12 3. Empirical Evidence on Transaction Cost Theory Outline Outline Transaction Transaction Cost Cost Economics Economics (TCE) (TCE) Evidence Evidence regarding regarding transaction transaction cost cost ory ory The The business business management management approach approach outsourcing outsourcing Evidence Evidence from from business business management management literature literature Implications Implications Air Air Force Force 8 8 Outline Next, we descri statistical tests predictions made transaction cost ory regarding relationship tween governance characteristics transactions. The empirical evidence related outsourcing includes analysis make vs. buy decision, contract design, temporal specificity, reputation effects. In general, evidence is consistent with predictions transaction cost ory.
13 Empirical Empirical Evidence Evidence Is Is Consistent Consistent with with Predictions Predictions TCE TCE Statistical Statistical tests tests TCE TCE relate relate governance governance characteristics characteristics transactions transactions Asset Asset specificity, specificity, uncertainty, uncertainty, complexity complexity Based Based on on survivor survivor analysis analysis Inefficient Inefficient governance governance are are weeded weeded out out competitive competitive pressures pressures Remaining Remaining should should efficient efficient Since Since Air Air Force Force doesn t doesn t face face same same kind kind competitive competitive pressure, pressure, it it learn learn from from experience experience private private firms firms 9 9 Empirical Evidence Is Consistent with Predictions TCE The empirical literature on TCE tests proposition that efficient governance structure is a function properties transaction in question, such as asset specificity, uncertainty, complexity, frequency. The governance structure a binary decision variable, such as make or buy, or a continuous variable, such as contract duration. The characteristics transactions are difficult measure, are ten based on surveys or interviews industry managers. For example, measures asset specificity include engineering or research development (R&D) expenditure on components (as measures physical specificity), worker-specific knowledge, physical proximity contracting firms, contract quantities (as a proxy dedicated assets). Statistical tests TCE are based on survivor analysis, i.e., proposition that inefficient governance will weeded out over time competitive pressure. Organizations that choose wrong governance transactions will have higher costs a given level output than organizations that choose efficient governance, will eventually driven out
14 market. Managers learn from success or failure or organizations adapt governance accordingly. Theree, active governance observed researchers should efficient, assuming that economy is close a steady-state equilibrium. 1 Government entities (such as Air Force) do not face same types competitive pressures that private industry does, although recent budget pressures serve as a substitute some extent. This lack competitive pressure suggests that Air Force have chosen non-optimal governance some transactions, could learn from experience private secr. For example, if Air Force uses organic provision when contracr provision could increase value permance net tal production governance costs, n outsourcing could correct some se problems. 1 As we discuss in greater detail in Section 5 low, empirical business management literature suggests that survivor analysis not always reveal most efficient industry structure. In particular, vertical integration decisions U.S. aumobile industry analyzed Monteverde Teece [1982a] [1982b] Masten, Meehan, Snyder [1989] have en a local optimum, but y were not a global optimum in comparison with integration decisions made Japanese aumobile industry. Even within U.S. aumobile industry, re is a great deal variation in degree vertical integration, which in 1980 ranged from 30-35 percent value added at Chrysler 50 percent at Ford 60-70 percent at General Mors. See Helper [1991b].
15 Asset Asset Specificity Specificity Makes Makes Outsourcing Outsourcing More More Difficult Difficult Vertical Vertical integration integration more more efficient efficient when when transactions transactions involve involve Asset Asset specificity specificity Uncertainty Uncertainty Thin Thin markets markets Outsourcing Outsourcing still still feasible feasible if if buyer buyer owns owns transaction-specific transaction-specific assets assets Government Government ownership ownership facilities facilities oling oling reduce reduce 10 10 Asset Specificity Makes Outsourcing More Difficult Statistical tests make vs. buy decision find that vertical integration is positively associated with site specificity (particularly when transportation costs are high), physical asset specificity, human capital or know-how specific transaction. Uncertainty about dem does not increase integration itself, but has an interactive effect with transaction-specific assets with thin markets (small numrs buyers /or ). However, outsourcing still feasible if ownership transaction-specific assets buyer mitigate. One group empirical results in this area is based on mine/refinery (or electricity generar) relationships, where need tailor plant quality ore high transportation costs create asset specificity. For example, Joskow [1985] found that mine-mouth electricity generars were six times more likely own associated coal mine than non-mine-mouth plants. Aluminum refiners typically own ir own bauxite mines cause high transportation costs specificity refineries ores, but tin refining is less likely vertically integrated cause lower transportation costs
16 ability refineries hle ores from different mines. (See Stuckey [1983] Hennart [1988].) Vertical integration decisions have also en studied extensively in aumobile industry. Klein, Crawd, Alchian [1978] Klein [1988] discuss General Mors (GM s) 1926 decision acquire Fisher Body. Facrs that influenced integration decision included need transaction-specific investments in stamping presses dies after transition from wooden bodies closed metal bodies, friction over price sales exceeding quantities covered in contract, refusal Fisher locate its facilities closer GM. Monteverde Teece [1982a] collected data on internal external procurement aumobile components GM Ford. They found that component production was more likely vertically integrated if component required a greater amount design engineering, which served as a proxy human capital specificity. Masten, Meehan, Snyder [1989], using an independent sample 118 aumobile components procured Big Three, looked at importance physical-asset site specificity in addition engineering intensity. Although y found that engineering intensity was a signifit determinant vertical integration, physical site specificity were not. The authors argued that buyer ownership transaction-specific physical assets sufficient reduce, whereas human capital assets are more difficult monir outside firm. This argument has en demonstrated Monteverde Teece [1982b], who found that aumobile manufacturers were more likely retain title oling used suppliers more specialized expensive it was. Similar evidence was found in rail freight contracting (see Palay [1984]), where shippers rar than carriers owned more-specialized rail cars internal racks secure specific parts. Masten [1984] also found that government retained title specialized oling test equipment in aerospace industry except in a few cases that involved proprietary technology or equipment with a high alternativeuse value or short useful life.
