Transaction Cost Theory of the Firm
The transaction cost theory of the firm is the understanding that firms must establish a price for goods and services below that of the market price. Establishing costs below the market price requires and understanding of transaction costs and how these costs work in the short-run relative to the long-run. Transaction costs are specifically the following: “search and information costs, bargaining and decision costs, and policing and enforcement costs.” (Watkins, 2013) Transaction costs tend to be higher with short-term contracts in comparison with long-term contracts due to the level of uncertainty and the relative non-stickiness of market prices in the short-run.
“The unsuitability of short term contracts arise from the costs collecting information and the costs of negotiating contracts. This leads to long term contracts in which the remuneration is specified for the contractee in return for obeying, within limits, the direction of the entrepreneur.” (Watkins, 2013) McIvor offers an explanation of transaction cost economies. “Transaction Cost Economies (TCE) and the resource-based view (RBV) of the firm have been extremely influential in the study of outsourcing both in theory and practice. The research findings emphasize the utility of integrating TCE and the RBV, and highlight the importance of operations management concepts such as performance management, operations strategy, business improvement and process redesign to the study of outsourcing.” (McIvor, 2013)
McIvor’s explanation of transaction costs is that of a resource utilization approach that seeks to define transaction costs as a function of the underlying resources used to enable the transaction. In a sense, McIvor’s explanation is akin to the Cost of Goods Sold calculation used in Managerial Accounting. The resource utilization approach however, as an economic approach, must take into account direct and indirect costs, as well as externalities such as a free rider problem, if any. The tangible framework of firm operations is addressed with TCE & RBV to which the effectiveness through efficiency approach to address the control of transaction costs is applied. A reduction in transaction costs are therefore enabled through the outsourcing and potential insourcing of activities related to the manufacturing and distribution of goods and the rendering of services.
Drawing from the 1937 Ronald Coase paper, Oliver seeks to argue that “governance is the overarching concept and transaction cost economics is the means by which to breathe operational content into governance and orga-nization.” (Oliver, 2009) Transaction cost economics is rationalized as the means that comprises the cost of the factors of production, which according to Oliver, does result in the operational content structured into the governance and organization of the firm. This hypothesis is rather intuitive, as transaction cost economics will inherently result in whether there is operational efficiency with regard to the factors of production within any firm. The interesting assumption is that with operations such as oil refining, where the factors of production are attempted to be streamlined and market estimates are used across the spectrum to estimate costs, will have essentially the same cost basis across each firm, from firm A to firm Z.
Analysis of Transaction Cost Economics: The Natural Progression
The Williamson paper seeks to address governance and organization as two critical facets of operation content as a concept of governance. The contract is the focal point of how businesses conduct transactions, since the contract is essentially a written performance metric that compares the firm’s agreed upon cost, which is the agreed upon efficiency to effectiveness ratio, to the firm’s actual cost after the fulfillment of contractual obligations. Contractual obligations and the continuity of fulfilling such obligations play a critical role in the long-run effectiveness of a firm in managing its underlying cost structure and therefore meeting profitability targets.
Williamson argues through is resources that “organization and the continuity of contractual relations as important, the resource allocation paradigm made negligible provision for either but focused instead on prices and output, supply and demand; second, whereas the price theoretic approach to economics would become the “dominant paradigm” during the 20th century (Reder, 1999, p. 43), institutional economics was mainly relegated to the history of thought because it failed to advance a positive research agenda that was replete with predictions and empirical testing (Stigler in Kitch, 1983, p. 170). The history of thought relative to institutional economics, lacked a positive research agenda mostly due to the framework of capitalism v. Marxism, which is a debate regarding the efficient use of resource relative to the needs of a population. The firm will undoubtedly apply a capitalist model before seeking to be more efficient though effectively redistributing resources. However the latter may make sense based on the rate of taxation.
The importance of contract performance relative to bottom line profitability is ostensibly what the paper is seeking to establish as a prime importance of business planning and contractual negotiation. The cost of negotiating contracts in the long-run relative to the short-run provides a more effective economies of scale and economies of scope relative to the cost management efficiency ratio of business management at the firm. Without the contractual basis of short-run v. long-run, the firm may run into highly inefficient cost structures that threaten its reputation by forcing decisions that may compromise the firm’s integrity with respect to its governance practices.