In order to set the groundwork for this discussion, it is helpful to begin by brieﬂy summarizing transactions cost logic as applied to vertical inte- gration decisions. Three sets of concepts are important in understanding TCE as applied to ﬁrm boundary decisions: governance, opportunism, and transaction-speciﬁc investment.
In TCE, governance is simply the mechanism through which a ﬁrm man- ages an economic exchange. While there are a wide range of governance options available to most ﬁrms, these diﬀerent governance mechanisms can generally be grouped into three broad categories: market governance, inter- mediate governance, and hierarchical governance. Firms use market gover- nance to manage an exchange when they interact with other ﬁrms across a nameless and faceless market and rely primarily on market-determined prices to manage an exchange. Firms use intermediate governance when they use complex contracts and other forms of strategic alliances, including joint ventures, to manage an exchange. Finally, ﬁrms use hierarchical gover- nance when they bring an exchange within their boundary. In hierarchical governance, parties to an exchange are no longer independent. Rather, some third party (‘the boss’) has the right to direct the actions taken and decisions made by the parties to an exchange.
Transactions cost economics suggests that two issues are important when deciding which of these governance approaches to use: the cost of a governance mechanism and the threat of opportunism in an exchange. In general, the more elaborate the governance, the more costly the governance (D’Aveni and Ravenscraft 1994). Thus, the cost of using market governance to manage an exchange is less than the cost of using intermediate gov- ernance to manage an exchange. In turn, the cost of using intermediate governance to manage an exchange is less than the cost of using hierarch- ical governance to manage an exchange. If all managers had to worry about was minimizing the cost of governance, they would always choose non- hierarchical forms of governance over hierarchical forms of governance, and they would always draw the boundaries of their ﬁrm very narrowly.
However, managers also must consider the threat of opportunism in an exchange. Opportunism in an exchange exists when a party to that exchange takes unfair advantage of other parties to that exchange. The threat of opportunism in an exchange is a function of the level of transaction- speciﬁc investment in that exchange.1 A transaction-speciﬁc investment is any investment that is signiﬁcantly more valuable in a particular exchange than in any alternative exchange. The threat of opportunism exists when one party to an exchange has made a transaction-speciﬁc investment, while others have not made such an investment. The ﬁrms that have not made these investments can ‘hold up’ ﬁrms that have.
According to transactions cost logic, ﬁrms can use governance to mit- igate the threat of opportunism. In general, the more elaborate the gov- ernance mechanism, the more eﬀective it will be in reducing the threat of opportunism created by transaction-speciﬁc investment. Thus, when exchanges are characterized by very high levels of transaction-speciﬁc investment, hierarchical governance can be used to reduce the threat of opportunism. When exchanges are characterized by moderate levels of transaction-speciﬁc investment, intermediate governance can be used to reduce the threat of opportunism. And when exchanges are characterized by low levels of transaction-speciﬁc investment, opportunism is not really a threat, and ﬁrms should opt for the least costly form of governance available—market governance.
Thus, the logic for determining a ﬁrm’s boundary—at least according to TCE—is: when the level of transaction-speciﬁc investment in an exchange is high, the high cost of hierarchical governance is more than oﬀset by the ability of this form of governance to reduce the threat of opportunism, and thus hierarchy is preferred over intermediate or market forms of gov- ernance. When the level of transaction-speciﬁc investment is moderate, intermediate forms of governance are preferred over hierarchical forms of governance, since the moderate threat of opportunism does not justify the extra cost of hierarchical governance. Intermediate governance is also preferred over market governance, in these conditions, because there is some threat of opportunism that cannot be managed through market governance. Finally, if the level of transaction-speciﬁc investment is low, then the threat of opportunism is also low, and the least costly form of governance—market governance—is preferred.
Note that in this entire discussion, never once do questions about the relative resources and capabilities of a ﬁrm and its exchange partners arise. Firm resources and capabilities simply do not play a signiﬁcant role in traditional transactions cost analyses of ﬁrm boundaries.
Source: Barney Jay B., Clark Delwyn N. (2007), Resource-Based Theory: Creating and Sustaining Competitive Advantage, Oxford University Press; Illustrated edition.