Transaction Economic Cost (TCE) is a transaction cost incurred in making an economic exchange. Or alternatively, a concept, which denotes the cost to using the market-such as cost of organizing and transacting exchanges–which can eliminate by using the firm. TCE argues that transactions have distinct characteristics that, in combination with the attributes of alternate governance structures, produce different production and transaction costs. These transaction cost broadly break down into motivation and coordination cost( Milgrom and Robest 1992), opportunism and agency cost( Jensen and Meckling 1976), and measurement cost (Stigler 1961).
TCE argues that transactions have distinct characteristic that, in conjunction with governance structure, produce different production and transaction cost. In general, the three main key transaction characteristics are (1) asset specificity, (2) uncertainty, and (3) frequency of transactions(Williamson 1981).
Before engaging themselves into a particular transaction, some deliberation required for these characteristics. Decision makers need to choose whichever governance structure minimizes the total cost associated with a transaction. ( Coase 1937).
Hidden opportunities and trap for the firm
Given a company that an investment entering a transaction is excessively costly for one party to develop the activities. And some market opportunities are high in uncertainty and questioning the probability the frequency transaction occur in future period. Firm may need to reconsider some other alternative options to mitigate these weakness.
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Economies of scale
Management have invested significant amount on its fixed assets. The logical approach for the firm is to achieve cost leadership. The idea is to spreading the indivisible fixed cost over an ever-greater volume of output. The capability for the firm to average out this fixed cost however is depending on the frequency of the transactions and the certainty of the transactions in future. One important factor also need to be consider is the specialization skills in performing out the task for the transaction. This known as the learning curve. Learning economies refer to reductions in unit costs due to accumulating experience over time. If the firm management potentially perform these activity internally, have to consider the capability of driving the average cost to minimum efficient scale (MES).
As MES begets efficiency, efficiency begets cost savings.
Significant relationship-specifics assets
Management need to bear in mind that a relationship-specific assets cannot be redeployed to another transaction easily without some sacrifice in the productivity of the assets or some cost in adapting the assets to the new transactions. Meaning that switching partner is not easy as such “investment” has lock the relationship. This ultimately reducing the number of alternative trading partners, from “large number bargaining” to “small numbers bargaining”. This changes known as “fundamental transformation”.
Management need to aware that such transformation has significant consequences for the economics bargaining between the buyer and the seller. “Rent” and “Quasi-rent” are the case in point. The fundamental idea of this point is that the trading partner may deliberately “Holdup” the transactions . Regardless of breaching the contract, the trading partner may renegotiate the terms/price that close to the firm second best alternative option. If the firm initial capital investment is enormous, then there is higher chances that the trading partner might exploit through “holdup”. This is possible through the risk of incomplete contract. Under such circumstances, the firm need to anticipate the prospect of holdup, then only made the investment decision to begin with.
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In addition to this, firm need to assess that the related specific investment whether is sufficient enough to achieve full technical efficiency. As certain capital investment may needed further specialized engineering skills to achieve its full technical efficiency.
To mitigate the risk, the firm can invest in “safeguards” to improve post-contractual bargaining positions such as acquire a standby production facility for a key input as a hedge against a holdup by the input supplier.
Risk of incomplete and nexus of contracts.
Due to TCE characteristics earlier on, transaction cost economics studies how trading partners protect themselves from the associated with exchange relationships. As TCE maintains that in a complex world, contracts are typically incomplete. A complete contract eliminates opportunistic behavior. As this particular firm are complex, thus might do not fully specify the “mapping” from every possible contingency to enforceable rights, responsibilities and actions. Normally , three factors which is (1) bounded rationality which limitation on capacity possessing information as deal with complexity and cannot contemplate or enumerate every contingency that might arise during transaction. (2) Difficulties in specifying- Language of law might not be what constitutes fulfillment of the contract. (3) Asymmetric Information- Knowledgeable parties might hide, distort or misrepresent information. All these are inherent risk that the firm need to consider.
As Williamson (1971, pp. 116-117) observed many years ago:
“…The contractual dilemma is this: On the one hand, it may be prohibitively costly, if not infeasible, to specify contractually the full range of contingencies and stipulate appropriate responses between stages. On the other hand, if the contract is seriously incomplete in these respects but, once the original negotiations are settled, the contracting parties are locked into a bilateral exchange, the divergent interests between the parties will predictably lead to individually opportunistic behavior and joint losses. The advantages of integration thus are not that technological (flow process) economies are unavailable to non-integrated firms, but that integration harmonizes interests (or reconciles differences, often by fiat) and permits an efficient (adaptive, sequential) decision process to be utilized….”
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Risk of income fluctuation
One of the strategic moved by the firm is to eliminate the volatility of income fluctuation by engaging vertical integration. This is ideal if the market is uncertain or imperfect and the firm bargaining power is low. High price uncertainty implies a high possibility that
a market price will fall outside a contract’s self-enforcement range in its own terms
along with the transactors’ reputation capital, resulting in holdup and costly renegotiation.
Because vertical integration eliminates the holdup possibility, a positive reaction of
vertical integration to price uncertainty is expected.
However, vertical integration is not the only option. Alternatively, the firm may enter long-term contract with suppliers or may even considering the strategic alliances and joint ventures to mitigate the fluctuation risk.
Vertical integration
As transactions characteristics embedded in governance structures, which in turn facilitate the organizational transaction cost, transaction benefits and individual benefits. Hence, it is possible for a combination of different governance structures to handle different aspects of their business. Through these mixed governance structures may be altered to adjust to specific organizational and individual needs.
