Transaction Costs: cost of conducting an economic exchange between two parties. Transaction costs have two important implications for the theory of the firm; firstly the theory of transaction costs predicts that economic exchange will tend to be organized in ways that minimize the costs of those exchanges (explaining the very existence of the firm), secondly transaction costs play an considerable role in limiting the size of firms.
Coase wrote in 1937 that Economic exchange will tend to be organised in ways that minimize the cost of exchanges.
One way to do this is to offer general contracts.If firms do not have general contracts, an employee cannot be asked to perform beyond his specific task- limiting the size of the firm. The firm, by offering general contracts, can minimize transaction costs. The firm may be described as a tool to minimise transactions costs. Any contract will be incomplete; there will be some chance of something happening that the contract does not cover.
This is because, firstly it would be impossible to foresee everything that can happen, secondly, even if everything were foreseeable, it would be prohibitively costly to have a contract that covered all possible bases.Consider what happens when an uncovered contingency arises.
Under market based relationship, each party would bargain to get a good deal for themselves.
Bargaining is costly, waste of time, may break down cooperation.
Also if purchase made now, other party may take advantage of this in future bargaining (Williamson 1985). However, when transaction takes place within firm, one party has residual control rights.
Transaction costs are minimised as bargaining taken out of the equation.For this reason we expect to see large scale firms which require the coordination of, and cooperation among, many people to take place within a firm, rather than through a market. Something that suggests that the size of the firm should be limited is specialisation. If the costs of buying in the product for firm 1 are less than the actual costs of making the product, then it should be left to the other firm 2 to make this product which it specialises in, and firm 1 to buy it.For example, take the household as a firm 1 and a bakery as firm 2.
It is more efficient for the household to buy in bread from the bakery, as the transactions costs are less than the cost of a bread maker, and the time and ingredients put into making the bread F, A, G p270-272 management economics book Teamwork occurs when an output is produced by the simultaneous cooperation of several team members to perform tasks. This cooperation reduces transactions costs. However, it can create other costs within the firm, such as shirking.Teamwork can cause, for the selfish individual, incentive to shirk, due to 2 related reasons. Firstly, it is difficult for the manager or principle to distinguish between the marginal products of each worker and detect which worker is shirking, and so production units within each team tend to be paid the same rate.
Secondly, the shirker reaps benefits from his shirking, whereas the other team members bear the costs.
The dilemma posed in providing motivation in these situations is termed the incentive problem.In the absence of perfect and cost-free monitoring, each team member can rationally be expected to shirk and hope to free ride on the efforts of other members. Another problem is that the productivity of any one-team member depends crucially on the input provided by other members. So if one team member shirks, the marginal product of the others, as well has total product of the team will fall. Giving employees some property rights, and a cut of the profits, through partnerships, or making the manager the residual claimant can reduce the incentive problem.1 Partnerships often exist where set-up costs are low, and where quality of production is difficult to observe, in markets such as accountancy, law and architecture.
2 The residual claimant should be the monitor, so he has incentives to increase profits.
He should be a capitalist as they are more able to bear risk; workers bear no risk and always get the same wage. Although most property rights are in the hands of capitalists, some may be owned by labour in the form of cooperates.