Transaction Costs Economy

Assignment 1.

Transaction costs economy

1. General overview

Transaction cost economy is an approach of comparing the effect of using firm internal resources with an opportunity to develop same result using market resources. In other words, transaction costs are the costs incurred in making economic exchange or the cost participating on the market.

Our life is full of choices. Making one choice we always have to refuse from the other one, which means getting one value instead of another. The same happening on the market environment. Companies always have to make a choice, and one the critical choices is «make or buy» dilemma.

The solution of this dilemma is based on transaction costs approach. Transaction costs appear when company decided to order goods or services needed within its working cycle from the market. Usually they consist of:

- expenses on contract agreements arrangement;

- expenses arising from incomplete information within the contracts;

- expenses from incorrect behavior of contract parties, such as renegotiations, distrust, reduced investments in relation-specific assets;

- specific assets related expenses.

However these costs are framed by market environment, so sometimes it is more efficient for the firm to go out of the its own production to market and look for the open-market opportunities. The reasoning for this is the following:

- niche specialization of supplier provide higher quality of the goods;

- market supplier can achieve lower break-even due to the economies of scale, so can provide better pricing on its goods;

- market competition also serve as lower boundary for both product quality and pricing.

Besides the benefits of the «buy» choice, there are also constrains here, which are realized at certain circumstances. These include:

- miscoordination of production flow within the vertical chain, due to the possible supply problems, such as delivery delays, inconsistency between the order made and finally produced goods, etc.;

- leak of know-how or other private information;

- transaction related direct expenses (contracts, legal support, due diligence costs, etc.)

So depending on its market environment, industrial specifics and strategic targets each company should decide its own "make or buy" dilemma in different stages of the workflow.

2. Real firm example

As I'm working within insurance industry, for me it is more common to describe transaction costs nature and coordination role within the insurance company.

Insurance is based on providing services of covering potentials risks to its clients. Services are usually divided in three parts - (1) pre-sales and sales part of services, which include product development, promotion and sale to the client, (2) post-sales part, which include insurance policy administration, renewal information, client relation maintaining (3) and the last is claims handling part which take place in case of a claim - it is loss appraisal, loss adjustment, claim payment and claim processing within the company's books.

Analyzing each part of the services we can define whether any transaction costs are possible at this stage of the workflow.

2.1. Pre-sales and sale stage

Product development usually include risk assessment (underwriting), reserves development, product pricing and sales motivation principles development. Any "market opportunity" here means high risk of data leakage or incorrect reserving which is crucial for insurer. So