Transaction Cost Economy and Its Key Characteristics

TRANSACTON COST ECONOMY AND ITS KEY CHARACTERISTICS

Written by CP Singh

With the development of technology and efficient industrial process and practices, the firms are expanding their economies in scale and scope by using markets. Markets are advantageous because markets exploit the economies of scale, learning curve, and eliminate agency and influence costs. However, Coase questioned that in spite of the efficiencies of the market mechanism, why there is lot of economic activity going within the firms. And he concluded that there are costs to using the market which can be avoided by using the firm. The cost of using markets is known as transaction costs. The theory of transaction costs is further developed by the economist Williamson. According to Williamson, transaction costs mainly depend on bounded rationality, opportunism and trust, asset specificity. Transaction Costs Economics emphasizes on the adverse costs of using market and the costs of trying to prevent them. Transaction cost covers a wide spectrum of possible costs starting from the cost of research and selection process of the market supplier to the preparation and management of the contract to avoid any opportunistic behavior.

The major elements of transaction costs are

1. Increased Contracting Costs:

Every contract should state clear deliverables, their quality and quantity, schedule, cost and terms and conditions to be followed when a foreseeable or unforeseeable event happens, to prevent any act of opportunism. Even though, writing a complete contract covering all eventualities is nearly impossible even by the best writers, however, firms still spend a reasonable amount to have very good and complete contracts. e.g. in Saudi Arabia most of the large organizations employ contact specialists and managers to avoid any pitfalls when dealing with the market, which is a cost to the company.

2. Bounded Rationality

Bounded rationality refers to the limitations of human knowledge to anticipate every possibility while preparing and exsecuting the contract.

For example in every IT project management, there is a risk type called unknown unknowns, for which nobody (including best project managers) has a mitigation plan ahead.

3. Performance Measurement

It is very difficult to clearly specify performance and quality requirements of the deliverables in contracts. e.g. in IT software development projects, the look and feel of an application are very subjective and always incur additional cost because of rework. One reason is the firms (users) cannot anticipate what they want during the project requirements definition and design phase

4. Asymmetric Information ( may lead opportunism):

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