Transaction Costs & Trade Between Multinational Corporations (RLE International Business)

C Hallwood, C Paul Hallwood

• Publisher: Routledge
• Year: 2013
• Print ISBN: 9781138007864
• eBook ISBN: 9781135133795
• Edition: 1
• Topic: Business
• Subtopic: Business General
• Index: Business

Until this book was published little had appeared on the matter of the organization of production in oil gathering. This book:

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• Describes the global offshore oil supply industry and its features on one of the world's major offshore oil services bases

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• Draws on the theory of the multinational corporation to explain why buyers and sellers should have internationalized themselves into a symbiotic relationship

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• Discusses the preference of the oil companies for vertical disintegration

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• Explains the transaction cost paradigm

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• Integrates the largely American literature on the transaction cost paradigm with the literature on the multinational corporation (which is largely British).

1

Introduction

This book presents an industry case study in ‘transaction cost economics’. Empirical, theoretical and policy-related matters are given detailed consideration. The presentation contains an economic appraisal of a major industry and it may be seen as an exploration in the economics of the multinational corporation. As we also discuss the economics of the invited tender-bid auction system, which the oil companies use to procure inputs from the offshore oil supply firms, some of the chapters are concerned with the economics of such auctions.

The international oil industry is, in fact, made up of two quite distinct groups of firms – the oil companies and the multinational offshore oil supply firms. The oil companies create ‘pools’ of demand in geographically widely spread offshore oil provinces and the offshore oil supply firms supply these markets, usually through affiliates which they establish for this purpose. Much of our discussion will concern itself with the nature of this particular globalized economic relationship – a relationship which we will describe as ‘symbiotic’.

We will combine standard’ microeconomic theory with transaction cost economics in a way which, we trust, will be illuminating. In fact, we will argue that these ‘schools’, if we may call them such, are not so nearly different as is sometimes imagined. However, there is the distinction that the transaction cost paradigm is primarily concerned with matters relating to the choice of organizational arrangements (or ‘organizational form’) at the level of the individual firm. This question has been largely, though by no means entirely, overlooked in ‘traditional’ microeconomics, or at least it has according to Oliver Williamson, a leading transaction cost theorist. Moreover, transaction cost economics, or the strand of it that we may characterize as the ‘rent appropriation approach’, bases itself upon some assumptions which differ from those made in neoclassical economics. These assumptions are concerned both with agents’ cognizance of their environment as well as with their behavioural motivations – these will be spelled out shortly.

The transaction cost paradigm, concerned as it is with comparative institutional arrangements, originated in the seminal work of Coase (1937) and has been further developed, particularly, by Williamson (1971, 1975, 1981, 1985), Klein, Crawford and Alchian (1978) and Barzel (1982) and by many other writers cited later in the book. These have become so influential that they have now given rise to what has been described as the ‘new institutional economics’ (Langlois, 1986),¹ and they have so challenged the established structure-conduct-performance models of industrial organization as to begin to push them from the pages of undergraduate textbooks (see Clark and McGuinness, 1987, for example).

A good deal of theorizing on the economics of the multinational corporation also concerns itself with choice of institutional arrangement through which a firm may gather rent on firm-specific knowledge (see, for example, Buckley and Casson, 1976; Caves, 1982; Dunning, 1977; Hennart, 1982; Hymer, 1976; McManus, 1972; Rugman, 1982; Vernon, 1966). Indeed, Williamson (1981) and Casson (1987) have commented on the broad similarities between transaction cost economics and the economics of the multinational corporation. Later we will try to exploit these similarities in our discussion of the organization of the international offshore oil supply industry.

Transaction costs: a paradigm with two blades

In a seminal paper, Coase asked ‘why [does] a firm emerge at all in a specialized exchange economy?’ (1937, p. 390). In a few pages he gave an answer which has sparked off a line, or rather two lines, of reasoning, which have continued on and off for more than fifty years.

Coase’s answer was that:

the main reason why it is profitable to establish a firm would seem to be that there is a cost of using the price mechanism. The most obvious cost of ‘organizing’ production through the price mechanism is that of discovering what the relevant prices are. (p. 390, emphasis added)

And he described the main ‘price discovery costs’ as: ‘the cost of negotiating and concluding a separate contract for each exchange transaction’ (p. 390–1, emphasis added).

But Coase did not specify exactly what these costs may be or what might influence their size, though he did note that ‘in certain markets, e.g., produce exchanges, a technique is devised for minimizing these contract costs; but they are not eliminated’ (p. 391). This latter observation on the cost of running a market is a most interesting point, suggesting as it does that cost-economizing motives lie behind the design of market organizational forms.

