Transaction Cost Theory

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The Transactions Cost Theory The question ‘why do firms exist’ has been answered by transaction cost theory (Coase, 1937; Williamson, 1975, 1985), which has also been used to explain the differing scale and scope of firms by predicting their efficient boundaries. 1. The ‘Coasian’ analysis One of the most powerful theories to explain the existence of firms is the Transaction Cost Theory put forward by Ronald Coase in 1937. A transaction takes place whenever a good or service passes from one party to another. Transaction cost refers to the cost of providing for some goods or services through the market rather than having it provided within the firm. For Coase, the main reason to establish a firm is to avoid some of the transaction costs of using the price mechanism. In other words, the reason for the firm being is to have lower cost than the market. Transaction costs include costs that arise in respect of: • Locating buyers and sellers (search cost) • Acquiring information about their availability, quality, reliability and prices (information cost) • Negotiating, re-negotiating and concluding contracts (bargaining cost) • Coordinating the agreed actions of the parties • Monitoring the performance with respect to fulfillment of contracts (policing cost) • Taking actions to correct any failure to perform (enforcement cost) (H. Davies & P-L. Lam, 2001) Transaction between two independent parties at arm’s length (through the market mechanism) would require an agreement, a contract which set out the obligations of the buyer and seller. However, such contracts cannot be complete because they cannot specify the obligations of the buyer and the seller in every possible future circumstance since there may be thousands of such circumstances. Incomplete contracts lead to uncertainty and according to
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