Transaction Cost Theory

• Interorganizational strategies provide control over forces in the specific and general environments, and large companies use them for environmental change. Transaction cost theory addresses why and when organizations choose and change strategies.

• Transaction costs are associated with negotiating, monitoring, and governing exchanges between people. Transaction cost theory proposes that organizations should aim to minimize transaction costs for inside dealings and outside transactions. Transaction costs reduce productivity; time spent monitoring and negotiating exchanges could have created value.

Sources of Transaction Costs

• Environmental uncertainty and bounded rationality

• Opportunism and small numbers• Risk and specific assets• Transaction Costs and Linkage Mechanisms• Bureaucratic Costs

Sources of Transaction Costs

• Environmental uncertainty and bounded rationality: People have a limited ability, known as bounded rationality, to process data and understand their environment. Bounded rationality makes it costly to manage transactions in uncertain environments. To reduce transaction costs, organizations use formal linkage mechanisms like minority ownership.

• Opportunism and small numbers: The potential for opportunism is high when relying on one supplier or a few trading partners. So, organizations increase transaction costs by using resources to enforce agreements for protection.

• Risk and specific assets: Investing in specific assets, one exchange relationship, is risky. After the company invests, a customer may buy products at a lower price.

• Transaction Costs and Linkage Mechanisms• Interorganizational linkage mechanisms depend on

transaction costs. Transaction costs are low when nonspecific goods and services are exchanged, uncertainty is low, and many exchange partners exist. Companies use informal linkage mechanisms, such as reputation and unwritten contracts.

• • Transaction costs increase when more specific goods

and services are exchanged, uncertainty increases, and potential exchange partners decrease. Companies do not trust each other, so they use formal linkages, such as contracts.

• A rise in transaction costs leads to more formal linkage mechanisms to gain control. Joint venture partners favor activities that create value for both parties. Merger partners seek mutual success because one firm owns the other. Transaction cost theory attributes the move from less to more formal linkage to reducing transaction costs.

• Bureaucratic Costs• Formal linkage mechanisms reduce

transaction costs but may not be used because internal or bureaucratic transaction costs are still incurred. Integration and communication are costly, whereas time spent in a meeting could have created value.

Using Transaction Cost Theory to Choose an Interorganizational Strategy

• Transaction cost theory considers the costs of linkage mechanisms and forecasts when and why a strategy should be selected. When choosing a strategy, managers must: Identify the sources of and level of transaction costs; estimate the savings from using different linkage mechanisms; estimate the bureaucratic costs, and select the linkage that achieves cost savings at the lowest level of bureaucratic costs.

• Transaction cost theory suggests that formal linkage mechanisms are appropriate when transaction costs are high. Otherwise, informal mechanisms with lower bureaucratic costs should be selected.

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• Three mechanisms minimize transaction costs while avoiding bureaucratic costs:

• • Keiretsu offers the benefits of ownership

without the costs. Toyota has a minority interest in its suppliers for control and reduced uncertainty, but without ownership and the management costs.

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• Franchising allows for marketing a company’s products in a particular area.

• • Q. How does a franchise reduce transaction

costs without incurring bureaucratic costs?•

• A. The franchiser gives a franchisee the rights to use resources in exchange for a flat fee or a percentage of the profits. The franchiser provides the inputs to the franchisee, who makes exchanges with the customer. The relationship is symbiotic. Franchisers give rights to franchisees because the bureaucratic costs of managing their businesses are too high.

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• An organization considers transaction costs when deciding on product distribution. For a complex product, a company will have formal control over franchisees or distribution outlets. Auto manufacturers control franchised auto repair dealers, but products such as groceries require less control and can be sold through retailers.

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Outsourcing,

• buying a specialized service, is another strategy for managing interdependencies. The decision to make or outsource products depends on whether value exceeds bureaucratic costs.

• The transaction cost approach considers why and how organizations choose different linkage mechanisms. The optimal mechanism minimizes transaction and bureaucratic costs.