Transaction cost theory
Transaction cost theory is an economic framework that examines the costs associated with exchanging goods and services. It posits that businesses should aim to minimize transaction costs, which can influence their operational decisions, such as whether to engage in internal production or outsource certain functions to other firms. The theory highlights that transactions involve costs related to searching for information, bargaining, and ensuring compliance, thereby affecting the overall efficiency of economic activities.
Originally introduced by institutional economist John R. Commons in 1931, the concept was further developed by Nobel Prize-winning economist Ronald Coase in his 1937 work, "The Nature of the Firm." Coase explored why firms exist and how they manage transactions, proposing that as businesses grow, the costs of organizing transactions can increase, potentially leading to a preference for external partnerships.
Transaction cost theory encompasses three main categories of costs: search and information costs, bargaining costs, and policing costs. These elements are relevant across various economic scenarios, including significant transactions such as real estate purchases. Overall, the theory provides valuable insights into why businesses opt for certain transactional strategies and the implications of these choices within the broader economic landscape.
On this Page
Transaction cost theory
Transaction cost theory is the theory in economics that there is a cost to transactions that exchange resources. The theory explains that businesses should try to minimize the cost of transactions and sometimes, therefore, limit the number of transactions it takes part in. Transactions happen when one party exchanges something with another party. A basic example is Business A buying an item it needs from Business B.
Overview
Ronald Coase was a Nobel Prize-winning economist who worked during the early twentieth century. Coase helped develop the transaction cost theory starting with his book The Nature of the Firm (1937), which explored theories about firms. In the book, he noted that all transactions had costs. He wondered why, then, businesses completed transactions since the point of businesses was to make as much profit as possible and cut unnecessary expenses. Coase explored reasons why he believed different businesses existed instead of just one large business that did everything so it could save on transaction costs.
Coase developed two theories to explain why different businesses existed instead of just one large business. His first idea was that the costs of organizing transactions increases as the scale of the business increases. His second idea was that a large business might not be able to organize itself in such a way that its transactions would cost less to complete than it would cost to perform the transactions with other, outside businesses. Coase’s ideas help explain why, on a smaller scale, businesses choose to transact with other businesses rather than completing all the transactions itself. For example, consider that Company A makes cars. Company A has a choice about either making or buying the computer that goes into its cars. Company A decides to purchase the computers from Company B so that Company A does not have to build a new facility and hire more employees to make the parts. Company A has decided that doing the internal transactions would be more expensive than completing external transactions with Company B.
Three types of transaction costs—search and information costs, bargaining costs, and policing costs—exist. These three types of costs are common to many different types of economic transactions. Think about a common economic activity, such as buying a house. A person buying a home will have to undertake a number of transaction costs. For example, the person will have to search and look up information about homes they want to buy. Then, the person will have to bargain with the seller, and this process could take days or weeks. Finally, the person will have to ensure the other party follows all the promises from their side of the agreement.
Transaction cost economics is a field of economics based on transaction cost theory. This field of economics deals with internal and external transactions, and it often focuses on contracts. Contracts are legally binding agreements made between parties.
Bibliography
Almlof, Hanna and Per-Olof Bjuggren. “A Regulation and Transaction Cost Perspective on the Design of Corporate Law.” European Journal of Law and Economics, vol. 47, 2019, pp. 407–433.
Bylund, Per L. “The Firm vs. the Market: Dehomogenizing the Transaction Cost Theories of Coase and Williamson.” University of Colorado Boulder, 2019, http://leeds-faculty.colorado.edu/jere1232/Bylund.pdf. Accessed 8 Apr. 2020.
Klein, Peter G. “Transaction Cost Theory.” Encyclopedia of Management Theory, edited by Eric H. Kessler. SAGE: 2013.
Masten, Scott E. “Transaction Cost Economics.” Society for Institutional an Organization Economics, 2017, https://www.sioe.org/field/transaction-cost-economics. Accessed 8 Apr. 2020.
Mooi, Erik. Transaction Cost Analysis. Wiley: 2013.
“Transaction Cost Economics.” Rand, https://www.rand.org/content/dam/rand/pubs/monograph‗reports/MR865/MR865.chap2.pdf. Accessed 8 Apr. 2020.
Watkins, Thayer. “The Transaction Cost Approach to the Theory of the Firm.” San José State University, Economics Department, http://www.sjsu.edu/faculty/watkins/coase.htm. Accessed 8 Apr. 2020.
“What are Transaction Costs?” CFI, 2020, https://corporatefinanceinstitute.com/resources/knowledge/economics/transaction-costs/. Accessed 8 Apr. 2020.