Transaction Cost Theory and MNE's

Running head: TRANSACTION COST THEORY AND MNE’S
TRANSACTION COST THEORY AND MNE’S
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TRANSACTION COST THEORY AND MNE’S
Introduction
In a market scenario, when economic trade takes place there is a cost involved in that
and it is called the transaction cost. The transaction cost is a very important determinant in
designing the structure of the firms and helps in taking major decisions of the firms (Wacker,
Yang and Sheu 2016). It helps the Multinational Enterprises in carrying out major decisions
when they are expanding such as whether they should expand vertically or horizontally or in
other ways. It also helps to take decisions regarding the FDI’s that is it helps in finding how
much money should be invested by the MNE from the home country to the host country for
carrying out various operations (Boddewyn 2015). Transaction cost helps to answer questions
such as why a firm exists at all and other related questions. This concept helps in explaining
whether the organizations should produce their own commodities and carry out their
operations by themselves or they should outsource the same (Williamson 2016). This
decision is the most important decisions for the multinational enterprises. This study will
focus on highlighting the importance of the transaction cost theory and how the transaction
cost theory helps the different multinational organizations in carrying out their major
decisions.
Transaction cost theory
The theory of transaction cost was developed by Ronald Coase in the year 1937 and
was improved by Oliver Williamson in the year 1975 (Shafritz, Ott and Jang 2015). The main
purpose of this theory was to understand the importance of the firm’s existence and growth in
the market scenario. According to the theory, the firms distribute the resources more
effectively than the market scenario. This theory suggests that the transaction cost is the cost
of providing the goods from some external sources rather than within the organization

TRANSACTION COST THEORY AND MNE’S
(Williamson 2016). There are various factors that need to be considered for the purpose of
understanding the market transaction such as the organization with whom the firm wants to
enter the contract with, to decide upon various negotiation factors, to create the contract and
the policies. The transaction cost includes the information and the search cost, enforcement
and policy cost and the decisions and bargaining costs. The search cost identifies the cost of
the goods in the market and this helps the organization or the firm in taking decisions of
producing or outsourcing. The bargaining cost takes into consideration the cost of entering
into contacts with different parties after discussing on various negotiations. Enforcement cost
relates to the cost for ensuring that the parties carry out the contract in a proper manner and
legal actions are taken against the party who fails to comply to the enforcement cost. The
market price affects the relationships of various forms but for carrying out decision within a
firm various types of entrepreneurial coordination factors are considered. According to the
transaction cost theory, the firms start to carry out internal operations when the cost of
transaction is higher in case of external operations in case of imperfect information about the
market place. Coase has said that the main reason behind operations of a firm is using price
mechanism to avoid this transaction cost. In the diagram given below, the transaction cost
mechanism is shown. If the external transaction cost is higher than the internal transaction
cost then the firm will grow but if the external transaction cost is lower than the external cost
of transaction then the firm will decide to downsize itself. Multinational enterprises therefore
decide to grow internationally when they find the external transactional cost as greater than
the internal transaction cost.
The transaction cost theory is thought to be developed by Ronald Coase who
suggested using his theories when an organization would carry out its operations by itself
internally and when it should be outsourced. His theory was actually focused on price
mechanism and not on transaction cost theory. The concept of transaction cost theory cannot

TRANSACTION COST THEORY AND MNE’S
be said to be defined by any particular individual because it can be dated back to monetary
economic literature. However, the concept came to existence through Oliver Williamson
work called the transaction cost economics (Jiang et al. 2015). This is how the relation
between the two concepts of transaction cost and economic came Into existence and the same
is used today in fact it is used to define various behaviours of the firm. According to him, the
transactions include not only the selling and the buying behaviour but also various forms of
interactions these costs arise because of the existence of institutions and therefore are referred
to as institutional cost in many places by many authors. The transaction cost is however
affected by the contract entered in t by then parties after proper negotiations and bargaining
activities and the authors has shifted there focus from what is transaction cost to the reduction
of the same using various practises of the firms for distributing and productions of various
services and goods.
Example of the transaction cost is- in a competitive environment, a supplier mat enter
into bidding with his customers in order to create widgets. For this purpose of providing the
widgets, the supplier needs too create machinery which cannot be used again to produce
different types and services. The relationship between the suppliers and the buyer however
changes from a competitive environment to monopoly environment. Therefore it can he said
that whenever there is a price cut, the customers are benefitted.
Williamson who is an economist he improved the transaction cost theory developed
by Ronald Coase and he has been awarded for his work in governance especially regarding
the boundaries of the firm. He has been able to identify the boundaries of the private sectors
and the public sectors through market and non-market decision making. He has distinguished
properly the activities of bargaining with that of contracts based on relationship’s. According
to Williamson , the transaction cost analysis helps lays down the basis for transactional cost
approach. It is important for organizations to carry out economizing of the transaction costs