Transaction Cost Theory
Introduction
In the contemporary business environment, the budget for each investment is tight. Today, business entities not only deal with domestic industries but also with international suppliers. According to ( ), transaction cost theory is an accounting school of thought that explores the actual cost of outsourcing the production of goods or services. It includes transaction costs, contracting costs, coordination costs, and search costs. The theory considers all the costs incurred when making a decision, not just the market price. The primary question that transaction cost theory seeks to answer is why economic transactions are organized the way they are in contemporary society. It strives to address why some internal transactions are internalized within organizations while others are procured to external factors.
The transaction cost theory emerged from the relative failure of neoclassic economic theory to sufficiently address and clarify economic occurrences. The neoclassic economic theory is based on the perfect competition ideology and it is highly criticized for being unrealistic, simple, and redundant. For example, according to the neoclassic economic theory, a firm is where factors of production, that is, labour and capital, are used and products come out. It measures efficiency by the input and output ratio. However, the transaction cost theory expounds the neoclassic view by examining the various aspects within and outside an organization. Transaction theory examines an entity as a hierarchy that enhances value by economizing transaction costs. It considers efficiency as a scenario where the operations of a firm are compared to their ability to facilitate transactions until a situation where it is impossible to make one party better off without making the other worse off. The transaction cost theory asserts that an organization embarks on a more efficient technique of operations because of the optimization of transaction costs.
Assumptions of the Transaction Cost Theory
The theory of transaction cost is based on several assumptions regarding human behavior and the business environment. These suppositions explain why organizations incur superior costs for certain transactions and why some entities may be more efficient than markets at addressing transactions. This entails the selection of a governance style from the available option that reduces transaction and production costs.
The transaction cost theory assumes that human behavior is guided by opportunism with guile. The neoclassic economic theory considers people are self-interested as individuals chase activities that fulfil their interests. The theory of transaction cost expounds on self-interest and assumes that people may participate in behavior that is both imperceptibly and explicitly dishonest before and after making agreements. The opportunist assumption examines the motivations for human behavior. The assumption is essential in the theory since the absence of opportunist behavior would mean that contracts would be costless to enforce. Consequently, there would be no need to establish economic entities other than to serve the market needs.
Moreover, the transaction cost theory is based on bounded rationality. The neoclassic school of thought assumes that people have perfect information about the market and act to maximize their utility. On the other hand, the transaction cost theory sees individuals as boundedly rational. This means that people cannot process huge amounts of information and have trouble allocating likelihood figures to the manifestation of future actions. Also, it assumes that people strive to make rational decisions but confined to their mental capacity and imperfect information.
Another assumption of the transaction cost theory is asset specificity. According to ( ), asset specificity entails the sustainable investments employed to aid specific transactions, in which the opportunity cost to invest in way lower than other alternatives should the initial transaction end precipitately. Unlike the neoclassic view which sees exchanges of standard nature, transaction cost theory comprises of distinctive qualities to ensure that agreements cannot be formulated costlessly. Therefore, contract and administrative protections are essential for transactions containing nonstandard assets. Additionally, transaction cost economics asserts that the market may be most efficient when assets are not specific to an exchange.
Furthermore, another assumption of the transaction cost theory is uncertainty. This is in contrast with the perfect information supposition of the neoclassic economics since data regarding the past, present, and upcoming event is not impeccably known. Bounded rationality and opportunism interfere with the rules of perfect competition leading to uncertainty. Nonetheless, the existence of these assumptions makes uncertainty fundamental since the inability to determine who is likely to engage in opportunistic behavior makes creating and enforcing contracts costly. Moreover, the frequency of the transactions is a key assumption of the transaction cost theory. When transactions are sporadic, then the cost of substitute administration systems may not be warranted. This means that huge volumes of transactions necessitate the need for substitute governance arrangements such as enterprises.
Benefits of Transaction Theory
Governance Structure
There are varying governance structures but none is used solely in a given scenario. In contemporary business, organizations are utilizing mixed governance structures made by combining several administrative systems. Eventually, based on the qualities of a transaction and its environment, mixed administrative systems may be changed to fit in unique enterprises and individual needs. Hence, the hunt for business transaction benefits, together with the need to offer workers with transaction doles and to economize firm transaction costs, leads to a mixed administrative structure. A firm must consider individual transaction benefits, like when it offers discretion to workers over their time and duty, it will seek a mixed administrative system that will try to leverage the importance of reducing operational costs and maximizing individual benefits. Also, the change from traditional to electronic-based knowledge and a service-driven business world allows for governance mixing. For example, universities use a mix of administrative arrangements, as the faculty navigates between teaching and research. Hence, the governance structure is determined after considering the transaction costs, individual transaction benefits, and the firm`s transaction advantages.