17 Contracts Contracts Can Can Be Be Tailored Tailored Fit Fit Characteristics Characteristics Transactions Transactions Increasing Increasing contract contract length length reduces reduces,, but but limits limits adjustments adjustments changing changing circumstances circumstances Contract Contract length length increases increases with with asset asset specificity, but decreases with uncertainty specificity, but decreases with uncertainty Or Or contract contract provisions provisions used used manage manage uncertainty uncertainty Minimum Minimum purchase purchase requirements requirements Price Price adjustment adjustment provisions provisions Opportunities Opportunities renegotiation renegotiation 11 11 Contracts Can Be Tailored Fit Characteristics Transactions To induce contracting parties make transaction-specific investments, buyer/seller relationship must last long enough realize a positive return on investment. The ability engage in opportunistic havior reduced long-term contracts that limit parties ability renegotiate. As expected, empirical literature on contract duration finds that contract length increases with greater site specificity, physical asset specificity, value dedicated assets. However, if circumstances are changing rapidly, long-term contracts that reduce opportunities renegotiation lock parties in an agreement that is no longer appropriate. Thus, se studies also find that contract length decreases with greater uncertainty, cause increased need adapt changing conditions. Joskow [1987] examined relationship tween contract duration asset specificity using evidence from long-term contracts tween U.S. coal mines electric utilities. He found that coal contracts in West, where coal is variable quality mines are large geographically dispersed, are 11 years longer on average than in East, where a large numr small mines produce
18 coal relatively unim quality. Contracts with mine-mouth plants are 12 years longer on average, contract length increases 13 years each additional million ns coal contracted delivery (which reflects size investment in transaction-specific assets). 2 Crocker Masten [1988] addressed effects uncertainty on contract duration using data on long-term natural gas contracts. They found that price regulation natural gas reduced ability contracting parties adapt long-term contracts reflect changing circumstances, reduced contract length an average 14 years. Uncertainty caused 1973 Arab oil embargo furr reduced contract length three years. Or contract features include take-or-pay provisions or or penalties refusing buy, protect seller s investment. For example, Goldrg Erickson [1987] examined long-term contracts tween petroleum coke refiners ir cusmers. Because high srage costs, a buyer s failure take delivery disrupt operations at refinery impose costs on seller. Furrmore, high transportation costs encourage cusmers locate near suppliers limit possibility sales alternative cusmers. As a result, contracts tend long-term, with minimum purchase requirements substantial financial penalties non-removal buyers. Many contracts also provided price flexibility using indices tied price crude oil or allowing negotiation within minimum maximum prices. Masten Crocker [1985] interpret take-or-pay provisions (requiring minimum payments even if delivery is not accepted) in natural gas contracts as damages breach contract buyer. Breach contract is efficient if buyer gains more than seller loses, which will case if minimum payment compensates seller difference tween contract price its nextst sale opportunity. The authors found that size take-or-pay requirements were negatively correlated with numr pipelines serving field (reflecting alternative sales opportunities), positively correlated with numr in field (which reduces value retaining gas in ground future sales, since are drawing on a common pool gas). Price adjustment provisions facilitate use long-term contracts mitigating effects price uncertainty. Although fixed-price contracts are 2 The sample 205 contracts accounted more than 30 percent contract coal deliveries in 1979. Contracts ranged in length from one 50 years. Approximately 17 percent contracts covered 5 years or less, 12 percent covered 6-10 years, 37 percent covered 11-20 years, 17 percent covered 21-30 years, 17 percent covered more than 30 years.
