Transaction Cost - Final (Endnote) (2) | Transaction Cost | Market (Economics)

MBA 9003 Make or Buy Decision

Executive Summary

Transaction Costs: The

Although transaction costs have existed as long as firms and industries have, they had not been specifically identified and studied till the 20th century. A reason for this could be that transaction costs are relatively ‘invisible’. R.H. Coase set the academic world thinking about the nature of transaction costs with his seminal work, ‘The nature of the firm’ (1937). Yet, till the 1960’s most practitioners considered transaction costs similar to commission costs or tariffs.

In recent times, the study of transaction costs have been spurred on by the increasing tendencies of corporations to operate globally and outsource many of their previously considered core functions to other firms.

Although, the cost-benefit logic behind outsourcing is simple, firms should look beyond the obvious and weigh in other factors before taking a decision whether to make a factor of the production process in-house or to buy it externally from the market. The increasing internationalisation of business could, in fact add on more transaction costs to the process.

Transaction costs are underpinned by four key concepts – bounded rationality, opportunism, asset specificity and informational asymmetry. It should be noted that transaction costs are different from production costs. Transaction costs are costs incurred in exchanging products or services through the market while production costs are costs incurred in the direct production process.

The key factors that determine whether a firm should manufacture in-house or farm out to the market are determined by asset specificity, prevailing uncertainty and the frequency of transactions.

MBA 9003 Make or Buy Decision

Transaction Costs: The

Logically, if there are costs involved in using the market, the question arises why a single gigantic firm has not emerged which carries out all production. Such a scenario is unfeasible due to the nature of operating firms; defined by diminishing returns, inefficiencies and unfavourable costs. Markets also have the advantage of exploiting scale and avoiding agency and influence costs.

The balance of internal transactions (make) and external transactions (buy) opted by the firm, determines to a large extent, the size and structure of the organization.

In conclusion, it can be seen that firms can produce everything internally, source the various factors from the market or engage in a combination of producing and sourcing. Depending on the nature of the industry, the relative size of the organization and the objectives of the management, the firm can decide on the balance between making and buying.

edu/doepke/teaching/resources/e102ch1. Costs are involved in bringing together the various factors of production. describing it as ‘just about all the conceivable costs in society except those associated with the physical processes of production and transportation’. the study of transaction costs did not gather much momentum till the 20th century. Despite the widespread existence of firms and industries in various forms since the industrial revolution in the 18th century. such as 1 A Robinson Crusoe economy refers to a situation where a single person or firm is engaged in labour and production and makes his/its own choices with no effect by markets. In simple terms. Cheung (1988) remarked that before the 1960s. Cheung (1988) defined transaction costs as all the costs that do not exist in a Robinson Crusoe Economy1. prices. transaction costs refer to the costs incurred in making a transaction. Such costs include the costs of searching for information about products. He further refined it.econ. By its very nature. the physical act of the transaction. but arise out of ‘organising’ the production. most economists tended to think of transaction costs as similar to transport costs.MBA 9003 Make or Buy Decision Transaction Costs: The Introduction The study of transaction costs have evolved a long way since Coase (1937) elucidated on the costs of using the price mechanism.pdf) . These costs are not associated with the production of goods and services. inputs and buyers or sellers (information costs). transaction costs can be relatively invisible and it can often be quite difficult to separate one kind from another. or to a tariff or commission. Coase (1937) implies that individual firms arose on account of the costs involved in using the price mechanism.ucla. trade or price (http://www.

