Transaction Cost Economic Analysis

Before the 19th century, there only existed a small number of firms and much of which were extensions of the state – in other words, was owned by the government. Some companies were also provided with exclusive rights to trade and conduct business in certain markets or products. These companies would include the Dutch East India Company and Hudson Bay Company.

The existence of firms started during the Industrial Revolution in Britain. The textile industry, serves as one of the concrete examples and basis for the establishment of firms. Originally, cloth has been produced domestically – at the individual worker’s homes. The entrepreneur provides both the materials and the equipment and bought all the finished products. This was known to be

Transaction costs are divided mainly into three categories – search and information costs, bargaining costs, and policing and enforcement costs.

For example, the buyer of a used car faces a variety of different transaction costs. The search costs are the costs of finding a car and determining the car's condition. The bargaining costs are the costs of negotiating a price with the seller. The policing and enforcement costs are the costs of ensuring that the seller delivers the car in the promised condition.

In 1937, Ronald Coase, introduces the market failure theory of the firm, which states that the firm exists because of the failure of the market in the presence of transaction costs. Coase has mentioned that some transactions in the markets would have high costs of price discovery, negotiation and of enforcement as well. Thus, it would be more efficient if these activities are brought inside the firm. In conclusion, the boundary of the firm is when the costs of organising the transaction within the firm equals that carried out in the market. However, Coase did not study firm’s internal operations, and why some entrepreneurs are better than