TRANSACTION COST

Executive Summary

The exchange of goods and services is not costless. The transaction cost consists of
discovering the relevant prices of the factors of production and of negotiating and
concluding a separate contract.

Firms are formed to avoid costs associated with undertaking transactions in the market.
A degree of asset specificity, bounded rationality and opportunism would be the main
attribute of the transaction used to explain a firm's governance strategies.

Transaction cost arises due to information is asymmetrically held by parties to the

exchange, asset specificity, quasi-rents and holdup problem. In term of activities
associated with the exchange there are ex ante transaction costs (search information and
negotiation) and post ante (cost of policing contract, coordination, arbitration and hold
up costs). Transaction cost different with production cost; where transaction cost arise
do to economic exchange, production cost is the cost of transforming inputs into outputs.

Market firms enjoy two distinct types of efficiencies, first they exploit economies of scale
and the learning curve, and secondly they eliminate “bureaucracy”. Firms are not
producing everything in the economy and focus their activities on what they do best and
leave everything else to independent outsourcing partners. Market firms may possess
proprietary information or patents that enable them to produce at lower cost. Some firms
might be able to aggregate the needs of many firms, thereby enjoying economies of scale,
and others might exploit their experience in producing for many firms to obtain learning
economies.

The size of the firm is dependent on the costs of using the price mechanism, and on the
costs of organisation of other entrepreneurs. The most efficient size for a firm is when the
organizing cost of adding more people is equal to the transaction cost of bargaining with
them, and that this is therefore the size that firms will naturally seek. Firms which try to
eliminate transaction cost and produce internally the size of the firm will be larger and
the firms which do outsourcing, the size and structure of the firm will be lean.

1. According to transaction cost economics what are the costs of using the price
mechanism to organize resources?

Neoclassical economists view the price mechanism as the key to resource

allocation, co-ordinating resources through exchange transactions in the market (Coase in
Rivers, 2006). The exchange of goods and services is not costless and the most obvious
cost of organizing production through price mechanism is that discovering what the
relevant prices are (Coase in Rivers, 2003, p.267). The transaction cost consists of
“discovering the relevant prices” of the factors of production and of “negotiating and

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concluding a separate contract for each exchange transaction” firm. Abdel-latif and
Nugent (1996) suggest that transaction costs include: (i) the costs of obtaining
information about market conditions, (ii) the costs of information (regulations, exchange
rate, restrictions, and tariff), (iii) the costs of each potential party of identifying
appropriate trading partners, (iv) the costs of negotiating, writing, and enforcing contracts
and resolving disputes between parties and (v) the costs of financing the transaction.
These transaction costs change substantially over time with changes in the identities of
the trading agents, environmental conditions and character of the respective markets.

Outside the firm, price movements direct production are co-ordinated through a
series of exchange transactions on the market (Coase in Formaini and Siems, 2003).
Firms are formed to avoid costs associated with undertaking transactions in the market by
allocating resources internally via management directives (Coase in Rivers, 2008).

In the case of medical services, where transaction costs are prohibitively high,
individuals may rely on self-sufficiently (i.e autarky-an economy that is self-sufficient
and does not take part in trade) to produce the final hospitalization service as well as the
composite intermediate product of medical services and capital structure and eliminates
transaction costs by avoiding the use of markets (Rivers, 2006).

If markets were costless to use, firms would not exist. Instead, people would make
arm's-length transactions. Within a firm, these market transactions are eliminated, and in
place of the complicated market structure with exchange transactions is substituted the
entrepreneur –co-ordinator, who directs production (Coase in Formaini and Siems, 2003),
given that markets are costly to use, the most efficient production process often takes
place in a firm (Coase in Pitelis and Pseiridis, 1999).

Firms or organisations exist as an alternative system to the market mechanism

when it is more efficient to produce in a non-price environment. In a labor market, it
might be very difficult or costly for firms or organisation to engage in production when
they had to hire and fire everyday their employees depending on demand/supply
conditions. It might also be costly for employees to shift companies everyday looking for

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better alternatives. Thus, firms engage in a long-term contract with their employees to
minimize the cost. In the case of services, notably by labor, a contract which allows for
the direction of the resources by an entrepreneur is argued to be desirable because it
reduces uncertainty and “marketing costs”. A firm emerges when the direction of
resources, within the limits of a contract, becomes dependent on the buyer (Pitelis and
Pseiridis, 1999).