The move is part of an effort to lift Cadbury’s operating margins to about 14-15% from the then prevailing levels of 10%. Jobs in the HR-related roles were sent to Genpact’s shared business services in India. transaction costs have been increasingly important in the business environment. firms today have greater leeway in determining whether to outsource an activity to the market or perform it in-house. Through the globalisation of commerce. The targets are to be achieved through cost-cuts and asset disposals2.html . stretching across geographical locations.com/companies/companies_c/cadbury_Schweppes/20070705_cadbury. Cadbury plc outsourced a significant part of its global accounting and HR activities to Genpact India.http://www. China and Romania.MBA 9003 Make or Buy Decision Transaction Costs: The negotiating and writing contracts (negotiation costs) and ensuring that all the pre-agreed terms of the transaction are met (enforcement costs) (Hobbs. especially due to the emergence of large scale outsourcing by firms. The various types of transaction costs are illustrated in Figure 1 Figure 1 – Transaction Costs Source: Hobbs. 1996 The increasing importance of transaction costs In recent times. Beginning in 2007.com . 1996).domain-b.domainb. 2 Sourced from www. About 500 jobs in the accounting domain were outsourced to India as a part of the company’s ‘Vision in Action’ programme.

MBA 9003 Make or Buy Decision Transaction Costs: The At a first glance. Perfect competition refers to a market structure in which there are many buyers and sellers and in which the firm. The costs of information about government regulations and other policies in both foreign and home markets (including exchange rate policy. . penetrating international markets should be a simple matter of production cost – comparative advantages determine which producers penetrate international markets and when. With wide variances prevailing across the globe in living standards. 2004) page 302. and health and environmental regulations) 3 In economics. Yet. the very international nature of business can drive up transaction costs. Abdel-Latif & Nugent (1996) state that in a world with perfect markets3 and zero transaction costs. companies are advantaged by manufacturing goods and providing services from relatively lower cost locations. the scope and scale of outsourcing has increased. The costs of obtaining information about market conditions in any foreign market (the quantities and qualities desired and the prices prevailing for each different quality) and the reciprocal costs for agents in foreign countries ii. With the technological advances (and resulting falling costs) in transport and communication. exchange restrictions. Abdel-Latif & Nugent (1996) say that transaction costs in international marketing become more complex due to: i. geographical resources and costs of production factors. as a seller. purchasing power (foreign exchange currency differences). the concept of outsourcing seems simple enough. is producing a homogenous product and is severely constrained by the threat of entry of new firms into the market (Rivers & Ward. a perfect market is defined by the conditions of perfect competition. tariff and non-tariff barriers.

Drawn. cited in Kulkarni & Heriot. A number of disciplines – including psychology. and importantly.MBA 9003 Make or Buy Decision Transaction Costs: The iii. bonding costs to effect secure commitments.Bounded rationality means that although people may intend to make a rational decision. which generally involves a long lag between placing an export order and making final payment for it. set-up and running costs associated with the governance structures. in part. their capacity to evaluate accurately all possible decision alternatives is physically limited. opportunism. writing. economic history and law . They are bounded rationality. The costs to each potential party of identifying appropriate trading partners in these markets iv. in case the transaction deviates from the specified terms. asset specificity and informational asymmetry (Hobbs. 1999) defined two types of transaction costs – (i) The ex ante transaction costs which include the costs of drafting. and enforcing contracts and resolving disputes between the parties and v. (a) Bounded Rationality . from these associated disciplines. four key concepts underpin TCA. negotiating and safeguarding an agreement and (ii) the ex post costs associated with the haggling cost. the maladaptation costs. The nature of transaction costs Williamson (1985. and of bearing the risks of default throughout the process.have all contributed to the theoretical development of Transaction Cost Analysis. The costs of negotiating. 1996). political science. The costs of financing the transaction. Bounded rationality poses a problem in situations of complexity or uncertainty .

