Transaction Cost Theory

Transaction cost theory helps us to understand how markets and hierarchies are chosen. In free market economies one can observe two basic mechanisms for coordinating the flow of materials and services through adjacent steps in the value chain: markets and hierarchies (Malone et al., 1987; Picot & Kirchner, 1987). Williamson (1981, pp. 1545-1551) classifies transactions into those that support coordination between multiple buyers and sellers, i.e., market transactions, and those supporting coordination within the firm, as well as industry value chain, i.e., hierarchy transactions.

The price a product is sold for consists of three elements: production costs, coordination costs and profit margin. Throughout the relevant literature, scholars often choose different terms to describe coordination costs; Chandler, e.g., labels them as administrative costs. The authors prefer the definition of production and coordination costs chosen by Malone et al. (1987):

Production costs include the physical or other primary processes necessary to create and distribute the goods or services being produced.

Coordination costs include the transaction (or governance) costs of all the information processing necessary to coordinate the work of people and machines that perform the primary processes. For example, coordination costs include determining the design, price, quantity, delivery schedule, and similar factors for products transferred between adjacent steps on a value chain.

Economic theory and actual market behavior assert that firms will choose transactions that economize on coordination costs. As information technology continues its rapid cost performance improvement, firms will continue to find incentives to coordinate their activities electronically. Often, this coordination takes the form of single-source electronic sales channels (one supplier and many purchasers coordinated through hierarchical transactions) or electronic markets (Malone et al., 1987). It follows too that electronic markets are more efficient forms of coordination for certain classes of product transactions. Utilizing cheap coordinative transactions, interconnected networks and easily accessible databases, economic theory predicts that a proportional shift of economic activity from single-source sales channels to electronic markets is likely to occur, as lower coordination costs favor electronic markets. Low cost computation favors electronic markets by simplifying complex product descriptions and reducing asset specificity. An evolution from manufacturer-controlled value chains to electronic markets can be anticipated. Stakeholders will opt for markets when increased volume is greater than loss in revenue from electronic market effect.

The above four explanations can already be observed in a number of applied settings. Competing computerized reservation systems (e.g., American Airlines' SABRE CRS), certain firms within financial markets, commodity markets and various niche markets have undergone the described shifts from hierarchies to markets. Firms like Dell, Gateway and Compaq have been able to lessen personal computer product specificity and have been highly successful in selling through mail-order channels. Electronic single-source channels will evolve from separate databases within the firm, to linked databases between firms (Electronic Data Interchange), to shared databases between firms. In time electronic markets will evolve from electronic single-source sales channels to biased markets where the market maker is one of the providers. In such markets, the market maker uses the market transaction mechanisms in its favor. Next, there will be a shift to unbiased markets and finally to personalized markets where customers can use customized aids in making their choices.