The Importance Of Transaction Cost Economics

Transaction cost economics and its application in the establishment of contracts

Introduction

Transaction Cost Economics (TCE) is a major theoretical framework used in economics, strategy and related fields, which is used to define the boundaries of a firm. The concept of TCE tries to explain how a buyer and seller choose an arrangement between them which offers protection for their relationship at the lowest cost (Shelanski & Klein, 1995).The theory behind TCE establishes whether a firm’s transactions are more efficiently performed internally (hierarchy) or externally (market governance) (Geyskens et al., 2006).

The Nobel Prize laureate Oliver Williamson is recognised as a seminal author in the field of TCE (Johanson & Mattsson, 1987). A

Williamson (1979) believes that simple governance structures should be used to facilitate simple contractual relations and complex governance structures reserved for complex contractual relations. This is because the use of a complex contract to govern a simple transaction generates unnecessary costs. In contrast to this, the use of a simple structure for a complex transaction invites risk. When selecting contracts, a firm should pay particular attention to the defining attributes of the transactions in order to distinguish between simple and complex situations (Williamson,

Demsetz (1988, p.p. 146-147) maintains that TCE only considers the cost of transaction, and ignores other important costs such as the costs of production. Demsetz argues:

“The cost of transacting is one element of the cost of purchasing from others, but not only one. There are a variety of others, including what we ordinarily call production costs…. The emphasis that has been given to transaction cost (or that has been claimed to be given) dims our view of the full picture by implicitly assuming that all firms can produce goods or services equally well (1988, p.p. 146-147).”

Masten (1996, pp. 51-52) asserts that “reduced-form estimates do not disclose the magnitude of transaction costs”, and consequently that “without additional information, the magnitude of transaction cost differentials and the effects of organizational form on performance cannot be inferred from standard empirical tests of transaction cost hypotheses”. Similarly, Heide and John (1990) draw attention to this issue by arguing that the observed governance model of the firm may have been chosen for strategic reasons, rather than for TCE