Report On Firm - Transaction Cost Theory
Added on 2020-02-05
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MANAGERIAL ECONOMICS A291081Managerial Economics A29108Name:Institution:
MANAGERIAL ECONOMICS A291082Discussion of the view that firms exist to minimize transaction costsA firm is a business organization. It can be a corporation or a partnership, and it has differentlevels of legal protection. However, regardless of its legal definition, a firm plays an importantrole in markets (What is a firm in economics?, 2016). Transaction cost theory is a theory thataccounts for the actual cost of outsourcing production of products or services. This includestransaction costs, contracting costs, coordination costs and search costs (what is transaction costtheory? Definition and meaning, 2016). According to Ronald Coase, firms exist because going tothe market all the time can impose heavy transaction costs. This is because of some time-consuming factors like hiring workers, negotiating prices and enforcing contracts (Economist,2010). In his book, "Nature of the Firm" (1937), Coase explained his perspective about why thefirms exist. He also explained under what conditions firms are expected to emerge. For a firm toemerge, an entrepreneur must come from somewhere and start hiring people. He says it makessense for an entrepreneur to hire people to help him do a certain job instead of giving a contractfor the task to be performed. To understand how the firms minimize transaction costs or to understand why firms exist, it isimportant to look at the theory of the firm. To put things clear, the aim of the theory of the firmis to answer some questions such as why firms exist, why they are structured in a certain wayamong other questions. When it is more efficient to produce in a nonmarket environment, thefirms exist as an alternative system to the market-price mechanism. This report's main focus is onwhy firms exist. They simply exist to minimize costs which result to profit maximization. Firmscan be categorized regarding sole proprietorship, partnership, and corporation. A soleproprietorship firm is where an individual owns the firm and directly operates it and has
MANAGERIAL ECONOMICS A291083unlimited liability. A partnership is when two or more individuals come together to make a firmwhile corporations are where a firm is run by appointed managers and are owned by a group ofinvestors. While transaction cost is any cost involved while making an economic transaction,firms work very hard to make it easy for customers to get services at the minimum possibleprice. For instance, if an individual is planning to import a vehicle from a foreign countrysituated several thousand miles away. There are very many transaction costs that the individualwould incur before the vehicle reaches this individual. In the absence of firms, the individualwould have to buy air tickets, book accommodation in the foreign country, have a variedpassport to go to the country among others with all need money. It would also consume a lot oftime for the individual before he/she gets the vehicle. All this work is eliminated by companieswhich sell imported vehicles. All the client would need is an internet connection and a computeror a mobile phone to access the firm's website and purchase online. This will have reduced thetransaction cost by a big margin and it will also save a lot of time for the client. In this example,the firm will have reduced the transaction cost regarding reducing the number of transactions aswell as reducing the overall cost per transaction. Firms can also form partnerships with other companies in a bid to reduce the transaction cost.This move is popularly known as vertical integration. This idea emerged in the 19th centurywhen Andrew Carnegie described the nature of his company, U.S. Steel. Carnegie had purchasedalmost every firm that his company relied on in the supply and distribution chain. This ensuredconsistent delivery of materials and distribution as well as reducing the transaction costs. Instead of choosing the vertical integration way, firms can also choose to have long termcontracts. When tow firms have long-term contracts, it means that the costs will also bemoderated reducing the transaction costs. This would also eliminate any problem that may be
MANAGERIAL ECONOMICS A291084associated with vertical integration. However, vertical integration sometimes can be the onlycertain method of ensuring consistent and low transaction costs. For example, if we think of fastmoving industries such as technology, vertical integration is the better way to preventexploitation of one party. Although vertical integration is seen as a way of reducing transactioncost, it is very important for a company to weigh the reduction of cost against financialimplications that will be caused by the integration. For example, the cost of managing thecompany will rise when more branches are added. It is the goal of every company to be able to sell it products and services to the customers at theminimum possible price and make lots of profit. For this reason, Toyota has tried some ways in abid to reduce the average cost of producing a vehicle. For example, it has long-term contractswith a body building company called Fisher. Toyota does not buy bodies from Fisher because it'sunable to produce its own bodies but it does this to reduce the cost of production. It alsopractices lean supply chain with the firm to ensure that it receives just what and how much isneeded, and where it's needed. This reduces Toyota's inventories and thus its partnership withFisher, in the long run, reduces the cost of the transactions. Over the years, some people have come up with other ideas as to why firms exist. A director andco-chairman of Deloitte's Center for the edge say that Ronald Coase's theory as to why firmsexist is becoming obsolete (Denning, 2013). However, some people still stick to the RonaldCoase's theory. A good example is Andrew Hill that defends the theory in the Financial Times.The big question of who is wrong arises between those defending the Coase's theorem of whybusinesses exist and those opposing it. According to Denning (2013), some Coase's assumptionswere wrong even in 1937. Coase claimed that "production could be carried on without anyorganization at all." This is not true because some companies offering complex services such as
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