Transaction Cost Economics: Firms vs. Markets
Transaction Cost Theory
Coase’s work, further developed by Williamson, examines why firms exist. It posits that the firm is a resource allocation mechanism, an alternative to the market.
Primitive societies lacked coordination mechanisms to promote trade. The emergence of these mechanisms is linked to the increasing complexity of modern societies.
A specialized company produces many goods. However, the absence of self-sufficient agents forces companies to buy from others. It is necessary to produce exchanges that grant the right to use or consume such goods. The problem is that with increasing specialization, the number of exchanges becomes enormous. There are two primary forms of coordination: markets and organizations.
Market Coordination
Market coordination is achieved through the spontaneous actions of economic agents, manifested in prices.
Under the conditions described by neoclassical theory, the free action of agents leads to optimal resource allocation, with prices acting as a guide to behavior.
But why aren’t all transactions conducted through markets? The reality is that firms exist, and their existence results from individuals’ decisions.
The Firm as an Alternative
Coase raised this question, arguing that using the price system is costly. Transaction cost theory views the firm as a way to organize transactions.
Coase raises two key issues: How can we explain the existence of firms, and why haven’t markets completely disappeared?
The answer lies in the concepts of *transaction* and *transaction costs*. Production costs are not the only source of expenses. The coordination model introduces transaction costs, which are related to agents’ access to information. Two fundamental assumptions underpin this theory: bounded rationality in decision-making and opportunistic behavior.
Types of Transaction Costs
Transaction costs are the costs of operating the exchange system. There are three fundamental sources:
- Information Costs: Searching for agents to participate in the contract.
- Contract Negotiation Costs: Costs arising from the wording and clauses of the contract.
- Guarantee/Enforcement Costs: Surveillance and monitoring of contract performance.
Given these costs, a company must consider whether to manufacture a component internally or purchase it externally (the “make-or-buy” decision).
Internal Coordination Costs
Organizations also face internal coordination costs:
- Loss of Control Costs: The larger the company, the greater the risk of misinterpretation.
- Influence Costs: The functioning of organizations, with a central decision-maker, creates agency costs and favors the emergence of opportunistic behavior.
Organizations coordinate transactions by joining resources.
Uncertainty associated with a transaction increases investment risk, making negotiation more complex and raising transaction costs. A higher recurrence rate (frequency of the transaction) generally reduces the risk associated with the investment.
Criticisms of Transaction Cost Theory
This approach has faced some criticism:
- The assumption of opportunism as a standard behavior doesn’t account for trust.
- Focusing solely on costs and efficiency neglects strategic considerations.
- The theory may underestimate internal coordination costs, assuming that internal disputes are always resolved efficiently through authority.