Transaction Cost Theory

Whenever people work together, there are costs—transaction costs—associated with controlling their activities. Organizations also interact just like people to get the resources they require, and they have to control those symbiotic and competitive interdependencies.

According to transaction cost theory, the goal of the organization is to minimize the costs of exchanging resources in the environment and the costs of managing exchanges inside the organization.

Organizations try to find mechanisms that make inter-organizational transactions relatively more efficient. This is achieved by trying to minimize transaction costs and bureaucratic costs because they siphon off productive capacity.

Sources of Transaction Costs

Transaction costs result from a combination of human and environmental factors. The sources of transaction costs are given below:

  1. Environmental uncertainty and bounded rationality.
  2. Opportunism and small numbers.
  3. Risk and specific assets.
  4. Internal transaction costs.

These sources of transaction costs are discussed below:

Environmental Uncertainty and Bounded Rationality

The environment is characterized by considerable uncertainty and complexity. People only have a limited ability to process information and to understand the environment surrounding them.

The rational model is based on the premise that managers optimize when they make decisions. Herbert Simon Opens in new window is of the opinion that “The assumptions of perfect rationality are contrary to fact. It is not a question of approximation; they do not even remotely describe the processes that human beings use for making decisions in complex situations”.

Since decision-makers do not follow rational procedures, Simon proposed the bounded rationality model.

The bounded rationality model represents the notion that decision makers are “bounded” or restricted by a variety of constraints when making decisions.

The bounded rationality model suggests that decision making is characterized by:

  1. Limited information processing: It is difficult for managers to identify all possible alternative solutions and hence fail to evaluate all potential alternatives.
  2. Judgmental heuristics: This represents rules of thumb or shortcuts. Shortcuts represent knowledge gained from past experience to evaluate current problems.
  3. Satisfying: Satisfying consists of choosing a solution that meets some minimum qualifications one that is “good enough”. Satisfying resolves problems by producing solutions that are satisfactory, as opposed to optimal.

Because of this limited ability or bounded rationality, the higher the level of uncertainty in an environment, the greater the difficult of managing transactions between organizations.

Environmental uncertainty may make the cost of negotiating, monitoring, and governing agreements so high that organizations resort to more formal linkage mechanisms such as strategic alliances, minority ownership or even mergers to lower transaction costs.

Opportunism and Small Numbers

People do not always behave honestly. They sometimes behave in an opportunistic way and attempt to exploit other stakeholders in the environment. This tendency of people to behave opportunistically increases if an organization is dependent on one supplier or a small number of suppliers.

In other words, if an organization is dependent on a small number of trading partners, the potential for opportunism is great. This situation is so because the organization has no choice but to transact business with supplier who may take things for granted because he is the sole supplier and might choose to supply inferior inputs to reduce costs and increase profits. When the prospects for opportunism is high because of small number of suppliers to which an organization can go for resources, the organization has to expand resources to negotiate, monitor and enforce agreements with its suppliers to protect itself.

Risk and Specific Assets

Specific assets are investments (in skills, machinery, knowledge and information) that create value in one particular exchange relationship but have no value in any other exchange relationships.

An organization that sees any prospect of being trapped will judge the investment in specific assets to be too risky. The transaction costs associated with the investment become too high and value that could have been created is lost.

The table below shows transaction costs and the conditions under which it is low or high:

Transaction costs and the conditions under which it is lowTransaction costs and the conditions under which it is high
  • Uncertainty is low
  • There are many possible exchange partners
  • Organizations are exchanging non-specific goods and services
  • Uncertainty increases
  • The number of possible exchange partners falls
  • Organizations begin to exchange more specific goods and services
Table 1.1 Transaction Costs and the Conditions Associated with It.

According to the transaction cost theory, an organization acting in a high-transaction cost should choose a more formal linkage mechanism to manage exchange as transaction costs increases. The more formal the mechanism used, the more control organizations have over the behavior of another organization. Therefore from the transaction cost perspective, the movement from less formal to more formal linkage mechanism occur because of an organization’s need to reduce the transaction costs of its exchanges with other organizations.

Internal Transaction Costs

Internal transaction costs are also called bureaucratic costs. managing an organization’s structure is a complex and expensive problem that becomes much more expensive and complex as the organization grows.

Transaction costs inside the organization must be minimized but we cannot eliminate the costs of managing transaction.

Employees and managers must still negotiate, monitor and govern exchanges between people inside the organization. Integration and communication costs money because managers have to spend their time in meetings rather than creating value.

Using Transaction Cost Theory to Choose Inter-Organizational Strategy

Transaction cost theory brings into focus the cost associated with the different linkage mechanism. Cost associated with different linkage mechanisms reduce uncertainty and make prediction of choosing an organization to be a trading partner.

Transaction cost theory can help managers to choose an inter-organizational strategy by enabling them to weigh the savings in transaction costs achieved from using a particular linkage mechanism against the bureaucratic costs of operating the linkage mechanism. Managers deciding which strategy to pursue must take the following steps:

  1. Know the different transaction costs and decide how high the transaction costs are likely to be.
  2. Estimate the transaction cost savings from the different sources.
  3. Estimate the bureaucratic cost of operating the linkage mechanism.
  4. Choosing the linkage mechanism that is the most cost efficient.

The implication of the transaction cost theory is that a formal linkage mechanisms should be used only when transaction cost are high enough to demand a formal linkage.

Relatively informal mechanisms avoid the need for organizations to avoid bureaucratic costs and minimize transaction costs. The most important linkage mechanism used by organizations are:

Keiretsu

Keiretsu is the policy of owning a minority stake in the supplier company gives the organization substantial control over exchange relationship and allows the organization to avoid problems of opportunism and uncertainty with its suppliers.

Keiretsu is the Japanese term for the mechanism for achieving the benefits of a formal linkage mechanism without incurring its costs.

Franchising

A franchise is a business that is authorized to sell a company’s products in a certain area. The relation between franchiser and franchisee is symbiotic.

Products like cars are typically sold through franchised dealers because the customers need adequate information before they buy a car and also because dealers need to provide customers with reliable car repair. The transaction cost approach offers an interesting insight into why inter-organizational strategies such as franchising emerge.

Outsourcing

Outsourcing is moving a value creation activity that was performed inside an organization to outside organizations.

The transaction cost approach sheds light on why and how organizations choose different linkage mechanisms to manage their interdependencies. Solutions exist for managing uncertain resource exchanges and organizational interdependencies.

These solutions range from less formal mechanisms like contracts to more formal mechanisms like ownership. The best mechanism for an organization is one that minimizes transaction and bureaucratic costs.