PAP 3370 Lecture Notes - Lecture 17: Transaction Cost, Oliver E. Williamson

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maroonhamster472

24 Apr 2014

School

University of Ottawa

Department

Public Administration

Course

PAP 3370

Professor

Frank Ohemeng

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Document Summary

For organizational economists, organizations exist in seething caldrons of competition where other firms, individuals, institutions, and government are seeking to obtain some part of the success that a particular firm may enjoy. Classical and neoclassical economic theories point to the surprising ability of markets to coordinate economic production and exchange at a very low cost and without government planning. According to adam smith who is seen as the father of classical economics, an economy could be coordinated by a decentralized system of prices. In most economic analysis, this idea is called the theory of the firm although the theory actually focuses exclusively on the structure and operation of markets and is unable to explain the existence of firms. Therefore given that markets are so effective in coordinating economic exchanges, it has always been a bit of a mystery why not all exchanges are managed through markets if the markets are perfect.

Related Questions

Market Analysis Market Participants Market participants act as if they are rational, self-interested, and forward-looking. For example, financial managers try to maximize the present value of profits for their particular companies, rather than ignore future values. Companies pursue many goals, but it is a financial mistake for managers to pursue any goal that conflicts with the primary goal of maximizing their firm's profits. Decentralized decision making by individual market participants is more economically efficient that centralized decision making by government policymakers. For example, it is more economically efficient to have financial managers obtain financing for their particular companies than to have government obtain it. A high degree of competition among market participants is the most economically efficient disciplining mechanism. For example, highly competitive financial markets discipline financial managers to pay fair market interest rates on the debt securities issued by their particular companies. The market system of prices is the most economically efficient allocative mechanism. For example, it is more economically efficient to distribute a firm's corporate stock to those buyers who are willing and able to pay the market price of the stock than to have the government distribute the stock. It is economically efficient for market participants to buy low and sell high globally. For example, it is economically efficient for U.S. firms to sell their financial securities to the highest bidders, no matter where they live in the world economy. Market imperfections can create considerable risk to market participants. For example, because of market imperfections, firms operating in the international financial markets encounter foreign exchange rate risk, political risk, interest rate risk, and default risk. Consumer Sovereignty The principle of consumer sovereignty tells us that by making their dollar votes, consumers indirectly determine the quantity and quality of products that firms will produce. For example, it is not economically efficient for financial managers to obtain more financing for their particular firms than is needed for their firms to produce the profit-maximizing level of output demanded by consumers. Market Economy A highly competitive market economy is largely self-regulating, in the absence of substantial market imperfections, in that economic conditions cannot be substantially improved by government regulation or other types of government intervention beyond laissez-faire policies. For example, if a firm's corporate stock is overvalued by a market economy, market forces will tend to drive down the value of the stock to a market price at which it is neither overvalued nor undervalued. As if by an invisible hand, highly competitive market forces will tend to create a harmony of interests among individual market participants, in the absence of substantial market imperfections. Consequently, the interests of shareholders and other stakeholders are compatible. For example, in trying to maximize profits, firms produce employment, income, consumer products, and wealth for households, as well as tax revenue for government, which helps maximize consumer utility and maximize social welfare. In a market economy, resources, products, and assets flow to their highest valued uses among alternative uses. For example, the shares of firms' corporate stocks will be acquired by those market participants who most highly value them, as indicated by the fact that they are willing to pay the most to acquire them. The efficient economic role of government is limited to Laissez-Faire ("hands off") policies, which create very little intervention in a market economy. For example, government regulations of banking and securities industries to maintain healthy, reasonably profitable, consumer-oriented financial markets would not be needed in a highly competitive market economy in the absence of substantial market imperfections. In a market economy, it is economically efficient for each market participant to specialize according to comparative advantage in producing what they can produce relatively better than other market participants, rather than produce all the outputs they can produce absolutely better than others. For example, it is economically efficient for people who are relatively better at being financial managers than others, to specialize in financial management even if they are absolutely better than others in doing many other types of work. If all labor were allocated to its comparative advantage, then no possible reallocation of labor would exist that could increase the rate of return to labor (i.e., the wage). There is no such thing as a free lunch, because all resources, products, and assets in a market economy are scarce. For example, current federal government budget deficits are not free to current market participants in that the deficits must be financed by future tax increases and/or future decreases in government spending and/or future inflation. For additional information on the Market Economy click here. Marks, R. E. (2006, December). There Is No Such Thing As Free Lunch. Australian Journal of Management. 31(2). 1-7. Financial Decisions An efficient financial decision, practice, transaction, or condition is one that is optimal -- meaning best; it cannot be improved, from society's perspective. If there is some profitable way to improve some business practice that would benefit society, that practice is somewhat inefficient. Any change in a financial decision, practice, transaction, or condition that improves society is an efficiency improvement. For example, it is an efficiency improvement for a business to cut production costs by reducing waste (e.g., by reducing spending on unprofitable activity. A financial decision, practice, transaction, or condition is fair-- meaning just or equitable, if the financial benefits are distributed to those involved in proportion to how much they each voluntarily contributed to produce those benefits. For example, a financial practice that discriminates against some people on the basis of race, age, gender, nationality, or religion is unfair. For example, an unethical business practice is unfair. For additional information relating to Market Analysis and fair financial decisions, click on the following: Teaching Ethical Economic Practices to Business Managers. Johnston, C. (2009, October). The Proceedings of the Annual Conference of The International Academy of Business and Economics. Fairness is a necessary condition, but not a sufficient condition, for efficiency. All efficient financial practices are fair, but some fair practices may still fail to be efficient. For example, embezzling company funds is an unfair and inefficient, criminal financial activity. As another example, an ethical business practice that could be improved is fair but not efficient. Opportunity Cost Principle Opportunity cost principle: The efficient measure of the cost of any allocation of resources, products, money income, wealth, or time is its opportunity cost -- the value of the next best use. The opportunity cost of how one uses his or her resources is the value of the highest valued alternative use. The opportunity cost of one investment is the expected return on the next best investment available to the firm. For example, the opportunity cost of a firm using some of its profits to pay dividends to its stockholders would be the present value of future income those profits could have earned if invested in the firm's highest valued investment project.