19 easier administer are associated with tter pre-contract inmation less, Goldrg [1985] argued that y result in an excessive pre-contract search inmation about future prices costs, in poor permance post-agreement jockeying ce a renegotiation if y are used in circumstances where prices are uncertain. There are also trade-fs involved with choice price adjustment mechanisms, which based on market price indices or allow some degree renegotiation. Less mulaic price adjustment mechanisms are more flexible, but y also allow greater during renegotiation. Joskow [1988] [1990] examined how well price adjustment mechanisms related production costs in long-term coal contracts reflect market prices over time. He found that se mechanisms worked well in 1970s, but diverged from 1980s market price coal, which fell while production costs continued rise. However, relatively few se contracts were renegotiated, possibly cause threat legal sanctions. There also have en less competitive pressure regulated or local-government-owned electric utilities minimize costs. However, in many cases, re is no relevant market price or index that serve as a guideline price adjustment mechanisms. Crocker Masten s [1991] study natural gas contracts found a trade-f tween very precise agreements that constrain loose agreements that permit adjustment changing economic circumstances. More-flexible price renegotiation was associated with longer contract duration greater price uncertainty, as well as larger minimum payment provisions. This suggests that quantity guarantees are a substitute stricter price adjustment mechanisms. There is also evidence that Air Force has tailored price adjustment mechanisms reflect transaction costs. Crocker Reynolds [1993] analyzed jet engine contracts F-15 F-16 with Pratt Whitney General Electric over period from 1970 1991. Price adjustment mechanisms varied from firm fixed price (no adjustment) through mulaic adjustment mechanisms incentive contracts allowing relatively open-ended renegotiation. They found that more-open-ended contracts were associated with greater uncertainty about costs or technology, longer contract duration, lower contracr (as measured contracr s litigation hisry presence alternative suppliers). The authors concluded that degree contract completeness is an optimizing decision parties that reflects a trade-f tween ex ante contract design costs ex post.
20 Timing Timing Reputation Reputation Can Can Influence Influence Outsourcing Outsourcing Decisions Decisions If If timing timing is is crucial, crucial, vertical vertical integration integration allow allow more more flexible flexible responsive responsive scheduling scheduling Temporal Temporal specificity specificity an an issue issue in in meeting meeting surge surge requirements requirements Reputation Reputation effects effects are are important important both both buyers buyers Using Using reputation reputation in in source source selection selection reduce reduce Opportunism Opportunism buyers buyers drive drive away away 12 12 Timing Reputation Can Influence Outsourcing Decisions Even when asset specificity is not a strong facr, importance timing in deliveries or in use assets associated with more integrated governance. Thus, temporal specificity an important issue Air Force activities that have a role in meeting surge requirements. For example, Masten, Meehan, Snyder s [1991] study subcontracting practices in naval construction found that probability integration increased with importance scheduling component in construction. This occurs cause interruptions at an early stage in construction process disrupt all subsequent operations, giving subcontracrs an incentive delay in order elicit price concessions. Pirrong [1994] found that in ocean shipping, spot markets, medium- longterm contracts vertical integration are all used, depending upon difficulty arranging alternative shipping services commodity at short notice. The duration shipping contracts incidence vertical integration were positively correlated with thinness market need specialized ships in bulk shipping markets 14 different commodities.
21 In some circumstances, reputation buyers an encement mechanism inmal, or not legally enceable, agreements. Short-term gains from fset long-term losses from a damaged reputation in industry community if or buyers n refuse deal with a party who has a reputation breaking agreements. Reputation effects important both buyers in cases where eir has engage in opportunistic havior. In particular, government entities must commit not expropriate assets from contracrs or regulated firms, get m invest in transaction-specific assets. For example, Wilson s [1980] study New Engl fresh fish market Acheson s [1985] study Maine lobster market found that reputation in local market is an important encement mechanism support long-term, inmal relationships. Given a price a catch, buyers or could act opportunistically sorting out high-quality or low-quality fish. To ensure quality, parties would incur moniring costs that would lower tal value relationship both parties. Reputation-based agreements avoided se additional costs, were supported interdependencies arising from sharing scarce resources, such as market inmation, fuel, bait. Gry [1989] studied effect opportunistic havior 19th century railroad regulars in New Jersey. He found that railroads were willing make large, specialized investments only when y were protected special corporation charters that limited state actions against m. Levy Spiller s [1994] international comparison telecommunications regulation showed that private investment is thcoming only when regulars commit not pursue arbitrary administrative actions that expropriate value assets. In eir case, if regulars were not able commit not set arbitrarily low prices, regulated firms were unwilling make infrastructure investments cause y might not able recover value ir investments. Thus, on whole results empirical literature on transaction cost economics are consistent with oretical predictions. Higher degrees asset specificity are associated with greater vertical integration, longer-term contracts, or contract clauses that help adjust changing circumstances protect transaction-specific assets. New insights, such as importance temporal specificity reputations buyers, also emerge from empirical literature.