PSY 6300 Module 3 Transaction Costs and Organizational Design Paper: Coase, Williamson and Agency Costs in a Make-or-Buy Decision Example

Own the Trucks or Hire Them? Transaction Costs and the Boundaries of a Food Bank

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Graduate Studies, Thomas Edison State University

PSY-6300: Organizational Theory

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Own the Trucks or Hire Them? Transaction Costs and the Boundaries of a Food Bank

Introduction

Our food bank owns six refrigerated trucks, three of which are near the end of their lives. Replacing them would cost several hundred thousand dollars. A regional logistics company has offered to handle all deliveries under contract. The board asked me to recommend which path to take. This classic make-or-buy decision raises a deeper question in organizational theory: why do organizations do some things themselves and buy others from the market?

Why Do Firms Exist?

Coase (1937) asked why, if markets coordinate economic activity efficiently through prices, so much activity takes place inside firms, where managers direct work instead. His answer was that using the market has costs: finding out what prices are, negotiating and concluding separate contracts for each transaction and dealing with uncertainty over time. Organizing activities inside a firm saves some of these costs by replacing many contracts with a single employment relationship. A firm grows until the cost of organizing one more transaction internally equals the cost of carrying it out through the market.

The Transaction Cost Approach

Williamson (1981) developed Coase's idea into a general approach to organization. He argued that transactions differ in ways that determine the best way to govern them. Asset specificity, investments that are valuable only in a particular relationship, makes parties vulnerable to each other. Uncertainty makes it difficult to write complete contracts. Frequency affects whether specialized governance is worth its cost. Combined with two behavioral assumptions, bounded rationality, the limits on people's ability to foresee everything, and opportunism, the possibility that some parties will pursue self-interest with guile, these features explain why some transactions are best handled by markets, others by long-term contracts and others within hierarchies.

Agency Costs

Jensen and Meckling (1976) studied what happens when an owner or other principal delegates decisions to an agent who carries out work in the principal's name. Because agents' interests differ from principals', agency costs arise: what the principal spends watching the agent, what the agent spends to assure the principal of good conduct, known as bonding, and the residual loss when the agent's decisions still diverge from what the principal would want. Although they focused on owners and managers, the logic applies to any delegation, including contracts with outside providers.

Analyzing the Decision

Applying Williamson's framework, our deliveries are frequent, daily and time-sensitive, especially for fresh produce that spoils quickly. They involve some asset specificity: our drivers know partner pantries' schedules and staff, and our routes are tailored to sites in small churches and community centers that a commercial carrier might not prioritize. Uncertainty is high, because donations arrive unpredictably and must be redistributed quickly. These features favor keeping delivery inside the organization or, at least, using a long-term contract with close coordination.

Agency Concerns

Agency theory highlights what could go wrong with a contractor. The logistics company profits by maximizing efficient routes, which may favor large, easy-to-reach pantries over small rural ones. Monitoring delivery times and food temperatures would add costs, and some divergence, such as late deliveries to the hardest sites, might remain.

The Case for Contracting

Contracting has advantages too. The logistics company has economies of scale, professional maintenance and the ability to add trucks during holiday surges. Our capital could go to programs rather than vehicles.

Recommendation

I recommended a hybrid: keep and replace three trucks for fresh produce and rural partners, where specificity and time sensitivity are greatest, and contract with the logistics firm for bulk shelf-stable deliveries to large sites, under a contract with clear performance standards and temperature monitoring. This matches governance to the features of each type of transaction, as Williamson's approach suggests.

Design Challenges Beyond Trucks

The same logic applies to other decisions, such as whether to run our own volunteer recruitment or partner with a volunteer agency, and illustrates a broader challenge of organizational design: deciding where the organization's boundaries should fall.

Bounded Rationality in Practice

Williamson's assumption of bounded rationality fits our situation well. No contract could list every circumstance a delivery service might face: a snowstorm that closes rural roads, a sudden donation of ten thousand pounds of yogurt with a short shelf life or a church pantry whose volunteer coordinator changes and forgets the delivery window. When contracts cannot cover everything, someone must decide what to do when the unexpected happens. Inside our organization, the operations manager can redirect a truck in minutes. Under a contract, the same change might require negotiation or extra fees.

Writing the Contract

If we contract part of our delivery, the contract itself becomes a tool for reducing agency costs. I proposed on-time delivery targets for each site category, continuous temperature logs shared with us daily, a monthly review meeting, penalties for repeated late or warm deliveries and a clause allowing either side to exit after ninety days' notice. Requiring the contractor to share data is a form of bonding, while our review of it is monitoring. Neither removes divergence entirely, but together they make it visible.

Costs Over Time

Buying trucks is a large capital cost spread over many years, while a contract is an operating cost paid every month. Board members tend to compare the purchase price with one year of contract fees, which makes contracting look cheaper. A fair comparison counts fuel, insurance, maintenance and drivers' wages over the life of the trucks against the full contract cost over the same period.

Limits

Transaction cost theory was developed for firms, and nonprofits have missions that go beyond cost. Its assumption of opportunism may understate trust in community partnerships. The food bank's figures are invented.

Conclusion

Coase explained that organizations exist because markets have costs, Williamson showed how asset specificity, uncertainty and frequency determine whether activities belong inside or outside an organization and Jensen and Meckling showed the costs of delegating work to others. A hybrid plan, keeping specific, time-sensitive delivery in-house and contracting routine bulk delivery, applies these ideas to the food bank's boundaries.

References

Coase, R. H. (1937). The nature of the firm. Economica, 4(16), 386-405. https://doi.org/10.1111/j.1468-0335.1937.tb00002.x

Jensen, M. C., & Meckling, W. H. (1976). Theory of the firm: Managerial behavior, agency costs and ownership structure. Journal of Financial Economics, 3(4), 305-360. https://doi.org/10.1016/0304-405X(76)90026-X

Williamson, O. E. (1981). The economics of organization: The transaction cost approach. American Journal of Sociology, 87(3), 548-577. https://doi.org/10.1086/227496