Transaction Cost - Essay Example

?Introduction Transaction cost refers to the cost incurred in any exchange or economic intermediation. In economic terms, more specifically, it is the cost of ‘participating in the market. The cost incurred for the exchange of stock is an example of transaction cost. For buying and selling of stock, commission has to be paid for the brokers and this commission is a transaction cost of dealing of stock. For purchasing any good from a market, the price is not the exact market price of that particular good; instead, some other costs above the exact price of the good is incurred. For example, the searching cost (the energy and effort taken to find out the good), the cost of traveling for availing it, waiting time to get it and even the effort of paying it self are the costs incurred above and beyond the market price of that particular commodity. This ‘above’ and ‘beyond’ market price is the transaction cost. Now days, transaction cost is significant in each and every potential transaction. Transaction Cost Economics and Economizing The Transaction Cost Economics is the approach of analyzing the economic organization which considers transaction as the basic unit of analysis and it stresses that economizing the transaction cost is the central part of the analysis in the study of economic organizations. The cost of factors of production (resource inputs) , ie, land ,labor and capital, should be called as resource cost and for the better production, the resource cost should be the minimum. For enhancing the production and productivity, the co-operation and investments in specialization are highly desirable. Co-operation between economic actors and investments in specialization are the major components of productivity enhancement. For achieving this co-operation and investment specialization, cost arises due to the inclination of self interested owners of inputs to shirk the commitments. The costs that incurred for the minimizing the shirking include: i) Searching cost incurred to identify the owners of the inputs (when, where and what type of the required good is available in the market with minimum price) ii) Negotiating or bargaining cost is the cost incurred for implanting an acceptable agreement between these two parties. In stock or asset market, it is the distance between ‘bid and ask’. It also includes the costs of any incentive given to minimize the shirking. iii) Monitoring cost and iv) Enforcement cost In spite of all these costs, residual loss from shirking may exist because of the inability of the above mechanisms to bring the shirking to zero in a complex and uncertain economy. Hence, the costs incurred to minimize the shirking plus the residual loss from shirking together constitute ‘transaction cost’(Hill, 1995). Contributions of Coase and Williams to the theory of Transaction Cost Economizing The origin of the theory of transaction cost economizing can be traced to a contributions of John R Common, 1932, Ronald H Coase 1937 and 1960, Friedrich Hayek, 1945, Herbert Simon, 1951, Chester Barnard, 1938, Philip Selznick , 1949 and Alfred Chandler, 1962. (Williamson, 1981). Among this series, the works of Ronald H Coase and Oliver Williamson are the real milestones. Coase laid the foundations of the Transaction Cost Approach while Williamson built a strong structure for the analysis. Both of them provide suitable and strong theoretical contributions to Transaction Cost Economics under the broad framework of Institutional Economics and they focus on how transactions have to be organized in order to economize the transactions. While describing the applications of transactional economics, it is assumed that different dimensions of transactions have to be identified and the alternative governance structure has to be described. Economizing of transactions can be achieved by discriminatory assignment of transactions to governance structures. The application of transaction cost approach lies both in the demarcation of efficient boundaries between firms and markets and in the governance organization. Coase starts the discussion of economizing transaction cost by focusing on the firms and markets while Williamson’s contributions are mainly around the organization ( Jacques, 1995; Tadelis and Williamson, 2010; Coase, 1984 and Hills 1995). Contributions of Coase- Firm/ Market as Governance Structure It was Ronald H Coase who laid the foundation of development of Transaction Cost Theory in his famous article title ‘The Nature of the Firm’ in 1937. According to Coase, market and firm are alternative methods for co-ordinating production. Firms were given the role of co-ordinators and firms are more preferred to the market as costs connected to the price mechanism exist in firms. The transaction costs related to the price mechanism in a firm consist of the cost discovering the relevant or suitable prices and the costs of negotiating and signing contracts. By the formation of an organization, some market costs can be reduced and the reduction of these market costs is operated through the active interference of some authority like an entrepreneur (Coase, 1937). By considering so, Coase regards firm as a governance structure ‘organizing production’ rather than as a technologically determined production unit. By viewing firm and market as “alternative methods of co-ordination production”, Coase examined that the choice of one mode of production than the other is not taken as given, but is a derived thing. Hence, Coase observed that the economists need “. . . to bridge what appears to be a gap in [standard] economic theory between the assumption (made for some purposes) that resources are allocated by means of the price mechanism and the assumption (made for other purposes) that allocation is dependent on the entrepreneur-coordinator. We have to explain the basis on which, in practice, this choice between alternatives is effected.” (Coase, 1937, p. 389). Later, in 1960, Coase enriched the theory in his article on “The Problem of Social Cost” by re-formulating the existing theory of externality and waving the assumption of zero transaction cost. By observing the Pigou’s advocacy of imposition of taxes on externalities, Coase started to stress on ‘the study of the world of positive transaction costs’ due to the