Opportunity Cost as Transaction Costs - Essay Example

Transaction Costs (development and definitions) and Opportunity Cost (developments and definition), once these have been identified opportunity cost should then be linked into transaction costs, i.e. As there is an opportunity cost associated with every transaction, opportunity cost should be considered as a transaction cost I. Introduction In order for a business to proceed to a decision regarding a specific area of its activities, there should be the criteria that have to be met in order for the above procedure to be considered as completed. However, although in the theoretical area there are plenty of models and empirical evidence that can help the management team to formulate a well grounded plan, in real terms the changes and the turbulences that tend to characterize the commercial markets create significant obstacles towards the establishment of an appropriate and effective business strategy. This paper examines particularly the influence of two economic variables, the transaction costs and the opportunity cost on the planning of the corporate strategy to the level that the above two elements can often interact and have therefore a more decisive role in the relevant process. The definitions and the particular characteristics of the above two criteria of ‘financial measurement’ are presented using a series of examples from their applications in practice. The findings of the literature are also been considered as crucial to the validity of the assumptions made. On the other hand, the reference to the work of Coese and Williamson has been proved valuable to the explanation of these elements’ existence and role in the business environment. II. Transaction Costs – Definition and Description In economics and related disciplines, a transaction cost is ‘a cost incurred in making an economic exchange; a number of kinds of transaction cost have come to be known by particular names, like a) Search and information costs are costs such as those incurred in determining that the required good is available on the market, who has the lowest price, etc., b) Bargaining costs are the costs required to come to an acceptable agreement with the other party to the transaction, drawing up an appropriate contract and so on, and c) Policing and enforcement costs are the costs of making sure the other party sticks to the terms of the contract, and taking appropriate action (often through the legal system) if this turns out not to be the case’. Today, transaction cost economics is used ‘to explain a number of different behaviors. Often this involves considering as "transactions" not only the obvious cases of buying and selling, but also day-to-day emotional interactions, informal gift exchanges, etc.’ [2] Alexander (1992, 191) stated that ‘in classic economics contracts between buyers and sellers mediate market transaction, and the only costs involve the production of goods and services; but in reality transactions may involve other costs as well: the cost of information (e.g., cost and supply data in the course of bargaining contracts, or production factor cost and product quality information in monitoring contract performance), and the investment cost of transaction-specific assets’. Furthermore, it has been found that transaction costs can have a series of forms. More specifically, it is stated that ‘transaction-specific investments include capital; for example, the capital required for a plant to produce a specialized part to a buyers specifications; accordingly, technological production linkages (as in automobile manufacture) are a typical case of transaction costs producing modifications in market forms of organization: in this case, vertical integration whereas human resources are another area of transaction-specific investment; these can include training costs of acquiring specialized skills and more intangible investments in time and energy to build trust between parties in a specific relationship (e.g., an expert consultant-client relationship for a specialized service)’ The determinants of transaction costs are according to Williamson (1985) frequency, specificity, uncertainty, limited rationality, and opportunistic behaviour. Regarding specifically the views of Williamson regarding the transaction costs, it is stated that ‘in the work of this researcher as in those of many economists who have adopted the transaction cost framework, the principle that guides interactions between firms is an economizing principle while the lessons drawn from Williamson are that firms operate within an environment where market power does not matter, where firms try first and foremost to economize, and where conjectural history derived from organizational theory, as bowdlerized by neoclassical economics, provides more information than careful business history’ (Knoedler, 1995, 390) Business economics are closely connected with a theory related with the transaction costs, the transaction – cost theory (as stated by Willimson in 1985). According to this theory ‘organizations and markets differ in their governance capabilities’. However there is also a different assumption regarding the role of transaction cost theory according to which ‘the transaction-cost argument is stated too strongly as