Why do firms exist:

Firms exist because they represent a more efficient way of organising production
to reduce market costs. The difference in cost is between governance cost and
the transaction cost of using the market. The firm exists to capitalise on the
lower governance cost.
Why transactions are done within the market and some within the firm:
Main factors why some transactions are done within the market and some are
completed within the firm include unexploited economies of scale and scope,
large number of suppliers, and high governance cost. Generally speaking,
transactions are done within the market when the transaction cost associated
with the activity is lower than the governance cost required to internalise it.
Firms would choose the cheaper option to remain competitive.
For example, one such reason is the unexploited economies of scale and scope.
The average cost per unit produced will fall as output increases. This is an
advantage to the specialised supplier can aggregate demand from a number of
firms. As a result of the high demand available, such a supplier is able to produce
the good at a lower cost. In this regard, a small firm should choose to buy rather
than produce the products themselves. By only producing a small quantity, such
a firm is unable to realise the benefits of costs savings, hence they are better off
procuring from the market to be more competitive.
Secondly, large number of suppliers in the market. Large number of suppliers in
the market will lower the price of good due to competition among themselves.
Furthermore, the variety of goods will increase too. In a buyer's market like this,
buyers have market power since they have the luxury of switching between
suppliers with ease. In this sense, firms can purchase inputs at a relative low cost
and there is no necessity to produce internally.
The third reason is high governance cost. Governance cost will increase as the
firm undertakes new production. For example, costs relating to the internal
processes of the firm such as incentivising employees, supervision and control
will increase. Firms should rather buy from market if such a cost is relatively
large compared to the market.
Yet another factor is the uncertainty in the market. Lack of information about the
future market or the supply of inputs may motivate a firm to produce internally
to avoid higher transaction costs such as covering a large number of
contingencies and complex and expensive contracts. In addition, a firm which
wants to command a higher degree of control over its inputs would produce
internally.
Additionally, the higher the asset specificity of the firm , the higher the tendency
to produce internally. Asset specificity is defined as the extent which the
investments made to support a particular transaction have a higher value to the
transaction than they would if redeployed for any other purpose, McGuinness
1994. According to Williamson, 1983, examples of such assets would be site-

specificity, physical asset specificity, human asset specificity and dedicated

assets.
Firm specific, idiosyncratic knowledge is a competitive edge to a firm, and firms
with these advantage would favour internalisation.

Factors causing firms to vertically integrate:

Vertical integration is the merging of firms of different stages of the production
chain. Firms vertically integrate for different reasons, perhaps transaction costs
of the market outweigh the costs of internal governance or when firms want a
greater degree of control over its inputs.
The advantage of vertical integration is that the firm skips the middleman by
producing its own products. This reduces opportunism by uniting previously
distinct firms into divisions of a single, integrated firm. Furthermore, by vertically
integrating, firms move towards greater monopoly power and raise barriers for
others to enter the market. This can weaken the position of its suppliers as well,
because they will have greater bargaining power to obtain supply at a lower
price. In the case of downward integration, firms aim to control retail outlet and
ensure market presence. Irregardless, firms will create cost savings by linking
production processes which would otherwise be seperate.
When transactions cost run too high, the only choice left for a firm is to set up a
facility to produce a good internally. This is vertically integrating to move up the
production stream to produce its own inputs.
Nature and causes of transaction cost:
A transaction cost is the excess of the actual amount paid to the input supplier.
The transaction cost of acquiring an input are locating a supplier, negotiating a
price, and putting the goods to use.
Firstly, search cost, which is the time and effort needed to search for a specific
product, eg brand,quality or type.
Secondly, bargaining cost, which happens during negotiations, to decide price,
terms and conditions. Fo example, after sales service or payment schemes.
Thirdly, policing and enforcement costs, which is to ensure suppliers keep to the
terms of contract. for example, using the legal system.
Another kind of cost is related to specific investment, an investment that cannot
be recovered in another trading relationship. For such investments, a relationship
specific exchange is a transaction cost by both parties that ties them together
due to asset specificity. According to mcguiness 1994, asset specificity is the
extent to which the investments made to support a particular transaction have a
higher value to that the transaction itself than if it were to be redeployed

