Tuesday, March 8, 2016

Minimizing Firm Transaction Cost

Ronald Coase in his landmark 1937 paper The Nature of the Firm believed that all businesses are defined by their transactions. According to his Theory of the Firm people form and establish businesses because they can build and create products cheaper than contracting out the work or doing so on the open market. Firms become a way of reducing transaction costs and improving production capacity.

Firms are tightly bound networks of internal transactions. The size of the firm can be determined by how many transactions exist within the confines of the firm. As firms get large they also become more inefficient because the transaction costs rise making creation more advantageous in other entities.

Transaction costs are associated with 1. Search and information, 2. Bargaining and decision costs, and 3. Policing and enforcement costs.

Firms are at their essence long-term contracts that form when short-term contracts are no longer advantageous. As "Islands of consciousness" the transaction costs within tightly connected firms make them more efficient when compared to outside its walls. As long as it is more advantageous for entrepreneurs to create products and services from inside the firm it will continue to grow.

Coase believed that without understanding transaction costs it is impossible to create sound economic policies. High level overviews of the economy are great but without understanding the inner workings of how information, goods, and services move it is impossible to set policy in a way that improves business fundamentals. Policy often misses the mark because it doesn't integrate into the daily micro actions of the firm.

Consider a policy that helps support a budding industry a nation needs to compete internationally. The policy doesn't consider the lost revenue of inter and intra-firm transactions that make it possible for those firms to compete. It may be more beneficial to develop policies that help firms improve their internal operational transactions and work within clusters to ensure maximum development based on their natural capacities emerges.

I view the internal workings of firms as one tight layer of efficient transactions that rest on industry knowledge. Firms exist together in clusters because they share the same needs for resources and intellectual capital. The stronger and longer the firms exist in a cluster the more efficient the cluster becomes as entrepreneurs seek to modify their environment to create more profits. Hubs are a collection of clusters that share similarities in knowledge and environment whereby advancement in one industry lends to the advancement in another (i.e. telecommunications and Navy). 

Coase, R. (1937) The nature of the firm. Economica, 4 (16).

Fell free to share with appropriate attribution. Dr. Murad Abel 

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