Economic Organization Theory by

Erlan Bakiev, Ph. D.

Zirve UniversitySpring 2012

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• Economic Organization Theories is the mix of economy and organizaiton theories (Also called as Transaction Cost).

• İt is the area where ECT stadies conjunct the rational concepts of classical theories, ecological approach and the economic perspectives of the organizational structure.

Economic Organization Theories

• The theory of the firm consists of a number of economic theories that describe the nature of the firm, company or corporation including its existence, behavior, structure, and relationship to the market (Demetri, 2007)

Theory of Firm

• In simplified terms, the theory of the firm aims to answer these questions:

• Existence – why do firms emerge, why are not all transactions in the economy mediated over the market?

• Boundaries – why is the boundary between firms and the market located exactly there as to size and output variety? Which transactions are performed internally and which are negotiated on the market?

Theory of Firm Cont.

• Organization – why are firms structured in such a specific way, for example as to hierarchy or decentralization? What is the interplay of formal and informal relationships?

• Heterogeneity of firm actions/performances – what drives different actions and performances of firms?

• Firms exist as an alternative system to the market-price mechanism when it is more efficient to produce in a non-market environment.

Theory of Firm Cont.

• Agency theory refers to a contract in which one party is designated as the principal, and the other, the agent.

• The agent contracts to carry out certain activities for the principal, and the principal contracts to reward the agent accordingly

Agency theory

Three assumptions are at the core of agency theory:

1.Common to most economists: individuals maximize their own self-interest.

2.More specific to agency theory: social life is a series of contracts, or exchanges, governed by competitive self-interest.

Agency Theory Cont.

3. Applies to internal organizational analysis: monitoring contracts is costly and somewhat

ineffective, especially in organizations, thus encouraging self-interested behavior, shirking, and especially opportunism with guile, or to put it more simply - cheating.

Agency Theory Cont.

Transaction Cost Theory

• Transaction costs: the costs of negotiating, monitoring, and governing exchanges between people

• Transaction cost theory: a theory that states that the goal of an organization is to minimize the costs of exchanging resources in the environment and the costs of managing exchanges inside the organization

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• Oliver Williamson has big influence on development of this theory.

• He accepts this approach as an open system and mostly focuses on the process of the output production and service that is exchanged by the people outside of the system rather than the technology and and production system of the organizaiton.

Transaction Cost

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The main point in approch is not the production, but the change in the output (products) and services and Williamson highlights that there is an organizaiton which is managing these exchanges.

Transaction Cost

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The main theme of this approach:

Organizations try to organize the change in their products and services in the most economic way. This change, on one side, is influenced by the bounded rationality of the decision-makers and on the other side influenced by the self benefit behaviors of the people involved in change.

Transaction Cost

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According to Williamson this approach can be used in the same field with complex diciplines such as, strategic management. Why?Because economy is one of the best strtegies. This is the most important message of the Çünkü ekonomi en iyi stratejidir. İşlem maliyeti yaklaşımını en önemli mesajı budur.

Transaction Cost

Transaction Cost Theory

• Ronal Coase set out his theory of the firm in 1937, making it one of the first (neo-classical) attempts to define the firm theoretically in relation to the market.

• The Nature of the Firm (1937) was a brief but highly influential essay in which Coase tries to explain why the economy is populated by a number of business firms instead of consisting exclusively of a multitude of independent self-employed people who contract with each other.

• Why and under what conditions should we expect firms to emerge?

Transaction Cost Theory Cont.

• Firms will arise when they can arrange to produce what they need internally and somehow avoid transactions costs.

• Coase argues that the size of a firm (as measured by how many contractual relations are "internal" to the firm and how many "external") is a result of finding an optimal balance between the competing tendencies of the costs outlined above.

• In general, making the firm larger will initially be advantageous, but the decreasing returns indicated above will eventually kick in, preventing the firm from growing indefinitely.

Transaction Cost Theory Cont.

Sources of Transaction Costs

• Environmental uncertainty and bounded rationality• Bounded rationality: refers to the limited ability

people have to process information

• Opportunism and small numbers – attempt to exploit forces or stakeholders

• Risk and specific assets• Specific assets: investments that create value in one

particular exchange relationship but have no value in any other exchange relationship

Sources of Transaction Costs

Transaction Costs are Low When These Conditions Exist:

1. Organizations are exchanging nonspecific goods and services.

2. Uncertainty is low.3. There are many possible

exchange partners.

Transaction Costs Increase When These Conditions Exist:

1. Organizations begin to exchange more specific goods and services.

2. Uncertainty increases.3. The number of possible exchange

partners falls.

Transaction Costs and Linkage Mechanisms

• Bureaucratic costs • According to transaction cost theory,

organizations will adopt increasingly formal linkage mechanisms with their exchange partners as transaction costs increase.

• But these mechanism also carry bureaucratic costs within the organization.

Transaction Costs and Linkage Mechanisms Cont.

• Transaction cost theory can be used to choose an inter-organizational strategy.

• Managers can weigh the savings in transaction costs of particular linkage mechanisms against the bureaucratic costs.

Transaction Costs and Strategy

• Managers deciding which strategy to pursue must take the following steps:1. Locate the sources of transaction costs that

may affect an exchange relationship and decide how high the transaction costs are likely to be

2. Estimate the transaction cost savings from using different linkage mechanisms

3. Estimate the bureaucratic costs of operating the linkage mechanism

4. Choose the linkage mechanism that gives the most transaction cost savings at the lowest bureaucratic cost