Suppliers provide the firm with resources in which they are specialised and have
invested over time in order to develop their operations. Thus, their capability is higher
than any firm that develops the operation in-house. That potential for competitive
advantage may be transmitted to firms that acquire the service, in that there will be lower
costs, higher professionalism and higher quality in the services (Espino-Rodríguez, Lai
and Baum, 2008). As an example Dyno Nobel signed a deal with US-based fertilizer
maker Koch Nitrogen Company to get reliable source of ammonia as a factor of
production for fertilizer and explosive (ammonium nitrate) to give flexibility in swing
production of explosive and fertilizers to meet growing demand for fertilizer instead of
producing own ammonia internally (The Age, 2008). Dyno Nobel choose to purchase the
factor of production from other firm because there will be higher costs or lack of skills to
acquire ammonia internally. Sometimes, to avoid high cost in acquiring resource in the
open market, two firms work together to give mutual benefit in getting the resource. In
the automotive industry, Nissan has a lot of expertise in small cars, while Chrysler has an
excellent truck competitive advantage. The two firms expected to have exchange deal
which Nissan will supply small cars to Chrysler and as an exchange get a pick-up truck to
be built by Chrysler (AFR, 2008).

A degree of asset specificity would be the main attribute of the transaction used to
explain a firm's governance strategies. Specific assets are those that are non-utilizable in
another activity or by another agent, except with loss of value. The more specific the
asset the more the firm will internalize the transaction via vertical integration (da Silva
and Saes, 2007).

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 Bounded rationality and opportunism make it difficult for companies to draw up
contracts that fully describe transactions under all future possibilities and will guide them
as circumstances change. Transaction frequency promotes vertical integration, because
transaction costs and risks will be too high, especially when uncertainty and counterparts’
opportunism occur. Companies sometimes integrate to defend against market power or to
create market power through barriers to entry. However, vertical integration is generally
expensive, risky and difficult to reverse (Spina, Campanella, and Codeluppi, 2000).

Highly integrated companies-such as the major oil companies that own and
control their value chain from exploring for oil down to the refining of gasoline tend to
have low expenditures on bought-in goods and services relative to their sales (Grant,
2005, p.393). The example is brewing and petrol industries in UK. Both industries
vertically integrated to guarantee sales in order to protect large sunk investments in
production facilities. A refinery of minimum efficient scale would cost approximately £3
billion, a brewery of efficient scale £200 million. In petrol industry the concentration has
fallen faster, profits have been less robust and the amount of investment committed to
specific assets grown more strongly. The increase in integration in petrol is counter to the
fall in power, but consistent with the increase in transaction costs. In brewing industry,
vertical integration has been more associated with relatively high and stable prices and
barriers to entry (Cook, 1997).

2. Why do transaction costs arise and how are they different from production cost?
Production is the conversion of resources to useful final products in the form of
economic goods or capital (Rivers and Ward, 2004, p. 303). Then, production cost is the
cost incurred in making the final products. In other word production cost is a cost in
transforming inputs into outputs (Mathiesen (1997). General production theory stresses
economies of scale, several factors affect production costs, including resource
requirements, scale effects and buyer experience (Bello, Dant and Lohtia, 1997).
Transaction cost different with production cost because transaction cost is cost
incurred in making an economic exchange, not a cost in making final products.
Transaction costs consist of costs incurred in searching for the best
supplier/partner/customer, the cost of establishing contract, and the costs of monitoring

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and enforcing the implementation of the contract. Transaction costs, often known as
coordination costs, are well defined as the costs of "all the information processing
necessary to coordinate the work of people and machines that perform the primary
processes," whereas production costs include the costs incurred from "the physical or
other primary processes necessary to create and distribute the goods or services being
produced"
Transaction cost arise because of information is asymmetrically held by the
parties to the exchange. The assumptions of the neoclassical economic model suggest
that all parties to an exchange process have the necessary information to make rational
choices. In particular, this implies that all parties to an exchange are able to process the
exchange at zero cost (Loader, 1997). Even with symmetrical information, there is a cost
of affixing prices to the quantities being exchanged, such as auctioneer appointment,
broker or dealer (who is compensated by some bid-offer spread), and may involve
expenditure on actuarial or cost accounting calculation (Hallwood in Rivers, 2003,
p.273).
Transaction cost arises also because of asset specificity. An asset is specific (site,
physical asset, dedicated asset and human asset specificity) or idiosyncratic when it
cannot be reallocated to another use without its value falling significantly ((Espino-
Rodríguez, Lai and Baum, 2008). Asset specificity raises the prospect for opportunism
(Demsetz, 1991). Rents and Quasi-rents led to arising of transaction cost (Besanko,
Dranove, Shanley and Schaefer, 2007, p. 122). As an example when a contractor
producing cup holder for Holden cars with certain amount of investment (unavoidable
cost) and expect to earn economic profit of $3,000; but if the contractor end up in selling
the cups to open market the contractor will get $2,000 economic profit only (because of
additional cost for product adjustment); then quasi-rent is the difference between the
profit from dealing with Holden and the profit with next best option (open market); that is
$1,000. Transaction cost may arise also when there is hold up problem. With incomplete
contracts and relationship-specific assets, quasi-rent may exist and lead to the holdup
problem (Rivers, 2008).
In term of activities associated with the exchange, transaction cost can be broken
down into ex ante transaction costs of market exchange (cost of searching, cost of

