also known as frictional costs, regard the overall expenditure/ expenses incurred by firm-entities or enterprises during an economic exchange of goods and services. It is hence incurred as a direct result in overcoming prevailing market imperfections. Definitively, transaction costs cover a wide array of aspects i.e. information cost (of finding product/ service durability, quality and pricing), communication charges and legal fees. Often included in this category are the accrued transportation/ logistical costs. Accordingly, these expenses are crucial in deciding whether or not to make or buy a product/ service (Cheung, 1987, p. 55). The paper will conduct a literature search and review that is related to a case study in transaction cost economics. Focus will be upon General Motors and the Fisher Body Company, during the 1920s, in regard to the pertinent economics of organizations. Background Information There is have to accentuate at the beginning that there is not and will never be one brought together hypothesis of vertical integration. While the writing on vertical integration has a tendency to concentrate on a basic dichotomy between the choice to "make" inside or "purchase" through the business, from a TCE or NIE viewpoint we must be delicate to the way that there are a wide exhibit of business based administration plans that speak to different options for both straightforward unknown rehashed spot market exchanges and vertical integration. These two administration plans are polar cases. Hypothetical and exact research in the NIE convention looks at not just the determinants of the limits in the middle of firms and markets additionally the sources of different "half and half structures" of administration structure that lie between basic mysterious spot market exchanges and bound together various leveled associations with fluctuating regions of vertical and even control. These crossover structures incorporate different sorts of long haul contracts, joint endeavors, double sourcing (incomplete vertical integration), holding organizations, and open undertakings (Williamson, 1996, 2000, p. 598). A classic case study in the economics of organizations, and pertinent to this discussion, regards the relations that prevailed between General Motors, Inc. and the Fisher Body Company, Ltd. during the 1920s. Accordingly, the first of accounts to be provided was by Klein et al, whose (1978) work – Vertical integration, appropriable rents, and the competitive contracting process – was to form the basis upon which all discussions were held. This was until Ronald Coase, presented his perceptions on the issue of transaction cost economics, through his 2000work - The Acquisition of Fisher Body by General Motors (Coase 2000, p. 15). Through this work, Coase was to decisively criticise the then ‘prevailing perception’ on the relations between General Motors and the Fisher Body Company. His criticism was founded upon the grounds that the long held perspective was factually incorrect, providing critical input in support of his arguments. Regarded as the founding father of modern (contemporary) transaction cost economics, his input and experience are thus considered critical towards effectively discussing the case under study. Of particular importance is his visit to the U.S, with specific focus placed upon the car manufacturer industry during the 1930s (Coase 2000, p. 16). He subsequently held a number of insightful interviews with various automobile industry executives, critically regarding the issue at hand. It is upon this experience that is lend significant authority to his dominant critique vis-à-vis the vigorous debate that sprung up as a direct result of the criticism. In particular, Klein (2007) has robustly defended these views, through presentation of a reformulation of the long-held perception on the case, founded upon subsequent availability of contemporary documents (Klein, 2007, p. 299). While a more exhaustive comprehension of the Fisher Body case is by all accounts attractive in its own right, it is likewise fascinating from a more general point of view. Apparently, a superior comprehension of how supply contracts and the decision of authoritative structure cooperate is by all accounts important to answer Coase' (1937) starting inquiry why some exchange are directed in business sectors, while others are led inside firms. A superior comprehension of this issue would likewise help to reveal insight into a debate in the middle of Coase and Klein, who have discussed under which circumstances extensive specific speculations and resource specificity undoubtedly require vertical integration: rather than Klein, Coase declares that advantage specificity issues can all in all be taken care of contractually without the requirement for vertical integration (Coase, 2000, p. 17). There are models that give backing to Klein's (2000) perspective that the starting contractual arrangement was ideal, yet that FB's refusal to put resources into another plant (consequent to a generous increment sought after for shut car bodies) made full vertical integration of FB by GM attractive. While Klein (2000) contends casually that the change sought after conditions pushed the introductory supply contract administration outside its "approving toward oneself territory", he stayed uncertain what precisely it was "about the vast, startling interest increment by GM that brought on Fisher to exploit the flawed body supply administration." One straightforward static model proposes that the change popular conditions intensified FB's venture motivations and did a change to an administration that boosted GM's speculation motivating forces desirable (Klein, 2000, p. 136). Transaction Cost Economics Coase (2000) portrays that the term transactional cost is essential in the effective development of a theoretical framework, upon which is based the prediction of specific economic tasks, as performed by firm-entities. This is in addition to when such