Transaction cost economics and the multinational enterprise

Summary of: Teece, D. (1986). Transaction cost economics and the multinational enterprise. Journal of Economic Behavior and Organization, 7, 21-45

TRANSACTION COST ECONOMICS

This paper uses transaction cost principles to categorize transactions into those which can be supported by unassisted markets and those which need to be embedded within the multinational enterprise if efficient governance is to be provided.

Markets will tend to be relatively more efficient than firms in handling transactions between a large number of buyers and sellers. Markets will be at a comparative disadvantage when transactions are subject to a high degree of uncertainty and when they consist of long-term exchanges of complex and heterogeneous products between a comparatively small number of traders.

-> The firm is a response to market failure.

The most important attribute for assessing whether a transaction requires a special governance structure, beyond that provided by unassisted markets, is the degree to which the parties to a transaction must invest in assets dedicated to the proposed exchange of goods and services.

Dedicated assets: transaction specific because their value in a given transaction is higher than in their next best use.

A transaction can be taken out of the market – that is, it can be internalized – and the specialized governance structure of the firm can be used to shield and protect the transaction and ensure the full utilization of the specialized assets in question.

Transaction cost economics provides a framework for discriminating between those transactions which need to be internalized and those which do not. Without such a framework, internalization theories of the multinational enterprise must be considered incomplete, and perhaps even tautological.

In order to apply transaction cost economics to the multinational enterprise, it is necessary to recognize two classes or groups of multinational firms:

1. Horizontally integrated multinational enterprises: turns out essentially the same line of goods from each plant in several different locations.

2. Vertically integrated multinational enterprises: produces outputs in some of its plants which serve as inputs into others located in different nation states.

Both are possible within a single firm.

The theory of comparative advantage reveals how differences amongst countries in comparative costs will cause the international specialization of production and concomitant trade. Economies of scale heighten the degree of specialization and may cause one country to be the world’s sole supplier of a particular commodity.

A firm is likely to become multinational if:

1. It has certain special assets which give it a competitive advantage over indigenous firms (strategic advantage factor)

2. These assets are more economically utilized in production facilities in parts of the world beyond the firm’s domestic markets (location factor)

3. The best way to obtain full value fro employing the asset in foreign markets is to transfer the asset internally within the firm to another affiliated business unit (transactions cost factor)

All three must be present to explain FDI. The multinational enterprise and FDI represent a response to high transaction costs by firms with unique assets/capabilities which have value when utilized in production facilities located in foreign markets.

Transaction cost problems will often arise because of difficulties associated with disclosing value to buyers in ways that is convincing and that does not destroy the basis for exchange. Because of information asymmetries, the less informed party (in many instances the buyer) must be wary of exaggerated representation by the seller, as to the performance properties of the technology in question.

• Know-how often cannot be codified, since it has an important tacit component, even when it can, it is not always readily understood by the receiver.

Figure 2 shows whether a foreign production location (to minimize costs) should be licensed or internalized. GC_L and GC_I represent the average unit costs of employing licensing (market) channels and internal (intra firm) channels to effectuate the sale and transfer of know-how. On the horizontal axis is an index of the complexity of know-how. Contractual and transfer problems are assumed to increase with the complexity of know-how (n refers to the number of transfers: k indicates a limited amount of transfers).

2b represents the differences in governance costs between licensing and internationalization. Point T is that threshold level of complexity for a given number of transfers, at which the governance costs associated with licensing become of such magnitude that internalization represents the more efficient governance mode.

(See Attachment figure 2 & 3)

The vertically integrated multinational enterprise – which sources inputs in one country for use in facilities in another – internalizes a market for an intermediate product, just as the horizontal multination enterprise internalizes markets for know-how and other difficult-to-trade assets. Vertical integration will represent the more efficient governance structure when a trading relationship requires the development of transaction specific assets.

The issue is whether the sourcing (in the case of backward integration) or supply (in the case of forward integration) will be more efficiently governed by contracts of various durations or by internal organization.

Figure 3a depicts the governance costs associated with markets GC_m rising with the specificity of the assets needed to support the transaction at leas cost. The average governance costs associated with vertical integration, while initially higher because of set up costs, do not vary with the degree of asset specificity because incentives for recontracting, and the associated costs, are assumed to be eliminated within the frim.

FDI, whether it is vertical or horizontal, internalizes intermediate contracts but creates a direct interface between MNE and the host government. To the extent that host governments treat MNEs differently from indigenous enterprises, the foreign firm may have circumvented one set of potential recontracting hazards through direct investment only to encounter another. The risk of expropriation or of host-government recontracting is such as to represent an important hazard for the multinational enterprise. Hence, the schedule will shift according to host-country recontracting proclivities.

In order to sell abroad, many firms are discovering that foreign governments require them to provide ‘offsets’ to domestic producers (i.e. subcontracting).
 

Dynamics are often underemphasized. The direct investment process is governed by more than just economic incentives; an initiating force is often needed. The presence of a sales office may assists information collection, thereby significantly lowering perceptions of uncertainty and raising the probability that a firm will engage in FDI.

Transactions cost principles can also be used to shed new light on host country/multinational-enterprise relationships in at least two important ways:

1. Analyzing the bargaining relationship between the host country and the firm:

• On the one side, the multinational enterprise is depicted as having the skill. On the other side, the host country is depicted as having the mineral resources. After the deal has been signed, the host country often acts opportunistic. To anticipate host-country demands for control and costly efforts to wrest it from the multinational firm (nationalization):

  • Establish an option for systematic divestment with a compensation schedule agreed to ex ante (safeguarded by a third party); or
  • Establish an ‘exchange of hostages’ (e.g. exchange of bonds).

2. Analyzing the implications offering the firm a management contract after its assets have been nationalized:

• Ownership is a continuing relationship, whereas contracts bear a terminal date (incentive problem once terminal date comes closer); and

• The lessened ability of the nationalized firm to adapt quickly to changed conditions in downstream markets (need to negotiate with host country).