Why Do Firms Exist: Transaction Cost Concepts

INFS 780

Rick Christoph

Value Innovation

Why do firms exist? Economists state that markets are the

most efficient way to distribute goods Think of commodities markets for oil, wheat,

corn, etc. If this is true, why create a firm to

distribute goods in place of a market? Firms must add expense over a plain market!

Why do firms exist?

Ronald Coase suggested in 1937 that transaction costs were the reason firms are created.

Transaction costs are all costs buyer and seller incur as they gather information and negotiate a sale. These quickly add up Consider trying to buy a car – what do you have to

do?

Example of transaction costs

Imagine you are selling digital TV’s You could engage in market transactions

with all makers of TV’s To do this, you would find the makers, visit

them, evaluate their product, negotiate the sale, delivery, support, etc.

This obviously costs you significant expenses

Example

Perhaps another person noticed you were going through this expense.

They decide to create a firm that would build, sell and ship TV’s to you. Certainly this new firm will make a profit, but it

might be worth it to you since they would save you time and money

This savings represent transaction costs.

Transaction costs

Costs are higher when the product is complex and varied; conversely, costs are lower when the product is a commodity Corn futures markets work well since there are low

transaction costs Home sales have high transaction costs, so firms

(Realtors) have developed

When firms are created, functions are “aggregated”

What about technology?

How has technology changed transaction cost over time? More information is quickly available This lowers transaction costs Reduces need for the middle firm

What were the E-value chains have large impact Technology allows dis-aggregation

Disaggregation Trends

What does this mean? This is considered outsourcing!

Why do it? To save money

Is this not the exact opposite of vertical/horizontal integration? Which is right?

How do transaction costs enter in this? Transaction costs are the key!