economic tasks would also be performed within the prevailing market arena. Critically, this term was essential during his discussion of the ‘costs of utilizing the price mechanism’ in his paper – The Nature of the Firm (1937). He further developed this concept in his later seminal work – The Problem of Social Cost (1960) – upon which the term referred to the ‘accrued costs of prevailing market transactions (Coase, 2000, p. 17). Arguably, OliverE.Williamson was to greatly popularise the term, through his work – Transaction Cost Economics – which has fundamentally aided in the explanation of a variety of organizational behaviours in the contemporary era. This is founded on the notion of not only regarding ‘transactions’ as pertaining to ‘buying and selling’, but also other pertinent interactions i.e. informal gift exchanges and daily emotional transactions etc. Further contribution is by Steven Cheung who conceivably regards transaction costs as pertaining to any cost expenditures which arise as a result of the existence of organizational-entities or institutions (Williamson, 1981, p. 548). Williamson differentiates in his work – The Mechanisms of Governance (1996) – the aspect of Transaction Cost Economics (TCE) from the then dominant ‘neoclassic micro-economics. His basis is founded on six points, regarding: Behavioural assumptions; Governance structure (of organization); Unit of analysis; Discrete structural analysis; Problematic property rights and contracts, as well as the aspect of ‘remedi-ableness. ’ it is within these six points that Transaction Cost Economics is substantially influential in contemporary economics (Williamson, 1981, p. 550). Case Study: An Analysis Regarding the case study at hand – the economics of organization in regard to Fisher Body Company and General Motors relations during the 1920s – it is critical to discuss what pertains to the economics of an organization. Particular focus is placed upon the ‘Transaction Cost Approach', which presents the business transaction as ‘the basic unit of analysis.' Importantly, as Williamson (1981) portrays, is that it also holds the understanding of the aspect of transaction cost economizing as the central element in the successful study of organizations. Accordingly, applications pertinent to this approach necessitate that all organizational transactions be categorized in terms of dimensional contexts (Williamson, 1981, p 551). In addition, is need for the description of prevailing and/ potential alternative structures of governance. Hence, economizing is effectively accomplished through the assigning of transactions to prevailing governance structures of an organization, in a discriminatory manner. The approach is applicable to both the organization of existing internal transactions (inclusive of the employment relations design), and the determination of efficient boundaries i.e. between prevailing market-arenas and firm-entities/ enterprises (Williamson, 1981, p. 555). Therefore, this approach is comparatively analysed in relation to selected parts of literature pertaining to organization theory. To be noted is that the proposition of the firm-entity as a production function to which the objective of ‘profit-maximization’ has been assigned, is less vivid in terms of the organizational theory than for economics. An important factor to add to this is the acknowledgement within the field of economics that the neo-classical theory of the organizational firm is also self-limiting (Cheung, 1987, p. 52). This is informed by the fact that a number of economic approaches have been proposed, in relation to the study of the organization, showcasing the vital importance of the aspect of ‘internal organization’ within firm-entities. Wright (2007) presents the ever-dynamic debate, between the authoritative Ronald Coase and Ben Klein, regarding issues around vertical integration (in organizations), specificity and the all too famous General Motors-Fisher Body example (Wright, 2007). While the example, originally from the Klein, Crawford and Alchian (1978) work – Vertical integration, appropriable rents, and the competitive contracting process – is over 3 decades old, it has and continues being the foundational basis on which the entire (April 2000) JLE Issue and various debates are rooted in (Klein, Crawford& Alchian, 1978, p. 297). However some disagreement prevails, especially in regard to the facts present, with core focus on what the data avails about the relationship between vertical integration and asset specificity. Notably however is the fact that this does not add much to the basic understanding of the crucial ‘theory of the firm’, in relation to the industrial organization setting. It is important to note however that it aids in better understanding what essentially happened with the General Motors-Fisher Body relation, and more so with reference to subsequent academic discourse in the field of economics. The two opposing figures have mainly been embroiled over the authenticity of each other’s contribution to the issue of organizational theory of the firm (Wright, 2007). Coase through his replying publication – The Conduct of Economics: The Example of Fisher Body and General Motors – was to essentially attack Klein’s account, as well as the JLE (April 2000 edition) response. This was based on the recent move made the Klein, upon obtaining a copy of the contract of 1919 between General Motors and Fisher body that was previously unavailable. Klein had sent both the contract copy and an early draft version of his paper to Coase, who subsequently responded as aforementioned. The attack by Coase on Klein was based on the former’s argument that Klein had made up this case context, in order to fit into the theory of the firm (Klein, 2007, p. 2). Accordingly, Coase further stated that the alleged ‘hold up’ essentially ‘never occurred’ based upon the fact that Fisher Body had not taken any actual steps in terms of mis-locating plants, or even adopted a