Application of Managerial Economics

Topics: Transaction cost, Economics, Cost Pages: 5 (1540 words) Published: June 20, 2011
Managerial Economics
Course Assessment 1

Transaction Cost of Economics (TCE) theory is to explain a firm’s structure and TCE’s key features are the determinants of the level of vertical integration. The process that begins with the acquisition of raw materials and ends with the distribution and sale of finished goods and services is known as the vertical chain[i]. A central issue in business strategy is how to organize the vertical chain. TCE, which was first contended by Coase in 1937 and developed by Williamson in 1975, is useful of facilitating decision-making process on vertical boundaries and organize vertical chain from input to output.

Transaction costs are the costs of time spend on searching with potential exchange parties, suppliers, negotiating the terms of exchange or contracts and the costs of monitoring contracts. Organizations purpose is to reduce transaction costs. We can see TCE as a framework that, based on cost efficiency, allows us to make the decision of how to coordinate exchange: will we use the market or buy? Transaction cost theory determines whether efficient firms should produce in-house or outsource production and distribution. When the cost of internal co-ordination is lower than the cost of using markets, the firm will decide to vertically further in order to internalise the costs of co-ordination between the different stages of production. For example, a lighting company used a vendor to paint their products when the production volume was below 10,000 pieces per month. Later on, frequency becomes higher and production volume above 10,000 pieces per month. The existing supplier cannot attain economies of scale that an in-house unit could not attain. Coordination becomes difficult. There is no need to have “intermediate” arrangements. The factory decided to buy a painting line and realize vertical integration with cheaper costs. Management of the factory must have compared the cost of internal co-ordination, which includes the cost of internal production and the cost of governance, to the cost of using markets, which includes external production costs plus transaction costs. Firms use the market (or “buy”) primarily because market firms are often more efficient.[ii]

A critical task for any firm is to “define its boundaries” by determining which tasks to make and which others to buy. Joeone Garment Co., a large fast-growing manufacturer in South China, analysed its boundaries few months ago. Joeone wants to find what their competitive advantage was. Joeone hired some retired famous garment designers from Spain to enhance their R&D team performance. Branding and product design are their boundaries. Management at Joeone decided to outsource their assembly workers job to other local vendor since cost of internal co-ordination is higher than the cost of using outsourced vendors in order to optimise efficiency. Great time spent on solving labour workers issues with high employee turnover rate 35%. After outsourcing production work in assembly line, Joeone therefore can focus on their core competitive advantage of R&D and Branding. The Firm enjoys benefit of exploiting economies of scale and the learning curve, and eliminating bureaucracy. Same story happened at Rougemont Juice Company, which needs colour box for packaging purpose. The existing packaging suppliers that can attain economies of scale that an internal packaging assembly line could not attain, and the supplier possess execution capabilities that an in-house unit would not. Besides, there are no significant relationship specific assets, and no coordination problems, and no leakage of private information possibilities, Rougemont decides to outsource their packaging part to a package company, which is an expert of colour box making. When the costs of internal production are higher than the cost of external production in this case, the firm will use the market mechanism which could result in outsourcing production. The above two...
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