Transaction cost theory of entrepreneurship

What is the transaction cost theory of entrepreneurship?

Transaction cost economics is often attributed to the work of Ronald H. Coase in the 1930s, who used it as a way to explain the existence of organizations. Transaction costs occur whenever an economic exchange happens. Search and information costs describe the work of determining the availability of inputs and identifying the most affordable source of inputs in a market, or finding the best partner for an exchange (Williamson, 1975). Oliver Williamson shared in the 2009 Nobel Prize in part for his work on transaction cost theory.

Bargaining costs describe the work of negotiating prices and agreements, such as contracts. Solid contracts may require considerable negotiation and the employment of lawyers with skill and experience with contract development. Policing costs describe the efforts needed to enforce agreements or to ensure that exchange terms are being met (Dahlman, 1979). For instance, such costs may be incurred when the legal system is needed to get a partner to do what they promised.

Transaction costs add on to normal production costs related to buying inputs to produce outputs. Transaction costs are seen as information processing costs and are often reduced by resorting to hierarchies. For instance, if a firm vertically integrates its supply, then it can save some transaction costs relating to search, bargaining, and policing. Similarly, hybrid governance structures such as joint ventures and strategic alliances can be used to reduce transaction costs.

Upon forming new ventures, entrepreneurs need to decide what to acquire in the spot market, what to acquire via contracts and relationships, and what to integrate into the venture. Typically, firms choose to integrate (buy or build) resources when specific investments are needed (e.g., a specialized machinery or highly custom software), whereas they tend to contract for more general resources like HR services, accounting services, and IT infrastructure (Williamson, 1975).

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Other Economic Theories of Entrepreneurship:


Coase, Ronald H. 1937. The nature of the firm. Economica, 4: 386.

Dahlman, C. 1979. The problem of externality. Journal of Law and Economics 22 (1): 141-162

Oliver, W. 1975. Markets and hierarchies: Analysis and antitrust implications. New York, NY: Free Press.