Transaction Costs Economics

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The conditions of doing businesses change dramatically for the past century and especially for the past 30 years. With the continuous improvement of the infrastructure marked by transportation, communications and technologies, as well as changing role played by the government and the financial markets, firms found new ways and equipped with new abilities to control their operations and interact with suppliers, customers, competitors and other stakeholders. Given the above infrastructure changes, vertical integration became a logical option for firms as the demand of product and market size increased tremendously which allowed the high-volume production since the early 90s. With the continuous advancement of the production and telecommunications technologies, it comes to a stage whereby market became a viable substitution of organisation as the exchange coordinator. Hence, one of the most important strategic decisions of firms is to define their boundaries and under what circumstances should they consider using market instead of internal organisation to coordinate exchange. This essay is to try to describe the key characteristics of Transactions Costs Economics (hereafter TEC) and with real life examples given as how it affects the decision of using market vs. organisation. Also, by quoting the example of Sony (battery), Apple (iPod) and firm that I am working with, we can see how firms define their vertical boundaries and what is the role played by coordination in a vertical chain.


One of the principle contributors to the study of TEC is Oliver E. Williamson. While Williamson drew on the earlier work done by Ronald Coase regarding the concept of transactions costs, he further advanced it and had developed the Transaction Costs Analysis (TCA) theory in the 1970s and the 1980s. In the neo-classical approach of economics study, firm is treated as a “black box”, and internal workings of which were not considered to be important. TEC, however, argued differently. It tried to explain why firms exist and why they existed in a particular form of structure and the extent to which it will integrate vertically, given the existence of transaction costs. Transaction costs can be aroused from: researching potential suppliers

collecting information on prices
negotiating contracts
monitoring the supplier’s input
legal costs incurred should the supplier breach contractual negotiations

Another key characteristic of TEC is its underlying assumptions, namely bounded rationality and opportunism. Bounded rationality refers to the fact that people are bounded by the limits of their own knowledge and memories. People may also be bounded in their rationality when they are overloaded with information which is beyond their processing abilities. Opportunism refers to the possibilities that people might try to maximize their own benefit by lying about their true intentions or chances that people might exploit another party by taking advantage of unforeseen situations. It is worthwhile to mention that while TEC had tried to modify the assumptions under neo-classical decision theory by adding the deceitful human behaviour element in TCA, the core assumption of profit maximisation is still maintained. One of the key methods to maximize profit is to minimize costs. By assuming that management and the owners of the firms are rational, they must compare the cost of internal co-ordination, which includes the cost of internal production and the cost of governance, to the cost of using the markets, which includes external production cost and transactions costs. In essence, management is considering the “Make or Buy” decision when they do the cost comparison exercise.

With the assumptions highlighted above, TEC then attempts to explain why a firm will integrate vertically by specifying three attributes that are used to characterize any transactions s, i.e. Frequency, Uncertainty and Asset...
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