Transaction Cost

Transaction costs represent the economic losses that can result from arranging market relationships on a contractual basis. While most economists studied frictionless models of perfect competition, John Commons and Ronald Coase were early students of contractual relationships and highlighted the various costs that could arise. In recent decades, transaction costs have come to the fore in scholarship on for-profit organizations and [Page 980]public bureaucracies, and this progress has had great significance for the field of governance.

The study of transaction costs originates from economics' aggregative social modeling arising from individuals operating under competitive self-interest. At the highest level of abstraction, there are only markets and everyone is free to enter into contractual relations with everyone else. Under this view, the firm is seen famously as a nexus of contracts. But proponents of the approach expect that contracts will be violated not occasionally, but whenever the parties to them find it possible. One theoretical line that emerges from this approach is agency theory, which sees firms in terms of contractual relations. But a different tactic has been transaction cost economics (TCE), which focuses on the limitations of contractual relationships.

The TCE approach seeks to explain why there are some markets with many organizations in them and why there are some industries dominated by just a few large organizations—called hierarchies. Oliver Williamson, the approach's leading innovator and architect, sketches a historical argument that explains the transformation of an economy based on many small transactions to one based on large hierarchies that transact among themselves and into which individuals are absorbed. The organizational developments that characterize our current economy, dominated as it is by such hierarchies, are seen as a more efficient way to organize economic relationships.

TCE consists of four main elements:

• 1.
  The world is uncertain and therefore unpredictable.
• 2.
  Small numbers bargaining and asset specificity make it costly for parties who enter into economic relationships to leave them.
• 3.
  Bounded rationality limits individuals' opportunities to scan the environment for all possible options.
• 4.
  The inherent opportunism of individuals in economic relationships makes contractual enforcement over a long-term period difficult.

Together, these four factors make it difficult to contract at low costs and create frictions (i.e., transaction costs) in the marketplace. The capitalist solution is to integrate up and down the production chain by buying out suppliers and the people one sells to. Variations in the way the four factors affect different economic relationships determine the degree to which an industry is concentrated or not.

TCE argues that the modern large firm represents a substitution of contractual relationships with an authority relationship. Entrepreneurs who create large hierarchies no longer have to write complicated contracts, but can instead use organizational tools such as incentives, coercion, and monitoring to maintain behavioral control. Hence, transaction costs represent a central idea for governance scholarship because governance structures form the rules by which parties interact in different organizational and political contexts. Governance structures in the firm award monitors power to oversee and discipline.

In the realm of political science, transaction cost ideas have been pushed most by the work of Terry Moe. He argues that we can understand the organization of public bureaucracies and the behavior of bureaucrats by thinking about the incentives and constraints that the political process and political structure (i.e., governance) impose on interest groups, politicians, and bureaucrats. Uncertainty and shifting fortunes distinguish the political realm, so these actors must design bureaucracies to attain long-run objectives within the constraints of the political process. They must make concessions to opposing groups while at the same time they lock in their gains by setting bureaucratic rules so the organization becomes inflexible and difficult to change. Moe stresses that Americans should not be surprised by the behavior of their bureaucrats because their behavior has often intentionally been designed to fit the context of American governance.

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