The Importance of Transaction Cost Economics - Literature review Example

1. INTRODUCTION: Transaction Cost Economics (TCE) represents one of the first and most influential attempts to develop an economic theory that takes seriously the structure of firms. Previously, the internal workings of the firm were not given much importance by the economic theories. Because of this reason it was felt by the old theories of economics that the management control of the firm is not in any way connected with the changes in the structures of the firm and such changes are a natural outcome of the external economic changes. However, "TCE's main theme is that transactions -which differ in their attributes - are aligned with governance structures-which differ in their costs and competencies - in a discriminating, economizing way"- Roland F. Spekle (2001). It may be observed that some organizations use very extensive and formal planning to direct their efforts, whereas other organizations may not attach that much importance for planning. Similarly rules, procedures and standards dominate the working of some firms while individual judgments provide the basis of working in other firms. Although, these phenomena do not find any statutory explanation for such organisational behaviours, Management Control theory has come a long way in providing satisfactory explanations in this direction. On a similar footing "TCE studies organization from a comparative point of view in which different institutional arrangements are considered alternative ways to organize economic activity" - Roland F. Spekle (2001). TCE tries to explain the rationale behind the behaviour of an organization in getting some transactions executed within the same organization while some other transactions are getting outsourced. The TCE's reasoning to this specific attitude of the firms lies in the fact a specific institutional arrangement is chosen to govern a specific transaction because that arrangement offers some distinctive set of control devices. Another filed of economics which deals with the organisational behaviours is the Evolutionary theories which have a long tradition in the literatures of socio-economics and strategic management and have influenced recent studies of the evolution of management accounting systems. "A review of the literature of economic indicates that three main concepts are at the core of evolutionary thinking: institutionalization, capabilities and learning and change". - Alan F. Coad and John Cullen (2006). Thus Evolutionary Theories also centre on the basic concepts of organizational changes due to these three factors. This paper envisages describing the basics of Transaction Cost Economics and Evolutionary Theories, the nature of their relationships and their relative contribution to Management Accounting. 2.0 TRANSACTION COST ECONOMICS (TCE): Transaction Cost Economics is most associated with the work of Oliver Williamson. It must be emphasized that while Williamson's work is very distinctive, it falls well within mainstream economic thinking. It is sometimes said that TCE attempts to explain why firms exist. That is why there are some transactions directed by managers in the context of a hierarchy, as opposed to taking place in an open market. It's more accurate, though to say that TCE tries to explain the particular structure of a firm, most importantly, the extent to which it will integrate vertically. Williamson's theory is based on the assumption that the primary aim of firms is profit maximising and that involves cost minimization. He also tried to make distinction between transaction costs and production costs. Production costs are assumed to be those which are incurred to build and run an 'ideal business setup' and transaction costs are those incurred for departure from the ideal set up. As it is the fact that the existence of the 'ideal set up' requires a perfectly efficient market and the prerequisites of such a market are the factors like availability of full information to all the parties and perfect competition among other requirements. Departures from these idealistic set up can result in firms incurring costs when they attempt to sell or buy goods or services. Such transactions can be internal or external to an organization. Under such circumstances: Transactions occur whenever a good or service is transferred from a provider to user Transaction costs depend on how the transaction is organized based on the governance structure Within an organization, costs include managing and monitoring personnel and monitoring personnel and procuring inputs When buying from an external provider, costs can include source selection, contract management and performance monitoring. 2.1 ASSUMPTIONS OF TRANSACTION COST ECONOMICS: The following are the basic assumptions of TCE: Bounded Rationality - refers to the fact that people have limited memories and limited cognitive processing power. It is humanly impossible to collect all the information pertaining to any issue and also it is not possible to predict the consequences of such accumulated information. This is applicable for the business mangers as well who cannot consider all the alternative courses of action and this limitation is further accentuated by the fact that while reaching decisions the managers have to take into account the actions of the competitors apart from the firm's own circumstances. Opportunism - refers to the possibility that people will act in a self interested way 'with guile' as Williamson puts it. It cannot be assumed that people will be entirely honest and truthful about their intentions. There may arise situations when people will try to take advantage of unforeseen circumstances that give them a chance to exploit the other party. It cannot be always told in advance that who is an opportunist and who is not. 2.2 FACTORS AFFECTING TRANSACTION COSTS: The following factors and characteristics of transactions can affect the transaction costs: Investments in transaction specific assets improve the efficiency of some transactions- examples of such investments to include investments according to size specificity, specialized equipment or tooling, specific skills or knowledge, dedicated capacity or brand name or reputation. If parties behave opportunistically (as per the assumption of TCE) they can capture the value of the investments made by others. The assumption of bounded rationality limits the ability of both managers and contract s to control incentives. Since the value of the transaction specific assets depends on the smooth and continued relationship of buyer and seller, the party who has not invested may threaten the other party of a possible walkout which is denoted by opportunism. This may create some loss to the party who has invested more. Because of the limitations on the managerial capabilities also organizations cannot effectively manage an unlimited number of transactions internally. 