The Institutional Truth of Transaction Costs

Since Adam Smith’s example of the pin factory, economists have never been able to produce a satisfactory theory of the industrial firm. They’ve thought of it as a black box, expressed it as a production function involving such illuminating variables as price and quantity, and they’ve reduced it to the agency relationship falsely claiming managers to be the agents of shareholders (see other postings on this site). This inadequacy may be part of the reason why, despite Adam Smith, mainstream economists give markets pride of place over the firm.

Belief in the extreme power of market forces, so long as they were free from regulation or any other form of interference, led to the curious belief that the market could produce any item at some cost: the costs of transactions in the market. Only if a firm could produce cheaper than the cost of market transactions, would the firm be justified in production. This fertile thread of economic theory, originated in an article by Coase in 1937, but was developed in the 1960s by a group led by Williamson – last year’s joint Nobel laureate. It challenged the legitimacy of managerial decision makers, arguing the power of market forces to decide.

Transaction cost economics (TCE), as it became known, has been a productive field of academic publication. A recent review article refers to around 900 TCE studies published in academic journals. However, practical application has been limited. It is unable to address technological innovation and so misses the point of much of what importantly takes place within a real firm, even one such as a pin manufacturer. In the real world, comparison with transaction costs is of limited value since a major part of entrepreneurial effort is explicitly focused on developing products which are differentiated from anything that is already produced.

Williamson argued transaction cost analysis as the key to ‘make or buy’ decisions. But, in the real world, management already had that comprehensively covered: if a firm could source an item cheaper elsewhere than it could produce itself, the firm should consider its position. However, costs are only part of the story. There may be solid strategic reasons why a firm might wish to continue in a technology, despite its cost. Transaction cost economics makes no practical contribution to the calculation of such decisions.

The problem for economic theory, here as elsewhere, is that real decisions within the firm are likely to be taken on the basis of the experience, discretion and expertise of managers, rather than by the market. The dominant free market fundamentalist mainstream has addressed the issue of management by the spurious claim that they are simply the agents of shareholders and, above every other consideration, should seek to maximise shareholder wealth. If it was simply a matter of theory, it would be of little importance, but it has a huge impact on practice. As Keynes said, ‘the world is ruled by little else’.

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