Transaction Cost Economics

Transaction Cost Economics

Transaction cost theory of the firm was firstly created by a British economist Ronald Coase in his article “The Nature of the Firm” in 1937 and later on refined by an American economist Oliver Williamson in 1975. Transaction cost theory basically tries to explain why companies exist and why they expand or outsource some activities to the external environment rather than doing them in-house. This theory is closely related to corporate governance and agency theory in that it is based on the principle that when you (principle) get someone (agent) to do something for you, the costs will rise. Both the agency theory and transaction cost theory believes that directors and top managers do not necessarily act on the best interests of their shareholders; rather they act in their own self-interest through various transactions. The only difference is that agency theory sees firm as a nexus of contracts, whereas transaction cost theory focuses on governance structure. So, we can say that transaction cost theory is an alternative variant of the agency theory of governance assumption. It describes governance frameworks in terms of the net effects of transactions that are carried out internally and externally, rather than as contractual relationships outside the firm.

What are transaction costs?

Coase defines transaction cost as the cost of using the price mechanisms. These are the costs that the firms incur while participating in the market carrying out various transactions. In other words, they are the cost that the firm has to bear when providing for some goods or services through the external market rather than having it produced in-house. The transaction costs can be broadly categorized into three types:

1. Search and information costs: Search and information costs are the costs incurred by the firm in searching relevant information regarding the availability of product in the market, the price of alternative products, product specifications and so on. These costs arise out of the lack of knowledge about the product, uncertainty about the actual quality of the goods offered and so on. These costs include travel expense, communication cost, consulting fees etc.

1. Bargaining and decision costs: Bargaining costs are the costs incurred by the firm in bargaining process with other parties involved in a transaction to come to an agreement and finalizing the contract. These costs arise out of the mismatch in objectives and interests of the parties in transaction. These costs include licensing fees, costs incurred in drafting and finalizing the contract etc.

1. Policing and enforcement costs: It is not always the case that the transacting parties fulfill their contract. Policing and enforcement costs are the costs incurred by the firm in making sure that the other party acts as per the contract and taking actions if the parties fail to do so. These costs arise out of uncertainty about the party complying with the specified terms. These costs include auditing fees, product inspection charges, litigation fees etc.

The goal of an organization is to minimize these costs of exchanging resources in the environment and the costs of managing these inside the organization because they are not directly creating the value for the firm. These are rather value sapping factors.  

Variables affecting transaction cost

The types of transaction costs that we have just discussed are affected by various factors. These factors are briefly discussed here under:

1. Bounded rationality: When making a decision, the rationality of decision makers (managers) is limited by the information that they have in hand, their ability to evaluate and process these information and the limited time available to make the decision. This limited capacity to understand the business situation limits the factors that are considered in the decision. So, may a times, they have to rely on past experiences. Relying on past experiences, however, has been found to decrease transaction costs in many cases through the reduced time and information collection costs associated with a transaction.

1. Opportunism: Opportunism is the case when an individual satisfies his/her own interest by providing false or incomplete information with the intention of redirecting profit from the other party. This increases transaction cost through the increased time and effort invested in developing a complete and robust terms in contract or increased supervision and monitoring costs to mitigate the parties from taking opportunistic behaviors. Transaction cost, however, can be reduced if there is a complete sense of trust and confidence in the information provided by the transacting parties.

1. Environmental uncertainty: There is a major impact of uncertainty on transaction costs. Managers are surrounded by a myriad of information the validity of which is uncertain. So, they have to put on huge time and effort in testing the validity of the information and its sources. Uncertainty leads to increased transaction costs as more effort needs to be put on collecting reliable information. Similarly, uncertainty surrounding the behavior of transacting parties increases the monitoring cost of contract implementation.

1. Asset specificity: Asset specificity refers to a specialized investment in physical and other assets that cannot be easily redeployed to alternative use or by alternative users without incurring a certain loss in its value. When a seller invests in specific assets, he/she is exposed to a risk of severe bargaining and contract enforcement problems in that seller might shy away from fulfilling the contract. However, it is highly unlikely because the buyer will have to incur additional costs in searching other suppliers and specifying them what actually is needed. As long as there is no opportunistic behavior among the transacting parties, the transaction cost is generally low.

1. Frequency: The frequency at which you transact with the same party again and again can influence the transaction cost. Frequent transaction done with the same party can reduce transaction cost because of less need for constant negotiations and the standardized processes and contracts. The need to search new information is highly reduced. Also doing frequent transactions can lead to the feeling of loyalty and trust, thereby eliminating the need for constant monitoring and policing.

Application of transaction cost economics: The make or buy decision

In light of all the transaction costs that have been discussed, the firm will always try to undertake the activity that has a minimum transaction cost. Whereas it is clear that transaction costs are potent in external transaction, they are also incurred in internal transactions. So, transaction cost becomes a critical factor in deciding whether to make a product or buy it.