2.3 VARIABLES OF TRANSACTION COST ECONOMICS: The variables that affect the Transaction cost Economics are: Frequency: Frequency is the variable which can be easily dealt with. As it is there may not be too many occasions that the firm would like to bring in a vertical integration proposal unless it is warranted by strong reasons of growth factors. Although this variable occurs in the life of a firm infrequently, the effect of this variable is tremendous on the transaction costs. Uncertainty: The longevity over which the transactions take place determines the impact of the transaction costs to the firm. Transactions that take place on 'spot markets' will have relatively little uncertainty, because one doesn't have to predict the future in the case of such transactions. On the other hand, transactions that involve a commitment over some time would have built uncertainty into the transactions. Bounded rationality is also partially responsible for the problems caused by uncertainties. Since it would be out of practicality for any one to foresee all the possible eventualities, it may give rise to additional transaction costs. Asset specificity: This is the most important element in the TCE theory. According to the theory, where transactions involve assets that are only valuable in the context of a specific transaction, transaction costs will show a lowering tendency as a result of vertical integration. Asset Specificity can further be explained in this way: some goods and services can be produced more efficiently if one of the parties invests in 'transaction specific' assets that cannot be easily be put to other uses if the buyer/seller relationship breaks down. Asset specificity can take a host of other forms as follows: Site or location specificity - to economise on inventories or transportation costs Physical asset specificity - to take advantage of the economies of investing in the specialized equipment or tooling designed for a particular customer Human capital specificity - involved in developing the skills or knowledge by one or both the parties specific to the buyer-seller relationships Dedicated capacity - created to cater to a large customer so that it would be difficult to find alternative customers Brand name capital - where there is a necessity to maintain the reputation of a shared brand name example being the franchisee relationships. There are defined relationships that exist between asset specificity, uncertainty and governance structure which makes out the cases for contracts, spot contracts and vertical integration which may provide for the changes in transaction costs at high and low levels of uncertainties as well as the investment patterns of the different parties; whether they are high or low for both parties and high or low for one and vice versa. 2.4 CRITICISMS OF THE THEORY OF TRANSACTION COST ECONOMICS: "Transaction cost efficiency, thus is pertinent to the explanation of the match between governance structures and transactions. It is, however, not fully deterministic" - Says Mark A. Covaleskia, Mark W. Dirsmithb, Sajay Samuel The following criticisms have been raised against the theory of TCE: Separation of production and transactions costs - the assumption that the production costs and transaction costs can be easily and precisely separated does not hold good in real life of a firm, as they are always intermittently mingled with each other. Conflicts between different interest groups like managers and the shareholders, among managers themselves, managers and the stakeholders do affect the decision making process and hence the assumption of the theory that profit maximization and cost minimization can be attempted with least problems is not sustainable. Reputation and Trust factors are not considered while the theory talks about the opportunism. To build trust and reputation among parties is not an easy task. It takes several years of continued business relation ship to get in to a position of comfortably doing the business. Hence it is out of place to assume that everybody will turn out to be opportunistic suddenly to take advantage of the disadvantageous position of the other parties with who continued business dealings are being conducted. 3.0 EVOLUTIONARY THEORIES: Evolutionary theories can also be described as resource-based or capabilities-based. There can be no assumptions that these theories form a uniform or entirely consistent view of organizations. 'They are themselves still evolving, and there is as yet complete consensus regarding the key terms and concepts. Nevertheless, the outlines of the perspectives are visible. Evolutionary theories of economic phenomena often make use of the analogy of biological theories of evolution to study the processes out of which novelty is generated".- Alan F. Coad and John Cullen (2006). 