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information, negotiation or bargaining cost) and post ante transaction cost of market
exchange ( cost of policing contract, coordination costs of contracting in the labor
market, arbitration and hold up costs of rent appropriation by the opportunistic party)
(Rivers, 2003, p.268-269,278).
In practice, it is not easy to distinguish between production costs and transaction
costs. An example if production is lost due to delays in planning, is it the result of slow
planning by the employee (transaction cost) or of a technology that cannot adapt quickly
to late changes in the plan (production cost)? (Sulejewicz and Graca, 2005).
Figure 1 shows how transaction cost are different from production cost (Rivers,
2003; Mathiesen, 1997):

All economic costs

Production costs Transaction costs

The costs of transforming inputs The costs of making exchange or
into outputs or the indirect production expenses
the direct production expenses

Motivation costs Coordination costs

The costs of motivating specialized agents
allign their interests, e.g:
- Cost of cheating or opportunistic behavior (ex post)
- Cost of policing contract (ex post)
- Agency cost among owners, managers
and debt holdres
The costs of coordinating the actions
between specialized agents, e.g:
- Cost of obtaining information, contract,
negotiation (ex ante)
- Cost of coordinating input in production (ex post)
- Cost of measurement (ex post)

Cost are mainly caused by Cost are mainly caused by

opportunism bounded rationality

Figure 1. All economic costs: production costs and transaction costs

Source: Rivers (2003), An indirect approach to the identification and Measurement of Transaction Costs

Mathiesen (1997), Encyclopedia about corporate governance

3. Why do we not have the situation of one single firm producing everything in the
economy?

According to Besanko, Dranove, Shanley, Schaefer; firms use the market (or
“buy”) primarily because market firms are often more efficient. Market firms enjoy two
distinct types of efficiencies. First they exploit economies of scale and the learning
curve, and secondly they eliminate “bureaucracy”. There are reasons why firms are not

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producing everything in the economy and focus their activities on what they do best and
leave everything else to independent outsourcing partners. Firstly, market firms may
possess proprietary information or patents that enable them to produce at lower cost.
Secondly, they might be able to aggregate the needs of many firms, thereby enjoying
economies of scale, and thirdly they might exploit their experience in producing for many
firms to obtain learning economies (2007, p 113).

Prompted largely by strategic and production cost considerations, the big three US
automobile manufacturers now routinely conduct joint primary research, and have
recently filed for joint patents. These manufacturers perceive the threat of international
competition as strategically far more important than the competition and rivalry between
themselves. Their cooperation is motivated by strategic and production cost
considerations. The high costs of internal production and strategic considerations account
for the large number of manufacturing partnerships that established in the microprocessor
industry (Bello, Dant and Lohtia, 1997).

The decision to outsource part of a company's functions or activities is prompted

by a variety of considerations. These include potential cost savings, access to
technological innovations and strategic considerations, concerned with scale and scope
economies and possibly growth expectations (Juma'h and Wood, 2000)

Costs/Risks Quality/Skills:
• Ex Ante Cost • Higher Unit Specifications
• Unit Price • Flexibility
• Ex Post Cost • Lower Error Rates

Decision to
outsource

Individual Situational
• Emotions • Political Context
• Values and Beliefs • Historical Development
• Bounded Rationality/Egoism • Operational Pressures

Figure 2. Factors that impact on the decision to outsource

Source : Dickmann & Tyson (2004), Outsourcing payroll: beyond transaction-cost economics

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 As illustrated on Figure 2, there are several categories for reasons to outsource
(Dickman & Tyson (2004) :

a. Rationale on Cost/ Quality motivation:

