Transaction Cost Economics

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Economic exchange among firms in the market has become the vital part of business. According to Coase (1937), for each exchange transaction, the firms apparently encounter costs of organizing production when they use the market and its price mechanism. It is mentioned that the noticeable costs are the costs pertaining to price discovery, including the costs of negotiating and finalizing the contract, which occurred when undertaking a contract for each transaction (Cited in Rivers, 2004).

Beyond the view of traditional neoclassical economics theory, which simply focuses on a firm as “a production function” (Williamson, 1998, p. 32), transaction cost economics (TCE) considers “the behavioral implications of economics actors” (Kulkarni & Heriot, 1999, p.43). The conception of TCE influences the firms to make the decision on the economic problem: how to produce. By considering TCE as a critical factor for managing their resources, managers can make the optimal choice of internalization or market for the firm’s decision (Joskow, 1993). Consequently, understanding the concept and implications of TCE is necessary for managers to efficiently manage and thus minimize transaction costs when confronting dynamic economic environments.

The rest of the essay is organized as follows: section 2 will describe conceptual framework of TCE, section 3 will address the implications of TCE in microeconomics and present some case studies which are subject to business practices, section 4 will conclude with some lessons learned.

2.Conceptual framework of TCE

2.1)Definitions and classification
Transaction costs are defined as “the costs related to the execution of a transaction, including the opportunity cost incurred when an efficient-enhancing transaction is prevented (Milgrom & Roberts, 1992 cited in Wood & Parr, 2005, p. 4). They pertain to the activities conducted inter-firm and intra-firm. Regarding Coase’s alternative approach of firms and markets, Arrow (1969) also refers transaction costs to the “costs of running economics system” (cited in Williamson, 1981, p.1541).

There are two categories of transaction costs, namely (1) The ex ante transaction costs – which include information costs, contract negotiating and safeguarding costs, and (2) the ex post costs – which include contract enforcement costs, coordinating costs, and holdup costs (Williamson, 1985 cited in Kulkani & Heriot, 1999; Hallwood, 1990 cited in Rivers, 2004).

2.2)Transaction costs and production costs
Transaction and production costs are the key factors when the firms decide how to perform the economic tasks. As mentioned above, transaction costs are the costs associated with exchange in economy. This is assumed that the firms encounter costs in any exchange activities (Hobbs, 1997). On the other hand, production costs are the cost of organizing a particular task by the firm itself. The production costs are influenced by the resources requirements, scale of operations and experience in performing a task (Bello, Dant & Lohtia, 1997). Coase (1937) elaborates that both costs are determined by the firms perform the economic activities. A firm is likely to persist the activities until the cost of manipulating an additional activity has become equivalent to that of organizing the same transaction by using the market. Obviously, these costs especially transaction costs affect to the firm’s choice, which will be explained in section 3.

As regards the theory of TCE, transaction costs of the firms are based on two assumptions: (1) bounded rationality and (2) opportunism (Williamson, 1981). Both of these focus on the behavior of economic agents. The term “bounded rationality” refers to the limitation of human’s capabilities in coping with the complex situation, processing the information, and attaining the rational objectives (Besanko, Dranove, Shanley & Schaefer, 2003). This imperfection of individuals tends to impinge on their...
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