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Transaction Cost Economics And Organized Labor

1055 words - 4 pages

Cooperation and exchange among individuals often organize in firms rather than adhering to market institutions. This anomaly of market systems can be explained through what Oliver Williamson calls “Transaction Cost Economics.” Transaction costs are defined as the “costs of running the economic system” (Williamson 18). Similar to friction in a physical system, transaction costs may be small compared to other costs such encountered by market players, but basing entire models on a ‘frictionless’ system is unrealistic. It is these transaction costs explain the development of firms and hierarchies rather than contracting by market forces.

There are three limitations to a market system: bounded rationality, opportunism and asset specificity. Bounded rationality describes the limitations of knowledge by market players. Whereas they will act rationally in a market situation, they are not always presented with all the information required to make a rational decision. Opportunism arises when certain market players are unwilling to accept the status quo and believe they have the ability to improve their position. Finally, asset specificity refers to certain players having technical and contractual inseparabilites. An example of asset specificity is an accounting firm with a long term contract with a given company. After the long term contract expires, the accounting firm would be first in line to renew their contract with the given company. There may be other accounting firms in the market that could also offer similar accounting services, but the company will likely keep its original accounting firm. Switching would incur transaction costs such as transferring of files over to the new accounting firm, legal fees associated with writing a new contract with a new firm, and errors associated with unfamiliarity with the company’s accounting. Staying with the original accounting firm insures that many of these transaction costs will be kept to a minimum and in some cases eliminated all together.

The three market limitations produce four concepts of contract: planning, promise, competition, and governance. Planning assumes high opportunism, asset specificity but no bounded rationality. Promise assumes bounded rationality, asset specificity but not opportunism. Competition assumes both bounded rationality and opportunism, but not asset specificity. Finally, governance assumes all three. The contract concepts of planning and promise can be ruled out of most market systems and are rarely observed in the real world. Their assumptions of no bounded rationality and no opportunism respectively are unrealistic assumptions about basic human nature. A basic assumption of a market system is that players will act rationally and work to improve their present position. In the absence of asset specificity, competition arises which accounts for the majority of the situations in a market setting. Since asset specificity is often absent or...

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