Managing Business Transactions: Controlling the Cost of Coordinating, Communicating, and Decision Making.

Lee, Dwight R.

In recent years economists have made important strides toward explaining why firms are organized as they are and why the intra firm contracts that define the firm and the extra firm contracts that describe its behavior across markets are written as they are. Building on Coase's 1937 argument that firms exist because there are costs associated with all transactions, economists have been able to open up what was, in economic theory, the black box of the firm and subject it to economic analysis. The transactions cost theory of the firm has developed primarily as a descriptive theory explaining the existing structure and practices of firms. Though much remains to be done in better understanding firms as they are, the transactions cost theory of the firm has reached the point where it can be used as a managerial tool to prescribe ways for firms to improve the efficiency of their operations. This prescriptive step is the one that Rubin takes in his book, Managing Business Transactions.

In standard economic theory the firm is a simple entity that somehow performs the complicated task of efficiently converting inputs into the profit maximizing quantity of output. While this theory provides the business manager with efficiency requirements expressed in terms of equating a set of marginal conditions, the generality of these conditions renders them difficult to apply to particular problems. For example, the standard economic theory of the firm provides almost no guidance to the business manager grappling with the choice between purchasing an input or producing it. Rubin devotes his opening chapter to an explanation of why the "make or buy" decision is of fundamental importance to business managers, and to a discussion of several factors that are crucial to this decision. This discussion begins introducing concepts that lie at the foundation of the transactions cost theory of the firm; concepts such as asset specificity, opportunistic behavior, quasi rents, residual claimants, and asymmetric information.

Purchasing inputs from another firm would typically be the best choice except for opportunistic temptations such purchases often create for the supplying firm. Any arrangement that reduces those temptations allows more of the benefits from market purchases to be realized. Court imposed penalties on parties that breach the terms of a contract provides some protection against opportunistic behavior. But for a number of reasons, relying solely on court enforcement of contractual term is not satisfactory. The ideal is to arrange the contractual relationship between buyer and seller so that the interests of both are best served by adhering faithfully to the terms of the contract. Although such a self-enforcing contract is not always a possibility, Rubin discusses several arrangements for reducing the likelihood that either party can benefit from violating a contract. These arrangements include the use of mobile specific capital, the exchange of "hostages," investment in nonsalvageable capital and reputational capital, bilateral exchange, and joint ventures.

The relation between a firm and its workers creates the potential for problems that are similar to those that can arise between a firm and other suppliers of productive inputs. Because of opportunistic behavior, or shirking, on the part of employees, as well as similar behavior on the part of employers, the incentives created by the employment contract are important to the success of managers. Under ideal circumstances efficiency is realized by paying workers on a piece-rate basis. But because of differences in risk aversion, the effects of specialized skills and training, and the importance of team production, the most efficient employment contract is seldom based on piece-rate performance. Rubin suggests several ways a manager can increase overall worker performance in ways that benefit both the firm and the workers through creative bonding schemes, salary structures, and salary contests. The importance of committing the firm in credible ways to its compensation promises is emphasized as equal in importance to (and essential to the realization of) workers making similar commitments to the firm.

In efforts to discipline shirking and opportunistic behavior for the benefit of all members of a firm and its trading partners, there are crucial differences between debt and equity financing that managers ignore only at great risk to themselves and their firms. Managers are responsible for raising capital as economically as possible. The relative cost of raising capital through debt and equity depends to a significant degree on how difficult it is for investors to monitor the investment activities of the firm. Understanding this connection between the cost of raising capital and investor monitoring gives the manager two advantages. The first advantage is a greater ability to choose the least-cost mix of equity and debt financing, and the second is a greater insight into how to credibly constrain management in ways that reduce management shirking and therefore reduce the cost of both equity and debt financing. Rubin provides useful guidance to managers concerned with the role of organizational structure in reducing the cost of raising capital by discussing the circumstances which favor single proprietorships, partnerships, hybrids that fall between these two alternatives, and the standard corporate form. This sets up another interesting discussion of ways managers can improve their firm's prospects, along with their own, by using the market for managers to impose additional discipline and accountability on themselves.

Rubin next makes use of theoretical and empirical evaluations of takeovers and restructuring to address managerial challenges. First, how can managers prevent their firm from being a takeover target, and second, under what conditions should they attempt to take over another firm? Rubin begins this chapter by considering the advantages realized from the conversion from equity to debt that characterizes leverage buyouts (LBOs). When a management team engages in an LBO it reduces the incentive and opportunity for shirking by concentrating residual claims and reducing free cash flow - cash flow in excess of the amount that can be invested profitably in the firm. LBOs also tend to put pressure on management to sell off activities previously, and inefficiently, acquired with free cash flow. This leads Rubin to recommend that the management team that wants to avoid being taken over should avoid subsidizing unprofitable divisions with profitable ones, a common form of managerial shirking with free cash flow. Also, management responses to potential takeovers such as golden parachutes, greenmail, shark repellents, poison pills, and lobbying for changes in state laws are considered. All of these responses can be advantageous to managers, at least in the short-run, and some can promote overall efficiency when properly employed. Rubin emphasizes that the advantage with efficient responses is that they increase the possibility that all affected parties gain. Rubin points out that taking over another firm is risky and the firm that is not careful in its takeover attempts is very likely to become an attractive takeover target itself.

Turning his attention to marketing, Rubin considers the problems that arise between manufacturers and the retailers of their products. In the case of products that carry no brand name and require little if any customer service at the retail level, the best strategy from the manufacturers perspective is to make their product available to as many retailers as possible, relying on competition to keep retail profits margins low and sales high. However, when retail efforts are important in promoting a product and insuring the quality of the service it provides, the manufacturer, retailers, and customers can benefit from restrictions such as retail price maintenance, exclusive retail territories, and exclusive dealing. These restrictions, though commonly seen as anti-competitive, can increase efficiency by reducing shirking by manufacturer and retailers that harms both them and their customers. Rubin extends the insights obtained from considering efficient arrangements between manufacturers and retailers by explaining how franchise agreements can be written in order to enhance the benefits of franchise arrangements by reducing the free-riding and shirking that can arise under such arrangements. The discussion on franchising draws heavily on some of Rubin's own important contributions to the transactions cost theory of the firm.

Many consumers want, and are willing to pay for, high quality products, but the quality of those products is often difficult for the consumer to determine. In such cases, firms can increase their profits, and promote efficiency, by establishing credible reputations for reliability. In his final full chapter, Rubin advances several ways managers can establish such a reputation for their firm. Reputations for reliability can be created by investments in nonsalvageable capital, temporarily charging low prices for a high quality product, selling several different products of similar quality under the same brand name, selling through retail outlets with an existing reputation for quality, advertising that signals the existence of quasirents that will be sacrificed if high quality is not maintained, and by offering warranties. While none of these investments in reputation is perfect, and Rubin discusses some of the problems, each of them offers the possibility of increasing the scope for efficient cooperation between those demanding high quality products and those willing to supply them.

The economist who wants a convenient and well written overview presentation of the transactions cost theory of the firm, can do no better than read Rubin's book. But Rubin does more than summarize key results from an important area of economic theory. He shows how those results can be put to practical use by managers facing the day to day problems of running a business. Rubin has forged a tight connection between the theoretical and the practical with his book, and

by doing so has pushed economics farther along in its colonization of yet another academic field; in this case, the field of management.