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date: 24 June 2017

Transaction Cost Economics as a Theory of Management

This is an advance summary of a forthcoming article in the Oxford Research Encyclopedia of Business and Management. Please check back later for the full article.

Which components should a manufacturing firm make in-house, which should it co-produce, and which components should it outsource? Who should sit on the firm’s board of directors? What is the right balance between debt and equity financing?

These three questions may appear different on the surface, but they are all variations on the same theme: How should a complex contractual relationship be governed to minimize cost and create transaction value? Transaction Cost Economics (TCE) is one of the most established theories of management to address this fundamental question.

In 1937, Coase was the first author to highlight the importance of understanding the costs of transacting, but TCE as a formal theory started in earnest in the late 1960’s and early 1970’s, as an attempt to understand and make empirical predictions about vertical integration (“the make-or-buy decision”). In its history, spanning now over five decades, TCE has expanded to become one of the most influential management theories, addressing not only the scale and the scope of the firm but also many aspects of its internal workings, most notably corporate governance and organization design. TCE is therefore not only a theory of the firm but, indeed, also a theory of management.

At its foundation, TCE is a theory of organizational efficiency: How should a complex transaction be structured and governed so as to minimize waste? The efficiency objective calls for identifying the comparatively better organizational arrangement among feasible alternatives to match the key features of the transaction. For example, a highly complex, risky, and recurring transaction may be prohibitively expensive to try to manage through a buyer-supplier contract. Instead, internalizing the transaction through vertical integration offers an economically more efficient approach.

TCE starts by seeking to describe and understand two kinds of heterogeneity. The first kind is the diversity of transactions: What are the relevant dimensions with respect to which transactions differ from one another? The second kind is the diversity of organizations: What are the relevant dimensions in which organizational responses to transaction governance differ from one another? The ultimate objective in TCE is to understand discriminating alignment: Which organizational response offers the least-cost solution to govern a given transaction? Understanding discriminating alignment is also the main source of prescription derived from TCE.

The key points when examining the logic and applicability of TCE are:

1. TCE is not only a theory of the make-or-buy decision but also has broader applicability to the examination of complex transactions and contracts more generally; the buyer-supplier contract is the paradigmatic canonical case.

2. TCE could be described as a constructive stakeholder theory, where the primary objective is to ensure efficient transactions and avoidance of waste. TCE shares many features with contemporary stakeholder management principles.

3. TCE offers a useful contrast and counterpoint to other theories of organizations, such as competence- and power-based theories of the firm. These other theories, of course, symmetrically inform TCE. TCE reminds us that in a world where resources are limited, the economics of organizing are always relevant.