Transaction Cost Economics (TCE) and the Modern Company

The management models in the Managerial Economics module offer a challenging look at the behaviour of modern management. The Baumol model will focus on maximising revenues and yields per customer as a key driver of growth – success will ultimately depend on the (price) elasticity of demand for its products or services. The Marris model will distinguish between achieving growth and achieving value in a company. Key determinants in securing balanced growth will include the rate of product diversification and the role of dividends in the company.

Modern companies are increasingly using business practices such as subcontracting labour, niche production or outsourcing production - a typical firm may depend on other firms or organisation to carry out its activities through a complex network of contracts and relations. Such a firm has morphed into a network organisation. The traditional boundaries of the organisation are thus diluted by a network of relationships with other organisations that uses markets as exchange co-ordinators as a substitute for internal exchange co-ordination.

Williamson’s transaction costs economics [TCE] studies this phenomenon through the understanding that firms compare the costs of internal co-ordination to the cost of using markets (transaction costs) in deciding how to co-ordinate economic exchange in order to optimise efficiency. Current developments in telecommunications and information technology explain the reduction in the cost of using markets to co-ordinate exchange through the use of networks between organisations.

The focus within economics has traditionally been placed on the study of markets as the most efficient co-ordinator. It was not until 1937 when Coase posed the question of why so much economic activity is carried out within organisational structures if markets are so efficient that organisations were studied as exchange co-ordinators. He addressed the question by suggesting that the existence of transaction costs, understood as the costs of using the market, would result in hierarchies being more efficient when the costs of negotiating, monitoring and enforcing contracts were too high. Hierarchies thus reduce the transaction costs connected to market co-ordination. This theory did not improve further until Williamson cohesively developed the theory of TCE in the 1970s and the 1980s to study governance structures and to determine whether markets or hierarchies are more efficient to co-ordinate exchange.

Sources of transaction costs

TCE is useful in a number of decision making situations such as in the determination of the most efficient organisational structure or to determine, as commented, whether organisations or markets are more efficient to co-ordinate exchange. In the latter case, which constitutes the focus of the rest of this document, managers must compare the cost of internal co-ordination, which includes the cost of internal production and the cost of governance, to the cost of using markets, which includes external production costs plus transaction costs. These transaction costs arise from:

• Researching potential suppliers.
• Collecting information on prices.
• Negotiating contracts.
• Monitoring the supplier’s output.
• Legal costs incurred should the supplier breach contractual negotiations.

Only when the costs of internal production are higher than the costs of external production, will the firm decide to use the market mechanism which could result in outsourcing production or using contract labour. On the other hand, when the cost of internal co-ordination is lower than the cost of using markets, the firm will decide to vertically integrate further or to use internal contracts in order to internalise the costs of co-ordination between the different stages of production. In this situation, the firm becomes a nexus of contracts between the exchanging parties.

TCE thus determines whether efficient firms should produce in-house or outsource production and distribution. Williamson contends that these transaction costs in turn depend on the set of assumptions and factors set out below:

• Read Unit 1 Management Objectives
• and Stakeholder Value

Bounded rationality refers to the fact that management (as individuals) are bounded by the limits of their own knowledge. Uncertainty exists when decision makers do not have enough information to make rational decisions, but individuals may also be bounded in their rationality when they have too much information. In the game of chess, for example, the two players have perfect information but cannot fully process every potential move or countermove. High levels of uncertainty and complexity thus result in higher transaction costs as the exchanging parties try to minimise bounded rationality.

Opportunism is a consequence of using a situation to one’s best advantage. Economists contend that asymmetric information arising when exchanging parties have different degrees of information, can lead the more informed party to use her position in her best interest. Thus, for instance, it is in the interest of a second-hand car owner who wants to sell the car and knows it is a lemon (term used to denote bad second hand-cars) to lie about its real state to a potential buyer. The potential buyer, who knows the seller has more information about the car, could incur a higher cost to reduce opportunism if she brought the car to a mechanic to get it checked before buying it. Transaction costs are thus incurred in exchange under asymmetric information when the less informed party tries to reduce the problem of opportunism. The number of potential sellers is important in determining opportunism. When there are a large number of second-hand car sellers, opportunism can reduce potential future sales. Opportunism thus is more likely to exist when there are a small number of trading partners.

