An efficient market will render economic activity within the firm to be vertically integrated with other market firms. Yet many economic activities are still carried out within the firm. Coase (1937)1 in “The Nature of the Firm” raised this question on Transactional Cost Economics (TCE). This essay will explore the key characteristic of TCE, analyzing the vertical boundaries of a firm and examining the key role played by coordination in a vertical chain.
For the purpose of illustration, a bank in Singapore, Bank A, and her relationship with market firms, Market Firm B, will be studied. In 2011, it undertook a massive project to revamp the internet banking website. It had utilized market firms B for system integration, development and web design. Due to confidentiality clause, name of bank, market firm and figures will be withheld.
One of the most common struggles manager face in the make-or-buy conundrum is in the area of how much of economic activity do they define within their vertical boundaries, determined by its cost benefit analysis.
Bank A will need to work closely with Market Firm B in coordinating its activity. It will be inconceivable for Bank A to define the requirements and request for Market Firm B to develop the backend system without a corresponding delivery of the front end design of the web user interface from other market firm. If there were to be any delays in the delivery of the output from any parties, it could lead to a slip in the project timeline. This is the issue of coordination cost when utilizing market firms.
Leakage of private information is an issue. While many firms mitigate the risk by signing Non-Disclosure Agreement (NDA), yet this is not foolproof. Bank A is a listed firm and such information has a bearing on their share prices. The risk of leak in private information comes from both the intentional and unintentional. Bank A had intentionally indicated to the market firms which area of product development they need to focus on as revenue drivers. Bank A did unintentionally reveal the impending launch of new products through the design stage where they had indicated they need more links in the internet banking site to cater for new products.
Cost of transacting with market firms can also take the form of other activity within the firm that was employed to support the project. In-house counsel will be needed to draft legal contract to work with the firms. Finance had to negotiate with the market firms on contractual and payment agreement.
Thus far, we had focused on the cost of using market firms but the benefits should also be analyzed and economies of scale are one of them. It is inconceivable for Bank A to employ a team of web designers with the expertise to design a modern day website. The cost of headhunting and employing the staff with the expertise may far outweigh the cost of coordination with a market firm. Agency cost could also be another factor.
Market firm exist in competition with other market firms. When determining on the market firm, Bank A select from a pool of market firms before deciding on Market Firm B. Market firms are bounded by market forces and need to be productive, efficient and relevant to continue to service Bank A in its vertical chain.
In examining the reason to “buy” versus “make”. Firms which choose to “buy” usually take advantage of the economies of scale and learning economics of market firms that specialize in their area of expertise and possess unique skillset enabling them to be strategically relevant, allowing them to produce output at lower cost. Given these advantages, market firms will be able to build on their scale to grow in learning economics and continue to exploit this scale.
Bank A’s expertise lies in its role as a lender. Market Firm B specialize in...