A static examination of markets indicates that some transactions do not occur at competitive market equilibrium because of transaction costs. Because the exchange of goods or services and monetary wealth is not free, the price of a good that is transacted often reflects costs involved with coordination of the transaction and not the creation of the good. The examination of transaction costs began with efforts to understand why firms are created to organize economic activity. Coase (1937) argued that firms organize themselves to minimize transaction costs so that they can be more economically efficient. Others have used transaction costs to extend Coase’s work to describe why firms are created and what distinguishes the boundary of one firm from the boundary of another (Alchian and Demsetz 1972; Demsetz 1968; Williamson 1979). As argued by Demsetz (1968) and Williamson (1979), procuring a product can be done within the boundary of the firm or done as a market transaction between firms. Whichever organizational model has lower transaction costs is preferred. Transaction costs are the costs incurred when goods or services are exchanged and not the costs associated with creating the good or service. Defining what is a firm and what is the boundary of the firm are ongoing issues in economics. The exploration of transaction costs is only one of many theories. For example, Hart (1989), Varian (1992), and Pindyck and Rubinfeld (1995) describes differences in the methodologies used in neoclassical economics, transaction cost economics, and by economists analyzing the firm as a nexus of contracts or owners of property. While some theories of the firm can give insight into choices of labor versus technology or the cost savings of introducing one technology over another, transaction cost economics is a more appropriate theory for understanding market friction than the alternative approaches. Transaction costs may decrease when information technology is used to facilitate market exchanges. As transactions become electronic, they may cost less than physical world transactions. Some argue that information technology may lower transaction costs because of lower:
1. search costs (Bakos 1997),
2. coordination costs (Malone, Yates, and Benjamin 1987), and
3. payment processing costs (Sirbu and Tyger 1995)
If transaction costs decrease within the firm more than they decrease between firms, then there will be an organizational shift from market transactions to intra-firm transactions. If the reverse is true, there will be more market transactions and fewer intra-firm transactions. Because the effect of information technology on transaction costs is far from certain, the further information technology research can explain the factors influencing the increase or reduction of transaction costs.
Transaction Costs in a Disintermediated Market:
The simplest transaction costs incurred in a direct transaction between a supplier and a consumer. The supplier is the firm that produces a product or service being exchanged and competes with other firms whose product can be a substitute. The consumer is the end user who derives value from possessing or consuming the product. This direct transaction does not require an outside participant (i.e. an intermediary) to coordinate the exchange between the supplier and consumer. Therefore, this direct exchange is “disintermediated.” The supplier, consumer, or both may incur the transaction costs.
The effect of the transaction cost is to decrease the quantity exchanged between supplier and consumer regardless of who absorbs the cost. When a supplier absorbs the transaction cost, there is a class of consumers that would have transacted at P that do not transact at P’ because the price is too high. These consumers account for the decreased quantity of Q – Q’. Similarly, when a consumer absorbs the transaction costs, there are a class of suppliers that do not transact because P’ is too low. Once again, there is a reduction in the quantity exchanged in this market that is Q– Q’. The quantity of transactions that did not consummate because of transaction costs is known in economics as deadweight loss. Deadweight loss is regarded as an undesirable outcome, to be minimized whenever possible. The nature of the product being transacted affects the amount of a transaction cost. Williamson (1979) points out that the transaction costs for goods with low asset specificity (such as commodities) are much lower than goods with higher asset specificity. As an example, a New York Times bestseller has low asset specificity because it is designed to appeal to a mass market and consumers choose to purchase or not purchase such an item at a given price. A power plant serving a factory, on the other hand, has a high degree of asset specificity because it is designed for a particular consumer with specific needs. There are very high production costs, and neither the consumer nor the supplier of the power plant can exit the contract easily because the plant has very little appeal to any other consumer. Because all people have bounded rationality, complex contracts for a transaction may not take into consideration all possible events. As contracts become more complex and less complete, transaction costs increase.
