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!