Frequency, uncertainty and asset specificity form the key components of Transaction Cost Economics (TCE) that sets out to predict the boundaries of the firm given the characteristics of a transaction along these key dimensions. (Nagpal, 2005)
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When a management needs to make a major strategic decision of either ‘make-or-buy’, an understanding of the company’s current relationship with its provider and the characteristic of the specific TCE can provide a useful tool in determining the right decision forward. TCE helps to identify the four main key points on vertical integration due to its behavioural perspective, reducing the effect of frequency, uncertainty and asset specificity of this decision.
PART 1 KEY CHARACTERISTICS OF TCE
TCE states that exchanges between two independent agents involve transaction costs of different degrees. Economic institutions then evolve to lower these transaction costs. However, the real explanatory power of the theory comes from the three variables that are used to characterise any transaction.
Williamson identified three critical variables to characterise a transaction: the uncertainty under which the transaction takes place, the level of transaction specific investment and the frequency that transaction occurs. Transactions can be frequent or rare; have high or low uncertainty; or involve specific or non-specific assets. According to Williamson’s theory, these three variables will determine whether transaction costs will be lowest in a market or in a hierarchy. It is thus necessary to consider these variables with respect to decisions about whether to integrate vertically.
Frequency refers to the number of times the transaction is expected to take place. If a transaction is a one-off transaction, it will not be efficient to devote significant resources to its coordination and control. On the other hand, if it is expected to take place many times over many years, the cost of making special arrangements for its management may be justified. There will never be a situation in which a firm would want to integrate vertically so as to bring “in-house” the provision of a good or service that is very rarely used.
Uncertainty can be stated as an imperfect knowledge about an event and its outcome. The uncertainty surrounding a transaction can assume different levels. On one hand, for the buyer, it can be an uncertainty of quality, a reliable supply, timeliness or quantity. On the other hand, it can be the seller searching for a buyer. And for both agents, price can be uncertain (Hobbs & Young, 2000).
Transactions that require commitment over a longer period of time will experience higher form of uncertainty that those that are executed on “spot markets” because one does not have the mean to predict the future.
As discussed in Part II of the assignment where the printer agreeing to provide a service to Longman publishing. Both parties are likely to want a reasonably long term agreement to enable them to plan. However, the long term nature of the contract adds to the uncertainty. How can the printer be sure that the publisher will not go out of business during the life of the contract, putting its investment in the printing equipment at risk? How does it know that, having invested in the equipment, the publisher will not re-negotiate the contract at some future time? How can the publisher trust the printer in delivering quality prints at all time?
Will uncertainty be reduced by vertical integration? If so, will any savings in transaction costs be enough to outweigh any costs there might be associated with vertical integration?
Asset specificity is defined as the transaction which the investments in asset would only be valuable from their use of the specific transaction (Williamson 1975, 1985, 1986). This means how specific the investment is for the activity and the costs required reallocating it for another use. It is considered the most important empirical determinant of the transaction (Globerman & Schwindt, 1986; Williamson, 1975) due to its measurability.
There are four forms of asset specificity, namely site specificity, physical asset specificity, dedicated assets and human asset specificity.
Williamson argues that where transactions involve assets that are only valuable (or are much more valuable) in the context of a specific transaction, transaction costs will tend to be reduced in a hierarchy than in a market i.e. vertical integration.
PART 2 ANALYSE THE VERTICAL BOUNDARIES OF A FIRM BY DESCRIBING THE CRITICAL ROLE PLAYED BY COORDINATION IN A VERTICAL CHAIN
In this assignment, we will analyse the vertical boundaries of Pearson Longman Publishing (Singapore) (“Longman”) on the productive technology and the costs of transacting business and evaluating the relative costs of internal versus external exchange to decide to organize transactions within the firm as opposed to on the open market – the “make-or-buy decision”, in Longman’s case i.e. to print in-house (to “make”) or to outsource its printing jobs (to “buy”) (Klein, 2005).
Longman has established itself in Singapore since early 1950s and has been providing local schools with educational materials written by local authors, in line with local syllabuses and adhering to Singapore’s education policies. Longman has a total of 200 employees in 5 departments, namely the editorial department, the sales department, the marketing department, the pre-press department and the logistic department.
Longman publish school textbooks for local Primary and Secondary schools and general titles for the retail markets. From conceptualizing, producing the manuscript to designing the book cover, the whole process is done in-house by the editorial and pre-press departments. When the script is ready to be printed into books, e-copy of the script is sent to Markono Printing Media to be printed; a long term printer who has invested heavily in their assets to service Longman who has a substantial printing contract with them.
Vertical Chain for Longman publications
Vertical Chain for “Buy”
The vertical chain of production for Longman to “Buy” is as follows:
Processing & Handling
Sales & Marketing
Transportation & warehousing
Human Resource Management
The issues of coordination of production flows through the vertical chain will be discussed below.
