This blog post examines the role of transaction costs in shaping firms’ decisions to buy from the market or produce internally, and specifically analyzes how these choices form firm boundaries and organizational structures.
The methodology of neoclassical economics, which explains economic phenomena starting from the choices of rational economic agents seeking to maximize their profits under given conditions, has long held a mainstream position in economics. Neoclassical firm theory, similarly grounded in this methodology, analyzes firm behavior and outcomes by assuming that the firm, as the agent of production, chooses the output level that maximizes profit given its production costs, technology, and demand conditions. However, this analytical framework has drawn criticism and raised questions because it treats the solitary production activities of an individual farmer as identical to the actions of a firm, where multiple people perform diverse roles for production. Various theories of the firm have been proposed to address these concerns.
Coase viewed the market system, where division of labor and exchange occur based on price, and the firm system, where planning and command operate based on authority, as fundamentally different. Therefore, he believed it was necessary to explain why hierarchical organizations called firms are required for activities not coordinated by the market. Consider, for example, a situation where a firm must decide whether to produce and procure a specific component needed for production itself or to purchase it externally. According to neoclassical firm theory, which considers only the concept of production costs, external purchasing might appear a more rational choice than in-house production, given the specialization and economies of scale arising from division of labor. If this logic were applied to all activities necessary for production, it would be difficult to find a sufficient reason for the firm’s existence. Therefore, Coase’s argument was that the reason for the firm’s existence must be found not in production costs but in transaction costs.
Côte defined transaction costs as the various difficulties inherent in market transactions. Specifically, transaction costs encompass the difficulties arising throughout the entire process: the search for counterparties with the willingness and ability to trade; the process of price bargaining; the negotiation and agreement of exchange terms to conclude a contract; and the verification and enforcement of contract fulfillment. When transaction costs become excessively high, offsetting the benefits provided by specialization, firms choose to procure internally rather than purchase externally. In other words, coordination is achieved not by market prices but by the authority of the hierarchical organization, the firm. The concept of transaction costs proposed by Coase demonstrated that market systems alone cannot fully explain economic phenomena, opening up the possibility of new analytical methodologies in economics. However, Coase’s explanation did not sufficiently clarify the principles behind the emergence of transaction costs, and mainstream economic methodology at the time was not prepared to accept the concept of authority as an analytical element.
Williamson introduced several new concepts to develop a theory of the firm based on the transaction cost concept. He first replaced the assumption of rationality with the assumptions of opportunism and bounded rationality. Economic agents strive to maximize their interests, but limitations in the amount of information or information processing capabilities prevent them from always achieving this goal perfectly. Furthermore, Williamson distinguished between barter and contracts—elements Coase had broadly categorized as market transactions—and introduced the concept of contract incompleteness. Unlike barter, contracts involve a significant time lag between agreement and actual fulfillment. Yet, due to bounded rationality, people cannot predict every future scenario, nor can they perfectly calculate countermeasures for every predicted situation. Furthermore, language itself inherently possesses a certain degree of ambiguity. Consequently, it is difficult to draft a contract beforehand that is so complete it can clearly prove the degree of fulfillment to a third party. Thus, contracts inevitably contain gaps.
If the counterparty fails to perform the contract, the value of the relationship-specific investment—the preparation undertaken in reliance on the contract’s fulfillment—can plummet. This is why Williamson explained that a fundamental shift occurs in the relationship between the contracting parties after the contract is signed. The greater the relational specificity, or the greater the potential for its value to decline, the greater the concern that the counterparty will opportunistically exploit the changed situation after the contract. Without safeguards, relational investments become difficult to undertake. Williamson termed this the lock-in problem arising from relational investments, arguing that the incompleteness of contracts makes it difficult to prevent this problem in advance through simple contracts of a standard level. Therefore, when this problem could lead to serious consequences, he argued that instead of a simple contract, more complex and sophisticated contracts would be used to establish safeguards. If even that proved insufficient, firms would opt for in-house production altogether.
Viewed this way, the world assumed by neoclassical economics is one where only transactions requiring no safeguards exist, while the world assumed by Coase is one where only in-house production by firms exists as an alternative, without considering various safeguards. Thanks to the achievements of Williamson’s firm theory, transaction cost economics gradually approached a mainstream position in economic methodology alongside the development of institutional economics and organizational economics. Today, it is widely utilized as a core theoretical framework for analyzing firm organization and contract structures.
