The New Institutional Economics (NIE) provides scholars with a useful framework with which to perform comparative institutional analyses. The notion of transaction costs is particularly valuable when comparing different institutional arrangements, such as vertically integrated and hybrid organisational structures, as it accounts for the inefficiency of boundedly rational decision-makers and other market frictions. This essay investigates the formation, costs and benefits of alliances through the lens of Transaction Cost Economics (TCE). A brief overview of TCE is provided, which is followed by a theoretical discussion of alliances. This perspective is contextualised with the aid of a transaction cost analysis of airline alliances. The findings indicate that there may be many perceived benefits to the formation of alliances in the airline industry. However, several unintended transaction costs increases may moderate these benefits.
Figure 1: Ronald H. Coase (1910-2013)
The Theory of Transaction Cost Economics
The insistence on the conception that transaction costs are nonzero, is a distinctive characteristic of the NIE. The notion is derived from the micro-founded assumptions of the bounded rationality and limited resources of error-prone decision-makers (Furubotn and Richter, 2005). Coase’s (1937) “transaction costs” constituted a major departure from the neoclassical assumptions of frictionless markets, rational actors and complete information. It is held that the relative inefficiency of real-world decision-makers as well as the concomitant market frictions, such as the costs of using the price mechanism, give rise to transaction costs (Madhok, 2002). Arrow (1969) simply defines these transaction costs as “the costs of running the economic system.”
Williamson, a pioneer in TCE, developed a more predictive and comparative theory by treating the firm as a governance structure and by offering a framework according to which transactions can be characterised (Williamson, 1975, 1985). His works have expanded on the tradition of comparative institutional analysis which was popularised in Coase’s The Problem of Social Cost (1960). For instance, Williamson’s use of “asset specificity” has enabled the comparison of transactions and its associated costs in alternative institutional settings (1979).
A transaction occurs “when a good or service is transferred across a technologically separable interface. One stage of activity terminates and another begins” (Williamson, 1985). Naturally, this interpretation is closely related to the physical and legal concept of delivery (Commons, 1934). Using this definition, a transaction can clearly take place within a firm and across markets. To a large extent, intrafirm- and market transactions are a consequence of specialisation and the division of labour (Furubotn and Richter, 2005).
An alternative definition extends the scope of a transaction to include the “alienation and acquisition” of property- and contract rights (Commons, 1934). Hence, a transaction is not limited to the exchange of physical goods, but also encompasses the transfer of the incorporeal, such as knowledge and information. Transactions are, therefore, necessary to establish, maintain and alter all social- or political relationships (Granovetter, 1985). These transactions can be characterised according to their frequency, uncertainty and the degree to which transaction-specific investments have been incurred (Williamson, 1979).
Consequently, transaction costs are not only the “the costs of running the economic system,” but are also the considered as the “the basic determinants of institutions” and thereby providing an analytical framework according to which economic activity could be investigated (Arrow, 1969). In other words, transaction costs are the costs of the establishment, maintenance and change of a system’s formal and informal institutional framework, in addition to the “frictions” that arise during market transactions (Furubotn and Richter, 2005; Williamson, 1985). Furthermore, transaction costs are the costs of specifying and enforcing the property- and contract rights and include those costs involved in capturing the gains from exchange (North, 1984).
A theoretical perspective on alliances
Williamson argues that when contracts are incomplete and switching costs are high in market economies, vertical integration may be a more efficient way of organizing production and distribution (Williamson, 1975, 1985). However, “hybrid forms” of organisation offer an alternative (Williamson, 1985; 1991). Alliances are an example of these non-standard organisational setups or hybrids.
Alliances are often the preferred mode of organisation, especially in cases where integration may cause inflexibility, irreversibility and weak incentives (Douma et al., 2000). In addition, the formation of hybrids usually takes place within a competitive environment and its specific type is determined along the lines of the nature of its transactions, market uncertainty and asset-specificity (Williamson, 1979). In addition, the type of the predominant intellectual property regime and other national institutional features may also dictate the characteristics of the alliance structure (Oxley, 1999).
