New Institutional Economics: Theory of the Firm & Transaction Cost Economics Yohanna M.L Gultom Hardiyanto Kuliah Ekonomi Kelembagaan MPKP – FE UI 14Juli 2009

What is firm/economic organization? How it behaves? The issues What is firm/economic organization? How it behaves? What is firm according to neoclassic economics compare to institutional economics? Clear definition about firm is needed: Tractable definition (with the idea of margin and substitution) Correspond with real world

Coase’s preconceptions Economists’s conception: the economic system is coordinated by the price mechanism and society becomes not an organization but an organism (See Hayek (1933), “The Trend of Econmoic Thinking). However, within a firm, the description does not fit. What is the role of planning in the economic system? There are alternative methods of coordinating production. E.g. in a department store, the allocation of the different sections to the various location in the building may be done by the controlling authority or it may be the result of competitive price bidding for space.

Coase’s preconceptions (cont.) How about the amount of vertical integration in a various range of industry that shows that price mechanism is superseded greatly by other coordination methods? If coordination of factors of production will be done by price mechanism, why a firm emerges in a specialized exchange economy?

The definition of firm – neoclassical economics “Firm is a collection or set of feasible production plans, presided over by a manager who, buying and selling inputs and outputs in a spot market, chooses the plan that maximizes owners’ welfare.” Firm exists to coordinate input factors (labor, capital, land) in a range of production function in order to produce output.

Weaknesses Provide no explanation about what is firm and how production is coordinated within firm (a black box mechanism) Provide no explanation regarding how power exercised within the firm and how conflict of interest resolved in order to maximize profit Provide no explanation on the issues of vertical integration or slit up

Coase’s theorem Offers new definition about firm to bridge what appears to be a gap in economic theory between the assumption that resources are allocated by means of the price mechanism and the assumption that this allocation is dependent on the entreprenuer coordinator. Discover the question of why a firm emerges at all in a specialized exchange economy? The reason why it is profitable to establish a firm would seen to be that there is a cost of using the price mechanism:

Coase’s definition of firm: Production function vs. Contractual relation A firm consist of the system of relationships which comes into existence when the direction of resources is dependent on an entrepreneur Strengths: Realistic assumptions  correspond with the real world Tractable  based on Marshallian marginal and substitution Differentiate types of production coordination (the allocation of resources) Market : price movement Firm: direction koordinasi oleh pengusaha/entrepreneur

“Why firm emerges?” A firm emerges to reduce the cost of doing transaction in the market. The costs of organizing production through price mechanism: price of discovering relevant price. Cost of negotiating and concluding a separate contract for each exchange transaction Cost of forecasting the details for the long-term contract A firm emerges when short-term contract is too costly A firm emerges to take advantages from not doing transaction in the market: Sales tax (untuk transaksi pertukaran) Quota scheme Price control

The tractability of the definition: Decreasing return to entrepreneurial function/management A firm becomes larger as additional transactions are organized by the entrepreneur and becomes smaller as he abandons the organization of such transaction: Why is not all production carried on by one big firm? Diminishing returns to management: As firm gets larger  decreasing returns to the entrepreneur function; As the transactions which are organized increase, the entrepreneur fails to place the factors of production in the uses where their value is greatest The supply price of one or more of the factors of production may rise, because the “other advantages” of a small firm are greater than those of a large firm

The tractability of the definition: (cont.) A firm will tend to expand until the costs of organizing an extra transaction within the firm become equal to the costs of carrying out the same transaction by means of an exchange in an open market or the costs of organizing in another firm. At the margin, the costs of organizing within the firm will be equal either to the costs of organizing in another firm or to the costs of doing the transaction in the market.

