Transaction Cost Economics

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Companies have two choices- hierarchy solution (production, supply and purchase of inputs internally) and market solution (production, supply and purchase of inputs externally in market place). The decision will be made based on the comparison of the transaction cost of these two choices. Managers, therefore, must carefully weigh the internal transaction costs against the external transaction costs before the company decides whether to keep some activity in-house or to outsource it. When the transaction cost of doing the activity externally is higher than doing the activity internally, the company will grow. On the other hand, if internal transaction costs exceed the external transaction costs, then the company will be downsized i.e. by outsourcing the activities.

The transaction cost of outsourcing is often high because you have to constantly monitor whether they are performing the activities up to the mark or not. The case is even more difficult when environmental uncertainties are high. They might also act opportunistically. Therefore, companies might choose to not outsource if the environmental uncertainty is very high. However, there is a natural limit to what can be produced internally. As the company grows bigger, overhead costs will ultimately rise and so will the internal inefficiencies. The diminishing returns will kick in. So, there is an extent to the firms growing large and there comes a point where external market becomes a cheaper option.

Transaction cost economics and corporate governance

Managers loathe uncertainty. So, they are likely to own things or have a long term contract in place. This would make their lives easier through increased control and certainty over the foreseeable future. Also, this would mean a reduction in transaction costs in terms of searching and bargaining with a new supplier every time.

So, does this mean that internalizing the transactions by entering into a long term contract or vertical integration is always good then? Not necessarily. Whereas uncertainty is reduced to a great extent, the managers might be missing the better opportunities that are available in the market. This will give rise to the case of bounded rationality. Managers might deviate from the goal of maximizing the shareholders’ wealth in making their own life easier.

The main theme of transaction cost economics is that a firm could significantly reduce transaction costs by internalizing the activities rather than outsourcing them in the external environment. The reason is that by internalizing the transactions, the uncertainties are minimized to a huge extent. If the market is efficient then goods and services can be procured at a low price. But, this does not mean that a firm should grow larger and larger. There comes a point where external market becomes relatively cheaper because of increased inefficiencies as the firm grows large.

In an attempt to internalize most of the transactions in order to reduce uncertainty and increase control, the company grows bigger and bigger by adding more staffs, assets, contracts and so on. The company might grow big so much so that the efficiency is lost. The gap between the directors and the shareholders also grows wider and wider giving rise to various corporate government issues. Agency problem increases in that directors make decisions that are good for them rather than for its shareholders.

So what could the large corporations do then? As stated by Williamson, large corporate groups could overcome the challenges posed by the diseconomies of scale by the choice of governance structures. The governing structures include internal and external audit controls, information disclosure, independent outside directors, separation of board chairmanship from CEO, nomination and remuneration committees and so on. Companies should, however, bear these costs up to the point where increase in costs is equal to the reduction of potential costs that might occur from non-compliance.