Transaction Cost Economics

from the Perspective of Competitive Advantage

by
Edwin B. Dean

I must thank Renee Stiles for bringing this cost topic to my attention and for providing a number of excellent references to get me started. Her guest contribution views overhead in terms of transaction costs.

As I view it, when we transact with others, we often assume that the other parties are out to win something from the transaction at our expense. We then begin to build defense mechanisms to protect our interests, and maybe even build offense mechanisms which will allow us to win at their expense. This creates a positive feedback which leads to further activities for both defense and offense by both parties. The net result is a complex of activities which do nothing but protect self interest. And these activities consume resources and hence generate cost.

In recent meetings within the NASA community, I have heard of a number of activities which, combined, probably represent hundreds of millions of dollars of opportunity costs which were lost because of an organization acting to protect self-interest at the expense of the NASA budget. I am convinced that transaction costs are possibly the largest category of costs existing within NASA today. I suspect that is also true for many other government agencies, as well as for many corporations.

The sad part is that these costs are unnecessary and would largely disappear if each party to the transaction trusted the others. The secret to a very large cost reduction is, thus, the establishment of a win-win environment through trust. Deming (1993) points this out clearly, even though the concept of transaction cost economics is never mentioned. Whitney (1996), who is well read in transaction cost economics, extends Deming's observations to clarify how to obtain major cost reductions by eliminating transaction costs.

Miller and Vollman (1985) provides an excellent perspective of transaction costs within the electronics industry.

Morita et. al. (1986) notes the practice of corporations in Japan to include a clause in contracts which states that

if, during the life of the contract, conditions changed in a way that affected the ability of either side to comply with the terms, both sides would sit down and discuss the situation.

Morita notes that

The American side could not understand how we could sit down together and talk in good faith if the two parties were having a major disagreement.

He further notes that Japanese companies typically operate on renewable 90 day loans because of the existence of trust between the bank and the company, a situation which his took his American colleagues a long time to understand and accept. He also mentions the lifetime jobs in Japan which also establish a trust between the company and the employee. These observations are consistent with my conjecture that a major part of the efficiency of the Japanese business system is based upon a trust that minimizes transactions costs.

It is interesting to note than transactions are the inputs and outputs of activities. Thus transaction cost economics is directly linked to activity based cost. It is a different, and very useful, perspective of the same cost phenomena.

Rajagopalan, Rao. and Chaudhury (1996) apply transaction cost economics in their analysis of information technology outsourcing.

The May 1996 COSTLESS Team workshop used the transaction cost perspective, under the guidance of Renee Stiles, in developing a proposed strategy for reducing cost within NASA space operations.

References

Deming, W. E. (1993). The New Economics for Industry, Government, Education, Massachusetts Institute of Technology Center for Advanced Engineering Study, Cambridge MA.
Dugger, W. M. (1993). "Transaction Cost Economics and the State," in Pitelis, C., ed., Transaction Costs, Markets and Hierarchies, Blackwell Publishers, Oxford, UK.
Miller, J. G. and T. E. Vollman (1985). "The Hidden Factory," Harvard Business Review, September-October, pp. 142-150.
Morita, A. with E. M. Reingold and M. Shimomura (1986). Made in Japan: Akio Morita and Sony, E. P. Dutton, New York NY.
Rajagopalan, K. N. S., H. R. Rao. and A. Chaudhury (1996). "A Two-Level Investigation of Information Systems Outsourcing," Communications of the ACM, Vol. 39, No.7, July, pp. 36-44.
Whitney, J. O. (1996). The Economics of Trust: Liberating Profits & Restoring Corporate Vitality, McGraw-Hill, New York NY.

Guest Contributions

Controlling Overhead Expense with Transaction Cost Economics by Renee Stiles

Bibliographies

Transaction Cost Economics and the Economics of Trust Bibliography

References

Deming, W. E. (1993). The New Economics for Industry, Government, Education, Massachusetts Institute of Technology Center for Advanced Engineering Study, Cambridge MA.
Dugger, W. M. (1993). "Transaction Cost Economics and the State," in Pitelis, C., ed., Transaction Costs, Markets and Hierarchies, Blackwell Publishers, Oxford, UK.
Miller, J. G. and T. E. Vollman (1985). "The Hidden Factory," Harvard Business Review, September-October, pp. 142-150.
Morita, A. with E. M. Reingold and M. Shimomura (1986). Made in Japan: Akio Morita and Sony, E. P. Dutton, New York NY.
Rajagopalan, K. N. S., H. R. Rao. and A. Chaudhury (1996). "A Two-Level Investigation of Information Systems Outsourcing," Communications of the ACM, Vol. 39, No.7, July, pp. 36-44.
Whitney, J. O. (1996). The Economics of Trust: Liberating Profits & Restoring Corporate Vitality, McGraw-Hill, New York NY.

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