What is immediately important to us is to recognize that contract negotiation costs depend positively upon (a) the pay and number of personnel engaged in contract negotiation; and (b) expectations about the potential future behaviour of the contractual partner. Point (b) arises because either of the parties to a contract may, for good reasons, desire to constrain the future behaviour of the other party.²

This ‘cost of negotiating contracts’ answer to the question ‘why firms, why markets?’ has, in fact, led to two separate versions of the transaction cost paradigm: one that stresses ‘measurement costs’ and one stressing ‘rent appropriation’ (the latter has also been called the ‘holdup’ version – Alchian and Woodward, 1988). The measurement cost approach emphasizes the incurred cost of executing transactions, while the rent appropriation concept refers to costs which might have to be borne in the event of an unforeseen contingency – especially an ‘unfriendly’ act on the part of the contractual partner. There is a relationship between the two versions as, in an effort to anticipate contingencies, transactors may attempt to draw up more complete contracts – so incurring increased contract negotiation costs.

The measurement cost version is the more closely associated with Coase’s original insights as it stresses factors which have to do with actually incurred costs of using the price mechanism, e.g. legal costs of drawing up contracts, the cost of inspecting or monitoring goods exchanged and the cost of determining (or discovering) prices. However, largely due to Williamson (1975, 1981, 1985), Klein, Crawford and Alchian (1978), Alchian and Woodward (1988) and, in the context of the multinational corporation, Buckley and Casson (1976), it is the ‘rent appropriation’ branch of the transaction cost paradigm which has dominated this literature for more than two decades. As Williamson has pointed out, the combination of a potential for opportunistic behaviour (i.e. ‘self-interest seeking with guile’) in the future and the existence of specific assets is likely to lead arm’s-length transactors to engage in protracted and expensive contract negotiation. Integration of such imperfect markets within the firm is a means of avoiding such transaction costs.³ Demsetz (1988) is critical of the idea that the cost of drawing up contracts can be crucial in the choice between firm and market. He argues that the extra cost of drawing up a contract when opportunism is thought to be present is unlikely to amount to much. It is in agreement with this view that here ‘holdup’ costs are viewed probabilistically as the cost incurred if a contract fails – rather than as the actual cost of negotiating a contract.

So, for both versions of the transaction cost paradigm, the firm may replace the market as a means of economizing, but not altogether avoiding, transaction costs although the nature of these transaction costs varies widely. Measurement costs are incurred with a probability of unity when the market is used, while rent appropriation cost at the point of drawing up a contract is probabilistic in nature. Thus, at the time of integration (of the market into the firm) a firm cannot be sure that an opportunistic potentiality would in fact have been realized. Moreover, rent appropriation, when it occurs, extracts quasi-rents that would otherwise be earned by the fixed factors and this is obviously a different sort of cost from the cost of drawing up a contract.

Motivational and methodological context

The methodological context employed here is straightforward: the case study is used as a ‘test’ of the predictions that may be derived from the transaction cost paradigm. In particular we will investigate whether the observed organizational features of the offshore oil-gathering industry are consistent with the constraints emphasized in the transaction cost paradigm.

A justification, if one is needed, for this case study is Oliver Williamson’s call for more detail in the application of (transaction cost) theory if the study of economic organization is to progress’ (Williamson, 1985, p. 105). He has also referred to Morishima calling for economic theory to be applied to actual mechanisms in the economy (p. 386) and Loasby (1986a) has written in similar vein.⁴ This book presents such an application. Furthermore, we will find that we will be able to make a small contribution to the literature on the multinational corporation; in particular, to the case of the internationalization of production of intermediate inputs.

Before going further, a word about the methodology used is necessary. Williamson has written that ‘There is no single correct unit of analysis for addressing issues of economic organization’ (1985, p. 104), and he cites eight different types of micro-analytical study that have been used (including the ‘case study’). He also points to the common methodology in these studies:

direct measures of transaction costs are rarely attempted. Instead, the comparative institutional issue of interest is whether transactions, which differ in their attributes, are supported by governance [i.e. organizational] structures in conformity with the predictions of the theory. (1985, p. 105)

This will be the methodology used here. The attributes of transactions made in the business of oil gathering will be described and we will see if the governance structures in which the transactions occur conform with the predictions derived from transaction cost reasoning. Special attention will be paid to the matter of the transactional efficiency (i.e. minimization of transaction costs) of the markets between the transactors. Joskow (1988) also recognizes the importance of the case study as an empirical test of the transaction cost paradigm, arguing that data collection problems are particularly difficult in this branch of industrial organization.

The most obvious task is to explain the high degree of vertical disintegration that exists at a certain juncture in the vertical production chain between the technical stages of oil exploration at the one end and the petrol or ‘gas’ station at the other. The explanation will be shown to accord with the economics of governance structures as hypothesized in the transaction cost paradigm. This approach accords with other industry case studies which have found support for a transaction cost explanation of vertical organization in automobile components (Monteverde and Teece, 1982), bauxite–aluminium production (Perry, 1980; Stuckey, 1983), aeroplane components (Masten, 1984), ‘inhouse’ sales force employment (Anderson and Schmittlein, 1984), coal production–electricity generation (Joskow, 1985) and the American automobile industry (Langlois and Robertson, 1989). Levy (1985) has also found support for the transaction cost paradigm using a cross-section analysis of sixty-nine American manufacturing firms.