Opportunism has been defined by Williamson (1979) as self-interest seeking with guile. This details the lack of ease with which human capital. In other words. the longer the duration of the contract tends to be.This refers to investments in certain assets for a specific purpose and which cannot easily (without cost) be adapted to other uses. . This does not imply that all those involved in transactions act opportunistically all of the time. Shanley. 1998). & Schaefer (2007) refer to bounded rationality as the limitation of human capabilities in coping with the complex situation. it recognizes that the risk of opportunism is often present. (c) Asset specificity .MBA 9003 Make or Buy Decision Transaction Costs: The where the ability of people to make a fully rational decision is impeded. it recognizes that businesses and individuals will sometimes seek to exploit a situation to their own advantage. Dranove. Besanko. additional transactions regarding the contract are required for safeguarding the opportunistic behaviour between economic parties (Dahl & Matson. physical assets and facilities specifically tied to the manufacture of a good or service can be used by alternative users or put to alternative uses. processing the information. (b) Opportunism . From a study of two hundred and seventy seven coal contracts in 1979 between coal suppliers and electric utilities. and attaining the rational objectives. Joskow (1987) concluded that the greater the relationship-specific investment is. rather. As it enhances the risk to the firms.

2006). On the other hand. The first involves ex ante opportunism where information is hidden prior to a transaction.MBA 9003 Make or Buy Decision Transaction Costs: The This occurs as the parties involved would prefer to finalise the terms of future ex ante transactions by agreeing to future trades and minimising repeated bargaining. (d) Informational asymmetry . production costs are the cost of organizing a particular task by the firm itself. so that all parties to the transaction no longer possess the same levels of information. They arise out of the implications of dealing with the market. Informational asymmetries can lead to opportunistic behaviour in two ways.Transaction cost analysis also allows for the relaxation of the full or perfect information assumptions of neoclassical theory. These parties may have the incentive to act opportunistically to increase their economic welfare because their actions are not directly observable by other parties. However. Production costs are costs incurred in the direct production process. Transaction costs are costs incurred in exchanging products or services through the market (Baye. This is ex post opportunism which occurs after a transaction because of the hidden actions of individuals or firms. Transaction Costs and Production Costs Transaction and production costs are the key factors when the firms decide how to perform the economic tasks. Information asymmetry arises when there is public information available to all parties but also private information which is only available to selected parties. the longer term contracts would be more costly. such as the cost of . Moral hazard also arises from informational asymmetry. it has to be noted that due to the uncertainties involved.

the key characteristics that determine the level and nature of transaction costs are: (i) Asset Specificity – Goods which are non-specific in nature. or produced with non-specific assets. 1997). a more formal type of vertical co- . make an asset specific investment (ii) Uncertainty – A low level of uncertainty lends itself to spot market transactions.MBA 9003 Make or Buy Decision Transaction Costs: The direct material and direct labour. These production costs are influenced by the resources requirements. Dant. The fixed cost is relatively constant for defined levels of output while the variable costs fluctuate in accordance with the level of output. According to Hobbs (1996). have many alternative uses and would tend to be sold in a spot market. a long-term contract or full vertical integration may depend on whether one party. we move along the spectrum of vertical co-ordination towards a more formal type of supply chain management such as vertical integration. or both. Transaction costs determine whether the firm prefers to perform its activities in house (also called vertical integration) or use the price mechanism in the market. When aspects of the transaction (such as quality characteristics) are highly uncertain. As asset specificity increases. Make or Buy (The Firm or the Market) Coase’s seminal work on ‘The nature of the firm’ (1937) stated that firms arose due to the costs of using the price mechanism (referred to as the market). scale of operations and experience in performing a task (Bello. Production costs include fixed and variable costs. Whether the result is a strategic alliance. & Lohtia.

customers and Dell's bright but unseasoned Indian support staff fuelled the flames.g. a strategic alliance. Dell took the rare step of rerouting its . following increased complaints about poor customer service in both the retail and business segments. a contract or some form of vertical integration (iii) Frequency of transactions – When transactions are carried out frequently. customers say they got frustrated when Dell employees fielding calls seemed unwilling to depart from a script. the incentive to act opportunistically and to exploit any informational asymmetries that may be present increases and we move further along the continuum of vertical co-ordination towards the extreme of vertical integration. both buyer and seller will probably value repeat business and will not wish to tarnish their reputations by acting opportunistically. Dell computers decided to move outsourced jobs back to the U. transactions repeated frequently tend to be carried out in the spot market.S. As transactions become more infrequent.MBA 9003 Make or Buy Decision Transaction Costs: The ordination . U. Language and cultural rifts between disgruntled U. Frequent transactions also provide buyers and sellers with information about one another. In November 2003. however.may result. e.S.where one party has more control over the outcome of the transaction . Dell was among the earliest computer companies to route customer service and technical support calls to India. Dell set up its first centre in Bangalore in 2001 and opened a second site in Hyderabad in 2003.S. For these reasons.

