TRANSACTION COST

THEORY (TCT)
How MNEs can use TCT to assess the Modes
of Entry in the Foreign Market?

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Contents
Introduction........................................................................................................... 2
An Overview of Literature on Transaction Cost Theory ........................................ 2
Evolution of Transaction Cost Theory ................................................................ 2
Transaction Cost Theory and International Transactions .................................. 5
Transaction Cost Theory and Modes of Entry .................................................... 6
Reflection on Modes of Entry by MNEs and Transaction Cost Theory .................. 7
References ........................................................................................................... 11

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Introduction

Transactions are one of the core marketing activities, and they have been used as a foundational
aspect of marketing thinking for quite a long time. Kotler (1972), in his article "A Generic Concept
of Marketing," describes that "marketing core idea is marketing transactions". Businesses of
every nature involve hundreds and thousands of transactions on a daily basis. In addition to
assisting and formulating ways to make these transactions happen, marketing scholars are also
much concerned about developing strategies that could help in facilitating these transactions and
give valuable insights on how customers respond to different transaction tactics (Chaudhuri and
Holdbrook, 2001). In addition, these marketing scholars are also interested in suggesting
plausible and feasible ways of organizing these transactions. Much of the research in this aspect
has been done keeping in view the Transaction Cost Theory (Reindfleisch and Heide, 1997).
Briefly, the Transaction Cost Theory suggests that conducting a transaction is a costly activity,
and there are different costs associated with other modes of organizing these transactions
(Coase, 1937). According to Coase (1937), the significant costs associated with transactions are
negotiation costs, monitoring costs, and costs related to resolving disputes. In addition, the cost
may differ based on the modes of the transaction; for example, if the transactions are inter-
departmental, then the costs would be different, and if they are intra-departmental, i.e., outside
the organization, then the costs would be different (Coase, 1937). This research paper would first
build a robust theoretical foundation regarding the evolution and development of this theory and
then, later on, analyze its impact on businesses. In the end, the paper will reflect on how the
Transaction Cost Theory helps MNEs to choose between different modes of the international
business organization when expanding overseas.

An Overview of Literature on Transaction Cost Theory

Evolution of Transaction Cost Theory
If we take a thorough overview of the evolution of the Transaction Cost Theory, the contribution
of three Noble Laureates, i.e., Ron Coase, Douglas North, and Oliver Williamson, seems
prominent in the literature. Rendfliesch (2019) categorizes the contribution of these thinkers in

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three groups based on the time in which they presented their theories and on the relevant
application of their arguments in respective periods. Rendfliesch (2019) categorizes the
arguments of Coase, Douglas, and Williamson as "Past," "Present," and "Future," respectively.

Ron Coase is one of the pioneering thinkers to lay the foundation of Transaction Cost Theory, and
that is why he is referred to be as "The Father of Transaction Cost Theory" (Benkler, 2006). In
1937, Coase published his seminal article "The Nature of the Firm," He posited a very intuitive
notion that "why a firm emerges at all in a specialized exchange economy." Coase (1937)
answered this intuitive question by saying that "The main reason it is profitable to establish a
firm would seem to be that there is a cost of the price mechanism." In his article, he further
delineated that "market transactions entail certain costs that may be reduced if the transaction
occurred within the firm." Later in 1993, he further affirmed his notion by saying that "Whether
a transaction would be organized within the firm or whether it would be carried out on the
market by independent contractors depended on a comparison of the costs of carrying out these
market transactions with the costs of carrying out these transactions within an organization, the
firm." In addition, he also identified some significant costs associated with market transactions.
For example, in his seminal article published in 1937, he recognized the negotiation cost and the
cost of building contracts to be two significant costs related to transactions. Later in 1960, in his
article "Problems of Social Cost," Coase described the nature of transactions of costs such as cost
of locating exchange partners and cost of conducting inspections."

