Transaction Cost Theory

What are transaction costs?

• In economics and related disciplines, a transaction cost is a cost in making any
economic trade when participating in a market.
• Transaction costs are the total costs of making a transaction, including the cost of
planning, deciding, changing plans, resolving disputes, and after-sales.
• Therefore, the transaction cost is one of the most significant factors in business
operation and management.
• The concept of transaction costs is the foundation of New Institutional
Economics.
• As Ronald Coase pointed out, the organization of transactions, with the inevitable
costs it incurs, determines what goods and services are produced and the
capacity of any economy to take advantage of the division of labor and
specialization.
• The extent of transaction costs then depend on the institutional environment.
1. Search and information costs are costs such as in determining
that the required good is available on the market, which has the
lowest price, etc.
• In perfectly competitive markets economic agents are assumed
to have perfect knowledge. The presumption is they can access
whatever information they need without incurring considerable
costs.
• But in reality, information are not only imperfect but also involve
costs.
• In addition, human being has limited ability to gather and process
information.. Behavioral economics!!
• The implications are that economic agents devote a lot of
resources to gather information.
2. Bargaining and decision costs are the costs required to come to an
acceptable agreement with the other party to the transaction, drawing up
an appropriate contract and so on.
• Having equipped with the required information, the transacting parties
must make a lot of bargaining in order to reach at profitable terms of
agreement.
• Depending on the complexity of the transaction, this can involve a lot of
resources –lobbying, financing meetings, payment for third party
mediating the bargaining, and the like.
• To achieve favorable terms and avoid possible risks, parties will have to
devote time and resource in the bargaining.
• Once agreement is reached on general and key issues, drafting,
reviewing and signing the agreement is not a simple task.
• It can involve a lot of cost.
3. Policing and enforcement costs are the costs of making sure
the other party sticks to the terms of the contract, and taking
appropriate action (often through the legal system) if this turns out
not to be the case.
• Once the agreement is signed, each party need to monitor the
other.
• Still this can take a lot of surveillances, supervision, hiring
consultants or forming an independent organ, etc.
• Enforcing when there are deviations could also involve a lot of
costs. This can be through legal court or through informal ways.

4. Add to these 3: Opportunity costs!!

 Examples:

1. Hiring a worker require finding a suitable worker, examining potential

applicants, bargaining on the wage rate, assessing the prevailing wage
rates, metering performances (marginal contributions), designing
appropriate incentive structure, penalizing shirking and the like.
Why firms need supervisors? It is because workers may shirk, underperform,
abuse firms resources, and the like.
2. The buyer of a used car faces a variety of different transaction costs. The
search costs are the costs of finding a car and determining the car's
condition. The bargaining costs are the costs of negotiating a price with the
seller. The policing and enforcement costs are the costs of ensuring that
the seller delivers the car in the promised condition.
 SSA food grains trade
Prices are not publicly announced
Goods are highly differentiated
No formal grading system
Variable weights
Contracts are oral and non-standardized
Little inspection or certification
No recourse to legal means of contract enforcement
Too slow, expensive, corrupt
SSA food grains trade: Resulting risks
• Both producers and traders are highly vulnerable to being cheated with
respect to:
Market prices
Qualities
Quantities
Timing of delivery
Product spoilage or loss during transport
Uncertainty and imperfect information
Genuine problem or opportunistic behaviour?
Risks discourage trade and investment
Transaction Cost- Definitions
• The founding father of this theory is Ronald Coase, who, in 1937, wrote an article
entitled “The nature of the Firm”.
• Douglass C. North argues that institutions, understood as the set of rules in a society,
are key in the determination of transaction costs. In this sense, institutions that
facilitate low transaction costs, boost economic growth.
• Oliver E. Williamson defines transaction costs as the costs of running an economic
system of companies, and unlike production costs, decision-makers determine
strategies of companies by measuring transaction costs and production costs.
• The firm exists to reduce the threat of opportunism, or behavioral uncertainty of
exchange partner, that occurs in the market transactions (Williamson, 1975;
1985).
• According to Kenneth Arrow (1969), “transaction costs are the costs of running the
economic system”.
• A transaction is a transfer of property rights!
Ronald Coase
• Nobel Prize in 1991 “for his discovery and
clarification of the significance of transaction
costs and property rights for the institutional
structure and functioning of the economy.
• Two influential articles
• “The Nature of the firm” in 1937
• Introduced the concept of transaction costs —
the costs each party incurs in the course of
buying or selling things. Such as broker fees
Coase : The nature of the firm
Why do firms exist? What is their size?
• Coase grasped earlier than almost anyone else that the firm was an
alternative to the market mechanism for organizing transactions.
• It offered an economic explanation of why individuals choose to form
partnerships, companies, and other business entities rather than trading
bilaterally through contracts on a market.
• In principle individuals could rely completely on the market and the price
mechanism to direct resources.
• Firms emerge because they are better equipped to deal with
the transaction costs inherent in production and exchange than individuals
are.
• Economists such as Oliver Williamson, Douglass North, Oliver Hart, Bengt
Holmström, Arman Alchian and Harold Demsetz expanded on Coase's work
on firms, transaction costs and contracts.
• Why the economy is populated by a number of business firms,
instead of consisting exclusively of a multitude of independent,
self-employed people who contract with one another.
• Modern firms can only emerge when an entrepreneur of some sort
begins to hire people, Coase's analysis proceeds by considering the
conditions under which it makes sense for an entrepreneur to seek
hired help instead of contracting out for some particular task.
• The traditional economic theory of the time suggested that, because
the market is "efficient" (i.e. those who are best at providing each
good or service most cheaply are already doing so), it should always
be cheaper to contract out than to hire.
• Coase’s most profound insight was that there are costs to using the
price mechanism and that in some cases it is less costly to perform
those transaction inside a firm rather than through the market.
• Coase noted that there are a number of transaction costs to
using the market; the cost of obtaining a good or service via
the market is actually more than just the price of the good.
• Other costs, including search and information costs, bargaining
costs, keeping trade secrets, and policing and enforcement
costs..ALL add to costs.
• For example, in a labor market, it might be very difficult or
costly for firms or organizations to engage in production when
they have to hire and fire their workers depending on demand/
supply conditions.
• This suggests that firms will arise when they can arrange to
produce what they need internally and somehow avoid these
costs.
• Similarly, it may be costly for companies to find new suppliers daily. Thus,
firms engage in a long-term contract with their employees or a long-term
contract with suppliers to minimize the cost or maximize the value of property
rights.
• The question then arises of what determines the size of the firm; why does the
entrepreneur organise the transactions he does, why no more or less?
• There is a natural limit to what can be produced internally, however. Coase
notices a "decreasing returns to the entrepreneur function", including increasing
overhead costs, bureaucracy and increasing propensity for an overwhelmed
manager to make mistakes in resource allocation. This is a countervailing cost
to the use of the firm.
• The upper limit on the firm's size is set by costs rising to the point where
internalising an additional transaction equals the cost of making that
transaction in the market.
• At the lower limit, the firm's costs exceed the market's costs, and it does not come
into existence.
• Coase argues that the size of a firm (as measured by how many
contractual relations are "internal" to the firm and how many
"external") is a result of finding an optimal balance between the
competing tendencies of the costs i.e., Transaction costs vs
Overhead and Bureaucracy Costs.

