Transaction Cost in Economics

Abstract

This chapter will set out to explain economists use the concept of a transaction cost. Central to the concept of transaction costs is the field of study that is called transaction cost economics (TCE). It is important to recognize, however, that TCE treats transaction costs in a different manner than this book does. From the title of the study, one might think that TCE is all about measuring and minimizing transaction costs, but this would be quite misleading. TCE does not even deal with transactions and transaction costs per se, as this book has been proposing, but instead addresses the purely economics-oriented question of how governance structures are selected to counter opportunistic behavior. Here governance structures refer to whether a company manufactures internally, manufactures within its family group, vertically integrates, or buys from the market.

Transaction cost economics does not deal with transaction costs per se. There is a need for a field of economics that deals with transaction costs.

These keywords were added by machine and not by the authors. This process is experimental and the keywords may be updated as the learning algorithm improves.

7.1 What Is Transaction Cost Economics?

Transaction cost economics deals with only governance issues.

This chapter will set out to explain how economists use the concept a transaction cost. Central to the concept is the field of study that is called transaction cost economics (TCE). It is important to recognize, however, that TCE treats transaction costs in a different manner than this book does. From the title of the study, one might think that TCE is all about measuring and minimizing transaction costs, but this would be quite misleading. TCE does not even deal with transaction and transaction costs per se, as this book has been proposing, but instead addresses the purely economics-oriented question of how governance structures are selected to counter opportunistic behavior. Here governance structures refer to whether a company manufactures internally, manufactures within its family group, vertically integrates, or buys from the market. The most accepted explanation about TCE is “a comprehensive model of governance choice between market and hierarchical (organization) regarding how to minimize the threat that exchange partners will be unfairly exploited in an exchange and to do so at the lowest cost possible.”¹ TCE centers on the question of how these forms of governance are selected.

To answer the question of why TCE is not addressing the issues of transaction costs, it is first necessary to understand the context of how and why TCE emerged within the larger field and history of economics. The aim of this chapter is to describe how TCE has emerged, to discuss the issues involved, and finally to propose some options to further develop the field.

The concept of a transaction cost was first proposed by Ronald Coase in 1937. The classical economics up to that point presumed complete markets, meaning that the market is frictionless, requiring no transaction costs, where resources are reallocated from ineffective organizations to more effective organizations by the “invisible hand” of the market. Reproaching this argument, Coase asked the simple question of why, if the market place is such a perfect mechanism, firms exist at all. He proposed that, actually, there are costs arising during transaction and organizations exist in order to reduce these costs, implementing internal mechanisms by the “visible hands” of managers. He was later awarded the Nobel Prize in 1991 for this and other lasting contributions to economics.

However, Coase only proposed the theory, simply calling attention to the existence of transaction costs. The economist Oliver Williamson was the one who worked out the details of why transaction costs arise in the first place and how the transaction costs should be reduced. He popularized the term, making it widely known in economics. His theory has not only made an impact on the field of economics, but has also summoned a lot of followers who helped spread the concept to other fields. Thus, today, TCE mostly refers to the theory formulated by Williamson, for which he also earned a Nobel Prize in 2009.

7.2 Williamson’s Theory of Transaction Cost Economics

Williamson’s TCE is complex and difficult to understand.

Before delving into the demanding explanation of Williamson’s theory, it is useful to provide some basic knowledge by defining some of the key notions: opportunistic behavior, bounded rationality, and asset specificity.

• (1) Opportunistic behavior

  Opportunistic behavior refers to behavior that involves persons or organizations deceiving others or breaking rules for personal gain. The existence of such behavior also implies that the complete market of classical economics is not functioning properly. Conventional economics presumes perfect rationality, which would make it possible to know everything about a potential business partner ruling out deception and opportunism. In fact, if we probe the idea of pursuing profits, which lies at the heart of utility maximization, another core premise of conventional economics, we also end up with potentially opportunistic behavior. The concept of opportunistic behavior was proposed to criticize the ideal concept of profit seeking governed by invisible market mechanisms. And while the concept of opportunistic behavior has existed in economics, it was Williamson who raised it to prominence in his main work.²

• (2) Bounded rationality

  Human beings have a limited capacity for absorbing information and making decisions. This contradicts the assumption made by conventional economics regarding complete rationality of individuals in the market. Conventional rational-choice theory made the assumptions that individuals have complete information gathering, processing, and transferring capabilities and thus are capable of acting rationally. In 1947, Herbert Simon criticized this stance and proposed the concept of “bounded rationality,” emphasizing the limitations to human rationality. Williamson, later, utilized the concept in his framework. Please note that the expression, “complete rationality”—the counterpart of bounded rationality—is not even used in economics, because it was such a major presumption of all conventional economic theories.

• (3) Asset specificity

  Literally, a specific asset is an asset that is difficult to trade in the market. However, it is quite a challenge to provide an exact definition. Even Williamson avoided defining the term in his books. Instead, in his main work cited in (1) above, he only pointed out that specific assets are assets that cannot be described as “transferable,” “fungible,” “redeployable,” “replaceable,” or “salvageable.” He described four “dimensions” of asset specificity: site specificity, physical asset specificity, human asset specificity, and dedicated asset specificity. Some scholars add brand asset specificity and temporal asset specificity to this list.

The next section introduces Williamson’s main theory, which deals with the problem of asset specificity arising from opportunistic behavior and bounded rationality.³

I Opportunism and Bounded Rationality Exist

Opportunistic behavior is possible because human rationality is limited. While opportunism and bounded rationality have been overlooked previously, it is necessary to incorporate them in future theories. These two concepts cast doubt on the central tenets of neoclassical economics, namely, the complete market and (complete) rationality.

II Opportunistic Behavior Arises (Only) When Asset Specific Transaction Is Involved

Opportunistic behavior arises when a transaction involves specific assets. This means that a company sourcing a product that can only be supplied by one specific firm may find that its partner betrays promises and acts for its own benefit. Williamson, however, did not discuss any other types of opportunistic behavior, implying that he considered transaction involving specific assets significant enough not to consider another source of opportunism.

III Transaction Costs Arise as a Mechanism to Avoid Opportunism

Bounded rationality (i.e., the limited information-processing ability of the human mind) makes opportunistic behavior possible, and a huge cost is required to protect firms against this opportunism.

IV Asset Specificity Leads to the Holdup Problem Resulting in Exploitation

The holdup problem arises when a partner exploits its weaknesses and gains control over a firm, creating a situation where the partner can set all the conditions. Unreasonably large amount of profits might be squeezed out of the firm in such a dependent position.