Coase identified the transaction cost while Williamson is known for extending the work of Coase,
thereby identifying and then describing the attributes of the transactions and the actors involved
in the transactions (Rendfliesch, 2019). In his seminal article "Transaction Cost Economics: The
Governance of Contractual Relations" that was published in 1979, Williamson outlined two main
assumptions about the actors involved in transactions, i.e., "bounded rationality" and
"opportunism," and identified three main dimensions of transactions, i.e. "assets specificity,"
"frequency" and "uncertainty." Bounded rationality refers to "our limited capacity to understand
business situations and the overcrowding information, which limits the factors we consider in the
decision." In contrast, Opportunism refers to "actions taken in an individual's best interests,

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which can create uncertainty in dealings and mistrust between parties" (Brouthers, 2003).
Frequency is defined as "how often a transaction occurs," uncertainty refers that "Long term
relations or very short term relations between actors are uncertain because there is a lack of
trust associated with both of them" and finally, Asset Specificity means "how unique the
component is of you need" (Brouthers, 2003). Williamson argues that all kind of transactions
requires specific assets to make them happen. Similarly, transactions occur frequently, and
uncertainty is associated with each transaction. He further contends that "bounded rationality"
and "opportunism" of the actors are two significant reasons for the high transaction costs.

Yochai Benkler is known for the modernization and radicalization of the Transaction Cost Theory.
The digital revolution that emerged in the 21st century reshaped the organization of economic
activities. Building on the work of his predecessors, Benkler incorporated the impact of
technology on economic transactions and the modes of transactions. In brief, Benkler (2006)
"suggests that the democratization of digital tools such as the Internet, personal computer and
video cameras has enabled new forms of economic organization such as crowdsourcing, idea
competitions, and user innovation." To describe these new forms of organization, he coined the
new term "Social Production" (Benkler, 2006). According to Benkler (2006), "Social production of
goods and services, both public and private, is ubiquitous, though unnoticed...It is, to be fanciful,
the dark matter of our economic production universe". Both Williamson and Coase suggest that
market and firm are two distinct elements besides both of them being part of a broader
competitive market environment. The only motivation that leads to operationalization in the
market is the monetary reward. However, on the contrary, Williamson (2006) argues that social
production works in a cooperative environment and is driven by non-monetary awards. He also
suggests that Social production, being distinct from markets and firms, provides a new and
emerging opportunity for information-based offerings and services. In addition, while
determining the transaction attributes, Wliiamson (2006) suggests, "transactions through social
production would be more organized if they have high levels of modularity and granularity."
According to Williamson (2006), Modularity refers to "a property of a project that describes the
extent to which it can be broken down into smaller components, or modules, that can be
independently produced before they are assembled into a whole." Similarly, he defines

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Granularity as "the size of the modules, in terms of the time and effort that an individual must
invest in producing them."

Transaction Cost Theory and International Transactions

The emergence and prevalence of technology in the 21st century have transformed the world
into a global village, and thus it has changed the perception of companies about international
transactions (Dabrowska, 2014). Local and regional markets are now transforming into global
markets giving access to any company from any part of the world. Foreign trade has become
profitable enough to be performed by the companies at the expense of even recession in the
local economy (Dabrowska, 2014). Thus, the question of "Should companies be involved in
foreign trade?" is no more relevant, while now the companies are excessively focusing on "how
to expand in the foreign markets?" (Dabrowska, 2014). The liberalization and globalization of
international trade have led companies to choose freely from various entry modes in the foreign
markets (Martins et al., 2010).

There is an ample amount of literature suggesting different ways of entering the foreign market,
and each of them gives other criteria for the assessment of international markets. After a
Bibliometric evaluation of the comprehensive literature, Dabrowska (2014) identified certain
variables affecting internationalization; however, he categorized all these variables into four
categories; Industry Specific Variables, Location-Specific Variables, Firm-Specific Variables, and
Transaction specific variables. Location-specific variables refer to "external macroeconomic
factors that originate in the institutional framework and social conditions" (Buckley and Casson,
2008). Industry-specific variables such as competition, industry development, industry progress,
etc., determine how to conduct business on an industry level (Kogut and Singh, 1998). While firm
Specific variables such as technology and know-how, management team, business strategy, firm
size, etc., recognize the idiosyncratic traits of the firm. (Meyer, 2004). In addition to these
variables and factors, there are similar other factors that affect internalization. Switching cost is
one of the critical costs associated with the internal transaction that has not been incorporated
in the models of international businesses (Gatigon and Anderson, 1988).