Transaction Costs in an Intermediated Market:
Transaction costs can also be absorbed by a third party other than a consumer and a supplier—and intermediary. The intermediary is the firm that sells the product but does not create or consume it. Therefore, intermediaries compete with other firms who may sell the exact same product or service. Existing definitions in the economic literature consistently define an intermediary as a firm between the supplier (producer) and consumer (buyer). Spulber (1996) describes an intermediary as “an economic agent that purchases from suppliers for resale to buyers or that helps buyers and sellers meet and transact.” Similarly, Cosimano (1996) describes them as an institution “between buyers and sellers.” Biglaiser (1993) differentiates the intermediary from the supplier and consumer by examining its objective for participating in a market transaction. He explains that the supplier is the originator of the good through original ownership or creation and the intermediary does not alter the good. Similarly, the intermediary is different than the consumer because unlike the consumer, the intermediary derives no utility from possessing or consuming the good. The intermediary changes the transaction costs of a market transaction by buying from suppliers at one price and selling to consumers at a different price. The stock market is one example where an intermediary, the broker, does this. Demsetz (1968) used Coase’s explanation of transaction costs to explain the ask-bid spread in the securities market. Demsetz explained that there is a time that a broker must hold on to the asset before they can sell it. There is a cost associated with this time when the value of that asset may drop in price. Therefore stockbrokers buy at a price less than the market equilibrium price ( P ) and sell at a price slightly higher than the market equilibrium price. If a market is in greater flux, the ask-bid spread increases. Furthermore, as the cost to coordinate the exchange increases, the ask-bid spread increases. Intermediaries may be in a better position to lower transaction costs than a supplier or a consumer. Since the intermediary is involved in many repeated transactions, they develop a set of relationships and experience that may lower the transaction cost. Furthermore, the intermediary could invest in technology that requires a large fixed cost, but reduces the marginal cost for additional transactions. The intermediary can then amortize the fixed cost over a larger number of transactions. Although intermediaries lower transaction costs, it is not clear what roles or what value they provide. The literature agrees that an intermediary is a market participant that coordinates transactions between a consumer and supplier, but more complex definitions detailing the roles of intermediaries are inconsistent. Often the roles of the intermediary are context dependent because they provide different roles for different sets of transactions. Confusion over the role of an intermediary is exemplified by the inconsistency in defining an intermediary from an economic perspective and other perspectives such as marketing (Dwyer, Schurr, and Oh 1987) where the value of an intermediary is very subjective. It is surprising to find a lack of consensus or attention given the intermediary’s importance. Analysis of intermediaries is “largely ignored by the standard theoretical literature.”
Menu Costs and Rate of Change:
Market friction can also be caused in dynamic markets through such economic factors as menu costs. The costs of changing prices are known as menu costs. Since neoclassical economics often analyzes markets in competitive equilibrium, it is important to understand how long it takes for markets to achieve this equilibrium. Markets with more friction take longer to achieve competitive equilibrium while markets with less fiction take less time. When the market is at competitive equilibrium, prices do not change. Sometimes the costs of changing prices are too high to warrant achieving equilibrium and this increases the time a market spends in a state other than competitive equilibrium.
Menu costs are the economic costs of “printing menus” which contain the prices for the items carried by a supplier or intermediary. Much of the economic exploration of menu costs examines its macroeconomic effects. For example, Sheshinski and Weiss (1993) describe how menu costs affect the setting of prices and often explain non-optimal prices in an economy. In a country with high inflation, it is impossible for every product price to be changed daily even though this may be necessary for optimal pricing. Research on the microeconomics of menu costs is not as well developed. Microeconomic studies such as Levy, et al. (1997) estimate menu costs in a given market. When there is an exogenous force in the marketplace, prices will change more quickly or more slowly because of menu costs. When menu costs are high, the entry of a competitor or a rise in inflation may not be significant enough to change prices quickly. This is especially true if the response to such an exogenous force (either lowering or increasing prices) fluctuates. However, if the menu costs are low, prices can change quickly because of exogenous forces and fluctuate just as often as the market conditions change.
The basic components of the technology are similar, regardless of where they are used, just as the task of information processing in organizations has many commonalities regardless of industry, product line, or location (Galbraith, 1977). However, some types of organizations may benefit disproportionately from technical advances in computing and communications. While energy-intensive methods of production are favored when the price of energy declines, so one would expect that “information intensive” methods of production would be favored when the price of (computer-generated) information declines.
Malone, Yates, and Benjamin (1987) have specifically predicted that declines in the costs of IT will tend to favor decentralized “coordination-intensive” structures over more centralized ways of organizing, which economize in coordination costs at the expense of efficient resource use and flexibility. theories that predict that lower information processing and communications costs will be especially beneficial for organizations that distribute decision-making.