Transaction Cost Economics

Cost Economics (TCE)

Ronald Coase (1937) observes that market prices govern the relationships between firms but within a firm decisions are made through entrepreneurial coordination.[i]

Suppliers in the market can leverage on economies of scale to produce goods and services at highly competitive prices by leveraging on core competencies and achieving unit-cost savings from their extensive reach into a bigger pool of customers serving a market with greater breadth, length and depth.

Coase conceives the transaction cost approach to the theory of the firm. Transaction cost refers to the cost of providing for some good or service through the market rather than having it provided from within the firm.

Transaction costs include direct costs such as:

• Price of the goods

• Information costs

• Bargaining and decision costs

• Leakage of Private Information

• Enforcement costs

Transaction costs also include indirect costs that arise when one or more firms act opportunistically by exploiting incomplete contract. The adverse consequences of opportunistic behavior, as well as the costs of trying to prevent it, are the main focus of transactions-costs economics (TCE).

Besanko et al (2010) postulates that contract law might address the opportunism that can arise under incomplete contracting, but it is unlikely to eliminate it. Thus, incomplete contracting will inevitably entail some transaction costs. Three important theoretical concepts from transactions-costs economies are: relationship-specific assets, quasi-rents, and the holdup problem.[ii]

Paul Milgrom and John Roberts (1992) explain that coordination is especially important in processes with design attributes, which are attributes that need to relate to each other in a precise fashion; otherwise they lose a significant portion of their economic value.[iii] Because of incomplete contracts, firms cannot rely on them to ensure adequate coordination of design attributes....