A Structure of Transaction Costs - Essay Example

Transaction costs theory and the existence of firms Introduction In his paper The Nature of the Firm, R.H. Coase (1937), brought forth the theory of costs transaction when he put in a strong question to challenge the traditional price theory. He asked, why do firms exist in marketplace if production is so well co-ordinated by price mechanism (Cease, 1937, 333) Coase explored various options that offered explanations on why firms exist, including different risk based options and division of labour theory, but later discarded them as being rather too sketchy for any firm derivations. After much study he concluded, “The main reason why it is profitable to establish a firm would seem to be that there is a cost of using the price mechanism” (Cease, 1937, 336). Coase’s theory that the transaction costs form the economic groundwork for all firms, thus becoming the sole reason for the existence of any organisation within marketplace, however has met with a number of contradictions. Many economists contend that existence of firms is not solely dependent on transaction costs. Other abilities (like being able to handle large variety of resources)  are of great advantage to any firm, especially in the context of new technologies, which create various opportunities where the organisation can improve their production values and increase their revenues, where the earned benefits accumulate to ‘start-ups,’ capable of creating more contemporary firms ( Alchian, and Demsetz, 1972, 777-795). Thus here the basic question is: does Coase’s theory on transaction costs present a holistic view on explaining why firms exist? Discussion What is transaction cost? In economics, transaction cost refers to the expenditure incurred while making a financial exchange, which can be stated as the cost incurred when one wishes to participate in a market. Humans by nature are social animals and tend to group together to conduct their various daily affairs, conducting business being one of them. Bartering is also another basic human nature, and this is most evident in marketplaces, where individuals tend to seek the best bargain by competing with their opponents (Maynard, 1982). Markets are organised social spaces for conducting such businesses or exchange of items and have been in vogue from the ancient times. Right from its origin there has been two forms of market: external market, where trade took place between communities, located at long distances from each other; and internal market, which is located within a particular society or community (Swedberg, 2005, 234-235). The producers gather here for gaining more customers; consumers get more range of goods and a better price bargain; traders to make profits minimise their distribution and trading costs; while the State earns revenues from traders with an overall benefit from the economic growth and development (Smith, 1978, 136-138). In such a competitive marketplace, the traders or consumers, when selling or buying goods/services, pay their brokers a sum known as the commission, which forms to be the transaction cost of the deal. As for example, while buying a good from a shop, the cost of that item covers not only the price of the good itself, but includes the efforts necessary to find the exact type required, the right place and price to buy the item, the expenses of traveling to and fro to the right store. Thus, the costs that are fall beyond the actual price of the item forms to be the transaction costs. While logically analysing any future transaction, it is necessary that one consider the transaction costs, which may prove to be important. To classify transaction costs, the production factors must be categorised into three divisions: human capital; financial and physical capital, and work intensity (shown in fig 1; Alston and Gillespie, 1989, 192). Financial and physical capital comprises of the production tools and machines, along with ‘liquid’ capital. Human capital comprises of skill, the knowledge, and labour of the each individual worker, necessary for the production processes. The last category work intensity pertains to the use or withholding of work effort by workers in the production process. The authors make a further distinction of the transaction costs by categorising production process into three periods: “pre-production period, negotiations between the buyer and the seller take place” (fig 1; ibid, 193). Fig 1: A structure of transaction costs (source: Alston and Gillespie, 1989, 194). Why firms exist? In a socially organised market (as described above), the basic question, which arises, is that in a fair and open market-place where the seller and the buyer can conduct direct face-to-face transactions, why must firms exist and why doesn’t the market take care of everything? Here Coase explained that any organisation, in principle, must be able to locate the cheapest yet most productive items from an open marketplace.  However, markets being non-fluid in nature, transaction costs come into being, while searching for the right item and place, negotiating for the right terms, coordinating, taking care of the intellectual rights, managing workers, etc. (Marsden, 1999). It is for this reason, according to Coase, that organisations were formed, where conduction of businesses was made easier and cheaper for any work to be done. Thus, here we find chief reason for creating firms was to avoid, to some extent, the large transaction costs. In orgamisations, such measures included locating the relevant prices by using specialists (costs, though not completely unavoidable, could be reduced); decreasing negotiation prices and making contracts, which were enforceable, thus cutting down on costs since uncertain contracts lead to large transaction costs and further re-negotiations, causing increase in costs. This is argument thus, reaffirms Coase’s notions of why firms came into existence. When an organisation within a market functions internally, many contracts would be necessary for its effective functioning. An actual firm however, has few (though more intricate) contracts, (like the managers authority over his/her subordinates), that are long-term, in exchange for the employee’s salary, and are generally created under uncertain situations. Though the situation was contrary to the neo-classical economic theory, Coase from his studies derived that “a firm is likely therefore to emerge in those cases where a very short-term contract would be unsatisfactory… [and that] it seems improbable that a firm would emerge without the existence of uncertainty” (Coase, 1997, 94). He further added that State market rules, like rationing of price/items, levied sales taxes, or imposed price controls, help to increase an organisation’s size, since internally, the firm would remain free from the aforementioned state imposed transaction costs. In this context, he claimed organisations are "the system of relationships which comes into existence when the direction of resources is dependent on the entrepreneur" (ibid, 95). Thus, here we find the organisation increasing or decreasing in size, as per the transactions conducted by the owner, making transaction costs an important factor in the existence of firms. Conclusion Many theories oppose the theory put forth by Coase, and each offer a deep insight into why firms exist. However, in each case the theories fail to take into view the notions put forth by others. Thus, we find that Alchian and Demsetz’s (1972) theory gives an explanation on the theory of firms, but remains sketchy and hence inadequate. Similarly, Williamson’s theory of asset specificity, and the other costs theorised by Cheung in 1983, all play a role to a certain degree, without giving a complete view, thus making Coase’ theory the only one with a more-or -less holistic perspective. References Alchian, A., and Demsetz, H., 1972. Production, Information Costs, and Economic Organization.  The American Economic Review (American Economic Association) 62 (5): 777–795. [JSTOR 1815199]. Alston, L., and Gillespie, W., 1989. Resource Coordination and Transaction Costs. Journal of Economic Behavior and Organization11, 191-212, North-Holland. Bowles, S., 2004. 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