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Transaction Cost Theory and Modes of Entry
As discussed earlier, Coase (1988) suggests that "without the concept of transaction costs, which
is largely absent from current economic theory, it is my contention that it is impossible to
understand the working of the economic system, to analyze many of its problems in a useful way,
or to have a basis for determining policy". However, contentions were created regarding which
costs to be included in the transaction. Allen (1999) suggests "the cost of transferring property
rights form the seller to the buyer" as the transaction cost. Later on, Wang (2003) indicated that
transaction cost is the "difference between the prices paid by the buyer and the price received
by the seller". The three dimensions of transaction cost as described by Williamson (1985) are
also essential criteria for the assessment of international markets. The asset specificity enable
"the organization to fully comprehend whether the contract requires individually-tailored
solutions or quite standardized investments" (Williamson, 1984). The Bounded Rationality and
Opportunism of the actors involved in transactions, collectively referred to as Behavioral
Uncertainty, may compel the actors to make decisions incongruent with the other actors in the
market. In addition to the behavioral uncertainty, there are external uncertainties, which deal
with the sudden and unexpected changes in the legal, technological and economic environment
(Bremen et al. 2010). Both the uncertainties have a significant impact on the mode of entry and
the profitability of the company. There is an inverse relationship between a company's
profitability from entering foreign markets with Opportunism and external Uncertainty
(Dabrowska, 2014). Greater is the external uncertainty, and the higher the opportunistic the
partners are, the lower be the firm's profitability. Williamson (1985) also draws a relation
between asset specificity and frequency of transactions. He says, "higher repeatability of
transactions increases the probability of investing in non-recoverable assets abroad"
(Williamson, 1985). After a comprehensive overview of the literature, Dabrowska (2014)
determines a matrix followed in the 1990s by businesses to assess different modes of entry in
the foreign market.

Asset Specificity
Low High

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 Frequency Low + +++
Non-Equity Modes Joint-Venture Modes
High 0 ++
Non-Equity Modes Wholly-Owned
Modes

The tables describe that companies often adopted equity modes of entry in the foreign market
with high asset specificity and a high frequency of transactions. Whereas, with low asset
specificity and minimal/high frequency, companies adopted non-equity modes of entry in the
foreign market.

After critical analysis of Transaction Cost Theory, many thinkers proposed other factors that could
be used as suitable criteria for assessing modes of entry in the foreign market. For example,
Brouthers (2002) suggests that the company's internalization process must be managed with due
consideration. In addition, the ultimate business model that emerges from dual-standard
operations in both the host and home markets may create differences. This difference is made
due to the cultural differences and different institutional frameworks in both countries.
Therefore, many thinkers also include these two factors as a cost associated with the transaction
cost. However, both are not directly related to transaction cost in a quantifiable manner (Gorynia
and Mrozeck, 2013). Similarly, Dunning (2002) claims that "the entry mode choice is motivated
by a group of three factors: ownership, location, and internalization." In addition, Trapczynski
(2013) proposed the Resource-Based View according to which companies must align their
resources with the entry in the foreign market to ensure sustainability and growth, thereby giving
them a competitive edge.

Reflection on Modes of Entry by MNEs and Transaction Cost Theory

The theoretical foundations of the Transaction Cost Theory that Coase and Williamson built
played a significant role in describing the ways to assess the different modes of entry by

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organizations in the international markets. However, as described above with the evolution of
literature, the Transaction Cost Theory has also undergone specific critical evaluations that have
led to many modifications within the Transaction Cost Theory. In addition, with the emergence
of technology and comprehensive research in the literature of transaction cost, many other
theories also emerged which described several other contributing factors that could be used to
assess modes of entry in the international markets. Therefore, this section of the report will
analyze how the companies can assess different modes of entry based on the premises of the
Transaction Cost Theory suggested by Williamson. It will also provide some other criteria that are
not covered by Transaction Cost Theory, yet they contribute evaluation standards for the
assessment of modes of entry.

