MEMORANDUM
To:Rajiv Krishnan Kozhikode
Business Organizational Theory Instructor
From:Lily Cheng, Jing Hu, Shirley Kim, Jiyeon Yoo, Mingyu Zhang
Team 13
Date:May 11, 2013
Subject:Analysis and Application of Concepts from “What is a Firm” by Alfred D.
Chandler Jr.
This memo presents details regarding theories that are discussed in “What is a firm? by Alfred D. Chandler. The memo will begin by critically evaluating neoclassical, principal-agent, transaction cost and evolutionary theories followed by the discussion of the transaction cost theory with an example. Finally, the effectiveness of theory will be examined with a real life example.
Theories presented in the article, “What is a firm?”, were developed in the 1990s, so it may not be applicable to today’s firms. In addition, Chandler’s views do not align with some of the theories discussed.
According to the article, “What is a firm?” (1992), a firm changes its focus from being labour-intensive to capital-intensive, it invests in three organizational capabilities: manufacturing, marketing and management. These three components build the basis for neoclassical, principal-agent, transaction cost and evolutionary theories of which a firm chooses to operate under (Chandler, 1992).
The neoclassical theory states that a firm utilizes employees’ ability to adopt a production plan that maximizes profits (Chandler, 1992). The principal-agent theory identifies the same concept with an additional component of functioning under a managerial hierarchy in which an agent will adopt a plan that will maximize their own benefits but may not of the principal’s (Chandler, 1992). For the most part, both theories are similar in which they focus on the investing in the management area within the firm.
While both the neoclassical and principal-agent theory view the firm as an entity developed to fulfill contracts with external parties, Chandler believes that when evaluating the concept of a firm, the firm is to be viewed as a unit (Chandler, 1992). Thus, there are transaction cost and evolutionary theory.
Transaction cost theory focuses on a firm’s transaction costs incurred in the production process and compares whether costs are lower in the market or in the firm (Chandler, 1992). However, Chandler (1992) states that his views differ from Williamson because Williamson does not place emphasis on the assets of the firm, rather than the transactions the firm is involved in.
Overall, the three theories discussed above differ from Chandler’s view. Chandler believes that the three theories are parts of the component of the evolutionary theory (Chandler, 1992). The evolutionary theory states that a firm’s strategy, structure and core capabilities must be known in order properly identify the firm to another (Chandler, 1992). Strategy is the objectives of the firm and the path the company will take to satisfy the objective (Chandler, 1992). Structure is both the hierarchy of the firm and the procedures in decision making (Chandler, 1992).
From the Apple iPhone to dollar store toothpicks, the words “Made in China” are found everywhere that consumers are insensitive to a product’s place of origin. Corporations of all sizes have outsourced production lines to manufacturers in China. We would like to define this recent organization phenomenon as the “Made in China” phenomenon. Over the last two decades, manufacturing industries in China were rapidly developed due to a comparatively lower labour cost. Based on the historical data obtained from Trading Economics (Trading Economics, 2012), exports in China increased from $33.58 hundred million USD in January 1993 to $1870.61 hundred million USD in May 2013.
As Chandler mentioned in the article, transaction cost theory advocates organizations, therefore, organizations are worried about the methods to reduce transaction costs. Such costs can be reduced by executing transactions within the organization.However, internalizing transactions for specialized assets, such as facilities and human skills, can only be used for the specific products or services, and will eventually lose value when products are no longer produced.
Alternatively, the transaction costs can be reduced by contractual agreements if costs are lower in the market than in the firm.This explains why the recent real world organizations minimize the transaction costs under a contractual arrangement in the market. This “Made in China” phenomenon illustrates how companies minimize transaction costs by signing contractual agreements. Many U.S. corporations, for example, have most of its products made under contract by manufacturers in China. According to the US-China Business Council (2013), United States is China’s top trade partner with the volume of 385.3 billion in 2010. This is because many recent organizations believe that the specific nature of the facilities and skills for one specialized asset, which often gives the firm a competitive advantage in a related product market, are more significant than bounded rationality. This respects Chandler’s view of the importance of physical and human assets of a firm, instead of the transaction.
Based on the transaction cost theory, capital-intensive industries should internalize their source of supplies, nature of technology of production, and the size and requirements of market (Chandler, 1992). Many foreign companies are not willing to expand their production lines beyond geographic boundaries because intellectual properties issues. Also, capital-intensive industries require high level of supervising during the production process that hinders these firms to outsourcing. Industries, such as food and machinery, that contract with Chinese producers are labour-intensive and it is profitable to outsource to manufactures, which is why the “Made in China” phenomenon exists (Chandler, 1992). These labour-intensive industries take advantage of lower labour costs in China in order to minimize their transaction costs. Based on the transaction theory, labour-intensive industries rely on independent distributors; therefore, many foreign companies sign contracts with companies in China to reduce costs (Chandler, 1992).
Numerous industries with low minimum efficient scale have outsourced activities to Chinese producers in order to minimize transaction costs; however, a number of labour-intensive companies have announced to move a proportion of their manufacturing back to headquarters. The increase of labour cost, intellectual property risk, and political risk are main reasons for them to withdraw their contracts with Chinese manufactures (Chang, 2012). Chandler claims that labour-intensive industries should count on independent producer for diminishing the transaction cost (Chandler, 1992). Nevertheless, the “Made in China” example indicates that some labour-intensive firms switch from reducing transaction cost to internalization when some external factors happened rather than outsourcing. Factors such as political issue and the fluctuation of labour cost may influence the feasibility of contractual agreement to minimize transaction cost.
Works Cited
Chandler, A. D. (1992). What is a firm?.European Economic Review, 36(2/3), 483-492.
Chang, G.G. (2012). Move over, Michigan, China is the world’s
next rust belt. Forbes. Retrieved from
China Exports (2013). Trading Economics. Retrieved from
US-China Trade Statistics and China’s World Trade Statistics (2013). The US-China Business
Council. Retrieved from
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