Discussion Questions These questions stem from the Class Discussion Questions you will be anwering in the Discussion Board. Think about the questions and how they relate to the financial management principles above.

2. Applications: State the financial management principle that appears to be violated in each of the following cases and explain how it is violated:

(a) A corporation is maximizing sales growth and the price of its corporate stock is falling.

(b) A highly paid financial manager in the auto industry quit his job to set up his own small auto repair shop, which is expected to incur a loss for the first three years then earn normal profits.

The primary costs of FDI to host countries are:

		Loss of sovereignty and patriotism
		Adverse effects on competition and exports
		Capital outflow
		Loss of sovereignty, adverse effects on competition, and capital outflow

____ suggests that FDI, unrestricted by government intervention, will enable countries to tap into their absolute or comparative advantage by specializing in the production of certain goods or services.

		The radical view
		The free market view
		Pragmatic nationalism
		Expropriation

What are the benefits of FDI to home countries?

		Repatriated earnings from profits from FDI.
		Increased exports of components and services to host countries.
		Learning via FDI from operations abroad.
		All of these answers

When one firm enters a foreign country through FDI, its rivals are likely to follow by undertaking additional FDI in a host country to:

		Create knowledge spillover
		Discover a new market for its goods
		Overcome and combat market failure through FDI
		Acquire location advantages or neutralize the first moverâs location advantages

Most countries practice:

		Pragmatic nationalism
		Free market based FDI
		Government embracing radical view
		French patriotism

FDI may be viewed as a reflection of firm motivation to extend firm-specific capabilities abroad and their responses to overcome imperfections and failures.

		True
		False

Most countries practice a totally "free market" view.

		True
		False

8. Outsourcing is the process of turning over an organizational activity to an outside supplier, located in a foreign country, which will perform it on behalf of the local firm.

		True
		False

Financial, physical, and technological resources and capabilities are all tangible assets.

		True
		False

A firm's resources and capabilities are tangible assets a firm uses to choose and implement its strategies.

		True
		False

An example of low power distance would be when subordinates address their bosses on a first-name basis.

		True
		False

Benchmarking is an assessment as to whether a firm has resources and capabilities to perform a particular activity in a manner superior to competitors.

		True
		False

A country with low-masculinity has a more subtle differentiation between the gender roles.

		True
		False

Setting up subsidiaries abroad so the work can be performed in-house but in the foreign location is also called captive sourcing.

		True
		False

Managers in low uncertainty avoidance countries rely more on experience and training than managers in high uncertainty avoidance countries who rely more on rules.

		True
		False

Informal institutions include laws, regulations, and rules.

		True
		False

The United States is often classified as a collective society.

		True
		False

A pure market economy characterized by the "invisible hand" of market forces is noted by

		John Stuart Mill
		Adam Smith
		Aristotle
		Amatya Zen

Culture is defined in the text as:

		The communication between members of similar location.
		The collective programming of the mind, which distinguishes the members of one group or category of people from another.
		The main component of formal institutions.
		The attitudes and behaviors characteristic of a particular social group or organization.

When an expat employee returns to her or his current employer but the employer does not provide attractive opportunities, she/he often may be hired by a competitor firm. Why?

		Competitor firms are also interested in globalizing their business.
		Former expats bring instant expertise and experience.
		Competing firms will pay a higher premium for expertise.
		All of these answers

The government taking a "hands-off approach" is known as:

		Laissez faire
		Command economy
		Mixed economy
		Liberal approach

Expatriate managers make ideal candidates for top management positions.

		True
		False

____ are defined as rights associated with the ownership of intellectual property.

		Patents
		Copyrights
		Trademarks
		Intellectual property rights

In a collective society:

		Family units are highly valued.
		Being an entrepreneur is a popular mindset
		Being different than your neighbor is important.
		Outsiders are easily trusted.

Which of the following definitions best defines an expatriate manager?

		A manager who works outside his or her native country
		A manager of great expertise
		An ex-manager rehired for advisory purposes
		None of these answers

PAP 3370 Lecture Notes - Lecture 17: Transaction Cost, Oliver E. Williamson

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