The tractability of the definition: (cont.) Diminishing returns to management: Other things being equal, therefore, a firm will tend to be larger: The less the costs of organizing and the slower these costs rise with an increase in the transaction organized The less likely the entreprenuer is to make mistakes and the smaller the increase in mistakes with an increase in the transaction organized The greater the lowering in the supply price of factors of production to firms of larger size

Factors to determine the size of the firm: The marketing costs (the cost of using price mechanism) The costs of organizing of different entrepreneurs According to Coase, only after determining these costs, we can determine how many products will be produced by each firm and how much of each it will produce. The fact that the cost curve of a firm slopes upward does not imply that a firm is limited in size because it will not pay to produce more than the output at which marginal cost is equal to marginal revenue (See Coase, 1937, p. 402) A firm will still produce more than one product: it is less costly to organize the exchange transactions of a new product than to organize further exchange transactions of the old product.

The realisticness of the definition: Considering the legal relationship of “master and servant” or “employer and employee”: The servant must be under the duty of rendering personal services to the master or to others on behalf of the masters, otherwise the contract is a contract for sale of goods The master must have the right to control the servant’s work, either personally or by another servant or agent.

From static equilibrium to a theory of moving equilibrium Entrepreneur menjaga equilibrium dengan keputusan-keputusannya: coordinating or transaction Faktor perubahan: pertimbangan antara biaya organisasi dalam firm vs. biaya transaksi/pemasaran  menjelaskan mengapa firm bertambah besar/kecil

Kekuatan pendekatan kontrak dalam menjelaskan: why firm emerges? Division of labor perspective: Firm muncul karena adanya peningkatan kompleksitas dalam pembagian kerja  ada kekuatan integrasi (integrating force) agar tidak terjadi chaos dan sebagai bentuk industri yang efisien Sanggahan dari Coase: Kekuatan integrasi adalah price mechanism (the main achievement in economic science) Diperlukan penjelasan tentang: mengapa dengan suatu kekuatan integrasi (entrepreneur) harus menggantikan kekuatan integrasi yang ada (price mechanism)

New Institutional Economics based on Coase’s Theorem Principal-Agent Theory Transaction Cost Economics

Teori Principal-Agent Managerial theory of the firm Teori ini bertujuan untuk menjelaskan fenomena konflik kepentingan antara aktor ekonomi disebabkan oleh asimetri dalam informasi (keterbatasan observasi). Firm masih dilihat sebagai set dari produksi, tetapi yang didalamnya terdapat konflik kepentingan, terutama antara pemilik & manager: Manager mengambil keputusan yang tidak terobservasi oleh pemilik perusahaan Manager memiliki informasi tentang profit perusahaan yang tidak dimiliki oleh pemilik perusahaan Tujuan/goal dari manager berbeda dengan pemilik Akibat konflik kepentingan ini maka diperlukan biaya monitoring dan skema insentif.

Teori Principal-Agent Hubungan antara principal-agent atau employer-employee tidak didasarkan oleh hubungan kekuasaan atau otoritas/fiat, tetapi didasarkan atas hubungan negosiasi kontraktual yang disepakati kedua belah pihak  team productive process. A Team process: Masalah penilaian/monitoring (metering) atas input produktivitas dan penghargaan (rewards) Kesulitan mengukur produktivitas individu yang bekerja dalam tim  shirking problem Belum menjawab “apakah firm itu?” dan “bagaimana bentuk-bentuk organisasi?”

The application of Coasean Theorem: Transaction Cost Economics (Williamson) Governance of Contractual Relation Governance structure: institutional framework within which the integrity of a transaction is decided Williamson: “Specialized governance structure is needed to the degree efficient supply necessarily joins buyers and sellers in a bilateral trading relation of a continuing nature” (Williamson, 1979: 257-8). Transaction cost becomes very vital for relationship-specific investment

Basic Concepts in TCE: Opportunism – central concept Opportunism is important for economic activity that involves transaction-specific investment in human and physical capital The efficient processing of information is a related concept The assessment of TC is a comparative institutional undertaking

Transaction = Contract Specific related investment  long term contract Independent from re-negotiating process: To minimize transaction costs To anticipate hold-up problem and opportunistic behavior ex post contract Long term contract (describe all the requirements of future transaction ex ante contract) is a protection tool for performance problem ex post contract