What is transaction cost theory
Transaction cost theory and Coase Theorem
To understand the basics of transaction cost you here is a blissfully short video where Paul Merison speaks on the topic:
From the video, transaction cost is the cost that quantifies your time, stress and effort to do business. It is something that is not accountable, but exists nonetheless. How can you explain to your accountant that he/she needs to include the number of nerve cells that were destroyed while trying to get credit from the bank? Not taking into account these costs would cause us to miss our profit maximization point.
Transaction cost theory tries to explain why companies exist, and why companies expand or source out activities to the external environment. The transaction cost theory supposes that companies try to minimize both the costs of exchanging resources with the environment, and the bureaucratic costs of exchanges within the company. Companies are therefore weighing the costs of exchanging resources with the environment against the bureaucratic costs of performing activities in-house. (Businessmate.org)
This chart sums up what has already been said so far:
The model shows institutions and the market as a possible form of organization to coordinate economic transactions. Source: http://en.wikipedia.org/wiki/File:Market-Hierarchy-Model.png
As shown, companies have internal transaction costs. For example, as a manager you experience stress or you have to spend a lot of free time to deal with work. These factors are rarely taken into account explicitly.
There are also external transaction costs. These are the costs of outsourcing business to the environment. An example of this is the cost of monitoring a company that is responsible for part of your business. In the Real World section of our website you can read an article that discusses this topic related to newspaper publishing corporation.
Ronald Coase best describes the relationship between internal and external transaction costs and the activity of firms: Every company will expand as long as the company's activities can be performed cheaper within the company (as opposed to outsourcing the activities to external providers in the market) (Businessmate.org). For example, if there is a risk of environmental uncertainty, external transaction costs will increase. Consequently, a company will be more eager to keep its economic activity internal. There will be fewer contracts with suppliers and less external meetings and supervision (Businessmate.org).
Oliver Williamson adds that a transaction cost occurs "when a good or a service is transferred across a technologically separable interface" (Businessmate.org). In other words, one should be clear whether “the transaction [is] easy and harmonious, or are their frequent misunderstandings and delays?” (Faculty.babson.edu) He also states that critical dimensions for transactions are 1) uncertainty 2) frequency, and 3) degree of durability (Faculty.babson.edu). This reflects the initial idea proposed by Coase. In addition to certainty, manager needs to know the potential future outcomes of a decision. Frequency refers to the concept that “with repeated interaction, the
incentive to maintain a reputation for fair dealing may be sufficient to mitigate opportunism…” (Klein P.)
The easiest way to understand this theory is to create an example. Imagine that you want to outsource marketing activity to another company. You need to make a decision. Normally you would base your decision based solely on calculations. However, according to Coase, a good manager needs to take into account bureaucratic costs of your company. When the transaction costs of monitoring another company are lower than the bureaucratic costs of your company, you will decide to outsource the activity to the environment.
Another area of transactional cost theory pertains to negative externality. Ronald Coase best explains this area of the theory with his Property Rights Solution when dealing with two agents. Before giving and example you should be familiar with this term: negative externality – it occurs when production and/or consumption impose external costs on third parties outside of the market for which no appropriate compensation is paid (e.g. air pollution) (Tutor2u.net).
Now imagine a scenario where you own a massive water-polluting car factory. There is also a guy who did not attend Cass Business School and he became a fisherman. In this scenario, your factory pollutes the water, and fish die. In this case, the fisherman is experiencing a negative externality. To address externality, Coase proposed the Property Rights Solution. The requirements for the Property Rights Solution are:
- Well Defined - In what manner rights can be exercised
- Divisible - Whether these rights are separable and tradable
- Defendable - Whether these rights are enforceable or are these rights recognized by agents or community
If the right to pollute is assigned to the factory, then the fisherman can negotiate with the factory to reduce the pollution. This is true if, for example, a filter that will decrease the pollution will cost fisherman less that his total loss from dead fish.
If the property right is assigned to the fisherman, then the factory has an incentive to pay the fisherman to allow the factory to pollute to a certain limit. In both cases, the pollution decreases and the externality is internalized. The factory and fisherman acknowledge the externality cost and are ready to pay for it, hence it is now included in their internal costs.
You can see a more detailed Q&A style example in our Quizzes page.
Works Cited for this page
Businessmate.org (2010) What is Transaction Cost Theory. [online] Available at: http://www.businessmate.org/Article.php?ArtikelId=182 [Accessed: 24 Dec 2012].
Faculty.babson.edu (1981) Williamson - Transaction Cost Approach. [online] Available at: http://faculty.babson.edu/krollag/org_site/org_theory/granovet_articles/william_trans.html [Accessed: 25 Dec 2012].
Klein, P. (2006) The Treatment of Frequency in Transaction Cost Economics. [online] Available at: http://organizationsandmarkets.com/2006/09/06/the-treatment-of-frequency-in-transaction-cost-economics/ [Accessed: 25 Dec 2012].
Tutor2u.net (2012) Negative Externalities. [online] Available at: http://www.tutor2u.net/economics/revision-notes/as-marketfailure-negative-externalities.html [Accessed: 24 Dec 2012].Source: cassb1.weebly.com