1. Cost/risks. Reasons to outsource are: lower external unit price, less investment in
software/maintenance and keeping up with changes in regulations. On the
contrary, reasons not to outsource are: lower internal unit price and lower
flexibility due to lesser information
2. Quality/Skills. There are reasons to outsource for higher quality-organisation too
small to employ specialist, acquire highly technical skills, and too high error rate
when done internally. Some reasons not outsource: lower flexibility to give
instructions to staff (e.g. carry out “quick” calculations), important to provide
good service for employees that will made better to be done in-house.

b. Beyond Cost/Quality motivation:

1. Situational. Reasons to outsource are: to keep human resource lean and there will
be a way to blame others when something wrong (political context); have always
outsourced before; specialist did not want to work in particular locations
(historical); get rid of mundane work to concentrate on more important activities
and too much to do to carry out payroll internally with existing staff (operational).
Reasons not to outsource are: no pressure to improve efficiency and keep power
base in particular department (political); always work internally or have bad
experience in outsource before (historical); and have sufficient skills to do
internally (operational)
2. Individual. Reasons not to outsource are people like in having full scale of
department to maintain director’s marketable skills and mistrust agreements with
service providers.

In the beginning of the 1990s, Fiat identified some crucial objectives: the reduction of
production and development costs; the improvement of quality standard levels; the
renewal of the product range; the enforcement of the globalisation strategy; and a new

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product development strategy and organisation. To achieve these goals Fiat decided to
revolutionise its business portfolio towards a strong rationalisation that led the company
to a straight process of outsourcing. Many other Fiat’s businesses, including in-house
operations, were sold off. Most of the sales involved a supply contract with Fiat which
gave new entrants in the Italian market profitability from the start. Whilst it was selling
its subsidiaries, Fiat also expanded its manufacturing activities in other countries and
started to buy components from non-Italian companies, both for its foreign and its Italian
activities. Today, Fiat out sources about 73 per cent (in terms of the production costs) of a
Fiat Punto, one of Fiat’s best sellers. Finally, in March 2000, Fiat Auto set up an
agreement with GM based on an equity swap and, from the operational point of view, on
the formation of two companies in which all the Fiat Auto and GM (Europe and Latin
America) activities related to purchasing, engines and transmissions design and
production have been merged (Zirpoli and Caputo, 2002).

3. Why would the structure or size of a firm change due to transaction costs?
Firm size is determined by benefits and costs of specialization of labour, resulting in
economies of scale. The degree of specialization would be limited mainly by the extent of
the markets. Enterprises have a finite size due to positive transaction costs. In the absence
of any transaction costs, firm size is limited by the size of the market only (assume
perfect competition). Transaction costs are necessary to ensure both a finite number of
hierarchical levels and a finite team size. When the enterprise has reached its optimal
size, marginal profits become zero and additional subordinates are no longer beneficial.
In other words, the production technology is modelled in such a way that after a certain
point, the supply curve becomes upward sloping (due to decreasing returns to scale) (den
Butter, van Gamerens, and de Kok, 2001).
Other things being equal, therefore, a firm will tend to be larger:
(a) the less the costs of organizing and the slower these costs rise with an increase
in the transactions organized;

(b) the less likely the entrepreneur is to make mistakes and the smaller the
increase in mistakes with an increase in the transactions organized;

(c) the greater the lowering (or the less the rise) in the supply price of factors of
production to firms of larger size.

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 Apart from variations in the supply price of factors of production to firms of
different sizes, the costs of organizing and the losses through mistakes will increase with
an increase in the spatial distribution of the transactions organized, in the dissimilarity of
the transactions, and in the probability of changes in the relevant prices. However,
efficiency will tend to decrease as the firm gets larger as more transactions are organized
by an entrepreneur, the transactions would tend to be either different in kind or in
different places. Inventions which tend to bring factors of production nearer together, by
lessening spatial distribution, tend to increase the size of the firm. All changes which
improve managerial technique will tend to increase the size of the firm (Coase in
Formaini and Siems, 2003).
Hence, if the firms try to eliminate transaction cost and produce internally the size
of the firm will be larger. If the firms expect to focus on the core competence and
outsource factor of productions to other firms (that in turn increasing transaction cost
through negotiations, long term contract and policing), the size and structure of the firm
will be lean. In the Fiat example, by doing outsource and sell non core business, Fiat
reduce the structure of the organisation and doing more transaction cost in term of value
and frequency.

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