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Transaction Cost Analysis

What are the alternatives to network organisations? There are two basic alternatives: vertically integrated firms, and the open market. How do firms decide what functions to perform in-house, and which to purchase on the market? Why aren't all functions purchased on the market?

E.g., a firm that makes a product based on a certain kind of computer memory chip. They buy the chips on a recurring basis from a few different suppliers. Demand for these chips varies widely from time to time so availability and prices are never givens. Also, there are wide variations in quality because the silicon wafer technology has not yet solved some basic production problems. Every batch of chips purchased has to be scrutinized carefully, and bad chips have to be sent back and replaced. The variations in availability and price force the company to overbuy and then maintain warehouses full of supplies so that their assembly lines do not have to be shut on and off with variations in the chip market. By maintaining a lot of inventory, they can buffer their core technological processes, doling out the chips in a measured, reliable stream. The trouble is, maintaining a lot of inventory is expensive, especially when the chips change over time and old chips are made obsolete.

The problem is even worse when the company needs specialized chips from their suppliers, custom products that they have designed themselves. Or, the other way around, each chip company does things differently, and the manufacturer has to adapt their designs to specific chips (the way operating systems are built for specific families of processors).

Under these conditions (frequent transactions, uncertainty of supply, and customisation) organisations will elect to bring the process in-house. That is, they will vertically integrate. The reason is that contracting with outsiders under these conditions is costly.

There are costs in maintaining inventories, costs in monitoring the exchanges for malfeasance, costs in searching for suppliers, costs in specifying legal contracts, etc. Furthermore, because they are working with this custom product, there are no other sources of supply that are ready-made. So they could be charged a premium price.

In contrast, for functions that do not require frequent exchanges, that do not suffer from uncertainty of supply, and which do not require customisation, organisations will contract with outside firms, because it will be cheap enough to do that. The costs of making and monitoring the transactions themselves will not be prohibitive, which allows the organisation to take advantage of hiring specialists to do the job. These specialist firms can deliver a higher quality product, and can often do it more cheaply because of the volume they do. According to economic theory, in a perfect competitive market, it is always better to hire out a function unless the transaction costs make that too expensive.

Date: 2016-03-03; view: 900

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