Transaction Cost Economics Free Essay Example

This essay draws upon the underlying dimensions of Transaction Cost Economics as a justification of why General Motors (GM) decided to acquire its producer in closed auto-bodies, Fisher Body in 1926. Prior to the Transaction Cost approach of organisation coined by Ronald Coase, understanding why firms existed was impoverished. Throughout conventional economics, emphasis was placed on mathematical modelling and mindless abstractions in which economists were fixated by what determined price, that any approaches to the study of organisation generally focused on efficiency (Williamson 1981).

The theory of perfect competition and monopoly sees the firm as a black box where certain inputs are entered into and as if by miracle, products are produced. Where conventional economics overlook the different ways in which activities can be coordinated, Transaction Cost Economics deems the ‘transaction as the basic unit of analysis and holds that an understanding of transaction cost economizing is central to the study of organisations.

‘ (Williamson 1981) Another words, by characterizing the transactions appropriately, it can help address the importance of costs in coordinating, issues regarding vertical integration and the determination of efficient boundaries between firm-type and market-type coordination.

Thus, the act of transacting within economic activities is considered the key element of understanding and assessing government structures within industrial organisations (Williamson 1981) particularly like that of Fisher Body and General Motors.

The basic framework to Williamson’s theory of Transaction Cost Economics lies with the notion that; i) there are limits to our cognitive abilities such that we are subject to bounded rationality and ii) human agents are capable of behaving opportunistically (breaking the spirit of contracts they are entered into).

By recognising that such behavioural traits can cause transactional frictions and different levels of government structures have different capabilities, strengths and weaknesses; we can develop a predictive framework for industrial organisations like that of Fisher Body and General Motors.

Such assumption will be supported by reference to Klein’s account of the hold up problem faced by GM as evidence of transactional friction between two parties and how it eventually led to GM integrating backwards in their supply chain. Lets first look at the behavioural assumptions of the human agent as described by Williamson and in observing these attributes in the Fisher-GM case study, we can justify in relations with Transaction Cost Economics why Fisher Body and General Motors went from a contract government structure to a vertically integrated firm.

According to Williamson, (1881: 553) rather than assuming that human agents are globally rational, we must appreciate that ‘agents experience limits in formulating and solving complex problems and in processing… ‘ – thus they are boundedly rational. This is because the notion of the human agent maximising their utility, subject to a budget constraint, through lightning fast calculations, or assuming that they have a substantial computational ability, is highly unrealistic. Instead, human agents fall back on rules of thumb, conventions or habits to get by.

This is true for Fisher Body’s incomplete contract with GM since it would be unrealistic to deal with ‘complexity in all contractually relevant respects. ‘ (Williamson 1981: 554) Another assumption we must recognise is that human agents are capable of behaving opportunistically. Conventional economics assume that once contracts are signed, then agents will live up to those contracts but Williamson argues that this fails to recognise that opportunism is always a possibility such that agents can often exploit loopholes in contracts and behave badly through pursuing our ‘self-interest with guile. ‘ (Williamson 1981: 554)