organizations and markets are not discrete institutions to which the theory can be straightforwardly applied while a central hypothesis of transaction-cost theory is that inter-unit relationships in which supplier assets are specialized have lower transaction costs inside an organization than when the relationship occurs between organizations’. On the other hand, ‘asset specialization increases the buyers loss if the supply relationship is terminated whereas the potential for a higher loss provides the supplier with an opportunity to bargain for a greater share of the value of the relationship’ thus, as the suppliers assets become specialized, it should be more reluctant to bear the costs of adapting to changes in the buyers needs’ (Poppo et al., 1991, 66). The creation of transaction costs theory can be rooted to the work of Coese who in his study ‘The Nature of the Firm’ (1937) ‘set out to answer a question to which, in his view, economic analysis to that point had offered no satisfactory answer: Why do firms exist? The (mainstream) economic analysis of the day, after all, assumed that the pricing mechanism could provide all of the coordination necessary within the economic system; yet, the firm obviously serves a coordinating purpose, performing functions that could be coordinated instead through the pricing mechanism’. According to the answer of Coese - to the above problem – ‘ there are costs associated with operating through the pricing mechanism, some of which could be reduced or eliminated by internal organization - the integrated firm relationship; this led straight-away to another question: Why then do markets exist? The answer, he suggested, could be found in the existence of costs associated with internal organization, such as bureaucracy costs, which could make coordination through the market superior to that through the firm; this, in turn, raised a third question: What determines the extent of firm versus market coordination? Coase argued that an answer to this question lay in the relative costs of these alternative modes of coordination - which the firm will organize additional transactions internally as long as the costs associated with internal organization are less than the costs of organizing the same transaction through the market; and, since the relative size of these costs differs across transactions, the extent of the firm will differ across, and even within, industries’ (Medema, 1996, 572) According to another researcher (Alexander, 1992 191) ‘the transaction cost theory of planning offers an alternative account of planning in both the public and private sectors’. In this context it has been found that ‘extending economic transaction cost theory into the public and inter-organizational domains suggest that markets - both economic and political - do not need planning; planning is associated with non-market hierarchical forms of organization and organizational systems’. It should also noticed that (Alexander, 1992 191) from a peer economical view, Economic Transaction Cost theory focuses on private organizations and their relationship in the market, deliberately examining and relaxing the market assumptions of classic economics while the same approach can be extended from private organizations and economic transaction to public and government organization and activities in the political market, and from single organizations to inter-organizational systems’. According to Foster (2000, 369) over the past decade, ‘transaction cost economics (TCE) has provided a major stimulus to research on the firm and other organizational forms in the economic system’. The researcher also makes a reference to the work of Oliver Williamson the work of whose ‘represents an important departure from the conventional neoclassical vision of the firm and its activities: rationality is bounded, the firm is not viewed through the lens of a production function but is seen as a governance structure; uncertainty is acknowledged; the specific character of human capital is recognized’. Coase (1937) is also mentioned in order to trace the roots of TCE. The most important argument of Coase, that can be used for the explanation of the creation and the development of TCE, is the one according to which ‘the existence of transaction costs explains the extent of the firm relative to a subcontracting arrangement; the firm, as an organizational structure, achieves lower transaction costs than would prevail in a set of market transactions; this is because subcontracting involves asymmetric information that can result in moral hazard and, therefore, contractual uncertainty that is costly to monitor’. Furthermore, it has been found that in recent years, TCE has dealt ‘with many of the implications of asymmetric information and attendant opportunism in a range of contexts; with regard to intrafirm contracts, TCE adopts a principal-agent perspective on relations between, for example, managers and workers that also involve monitoring costs’ (Foster, 2000, 369). A very important issue regarding the application of transaction cost theory is the existence of inefficient externalities and the method of evaluation of their influence on the firm’s decisions. In this context, Medema (1996, 572) referred to the work of Coese (1960) who demonstrated