Performance Implications of Transaction Cost Economics

Transaction Cost Economics (TCE) posits that the efficiency of organizational performance depends on the alignment between transaction characteristics and governance structures. Transactions involving high asset specificity—where investments are tailored to a particular relationship—are more vulnerable to opportunism and contractual hazards, thus better managed through hierarchical governance (i.e., within firms), especially under uncertainty. In contrast, transactions with low specificity or high appropriability tend to be efficiently governed through market mechanisms. While this theoretical logic is widely accepted, the empirical question remains: does aligning governance with transaction characteristics improve firm performance?

Evidence shows that misaligned governance structures impose substantial performance penalties. Misalignment can increase governance costs by 70–200% and reduce firm profitability or satisfaction. Several empirical strategies demonstrate this effect: structural models isolate the causal impact of governance after controlling for firms’ endogenous choices; natural experiments like deregulation reveal how sudden environmental changes expose the cost of misfit; and time-dynamic studies highlight the evolving advantages of hierarchy versus market over a product’s lifecycle. For instance, outsourced components in car manufacturing show early quality advantages, but in-house governance enables better long-term improvement.

Importantly, while firms often adjust their governance structures to regain alignment, such adaptation is constrained. The same asset specificity that creates governance challenges also makes realignment costly due to sunk investments and contractual rigidity. Thus, performance consequences of misalignment are real, but correcting them is not immediate. Overall, TCE offers a compelling explanation of why efficient governance matters, how misalignment undermines performance, and why firms cannot always instantly reorganize in response.

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