TRANSACTION COST ECONOMICS
The
first academic discipline that addressed the role of firms from a theoretical
point of view was economics. However, classic economic theory viewed the firm
just as a production function, a black box that was able to (somehow) transform
a set of productive factors into a set of products and services. Such an
oversimplified view of the firm is appropriate to study the functioning of
markets, but it proves limited for managerial purposes, since it ignores the
big issues of internal coordination and motivation that distinguish firms
from markets. Along the 20th Century several theories of the firm have tried to
open the black box and explain the role of firms in the economy and their
internal functioning.
The contractual theories of the firm have their origin in the early work of Ronald Coase (1937) on the Nature of the Firm, which was expanded later on by Oliver Williamson (1975) in his path-breaking book Markets and Hierarchies. Both authors were awarded the Nobel prize in 1991 and 2009, respectively. The first of the three contractual theories is known as Transaction Cost Economics (TCE) and comes from the work of these two authors. TCE is interested in explaining why we need firms in a market economy. In theory, if markets worked perfectly we would not need any firm, since market forces would suffice to provide all the coordination and incentives needed for production activities. TCE understands the firm as a hierarchy which allocates productive resources by command (the exercise of authority). Markets would do just the opposite, by allocating productive resources using the price system (bargaining). TCE argues that in some circumstances a hierarchy (a firm) can make a more efficient allocation of resources than a market (a bargaining system). This is due to imperfections in markets such as imperfect information and bounded rationality. While theoretical economic models do not contemplate these imperfections, they are present in real markets and contribute to generate three types of transaction costs:
According to TCE, the existence of transaction costs and the ability of entrepreneurs to minimize them when governing certain transactions explains the existence of firms within free market economies. Firms are viewed as efficient alternatives to market coordination for the government of some transactions. Furthermore, as the firm and the entrepreneur gain advantages in governing additional transactions, firms will grow and incorporate additional activity. The limits of the firm will be established by the relative ability of markets and firms to coordinate transactions.
The contractual theories of the firm have their origin in the early work of Ronald Coase (1937) on the Nature of the Firm, which was expanded later on by Oliver Williamson (1975) in his path-breaking book Markets and Hierarchies. Both authors were awarded the Nobel prize in 1991 and 2009, respectively. The first of the three contractual theories is known as Transaction Cost Economics (TCE) and comes from the work of these two authors. TCE is interested in explaining why we need firms in a market economy. In theory, if markets worked perfectly we would not need any firm, since market forces would suffice to provide all the coordination and incentives needed for production activities. TCE understands the firm as a hierarchy which allocates productive resources by command (the exercise of authority). Markets would do just the opposite, by allocating productive resources using the price system (bargaining). TCE argues that in some circumstances a hierarchy (a firm) can make a more efficient allocation of resources than a market (a bargaining system). This is due to imperfections in markets such as imperfect information and bounded rationality. While theoretical economic models do not contemplate these imperfections, they are present in real markets and contribute to generate three types of transaction costs:
- Search and information costs: those associated with searching relevant information and meeting the agents with whom the exchange will take place. The stock exchange, for instance, is a very efficient financial institution that emerges from the inability of markets to costlessly make buyers and sellers of financial assets come together. Stock brokers mediate the market transactions of investors and their fees reflect the nature and importance of information costs.
- Bargaining costs: those associated with coming to a reasonable agreement and drawing up an appropriate contract. Of course, bargaining costs are negligible in many market transactions, such as buying a newspaper. However, some other market transactions incorporate huge bargaining costs. Think, for instance, in how costly it is to negotiate the transfer of a star soccer player from one team to another.
- Policing and enforcement costs: those related to supervising the fulfillment of the contract and make sure that the other party sticks to the terms of the contract. In a world of candid people these costs would be unnecessary. Real people, in contrast, may occasionally deviate from the terms of the contract and this is why enforcement costs are unfortunately needed to govern real world transactions. Litigation costs are the most obvious manifestation of this type of transaction costs.
According to TCE, the existence of transaction costs and the ability of entrepreneurs to minimize them when governing certain transactions explains the existence of firms within free market economies. Firms are viewed as efficient alternatives to market coordination for the government of some transactions. Furthermore, as the firm and the entrepreneur gain advantages in governing additional transactions, firms will grow and incorporate additional activity. The limits of the firm will be established by the relative ability of markets and firms to coordinate transactions.