Transaction cost theory focuses on an organization’s transactions. The central idea is that when organizations make decisions about their key operations, they either incur transaction costs or production costs. The transaction costs include costs and difficulties associated with the searching for the best supplier, as well as the creation implementation, and monitoring of a contract. Production costs, on the other hand, involve costs associated with the coordination of the people and processes inside a firm. The selection of one set of costs over the other is called the “make or buy” decision. Two factors associated with the choice to buy or make a key component of production is the level of uncertainty and the asset specificity. Both of these concepts are related to risk and the role it plays on a firm’s decisions.
This theory takes the transaction as the fundamental unit of analysis. This theory asks what determines if transactions are organized inside the firm (make, hirerchy) or outside the firm (buy, market). This is another way of thinking about the boundaries of an organization.
Seminal contributions have come from Alchain & Demsetz (1972), Coase (1937) and Williamson (1975, 1985). They hypothesize that there are costs associated with executing certain transaction via a market. Alchain & Demsetz, for instance, place an emphasis on measurement problems in cases of team production. Williamson emphasizes opportunism in contexts where undertaking exchange requires asset specific investments.
Transaction costs can be economized by internalizing the transaction within an organization, so long as the economic benefits of doing so exceed the bureaucratic costs of managing the transaction within a hierarchical setting (Jones & Hill, 1988). Transaction cost theory assumes (as does agency theory) that in the long run, only firms that economize on transaction costs (or agency costs) will survive.
Product and capital markets perform a rough sort between the efficient and inefficient. This has implications for corporate strategy. A corporation may choose:
- Diversification (Teece, 1980, 1982; Jones & Hill, 1988)
- Vertical integration (Klien et al, 1978)
- Foreign direct investment decisions (Hill & Kim 1988),
- Quasi-integration (alliances – Hill, 1990).
- They shape behavior and become self-fulfilling prophesies (Ghoshal & Moran, 1996)
- They ignore the fact that economic transactions are embedded in social networks (Granovetter, 1985; Perrow, 1986), and that societal issues shape organization form.
- They make unrealistic assumptions about selection mechanisms (Robins, 1987).
- They assume away the costs of internal hierarchy, and ignore the “fact” that a desire for market power drives much of corporate strategy (Perrow, 1986; Peffer & Salancik, 1978).