Transaction Cost

Economics
MGS611 Management of Globally Distributed Services
Professor Rajiv Kishore

Hierarchies vs. Markets

Hierarchies

Hybrid/Relational

CEO

COO

Plant
Manager

CFO

QA Head

Bills Payable
Manager

Management and Control

by Authority/Fiat
Boss is the Principal
Worker is the Agent
Visibility of Agents Work is Higher

Management
and Control
by Joint
Action/
Joint
Decision
Making/
Information
Sharing/
Relational
Norms

Markets

Management and Control

by Institutional Structures
and Contract
Client is the Principal
Vendor is the Agent
Visibility of Agents Work is Lower

Social (Trust) Economic (e.g., JV)

Costs in Economic Production

Various classifications when thinking about costs
Fixed Costs and Variable Costs
Direct Costs and Indirect/Overhead Costs
Production Costs and Governance Costs

Production and Governance Costs

Production Costs (PC) those costs (such as labor and material)

that are incurred in the production (this is the economic transaction

of interest here) of a good or service
Governance Costs (GC) those costs that are incurred in assigning
and controlling the production of the good or service of interest
Transaction Cost (TC) is the sum of PC and GC

What are Governance Costs?

Transaction costs, including both PC and GC, are incurred in

economic exchange in any governance arrangement

including:
market
hierarchy
or any other arrangement in between these two endpoints

Governance costs are incurred both ex ante (i.e., pre-contract

phase, before signing the contract) and ex post (i.e., postcontract phase, after signing the contract)
Ex ante

Contract
signed

Ex post

Ex ante Governance Costs

Search and information costs
these costs are incurred in determining whether the required
goods, services or providers who produce them are available on
the market (or in a hierarchy, e.g., the employees with the right
skill set), where it is available at the lowest price, who are the
appropriate vendors (or employees), etc.
Contracting costs
these costs are incurred in coming to an acceptable agreement

with the other party to the transaction, drawing up an

appropriate contract, and so on (remember contract is also
signed with an employee).

Ex post Governance Costs

Contract Monitoring and Enforcement Costs
these costs are incurred to ensure that the other party sticks to
the terms of the contract, and taking appropriate action
otherwise (in both markets and hierarchies).
Contract Adaptation Costs
these costs are incurred to change the contract when

requirements for products and services included in the contract

change due to changing environment, changing business needs,
etc. (within both a hierarchy and a market)

Transaction Cost Economics

To maintain its competitive advantage, a firm must consider:
What kind of business model minimizes the total costs of
producing and distributing a particular good or service?
TCE provides a framework for making the make-or-buy

decision

Assumptions underlying TCE

Opportunism
People will be motivated by self-interest. They may not be
wholly honest and truthful, and may take advantage of
circumstances.

Bounded Rationality
People have limited memories and limited cognitive processing

power. They cannot always accurately foresee positive

possibilities or negative consequences.

Transaction Characteristics
Frequency
Firms would not want to bring in-house the process of supplying a

requirement that is very rarely used

Uncertainty
All possible eventualities cannot be foreseen. Will doing the work

in-house minimize uncertainty? Balance with lock-in and cost

uncertainties
Asset Specificity
Most important element, it refers to the degree to which the assets

needed to perform a production activity are not transferable to

other production activities, e.g., specialized machines, special
training for employees required for one product may not be
transferable in the production of another product

The Make-or-Buy Decision

Cost

(Based on Asset Specificity)

DPC ( H - M ) + DGC ( H - M )

DPC ( H - M )
DGC ( H - M )
0

Market

Hierarchy

PC Production Cost
GC Governance Cost

Asset Specificity

Conclusion
Transaction Cost Economics can be used to decide upon a

firms business model by analyzing the make/buy decision