Transaction Cost Economics

1. What are transaction costs?

There are two main ways of applying transaction costs reasoning. The first one is the direct-measurement transaction cost approach (DMA), and the second one is the indirect or frequency-measurement transaction cost approach (IMA). The first approach may be applied only if all elements of transaction costs may be compared and estimated (Chang & Ive 2000, p. 4). Transaction costs may be observed in the construction industry, as well. They determine the size of the firms and their specialisation. Transaction costs exist when goods and services are transferred across separate stages of production and distribution (Chang & Ive 2000, p. 9).

2. What are the behavioural assumptions of TCE?

Transaction cost economics is based on a number of behavioural assumptions. Different economic agents have different economic interests. For example, firms try to maximise the amount of their profits and capitalisation in the long run. For this reason, they use the marginal approach in the process of determining those spheres that may be potentially profitable for the firm. However, firms should take into account the amount of transaction costs. If the expected marginal revenue is higher than the expected marginal and transaction costs, then the project under consideration should be realised. Otherwise, it is unreasonable to realise it as the total level of the firm’s profits may diminish.

3. What is the nature of the hold-up problem in the manufacturing setting?

The hold-up problem in the case of asset specificity may create significant transaction hazards. The level of asset specificity is essential for the understanding of the problem and finding the optimal solution. In relation to construction projects, the main form of asset specificity is process specificity (Chang & Ive 2007, p. 394). It helps to determine the essence of the problem. The market uncertainty is also significant as it refers to non-insurable risks. The company’s management should use his/her understanding of the external environment as not all aspects may be correctly estimated with the help of formal models.

4. What are the key factors whose presence in a transaction would affect its efficiency?

The following key factors may be determined. They include asset specificity, uncertainty/complexity, and frequency. If a given asset is very specific, then transaction costs associated with it will be higher in comparison with less specific assets. It will happen because there are a number of alternative uses for all factors that are not specific. In other words, they may be comparatively easy transformed from one type of employment to another one.

Uncertainty/complexity is also directly related to the amount of transaction costs. If the situation tends to become more uncertain and complex, the firms will face additional problems. They will have to re-allocate their resources accordingly. It may be necessary to have additional reserves. In any case, they will experience higher transaction costs. More complex production processes also correspond to higher transaction costs. Firms have to take into account all aspects of the entire situation and operate in accordance with their missions and strategic objectives. Frequency also affects the level of transaction costs. Other things being equal, if the company operates in a more dynamic environment, it will suffer higher transaction costs.

5. Why do markets and firms have differential competencies in governing transactions?

As different markets and firms have different characteristics, their competencies in governing transactions are not the same. These differences may be attributed to the following issues: adaptability, incentive instruments, and efficiency of dispute resolution. Those firms that are able to adapt in a shorter period of time will have lower transaction costs. In this way, the market forces will stimulate efficient methods of production. Those firms that cannot quickly adapt to new market conditions will suffer higher transaction costs. As a result, their market positions will tend to weaken. Some of these companies may even suffer losses and leave the market.

Incentive instruments may allow decreasing the amount of transaction costs. If the company’s management introduces efficient motivation techniques, the company’s personnel may be greatly motivated that will lead to higher overall productivity in the company. Those companies that are not able to provide adequate motivation for their employees will suffer additional expenses. In fact, transaction costs indirectly influence the amount of resources that should be allocated to the company’s management and different lines of production.

Efficiency of dispute resolution is of utmost importance nowadays especially in the international markets. As the dynamics of modern commercial operations is very high, the number of disputes tends to increase. Therefore, firms should develop an effective system of their resolution. It will allow minimising transaction costs and receiving additional profits. The company’s competitive positions may be improved, as well.

6. What is the meaning of process specificity? In what aspects is it different from other types of asset specificity?

Process specificity is typical for the construction industry. Consequently, this industry is characterised by a specific legal environment. Contractors have to organise their behaviour in such a way that will maximise their market opportunities. Process specificity refers to the situation when the firm has not a large number of options regarding the organisation of its production processes. In order to produce its goods, it should refer to specific production methods. Such a situation may lead to higher transaction costs. However, the existing level of transaction costs in the industry will not influence the profitability of a given firm. The company should be focused on its comparative positions in the industry rather than the absolute level of costs. Some transaction costs are necessary and even beneficial for the firm if they help to produce a higher marginal product. Process specificity is different from other forms of asset specificity because it refers not to material objects but to the method of their employment.