What is Transaction Cost Theory?



Ans.    This theory attempts to define firms in relation to market and give an economic explanation for the existence of the company. Ronald Coase in 1937 propounded this theory which was further expanded by Williamson in 1996.

According to R.Coase, a firm is system of relationship which comes into existence when direction of resources depends on entrepreneur and therefore firms get larger or smaller in size based on whether the entrepreneur organizes more or favor transaction. Transaction cost, according to him, is cost incurred in making and economic exchange or cost of participating in market. He further adds that price mechanism does not work costlessly and that firms exist to economise on this costs. The extend of a firm is therefore determine by balancing the cost of coordinating production in the market through price mechanism as against the cost of the market of organizing production within the firm. The extent of firm will shrink when the cost of using prices to transact in market falls relative to cost of internal organization. R.Coase use the term transaction Coase to predict when certain economic tasks will be perform by a firm and when they will be perform by market. Hence when external transaction cost are higher, that internal transaction cost, company will grow and if external transaction costs are lower, that internal transaction cost company will or outsource.

Alike the belief of traditional economic that all economic agents are rational, the transaction cost economic attempts corporate human behavior in a more realistic manner. It states that managers and other economy agents practice ‘bounded rationality’ and ‘opportunism’. Here ‘bounded rationalism’ refers to behavior that is intentionally rational but only limitedly so and ‘opportunism’ means self interest seeking behavior of managers.

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MT UVA- University, Vocational and Affiliated Education for BMS


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