V A Huge Amount of Transaction Costs Are Required to Protect Against or to Get Out of Such a Situation

Constant monitoring is required to avoid holdup. Monitoring cost (part of transaction costs) can become very high even by itself, but should a firm be caught up in a holdup, extremely large costs can be incurred while escaping the holdup, looking for a new partner, negotiating a contract, and making further adjustments for the new transaction.⁴

VI A Proper Governance Structure Is Needed to Avoid Holdup

To avoid such a destructive situation, it is necessary to carefully select a proper organizational form (or governance structure). Although there may be many such derivative forms, the two that are considered by Williamson are whether a firm buys a product from the market or manufactures the product internally.

• VI-1 Market transaction occurs frequently and thus information about bad conduct spreads quickly, protecting against opportunistic behavior. That is why market transaction is preferable.

• VI-2 Asset specificity leads to opportunistic behavior; therefore, it is preferable to produce within an organization, where such behavior is easy to monitor and manage.

7.3 Unrealistic Presumptions in TCE Theory

TCE theory assumes situations that have no realistic foundations, and thus many of the hypotheses are unfounded.

In this section, each proposition will be dealt with in the same order as presented above, pointing out its unrealistic scenario.

I Opportunism and Bounded Rationality Exist

It is unnecessary to debate this point, as both concepts have a strong basis in reality. It is clear that opportunistic behavior is a real concern in the human society. One may even say that self-interestedness is encoded in the DNA of living things⁵, for preserving and transmitting one’s own DNA, while sacrificing others’ very easily. The existence of limitations in human rationality is so obvious that it can also be accepted without any further discussion.

II Opportunistic Behavior Arises (Only) When Asset Specific Transaction Is Involved

According to Williamson, the setting where opportunistic behavior is most likely to arise is when asset-specific goods are involved and the transaction partner has a choice of acting opportunistically. This setting is chosen in order to highlight the fact that these kinds of opportunistic betrayals can happen. However, as will be explained in full detail below, this is very unlikely to occur in real life.

Although human beings possess their self-interested DNA, there are social mechanisms that suppress such destructive behavior. Yet lack of vigilance against opportunism can make firms victims of opportunistic behavior. This is why, in reality, business people consider trust one of the most important values.

Before the spread of the Internet, where information about opportunistic behavior spreads in an instant, people relied more on personal and family relationships instead of the quality of goods and technologies. This kind of business convention still hinders Japanese venture start-up companies from easily establishing transactional relationships with large companies. People involved in business spend time to draw out detailed contracts for new transactional relationships (i.e., “complete contracts”) and rely on the authority of the state to protect their interests from opportunistic behavior. Consequently, one of the major roles of the state is to facilitate and enhance transaction by restricting opportunism.

Another protection mechanism is to second source parts to other manufacturing companies in order not to depend solely on one source. This intended redundancy also has a role of defending against shortages caused by natural disasters and other emergency situations, but actually its main function is to protect against opportunistic behavior. Firms also involve third parties actively to swiftly resolve disputes and avoid the high cost required by the enforcing mechanisms of the state. In this context, unskilled managers abated by opportunism in an asset-specific transactional relationship become uncompetitive and subject themselves to the forces of natural selection. It is quite unlikely for opportunistic behavior to actually arise in an asset-specific transaction in which all firms and individuals without exception have developed their predicting mechanisms against opportunism in modern societies.

III Transaction Costs Arise as a Mechanism to Avoid Opportunism

It is quite reasonable to accept the ideas of bounded rationality, opportunistic behavior, and transaction costs as the results of bounded rationality and opportunistic behavior. However, TCE focuses only on transaction costs required for handling the opportunistic behavior of existing partners, such as costs from monitoring, negotiating, enforcing, and problem solving, and it fails to address many other types of costs arising during transaction.

Williamson, in other words, equates transaction costs with costs for handling opportunism. Yet, for one thing, there are huge costs incurred by preliminary information gathering, even before starting a new transaction.⁶ During a transaction, there are substantial costs involved with handling mistakes in communication and operations, adapting to changing environments, and preparing for possible mistakes and unavoidable changes of circumstances. In each case, it is necessary to gather information, monitor partner activities, and shape and execute solution plans. These are much more significant activities in the ordinary operations of a firm, and transaction costs associated with actions taken against opportunism can be conceived to be simply embedded in these activities.

These various other types of transaction costs must be addressed, instead of merely focusing on the ones arising from action taken against opportunism. These and their transactional elements are measured, analyzed, and managed in reality.

IV Asset Specificity Leads to the Holdup Problem Resulting in Exploitation

The best example of a holdup involving a specific asset, arguably, is the Windows operating system by Microsoft. However, the actions of Microsoft led to the verdict that the company was against market competition and breached the US antitrust laws. The U.S. Department of Justice decided that Microsoft overcharged products and that its practice of bundling its Internet Explorer software with the Windows operating system was illegal.

As mentioned in Chap. 3, these days it is quite difficult to use a firm’s own platform (or standard) to gain an unfair advantage over its competitors. Firms that try to do so often fail to earn credibility for their standards, and they end up running into antitrust laws and potential litigation. Even Microsoft, which once conquered markets all around the globe, found its power waning after the antitrust case. Put simply, it is illegal to abuse partners or customers for opportunistic means, and opportunistic behavior comes with a huge risk that can even lead to the breakup of the company.

The USA has relatively well-functioning antitrust laws. In the past, there were many precedents of ordering violating conglomerates, such as Standard Oil, AT&T, and IBM, to break up, with some even driven to near-bankruptcy by the verdicts. There are cases where the illegal activity was sanctioned by penalties and imprisonment. The European Union antitrust law has similarly strict regulations.

Laws are in place against the abuse of superior positions if a company finds itself in a holdup. This “superior position” does refer not only to monopolistic superiority but also to regular relative superiority in business relations. Unless a country is in a state of anarchy, it is too much of an exaggeration to regard the main function of organizations to be a mechanism to counter illegal activities. At least, in reality it is not like the theory.

In fact, many parts manufacturing firms with highly differentiated products could easily manufacture and sell end products, yet have strong company policies against interfering with customer business. Parts manufacturing firms understand that if they yield to the temptation of a short-term gain, they would lose trust and ultimately wither and fall. These parts manufactures are very keen on gaining the trust of their customers (i.e., the end product manufacturers). High trust means that they can take market share from second source manufacturers, because the redundancy becomes unnecessary. It is not an exaggeration to say that showing even the slightest sign of opportunism might almost equal suicide for these firms.

