Dr.

Paul Essey

Student number : 76560699

Assessment Reference ME/Jan10/1

Introduction to Transaction Cost Economics

It has been over six decades since Ronald Coase wrote his now famous article “The

nature of the firm” (1937), in which he grappled with the nature of the firm within the

context of the institutional structure of production. Coase questioned the notion of

frictionless markets and argued that there was a cost of using the price mechanism.

The most obvious cost of organizing production through the market mechanism is that

of discovering what the relevant prices are. These transaction costs make it more

efficient to organize an activity within the institution of the firm. Coase’s main purpose

was to explain why economic activity was organized within the firm.

Transaction Cost theory did not develop further until Williamson developed the theory

of Transaction Cost Economics ( TCE ) in the 1970s and 1980s. Williamson made the

theory more predictive by approaching the firm as a governance structure more micro

analytically , and by identifying the particular transaction characteristics. Since

Williamson, the theory has shifted away from Coase’s initial and more general

treatment to a concern of issues of appropriation, ownership, alignment of incentives

and self-interest. Both Coase and Williamson saw firms and markets as alternate

means of coordination, the firm being characterized by coordination through authority

relations and the market being characterized by coordination through the price

mechanism.

Key characteristics of Transaction Cost Economics

TCE at its core focuses on transactions and the costs that attend completing

transactions by one institutional mode rather than another. The transaction, a transfer

of a good or service, is the unit of analysis in TCE, and the means of effecting the

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transaction is the principal outcome of interest. The central idea of TCE is that

transactions will be handled in such a way as to minimize the costs involved in carrying

them out. The emphasis here is on the costs of using the market versus the costs of

performing an activity “in- house” leading to the so called make or buy decision or a

firms decision to perform an activity itself or to purchase it from an independent firm,

this includes the total cost and will encompass the processing and handling of a good

or product as well as the support services involved in getting the good or product or

service to market such as accounting, legal, marketing and associated administrative

costs.

Transaction Cost Economics assumes that individual economic agents are bounded

rational as well as potentially opportunistic. This leads to the conclusion that to design

the terms of a contract in such a way that all possible contingencies are covered is very

difficult.

There is also an asymmetry of information between contracting parties that can lead to

potential opportunism, people cannot be blamed for pursuing their self interest and all

information including that obtained from the contracting party can lead to distortion of

the truth and withholding of facts that makes designing counter measures difficult and

costly. This can lead to hold up problems and incomplete contracts.

Asset specificity refers to the extent to which a resource is specific to its current use.

Assets that are highly specific are likely to have almost zero other usage. Specialized

assets allow products to be differentiated and margins to be increased. To the extent

that assets are specific to a transaction, the firm will need to sustain the transaction

during the period in which returns on the investments are generated, for example the

construction of an iron ore smelter near a steel production plant will lead to substantial

savings but the value of the smelter is much lower for other transactions eg.

Transactions between the smelter and a steel mill located farther away. To generate a

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return on the investment in the smelter the transaction with that particular steel mill will

have to continue for a particular period of time to generate sufficient returns on the

investment.

The higher the transaction costs involved in coming to a make or buy decision will

ultimately lead to market failure and increasing vertical integration within the firm. The

lower the transaction costs in coming to a make or buy decision will lead to more

effective use of the market (outsourcing of a particular economic activity).

Externality exists in transaction cost economics, meaning that a particular situation

may arise in which the market cannot or fails to recognize all of the economic costs or

benefits that arise from a particular transaction. A good example is a pollution tax,

which will lead to higher transaction costs.

Another important dimension of transactions is uncertainty, as uncertainty increases so

does the transaction cost of governance. Frequency of transactions is another

important element of TCE, one off transactions do not require a high level of

transaction costs, however, very frequent market place transactions increase the

monitoring and bureaucracy associated with them.

Vertical chain and coordination

The vertical chain includes activities directly associated with the processing and

handling of materials from raw inputs to the finished product. This includes acquisition

of raw materials, manufacturing, distribution and sale of finished goods and services.

The vertical chain also involves many specialized support activities, such as

accounting, finance, human resources management, and strategic planning. For

example, in general, the production-marketing chain consists of producers, assemblers

or intermediaries, processors, wholesalers, retailers and consumers. It varies with the

type of product and various other factors. For instance farmers selling vegetables at a

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farmers market would be an example of a simple single stage market structure.

Processed beef however, has to go through several stages such as producers,

slaughterhouse, processors, manufacturers, wholesalers/retailers and finally

consumers. Some firms cover just a small part of the chain eg. Nike, Reebok and can

be referred to as being vertically disintegrated. Others span several links and are

vertically integrated eg. construction companies and wood pulp producers.