Specialisation and co-ordination

The most common co-ordinators are markets and organisations. In the case of markets, the price mechanism ensures that consumers’ demand meets producers’ supply. The outcome is efficient as consumers buy the quantity of the good or service they demand and producers sell the quantity they supply at the market price. There are no shortages or surpluses. The price includes all the necessary information for producers and consumers. In contrast to the price mechanism, decision makers allocate resources in organisations. Thus, authority is the co-ordinating mechanism. There are many different types of organisations such as families, clubs or teams, but the firm, an organisation with the objective of producing a good or service to sell for money, is the organisation of interest to the current analysis.

Douma and Shreuder contend that Wiliamson’s view that co-ordination is carried out through markets or hierarchies is too limited and argue that there is a set of mechanisms, other than authority which co-ordinate exchange within organisations. For example, exchange can be co-ordinated through markets ,which use the price mechanism, or organisations, not only hierarchies, which use a set of mechanisms such as authority, bureaucracies or socialisation. Thus, for instance, Ouchi (1980) holds that bureaucracies use rules as a substitute for authority. Ouchi also contends that socialisation of individuals to ensure they have the same common values and beliefs could be used as a co-ordination mechanism. He provides the example of Japanese firms which rely on hiring and socialising inexperienced workers so that they accept the company’s goals as their own. There is therefore no requirement for the firm to control workers because socialisation ensures they work in the benefit of the firm. [read about the s-firm in the Study Guide Unit 2].

Williamson also stresses the role of asset specificity in the analysis of transaction costs. Thus, an asset is specific when it has no value in an alternative use. The existence of specific assets in exchange increases the transaction costs since the parties involved must bear the risk of hold up. Suppose for example supplier A must retool her machine to produce a component that can only be sold to producer B a stage up the value chain. She would bear the risk of hold up if producer B stopped production or decided to change supplier. Producer B also has the power to renegotiate the contract ex post in her own interest and ensure A keeps supplying her as long as she pays A a price which only covers the variable costs. The existence of asset specificity thus increases transaction costs so much that it may push potential firms away from the market exchange. Producer B might not be able to find a supplier interested in committing to such specific investment and might have to end up internalising the exchange by vertically integrating the supplier.

The network organisation

The existence of transaction costs will determine whether markets, organisations or a combination of them are more efficient in co-ordinating exchange. Indeed, in the real business world hybrids of the two co-ordination methods also exist. The use of franchising, where a franchisor gives the right to use a name and an established formula to a franchisee in exchange for a fixed fee and a percentage of sales, illustrates the example of a structure which combines elements of market and hierarchical co-ordination.

One of the most current trends in a number of sectors is the rise in importance of the network organisation which depends on others to carry out its activities through a complex network of transactions and relations with external organisations. Some of these relationships are rooted in:

• The use of contract staff. Firms use a higher proportion of part-timers and contract staff not only to cope with periods of increased work pressure, but also to reduce the dependence on potentially non-required workforce. In this sense, the existence of the shamrock organisation, composed of a small core of managers and highly skilled workers, a number of low skilled temporary peripheral workers and a number of subcontractors, should be noted.
• The lease of capital assets in high capital cost industries.
• Outsourcing. Firms outsource from outside suppliers a proportion of their production or distribution. European and American firms outsource increasing proportions of their operations to lower cost countries such as China to reduce production cost.

These practices suggest a higher use of markets to co-ordinate transactions but do not question Coase’s contention that exchange is to be carried out within organisations when transaction costs are high. Current developments in telecommunications and information technologies which have resulted in the increased use of electronic data interchange (EDI), e-mail, the internet or computer integrated manufacturing (CIM) have reduced the cost of transacting with other producers, thus encouraging the use of markets to co-ordinate exchange.

• Read the Unit 2 on Cost Leadership and
• the Production Process

It is also important to stress the development of relationships built on trust. The use of business philosophies such as Just in Time (JIT) or Total Quality Management (TQM) require close relationships between different organisations on the value chain. The understanding that their success is built on interdependence with other organisations has encouraged the development of trust between the firms in the value chain and thus reduced transaction costs connected to opportunism.

The increased trend in market provision could also be due to the underestimating of costs of internal co-ordination. These could include management supervision, budgetary control systems, recruitment, etc which have not been traditionally considered as relevant in the decision to use markets or to co-ordinate internally. New approaches do consider these costs resulting in an increase in the cost of internal co-ordination.

In conclusion, the comparison of the costs of internal and external co-ordination determines management’s decisions to co-ordinate through organisations or markets. The transaction costs incurred in using the market are rooted in bounded rationality, opportunism and asset specificity. The use of telecommunications and I.T., and the development of trust relationships between organisations have reduced the transaction costs encouraging the network organisation and the use of market co-ordination.