TRANSACTION

COST
THEORY
 TRANSACTION
COST

EXCHANGE OF
RESOURCES WITH
ENVIRONMENT

COST
BUREAUCRATIC COST
(INTERNAL TRANSACTION COST)

EXCHANGE BETWEEN
PEOPLE INSIDE
ORGANIZATION
Transaction cost

Cost of governing , negotiating and

monitoring exchanges between people.

Transaction cost arises -

 When people work together (their activities
should to be controlled)
 When organizations exchanges info or
resources.
Resource dependency Transaction cost
theory theory

Reduced dependency on Minimize cost of

other organizations for exchanging resources in
resources. the envt.

Gain control of Minimize cost of

resources. managing exchanges
inside the organization.
Example

Transaction cost be really high as in case of

health care sector.

In US 40% of the US healthcare budget is

spent in handling exchanges (like bills and
insurance claims) between doctors ,
hospitals, govt, insurance companies and
other parties.
Sources of Transaction cost

ENVIRONMENTAL BOUNDED
UNCERTAINTY RATIONALITY

SMALL
OPPORTUNISM
NUMBERS

SPECIFIC
RISK ASSETS
 Sources of Transaction cost

Environmental uncertainty & bounded rationality

People have limited ability to process information

and understand the envt. This limited ability is
bounded rationality.

Bounded rationality = high level of uncertainty in

envt = greater difficulty in managing transactions
between organizations.
Example:

Org A and Org B

(potential value was lost due to bounded
rationality and high cost of transaction)

Envt uncertainty may make the cost of

transaction so high that orgs look towards
more formal linkage mechanism like
merger, strategic alliances or minority
ownership- to lower transaction cost)
 Opportunism and small numbers

When org is dependent on one supplier or small

no of trading partners, the potential of
opportunism is great.

As the org has no choice but to transact

business with the supplier, hence will expend
resources to monitor , negotiate and enforce
agreement with supplier to protect itself.
Example:

US govt spends billions of dollars per year to

protect itself from being exploited by defence
contractors like Boeing and General Dynamics ,
which are known to take advantage of their
ability to exploit the govt they have very few
competitors fro defence related work.
 Risk and Specific Assets

Specific assets are investment in skills,

machinery , knowledge and information that
create value in one particular relationship but
have no value in any other exchange
relationship.
Example

 A company that invest $100 million in a

machine that make microchips for IBM
machines only – specific investment in very
specific asset.

 Involves high risk , high chance of

exploitation and blackmailing by the other
party
Transaction cost and Linkage Mechanism

Low Transaction High Transaction

cost cost
• Exchange of non • Exchange of more
specific goods and specific goods and
services services

• Uncertainty is low • Uncertainty is high

• Many exchange • Few exchange

partners available partners available
 As per transaction cost theory-

Organizations should choose more formal approach

of linkage to manage exchanges as the transaction
cost increases.

More formal mechanism = More control over

each other’s behaviour

Formal linkages are - Strategic alliances like JV,

merger, takeover.
 FORMAL MINIMIZE
MECHANISM TRANSACTION
COST

ASSOCIATED

WITH

REDUCING

ENVIRONMENT RISK
OPPORTUNISM
UNCERTAINTY
Why org uses informal linkage mechanism
like contracts when more formal approach
like JV , mergers etc provides them with
minimum transaction cost ?
Along with the cost of managing exchanges
with environment comes the cost of
managing transaction inside/within the
organization known as -

Internal Transaction Cost

Or
Bureaucratic Cost
 USING
TRANSACTION COST THEORY
TO
CHOOSE AN
INTERORGANIZATIONAL
STRATEGY
Why is transaction theory helpful?

1. It takes into account the cost associated with

different linkage mechanism to reduce
uncertainty.

2. Make better predictions about WHY and

WHEN a company will choose a certain inter
organizational strategy.
How to choose a strategy ?
1. Locate the source of transaction cost (is the cost
high or low?)

2. Calculate the transaction cost savings by the use of

different linkage mechanism.

3. Estimate the bureaucratic cost of operating the

linkage mechanism.

4. Choose the linkage mechanism that provides with

most low transaction cost saving at the lowest
bureaucratic cost.
Examples

1. EKCO GROUP

Obtaining a wide range of products from one

supplier reduces the transaction cost associated
with building many supplier relationships.

EKCO offers a wide range of products to WAL-

MART and helps the retailers to minimize the
no. of companies they must go to for products
they want to carry.
EKCO thus implicitly invite customers to increase
their links with EKCO.

To foster long term commitment and trust with

its customers EKCO has installed a state-of-art
$4 million data processing system that allows it
to provide JIT inventory service to retailers who
supply the company with the data. It also helps
retailers to simplify their ordering and inventory
tracking
2. The Japanese system of Keiretsu (Toyota)
They achieve benefits from formal linkage
mechanism without incurring its cost. By owing
minority stake in its suppliers it avoids problems
of opportunism and uncertainty with suppliers.

3. Outsourcing

4. McDonald’s Vs Burger King

McDonald’s uses franchising as a linkage
mechanism (relation between franchisee and
franchiser is symbiotic) but most Burger King
outlets are owned by the company.
Why McDonald’s is using franchising linkage?

1. It is reducing its bureaucratic cost of

maintain quality and consistency at all
outlets.

2. It spreads the cost of employing a

management team over many restaurants
and reduces bureaucratic cost.

Cars are typically sold through franchised

dealers, why?
 Resource
Transaction Cost
Dependency
Theory
Theory

Reduce
dependency on Reduce transaction
other organization cost of linkage
for resources

With least With least

loss of control bureaucratic cost