Economizing and Strategizing

20 May 2007 at 1:56 pm Nicolai Foss 5 comments

| Nicolai Foss |

In a much-cited 1991 paper in the Strategic Management Journal, “Strategizing, Economizing, and Economic Organization,” Oliver Williamson introduced the distinction alluded to in the title of the paper between “economizing,” that is, economizing with transaction costs, and “strategizing,” that is, the exercise of market power (in the standard sense of setting p above mc and imposing a deadweight welfare loss on society). Whereas strategizing is only available to relatively few, large players, Williamson argued, any firm can engage in economizing. Thus, “… economy is the best strategy. That is not to say that strategizing efforts to deter or defeat rivals with clever ploys and positioning are unimportant. In the long run, however, the best strategy is to organize and operate efficiently.”

However, in a certain sense, economizing and strategizing are made of the same stuff, and the distinction may, for this reason, be somewhat overdrawn.

The stuff in question is transaction costs. If transaction costs were zero, the scope for strategizing would also be zero. To be sure, value appropriation would still be a matter of bargaining power, but Coasian trading would ensure that no welfare would be lost from the exercise of market power.

In the zero-transaction-cost benchmark, institutions and contracts do not matter for allocational outcomes. As soon as transaction costs are introduced, however, different institutions and contracts need to be compared in terms of their efficiency properties. Though seldom recognized as such “comparative contracting” is a central tool in competitive strategy for the reason that it helps to identify impediments to value creation. For example, firms that draft superior contracts with their suppliers may enjoy a competitive advantage from this.

However, the notion of comparative contracting goes beyond the comparison of actually existing, concrete contracts. It may also be used in counterfactual reasoning. For example, consider a would-be price-discriminating monopolist. Here, the relevant comparison may be between situations where the buyers through mutual contracting can hinder the attempt at price-discrimination, and situations where contracting costs hinder this. Assessing the size of the relevant contracting costs is evidently important for the would-be price discriminator. In other words, the price discriminator’s possibilities of capturing consumers’ surplus and increasing his returns through this competitive strategy is constrained by the underlying transaction costs, in this case, contracting costs.

As another example, consider so-called “predatory pricing”. The relevant preys are the predating firm’s competitors and buyers. However, preys are not defenceless against a monopolizing predator. Thus, the notion of comparative contracting may shed lights on how contracting may influence the outcome. For example, the preyed-upon firm(s) can enter into long-term supply contracts with consumers that will protect them against the predator. A contract that stipulates the prevailing competitive price as the one under which future transacting will take place may be sufficient to protect the preys (see this paper).

Thus, transaction costs and strategizing may be more intimately related than we usually think. I am not quite sure what the implications are of this. I hope to be able to explore this theme more in future work (for an early attempt, see this paper), and would therefore be grateful for the thoughts of the readers of O&M.

Entry filed under: - Foss -, New Institutional Economics, Strategic Management.

Random Post Link Craft Production Is Fun

5 Comments Add your own

1. Joe Mahoney | 21 May 2007 at 12:13 pm

Dear Nicolai,

First, it is insightful of you to note that both the monopoly branch of strategy and the organizational economics branch of strategy share the importance of the concept of MARKET FRICTIONS. Frequent insights such as these that you offer are why you are one of the top theorists in the world in Strategic Management.

While I agree fully with your insight, let me suggest why the distinction between monopoly strategizing and economizing is useful. If we think in terms of antitrust logic — which those in the Strategic Management field should be aware — there does seem to be a useful distinction to keep in mind.

Some theories seem focused on extracting consumer surplus: (1) Leveraging: to extend monopoly power; (2) Price discrimination; (3) Increasing Entry Barriers and in the longer run (4) Strategic behavior for raising rivals’ costs.

In contrast much of organizational economics — which has become increasingly adopted in Strategic Management in recent years — such as Measurement (Barzel, 1982), Governance in Transaction Costs Theory, Agency Theory, and more recently Property RIghts Theory have emphasized efficiency and economizing.

My reading of Williamson (1985, 1996) suggests that some industrial organization models, such as deliberately building excess capacity to deter entry receives a large amount of attention, but that it is NOT where much of the action in Strategy in the world of experience resides. Further, while there is a very large literature on predatory price (P
2. Joe Mahoney | 21 May 2007 at 12:18 pm

Part II (con’t)

My reading of Williamson (1985, 1996) suggests that some industrial organization models, such as deliberately building excess capacity to deter entry receives a large amount of attention, but that it is NOT where much of the action in Strategy in the world of experience resides. Further, while there is a very large literature on predatory pricing( P is less than MC), it is doubtful that this strategy occurs with much frequency.

Thus, in general, economizing is the best strategizing, and duly proportionate attention should be given to where much of the (efficiency) action resides in BOTH our doctoral seminarrs and in our MBA and undergraduate teaching of the subject.
3. Peter Klein | 21 May 2007 at 12:46 pm

The contestable-markets challenge to structure-conduct-performance models of industrial organization may be relevant here as well. I.e., in a zero-transaction-cost world, firms could maintain the trappings of strategizing, without strategizing having any effect as such. Potential competition would be a perfect substitute for actual competition. A firm could have an exclusive contract with a preferred supplier, for example, but if the contract can be voided at will, then the terms of the contract might mimic exactly the terms of an open-market arrangement, simply because any deviation from these benchmark terms would invite entry from another buyer.

It’s also worth emphasizing that Williamson does not say much about the potential heterogeneity among entrepreneurial or managerial teams. Economizing is treated as if it were, in principle, a strategy available to any firm. But perhaps not everyone can “align transactions (which differ in their attributes) with governance structures (which differ in their costs and competencies) in a discriminating (mainly transaction cost economizing) way.”
4. Steve Phelan | 21 May 2007 at 4:37 pm

Nicolai, an interesting observation that the effectiveness of strategizing may rely on the transaction characteristics of the market.

Your example on predatory pricing seems to imply that spot markets may be more amenable to this behavior whereas markets with “sticky prices” or long term contracts may be less affected.

Anecdotally, my experience in the airline industry, where I have witnessed conscious predatory pricing, may be enabled by the airline reservation system which allows very rapid (and visible) price changes and thus the potential for rivals to undercut one another.

Just my $0.02 worth
5. spostrel | 23 May 2007 at 10:08 am

The strongest case for the importance of “strategizing” in the Williamson case can be found in Ghemawat’s Games Businesses Play. It has a bunch of careful case studies worked out quite carefully and rigorously, employing game theoretic reasoning in supple ways to illuminate the outcomes. In many of the cases, Ghemawat sets up explicit “economizing vs. strategizing” tests and makes a decent empirical case that the latter is more important.

I don’t completely buy all of Ghemawat’s analyses, and I lean more toward the “economizing” side (although I think positioning and management choices are more important to profitablility than governance in a Williamsonian sense), but he makes a strong case that commitment games, etc. have a big impact on profit distributions.