• In general, making the firm larger will initially be advantageous, but the
decreasing returns indicated above will eventually kick in, preventing
the firm from growing indefinitely.

• According to Ronald Coase's essay, people begin to organise their

production in firms when the transaction cost of coordinating production
through the market exchange, given imperfect information, is greater
than within the firm.
Other things being equal (ceteris paribus), a firm will tend to be
larger:
1. The less the costs of organizing and the slower these costs rise with an increase in
the transactions organized.
2. The less likely the entrepreneur is to make mistakes and the smaller the increase in
mistakes with an increase in the transactions organized.
3. The less the rise in the supply price of factors of production to firms
• The first two costs will increase with the spatial distribution of the transactions
organized and the dissimilarity of the transactions. This explains why firms tend to
either be in different geographic locations or to perform different functions.
Coase concludes by saying that the size of the firm is dependent on the costs of using
the price mechanism, and on the costs of organisation of other entrepreneurs.
• Additionally, technology changes that mitigate the cost of organizing
transactions across space will cause firms to be larger—the advent of the telephone
and cheap air travel, for example, would be expected to increase the size of firms.
Oliver Eaton Williamson

• Recipient of the 2009 Nobel

Memorial Prize in Economic
Sciences, which he shared
with Elinor Ostrom

• “for his analysis of economic

governance, especially the
boundaries of the firm”
Factors impacting transaction costs
TCE is founded on two of the key behavioral assumptions that are
spring from self-interest assumption.
1. Bounded rationality :An economic agent is assumed to be self-interest
seeking but has bounded rationality.
Information problem: access to information and limited computational and
cognitive capacity. Thus, they cannot be purely rational but boundedly
rational.
2. Opportunism: agents are assumed to seek their self-interest with guile(i.e
cunning intelligence).
Economic theory based on simple self-interest seeking (without including guile)
imply that transacting parties will act in farsighted and responsible way.
TCE modify the self-interest-seeking by including guile.
Agents are generally assumed to be opportunistic….if the environment allows
Options to constrain this opportunistic behavior
• Self-enforcement: psychological conviction that such behavior is bad
Traditional beliefs, cultural beliefs, religious beliefs, keeping promise,
oath taking.
These (informal) institutions are intended to impose some
psychological
cost (guilty feeling)
• Second party enforcement: If a person act opportunistically, the
victim can retaliate… depends on power balance i.e political, social
and economic power
• Third party enforcement. (Institutions) : Social sanction, ostracism,
use of powerful close person to retaliate, calling for local leaders.
One of the reasons for the emergence of diverse informal and formal
institutions is to reduce opportunistic behavior of agents and
information problems associated with transactions.
The degree to which bounded rationality and opportunism affect
transaction costs depends on 3 dimensions:
Frequency: The frequency of the transaction affects the costs involved
to make the exchange.
If you are a frequent buyer, you will have the chance to retaliate…
cooperation repeated game….Nash equilibrium pareto optimal.
Uncertainty: behavioral uncertainties and uncertainties posed by the
transaction environment(exogeneous shocks).
To minimize risk costs, transacting parties have to devote resources
to search costs.
Asset specificity: A specific purpose asset vs a General purpose asset
• Williamson (1991) argues that transaction costs increase
with a higher degree of asset specificity, a higher degree of
uncertainty, and lower frequency of transaction.
• Transaction cost theories are not replacements neoclassical cost
theory. The neoclassical production cost theory still hold.
• In the NIE sense then, costs are neoclassical production costs
plus transaction costs.