Transaction cost economics (TCE) is most associated with the work of Oliver Williamson (see his book The Economic Institutions of Capitalism on the reading list), though he was building on earlier work, particularly by the Nobel prize winner Coase. One reason why the theory is so important is that it represents one of the first and most influential attempts to develop an economic theory that takes seriously the structure of firms. Previously, economic theories tended to treat the firm as a sort of “black box,” the internal workings of which were not considered to be important. This, of course, contrasts with most other people’s view of businesses, where the internal workings of the organization is given prominence.
It is sometimes said that TCE attempts to explain why firms exist. That is, why are some transactions directed by managers in the context of a hierarchy, as opposed to taking place in an open market? It’s more accurate, though, to say that TCE tries to explain the particular structure of a firm, most importantly, the extent to which it will integrate vertically. It must be emphasised that while Williamson’s work is very distinctive, it falls well within mainstream economic thinking. It assumes that firms are profit maximising, and that profit maximisation involves costs minimisation. By implication, it is an equilibrium theory. It assumes rationality on the part of owners and/or managers. Where it differs is in stressing transaction costs as well as production costs. Williamson envisions production costs as being analogous to the cost of building and running an “ideal” machine, while transaction costs are those costs which are incurred by departures from perfection, such as friction. In the economic sector, the ideal machine would be a perfectly efficient market. As you know, such a market requires full information to be available to all parties and perfect competition, among other factors. Departures from this perfection (sometimes called “market failures”) can result in firms incurring costs when they attempt to buy or sell goods or services. For example, lack of information about alternative suppliers might lead to paying too high a price for a good. Lack of information about a customer’s creditworthiness might result in a bad debt. These are transaction costs. Williamson argues that firms want to minimise their total costs, which are made up of both production and transaction costs. Under some circumstances transaction costs may be lower if the transaction takes place in an open market, which in other situations costs will be lower if managers coordinate the transaction.
Williamson’s contribution rests in specifying the variables that determine whether “market or hierarchy” will have the lower transaction costs in various circumstances. Before discussing these variables, though, we also need to mention the assumptions that Williamson makes that underpin the theory. It is important not to confuse these assumptions with the variables. The assumptions are unchanging contextual factors. They are important in that if these assumptions were not valid, then the arguments about the effects of the variables would not be valid. But the factors mentioned in the assumptions don’t themselves vary, and so they cannot explain variation in organizational structure. Assumptions
1. Bounded rationality
Bounded rationality refers to the fact that people have limited memories and limited cognitive processing power. We can’t assimilate all the information at our disposal, we can’t accurately work out the consequences of the information we do have. A good metaphor is the game of chess. Despite knowing all the rules which fully specify the game, no one is capable of faultlessly analysing any given position during a chess game. This is partly because the game itself is inherently too complex (there are too many alternatives), and also because the actions of the opponent are...