Last Updated 08 May 2020

Transaction cost economics

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In the 1840’s the firm was characterised by being family owned. Therefore businesses were small and widely dispersed. Businesses were limited by the infrastructure at the time – transportation was done mainly by sea; hence it was very slow, communication was also done by the same medium, financing was basically none existent because the banks did not want to take on what seemed at the time a risky venture. If loans were given it was based on personal relationships. There was nothing to prevent price fluctuations in the market. Product technology was not developed. Government was not actively involved in the business environment.

In the 1910’s, as a result of the introduction of railways businesses began to expand and looked to vertically integrate. Mass production led to less companies being around but the ones left were much larger and were able to collude in the market; therefore government had to intervene in the market. The infrastructure now facilitated agency-principal relationship in business. The telephone drastically reduced the time spent in communicating and suppliers and distributers could keep abreast of what was happening in the market place so that they would know how to plan production so to minimize oversupply.

In the world today globalization plays a major role. Specialists are emerging as firms no longer see the need to vertically integrate. New modes of transportation: - air travel, interstate trucking were introduced. The computer has made communication almost instant. Banks have large sums available for investment based of the firm’s ability to pay back. Changes in production technology create better quality of goods at lower costs. Government regulation increased and this changed how firms compete in the marketplace.

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Formal definition of ‘Transaction costs” is rare in the literature. Generally, as definition, a transaction costs are costs incurred in making an economic exchange. They are defined as “those costs associated with an economic exchange that vary independent of the competitive market price of the goods or services exchanged. They include all search and information costs, as well as the costs of monitoring and enforcing contractual performance” (James.A.Robins, 1987). They consist of costs incurred in the searching for the best supplier/partner/customer, the costs of establishing a supposedly ‘tamperproof’ contract, and the costs of monitoring and enforcing the implementation of the contract.’ Transaction costs are also known as coordination costs.

Alchian and Woodward (1988) have argued that there are two distinct traditions in transaction-cost analysis. 'One emphasizes the administering, directing, negotiating, and monitoring of the joint productive teamwork in a firm. The other emphasizes assuring the quality or performance of contractual agreements' (Alchian and Woodward, 1988). The total cost incurred by a firm consists of two components – transaction costs and production costs.

Transaction costs include all information needed to coordinate the work of people and equipment that perform the primary processes. Production costs include costs incurred from the physical or other primary processes necessary to create and distribute the goods or services being produced. Firms are faced with difficulties with the market which leads them to transact in house production of the goods. When the market is favorable it is used.


Transaction cost economics (TCE) is similar to game theory where all the parties to the contract is assumed to understand the strategic situation and will position themselves accordingly; but TCE differs from game theory because contractual incompleteness sets in as the limits on rationality becomes binding in relation to transactional complexity. TCE uses authority as a way to deter ‘bad games’.

According to Maria Moschandreas, TCE claims that it is the interaction between transactional/environmental characteristics (mainly asset specificity, uncertainty, and complexity) with behavioral at-tributes (bounded rationality and opportunism) that creates transaction costs. The key characteristics of transaction cost economics are: Bounded rationality: “Bounded rationality is a school of thought about decision making that developed from dissatisfaction with the “comprehensively rational” economic and decision theory models of choice” (Bryan.D.Jones,1999).

This means that decisions are made on the basis of well defined and fixed outcomes. This concept relies on the fact that decision makers have to work under three unavoidable constraints which are: only limited, often unreliable information is available regarding possible alternatives and their consequences, human mind has only limited capacity to evaluate and process the information that is available and finally, only a limited amount of time is available to make a decision.

Opportunism: “opportunism is a necessary condition for the creation of transaction costs” (Maria Moschandreas, 1997). Opportunism is considered as an endogenous factor in TCE. It forms an inherent part of business relationships. According to Williamson, opportunism is one of the "rudimentary attributes of human nature". Whenever individuals will be given the chance to act opportunistically, they will do so. Behavioral uncertainty: Uncertainty is a situation where the current state of knowledge is such that the order or natures of things are unknown. Although too much uncertainty is undesirable, manageable uncertainty provides the freedom to make creative decisions.

Behavioral uncertainty is the uncertainty that may be present in a transaction due to the opportunistic inclinations of the transacting parties (John & Weitz, 1988). Behavioral uncertainty thus results from the possibility for the “strategic nondisclosure, disguise or distortion of information” by the transacting parties (Williamson, 1985), and thus concerns the chance that a contracting party may behave opportunistically, and thereby harm the other contracting party.

TCE’s uncertainty proposition holds that the greater the uncertainty associated with the undertaking of an activity, the more difficult contracting becomes. This contracting problem signifies that uncertain activities will tend to be insourced in an attempt to avoid opportunistic behaviour that may result from a deficient outsourcing contract (Birnberg, 1998). Frequency: Frequency refers to the repetitiveness (and volume) of similar transactions. TCE’s frequency theory proposes that the more extensively an activity is performed, the more likely it will be insourced due to the economies of scale that can be achieved inhouse. This means that the greater the extent of a transaction the more likely the transaction will be internally managed due to the production economies that can be obtained.

Asset specificity: Asset specificity is usually defined as the extent to which the investments made to support a particular transaction have a higher value to that transaction than they would have if they were redeployed for any other purpose (McGuinness 1994). Williamson (1975, 1985, 1986) argued that transaction-specific assets are non-redeployable physical and human investments that are specialized and unique to a task.

Williamson (1983) identified four dimensions of asset specificity: Site specificity, like natural resource available at a certain location and movable only at great cost; Physical asset specificity, like specialized machine tool or complex computer system designed for a single purpose; Human asset specificity, like highly specialized human skills, arising in a learning by doing fashion; and dedicated assets, like discrete investment in a plant that cannot readily be put to work for other purposes.

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