Transaction cost theory states that transactions be organised to minimise the cost of exchange and the costs of managing the organisation. Transaction cost is the amount incurred for transactions to take place. In other words, it can be called the cost of exchange or sunk costs which are results of economic trade in the market. These involve the costs of monitoring, controlling and managing transactions.
This image gives a clear picture of where transaction cost is involved
The decision regarding the cost of the transaction is made after considering the impact which it would have in building a corporate relationship. The key elements are:
Frequency: This determines how often does the transaction take place.
Uncertainty: The world is very uncertain and unpredictable. The length of the relationship or the degree of trust between the parties is the factor that is seen to predict the risk level.
Asset specificity: The uniqueness of the asset or degree of its requirement shows its importance.
Bounded rationality: Individual rationality is limited to one’s knowledge. Decision making by them becomes bounded as it is limited to their rationality and time available to them for the decision to be made.
Opportunism: Individuals take actions keeping in mind their best interests due to which there is uncertainty in dealings and mistrust can arise between parties making long term contractual obligations difficult to conduct.
A brief description of transaction cost
Considering these elements and the control over the transaction makes it significant to decide whether the expansion needs to be external or internal. These transactions are divided into External transactions and Internal transactions.
External transaction
Transaction cost that occurs while dealing with any contractual relationship with an external party is covered under it.
Search and Information: The cost incurred while finding the required information or agent with whom further dealings are to occur. For example, Commission paid a broker for finding a warehouse.
Bargaining Costs: These involve the negotiation costs while making the final contractual decisions. For example, making of the appropriate contract.
Policing and Enforcement costs: This cost is to monitor that the terms of the contract are being followed and no party defaults from them. For example, a lawyers fee is such a cost.
This image displays what aspects come under transaction cost
When buying a new machine the company first needs to bear search cost and find the required machine, bargaining cost is incurred while negotiating the price with the seller. Policing and enforcement costs make sure that the machine is delivered in agreeable condition.
Internal transaction
Transaction costs occur within the company as well while dealing between different departments. Transaction cost theory states that managers need to arrange transactions in an opportunist manner. Bounded rationality and opportunism in the management positions help to know the reasons behind decision making. Degree of impact frequency of actions, the certainty of one’s position and asset specificity for the manager’s personal gain are seen to determine the level of control senior management needs to have in the decision-making process.