The vertical chain of production for Longman to “Make” is as follows:
Vertical Chain for “Make”
Processing & Handling
Transportation & warehousing
Sales & Marketing
Human Resource Management
Transportation & warehousing
Issue Tree (Besanko, 2007)
In Longman’s case, the decision on whether to print in-house or to outsource is based on the Issue Tree as follows:
Defining the boundaries
Benefits of using the market
Market firms can achieve economies of scale that in-house departments producing only for their own needs cannot achieve.
They are subject to the discipline of the market and must be efficient and innovative to survive. Overall corporate success may hide the inefficiencies and lack of innovativeness of in-house departments
Costs of using the market
Coordination of production flows through the vertical chain may be compromised when an activity is purchased from an independent market firm rather than performed in-house.
Private information may be leaked when an activity is performed by an independent market firm.
There may be costs of transacting with independent market firms that can be avoided by performing the activity in-house
Evaluation of decision
Issue 1 – Market availabilities
In the make-or-buy printing dilemma for Longman, the market does provide many alternatives to vertical integration. In fact, there are many printers in the market who can provide printing service for Longman. In year 2007, in the attempt to stay price competitive against others small/medium size publishers by reducing printing costs, Longman has engaged the service of a lower cost printer in Johor Bahru, Malaysia. The Malaysian printer provides cheaper service than Singapore printer, but the print quality of the final products were not as ideal as those printed in Singapore and turnaround time differs from the schedule occasionally.
Issue 2 – Specific Assets
To “Buy”, Longman will not require any specific assets.
To “Make”, Longman will need to invest in printing and binding equipments that cost few hundred thousand each. It also needs to engage skilled printers or operators to operate these machines, and extra spaces are needed for the bulky machines. These will incur additional production costs in terms of additional manpower to operate, storage space and maintenance costs, as compared to “buy”.
Issue 3 – Coordination Problems
Longman decided to continue printing in Malaysia even though she faces numerous problems in coordinating the print quality and exact delivery date as its core intention is to reduce production cost.
For “make”, the coordination problems of print quality, logistics and delivery issues will be minimized as Longman is able to be in control of the production. However, the higher costs of hiring of additional qualified manpower to avoid diseconomies of scale, coupled with a high initial investment capital that Longman will incur will be outweighed by enforcing a clearer contract that spells out the penalties of late deliveries and poor print qualities. Longman can also dedicate a manager to oversee and coordinate the Malaysian printing process; refining the procedure to ensure a more timely delivery with higher quality print.
Issue 4 – Leakage of Private Information
To “buy”, Longman may risk divulging the book content to its competitors if the competitors use the same printer and chance upon the manuscript. However, such issues can be resolved with protection by the Copyright Act against any competitors plagiarizing the manuscripts.
Issue 5 – Transaction Costs
Transaction costs for Longman to use the market include transportation costs to travel to Malaysia to visit the printer, manpower costs, contract legal costs and insurance costs. This also includes the costs when there is a product defects and exploitation of incomplete contracts to act opportunistically. However, these cost are insignificant compared to the benefits of ‘Buying’ from the market i.e. cost savings from economies of scales, expertise in printing etc.
Issue 6 – Incomplete contract
Longman faces the problem of late deliveries and inconsistent print quality from her Malaysian printer due to the problem of an incomplete contract. There is the difficulty in specifying and measuring the performance which is stated in the contract as complex task or language is not clearly stated. In addition, parties to the contract face problems of bounded rationality and asymmetric information; parties to the transaction have access to different and incomplete information which leads to certain action that is not known to one of the parties of the contract. All this leads to an incomplete contract causing parties involve in the contract to face an unforeseen situation which none of them has anticipated when the deal was agreed. However, when this happen, the parties can re-negotiate and come to an amicable agreement to extract the full value of the transaction.
The change in the business environment creates the constant need to evaluate the vertical boundaries within the company. Leveraging on the existing and new services in the industry, firms can make an informed decision to vertically integrate or outsource any particular function.
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With the issues discussed above, I would recommend Longman’s management to continue its existing business model i.e. to outsource print jobs to both Malaysia and Singapore printers, with periodic review of the contracts and comparison of the cost structures and print quality.
Balancing vertical integration and strategic outsourcing
Balancing vertical integration and strategic outsourcing helps to optimize a firm’s product portfolio and to improve product success. (Rothaermel & Jobe, 2006).
Although outsourcing represents a move away from vertical integration to one of the contracting options, such decision is dependent on the characteristic of the transactions involved. Printing services can be produced more efficiently if one of the parties invests in ‘transaction-specific’ assets that cannot be easily put to other uses if the buyer/seller relationship between Longman and her printer breaks down. Longman is a big publisher with sizable contract that enables Markono and the Malaysian printer to invest heavily in dedicated capacity to serve Longman, asset specific investments that would be difficult to find alternative customers. Longman can threaten to walk away from this relationship if she cannot realize the full value from this relationship and seek alternative firms in the markets that supply such services.