Nevertheless, there are some ambiguous cases that seem to contradict the above. For example, there are the cases of the developments by Google, the developer of the Android operating system, of tablets (manufactured by ASUS) and smartphones (manufactured by LG). However, as mentioned earlier, it is an open source platform with a nearly completely open license, so Android user firms can never be locked in to a holdup.

Apart from standard products, how many products (or technologies, transactions) are there, or are there any that would make buyers locked in to suppliers, even though the buyers expend enough costs for switching? Williamson, at least, has not provided exact examples that would answer this question, so it is not quite clear what he assumed. He actually gave four examples for asset-specific transaction in his forecited book:

• (1) Site Specificity: Supplier facilities located near the site of the buyer

• (2) Physical Asset Specificity: Specifically manufactured molds and dies

• (3) Human Asset Specificity: Engineers with firm-specific knowledge

• (4) Dedicated Assets Specificity: Customized equipment investment at customers’ firms

However, all of these examples are either cases of suppliers locked into buyers (Cases 1, 2, 4) or bilateral lock-ins (Case 3), instead of buyers locked in to suppliers, as assumed by TCE theory. He provided no example for his theory.

The most widely discussed problem related to opportunism and holdup in economics textbooks is the acquisition of Fisher Body (a General Motors supplier) by General Motors.⁷ This is clearly a case of a supplier (Fisher Body) getting locked into the buyer, General Motors (Case 1). In reality, most of the cases have to do with small- and medium-sized companies (suppliers or subcontractors) being locked into large companies (buyers or original contractors). Yet this is exactly the opposite of what TCE theory assumes.

In addition to this, it is also a well-known fact that for a long time buyers had been exploiting suppliers in Japan, and this was treated as Japanese practice. For example, it was customary to send the order documents after the delivery had been made, a practice that clearly favored the buyer. However, as societies matured, these malpractices have been acknowledged as serious problems and proper regulations have been drafted. Today, there is the subcontract act, which prohibits delaying proceeds and beating down the price by taking advantage of the supplier’s weak position. In the USA, there is no particular subcontract act, but there are specific reports, such as Dun & Bradstreet (D&B) reports, similar to consumer reports (often called Dun Reports for short). These reports make it possible to identify and avoid future transaction with large companies that fail to conform to decent transactional practices.

Another well-discussed example of holdup is when railway companies build railroad tracks to a particular factory. In this case, railway companies can get locked into the factory (i.e., the buyer) because the railroad tracks can only be used for one purpose. This corresponds to Case 1 above. However, this again is the case of a supplier (a railway company) being locked into a buyer (the factory).

The problem is that all of these are opposites of what TCE theory assumes, and therefore, these are not only inappropriate cases for explaining the central issues of TCE, but might potentially lead to misunderstanding. Most researchers, and especially the graduate students of the author, often mistakenly think that TCE is about suppliers (subcontractors) being locked into buyers (original contractors). Although all of these examples create a vivid mental image about the holdup problem, these are the opposites of what TCE should be explaining (it should explain the cases about buyers locked into their suppliers).

Let us examine other possibilities. For example, there are some examples from the 1980s where a particular supplier offered a specific product catalog platform or electronic ordering system. When these became standards, buyers found themselves locked into their suppliers. American Airlines and Misumi Corporation are examples of this. However, lately, the trend toward open systems made these standards disappear.

Looking back in history, there are actually many cases of buyers being locked into suppliers, but there is no asset specificity involved in these cases. For example, in developing countries the supply of certain goods is quite limited, and there may be no alternative options for buyers. The modernization of manufacturing and the growth of manufacturing companies are likely to occur simultaneously, as a result of which end product manufacturing companies could grow faster than retail companies (the reason is automation is easier with processes in production than in transaction). Therefore, retailers usually grow as subsidiaries of large manufacturing companies—or in other words, suppliers (i.e., manufacturers) controlled buyers (i.e., retail companies). This structure still remains in industries of Japan, such as household appliances, automobiles, commodities, and steel industries. Resale price maintenance has been noted as an issue that can be the object of antitrust litigation. In addition, there is also the case when a retailer intends to procure from other manufacturing firms, but the manufacturing company stops supplying goods in order to negotiate various conditions advantageously and to hinder retail firms from growing independently. Historically, however, there appeared entrepreneurial leaders in retail companies who have torn up the long-established inferior position of buyers and changed the industry structure. In fact, the first clause of the Japanese antitrust laws is about prohibiting the rejection of supply, and the Japanese society in general has been supporting the attempts to mend these situations. These kinds of lock-ins are in the same direction as TCE theory suggests; however, they have nothing to do with asset specificity because there is already competition. These are simply cases of free transaction being obstructed by the power relationships or combines of suppliers.

Patents are basically specific assets that are difficult to substitute in other firms. However, because these days there might be fierce fighting for gaining essential patents, most patent wars end in cross-licensing agreements. The patent on the blue light emitting diode (LED) owned by Nichia Corporation of Japan is often given as an example of a non-substitutable asset, but actually there are other substitute technologies to achieve blue LEDs, and there are a multitude of patented manufacturing methods that also produce a blue LED. Many competitors of Nichia Corporation, including Taiwanese and South Korean companies, are indeed manufacturing and selling blue LEDs based on different patented technologies. Patents are not only insufficient to lock in customers, but setting above-market prices can lead to giving an opportunity for competitors to enter the market and develop alternative technologies. The more significant and widely accepted strategy these days is for a company to standardize its technologies with lower prices or even zero-price and to challenge the various utilization of the standard position for earning profits.

For another example, state-run company products are non-substitutable, as is often the case with developing countries, simply because of regulations, which are not asset specific in the above sense. Therefore, they should be excluded from the discussion.

Source code without any accompanying manual may qualify as a specific asset as assumed by TCE theory because it can only be understood by the programmer who made it. In Japan, this specificity is fueled by organizational systems that do not necessitate manual writing and the village community mentality that is outright against any kind of manual making. In old-style Japanese firms, this was true not only for the software programmers but for almost all employees. The employees are likely to refrain from externalizing their work procedures in order to avoid substitution and to increase their own value in organizations. Although it is an omnipresent problem, there exist no cases for holdups that would utilize this ambiguity, as they are controlled in the villages.

Different historical backgrounds may partly be the cause of the presumptions seeming so estranged from reality. The period when Williamson created TCE still lacked the same strong antitrust regulations and value systems that exist today, and he might have thought of TCE as a mechanism against monopoly. In monopolies, assets are non-substitutable, regardless of whether they are specific or not. Although monopolies are caused not only by asset specificity, it is true that asset-specific products can lead to monopolistic relationships.

Williamson’s abovementioned book emphasized that by not considering asset specificity, one can easily find himself in the monopolistic reality of the past. As we know Williamson to be a researcher with a strong critical approach, then it might be possible to see that his work has provoked the antitheses against monopoly.

