Controlling Overhead Expense with Transaction Cost Economics

Among the human factors, bounded rationality refers to the fact that in transaction cost economics, the principal actor is not the omnicient "economic man" of classical economic theory, but rather has less than perfect knowledge of the choices available (Pitelis, 1993). Thus, whereas microeconomics postulates that a transacting partner has full knowledge of the market and will complete transactions in such a way as to maximize a utility function, the transacting partners described in TCE either incur costs to gain additional information, or simply make decisions (transaction choices) from a base of imperfect knowledge. The assumption of opportunism also departs from traditional economic theory because in transaction cost economics, actors are not dispassionate utility maximizers, but guileful individuals seeking to advance their own interests at the expense of those with whom they transact (Pitelis, 1993). The combined effect of bounded rationality and opportunism is that actors realize that their knowledge is limited, further realize that those with whom they transact are not to be trusted, and thus incur costs, transaction costs, as they try to mitigate those factors.

The environmental factors pertain to the context and terms of transactions themselves, as opposed to the motives or characteristics of the exchange partners. Thus, uncertainty refers to the fact that circumstances change in unpredictable ways, and such changes may disrupt existing patterns of transactions (Williamson, 1975).

Uncertainty is distinct from bounded rationality because while one may reduce or eliminate bounded rationality by expending more effort or incurring more cost, by its very nature, uncertainty can never be eliminated.

Asset specificity reflects the extent to which resources committed to the transaction relationship are unavailable for alternate uses (Pitelis, 1993). Frequency of exchange is a straightforward assessment of how often partners interact.

To some extent, the distinctions outlined here are artificial. This is because transaction costs cannot be understood apart from the context in which they are incurred, and it is the combined characteristics of transaction partners and the environment that ultimately define that context (Williamson, 1975). Thus, opportunistic behavior is more threatening when asset specificity is high, and bounded rationality regarding a partner's trustiworthiness diminishes as more frequent exchanges occur and direct experience provides information regarding the partner's honesty and performance.

In sum, transaction costs are often described as the costs of assembling and assimilating information, planning and proposal development, contract negotiation and enforcement costs, environmental search and assessment costs, inspection fees, lobbying expenses, etc. They are infrequently noted as distinct line items in budgets, and are instead subsumed in supervisory, overhead, or administrative cost categories. Recognizing patterns in transaction cost behavior improves cost control by alerting the organization to the underlying source of those costs (uncertainty, opportunism, etc.). TCE provides a theoretical framework that focuses organizational analyses of overhead cost trends.

References

• Pitelis, C., Ed. (1993). Transaction Costs, Markets, and Hierarchies, Blackwell Publishers, Oxford, UK.
• Williamson, O. E. (1975), Markets and Hierarchies: Analysis and Antitrust Implications, The Free Press, New York NY.

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