Uncertainty, Flexibility, and Economic Organization: Foundations for an Options Theory of the Firm

This paper combines transactions costs theory and options theory to propose a more complete model of the problem of economic organizing. The combined transactions costs and options model provides a means to recognize and evaluate the opportunity costs associated with internalization of specific use assets (rather than using flexible production assets) under conditions of significant market demand uncertainty. In transactions costs analysis, decisions about economic organizing are often characterized as seeking to minimize the sum of production costs and transactions costs, or to maximize the value of each product design, production technology, and governance mode possibility. In the combined transactions costs and options theoretic model, decisions about economic organizing are characterized as seeking to optimize the value of a firm’s set of product options, each of which may be produced on production assets with varying times to market, varying flexibilities to be switched to production of other products, and varying sunk costs, all subject to varying costs of governance. This expanded model of economic organizing leads to predictions of three optimal forms of economic organization under varying conditions of contracting (supply-side) and market (demand-side) uncertainty: internalization of specific-use assets, internalization of flexible-use assets, and marketing sourcing of the services of flexible-use assets.