that ‘under appropriate conditions (in essence, under the standard assumptions of neoclassical theory), including zero coordination costs, inefficient external effects would not persist; the externality problems would be resolved efficiently through bargains among affected agents, and, furthermore, the resulting allocation would be invariant across alternative legal rules of liability; the more general implication of this is that the structure of law does not affect the allocation of resources in society; transactions between agents will move resources into their highest-valued uses irrespective of the legal rules in force’. It is also noticed that ‘returning to the issue of externalities, Coase pointed out that, in a world in which coordination costs are zero, externality problems also could be efficiently resolved through either a single-owner firm (which would take all relevant costs into account) or the government, which could employ various "Pigouvian" remedies to internalize the external costs; however, he argued that the reality of coordination costs - costs associated with market transactions, transactions within the firm, and the bureaucratic, legislative, informational, rent-seeking, etc. processes associated with the Pigouvian remedies - and the fact that these costs differ across mechanisms imply that the final allocation of resources will be impacted by the mechanism employed to resolve externality problems’. On the other hand, Slater et al. (2000, 61) tried to examine a specific aspect of the transaction costs theory, this of the uncertain. In this context, they found that uncertainty is ‘a core assumption in transaction costs theory; it forms the basis of the explanation of transaction costs and also provides a vital link in the conceptual analysis of the transition from market coordination to internal organization; yet, the term itself has been relatively neglected in transaction costs economics; issues of opportunism and bounded rationality have tended to assume a much higher status in analysis’. Towards that direction, the reference to the work of Coase and Williamson is considered as necessary in order to explain the above findings. Regarding specifically the above issue, Slater et al. (2000, 61) stated that ‘Ronald Coase and Oliver Williamson, have steered away from offering a detailed explanation of the nature and origins of uncertainty; Coase, in particular, passes over the Knightian distinction between risk and uncertainty, leaving unclear his own position on uncertainty whereas Williamsons approach places great emphasis on bounded rationality, creating problems in distinguishing uncertainty from complexity; in neither case is close attention paid to the essential "unknowable" character of future events and outcomes--the endemic lack of knowledge about a future world still to be created’. III. Opportunity Cost – Definition and Characteristics Opportunity cost is a term used in economics to mean [1] ‘the cost of something in terms of an opportunity forgone (and the benefits that could be received from that opportunity), or the most valuable forgone alternative; as an example, if a city decides to build a hospital on vacant land that it owns, the opportunity cost is some other thing that might have been done with the land and construction funds instead; in building the hospital, the city has forgone the opportunity to build a sporting center on that land, or a parking lot, or the ability to sell the land to reduce the citys debt, and so on’. Furthermore, opportunity cost has been considered as having a central role in the decision making process as it represents the value of ‘the next best alternative’. In this context, its estimation should be viewed as a priority for the management accounting team of an organization which should try to ‘measure the opportunity costs of resources, which, though simple in concept, are difficult to measure, objectively’. As a result of the above difficulties, firms use ‘cost allocations to attribute the cost of shared resources to decision alternatives’ (Balakrishnan et al., 2004, 197) The simplest way ‘to estimate the opportunity cost of any single economic decision is to consider, ‘What is the next best alternative choice that could be made?’ (This is even though most economic decisions involve multiple alternatives) while it is important, as individuals and as societies, to compare the opportunity costs associated with various courses of action; however, some opportunities may be difficult to compare along all relevant dimensions and for this reason economists often try to use the market price of each alternative to measure opportunity cost; this method, however, presents a considerable difficulty, since many alternatives do not have a market price as it is very difficult to agree on a way to place a dollar value on a wide variety of intangible assets’ [3]. In this context, it is stated that since ‘their costs are difficult to quantify, intangible values associated with opportunity cost can easily be overlooked or ignored; to overcome this difficulty, economists have identified certain opportunity costs as spillover costs (or external costs)’. As an example [3], ‘if a chemical producer dumps its waste products into a river, the company has effectively shifted