V A Huge Amount of Transaction Costs Are Required to Protect Against or to Get Out of a Holdup

Lock-in refers to a relational situation where it is impossible to change existing partners because of the high switching costs involved. In Chap. 4, where there has been a discussion on the level of modularization, lock-in is a key perspective for analyzing the level of modularization, because it is the exact opposite of ease of substitutability and independent decision making.

TCE holds that it is not possible to switch partners in lock-in situations, but it could be argued at least that some of these are not real lock-ins because if the profit from switching is expected to be above the switching cost, then there is an incentive to switch, no matter how high the costs are. This idea will be further discussed as an issue regarding the levels of modularization here.

Switching costs can be classified into costs related to production and costs related to transaction: switching costs related to production entail costs incurred while replacing manufacturing equipment. In a similar vein, switching costs related to transaction to set up the relationship with new transaction partners include search costs; presentation costs for exchanging information regarding credit, capability, and potentiality about the prospects; and negotiation/contracting costs.

In the following, those will be explained respectively. It is especially essential to analyze by further segmenting the switching costs related to transaction into each transactional element. In addition, it is important to note that switching costs only include costs that are incurred during the process of switching transactors, and it is completely different from the transaction costs incurred during ordinary transaction, as discussed previously in IIITransaction costs arise as a mechanism to avoid opportunism.

• (1) Switching costs related to production

  On the customers’ side, even if their equipment is developed that is specialized for a product of a supplier, it is possible to procure the product with the same specification from another supplier, so there occurs nearly no switching cost. In the case of specific assets, there would be higher switching costs; however, as discussed previously, there are hardly any cases for such specific assets.⁸

  On the other suppliers’ side, if some equipment is specifically designed for a particular customer, then switching partners can lead to incurring a huge amount of switching costs for deploying new equipment (e.g., design and development) and dealing with the new suppliers.

  It is clear that lock-ins related to production can only occur in the supplier-to-buyer direction (this is a lock-in from supplier to buyer, which is contrary to TCE theory). In order to avoid the lock-ins, suppliers need to take the risk of owning the product specification and rights related to production. If the rights for product specification do not belong to the supplier, then switching can become very problematic due to high switching costs.

• (2) Switching costs related to transaction

  Lock-in can happen in respect to each individual transaction element. Switching costs are incurred by switching interfaces owned by the partner. An example for this is EDIs. Originally, large buyer firms had their own firm-specific EDIs and required suppliers to buy expensive terminals to access them. Switching costs related to EDI terminals made it almost impossible to switch customers. Even today, there are buyer companies that refuse to transact with companies who do not participate in their online marketplaces (buyer-specific commerce sites can be thought of as the extension of firm-specific EDIs).

  Similar costs can be incurred by presentation, negotiation, and monitoring. If interfaces are owned by buyers and suppliers need to adjust their internal interfaces to them, it can lead to huge switching costs.

  The above describes a case of suppliers locked into a buyer, but customs and tacit rules can lead to a bilateral lock-in, where buyers can also get locked in.

In this manner, if switching cost is divided into production-related and transaction-related costs, it becomes clear that there are no switching costs associated with the buyer-to-supplier direction. In other words, there is no lock-in only in the direction from buyer to supplier. If the only possible lock-in direction is suppliers being locked into buyers (which is the opposite of TCE theory), then a solution will be much different than selecting proper governance structures, as proposed by TCE. Supplier firms used to get locked in because they could not afford the high switching costs. However, based on the discussions in the previous chapters, it should be obvious thus far that the increasing reduction in transaction costs (because of the spread of the Internet and other standards) led to a dramatic decrease in the switching costs.

Currently, the biggest two problems faced by developed countries are (1) how to make SMEs independent from their original contractors and allow them to grow into global firms and (2) how to make them spearhead innovations, raise employment, and revitalize local economies. Even South Korea, where large companies have a huge influence under the governmental protection, is trying to generate policies to encourage SMEs to become more independent and global. In order to revitalize societies and enable innovations, it is vital to help SMEs become independent from large firms.

Four essential solutions have been proposed in Chap. 4, namely, increasing the applicability of products by modular design, adapting to multiple customers with lowest costs, decreasing dependence on main customers, and enhancing sales and marketing capabilities. Even if a SME depends on contracted business, with the rise in the number of users, it can extract fixed interfaces as its own standard and deploy modular design to create its own standard product lines applicable to various customers’ needs.

Promoting this transformation has become a critical, general management issue. The main focus of research on strategies for avoiding opportunistic behavior should not be the buyer-to-supplier direction, but the more general supplier-to-buyer direction.

VI A Proper Governance Structure Is Needed to Avoid Holdups

• VI-1 Market transaction occurs frequently and thus information about bad conduct spreads fast, protecting against opportunistic behavior. That is why market transaction is preferable.

• VI-2 Asset specificity leads to opportunistic behavior; therefore, it is preferable to produce within an organization, where such behavior is easy to monitor and manage.

The presumption here is that the ill reputation following opportunistic behavior during transactions outside the market is difficult to transmit. Yet historically in the Western world, firms have expended huge costs involved in obtaining references and information on the creditworthiness and trustworthiness of potential partners. For example, tenants often sublet their apartments to complete strangers during the summer when they are away, but they do carefully check the character and background of the person through friends. New company hires are also prudently checked before employment by acquiring information about past conduct from professional firms specialized in these checks, which obtain references from multiple concerned persons. In Japan, it is also common to approach involved parties and go-betweens to acquire information about future partners before any transaction takes place in order to avoid opportunistic behavior. Obtaining information on creditworthiness and trustworthiness has been an indispensable part of business transaction.

Does the next presumption, internalizing a specific asset in order to dissolve holdup situations, assume M&A in particular? A company that has such a competitive product that can lock in others cannot be acquired easily or its product produced internally. In developing countries, it is quite common to acquire confidential know-how through employing engineers or retired employees from competitors, but this unethical behavior is certainly not what internalizing a specific asset has meant.

This kind of decision about internalizing specific assets is not applicable for modern core-competence-oriented management. These days, firms need to concentrate their valuable resources in a select area in order to avoid decreasing efficiencies by overspreading their resources among highly dispersed areas. This is how even venture start-up companies, by concentrating their resources in core areas, have chances to beat behemoths. Competitive technologies that could lead to holdups require a huge amount of investment and costs for developing, marketing, maintaining, and improving products. In today’s highly competitive markets, it is inefficient to internalize different technologies that require additional huge investments and costs.

