Introduction
Firms are an important component of the functioning of an economy because of their intermediary role between buyers and sellers. Thus, firms facilitate the establishment and operation of markets (Spulber 2009). Diverse theories of firms have been developed to explain the establishment and operation of markets. One of the inherent aspects of the operation of firms and markets entails the incurrence of transaction costs, which involves the cost incurred in running the established system. In the course of running firms, entrepreneurs must facilitate the creation of value. Thus, they have to make a choice on which decisions should be made within the firm and those that should be left to the market. This indicates the existence of a boundary between a firm and the market. The boundaries theory postulates that a firm’s operations are influenced by different directional forces that are closely interrelated. This paper focuses on the evaluation of Williamson’s theory of the boundaries of the firm and contrasts it with the neoclassical theory of the firm.
Boundaries of the firm
Zenger, Felin, and Bigelow (2011) assert that firms’ operations are impacted by competing directional influences. Some of the influences are intended to expand a firm’s boundary while others drive towards its retraction. In deciding on firm activities, managers assess whether the success of such activities will achieved if the activities are governed within its boundaries or via the market (Hult 2011). Thus, the boundaries of a firm are based on an assessment of the parameters that influence the associated costs and benefits. This means that the boundaries of a firm underline the interaction between different internal and external influences. On the contrary, neoclassical theory is largely concerned with how a firm transforms inputs into outputs. This means that under the neoclassical theory, a firm is merely perceived as a unit of production (Spulber 1998). Neoclassical theory largely emphasizes that an organization’s production processes largely target outsiders (Walker 2016). Moreover, the neoclassical theory does not a firm’s organization, authority, and how decisions are made, which are emphasized under the boundaries of a firm. Thus, the neoclassical theory treats a firm just like a black box (Walker 2016).
Opportunism, bounded rationality, uncertainty, transaction-specific asset and frequency
Bounded rationality; this concept proposes that decision making by managers is constrained by their level of rationality and cognitive capability. In spite of the fact that the decision makers may act rationally, their decision making capability might be hindered by difficulties in communication.
Opportunism; involves an assumption that faced with a particular opportunity, decision maker may deceitfully pursue self-interests. Dietrich (2012) asserts that opportunism presents a major problem in that relationships are based on specific assets whose value is considerably limited outside such a central relationship. Opportunism hinders the efficiency of a market because market competition cannot successfully eliminate it.
Uncertainty; transaction costs which constitute a critical component of the theory of firm are also underlined by the assumption of uncertainty. Uncertainty is conceptualized based on two main dimensions that include behavioral and environmental uncertainty. Environmental uncertainty is comprised of the unanticipated changes in situations that surround a transaction or exchange. Considerable transaction costs can be incurred as a result of environmental uncertainty. Conversely, behavior uncertainty arises from the conduct of parties involved in a transaction for example challenges in evaluating the contractual performance of the parties involved in the transaction.
Transaction-specific assets; Williamson underlines the concept of asset specificity which entails the transferability inherent in an asset that supports a particular transaction. Zenger, Felin, and Bigelow (2011) emphasize that an asset that is characterized by a high specificity amount has minimal value beyond its specific exchange relationship. Williamson emphasizes that there are diverse types of transaction-specific assets such as temporal specificity, human asset specificity, and physical asset specificity.
Bounded rationality, uncertainty, and incomplete contracts
In line with the concept of bounded rationality, managers might not optimally act on information in responding to influences from the external environment (Moroni 2006). Neoclassical theorists argue that individuals can't undertake a complete appraisal of all the available alternatives (Sautet 2002). Subsequently, the concept of bounded rationality coupled with the element of uncertainty might result in the formulation of incomplete contracts.
How transaction-specific assets result in a bilateral monopoly
The concept of transaction-specific assets emphasizes on establishment of transaction relationships between trade partners. Subsequently, the partners in the transaction might establish strong alliances or ties characterized by a hybrid structure. The alliance established might increase the parties’ capacity to control certain aspects such as of the market such as the manufacturing and distribution of a particular product. The ultimate effect is the establishment of a monopoly (Zenger, Felin & Bigelow 2011; Colombo 2003).
Incomplete contracts combined with bilateral monopoly results in transaction costs
Incomplete contracts, which arise from prevalence of bounded rationality coupled with bilateral monopoly might result in increased transaction costs. This arises from existence of high degree of uncertainty because minimal attention is paid to the element of learning and evaluation of information which is a critical aspect in transaction cost economics.
Make or buy decision.
In making production decisions, firms are faced with two main decisions, which entail make or buy. The decision on whether to make or buy depends on the costs and benefits involved. If the benefits of producing in-house exceed the cost of buying, then the most optimal choice is to make.
Summary
The analysis above underlines the existence of significant differences between Williamson’s theory of the boundaries of a firm and the perspectives on the theory of the firm advanced by the neoclassical theory. The boundaries theory of a firm emphasizes on the importance of the importance of employing rationality in making transaction decisions while neoclassical theory disregards information and learning as a central element in making transaction decisions. Thus, the theory of boundary and neoclassical theory differ significantly in the approach to reducing transaction costs.
References
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