Support for small-business and consumer accounts remain in India4. Texas. i. the firm may falter in allocating the factors of production to their best possible use. one can eliminate certain costs and in fact reduce the cost of production. why market transactions exist.com/id/4853511/) . Again. fail to make the best use of the factors of production.e. Diminishing Returns – When a firm gets larger.MBA 9003 Make or Buy Decision Transaction Costs: The large. these costs may be equal to the costs involved in carrying out the transaction in the open market.msnbc.and medium-business support work out of India and back to Austin. leading to higher costs. 1999) 4 Sourced from www.msnbc. ii. why is all production not carried out by one big firm? Coase (1937) addressed the question through the following points. Unfavourable cost – At higher levels of output.com (http://www. a point may be reached where the loss through the waste of resources is equal to the costs of the exchange transaction in the open market. Individual firms can obtain advantages from the market discipline that forces market to be efficient and innovative (Roodhooft & Warlop. the supply price of one or more of the factors of production may rise. Inefficiency – As the number of transactions increase. At a point.. Production by a single firm The question arises then that if firms emerged due to the costs of using the price mechanism.msn. iii. i. the costs of organising additional transactions within the organisation may rise. If by organising.

Influence costs include not only the direct costs of influence activities (e. the firm will not produce over and above this point. Third. Under normal circumstances. Influence costs occur when managers try to influence the allocation of limited internal resources to favoured departments or divisions.MBA 9003 Make or Buy Decision Transaction Costs: The The firm’s optimal output occurs when the marginal revenue equals the marginal cost. Market firms enjoy two distinct types of efficiencies: they exploit economies of scale and the learning curve. market firms may possess proprietary information or patents that enable them to produce at lower cost. infer that firms use the market (or buy) primarily because market firms are often more efficient. First. Second. et al. . b) Bureaucracy effects: avoiding agency and influence costs – Agency costs refer to the costs associated with slack effort and with the administrative controls to deter it. There are several reasons for this. the firm earns maximum profit. they might exploit their experience in producing for many firms to obtain learning economies. thereby enjoying economies of scale. (2007). Besanko. As organisations grow large and complex. such costs may tend to be unnoticed – and thus undeterred by senior management. and they eliminate bureaucracy. they may be able to aggregate the needs of many firms.the time wasted when a division manager lobbies central management to overturn a decision that is unfavourable to his or her division). they also . a) Exploiting scale and learning economies – It is conventional that firms focus their activities on what they do best and leave everything else to independent outsourcing partners.g. At this point.

If a firm decides to bring all factors of production in house. Depending on the industry it is operating in and the scale. Klein (1983) states that there are internal transaction costs within the firm and external transaction cost when dealing with the market. conglomeration. the efficiencies enjoyed by the firm would also tend to decline. beyond an optimal size. the size of the firm will be larger. as the organisation grows larger and the structure becomes complex. multidivisional organization. average employment (size of the firm) will decrease. the size and structure will be lean. If the transaction efficiency is improved in such a way that the transaction efficiency for intermediate goods becomes higher than that for labour. a firm would endeavour to minimise its transaction costs internally through a combination of any or all of the following . if it decides to internally produce and manage only the core processes and outsource a significant part of the non-core processes to the market. On the other hand. Where the internal transaction cost is greater than the external transaction cost. and trans-nationalization.vertical integration.MBA 9003 Make or Buy Decision Transaction Costs: The include the costs of bad decisions that arise from influence activities (e. . scope and nature of its business. the firm will outsource and when external transaction cost is greater than internal transaction cost. the firm will expand. The flip side of this is that. Impact on structure and size of firm Liu & Yang (1999) imply that the change in average firm size (average employment) depends on the change in transaction efficiency for intermediate goods relative to labour.g. resources that are misallocated because an inefficient division is skilful at lobbying for scarce resources).