part of the cost of its production onto those living downstream who like to fish; at the same time if a billboard company blocks the seaside view of passers-by, some of its gain in advertising revenue is being paid by the passers-by who enjoy natural vistas, instead of by the companys advertisers’. Typically, spillover costs ‘are imposed by a narrower group (often called a special interest group) which benefits more quantifiably and more concretely, and they are borne by a wider group -- perhaps even the public at large -- which pays less quantifiably and less concretely’. On the other hand, it is stated [1] that ‘opportunity cost need not be assessed in monetary terms, but rather can be assessed in terms of anything that is of value to the person or persons doing the assessing; furthermore the consideration of opportunity costs is one of the key differences between the concepts of economic cost and accounting cost while opportunity cost is not the sum of the available alternatives, but rather of benefit of the best alternative of them’. A common model for the representation of the opportunity cost [4] – in the economics area – is the ‘production possibility boundary (the PPB, also called the production possibilities curve (PPC) or the “transformation curve”) which is a graph that depicts the trade-off between any two items produced while it indicates the opportunity cost of increasing one items production in terms of the units of the other forgone; an additional trade-off exists between the reward (i.e. sales) of the produced good and the opportunity cost of that good; a choice is non-improvable if the direct reward is higher than the opportunity cost; there is an equilibrium between these two’. Figure 1 – Representation of opportunity cost – [4] IV. Interaction between Transaction Costs and Opportunity Costs A common point between transaction costs and opportunity cost is that they are both treated differently among the markets and the particular organizations. Especially regarding the transaction costs they have been found to be treated differently in accordance under the influence of specific geographic, financial and cultural elements. Moreover, the ‘basic proposition of transaction-cost economics is sound: supplier asset specificity within the corporation is associated with lower transaction costs than asset specificity in the market; in this context the hybrid characteristics of the organization and markets have been found to be major factors of influence when estimating the transaction costs’ (Poppo et al., 1991, 76). The opportunity cost, to an analogous manner will be evaluated differently in accordance with the local sociocultural and financial conditions of a specific market. Regarding the business decision for the entrance in a foreign market, transaction cost theory accepts that ‘the costs of finding, negotiating and monitoring the actions of potential partners influence entry mode choice; it also suggests that market based modes are normally preferred because a firm can benefit from the scale economies of the market place; however, a firm may encounter increased costs in finding or negotiating a market based agreement either (1) because of the difficulties of estimating and including all contingencies in the agreement, or (2) because of the inability to receive a fair price due to problems with information asymmetry while monitoring and enforcing market contracts may be difficult due to distance, communication problems or the lack of measurable outputs’ (Brouthers, 2002, 204). As for the opportunity cost, it is a variable which has to calculated before any relevant business decision and for this reason its influence on the specific choice of entering a foreign market will be in any case crucial. Regarding especially this use of transaction cost theory the study of Luo (2004, 524) showed that ‘as one of the most critical decisions in international expansion, entry mode choice has strong implications for organizational control over foreign operations, investment risk involved, and resource commitment required while research has hence proliferated in the past 15 years to explore how entry mode is selected, and the factors that determine this selection; in this context major theoretical explanations of foreign entry mode choice include evolutionary process logic, the knowledge-based perspective, and transaction cost economics (TCE)’. On the other hand, Brouthers et al. (2004, 229) referred specifically to the international entry mode choice of the medium-sized enterprises using as a criterion for the formulation of the relevant decision the transaction cost theory. According to their views, small and medium-sized enterprises (SMEs) are not smaller versions of larger companies, but mainly due to their size they tend to interact differently with their environment; what differentiates SMEs from large multinational enterprises (MNEs) are their managerial style, ownership, and independence; moreover, their limited resources may lead them to very different international strategic choices in comparison to larger firms’. According to the above findings, transaction cost theory can be used equally for the firms of all types both locally and internationally. On the other hand, the research of Brouthers (2002, 