3.4.1 Transaction costs economics theory

The TCE theory is partly based on the influential article of Ronald Coase (1937), in which Coase shares his view on the reasons why companies exist. The reason for the existence starts with the acknowledgement of the shortcomings of the price mechanism, which determines the allocation of production factors according to the classical economic theory (Coase 1937: 387-389). When the price of factor A becomes higher in location X than in location Y, A moves from Y to X until the difference in price between X and Y disappears. The first shortcoming is best illustrated by an example; if a workman moves from location X to Y, this is not the result of changes in relative prices, but the result of his superior’s orders. This means that not all movements of production factors are the result of the price mechanism, but of organisation, which can be considered to be a fourth factor of production1 or the coordinating function of the manager/entrepreneur. A second shortcoming is the fact that using the price mechanism in a production process is not costless, according to Coase. There are costs involved in discovering the relevant prices of production factors:

transaction costs. In this respect, ex ante and ex post costs are distinguished (Williamson 1985: 20-22). Ex ante costs are the costs of drafting, negotiating and safeguarding an agreement for a transaction. Safeguarding can be realised through common ownership, which creates commitment between companies and restores integrity. Ex post costs comprise costs of maladaptation when transactions drift out of alignment, haggling costs in situations of misalignment that needs to be redressed, setup and running costs for private ordering and bonding costs for secure commitments.

By organising production within one company, the transaction costs are reduced, but not eliminated (Coase 1937: 390). Or as Coase states: ‘[…] the operation of a market costs something and by forming an organisation and allowing some authority (an entrepreneur) to direct the resources, certain marketing costs are saved. The entrepreneur has to carry out his function at less cost, taking into account the fact that he may get factors of production at a lower price than the market transactions which he supersedes, because it is always possible to revert to the open market if he fails to do this’ (1937: 392).

The size of a company becomes larger when more transactions are organised by the entrepreneur and becomes smaller when he abandons such transactions. However, companies do not become infinitely large and if the existence of companies is caused by avoiding marketing costs, why is there not one big company? The first reason why there is not one big company is the diminishing returns to management. Examples of these diminishing returns to management are the decreasing returns to the entrepreneur function, which means that the costs of organising additional transactions within the company may rise. And the problems some entrepreneurs have to allocate factors of production in the uses where their value is greatest. This is especially true when the number of organised transactions increase. Another reason for a maximum size of a company is the possibility of a rise in supply price, because other advantages of a small company are greater than those of a large company. In sum, a company will tend to be larger ‘(a) the less the costs of organising and the slower these costs rise with an increase in the transactions organised; (b) the less likely the entrepreneur is to make mistakes and the smaller the increase in mistakes with an increase in the transactions organised; (c) the greater the lowering (or the less the rise) in the supply price of factors of production to firms of a larger size’ (Coase 1937: 396-397).