As discussed by Williamson, asset specificity is one of the critical elements of the transaction cost.
The mode of entry is highly dependent on the specificity of the asset. If the companies have low
specific assets, there is not much risk in entering the market. However, a company whose assets
are highly specific may enter the market with higher risk. For example, a company that produces
genetically modified seeds, a company that is currently producing the vaccine of COVID-19, etc.,
possess highly specific assets. This is because the know-how of these products is highly specific
to the host company and could be easily copied by competitors in the foreign market. Ultimately,
to preserve intellectual property, companies have to take control of the assets in the form of
patents, copyrights, etc. All of these preservation efforts eventually increases the transaction
cost. Therefore, when the asset specificity is low, firms usually adopt non-equity modes of entry
such as direct and indirect exporting, franchising and licensing, etc. However, when the asset
specificity is high, firms generally make increased investments in specific assets, thus adopting
hierarchal equity modes of entry. In this way, the companies invest in wholly-owned subsidiaries
(acquisition and Greenfield operations), regional centers, resident sales representatives, etc. This
enables them to have more control over their specific assets, thereby protecting their proprietary
assets. There are two fundamental reasons for the increase in the transaction costs when
companies have highly specific assets, and they adopt hierarchal equity modes of entry. First, in
this case, the cost of switching agents is comparatively higher. Secondly, any loss of foreign
intermediary can be costly for the company as these foreign intermediaries have direct

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knowledge of your specific assets. Thus there is a high probability that they would become
potential competitors.

The bounded rationality and Opportunism as described by Williamson are also essential criteria
for assessing modes of entry in the foreign market. To minimize the opportunistic behavior of
the actors involved in transactions, companies need to design a control mechanism. One way the
company can control the opportunistic behavior of actors is to develop an internal control
mechanism. This means that the company owns the right to control the behavior and decisions
of the actors. A hierarchal ownership structure gives the company the right to control the
behavior and decision of its employees. However, just having the right to control opportunistic
behavior does not yield results. The company must implement it, and for that, they require
specific resources and means. "Controlling foreign operations is a special skill that requires time
to develop and refine" (Anderson and Gatingon, 1986). This entails a valuable insight, i.e., firms
with a solid international presence and ample experience in the foreign market do not need much
resources and time to develop an internal control mechanism. However, companies that are just
entering the international market need to develop a robust internal control mechanism to control
the opportunistic behavior of the actors. Thus, the firms, which lack the experience and resources
of developing a strong internal control mechanism, should prefer non-equity modes of entry such
as direct exports, franchising and licensing, etc. Whereas the companies having the experience
and resources of controlling the opportunistic behavior of their employees should prefer
hierarchal equity modes of entry such as acquisitions, wholly-owned subsidiaries, etc.

In addition to these factors described by Transaction cost theory, several other factors also affect
different modes of entry. For example, countries that prioritize the sustainability of the
environment demand companies to use minimal renewable resources and demand sustainable
products and process designs. In such countries, the most favorable modes of entry for
companies that want to develop a control mechanism is through non-equity modes of entry. In
addition, from a purely an economic perspective, the growth opportunity, the economic and legal
environment, level of competition, alignment of the mode of entry with the company's core

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competence, profitability, overall market size, culture, and customer preferences, all of them are
also suitable criteria for selecting any mode of entry in the foreign market.

Conclusion

The main argument of Transaction Cost Theory revolves around the fact that along with the
economic costs, i.e., cost of production and distribution, there are some other significant costs
in the form of transaction costs, which affect the firm's profitability while entering and operating
in the foreign markets. Although the Transaction Cost Theory builds a robust theoretical
foundation for the assessment of modes of entry in the foreign market; however, flexibility
always lies there, and modifications are being made in the literature to incorporate other factors
as well to assess the modes of entry. However, the emergence of Transaction Cost Theory has
inevitably revolutionized the international business realm by first identifying a significant cost
and then suggesting ways to manage that cost.

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