Vertical coordination refers to all possible economic arrangements involved in

transferring resources between economic stages. A firm’s decision to vertically

coordinate is based on a number of factors eg. Profit incentives, cost reduction and

control incentives. Some firms prefer to merge with an upstream firm (backward

integration) or a downstream firm (forward integration). The decisions made by firms at

any level concerning supply and demand depends on the extent to which a firm has

control over the supply and demand factors. Sometimes firms in subsequent stages

may enter into an agreement regarding the production, supply and/or distribution of the

product. Transaction costs may be avoided if economic coordination takes place within

the firm. Thus the importance of transaction cost analysis is that it can explain why the

firm/organization itself comes into existence.

Management’s role is to find out as much information as possible to consider ways in

which costs of production can be reduced. When management is incapable of doing so

coordination becomes expensive. Thus there is a need for both organizations and the

market to coordinate economic activities. Whether the organization does all the

arrangements itself or uses the market depends on comparing the transactions costs of

the market with the management costs of the organization. Firms often rely on

contracts to ensure coordination. Effectively drafted contracts will reduce transaction

costs because “complete” contracts eliminate opportunistic behaviour and litigation is

costly. Because contracts require production coordination, good coordination between

independent firms is essential for assuring the coordination of production, this in turn

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will lead to reduced time and prevent bottlenecks from forming. Furthermore, with good

coordination stock levels can be kept to a minimum. Penalty clauses and bonus

incentives may be built into contracts to ensure coordination for example a lot of

building contractors have penalty clauses for late completion of projects. Standardized

products are easy to co-ordinate. Tailor made goods with high specifications and

critical activities are more difficult to coordinate and the firm may choose to keep these

in house. Coordination may also take the form of merchant coordinators that are

specialized firms that can link suppliers, manufacturers and retailers. Organizations

may prefer not to coordinate if a firm risks losing private information, which is essential

to the firm.

Vertical boundaries of a firm

The vertical boundaries of a firm define the activities that the firm itself performs as

opposed to purchases from independent firms in the market, the “ make or buy “

decision. There are costs and benefits associated with both making and buying which

the firm needs to balance. Key issues in determining how much to vertically integrate

are to make use of the least cost production process (technical efficiency) and the

degree of exchange of goods and services in the value chain to minimize coordination,

agency and transaction costs (agency efficiency). Intermediate solutions such as

strategic alliances and joint ventures may also be feasible the market is superior for

minimizing production costs and vertical integration is superior for minimizing

transaction costs. Optimal vertical integration minimizes the sum of technical and

agency efficiencies. The case for buy is to exploit scale and learning economies

because market firms can often perform more efficiently and may have deep

technical/managerial expertise or proprietary methodologies, they may be able to

aggregate the needs of many firms and leverage their experience in doing the same

activity for many firms, agency and influence costs may be minimized (the so called

bureaucracy effect).

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A decision to make may be made because of the costs imposed by poor coordination,

the reluctance of partners to develop and share valuable private information, and the

transaction cost that can be avoided by performing the task in house. Each of these

problems can be traced to difficulties in contracting because of bounded rationality,

difficulties in specifying or measuring performance, asymmetric information, the

adverse consequences of opportunistic behavior and the reluctance to pursue litigation

in view of the costs involved.

When a transaction involves relationship specific assets switching trading partners is

not easy and gives rise to quasi rents and hold up. The potential for hold up raises the

cost of market transactions by making contract negotiations more contentious, inducing

parties to invest in safeguards to improve post contractual bargaining positions, and, by

engendering distrust.

Use of the issue tree in make or buy decisions and examples

Make or buy decisions involve estimating the costs and benefits of integration. The

manager must assess if the market provides any alternative to vertical integration. If

the answer is no the firm must take on the task itself or prop up a quasi-independent

supplier through a joint venture or strategic alliance. If there are information,

coordination or hold up problems the firm should determine whether these problems

can be prevented through contract (thus favoring the market) or internal governance

(favoring integration). The firm also needs to determine if double marginalization is

occurring and profits are suffering as a result.

A good example is PepsiCo and its bottlers. Initially PepsiCo was primarily a syrup

manufacturer purchasing raw materials from the market and using independent forms

to bottle and distribute the product. Over time Pepsi has consolidated distribution and

marketing. Changes in the technology of bottling have created economies of scale and

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the emergence of national retailers like Wal-Mart created the need for a sophisticated

centralized sales information system. Sophisticated advertising and promotion

campaigns demanded national coordination and the cooperation of bottlers. For better

coordination, Pepsi bought out many of the bottlers. Pepsi bottling group controlled

over 60% of worldwide bottling operations by 1990. In 1989, Pepsi spun off the Pepsi

bottling group but retained a 40% stake thereby retaining defacto control.

Li and Fung is a Hong Kong based trader with a network of suppliers Asia. They tightly

control design and marketing and manufacture at cheap locations. By working closely

with vendors they are able to cut costs considerably and have a globally dispersed

value chain. They enjoy an optimal blend of company involvement and vendor

independence.