Neo classical economics theory defined the firm as an owner controlled body operating in a timeless environment with a sole aim of maximizing profit (McNutt, n.d.). This theory is relevant to small firms where management falls under the responsibility of the owner assuming perfect knowledge and rational logic (McNutt, 2010).
Firms evolved and the separation between ownership and management emerged which led to new set of difficulties of which we observe the principal/agent issue when owners/shareholders start hiring CEO’s to drive firm strategies which will impact the payoffs to the owners (Besanko, et al., 2009).
Herbet Simon argued that perfect knowledge and rationalism does not exist, as management are bounded rationally, thus paving the way for the development of Game theory and the arising of new management models where profit maximization is not the only objective (McNutt, n.d.).
Firms are more complex now, new markets developed, technology became easier to acquire, less time to make decisions that are taken on daily basis and are inter-dependent between market players. It becomes more crucial to understand the market as a game and analyze actions as signals. Ultimately ‘Game Theory’ focuses on observed behaviors and allows us to explore signals to predict future outcomes; The Behavioral approach (McNutt, 2010), where the aim is moving away from single goal ‘maximized’ result to a multiple goals ‘satisficed’ result , knowing that focusing on a single goal is unrealistic and what count is the outcome.
‘Baumol’ type management focuses on revenue maximization, of which ‘price’ is the focus and ‘price elasticity’ is the driver; preserving a minimum profit constraint. For elastic demands where price elasticity (Ep) Ep>1, price decrease would result in increase in total revenues, while for inelastic demands where Ep<1, price increase would result in increase in total revenues (McNutt, 2010).In Baumol ‘Type’, management benefits from economies of scale (Besanko, et al., 2009).
‘Marris’ type management focuses on organic growth and product diversification, of which ‘paying dividends’ is the driver. Management tends to satisfy owners/shareholders by paying higher dividends.
To achieve growth ,which should be planned based on a balanced growth plan, firms need to invest in R&D division through either internal funds or new debts, this will result in fewer dividends to pay to shareholders and may lower the valuation of the firm and expose it to the risk of takeover, to overcome this issue Shareholders need to be engaged in positive learning transfer (PLT) where they should be educated that investment at time t and postponing their dividends payment will result in higher dividends at time t+1 and may also increase the value of the firm, in brief the core of this management model is the tradeoff between paying dividends and investing in R&D (McNutt, 2010).
Coordination and Introduction to TCE:
In current business world, firms are known as network organizations due to the increasingly use of market to contract staff for efficient control of its workforce and outsourcing for reduction of production cost. The transaction cost economics (TCE) approach tends to analyze both, the internal cost of coordination and the use of market, in order to decide how to coordinate economic exchange in an efficient way (McNutt, n.d.).
Transactional costs are the time invested by a firm to use the market, researching potential suppliers and collecting information, the cost of contracts negotiation with market suppliers, monitoring the performance, writing contracts and enforcing them on the suppliers, The cost of incomplete contracts, even Legal costs are incurred should the supplier breach contracts (Besanko, et al., 2009).
The incomplete contracts transactional costs are due to ‘bounded rationality’ of management and individuals which exists due to limited capacity in complex situations and possession of lack/excess of information, more uncertainty more research time higher transactional costs, ‘Difficulty in measuring the performance’ in case the performance indicator is ambiguous and hard to measure, ‘opportunism’ due to ‘asymmetric information’ in case a knowledgeable party either the firm or the supplier hides critical information from the other party and make use of it for its own benefit (Besanko, et al., 2009).
Another sources of transactional costs arises from theoretical concepts, ‘Relationship-specific asset’ which is the investment to support a specific transaction where they hold no value in case to be used in another transaction, it can be further segmented into ‘Site specificity’ which is the investment to build side-by-side assets in order to minimize transportation and inventory cost and thus increase efficiency, ‘Physical Asset Specificity’ the investment in physical assets that fits a specific transaction, ‘Dedicated Assets’ the investment in an asset that is only relevant for a particular transaction, ‘Human Asset Specificity’ the investment in human resources to tailor them to the needs of a specific transaction (Besanko, et al., 2009).
‘Quasi Rents’ is the extra profit a supplier may get versus the profit of selling to the next best option. In short it is the calculated risk in case contract is incomplete and highlights the magnitude of holdup problem in case of existence of relationship specific assets (Besanko, et al., 2009).
‘Holdup Problem’ occurs when a firm decides to holdup a contract due to large quasi rents in relationship specific asset in attempt to renegotiates contract, reduce the investment in relationship-specific assets and strengthens its post bargaining positions causing Distrust which implies raise in transaction costs due to harder renegotiations, hindering of valuable information and causing lower productivity and higher production costs due to less investment in relationship-specific assets (Besanko, et al., 2009).
Now after going through sources of transactional costs and Co-ordination, what is the best way to coordinate exchange? Vertically integrate or use the market? This is known as the ‘Make or Buy Dilemma’, to address such dilemma management should be able to identify reasons to make and reasons to buy and accordingly take best decision.
‘Reasons to Make’ which is implicit to high ‘buy’ costs, Avoid costs derived from ‘TCE’ due to incomplete contracts such as ‘bounded rationality’, ‘distrust’ and ‘relationship-specific assets’, Avoid costs derived from ‘coordination of production flows’ such as penalties and losing credibility in case missing contract key target dates, Avoid costs derived from ‘leakage of private information’ that are critical to the firm survival and maintaining its competitive advantage (Besanko, et al., 2009).
‘Reasons to Buy’ which is implicit to high ‘make’ costs, benefit from ‘Learning Economies’ such as economics of scale where the firm benefits from experience, possessing proprietary information and producing for multiple firms to help achieve lower cost for higher output, avoid “Bureaucracy effects’ such as ‘agency and influence costs’ where management takes decisions for their best interest not the firms’ and this is more relevant to big firms where the structure becomes more complicated and different teams end up having different goals influencing management on resources allocation thus reducing overall efficiency and profitability of the firm, cost-centers are another example of agency costs due to their nature being non revenue generating divisions it becomes almost impossible to assess the performance of such centers (Besanko, et al., 2009).
There are several ways to reduce cost of TCE, by building Trust based relationship between firms, by writing better contracts that consider all possible issues that may arise from incomplete contracts and by using IT and telecommunications which have resulted in e-trading and computer integrated manufacturing (McNutt, n.d.).