The pooling of resources is a common feature of hybrids. Through allied-member coordination, joint activities are organised and resources are shared where markets have not adequately allocated the relevant resources and capabilities (Teece and Pisano, 1994). However, the sharing of resources may also be a source of conflict. The distribution of rents in such an arrangement would entail discretionary decision-making and could lead to higher costs of bargaining (Menard, 2006). In addition, firms may lose some of the advantages of autonomous decision-making with regards to their shared resources, thereby increasing decision-making and negotiation costs (Furubotn and Richter, 2005).
Relational contracting is another distinctive feature of hybrids (Menard, 2006). For hybrids, contracts create a framework which promotes “transactional reciprocity” and secures relationships by linking the coordinated activities and resources of partners, while firms are also independently performing other transactions (Park, 1996). Relational contracting entail advantages such as increased market shares, access to scarce resources and the transfer of competencies (Baker et al., 2002). However, this type of contracting may also increase transaction costs due to incomplete contracts, repeated negotiations and the risks associated with uncoordinated activities (Menard, 2006). The lack of appropriate governance structures, good relationships and trust dynamics between contracting parties in fact tend to drive up transaction costs (Riordan and Williamson, 1985).
Hybrid organisational systems, such as alliances, are also subject to complex competitive dynamics (Menard, 2006). This is partly due to the simultaneous interdependence and autonomy of partners within an alliance. Competitive pressures arise on two fronts, namely intra- and inter-alliance competition (Zhang and Czerny, 2012). Despite cooperating on some activities, internal competition remains inevitable given partners’ distinct and self-interested strategies, recurrent competition through subcontracting and concurrent competition for the same subset of customers (Dyer, 1997; Baker et al., 2002). Furthermore, hybrids also compete with other hybrid arrangements. That is, alliances are competing against other self-interested alliances that are pooling equivalent resources and undertaking relational contracting to entrench positive mutual dependence and overcome market uncertainty. Therefore, alliances may become unstable where switching costs for partners are low and investment is moderately specific (Menard, 2006).
Airline alliances
Benefits
Membership to airline alliance groups is widely accepted to be a necessary condition for the long-run sustainability of airlines with global objectives (Agusdinata and Klein, 2002). The globalisation and economic integration of all industries have made access to foreign markets increasingly possible, thereby increasing demand and global competition in the airline industry (Bryan and Fraser, 1999). Alliance formation increased in an effort to reap the gains from new opportunities, such as the surge in demand for seamless travel across the world and access to foreign regional networks, and to mitigate the effects of increased uncertainty and competition in the market (Agusdinata and Klein, 2002; Bilotkach and H"uschelrath, 2013). This necessitated collaboration with global partners in order to diversify the dependence on a particular region, resource or asset (Ernst and Halevy, 2000).
The institutional environment surrounding the global airline industry is wrought with protectionist national regulations. Despite globalisation becoming commonplace in the airline industry, it is still subject to strict prohibitions on foreign ownership or control of domestic and national airlines (Zhang and Czerny, 2012). Therefore, it was necessary for governments to establish bilateral agreements with other countries in order to designate the use of their airports and territories to approved airlines. This has led to a global web of separate bilateral agreements with different pairs of countries (Agusdinata and Klein, 2002). Consequently, global airline alliances became the preferred organisational form given its flexibility, growth potential and ability to provide a seamless global service by circumventing the restrictions on foreign ownership and control. This is evidenced inter alia by the very few cases of mergers that have originated out of existing alliances (Douma et al., 2000).
