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 and policing costs are two types of transaction costs that can significantly impact the efficiency of exchange. Bargaining costs refer to the time and effort required to negotiate prices, contracts, and other agreements. In some cases, this may involve employing lawyers or other professionals with expertise in contract development to ensure that agreements are solid and legally enforceable.

Policing costs refer to the effort required to enforce agreements and ensure that all parties are adhering to the terms of the exchange. This may involve monitoring the behaviour of partners, and in some cases, resorting to legal action or other formal mechanisms to ensure that agreements are being honoured. These costs can be substantial and can have a significant impact on the overall efficiency of the exchange.

Transaction costs are an important consideration for firms when making decisions about how to structure their operations. These costs represent the additional costs incurred as a result of engaging in exchange, over and above the costs of producing goods or services. Transaction costs are often associated with information processing and may include costs associated with search, bargaining, and policing.

One common way of reducing transaction costs is by resorting to hierarchies. For example, a firm may vertically integrate its supply chain, bringing production inputs in-house to reduce the costs associated with searching for suppliers, bargaining for prices, and policing agreements.

Another way of reducing transaction costs is through hybrid governance structures such as joint ventures and strategic alliances. These structures can enable firms to pool resources and share risks while reducing the costs associated with exchange.

Overall, understanding transaction costs is an important consideration for firms when making decisions about how to structure their operations. By minimizing these costs, firms can improve their efficiency and competitiveness in the marketplace.

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).


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.

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