As due to incompleteness and income uncertainty of transactions, parties who invest in relationship-specific assets expose themselves to a hazard: If circumstances change, their trading partners may try to expropriate the rents accruing to the specific assets. One way to safeguard those rents is through integration, where the parties merge and eliminate adversarial interests. There are many potential explanations for vertical integration, including risk aversion (Blair and Kaserman, 1978), price inflexibility (Carlton, 1979) price controls (Stigler,1951) and market power. Vertical integration relatively more attractive (1) when the ability of outside market specialist to achieve scale or scope economies are limited (2) the larger the scale of the firm’s product market activities,(3) the greater the extent to which the assets are involved in production are relationship-specific.
The Essay on Advantages And Disadvantages Of Vertical Integration
... the different firms will have different market shares so the advantage cost will be different leading to control of market imperfection. DISADVANTAGES OF VERTICAL INTEGRATION Vertical integration boosts ... ADVANTAGES OF VERTICAL INTEGRATION It leads to reduction of transportation costs as the common ownership results in closer geographic proximity. The transaction costs can be controlled ...
Firm boundaries & vertical chain
Before deciding on actual integration, a Company first needs to define the firm’s boundaries. This is a critical task. The management need to identify the company’s core competencies such as the main strengths or strategic advantages of a business. Core competencies are the combination of pooled knowledge and technical capacities that allow a business to be competitive in the marketplace. Where such core competencies form an ultimate synergies that hard for competitors to replicate.
According to Evolutionary economics (EE) (Nelson & Winter, 1982) holds that when firms grow by vertical integration they grow in a direction of something closely related. Resource based theory (RBT) and the core competence approach argue that firms will expand in those areas where their existing competence is the foundation for a firm’s value creating process.
Hence, management needs to map out the value creation process from the series of activities, which also known as the value stream. This assessment encompasses the predictability of work flows and the expectation effect that encapsulate the final products. Work flows are such as coordination of production flows through this vertical chain to avoid any bottlenecks arise. According to Paul Milgrom and John Roberts, coordination is particular useful with design attributes, which are attributes that need to relate to each other in a precise fashion: otherwise they lose a significant portion of their economic value. Thus, customer satisfaction is the expectation effect from the integration.
Make or Buy dilemma
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Process Essay Thesis: The majority of the American population has very little, or no understanding of the used car trade. A simple understanding on when and where to sell, how to get your car ready, writing a classified ad, negotiating, and making a contract. With consumer demand rising and supply constrained by several factors, including the tendency of new-car owners to hang on to them longer, ...
Common perceptions towards “Make”
Normal argument for “Make” is that there are three major cost associated with using the “Market” include the cost of poor coordination between steps in vertical chain, the reluctance of trading partners to develop and share valuable information and transaction costs. In addition of transaction exchange relationships associated with writing and enforcing contracts.
Benefits of- “Buy”
Most of the cases, market firms enjoy two distinct types of efficiencies. They exploits economies of scale and the learning curve. First, market firms may possess proprietary information or patents that enable them to produce at lower cost. Second, they might be able to aggregate the needs of many firms, thereby enjoying economies of scale. Third, they might exploit their experience in producing for many firms to obtain learning economies. Another pertinent point to ponder is if firms using market, firms can excessively avoiding “Bureaucracy Effects” such as agency cost and influence cost.
Other possible options
Less extreme options include reciprocal buying arrangements, in which each party exposes itself to form a mutual exchange of “hostages,” and partial ownership agreements. Others such as Value added partnership via strategic alliance and collaborative relationships. This not only entail flexibility but also exploiting each strong competencies in the “value stream”.
Simply put, TCE tries to explain how trading partners choose, from the set of feasible institutional alternatives, the arrangement that offers protection for their relationship-specific investments at the lowest total cost.
Conclusion
As the above evidence makes clear, is all depends on “How to make” and “Whom to buy from”. Experts advised that vertical integration is preferred to arm’s length market exchange when it is less costly to organize activities internally. If the management doubting their capability for achieving in-house economies of scales and lack of expertise in certain areas , perhaps the option “Buy” from a reputable and trustworthy downstream or upstream trading partner is more practical in this case.
Sources of reference
The Essay on The Cost of the Decisions We Make
The Cost of the Decisions We Make For every course of action that one takes in life, there is a cost associated. This cost may be large or small but one can weigh this cost with the alternative before he or she makes any decision. In the essay, “The Price of Crossing Borders” written by Eduardo Porter, the concept of understanding that there is a price for everything is conveyed. There is no ...
(1) Article: Price uncertainty and vertical integration: an examination of petrochemical firms.
Journal: Journal of Corporate Finance 6 (2000. 345–376).
Author: Joseph P.H. Fan.
Available from :
(2) Article: Core Competencies, Vertical Integration and Governance Costs Buyer- Supplier Relationships.
Journal: Competitive Paper submitted to 17th IMP Conference, 9th – 11th .September 2001 Norwegian School of Management BI.
(3)Book: Transaction cost of economics.
Author: Oliver E. Williamson.
(4)Article: The vertical integration of productions: Market failure consideration.
Author: Oliver E. Williamson
(5)Article: Designing the boundaries of the firm: From “Make, Buy or Ally” to the dynamic benefits of vertical architecture.
Author: Michael G. Jacobides, et al.
(6)Book: Economics of strategy. (Fifth Edition)
Author: David Besanko, et al.