The trust and mutual-forbearance between partners of airline alliances shape the stability of an alliance and aid the reduction of transaction costs (Gomes-Cassares, 1996). These attitudes are necessary conditions for a reinforcing cycle that promotes mutual understanding and cooperation, which in turn lowers the cost of information transfer and intra-alliance competition. For instance, if partners can trust one another not to take unilateral action to the detriment of other partners, internal competition may lead to increased innovation and stability that instigates the aforementioned cycle. It has indeed been shown that trust between alliance members can alleviate contracting costs and improve contract design (Faems et al., 2008). Furthermore, such an environment is suitable for collaborative learning that promotes mutual dependence and provides members with a competitive advantage (Faulkner, 1995; Barringer and Harrison, 2000; Inkpen, 2000).
Costs
When controlling for asset specificity, increases in transaction complexity may lead to increases in transaction costs (Tadelis, 2002). Contract incompleteness and its associated costs of renegotiation and adaptation are also closely linked with transaction complexity (Forbes and Lederman, 2009). Airline operations are particularly complex given its exposure to variable weather conditions, regular mechanical issues and air traffic control irregularities. This precludes the conclusion of fully specified contracts between carriers and can lead to frequent and costly ex post renegotiations and adaptations. Therefore, airline alliances are forced to deal with incomplete contracts on a regular basis (Gomes-Cassares, 1996). Regional airlines are vulnerable to weak contracts which can lead to uncertainty, higher transaction costs and poor performance (Merkert and Hensher, 2013), particularly during times of government austerity or cyclical economic downturns when clients in the airline industry are more price sensitive (Gialloreto, 1988).
Airline alliances are formed along the lines “hub-and-spoke” global networks of partnerships and their associated capital and infrastructure (Agusdinata and Klein, 2002; Bilotkach and H"uschelrath, 2013; Zhang and Czerny, 2012). This has led to a reduction in the duplication of capital investment, particularly the fixed costs associated with establishing a new station (Zhang and Czerny, 2012). The combination of multiple hub-and-spoke networks can ensure higher traffic density and, therefore, higher load factors in these different networks (Nero, 1999). However, the increased dependence on hub-and-spoke strategies will increase the toll on and costs of infrastructure, personnel and scheduling to meet the heightened peak requirements which results from artificially concentrated activity at certain stations (Dennis, 2000).
Consequently, airports become more congested (Agusdinata and Klein, 2002). Rigorous competition for available slots at airports are partly due to shortages as a result of inter-alliance competition for slots and other factors such as the restrictions imposed by environmental regulations (Ashley et al., 1995). In turn, limited airport facilities can also lead to heightened intra-alliance competition, which is discussed below. Furthermore, the lack of available slots to non-allied members limits the growth potential of an airport, which in turn diminishes the capacity of said airport to be a functioning and competitive hub for the alliance (Button et al., 1998).
The membership of new partners during the initial phases of an alliance gives rise to benefits such as larger network coverage, the provision of a global seamless service and the economies of scope, scale and learning (Agusdinata and Klein, 2002; Barringer and Harrison, 2000). Yet, these marginal benefits diminish as the alliance increases in size. When the addition of new partners leads to an increase in the overlap in members’ network and city duplication, it may result in the intensification of intra-alliance competition or in unwanted intervention from competition authorities if partners decide to cooperate on duplicated routes (Faulkner, 1995; Zhang and Czerny, 2012). Furthermore, the saturation of the alliance increases the risk of internal conflict and necessitates further centralisation of managerial control (Gomes-Cassares, 1996). Undoubtedly, the increased strain on central management and concomitant relinquishing of individual autonomy increases managerial-, bargaining- and agency costs (Baker et al., 2002).
Conclusion
The findings from the transaction cost analysis of alliances suggest that there are many benefits to be had through the formation of hybrid organisational forms. Hybrids, such as alliances, are a product of their environment. The pooling of resources, relational contracting and complex competitive structures are required to survive in highly competitive and resource-scarce markets. TCE predicts most of the reasons for- and benefits of alliance formation in the airline industry. However, an industry that is characterised by complex transactions, intricate competitive partnerships and intensive demands on infrastructure leads to many unintended costs during alliance formation. This research suggests that firms perform a rigorous cost- and benefit analysis before pursuing alliance formation.