3.1 BASIC CONCEPTS OF EVOLUTIONARY THEORIES: A review of the literature of the evolutionary economic theories indicates that there are the following three concepts which form the fundamental core of the evolutionary thinking. They are: Institutionalization: " Our choice of institutionalisation as one of the three concepts in evolutionary theories is intended to reflect the process of habitualisation of social activity, where repeated actions in organisational life become routinised and such routinisation provides a relatively stable environment for social actors that simplifies organisational decision making and reduces the overheads incurred when confronting novel but similar activities" - Alan F. Coad and John Cullen (2006). It may be observed that the evolutionary theory while expects innovation and change in organisations, it also expects some kind of stability in the organisation structure. Capabilities: As per the old schools of economic thoughts, the primary economic function of an organisation is to make use of the productive resources for the supplying goods and services to the economy. "Rather than the mere possession of resources, it is the knowledge of the services provided by a firm's resources, in addition to an understanding of the threats, opportunities presented by its environment that allow organisational actors to create an image of productive opportunities that can be leveraged for competitive advantage".- Alan F. Coad and John Cullen (2006). It may be noted that such resources may take the form of physical, human or organisational resources representing tangible or intangible resources. Moreover, the manner in which these resources are assembled, integrated and utilised determines the competitive advantages of such resources. Hence resources may be regarded as inputs to the production process, whereas the tem 'capabilities' refers to the capacity of knowledge based individuals to transform such resources into a performing economic activity. Learning and Change: Organisational development is often depicted as an evolutionary and cumulative process of learning about organisational resources, in which increased knowledge creates opportunities for further growth of the firm. The key sources of learning and change in the organisations have been distinguished as 'operational' and 'dynamic' capabilities. An operational capability can be defined as a high level routine or collection of routines which generally involves the performance of an activity for specified purpose, such as manufacturing a particular product, using a collection of routines to execute and coordinate the variety of tasks required to perform the activity. Dynamic capabilities on the other hand do not involve the production of a product or provision of a marketable service. Instead they build, integrate, or reconfigure operational capabilities. Like operational capabilities, dynamic capabilities comprise routines of behaviour that are learned, patterned, repetitious and founded in part on tacit knowledge. 4.0 A COMPARATIVE ANALYSIS OF TCE AND EVOLUTIONARY THEORIES: As outlined above, the objectives of TCE mainly is to find out the rational behind orgasniational behaviour in determining whether vertical integration or any change in the organisational activity is necessary in the light of the Transaction costs involved in the operation of the firm. For this purpose it tries to distinguish between production costs and transaction costs. While Evolutionary theories also aim at analysing the organisational behaviour in a given set of circumstances, there is no relevance to costs incurred on the activities. This is the basic ideological difference between both the theories. Cost has not found a place in the evolutionary theories. First of all the period of existence and development of both the theories vary which makes a world of difference in their approaches to the theory of economic development. Evolutionary theories attempt to follow the development of economic activities based on the theory of biological developments, whereas the TCE approach is relying on more tangible approach of differentiation in the costs incurred by a firm. Evolutionary theory talks about the operational and dynamic capabilities of organisations to be acquired through the process of learning and change, but TCE assumes the pre-existence of such capabilities at various levels of organisation, which just need to be exercised as and when necessary to adapt to the profit maximisation and cost minimisation objectives. Evolutionary theories, because of the period of existence and development, talks about the institutionalisation of the organising abilities, while TCE, since of recent origin bases its theory on the already developed organisations and their behaviour to certain cost factors. Both the TCE and the Evolutionary theories basically work on the change in the organisational behaviour of course with different ideologies aiming to bring out the excellence of change in the behaviour to the development of the organisations concerned. 5.0 EFFECTS OF TCE AND EVOLUTIONARY THEORIES ON MANAGEMENT ACCOUNTING: "While the research to date is to be commended for exposing the extent of accounting change at an organisational and/or inter(national) level, minimal attention has been devoted specifically to understanding and explaining why and how accounting evolves in the manner it does, though time and within specific organisational settings" - John Burns (2000). This statement goes to prove the fact that although the fundamental changes in the management accounting has been brought about by the changes in organisational behaviour on the basis of the theories of TCE and Old Institutional Economic theories. However, no due recognition has been given to such theories in the various research works conducted so far in the areas of analysing the changes in the accounting methods. In fact these theories are basically responsible for bringing about the changes in accounting systems, accounting techniques, the accountancy profession and the role of an accountant. It was identified that processual studies of accounting have important implications in the development of accounting by analysing the dynamics of changes in the processes which are organisational specific. The idea to perceive such organisational changes have been brought into existence only by both TCE and