Furthermore, it is not only opportunism that must be taken into account when selecting a governance structure; there are a myriad of other factors. For example, there is the policy regarding company size. Larger companies have greater social reputation, have access to better labor, have more political influence, can create synergy among business areas and among products, can satisfy a desire for power, and can receive capital gains from revenue growth due to in-house transaction. For these reasons, especially in developing countries, company growth by internalizing transaction may be preferred in societies where growth is ordinarily of value. In Japan, the companies’ goal has been to enclose transaction within Keiretsu groups, for which the social respect had been extensive. Nowadays, however, there is a change in sentiment calling for firm size reduction, core competencies, and higher profitability. Strategic significance of the technology/product, consequent synergetic effects, future potential, accordance with own corporate mission and strategy, and environmental factors are also important issues for the decision about internalization.

Apart from these, there are also many other factors that influence the decision about the internalization, such as the potential for existing employees and technologies at the company to be merged, past relationship with the company, the market potential for the technology/product to be internalized, and one’s own excess resources at the moment. It is absolutely not true that the choice of governance mechanism would be decided only based on arguments about protecting against opportunistic behavior. It may even be said that in today’s reality, it is only opportunistic behavior that is not really taken into account when deciding about governance structure.

On the background of this assertion, Williamson has replaced the production function, which corresponded to the company by conventional economics, with the governance function. In order to exaggerate this pass-breaking argument, the larger question of “corporate governance” was converted into the issue of the “make or buy” problem of a single product. This possibility will be delved into more deeply in the following section.

7.4 Historical Background of the Emergence of TCE

Today, decision making of firms proceeds in the direction opposite to what TCE assumes.

7.4.1 TCE, Which Proposed Existence of Governance Function of Firms

The assertion that firms have decision-making functions became revolutionary in economics.

For argument’s sake, let us assume that there are indeed asset-specific products for buyers, and therefore, as a countermeasure to difficulties in market transaction, it is appropriate to manufacture them internally. In this situation, TCE is perceived as the simple problem of choosing between internalizing and outsourcing (the “make or buy” choice). This makes sense to some extent. In fact, many scholars interpret TCE in this way.⁹

However, the question of “make or buy” is a decision about a single product. TCE deals with selecting a corporate-wide governance structure, such as vertical integration or building Keiretsu-style relationships. A whole company’s governance structure is simply not decided on the basis of the “make or buy” decision of a single product. Besides, if there are multiple products, then different decisions would be made for each product anyway.

Even if TCE is perceived as “make or buy,” the direction of discussion should be different. The managerial choice of “make or buy” is usually made from the following perspectives:

• Comparison of sourcing costs: self-manufacture or outsourcing? As a matter of course, transaction costs should be taken into account (including cost of searching for partners, checking credits, conducting product examinations, communicating specifications, transporting, customization, monitoring, problem solving, taxation, and so forth).

• ROI: Are there sufficient returns to be expected in the future from the internalization?

• Accordance with company strategy: Is the internalization of certain products within the domain of selection and concentration?

• Growth policy: Is it consistent with the whole company’s growth policy? The choice of product sourcing should be complied with the whole company’s policy (e.g., expansion of scale, focus on a domain), as explained above.

• Others: Regulatory and political factors, potential information leakage to other firms, personnel management issues such as treatment of a director in charge, and so forth should be considered for the shift from self-manufacture to outsourcing.

Williamson has only used terminologies such as “governance structure,” “vertical integration,” and “hybrid forms” without explicitly referring to outsourcing strategies or “make or buy.” Hence, it is quite problematic to interpret Williamson’s TCE as a problem of the “make or buy” type.

In fact, the starting point of Williamson’s research was to provide an antithesis to the widely held belief of economics that describes only the behavior of the market, looking at firms as mere dots. He argued that these dots actually are agencies in the form of governance functions and make their own decisions. The “make or buy” problem is nothing more than a decision within a dot (namely, one product in one company); it is not likely to have been of interest to Williamson and it should have not been so. While firms were considered as a mere dot in the complete market without any decision-making capabilities, Williamson conceived that firms were equipped with the capability of making outsourcing through the market or in-house production decisions, which he represented by the term “governance.” It can also be perceived as firm’s capability to stand apart from the market mechanism and to establish its own governing mechanism. He must have seen the very first function of firm as a decision about whether to leave the market or not.

However, as discussed in Chap. 5, organizations and the market are basically identical, and the only differences are:

• An organization has fixed interfaces to determine ad hoc interfaces easily.

• An organization is physically collocated (a fixed interface as collocation).

The raison d’etre of the organization is related to the above two advantages, but these features exist in the market as well. There is only a difference in degree. It is exactly this identicalness that firms increasingly use to create internal markets within them (internal market transaction). That is, the reality is now reaching to the conventional assumptions of economics.

Regardless of whether TCE is about the problem of governance or the problem of “make or buy,” opportunism plays only a minor role in decisions on these. Therefore, although Williamson can be highly evaluated for calling attention to the existence of opportunism and the governance function of firms, it must be said that it is much exaggerated to claim that the most significant function of firms besides production is selecting proper governance structures to guard against opportunism.

7.4.2 Factors Contributing to the Increase in Transaction Costs that Were Neglected by Williamson

The variance of transaction entities overlooked by Williamson has a significant impact.

Williamson has proposed “uncertainty of transaction” and “frequency of transaction” as analytical dimensions of transaction costs, alongside “asset specificity.” He uses the term “dimension” instead of axis, but if we interpret these as factors causing an increase in costs, then it is obvious that the most important factors are well covered. The real research purposes of Williamson will be examined below by comparing the three dimensions with the transaction cost elements that were proposed in Chap. 1 (Fig. 1.4).

First, the factors that are not covered due to the difference of the definition should be excluded. Williamson places contracting activities at the center of a transaction, so it is quite likely that he has disregarded physical costs such as transportation costs, installation costs, and training costs, although he did not state it clearly whether he excluded these (to facilitate the objectivity of research, it would have been quite important to clearly delineate the boundaries of the research object).

The exclusion of the physical costs (that is, inclusion in a production cost) results in a serious problem that those costs incurred on the buyers’ side become neglected (because buyers never produce). Excluding these costs, however, the comparisons with Fig. 1.4 are described below:

• (1) Asset-specificity dimension: If a product is difficult to be procured on the market, then the supplier is also specific. This means that it costs more to search for and gather information about the specific product and the specific supplier. These can be also applied to monitoring and problem-solving costs; however, the substantial point here is the low frequency of transaction which leads to increased costs due to dependence on ad hoc interfaces, instead of asset specificity.

