Use of Hierarchy to mitigate-possible abuse of transaction specific investment

In the last blog we looked at how bounded rationality is addressed in the 2 governance mechanism and what are the problems associated there in. In today's blog we look at how transaction specific investment influences the 2 governance mechanisms.

In many transactions, it could be realized that one of the parties involved in the transaction would have to make an investments in the specific transaction to facilitate its completion. This investment could in a physical modification of the technology or, modification in policies, or learning a new thing. While some of these have value only in the specific transaction, for some others it could be transferred to some other party transaction too. Transaction specific investments in general are much more valuable in the first scenario than any other use.

The existence of transaction specific investment raises the threat of opportunism. In fact, greater the transaction specific investment - greater the threat of opportunism. In such a scenario, the market governance mechanism would find itself short of satisfaction, despite the additional cost hierarchical form of governance would be chosen. The two activities done by the parties would be brought in together under a "manager" who mediates the relationship between the parties. Thus the issue of opportunism when a transactions specific investment is made would be mitigated.

Thus – hierarchy arises to resolve the problems in market governance when transaction specific investments are made and under conditions of uncertainty