Some bask concepts used in the transaction cost paradigm

As we have already said, two broad strands of the transaction cost paradigm have been identified: the rent appropriation approach and the measurement cost approach. As it happens the first of these concepts is also one of the main planks upon which the modern theory of the multinational corporation stands and we will have occasion to draw upon both approaches in some depth.

In transaction cost economics it is asserted that vertical integration is largely due to contractual incompleteness (Williamson, 1971, p. 120, and 1975, p. 95, for example; Grossman and Hart, 1986; Hart, 1988): complete contingent claims contracting – in one giant haggle before production begins – is, in practice, impossible. It is impossible because all future contingencies (together with their associated probabilities) are unknowable. This is the ‘nature of the universe’ and, even if knowable, could not be coped with by the limitedly rational brain of the human being (even if computer assisted). Thus, bounded rationality is the first cognitive assumption upon which the two strands of the transaction cost paradigm rest themselves.⁵ A related concept is that of impacted knowledge, where the knowledge that does exist is not known to all of the transactors. We will make use of both concepts in our industry case study.

Opportunism is th key behavioural assumption lying at the heart of the rent appropriation view, but it plays little or no role in the measurement cost approach. Opportunism is defined as ‘self-interest seeking with guile’ (Williamson, 1985, p. 30) where a transactor may not go into a transaction in all good faith. Relevant information (e.g. on the true length of time that one of the parties wishes to maintain a particular exchange relation) may be withheld or falsified. At the recontracting stage, one (or both) of the transactors may reveal the truth and haggle to drive price in the desired direction, so appropriating an increased share of the rent due to the reordering of resources brought about by a given transaction.

This opportunistic behaviour would not be of great importance, however, except for the existence of asset specificity. This is a ‘state of nature’. A durable asset (human or non-human) with few alternative uses (i.e. low transfer earnings) may have been obtained by one of the parties to a transaction in order to facilitate that particular transaction (e.g. special skills learned, special machinery installed, or relocation to a specific site undertaken). The opportunistic party may, at a later recontracting stage, attempt to appropriate the quasi-rent due to this asset for himself. (Klein, Crawford and Alchian, 1978, have dwelt on this point.)

With asset specificity, an ex ante competitive environment (many potential buyers and sellers may be reduced to an expost small numbers bargaining situation – where monopoly, monopsony or bilateral monopoly prevail. Williamson calls this ‘the fundamental transformation’ and makes it the centrepiece of his 1985 opus. The existence of any of these anti-competitive elements is likely to compromise the efficacy of market exchange (for one of the transactors at least) and the market may be superseded by vertical integration or some organizational form intermediate between the market and hierarchy such as quasi-integration or the long-term contract. Or, posted price markets could be replaced with an auction market – as has been suggested by Demsetz (1968a) in his study of franchise bidding.

Transaction costs and governance structures

Thus the main question in transaction cost economics is ‘What governs the limits of the firm?’ Or, where should administered, hierarchical, resource allocation end and use of the market begin? In principle, the firm could be decomposed into the smallest possible unit, which might be a separable technological unit, or, conceivably, to the level of the individual worker. If this was to be so, all economic activity would be organized through markets and hierarchical organization would be at the minimum.

To repeat, the transaction cost theory of the choice of governance structure predicts that organizational form will be determined so as to minimize the cost of organization. Transaction costs are defined as the costs of organizing business (that is, the cost of making transactions). The ex ante costs of carrying out a market transaction includes finding a suitable transactor and informing it of the desire to transact, negotiation costs, the costs of drawing up contracts, policing costs, and contract renewal costs. But further substantial ex post costs may be incurred if opportunistic behaviour by one of the transactors occurs. These ex post costs include haggling costs, the costs of any disputes machinery that may be used and th...

Table of contents

• Front Cover
• Half Title
• Title Page
• Copyright
• Title Page1
• Copyright1
• Contents
• List of Tables
• List of Figures
• Author’s Preface
• Dedication
• 1 Introduction
• 2 Measurement costs, auctions and the process of price formation
• 3 Vertical disintegration
• 4 The offshore oil supply industry
• 5 The multinational offshore oil supply industry: the theoretical aspect
• 6 The offshore oil supply industry in its main British service base
• 7 Legal and customary practices in the offshore oil supply industry markets
• 8 Bid-prices, rent distribution and adjustment in the long run
• 9 Measurement costs and optimization of the number of invited tender-bidders
• 10 The buyers as market-makers
• 11 Host countries and the international offshore oil supply industry: problems of entry and exit
• 12 Conclusions: on choosing a market in the offshore oil-gathering business
• Bibliography
• Index