• (2) Uncertainty dimension: In order to minimize future costs and risk related to uncertain transaction, it is necessary to collect information with maximum prudence. More agreements and contracts must be prepared for any possible contingency. And then, to exclude further uncertainty, it is necessary to circumstantially monitor and inspect existing operations. All of these result in increased transaction costs.

• (3) Frequency dimension: It is less likely that fixed interfaces are installed when frequency of transaction is low. If there are fewer fixed interfaces in place, then there is a natural increase in costs because there is a need of ad hoc information gathering, negotiation, adjustment, monitoring, and problem solving.

This shows that Williamson could cover most of the important factors causing an increase in transaction costs. However, it can be pointed out that there are some factors missing.

• (1) The physical, institutional, and conventional distance between transaction entities (the number of interfaces necessary to bridge it):

  After the second half of the 1990s, transaction costs have been on the decline, boosting the transactions all over the world, even with originally unconnected countries, firms, and individuals. Missing factors can be examined from a perspective of the causes of the massive transaction costs of the past.

  The transaction cost reduction was brought about by the spread of the Internet and various applications that were built on top of it. At that time, transaction costs that had been proportional to distance were reduced not just in the sense of physical distance but also in that of institutional and conventional distance. Distance between heterogeneous entities (e.g., firms and individuals) incurs the costs associated with establishments and maintenance of interfaces. This concept of “distance” was overlooked by TCE theory, which looked at transaction entities as uniform. In fact, depending on the transaction partners, transaction costs differ. This was a factor that TCE did not take into consideration.

• (2) The interface-building capability and intent of the transaction entities:

  In order to reduce these distances, heterogeneity was reduced by finding and fixing common interfaces. Differences in location, language, information exchange methods, ordering and delivery systems, payment and remittance methods, monitoring and assessment customs, and so forth, most of which necessitated high transaction costs, have been bridged by interfaces, fixed interfaces in particular.

  Communication has been first fixed and standardized through the postal service reducing worldwide costs of delivery, and then later digitalization brought about a further ease of information exchange. Even before the Internet, there were different attempts for fixing transaction interfaces. Firms designed and introduced their own EDI systems, which led to fixed interfaces even locally. There were also OSIs that had been pioneered by national governments just before the spread of the Internet. Similarly to networks, databases fix interfaces for sharing and increase efficiency. The accumulation of these efforts led to the present world of global transaction, which is still being and will be expanded as prospects for further declining transaction costs are promising.

  Conventional economics perceived not only individuals but even firms as mere dots in its models, so it comes with no surprise that the capabilities of participants have not been dealt with in the economics. Even in management science, tacit knowledge issues must be more influenced by individuals who deal with the knowledge (their capabilities and intents) than the knowledge per se, but it has been neglected. In fact, the externalization of tacit knowledge undermines the competitiveness of individuals who could before rely on his advantage gained from leveraging tacit and, thus, specific knowledge. Therefore, a major obstacle to externalizing tacit knowledge, which corresponds to fixed interfaces in general, is a lack of intent to do so, not the awkward characteristics of the knowledge per se.

  When the analysis of economic activity comes to transaction, a minimal unit of economic activity, it is unavoidable to consider the difference of individual entities. It is indisputable that the individual capabilities of modularization, standardization, and process design that were described in Chap. 6 have a large influence on the determination of transaction costs. It is simply no longer tenable to disregard these issues. If the differences both in transaction entities (capabilities and intent) and in the distances between transaction entities are not taken into consideration, the discussion cannot be sufficiently accurate.

In order to deal with these issues, measurement and analysis including benchmarking of transaction costs with precise operational definitions and methodologies for designing and managing interfaces are required as proposed throughout this book.

7.4.3 The Historical Background Behind Williamson’s Radical Contributions

Williamson made various radical contributions at the time.

Although the theory, considerably removed from reality, was created in the past based on a different historical background, Williamson did provide creative new explanations for his time. His goals with TCE theory were considered to be the following:

• (1) Opportunism and bounded rationality exist (therefore, the market is not complete).

  • Opportunism exists because of bounded rationality.

  • Opportunism manifests itself in the holdup problem most clearly (however, as seen above, it is important to understand that real-life holdup happens in the direction of supplier to buyer and not buyer to supplier as assumed by TCE).

• (2) Transaction costs exist (therefore, the market is not complete).

  • Firms exist as means of reducing transaction costs.

  • Firms reduce transaction costs by selecting proper governance structures.

• (3) The function of firms is not only to produce but to select proper governance structures (therefore, the market is not complete and agency of firms has value).

• (4) There are some products that are not standardized and specific assets, which are difficult to substitute, and those are untradeable on the market (therefore, the market is not complete).

• (5) Firms and the society should utilize these arguments in their decision-making processes (economics has a relevant use in real life).

In that time, there were only a couple of scholars who had criticized the assumptions of the complete market, such as Herbert Simon and Thorstein Veblen. Williamson, however, tried to prove that the market was not complete. He intentionally dealt with all five radical propositions. The confusion that has been described in this chapter has probably been caused by the fact that he mixed up holdups as the easiest examples of opportunism with holdups as the most frequent examples (or the only example) of opportunism and the make or buy problem with the governance structure selection problem. It was not easy to disentangle the complex theory and find the contradiction through the careful study of the direction of holdups. Eventually, the economics community at the time welcomed the theory for its groundbreaking ideas of (1), (2), and (3). While (4) is somewhat supplementary, (5) was also quite revolutionary as well at the time.

Williamson’s TCE pointed out that the market was incomplete, where opportunism and transaction costs existed and firms were not simply dots but entities with significant agency. To develop this radical view, he then turned to the empirical research on opportunism and transaction costs in asset-specific transaction. And to increase the relevance of his research, he proposed that firms had the choice of determining their governance structure in asset-specific relationships in order to reduce transaction costs. His revolutionary idea has given birth to many research areas, such as contract theory, new institutional economics, property rights theory, and principal-agent theory,¹⁰ none of which deals with transaction costs per se. While this thinking was a great contribution to conventional economics, it is quite unfortunate that it robbed research completely from its main focus on transaction costs.

7.5 Comparing TCE and Modularization Theory

TCE and modularization theory provide exact opposite answers for the identical problems.

The asset specificity concept central to Williamson’s TCE theory is actually identical to the idea of ease of substitutability embodied by modular products. This section discusses modularity from the perspective of Williamson’s theory.

