Transaction Cost Theory

Conceptual Overview

Ronald Coase's landmark 1937 essay “The Nature of the Firm,” which postulates that firms exist due to the cost of using the market, is widely regarded as the origin of TCE. Coase's starting argument is that resource allocation in a world of perfect competition, as regarded by classical microeconomics, takes place through the market mechanism. The question then arises as to why alternative institutional forms of resource allocation, such as the firm, come about. Coase argues that the market does not operate smoothly, as assumed, but is rather associated with specific costs, such as information and negotiation costs. Thus, firms exist in order to reduce the costs associated with the use of the price mechanism. At the same time, Coase suggests that despite those costs, markets still exist because there are also costs associated with the internal organization of economic activities, such as coordination costs.

Coase's argument is further and significantly developed by Oliver E. Williamson, who is regarded as the leading figure of TCE. Williamson suggests that the decision upon the optimal institutional form of economic activities depends on the analysis of the costs of planning, control, and modification associated with a particular economic transaction. Williamson proposes an integrated framework for the analysis of the alternative institutional forms of the market and the firm and includes later the study of hybrids. This framework is based on three critical assumptions in regard to the characteristics of economic actors, economic transactions, and governance forms.

TCE postulates that human actors are characterized by bounded rationality (thus all complex contracts are unavoidably incomplete), opportunistic behavior (parties on long-term contracts will breach the spirit of a contract if this is in their self-interest), and feasible foresight (parties to a contract have the capacity to look ahead and to integrate those insights into the ex ante design of governance). Due to these characteristics, the organization of economic activities involves costs, which are called transaction costs—the costs of running the economic system. Examples include information costs, measurement costs, bargaining and decision costs, and contract enforcement costs. A major decision that economic actors need to make is how to reduce transaction costs in order to maximize the outcome of their activities. This decision is influenced by the characteristics of the particular economic transaction.

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