Assessment Reference: ME/July10/1

Student Name: Wadih Cordahi

Student Number: 7763018

MANAGERIAL ECONOMICS

Assessment 1

A firm is a single entity whether an organization or a company that is normally influenced by the

demands and needs of the market in which it operates. Whereas a market is an assortment of systems in

which a firm’s products and services are exchanged. In our daily life, both firms and markets, whether

local, international or multinational are inseparable and depend on each other’s to form competition,

business relationships and economical transactions. And, the use of transactions is essential to determine

the structure of the firm. It is also responsible for the coexistence of various forms of organizations. A

firms’ coexistence represents its continuation, evolution and persistence in a specific market and it is

directly influenced by the firms’ economic situation. That is, if well organized and structured, a firm will

be able to grow in an efficient and sustainable way.

Transactions Cost Economies or TCE are methods used to secure a company’s growth. In 1937, Ronald

Coase mentioned that: “Transactions Cost Economies or TCE are The Nature of the Firm.” This is in fact

true since TCE normally focus on the transaction cost obtained to make an economic exchange.

Transaction Cost Economies studies how different parties protect themselves from the risks that might

come up from their relationships. For that reason, TCE is identified through several characteristics such as

Asset Specificity, Uncertainty and Bounded Rationality, Opportunism and Frequency of Transactions.

Asset Specificity refers to the level to which a party is attached in a mutual relationship or contract. For

example, the African GSM and ISP leader COMIUM is composed of eight international companies.

COMIUM is currently tied in a contract with one of its subsidiaries providing the internet backbone link.

If we want to consider the internet backbone link as a transaction, then COMIUM has made a high

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investment to support this transaction if compared to transferring it to a specialized third party at a lower

cost. In 1983, Williamson recognized this type of Asset Specificity as being part of the Site Specificity

and Dedicated Asset. Another characteristic of TCE is the Uncertainty and Bounded Rationality. If

present on both environmental and behavioral levels, Uncertainty will make impossible to identify and

write contracts, resulting in reassessment of the situation and preparing for contract renegotiation. This

will definitely increase the transaction costs and force the firm to produce products and services internally

if contracts are not approved by both parties. According to Coase, “a firm is likely therefore to emerge in

those cases where a very short-term contract would be unsatisfactory,” and that “it seems improbable that

a firm would emerge without the existence of uncertainty.” The third TCE characteristic is Opportunism

where asymmetric information is provided by both parties resulting in the uncertainty of their intentions

so as to take advantage of the situation. According to Williamson, “Opportunism refers to the possibility

that people will act in a self-interested way “with guile””. On the other hand, Opportunism and Frequency

of transactions are sometimes present together and might affect both transaction and production cost if for

example Opportunism is used to arrange internally for the production of a product or service that is rarely

used by the firm. However, this is not always the case and a firm selection to perform an activity itself or

to purchase it from an independent party is known as the “Make or Buy” decision.

“Make or Buy” are two extremes in vertical integration. A company might chose to “Make” an activity

that is to perform the activity in-house or chose to “Buy” the activity by outsourcing it to third parties in

the market. Some believe that market firms are more efficient and can produce the task at a lower cost

since they hold its proprietary information and can combine the needs of many firms at the same time to

have the benefit of economies of scale. Usually, vertically integrated companies in a supply chain are

owned by one person who owns a group of companies that each produces a different product or service.

The outcome of every company is combined to produce the required product. Nowadays, many modern

companies follow the strategy of outsourcing a certain task and rely on third parties to perform it. For

example, Qatar Telecom is outsourcing under a specific contract its Contact Center unit to several third

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parties more specialized in the field and that can meet the company’s requirements. Also, the Data Center

was outsourced few years later to Navlink, an AT&T affiliated company, to open the gate into

international markets and expertise, ameliorate the skills of the local team and provide high standard level

of service to customers in the country. This type of outsourcing is closer to joint venture agreements

usually made between a firm and a market firm with intention to rely on the resources of each party. Also,

when “Buying” form the market, firms and market firms can enter into a long term contract tying their

interest together to ensure typical product delivery throughout the whole period. Contracts can be

applicable in such cases, whether complete or incomplete, and they are usually used to identify each party

job and responsibility. Complete contracts are used to eliminate the opportunistic behavior and prevent

any party from abusing the other’s weak situation while any transaction is in process. While incomplete

contracts are sometimes intended to exist and neither party’s rights nor responsibilities are clearly

specified. There are three factors that might prevent a contract from being complete. First, the Bounded

Rationality where limits are set on decision makers to process information that result in finding the

optimal option with the information and resources available. Second, the Difficulties in Specifying or

Measuring Performance that is unclear and hard to measure. For example, the relationship between ATM

machine suppliers and the speed of the internet link provided by Internet Service Providers or ISPs for

complicated sites at the highways of the desert in the Gulf. The speed of the internet link cannot be

measured exactly since it is affected by the variation of the temperature in the desert from very hot to very

cold within the same 24 hours of the day. Third factor is the Information Asymmetry where one party

knows more information than the other creating an inequality of power in transactions. As a result,

contracts are important to ensure the coordination of production flows through the vertical chain.

However, coordination problems are often present and arise when the best action for one individual

depends on the actions taken by the others. Therefore, for coordination to succeed each party must make a

decision depending on the decision of the others and the firm’s organizational structure must be used to

identify decision makers in the company and enable proper flow of the information. Make-or-Buy

decision, whether accompanied with a contract or not, is critical but also essential for a firm to define its

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boundaries by verifying the benefits and costs of using the market firms instead of performing the job in-

house. For this reason, a firm should periodically check its peak demand on the product, achieve

equilibrium between making an asset and buying it, agree that the margin of profit of market firms is

sometimes negligible in large projects and compare between having different distribution channels than

tying up with only one.

In the following example, COMIUM (the leader GSM in Africa) is a holding company which consists of

six firms that are owned by one person. The holding company is having partnership and joint venture

agreements with key players in the telecom industry to transfer professional knowhow to its staff that is

spread around its operations in Africa and to ensure high level of service is provided to its customers.

Even though COMIUM is vertically integrated, the company still uses both Make and Buy decisions in

daily activities. Some of the in-house developed products and services are utilized within the operations.

At the same time, these firms are specialized in their field and they became market firms ready to be

bought by other firms. The process of buying one of the group companies for a specific activity is usually

done under a complete contract to ensure privacy for the provided information. On the other hand, the

company also buys some services such as, the satellite backbone link and many others, from market firms

and suppliers’ experts in the field and who were able to reach economies of scale that in-house firms

wasn’t able to reach. This is again usually achieved in the presence of complete contracts obliging the

second party to provide high level of services with top quality of products. Therefore, the coordination

between both parties is most of the time relying on the contract itself. Contracts related to critical projects

usually specify the delivery dates for each product. In some cases where critical services are provided,

service level agreement (SLA) is signed by both parties; these services are usually implemented on the

company’s live network. In the case the service did not meet the predetermined requirements; the market

firm will be penalized and normally financial payments are made until the service is recovered and

customers’ satisfaction is attained. Also, from time to time, the company uses its affiliation and joint

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venture agreements with key players in the telecom industry to share information and resources intended

to improve the network and provide advanced type of services.

References:

http://books.google.com

http://www.wikipedia.org

http://www.economist.com

http://www.comium.com

http://www.qtel.com.qa

Economic Insights (Federal Reserve Bank of Dallas)