As described previously, Williamson defined the properties of non-asset-specific assets as “transferable,” “fungible,” “redeployable,” “replaceable,” and “salvageable.” “Substitutability”¹¹ generally represents these, which happen to be the very same properties of modular products. Of course, there is a strong connection between the lock-in problem and the level of modularity issue of this book (which is determined by ease of substitutability and independence of decision making, as explained in Sect. 4.1.6). Although this was not reflected in the previous literature on modularity, in fact Williamson had already been unconsciously investigating the question of modularity. The areas covered by research on modularity and TCE are identical, dealing with problems such as the borderline between the market and organizations and the borderline between commodities that should be outsourced to external partners and products that should be insoursed.

However, Williamson’s conclusion is the opposite of the answers that the modularity studies provide. In other words, while the modular strategy is external oriented, exploring an open social structure by establishing collaboration between modules that have the competitiveness with asset specificity features, the strategy underlying TCE is internal oriented, encapsulating a wide range of asset-specific products and technologies within the boundaries of firms. These two types of completely opposite strategies also reflect the difference in historical backgrounds. This question will be investigated further by carefully looking at Table 7.1, which compares TCE with modularity theory.

Table 7.1 Comparing TCE with modularity

The first main difference between historical backgrounds is the recent dramatic decrease in transaction costs due to the spread of the Internet. This has led to horizontal division of functions and business processes globally, and the modular strategy adapted to the rapidly developing emerging markets. In the past, high transaction costs limited the size of the accessible market and led to limited potential for modular deployment investments, but these days it is possible to reap the benefits of modular design and standardization strategies. Strategies with excess risk have intensified competition, and more competition in turn has led to accepting even more risk. The modularization strategy has adapted to this environment very well. It goes without saying that as customers it also becomes necessary to select and utilize those modular products with such values.

Onto the global standard of the Internet, further layers of standards are being added continuously. This is a characteristic of globalization; however, firm strategy differs greatly based on their belief: whether external sources are increasingly utilized by acknowledging change as permanent or internalized processes are preserved by disregarding change as only temporary. This difference has been creating considerable differences in performances of firms. In the past, it might have been a clever strategy for large companies to adopt the vertically integrated (or internalized) governance structure in particular as a response to asset specificity, but in the end the modularized structure gained higher competitiveness from the effective use of resources. Today, the trend is to move in this latter direction. The Internet is merely one cause underlying this change.

The second difference in historical backgrounds is the shift in resource from large companies toward SMEs and venture start-up companies in order to escape stagnation and promote innovation (at least in developed countries).

Nowadays, a key research interest is finding out how to facilitate social and technological innovation by independent SMEs and venture start-ups, instead of enhancing the competitiveness of large companies. TCE approaches the problem from the perspective of control and integration by large companies, discussing strategies for avoiding lock-ins by SME suppliers. In contrast to this, the modularity theory looks at the situation from the subcontractor perspective and; it deals with strategies for advancing independence from large, final-assembly manufacturers in order to avoid lock-ins by these large companies.

The former is against modularity that would benefit small companies and proposes that large companies should internalize processes to gain competitive advantage. The latter accepts modularity and presumes independence, emphasizing a market structure that is built upon groups of independent companies. Depending on the perspectives, the end result is quite different.

These days, it is a widely held view that revolutionary ideas from SMEs and venture start-ups are necessary to innovate the market and the society. From the 1980s onward, the US government, by pro-patent policies, fueled the shift of power from large companies, such as IBM, to swifter and leaner companies, such as Microsoft, Intel, and various other small venture start-ups in favor of innovation.

This ended the era of large companies with diverse product portfolios and led to the rapid proliferation of SMEs that have embraced modular designs. Modularity means that there is no need to worry about lock-ins by suppliers because products and their suppliers are fungible, replaceable, and substitutable. In order to resist this, suppliers attempt to increase their market share by standardizing their modules. In an age when modular products can be easily substituted, it is critical to profoundly differentiate to gain competitive advantage. Suppliers need to surpass competitors on every point of technology, quality, cost, delivery time, and so forth. If these goals can be achieved, then companies enter a positive feedback loop where increased market share leads to even stronger differentiation.

This also means that orders (purchases from customers) concentrate on a specific supplier as it supplies the best module product, leading to a situation that is similar to a lock-in. Buyers counter this by building a second source relationship. In other words, by maintaining potential substitutable suppliers, they increase their negotiation power and stop any holdups and opportunistic behavior before it could happen.

Yet, in reality there are many cases of quasi-monopolistic markets with more than a world market share of 80%, where opportunistic behavior might arise due to the lock-in situations. For example, there are numerous products holding quasi-monopoly market shares, such as Fujifilm’s TAC film, ARM’S embedded processor, Mitsubishi Chemical’s red LEDs, Nidec’s HDD spindle motor, Advantest’s DRAM testing device, Dainippon Screen’s silicon wafer cleaning device, Japan Vilene’s nonwoven fabrics, ASML’s semiconductor stepper equipment, Tokyo Electron’s semiconductor resist coating equipment, DISCO’s laser dicing saws, Ushio’s digital cinema projector lamps, NSG’s glass panels for thin-film PVs, Nidec Copal’s shutters for compact digital cameras, JSW Muroran’s various parts of power generators for nuclear power plants, Toppan’s LCD anti-reflection films, Okamoto Glass’ digital light mirrors for dentists, Shimano’s bicycle components, and possible many others.

These quasi-lock-in situations arise because of the swiftly changing technological landscape and the desperate effort made by the supplier-side management. This is the result of suppliers earning the absolute trust of their customers by providing complete and prompt response to the buyers who have been trying to secure second source relationships in order to avoid lock-ins and opportunism. For example, Foxconn, the main manufacturer of Apple products, is famously keen on satisfying every need of Apple, no matter how difficult it is, in order to build trust and convince its customer that there is absolutely no threat of opportunism. In some relationships, both parties jointly decide prices by openly sharing the cost information.

If buyers are able to trust their suppliers and concentrate on only one company, then both companies can attain scales of economies greatly. However, even these seemingly stable relationships are subject to potential substitution, due to the drastic reduction of the transaction costs and technology innovation enabled by that.

The third difference in historical backgrounds is the progress of globalization and openization (i.e., open intellectual properties, open relationships, and open innovations), which are caused by and promotes the shift from opportunism and exploitation toward trust and sharing. In the previous chapter, there was discussion about coevolving organizations and the market. This coevolution can be described as the history of continuously increasing and expanding interfaces. The establishment of the interface decreases transaction costs and makes sharing fundamentally easier as well as substitution.

The advent of the Internet has been facilitated by the philosophy of open intellectual properties and sharing, and its spread has been accelerated due to its trust-building mechanisms. Trust building made remarkable progress by methodologies that visualize, depict, and monitor it. Of course, this is exactly the methodology of fixing interfaces. Without this methodology, trust building would require a huge amount of time, making large-scale governance structure indispensable for organizational expansion. In the era of TCE, before the advent of the Internet, these ideas of globalizations and openization did not exist.

