Transaction costs are related to the problems of co-ordination and motivation. Costs will occur whichever method of transaction is used, spot markets, long-term contracts or internalization within the firm, but they will vary according to the method.
a. Co-ordination costs
These costs are sometimes referred to as Coasian costs, since Coase was the first economist to examine them in detail.2 The following categories of costs can be determined here:
1. Search costs. Both buyers and sellers have to search for the relevant information before completing transactions. Such information relates to prices, quality, delivery and transportation; in markets this search is external, while within organizations, information held in different parts of the organization must be transmitted through the relevant channels to the decision-makers. Even in highly efficient markets like stock exchanges a large amount of resources, in terms of physical assets like buildings and computers and human assets in the form of brokers, is devoted to providing the relevant information.
2. Bargaining costs. These are more relevant when markets are involved, where negotiations for major transactions can be protracted, but even within the firm, salary and wage negotiations can also be costly in terms of the time and effort of the parties involved.
3. Contracting costs. There are costs associated with drawing up contracts; these take managerial time and can involve considerable legal expense.
b. Motivation costs
These costs are often referred to as agency costs. This area is discussed in more detail in section 2.4 on the agency problem, but at this stage we can observe that there are two main categories of such costs.
1. Hidden information. This relates to asymmetries referred to earlier. One or several parties to a transaction may have more information relevant to the transaction than others. A classic example of this is the secondhand car market, where sellers have a big advantage over buyers. This has many consequences for the market, which are discussed later, but one obvious effect is that buyers may have to devote resources to obtaining more information (for example, paying for an engineer's inspection of a car).
2. Hidden action. Even when contracts are completed the parties involved often have to monitor the behaviour of other parties to ensure that the terms of the contract are being upheld. Monitoring and supervision are costly, and there is a further problem because this behaviour is often difficult to observe directly. This problem is known as 'moral hazard'. The situation is even more costly if legal action has to be taken to enforce the terms of the contract.
Transactions have a number of attributes which affect the above costs and therefore affect the way in which they are conducted, in particular asset specificity, frequency, complexity and relationship with other transactions. Asset specificity refers to how easy it is for parties in a transaction to switch partners without incurring sunk costs, meaning costs that cannot be recovered. For example, a firm that commits itself to building a facility designed for a specific customer will usually want to be protected by a long-term contract. Again, transactions that are repeated frequently may most easily be conducted by having a long-term contract instead of negotiating individual spot transactions, as with obtaining cleaning and catering services.
One of the main implications of transaction cost theory is that there is an optimal size of the firm from the point of view of minimizing transaction costs. Generally, as the firm increases in size and incorporates more transactions internally as opposed to transacting in the market, those costs associated with using the market decrease, while those costs associated with co-ordination increase as the amount of administration and bureaucracy increases. There is thus a trade-off situation, with the optimal size of the firm being at the point where 'the costs of organizing an extra transaction within the firm become equal to the costs of carrying out the same transaction by means of an exchange on the open market or the costs of organizing another firm'.3
It should be realized that the optimality situation described above is only optimal from the point of view of transaction costs. In practice there are a number of other considerations that will be relevant in determining the actual size of the firm, and these will be examined in the remainder of this chapter.
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