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!