the architectural firm agreed to supervise and oversee the actual construction. sand. we decided to engage an architectural consultancy firm for drawing up the land use plan and building design. As we had little experience in construction. Once this was completed. The enterprise owned a plot of land located adjacent to a major national highway close to public transport hubs.MBA 9003 Make or Buy Decision Transaction Costs: The A recent instance when transaction costs were a consideration was when our family enterprise decided to enter real estate development. next on the agenda was the actual task of construction. We received quotations from three independent construction contractors based on the building plan (subject to a +10% variance) and selected the most economical one. Since design and development was not our core area of expertise. The plot was ideal for retail and commercial office purposes. The terms of the contract were that we would provide the cement. When the legal formalities were completed. we engaged the same firm to process the paperwork and get the approvals from the local authorities for the building permit. . metal. and steel and the labour and machinery would be provided by the contractor. The contract was also subject to penalties and bonuses in case of time overruns. For a commission of 5% of the actual cost. we preferred to outsource this activity too.

• Time – The architectural consultancy was well versed with the paperwork required for the building permit and the process for application. The costs incurred in this instance were • Quality control – the architectural firm was paid a 5% commission to ensure that the contractor maintained quality . The benefits for the enterprise from outsourcing in this instance were • Gaining expertise – Design and construction knowledge were not our key strengths. we extended the time frame for completion.MBA 9003 Make or Buy Decision Transaction Costs: The During the course of construction. The contractor could divert his resources to the other sites • Cost – Engaging the labour and machinery required for construction would have cost us a lot more independently than if we had outsourced to the contractor. the real estate market suffered a minor downturn. we could get permissions relatively quickly • Flexibility – As the contractor was working on multiple sites simultaneously. we could slow down the construction process without any cost. Through mutual consent between our enterprise and the contractor. We leveraged on the experience of the architectural firm and the construction contractor. we decided to go slow on the construction. Due to this.

MBA 9003 Make or Buy Decision • Transaction Costs: The Store keeping – As we were supplying the cement. . we had to employ a storekeeper to ensure that materials were consumed in the appropriate mix and to reorder new stock when required. sand. metal and steel.

The key benefits of using the firm for production are: • • • • Ensuring quality of the product or service provided Protection of trade secrets and confidential information Bottlenecks and holdups caused by external parties avoided Lower costs of negotiation and enforcement Costs and risks involved in using a firm are: • • • The firm may incur agency and influence costs The firm may not have expertise to effectively manage all the functions If operating on a small scale. the per unit costs may be higher The key benefits of using the market are: . What they opt for would depend on their objectives and the nature and scope of the product / service provided and the size of the firm.MBA 9003 Make or Buy Decision Transaction Costs: The Conclusion It can be seen that firms have three choices open to them – (a) Produce everything within the firm (b) Source the factors of production from the market or (c) Engage in a combination of producing within the firm and sourcing from the market.

Before engaging with the market. (2007). The risks of data compromisation and on time delivery should also be considered. it would be prudent to assess the impact on efficiency and costs. holdups and delays are likely In view of all these benefits and costs. . et al. Besanko. The market can be used in activities where the firm can benefit from the specialised and technical knowledge of the provider. has provided a framework for the management process before make-or-buy decisions (Figure 2). managements can decide which activities can be brought in-house and which can be outsourced to the market.MBA 9003 Make or Buy Decision • Transaction Costs: The The market can achieve better economies of scale on larger volumes and pass this to firms • Innovations and learnings can be transferred to firms The costs and risks involved in using the market are: • • Private and confidential information may be compromised The costs of co-ordination may rise. Care should also be taken that the contract is legally binding provides for clauses and penalties in case of non-performance.

MBA 9003 Make or Buy Decision Transaction Costs: The .

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