Evolutionary theories. Accounting changes have based their development on the aim of profit maximisation and cost minimisation which form the basic principles of TCE and which is the natural outcome of 'rational' behaviour. By a constant study of such constant changes at any particular point of time the dynamics of changes have been traced to the underlying logics at work or the organisational roles. It is also observed that the politics and power change have also had their impact in bringing about dynamic changes in organisational behaviour which necessitated the changes in the accounting as well. Old Institutional Economic theories advocate the 'institutionalisation' aspects of organisations as opposed to 'static' rational-actor economic theorising. "Accounting practices and emerging routines can be said to be institutionalised when they become widely accepted in the organisations such that they become the unquestionable form of management control. In which case, they are an inherent feature of the management control process and represent expected forms of behaviour and define the relations between the various organisational group" (Burns and Scapens 2000) "However it can not be construed that all accounting becomes routinised and institutionalised but there is potential for routinisation and institutionalisation to occur as well as change in these settled ways" - John Burns (2000) From the foregoing discussion it is evident that both the schools of economic theories TCE and Evolutionary theories had their own impact in the development and changes in the accounting methods and policies over the period. 6.0 CONCLUSION: "Recent years have witnessed fluidity and blurring in respect of organisational boundaries. Both public and private sector organisations have outsourced existing activities and have engaged in new forms of cooperation with others" - Alan F. Coad, John Cullen (2006) "Management control has been defined in numerous different ways. Nevertheless, the many definitions that are proposed in the literatures do share a lot of common ground"- observes Roland F. Spekle (2001). According to this observation, whatever are the approaches, when they come to concentrate on bringing about changes in organisational behaviour they adapt to the common methodology of analysing the reasons and the factors that are responsible for bringing about such changes. Based on such analysis the theories have advocated various methods and measures to be adopted by the organisations in deciding on the changes required- may be it is in the areas of management accounting or management control. Using the same analogy, the Evolutionary Theories have used the concepts of routinisation and institutionalisation and TCE has used profit maximisation and cost minimisation aspects for bringing about the changes in organisational behaviour. "In the process of routinisation, previously formulated rules may become modified as the group locates mutually acceptable ways of implementing them" - observes John Burns and RobertW. Scapens (2000). It may be observed both the theories' although they have adopted different methodologies have used the basic common platform of changes in the organisational behaviour to explain their conceptual contents. Not only in the commercial field, but also in the field of utility organisations also, these concepts have found to be useful in bringing about the necessary changes. "That organizations are both responding to and constructing these strategic transactions, renders particular organizing and governance structures ''endogenous'' in that the content and meaning of these transactions are determined within the social field that they are designed to govern. Therefore, organizations and social actors involved with utility regulation should not solely be considered as efficiency seeking, but rather were also legitimacy seeking.- Mark A. Covaleski, Mark W. Dirsmith, Sajay Samuel (2003) "An important feature of institutions is their seemingly normative and objective character" - John Burns and RobertW. Scapens (2000).Thus significant changes in management accounting and management control have been brought through various analysis and researches. But it may be said that all those works conducted in this direction basically used the organisational changes due to varying circumstances as the basis for arriving at major and minor contributions to the development of new concepts to bring improvements in the management accounting and control areas. However it cannot be affirmatively stated that the efforts have reached an end. Constant studies are being conducted in these areas, and changes are brought over the periods of time. One example of such a development in the accounting is GAAP. The profit maximisation and cost minimisation aspects assumed by Transaction Cost Economics are ever green concepts in the business environment and hence these will be touched by researchers for time immemorial and consequently the theory of TCE also irrespective of its shortcomings if any. Reference List: 1.Roland F.Spekle (2001) Accounting Organisations and Society Explaining management control structure variety: a transaction cost economics perspective Vol 26 pp 419-441 2. John Burns and Robert W.Scapens (2000) Management Accounting Research Conceptualizing management accounting change: an institutional framework Vol 11 pp 3-25 3. John Burns (2000) Accounting, Auditing & Accountability Journal Bradford The dynamics John Burns of Accounting Change Interplay between new practices, routines, institutions, power and politics Vol 13 Issue 5 PP 566 4. Mark A. Covaleskia, Mark W. Dirsmithb, Sajay Samuel (2003) Accounting, Organizations and Society Changes in the institutional environment and the institutions of governance: extending the contributions of transaction cost economics within the management control literature Vol 28 PP 417-441 5. Alan F. Coad, John Cullen (2006) Management Accounting Research Inter-organisational cost management: Towards an evolutionary perspective Vol 17 pp 342-369 Read More