Transaction Cost Economics

In economics and related disciplines, a transaction cost is a cost incurred in making an economic exchange. A number of different kinds of transaction costs exist. Search and information costs are costs such as those incurred in determining that the required good is available on the market, who has the lowest price, etc. Bargaining costs are the costs required to come to an acceptable agreement with the other party to the transaction, drawing up an appropriate contract, etc.. Policing and enforcement costs are the costs of making sure the other party sticks to the terms of the contract, and taking appropriate action (often through the legal system) if this turns out not to be the case.

Transaction costs consist of costs incurred in searching for the best supplier/partner/customer, the cost of establishing a supposedly “tamper-proof” contract, and the costs of monitoring and enforcing the implementation of the contract. Transaction cost theorists assert that the total cost incurred by a firm can be grouped largely into two components—transaction costs and production costs. Transaction costs, often known as coordination costs, are well defined as the costs of “all the information processing necessary to coordinate the work of people and machines that perform the primary processes,” whereas production costs include the costs incurred from “the physical or other primary processes necessary to create and distribute the goods or services being produced”

Transaction cost economics suggests that the costs and difficulties associated with market transactions sometimes favor hierarchies (or in-house production) and sometimes markets as an economic governance structure. An intermediate mechanism, called hybrid or relational, between these two extremes has recently emerged as a new governance structure.

TCE Approach

The transaction cost approach to the theory of the firm was created by Ronald Coase. Transaction cost refers to the cost of providing for some good or service through the market rather than having it provided from within the firm. Coase describes in his article “The Problem of Social Cost” the transaction costs he is concerned with:

In order to carry out a market transaction it is necessary to discover who it is that one wishes to deal with, to conduct negotiations leading up to a bargain, to draw up the contract, to undertake the inspection needed to make sure that the terms of the contract are being observed, and so on.

More succinctly transaction costs are:

• search and information costs
• bargaining and decision costs
• policing and enforcement costs

SCM and TCE

The main question that TCE tries to answer is why firms exist? In SCM context, TCE aims to reduce the costs associated with carrying out a transaction when deciding whether to make-or-buy. There are three attributes which influence a firm’s decision to make or buy: frequency of transaction, asset specificity and degree of uncertainty associated with a transaction. In general TCE theory argues that different control and governance mechanisms should be employed to mitigate the risk of opportunistic behaviour of supply chain firms when outsourcing.