Transactions Costs
 Inside the ‘black box’
 Certain products require teamwork – either to
be produced at all or to be produced
efficiently
 Markets are not free – the market is a
powerful co-ordinating device but there are a
range of transactions costs associated with it
Transactions Costs
 Coase (1937) – transactions incur contracting
costs
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Trading on spot markets
Long-term contracts
Internalizing the transaction within the firm
 Choice should be made dependent on which of
these minimises transactions costs
Characteristics of Transactions
Costs
 Frequency
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Infrequent transactions – spot markets
Frequent transactions – long-term contract with
single supplier or internalization?
 Timeliness/reliability
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JIT or inventory?
Timeliness – long-term contract
Timeliness & Reliability - internalization
Characteristics of Transactions
Costs
 Complexity
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Occurs when the transaction involves a significant degree
of private information e.g. difficulty in measuring
quantity and/or quality
Supplying party has incentive to engage in post-contract
opportunism
If transactions are complex, frequent but with a relatively
short period of time before quality is revealed – longterm contracting
If period of time is long integration may be preferred
Characteristics of Transactions
Costs
 Asset Specificity
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Buyer-specific investments and sunk costs
Positive sunk costs mean that the supplier may only be
prepared to make the investment if a long-term contract
is offered
Ex-post opportunism may occur
External supply may therefore be a problem and the input
will not be outsourced but produced internally
Categories of Asset Specificity
 Site or locational specificity – process has to
be located close to other assets – coal mine
and electricity generating station (Joskow)
 Type specificity – plant & machinery that
can only be used in a particular firm
 Human asset specificity – individuals may
have knowledge/skills which are not easily
transferable
Asset Specificity – An Example
 Fisher Body supplied car bodies to General Motors
(market transaction)
 GM wanted Fisher to invest in a new dedicated
plant adjacent to one of GM’s assembly plants
 Planned reductions in:
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Transport costs
Cost
Inventory
Asset Specificity – An Example
 Fisher refused – they were afraid of ex-post
opportunism in the form of pressure to reduce
prices
 GM eventually acquired Fisher
 This strategy to reduce transactions costs was:
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Internalization
Vertical Integration
In-sourcing
Coasian Transactions Costs
 Search and information acquisition costs
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In markets buyers need to search for best prices,
quality, availability. Sellers have to decide which
prices to set – market research, monitoring
competitors – and may need to invest in
advertising.
In organizations information is gathered at lower
levels and passed up the hierarchy, then
decisions are made and passed back down.
Coasian Transactions Costs
 Bargaining and negotiating costs – can be
long and costly e.g. wage negotiations
 Contracting costs – both for new contracts
and the termination of existing ones
 Policing and enforcement costs – the need
for costly monitoring
Agency-based Transactions
Costs
 Hidden information – pre-contract
opportunism can cause mutually beneficial
transactions to fail
 Hidden action – post-contract opportunism
can cause inefficient outcomes when the
actions of one (or more) of the parties is not
observable
Transactions Cost Minimisation
 Taking the technology of production as given
the organization should be structured to
minimise transactions costs
 Market transactions may be attractive but
firms exist to reduce transactions costs by:
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Reducing the number of transactions
Reducing the overall cost per transaction
Cost Minimisation by Reducing
the Number of Contracts
 All Coasian transactions costs increase with
the number of parties involved
 The firm as a ‘nexus of contracts’
 Bilateral and Multiparty contracts
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6 workers & 3 products
Firm negotiates 6+3=9 contracts
Market would require 6x3=18 contracts
Cost Minimisation via Implicit
or Incomplete Contracting
 Internalization reduces the costs in drawing
up, monitoring and enforcing explicit
contracts which are required for market
transactions
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Spot contracts
Sequential Spot Contacts
State-Contingent Contracts & Bounded
Rationality
Cost Minimisation via Implicit
or Incomplete Contracting
 Most contracts within firms are incomplete –
this makes them easier to write but more
difficult to enforce – the employment
contract
 Implicit contracts are unwritten – extremely
difficult to enforce - promotion
Caveats on Transactions Costs
Theory
 Economies of scale – the volume of input required
by a firm may be too small for the firm to produce
it internally – utilities
 Competitiveness of External Market
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Competitive=Out-sourcing
Non-Competitive=In-sourcing
 Interdependencies between Transactions &
Technologies – JIT technology & efficiency of
contracting