SBenegaL

Category: Organizational Theory

  • Uncertainty as a determinant of the transaction governance mechanism

    In the last blog, we discussed what could be the underlying logic for comapnies to choose between hierarchy and market to deal with transactions.In today’s blog we look at how bounded rationality influences this choice, and what are the problems that could come by. When organizations try to deal with transactions, it is the uncertainty and the transaction specific investments that have been seen to create a large variety of problems.
    It is pretty clear that bounded rationality has grown on the uncertainty organizations face – if not for the uncertainty, the bounded rationality would have no meaning. All parties involved in the transaction could ancticipate precisely how the transaction would evolve over time, and so managing it over time is very simple.A contract that specifies all the possible current and future states of the exchange and a clear statement of rights and responsibilities of the parties involved would have made the trick. 
    It could thus be said that greater the level of uncertainty in a transaction, the usage of contracts as a means of governance would be difficult if not impossible; hence a more likely form of governance in that case is the hierarchy one.
    In hierarchical governance, there is a dedicated third party, who decides how the unaniticipated issues that occur during the course of the transaction could be resolved. The parties donot need to anticipate the problems that might emerge eventually – they are taken up on and mediated as and when they arise.

  • When to choose Markets/Hierarchy as a governance mechanism

    In the last blog, we looked at the 2 underlying assumptions of the TCT. In today’s blog we shall discuss about how a choice of governance could be made between the market based approach and the hierarchy based approach.
    Organizations will invariably choose that form of governance that reduces any potential exchange problems created by bounded rationality compared to the threat of opportunism. There is not second thought that governance of economic transactions is a costly venture. Given this premise, we could state the following regarding the choice
    If organizations had to worry about minimizing the costs of governing their economic exchanges, then they would always choose market forms of governance. Alternatively, if the worry was about minimizing the effects of bounded rationality and opportunism on their exchanges, organizations would always choose hierarchical forms of governance.
    The organizations necessarily would have to take a call on which approach to take considering the priority and looking at the potential outcomes of the choice of governance they make.

  • Assumptions of the transaction cost theory


    In the last blog, we looked at Williamson’s TCT formulation. In the current blog we look at the 2 essential assumptions about economic actors engaged in a transaction.
    1. Bounded Rationality
    2. Opportunism

    Bounded Rationality is a term that we have used multiple terms thus far and essentially means – those who are engaged in a transaction are rational but have a limit to this rationality. What does this mean? I helps us realize that we would in the absence of such an assumption be writing contracts that would have unlimited complexity. Economic actors involved in the transaction simply cannot envision all the possible outcomes in an exchange relationship and there for formulate contracts for all eventualities.

    Opportunism refers to incomplete or distorted information disclosure towards misleading or confusing partners in the exchange. It would be highly complex to assume that all actors are always opportunistic, however it would be easier if we begin with the assumption that actors may behave opportunistically and it is extremely costly to make the distinction who is opportunistic and who is not – this is what TCT assumes. It is this threat that in the world we deal with much more than merely the promises.

    These two are important considerations – firms and people should always safeguard to avoid being victimized by the others.

  • Formulation of the Transaction Cost Theory – Williamson

    In the last blog, we looked at how hierarchies could enable effective and efficeint handling of the transactions within the organization. In today’s blog, we look at how Williamson formulates the Transaction Cost Theory – and discuss this further over the next few blogs.
    Williamson approahes TCT stating that markets and hierarchies are alternative instruments for completing a set of transactions. These are called “Governance Mechanisms”.
    While market form of governance relies on prices, competition and contracts to keep all parties to exchange informed rights and responsibiltiies; the hierarchical form of governance get these exchanges doen under an autoritative third part (the boss) who attempts to keep all parties in the exchange informed of their rights and responsibiltiites.
    The following picture summarizes these alternatives as suggested by Williamson’s TCT

  • Hierarchy as a reason for existence of firms – Efficiency derived there in

    In the last blog, we
    discussed why an organization would be necessary when we already have the
    markets that are efficient. In today’s blog we look at interesting reason why
    organizations have a hierarchy – stated differently this approach by
    Alchian-Demsetz approaches the reason for firm’s existence to be measurement
    and metering the problems.
    The measuring problem
    emerges when we talk about ‘team production’; where the underlying motivation
    is the production gains that occurs through cooperation amongst the people when
    executing a complex task. There exists an incentive to cooperate. It is always
    a possibility that there could some Shirking amongst team members and when this
    happens the incentive to cooperate reduces. Shirking could range from cheating
    to merely giving less than one’s efforts.
    The team production
    in such a scenario makes it difficult to assess the contribution of individual
    member – the means to monitor or measure do not enable rewarding based on
    individual productivity. This imperfect connectivity to the reward system could
    potentially get the members to work less diligently. Measures like, splitting
    the income generated equally amongst the members doesn’t eliminate the
    incentive to shirk. (This view might not strictly hold in the J-Form
    organization we discussed earlier; this again would have to be understood in
    the context of the society)
    Such a shirking
    behavior would potentially prevent a high-output individual to join the team;
    or if s/he joins the team, they may become shirkers too!
    In such a scenario it
    would become essential to monitor the team. Monitoring each individual would
    reduce the likelihood of shirking. This introduces a hierarchy of sorts for the
    first time. This doesn’t completely eliminate the hierarchy and there might be
    a need to monitor this monitor and so on. A strong case for this monitoring
    hierarchy with reduced chances of shirking emerges when the monitor is given
    the right to negotiate contracts with all the team members,  monitor their productive efforts and
    (crucially) claim any residual value created by the team has received their
    expected compensation. The final level of this monitoring would rest at the
    stockholders of the company – who could gain from the firm’s residual profit.

  • Why do we require organization?

    In the last blog we
    began our journey towards understanding the various organizational economic
    theories. In today’s blog we initiate a discussion on “why organizations
    exist?”
    For many this
    question would raise some odd feeling – Why even as such a question? We know
    organizations exist, so why did into this at all? It is important to understand
    this question – since in many ways this forms the starting point of
    organizational analysis and there by organizational economics.
    We shall begin
    attempting to answer this question with Adam Smith’s insight that – economy
    could be coordinated by a decentralized system of prices – “the invisible
    hand”. Economics post this aimed at identifying the necessary conditions
    for the effective use of the invisible hand, and designing changes in these
    settings where the conditions are lacking. Continuing on the same lines, it
    would be interesting to ask – since the market is so effective in coordinating
    economic exchanges why would we ever need firms to manage this?
    The answer to this
    question of the existence of firm was provided for the first time by Coase (1937)
    who suggested that sometimes the cost of managing economic exchanges across
    markets is greater than the cost of managing economic exchanges within the organizational
    boundaries. – This argument essentially placed “transaction costs” at
    the center of the analysis of the reason for firm’s existence. In a way the
    theory put markets and organizations as alternatives to managing the same
    transaction.
    Over the next few
    blogs we look at understanding the various theories that fall into this stream
    of organizational economics