In today’s societies, information is so easily transferred and shared that even one product extracting unjust profits would lose trust, leading to eventual substitution. The supplier would lose even the future opportunities of businesses. Although opportunistic behavior is part of human nature, it has been increasingly banished from healthy and competitive societies. It is impossible to objectively judge whether our society is based on trust or opportunism, but from the experience of the author, it can be safely said that the world is moving faster toward trust-based societies. Without trust, globalization and openization would not be possible in the first place. And also the move toward a world with human rights as a core value can clearly be seen from the trends in world history, which also supports the above claim.

7.6 Possibilities for Further Development of TCE Theory

There are limitless possibilities for further developing TCE by measuring transaction costs.

Thus far, three main issues with Williamson’s TCE for further development of the theory have been shown:

• It does not deal with transaction costs per se.

• It does not provide effective solutions applicable to real-world situations.

• It does not address the structure of transaction.

Now there is a call for an advancement of the theory by tackling these issues.

One advocator of this research stream is a group of scholars gathered around Ronald Coase, the originator of the concept of transaction costs before the concept had been appropriated by Williamson. Although indeed transaction cost economics is mostly associated with Williamson’s research, these researchers affiliated with the Ronald Coase Research Institute in St. Louis, USA, are now searching for a new direction. Lee. K. Benham, the director and secretary of the institute, and Alexandra Benham are calling for research to quantify and measure transaction costs, and they warn that without such moves TCE would reach its limits.¹² They also point out that the definition of a transaction cost and its taxonomy are very confusing and ambiguous.¹³ There are multiple definitions of a transaction cost, which adds to the confusion. The below is the partial list.

• (1) Coase’s definitions

  • “the costs of using the price mechanism, which includes the costs of discovering relevant prices, and negotiating and concluding contracts” (Coase, 1937)¹⁴

  • “the costs of resources utilized for the creation, maintenance, use, and change of institutions and organizations” (Coase, 1960)¹⁵

• (2) Broad definitions

  • “all the costs which do not exist in a Robinson Crusoe economy” (Cheung 1988)¹⁶

  • “the costs of running the economic system” (Arrow, 1969)¹⁷

  • “the costs of processing and conveying information, coordinating, purchasing, marketing, advertising, selling, handling legal matters, shipping, and managing and supervising” (Wallis and North 1986)¹⁸

  • “the sum of the costs associated with engaging in exchange and contracting activities, which are distinct from the costs of production” (Polski 2001)¹⁹

  • “the costs that arise when individuals exchange ownership rights to economic assets and enforce their exclusive rights” (Eggertsson 1990)²⁰

• (3) More narrow definitions

  • “the cost of arranging a contract ex ante and monitoring it ex post, as opposed to production costs, which are the costs of executing a contract” (Matthews 1986)²¹

  • “those [the costs] involved in the transfer of goods and services from one operating unit to another…they usually involve the transfer of property rights and are defined in contractual terms.” (Chandler and Hikino 1990)²²

  • “the costs associated with the transfer, capture, and protection of rights.” (Barzel 1989)²³

  • “the costs of acquiring and handling the information about the quality of inputs, the relevant prices, the supplier’s reputation, and so on” (Vannoni 2002)²⁴

• (4) Middle-range definitions

  • “those costs associated with “greasing markets,” including the costs of obtaining information, monitoring behavior, compensating intermediaries, and enforcing contracts” (Davis 1986)²⁵

  • “the costs of running the systems: the costs of coordinating and of motivating” (Milgrom and Roberts 1992)²⁶

  • “the costs of defining and measuring resources or claims, plus the costs of utilizing and enforcing the rights specified” when considered in relation to existing property and contract rights, and, quoting Coase (1960)²⁷, the definition includes “costs of information, negotiation, and enforcement when applied to the transfer of existing property rights and the establishment or transfer of contract rights between individuals (or legal entities)” (Furubotn and Richter 1997)²⁸

As it can be seen from the above definitions, there are very broad sense of transaction costs such as “all the costs which do not exist in a Robinson Crusoe economy” by Steve Cheung and the definition including all the costs of the firms that deal with transaction costs of the society, such as distribution and logistics by the 1993 Nobel Prize-winning Douglas North (Wallis and North 1986). There is yet another set of definitions that specify transaction costs as all costs other than production-related costs, although the definition of a production cost is not given, so it is still not clear what exactly is a transaction cost.

In a narrow sense, transaction costs can also mean those costs that are related to only ownership right transfer based on contract theory.

The transaction cost concept used in this book is nearly corresponding to the definition that Coase proposed in 1960 (i.e., “the costs of resources utilized for the creation, maintenance, use, and change of institutions and organizations”). But to give a definition of a transaction cost that emphasizes interfaces, transaction costs might be defined as “the costs of resources utilized for the creation, maintenance, use, and change of interfaces in institutions and organizations.” However, in this book institutions and organizations are used with a similar meaning as interfaces, so there is not much difference between this and Coase’s definition (although the costs utilized for the creation, maintenance, use, and change of institutions and organizations only apply to fixed interfaces, while ad hoc interfaces are not clearly included).

TCE proposes that transaction costs are being reduced by avoiding lock-ins, but as it has been discussed thus far, lock-ins do not occur in real life, and therefore, if at all, transaction costs related to lock-ins are only a very, very small part of the whole cost incurred. It has been also pointed out many times throughout this book that it becomes much more significant to focus on managing transaction costs, compared with production costs. The traditional production cost-oriented mindset needs to be changed. If one realizes the significance of transaction costs, then it is obvious to assent to their advocate’s position that transaction cost economics still have a great mission to fulfill—that is, transaction costs need to be measured and analyzed. Such an analysis would most certainly yield a great amount of insight.

However, in order to succeed in real cost reduction, each cause giving rise to transaction costs needs to be handled respectively. Every company makes great efforts in reducing these costs in their day-to-day operations, and most of the difference in the level of competitiveness between companies can be accounted for by looking at how good these companies are at this reduction process. In this book, it was argued that this difference in the level of the competitiveness is actually determined by the difference in the level of individual processing skills.

Transaction costs must be decomposed into its parts; each part, then, must be measured and analyzed in order to understand its underlying causes. Only then can potential countermeasures be extracted. Understanding the circumstances of when and where transaction costs arise is of utmost importance, but it has been not yet touched. It is time to answer the calls of the scholars at the Ronald Coase Institute, that measuring and analyzing transaction costs are what should be the real focus of transaction cost economics.