Transaction Costs

Transaction Cost Economics

The best-developed articulation of the impact of transaction costs on business and society is a branch of economics (and increasingly law) known as transaction cost economics (TCE). TCE focuses on comparing the transaction costs associated with different institutional means of completing a transaction, thus explaining why some economic transactions occur within hierarchies, such as firms, rather than between individuals across a market. The most fundamental claim of TCE [Page 2097]is that transactions will be governed by institutions that minimize their associated costs. Two main types of institutions are identified. First are markets, in which the identity of the transacting parties is irrelevant because there is no dependency between them; if one party reneges on the terms of the transaction, the other party is not significantly worse off, typically because the “aggrieved” party can seek legal redress through classic contract law and because the assets can often be redeployed at low, or little, cost. However, in some transactions, the identities of the parties do matter, or courts cannot realistically enforce contracts. This, of course, raises the issue of institutional morality: The governance of economic exchanges by contract reduces opportunism only if there is a well-developed, efficient, and noncorrupt legal system to enforce contracts. In places where lawsuits take decades to resolve, or where judges decide cases based on cronyism rather than legal merit, the threat of suing for breach of contract does not constrain an opportunistic party from taking advantage of their “honest” partner.

The second institution is a hierarchy, or an internal organization, where responses to unanticipated disturbances to a transaction are resolved internally, by fiat. Fiat is the power exerted by the central authority in the organization to ensure smooth and efficient transactions. In addition, hierarchies can also control behavior through organizational culture. For example, Enron had a well-known culture of risk taking and pushing legal limits in pursuit of new markets and profits prior to its downfall. Conversely, Starbucks has a strong corporate culture of social responsibility and integrity and thus is less likely to become a future corporate malfeasant.

The main costs associated with hierarchies are bureaucratic and organizational costs. The market will be used to govern transactions where the parties are not vulnerable to reneging; conversely, hierarchies arise when the parties would be made significantly vulnerable or worse off if one of them were to pull out of the transaction. TCE emphasizes three sources of vulnerability: bounded rationality, opportunism, and asset specificity.

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