TRANSACTION COST

Transaction Cost

Transaction Cost

The transaction cost approach to the theory of the firm was created by Ronald Coase (Boisot 2008). 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 (Boisot 2008 ).

More succinctly transaction costs are:

search and information costs

bargaining and decision costs

policing and enforcement costs

Coase contends that without taking into account transaction costs it is impossible to understand properly the working of the economic system and have a sound basis for establishing economic policy (Boisot 2008).

Coase observes that market prices govern the relationships between firms but within a firm decisions are made on a basis different from maximizing profit subject market prices (Bolton 2004). Within the firm decisions are made on through entrepreneurial coordination. Coase quotes D.H. Robertson on there being,

"Islands of conscious power in this ocean of unconscious co-operation like lumps of butter coagulating in a pail of buttermilk."

There are a great variety of arrangements in producing goods. In agriculture often most of the labor force works on a day-to-day basis. In other industries the labor force may be permanent, tied to the firm with long-term contracts (Bolton 2004). Repair services in some firms may be supplied by an internal organization; in others it is provided by specialized firms from outside. A firm is a system of long-term contracts that emerge when short-term contracts are unsatisfactory.

The unsuitability of short term contracts arise from the costs collecting information and the costs of negotiating contracts (Bolton 2004). This leads to long term contracts in which the remuneration is specified for the contractee in return for obeying, within limits, the direction of the entrepreneur.

Coase notes that the economic theory of the production level of a plant in the short run and long run are well worked out, but the theory of the size of the firm is not well developed (Bolton 2004). This is clear ...