Moreover, knowledge-intensive industries, like the medical sector, frequently lack the talent and knowledge to remain competitive. For such personnel, motivation through financial compensation may not be enough, and other transactions benefits may be required to entice and retain competitive employees. Thus, for knowledge-intensive industries call for the application of mixed governance because of a scarcity of expertise. In such industries, innovation is probably the only means of competitive advantage. Hence, for most cutting edge organizations and research bodies, having strong hierarchical authority or market discipline is not the solution. Such enterprises require a community administrative structure that facilitates innovation. Moreover, organizations and their workers can utilize information systems to support substitute administrative systems.
Google Case Study
Google is the leading internet search engine which generates most of its revenue from online advertisement. The company offers a variety of products, concepts, and projects, like Google Drive, Google Maps. Today, the multinational enterprise is more than just an internet search engine, it has become a common household name. As a knowledge-intensive organization, Google has many engineering offices located all over the globe. As the company strive to realize its mission of concurring the world`s information sector, it has been focusing on managing knowledge and talented employees in their offices to maintain a competitive advantage in the industry.
By employing a diversified governance arrangement, Google has created a working environment that encourages the flow of knowledge and values innovation. The company has given its engineers a lot of freedom resulting in increased creativity and fast outcomes. One of their effective programs is the `20 per cent time` which allows engineers to spend one day a week on their wants. During this period, engineers are allowed to engage in other projects not linked to their task and to formulate new ideas. The freedom and a motivating workplace allow the engineering team to remain creative, as the workers derive job gratification from having their work recognized. Although Google does not have a formal hierarchal authority during the `20 per cent time`, it has seen a tremendous increase in revenue caused by keeping the employees satisfied.
Moreover, Google has a flat organizational structure. Here, the engineers can share their thoughts about a product via active and proficient feedback platforms, instead of navigating up a hierarchical organizational arrangement. Google seeks to take care of each employee`s interests by offering them a chance to participate in projects they are passionate about. It has an open communication policy that enables workers to share ideas with the rest of the company for peer-review.
Consequently, Google is seen as the best work environment for talented engineers. It is a place where an engineer has the freedom to engage in personal projects and work together with other talented engineers from all over the world. With the current mixed administrative structure, every worker holds a specific position in the firm`s hierarchy, while they are allowed to pursue personal projects. For the company to maintain its competitive edge, it attracts and retains innovate engineers by establishing and preserving a collective and creative environment. This entails cultivating a relaxed organizational culture and focusing on enjoyable aspects at work. Ultimately, Google`s case illustrates how the transaction cost theory is used to determine the most suitable governance structure in multinational organizations. The transaction costs are greatly reduced when Google switched a combination of command and control hierarchy with the environment of a collective and control community. Also, the company offers several individual transaction benefits that entice the much-needed creativity and engage them innovatively. Hence, Google`s primary organization transaction advantage in nurturing innovation.
Criticism of Transaction Cost Theory
Despite the remarkable impact of transaction cost economics to management in the last five decades, the theory has received criticisms from scholars. Most of the critics claim that the assumptions of the transaction cost theory are flawed. The assumption of opportunism has been attacked for overlooking what drives human behavior, hence presents an under-socialized perspective of human motivation and overemphasized viewpoint of institutional control. Williamson ( ) responded to the sentiments by asserting that the opportunism in his theory may vary from one individual to another much like character or aptitude. However, transaction costs change because of variations in the surroundings, and not within an individual. Similarly, ( ) employed an interactionist viewpoint instead of a dispositional one to assert that opportunism can be viewed as both a temperament and a psychological caused by the combination of individual and situational aspects.
Another criticism of the transaction cost theory is that opportunism with guile is harmful to the business world. ( ) argues that opportunism with guile is detrimental for any organizations. Hence, the implementation of transaction cost theory will intensify the manifestation of opportunism instead of reducing it. At the same time, ( ) attacked the theory for failing to illustrate how opportunism is minimized via substitute government structures. The author claimed that the primary issue with the transaction cost theory was the opportunism, and there is a significant variation between the propensity to act opportunistically and the psychological state of opportunism. It means that the exact uncertainty factors that may cause some people to engage in opportunistic behavior may cause others to trust. Similarly, in certain scenarios trust and collaboration may be the most sensible and effective self-interested action. Thus, the propensity to trust as a condition is a more practical assumption regarding individual actions given uncertainty.