212) showed that ‘an extended transaction cost model of mode selection does a good job of predicting entry mode choice’. Moreover, it has been found that ‘although not all the transaction cost and cultural context variables were significant predictors of international mode choice, mode selection appears to be driven by a combination of general transaction cost characteristics, institutional context (legal restrictions), and cultural context (investment risk) variables’. In this context, it has been stated by Luo et al. (2004, 524) that ‘in entering foreign markets, firms progressively shift from exporting to higher forms of international operations such as foreign direct investment as they gradually accumulate and integrate the knowledge of foreign markets’. On the other hand regarding the role of TCE to the formulation of the relevant business decision the above researchers state that ‘whereas this logic emphasizes the importance of the learning experience and cultural familiarity as determinants of entry mode choice, the TCE perspective views the entry mode choice as a critical decision of governance; resting on the interplay of two key assumptions of bounded rationality and opportunism and the three key dimensions of transaction (i.e., asset specificity, uncertainty, and frequency), TCE advocates a governance form that can minimize the costs associated with governing and monitoring transactions’. Especially regarding the disputes that may arise when estimating transaction cost, Williamson accepted that sovereignty can be used as an authority to settle this disputes and therefore to create an order. Furthermore, according to Williamson (1985) two different social sites support two different kinds of sovereignty: ‘legal centralism’ or court ordering on one hand, and private ordering on the other’. In this context, dispute settlement is described as a mechanism that provides ‘remedies prescribed in some body of authoritative learning and dispensed by experts who operate under the auspices of the state while private ordering is defined as a sovereignty sited within the social setting of the disputants themselves’ (Dugger, 1996, 427). Regarding this specific issue of dispute settlement, it could be stated that there is a point of interaction between transaction cost and opportunity cost. More specifically, according to the above the dispute settlement can be used as a method of finding solutions in case that there are different claims among the parties regarding the transaction costs. In the field of opportunity cost, this procedure can be indirectly related to the level that when the evaluation of the opportunity cost has failed then a dispute can equally appear which will have to be settled. This assumption can also be supported by the fact that opportunity cost can be regarded as a part of the transaction costs, so that every dispute that may arise regarding the latter will automatically involve the former. Regarding the use of transaction costs and opportunity cost in a social framework, it has been stated by Coase (1960, 23) that ‘in choosing between social arrangements within the context of which individual decisions are made, we have to bear in mind that a change in the existing system which will lead to an improvement in some decisions may well lead to a worsening of others; furthermore we have to take into account the costs involved in operating the various social arrangements (whether it be the working of a market or of a government department), as well as the costs involved in moving to a new system while in devising and choosing between social arrangements we should have regard for the total effect’. V. Conclusion The presentation of the above issues regarding the existence and the role of the transaction costs and the opportunity cost has proved that their interaction cannot be denied in all areas of their application. More specifically, opportunity cost has been found to be – in fact – a part of the transaction costs for every consequence that such an interaction may have for the business activities. However, this assumption cannot be considered as unexpected because in practice all economic variables can interact in particular cases as they are related with the performance either of a business or of a market. Regarding specifically, their level of dependence it has been found that when calculating the transaction costs, a firm has also to estimate the level of the opportunity cost in order to formulate a more complete strategy and to be as secure as possible regarding a specific initiative – particularly when this is of a high value. 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Williamson, Oliver E. ‘Transaction Cost Economics.’ In Handbook of Industrial Organization, edited by Richard Schmalensee and Robert D. Willig. Amsterdam: North Holland, 1989. Williamson, Oliver E. The Economic Institutions of Capitalism. New York: The Free Press, 1985 Zhang, Junxi ‘Liquidity, Transaction Costs and Real Activity.’ Southern Economic Journal 65.2(1998): 308-317 http://en.wikipedia.org/wiki/Opportunity_costs [1] http://en.wikipedia.org/wiki/Transaction_costs [2] http://en.wikipedia.org/wiki/Microeconomics#Cost_of_Taking_an_Opportunity [3] http://en.wikipedia.org/wiki/Production_possibility_frontier [4] Read More