Transaction Costs

Transaction costs an important device for

explaining existence of different
organizational forms

Also for explaining alternative economic

institutions – markets vs. firms (make vs.
buy)
 Two types of costs
• Managers must consider two distinct types
of costs:
Production and distribution costs – those
costs involved in manufacturing and selling
goods or developing and selling services
Transactions costs – those are costs
incurred in making an economic exchange
Taken together, these determine the total
cost of an activity
 The theorists
• The two economists most closely
associated with transactions costs
economics are Ronald Coase and Oliver
Williamson
• Coase (1937): “The nature of the firm” –
explored why some economic transactions
occur inside of the firm while others are
mediated by the market
 Sources of transaction costs
Two major sources of transaction costs:

1. Human beings have bounded rationality.

(Herbert Simon)
Bounded rationality refers to human
behavior that is intendedly rational but
only limitedly so
 Bounded rationality
• Human beings try to behave rationally (optimize).
• But they are faced with both neurophysiological
limits as well as language limits.
- There are limits on the power of individuals to
receive, sort, retrieve and process information
without error.
- Language limits refer to the inability of individuals to
articulate their knowledge or feelings by the use of
words, numbers or graphics in a way that permits
them to be understood by others.
 Bounded rationality
The presence of bounded rationality means
that comprehensive contracting is not a
realistic organizational alternative.

Because of the existence of bounded

rationality, the parties to a transaction
cannot make provision for every
possible contingency.
 Bounded rationality
Bounded rationality is important when the
limits of rationality have been reached -
i.e., under conditions of uncertainty and/or
complexity.
 Opportunism
2. The second source of transaction costs is
opportunism.

Opportunism refers to self-seeking with guile.

Since contracts cannot be comprehensive,

agents will try to behave opportunistically
when unanticipated events arise.
 Opportunism
They can try to take advantage of existing
loopholes in the contract or even try to
modify the terms of the contract,
• either through actions that directly benefit
them
• or by imposing costs on trading partners to
elicit concessions (examples being strikes,
false claims of dissatisfaction with the
existing terms, etc.)
 Key Dimensions of Individual Transactions

• One can identify key dimensions of

individual transactions such that, in terms
of these dimensions, every transaction can
be mapped into a most efficient
institutional arrangement
• Williamson – three transaction
characteristics are critical: frequency,
uncertainty and asset specificity
 Key Dimensions of Individual Transactions

• The more frequent is a transaction, the

more widely spread are the fixed costs of
establishing a non-market governance
system
• Higher levels of uncertainty and asset
specificity result in a more complex
contracting environment
 Asset specificity
• The problem of opportunism assumes a
serious form under conditions of asset
specificity.
• Asset specificity refers to investments that
are specific to transactions in the sense
that their values in alternative transactions
are significantly lower.
 Asset specificity
• Site specific investments to minimize inventory
and transportation expenses
• Human asset specificity – knowledge valuable for
specific work (that arise from firm-specific
training or learning by doing)
• Dedicated assets – value from significant sales to
a single customer (large discrete investments
made in expectation of continuing business, the
premature termination of which business would
result in product being sold at distress prices)
• Physical asset specificity – design of specific tools
(such as a die for stamping out distinctive metal
shapes)
 Asset specificity
• An example is a rail line built to carry coal
from the pithead to a steel plant.
• If the coal mine were to close down, the
rail line might be useless, i.e., there might
not be any alternative goods to carry.
• Asset specific investments often permit
significant cost savings to be realized (the
cost of transporting coal by trucks will be
much higher).
 Asset specificity
• But such investments are risky in that
specialized assets cannot be redeployed
without sacrifice of value if contracts
should be interrupted or prematurely
terminated.
• This creates the scope for opportunism.
• The Fundamental Transformation
 The Fundamental Transformation
• The Fundamental Transformation applies to
that subset of transactions
- for which large numbers of qualified
suppliers at the outset are transformed into
- what are, in effect, small numbers of actual
suppliers during contract execution and at
the contract renewal interval.
- “lock-in” effect
 The Fundamental Transformation
• The distinction to be made is between generic
transactions where "faceless buyers and sellers...
meet... for an instant to exchange standardized
goods at equilibrium prices" (Ben-Porath, 1980, p.
4) and exchanges where the identities of the
parties matter, in that continuity of the relation
has significant cost consequences.
• Transactions for which a bilateral dependency
condition obtains are those to which the
Fundamental Transformation applies.
 Example
• Upstream and downstream firms
• Upstream firm has spent time and effort in
developing a new software specially fitted
to the needs of the downstream firm
Total costs 200 (140*)
Value to downstream firm 240
Surplus 40
Sunk costs K
Recoverable costs 200 – K
(from other firms)
 Example
• Quasi-surplus = value of the asset in its
present use – value in alternative use =
revenues – the recoverable costs
• Quasi-surplus = 240 – (200 – K) = 40 + K
Suppose that bargaining powers are such
that half of the (quasi) surplus goes to
each party
Without hold-up, upstream firm would get
220 and downstream firm would get
surplus of 20
 Example contd.
Possibility of hold-up:
• Suppose that K = 60, i.e. upstream firm
would at the most get 140 in alternative
use
• Opportunistic downstream firm knows this
and realises that upstream firm can only
refuse to deal with it if it gets less than
140
 Example contd.
Ex ante Ex post
Upstream inventor 200 140
Downstream party 240 240

Downstream party uses unforeseen circumstances

as an excuse to reduce the price (hold-up)
Ex ante Ex post
Contract price 220 190
 Asset specificity
The mine owner who invests in the rail line may
find herself at the mercy of the steel plant using
the coal.
The steel plant may threaten to get coal by trucks.
On the other hand, the steel plant might worry that
after railroad is built, the mine will try to raise the
freight rates, banking on the fact that alternative
transportation modes are too expensive.
This possibility of opportunistic behavior is called
the hold-up problem.
 Hold-up
Is hold-up inefficient?
No, if the investment goes through. There
is only a redistribution of surplus
However, the possibility of hold-up may
discourage investment
 Asset specificity

• If contracts were complete, the hold-up

problems would not arise. The full range of
possibilities and safeguards against these would
be specified in the contract.
• Even though complete contracting is not
possible, the parties can draw up long term
contracts, and try to build into the contract
safeguards against such opportunism, e.g.
through price indexing clauses, cost-plus pricing
clauses, liquidated damages and arbitration
provisions.
 Asset specificity
• However, when asset specificity is substantial,
contractual governance may become very costly.
• That is, the transaction costs of negotiating and
enforcing contracts make it prohibitively costly
to write long-term contracts which specify all
obligations under all contingencies.
• Internal organization of the exchange may then
be the more efficient governance structure and
this provides the rationale for the existence of
firms
• Thus the railroads may buy up the mine –
vertical integration takes place