Additionally, transaction cost theory sees individuals as passive and protective when faced with an uncertain surrounding. It considers environmental uncertainty a menace that must be controlled via administrative systems that enable supervisors to reduce transaction costs. Critics assert that uncertainty and bounded rationality should not be treated as a menace but instead, they should be considered as opportunities to take advantage of in the market. It means that firms can take advantage by leveraging the individual capacity to take initiative, to collaborate and to adopt.
Others criticize the transaction cost theory as a model that explores only two extremes techniques of facilitating transactions that do not exist. They assert that the market versus hierarchy model is unachievable because most transactions are facilitated via a hybrid governance system. ( ) critics the theory by attacking its tautological nature. The author shows how the theory has refused to operationalize the measurements of transaction cost, leading to a repetitive claim. The existing model of the theory does not define and account for all transaction cost. Hence, it is flawed and will eventually be replaced by a structure that minimizes these costs. This means that comparing transaction cost under varying administrative arrangements is void since the control structure utilized to manage a transaction alters the characteristics of a transaction.
The transaction cost theory is often criticized for not illustrating the alternative organizational structures and other events. Nonetheless, the theory does not claim to offer solutions to everything. It only seeks to illustrate certain organizational scenarios as well as why transactions are arranged in particular manners. Hence, despite its significance in organizational theories, transaction cost theory must not be utilized solely to illustrate enterprise events.
PART B
Outsourcing
Every decision within an organization centres around the cost-effectiveness of the products offered. Outsourcing is a suitable strategy for corporations planning to expand their activities into other regions. Before any entry market strategy is chosen and implemented, the costs of the new venture must be determined to realize maximum economic benefits. It is here that the transaction cost theory helps a firm to make the most appropriate approach when entering a new market. When an organization decides to embrace outsourcing, it creates a probably chance to convert its fixed costs into variable expenses. Similarly, it increases an organization`s options for cost-cutting by decreasing the piece and amassing the flexibility of transactions.
Globalization has changed the viewpoint in which enterprises explore international transactions. Today, overseas markets are no longer considered inaccessible. The existence of many multinationals is an indication that organizations strive to enter the global business environment. Also, enterprises seek to take part in international trade as a way of expanding their operations to mitigate the effects of domestic economies. Hence, the appropriate question is not if a company expands overseas, but the strategy it will utilize to expand. As the global economy continues to be more integrated, a company needs to select a suitable entry mode approach, ranging from exports to foreign direct investments.
Numerous studies on entry mode strategies have revealed the various why organizations choose a specific approach of operating in an oversea market. Over the years, the evaluation of the entry approach determination has been greatly influenced by concepts, such as transaction cost approach, internalization theory, institutional theory, review-based view, and process paradigm.
Nonetheless, the transaction cost school of thought dominates entry mode strategies. It is impractical to comprehend the functioning of the economic system without the concept of transaction costs. The costs of operating an economic entity are the transaction costs which are defined as the expenses of operating in a specific market. These costs make the contracting process costly and ineffective.
When conducting entry mode research, transaction costs are typically recognized in three categories which include asset specificity, uncertainty, and frequency. Asset specificity is the most fundamental aspect of the transaction. It allows an organization to fully gauge if a contract necessitates individually-made resolutions or relatively homogeneous investment. This aspect applies to both fixed assets and human personnel based on the organization`s operation in production or services. Here, a multinational must decide whether to change its products and services to fit the needs of a specific market or enter the market with standardized products.
The presence of imperfect information and opportunist behavior among partners may lead to a scenario is where both partners are mandated to make choices oblivion the behavior of other businesses in the market. This behavior is referred to as behavioural uncertainty since the outcomes of these actions are not grounded on rational human behavior. Also, external uncertainty examines the likelihood of facing unexpected changes in the legal and economic climate since it impacts the expected revenue. Hence, the entry mode strategy is heavily dependent on the goals set up by an enterprise. It means that if the uncertainty level is higher than what a company may afford, it may seek an approach that offers higher control. An organization may choose to use exporting as an entry strategy to the overseas market instead of foreign direct investments because of uncertainty in the foreign economy. Exporting is relatively less risky because a company does not have to invest in a foreign market. Instead, it only needs to export product, which means fewer risks from the abroad market conditions. On the other hand, foreign direct investments require a firm to invest capital directly in the foreign economy, increasing uncertainty because of operating in a foreign economy.