Internal compliance reflects the costs of auditing divisions, paying high-productivity workers appropriately, quality assurance, and timeliness of service or component delivery. Enforcement costs are those associated with handling issues such as malingering, low productivity, and mismanagement of divisions, and can range from disciplinary action to firing.40
Compliance costs arise from the combination of bounded rationality and opportunistic behavior. Because coordination, like contracts, may be incomplete and allow for some adaptation that is beneficial to both agents (i.e., managers, employees, divisions), when an agent behaves opportunistically, the firm may have no recourse but to resort to some disciplinary action.41
An employee that has proprietary or protected knowledge may act opportunistically, assuming that the firm or division cannot run without him, especially when that knowledge is specific to the transaction. The resultant information asymmetries may increase enforcement costs, because the firm does not want to deal too harshly with the employee until the knowledge has been transferred.
On the other hand, the employee may comply with the rules, even to his disadvantage, because he hopes to have continued employment that will bring greater benefits than noncompliance does. Should the employee find that the specialized knowledge has been transferred or been used inappropriately, he may use self-protecting measures, thereby creating higher enforcement costs.
How Governance Structure Is Chosen
TCE posits that three basic governance types exist for transacting: market, hierarchy, and hybrid. The choice of governance structure is determined by the costs associated with a specific choice. The choice of governance structure is often referred to as the "make or buy" decision. The main premise of TCE is that of the classic strategy-structure-performance model. Therefore, one should: 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.42
The following model, based on Williamson43 indicates which structure is the most efficient given asset specificity and investment safeguards.
When assets are generic and no investment safeguards are needed, transactions should be made in the free market, where simple contracts or implied contracts exist and disputes are handled by the courts (A0;S0). In the "unrelieved hazard" zone, where assets are generic, but minimal investment safeguard are needed, complex contracts are the norm (A0;S1). Hybrid forms of governance (e.g., alliances, joint ventures, and long-term contracts) become needed as assets become more specific and more safeguards are needed (A1;S1). At some point along the continuum, assets become so specific and the need for investment protection becomes so strong, that the firm is compelled to bring the transaction in-house (An; Sn). To recap, when investments in specific assets and the need for safeguards increases, the more important it is that the firm consider bringing the transaction in-house rather than use market governance.
A market-governance structure simply means that one firm will purchase the needed goods or service from another firm. This transaction may be as simple as purchasing a toothbrush from the grocery store or as complex as having customized components built for an aircraft. A market transaction is the "buy" choice and is associated with generating market costs. Firms choose to transact in the market when market costs are lower than bureaucracy costs.
The more generic the product or service the firm needs, the lower the costs of transacting in the market are, and the higher the associated bureaucracy costs. Generally, the less specialized the assets needed to complete the transaction, the more likely it is that the firm will choose a market-governance structure. However, asset specificity, as discussed earlier, is not the sole determinant of governance choice. Ultimately, however, when market costs are lower than bureaucracy costs, the transaction should take place in the market to obtain the most efficient strategic fit.44
Hierarchical governance structures are those in which the production or services are provided from within the organization. Hierarchy is the "make" choice and is associated with created bureaucracy costs.
These transactions are generally complex in nation, and may require that the firm develop new skills and other specialized assets. Although the bureaucracy costs of the transaction will increase, the market costs become nonexistent. Four major issues should be considered before choosing hierarchical governance: (1) asset specificity (the more specialized the asset, the higher the need for in-house production); (2) contract complexity (the more complex the contract needs to be, the higher the need for in-house production); (3) uncertainty of any kind, be it volume, supplier, customer, or technology (the more uncertain the situation surrounding the transaction, the higher the need for a hierarchical structure); and (4) exchange frequency (the more often an exchange is made, the more likely it will be less costly to perform within the firm). Asset specificity and contract complexity are the more important areas of concern. Generally, however, when overall bureaucracy costs become lower than the costs of transacting in the market, the transaction should take place in a hierarchy in order to capitalize on the strategic fit.45
In situations where a hierarchical governance structure is needed, but the firm does not have the ability to bring the transaction in-house for lack of some resource (e.g., knowledge, plant, equipment, patent), the firm may choose to vertically integrate (either backward or forward) in order to obtain those resources.
Hierarchy should always be the last choice of the firm because markets inherently have more incentives to perform at peak efficiency, whereas hierarchies have fewer incentives.
Hybrid forms of government are those that are neither pure market nor pure hierarchy, such as joint ventures, partnerships, and alliances. Hybrid governance structures fall between the two dichotomies of the "make or buy" choice and are associated with producing both market and bureaucracy costs.
A hybrid governance structure enjoys the benefits of lower costs than it would if it contracted either in-house or in the market only. Pure market transactions may be subject to small numbers exchange or bilateral dependency, making a hybrid form more efficient. Market costs of monitoring and enforcing in-house transaction may become too high, also making a hybrid form more efficient.