Transaction Cost Economics

A firm is an organisation which sells or produces something or which provides a service you pay for with the aim of making a profit. The existence of firms was a result of three main conditions that allows the shift from markets to firms. These are government actions, introduction of technology, and the large-scale production which had contributed to firm formation. Transaction cost as discussed by economists Ronald Coase and Williamson was used to explain the existence of firms. However, theories as discussed by the afore mentioned professors were not all. Managerial Capitalism introduced by Alfred Chandler and Financialisaton theory introduced by Davis are crucial theories that explain the existence of firms.

Government started the building of firms and such firms were largely the extension of state power. For example, during the mid 16th century, Venice Arsenale started to built ships based on Assembly line. Churches were built through the Jesuits and it resulted in the global spread of religion. In the UK, government established the Hudson Bay Company and the Dutch East India Company. The firms were given exclusive rights by the Government to trade and conduct business. The introduction of steam power, technological innovation in equipment and scale and scope of firm led to increase in output as well. Thus, the focus slowly shifted from the firms to markets.

The transaction cost approach to the theory of firm was created by Coase. Transaction costs relates to information costs, bargaining costs, keeping trade secrets and policy and enforcement cost. Within a firm, transaction costs are much lower as compared to that in the market. Coase’s transaction cost approach explains as to why firms exists, expands, and why firms source out activities in the external environment. Firms could minimise the cost of exchange resources with the environment and at the same time, minimise the bureaucratic costs of exchanging within the firm. As such, Coase focused on the formation of firms because of transaction costs of production and exchange. He mentioned that firms came to exist as an alternative to market price mechanism and thus economy witnessed the supersession of markets to firms.

Entrepreneur internal allocation of production was preferable and this was also the distinguish trait of firms. Entrepreneurs coordinated resources to reduce the marketing costs. Coase believed that entrepreneurs were able to do the same as what market does and even better. For example, government imposes on the market sales tax, rationing and price control. On the other hand, no such external transaction costs exist in firms. Hence firms could cut costs and not only survive in the economy but also expand.

Firms tend to be larger under the following three conditions. First, the lower the cost of organising and slower these costs rise with an increase in the number of transaction organised. Second, the less likely the entrepreneur is to make mistakes and the smaller the increase in mistakes with an increase in the transactions organised. Lastly, the lower the supply price of factors of production. However, transaction would be different in different geographical locations. Also, technology helps to overcome spatial distance as it mitigates the cost of organisation transaction across distance and allow firms to become larger.

While transaction cost theory explains the existence of firms, Coase noted that there is a diminishing return as well. There is a limit to what a firm can do internally as firm saw the decreasing returns to the entrepreneur functions, including increasing overhead costs and increasing propensity for an overwhelmed manager to make mistakes in resource allocations. Such factors became countervailing costs to the use of the firms.

Williamson theory further supported how transaction cost framework explains the existence of firms. Williamson treat transactions as the basic unit of analysis and that minimising transaction cost would drives an organisation structure. The sources of transaction costs include environmental uncertainty, opportunism, risk, bounded rationality and core company assets. As environmental uncertainty becomes higher, the value created by firm is lost. Firm would resort to more linkage mechanism such as strategic alliances and mergers to lower the transaction cost. For example, Singapore Airlines is a part of Star Alliances. Due to the limited ability to process information or bounded rationality, it is tougher to understand the environment around them. Firms limited to constraint conditions faces higher environmental uncertainty and finds it increasingly difficult to manage transaction.

However, such transaction costs make it more advantageous to focus on firms rather than market. Internal organisation can invoke fiat to resolve differences and the sources of transaction costs. Firms are able to have better access to information and there is greater incentives to shift transactions inside the firm when there