existence of vertical integration in the intermediate product markets (Coase, 1992). By accepting positive transaction cost, Coase introduced three problems. First, while the “black box” or Pandora’s box which consists of all kinds of positive transaction costs gives a “well deserved bad name” (Fischer, 1977, p.322). Second, the transaction costs have immense institutional significance only when they are shown to differ among the different modes of governance (that is, markets and hierarchies). Third, comparative contractual significance will be relevant in a conceptual framework only in a context that allows derivations of predictions and empirical testing. Coase also specifies that without transaction cost, the choice of an institution will not be relevant. Though, Coase has not given precise definition of what a firm is and vivid propositions on when to substitute coordination on the market in the firm, he put forward some important premises like ‘bounded rationality’ and ‘dissimilarity of the transactions’ (Garrouste and Saussier, 2005). The concept of bounded of rationality of entrepreneurs is analyzed by Coase in order to explain the limits of the firm. And the ‘dissimilarity of the transactions’ will increase the costs incurred for a transaction within a firm. The introduction of the term ‘uncertainty’ explaining why sectoral considerations are dependent , is another conceptual contribution, which was enriched later by others in order to formulate the transaction economics in a more structured way. Coase has also considered how a change in the ‘institutional environment’ is crucial in the creation of a firm. All these concepts are strong foundations of transactional economics and real advancements in the theory of institutional economics. Contributions of Williamson- Organizational Failures Framework By 1970’s Oliver E. Williamson put forward new insights into the theory of transaction cost economizing. In his book, “Markets and Heirarchies”, Williamson introduced the concept of “organizational failures”. He indicates that market failures may happen because of the environmental and human factors and the market failures can be better managed by the ‘internal organization of a transaction’ (Garrouste and Saussier, 2005). The main points of argument have been summarized by Williamson as: "(1) Markets and firms are alternative instruments for completing a related set of transactions; (2) whether a set of transactions ought to be executed across markets or within a firm depends on the relative efficiency of each mode; (3) the costs of writing and executing complex contracts across a market vary with the characteristics of the human decision makers who are involved with the transaction on the one hand, and the objective properties of the market on the other; and (4) although the human and environmental factors that impede exchanges between firms (across a market) manifest themselves somewhat differently within the firm, the same set of factors apply to both." (Williamson 1975: 8) Williamson observed that, the binding factors of these ‘human factors’ are ‘rationality’ and ‘opportunism’. ‘Bounded rationality’ means that human beings are likely to be rational, but the physical limitations restrict them (which include the limited capacity of brain to receive and process the information and language limitation of expression). As a consequence of this, humans are not able to identify all future uncertainties and emergencies. These human factors lead to ‘organizational failures’ if they are combined with the ‘environmental factors’. These organizational failures in terms of human factors and environmental factors cause the writing of long-term contracts become costly. And this may lead to a rise in transaction cost. In many situations, opportunist character of human factor may lead to ‘lock-in’ and ‘hold-up’ issues (Williamson 1975). When specialized investment is made by one actor as a transaction, hold up problem occurs. In the situations of ‘hold up’, problems due to the human and environment factors, a system of internal organization is promoted by Williamson as it deals with these problems more efficiently. Adaptive and sequential decision processes are involved in internal organization. Conclusion To sum up, Coase gives an explanation of transaction cost theory through the concept of governance structures while Williamson’s observation is based organization. Coase’s analysis of firm or market as governance structures and William’s ‘organizational failure’s framwork’ are innovative thoughts to Institutional Economics and get more and more importance. And the contributions have become more relevant in the context of newly emerged Information and Communication Technology in which the approach of transaction cost can more aptly be applied (Toyama, 2007. Reference Coase. Ronald, H (1937). “The Nature of the Firm”. Economica. 4(16). 386-405. Coase, Ronald H. (1960). “The Problem of Social Cost”. Journal of Law and Economics. 3(10). 1-44. Coase, Ronald H. (1984), ‘The New Institutional Economics,’ Theoretical Economics, 140 (March), 229-231. Corder, Christian , Richeson, Peter and Mcelreath, Richard (2010). “How Does Opportunistic Behaviour Influence Firm Size? An Evolutionary Approach to Organizational Behaviour. Journal of Institutional Economics. 10 (17). 1-21. Dreze, Jacques (1995), ‘40 Years of Public Economics – A Personal Perspective,’ Journal of Economic Perspectives 9 (2), 111-130 Garrouste, Pierre and Saussier Stephane (2005). Looking For a Theory of the Firm: Future Challenges. Journal of Economic Behaviour and Organization. 58. 178-199. Hill, Charls W. (1995). National Institutional Structures, Transaction Cost Economizing and Competitive Advantage: The Case of Japan. Oraganization Science. 6(1). 119-131. Tadelis, Steven and Oliver E.Williamson. (2007). ‘Transaction Cost Economics’. Manucript. University of California. Berkeley. Toyama, Masao (2007). “A Trnasaction Cost Approach to the Effects of Network Growth on Cost and Price”. Contemporary Management Research. 3(1). 71-82. Williamson, Oliver E. 1975. Markets and Hierarchies: Analysis and Antitrust Implicatiosns, New York: Free Press. Williamson, Oliver E (1981). Economics of Organization: Transaction Cost Approach. American Journal of Sociology, 87(.3). 548-577. Read More