low-capital technology of production. In reference to the alleged ‘hold up’, Coase was of the view that it is upon these two aspects that Klein had founded his initial ‘disputable’ researches. Furthermore, Coase’s vivid criticism of different economists who generally fail to check-out data/ facts and their subsequent inclination towards reliance on the theory (of the firm) solely in their different endeavours is also important in this case (Coase, 2000, p. 20). Klein however was not to be easily challenged, subsequently responding with his work – The Economic Lessons of Fisher Body-General Motors (2007). According to his analysis, he subsequently incorporated the 1919 contract, previously unavailable to the Dupont case record. Within his new analysis, he showcased vivid evidence of the expressed refusal by Fisher Body, to locate its plants next to facilities operated by General Motors. Additionally, he further provided evidence of the subsequent remarkable increase in the measured capital to sales ratio of Fisher Body after 1922. Critically as he asserts, it is this evidence that demonstrates the position taken by Fisher Body, in terms of leveraging its ‘bargaining power/ position.’ The leveraging was in response to GM’s restricted purchasing commitment, in terms of re-negotiating a ‘more-favourable contract adjustment’ during the year 1922, prior to the subsequent agreement to co-locate their plants. From this new analysis, aided by the presence of new evidence i.e. the 1922 contract adjustment and the contract itself, Klein further advanced his factual record through correcting various details of his prior account. Accordingly, he corrected his earlier account through stating that the issue at hand was not mi-location of the concerned plants but rather, a threat to the crucial aspect of mis-locating the plants (Klein, 2007, p. 12). This was in addition to a reduction in the capital to sales ratio that had resulted in the substantial increment of profits by Fisher Body during the 1922-26 time-frame. He provides that through focus on the 1922 contract adjustment, in regard to the manner in which Fisher Body ‘held up’ General Motors, there is a reconciliation of all existing evidence. Specifically, he portrays, is that no plants had been mis-located and that Fisher Body had been bound by the contract to utilize efficient production technology. This is fully consented by Fisher Body’s original refusal to relocate its ‘body-parts’ plants next to assembly facilities operated by GM. Argumenting his argument is the fact that Fisher Body experienced a reduction in its actual, measured capital to sales ratio. Pertinent also are the resultant complaints by GM, concerning the extra costs that it was bearing as a result of the capital intensity reduction of Fisher Body. Furthermore is the fact that the contractual adjustment of 1922 proved consistent with his proposed ‘theory of the firm (holdup behaviour)', in which participating transactors are portrayed as attempt to ‘hold up’ their pertinent transacting partners, in the most efficient of ways possible (Klein, Crawford & Alchian, 1978, p. 300). Conclusion General Motors and the Fisher Body Company case that occurred during the 1920s has significantly affected economic discussions and undertakings in the current world. The debate between the two scholarly authorities aptly demonstrates what is positive in terms of developing the crucial economic theory. The original seminal Klein, Crawford and Alchian (1978) seminal work on asset ‘hold-up and specificity’, motivated the subsequent discussion of transaction costs, especially in relation to long-term contracts. Subsequent attacks by Coase amongst others, challenging the account by Klein, in terms of not only the facts, but more so how these facts ought to be interpreted in terms of the theory of the firm. Klein’s subsequent response in the JLE (2000) was to provide detailed account of the then prevailing contractual relationship between GM and Fisher Body, thereby enhancing contemporary understanding of what really occurred. Furthermore is the fact that this debate was to eventually spur increased empirical literature that tested the prevailing association between vertical integration and asset specificity, which essentially confirmed the theory of the firm. List of references CHEUNG, S.N.S., 1987. Economic Organization and Transaction Costs. The New Palgrave: A Dictionary of Economics, 2, pp. 55-58. COASE, R., H, 2000. The Acquisition of Fisher Body by General Motors. Journal of Law and Economics, 43(1), pp. 15-31. GMFB, 1919. Contract between General Motors and Fisher. Study Space. KLEIN, B., 2007. The Economic Lessons of Fisher Body - General Motors. International Journal of the Economics of Business, 14(1), pp. 1-36. KLEIN, B., CRAWFORD, R. and ACHIAN, A., 1978. Vertical Integration, Appropriable Rents and the Competitive Contracting Process. Journal of Law and Economics, 21(2), pp. 297-326. Klein, B. (2000). “Fisher-General Motors and the Nature of the Firm.” Journal of Law and Economics. 43, pp.105–141. WILLIAMSON, O.E., 1981. The Economics of Organization: The Transection Cost Approach. American Journal of Sociology, 87(3), pp. 548-577. Williamson, Oliver. 1996. The Mechanisms of Governance. New York: Oxford University Press. Williamson, Oliver. 2000. “The New Institutional Economics: Taking Stock, Looking Ahead,” Journal of Economic Literature 38: 595-613. Critical Bibliography Williamson’s work is cited since is he is the founding father of transaction cost economics and he mainly based his ideas on papers done by Coase (19937, 1960). Coase papers are also cited because of their importance on the GM-Fisher case in addition to the fact that his views were contradictory to those of other authors who had an interest in the GM-Fisher case Klein et al (1978) have been used as he was the first one to break the GM-Fisher case to the public. Klein also published many papers in regard to the GM-Fisher case. Read More