elsewhere. Some examples of specialised investment include: Site specificity,

physical asset specificity, dedicated assets and human capital, according to
williamson 1983. This feature creates transaction cost due to the sunk nature of
the specific investment.
Main factors affecting transaction cost and managerial costs:
Transaction cost are costs associated with acquiring an input that is in excess of
the amount paid to the input supplier. The main factors are specialised
investments that come in various forms such as 'site, physical asset, dedicated
or human capital specific, williamson, 1983. All these increase transaction cost
because they lead to costly bargaining, underinvestment and opportunism.
Specialised investments are asset specific investments which are made to
support a particular transaction that has a higher value to that transaction itself
than if it were to be redeployed elsewhere, Mcguinness 1994. Generally, there is
no market price for such such inputs, and the two parties have to bargain to
negotiate a selling price for the production of such an input, which makes the
bargaining process more costly.
While specialised investments are required to facilitate exchange, the level of the
specialised investment is often lower than the optimal level. More often than not,
the human capital or machines do not return the value of the initial investment,
hence underinvestment occurs leading to inferior quality and higher transaction
costs.
Both side of the trading relationship are required to make specialised
investments to acquire an input, in which case both parties may engage in
opportunism by capitalising on the sunk nature of the investment. This results in
two parties spending more time negotiating how much to pay for the input and
incurring transaction cost in the form of bargaining.
Managerial costs are forces that disclipines managers and a system of incentives
to compensate for labour inputs, thus ensuring that managers put in their best
effort to generate profit for the company. These costs come in the form of
internal and external incentives.
Internal incentives are stock options, profit sharing and revenue sharing, often
monetary compensation which induce greater effort from the manager. These
allow the manager to be paid a fraction of the firm's profits and thus create the
incentive to increase the firm's profits.
External incentives are forces outside the firm that provide managers with an
incentive to maximise profits. One such incentive is reputation. Managers have
increased job mobility when they demostrate to other firms that they have the
managerial skills needed to maximise profits. On the other hand, it is costly to be
found out by the market that you are an ineffective manager. In the long run,
this reputation can serve as a market premium to managers.

Another external force that incentives managers to maximise profits is the threat
of a takeover. If the manager is not operating the firm in a profit maximising
manner the confidence and market value of the firm will fall, and investors will
attempt to buy the firm and replace it with new managers who do a better job.
Relationship between uncertainty and transaction cost
Uncertainty leads to opportunism which then leads to transaction costs.
The behavioral assumptions of bounded rationality and opportunism when acted
upon by uncertainty and small number exchange, respectively act as friction in a
machine essentially preventing a transaction from being completed efficiently or
smoothly. The market parameter of uncertainty acts on bounded rationality and
depending on their relative magnitudes worsens it. Correspondingly, small
number exchange acts on opportunism and worsens it. Hence, bounded
rationality or limited cognitive capacity is worsened when uncertainty is high;
and opportunism or self-interest with guile is worsened when small number
exchange is significant. This transformation of the twin assumptions is the
intervening variable that acts on the independent variablethe transaction
attribute of asset specificity.
Individuals may behave deceitfully in relaton to the quality or price of their
product. This is more likely to happen when there is only one suppliers as no one
would know how the level of quality is supposed to be. Obtaining information on
quality or other aspects of trade are costly and bilateral bargaining takes time. At
this point, managers may consider to produce inhouse or continue to purchase
from the market. Transaction costs would be the main factor.
Williamson's (1975) argument is that in an imperfect world where individuals are
irrational and opportunistic, high uncertainty makes it more difficult for the buyer
of good to evaluate supplier action. Transactions with high uncertainty, to which
no tangible asset has been dedicated, will be more efficient if governed
completely by the buyer than is governed by the buyer and supplier in the
product market. The problem of evaluating supplier performance under high
uncertainly is reduced when the buyer has unilateral control over the transaction
by producing component in house.
Transaction cost can also arise from taking time to discover potential suppliers
and market price, negotiating with suppliers and monitoring the terms of
contract. During this process uncertainty and risk would arise as managers are
also uncertain of the market and the future. There would also be difficulty
drawing up long term contract, as the longer the contract, the higher the cost,
time and effort involved. At times, when transaction cost would end up being
costly, it would be better to produce in house.
For example, when buying a a machine from a supplier, your cost would not only
be the price of the machine itself, but the energy and effort it takes to find the
specification of the machine, the brands, where to get and price, the cost of
travelling to the supplier. The costs above and beyond are transaction cost.

When evaluating a potential transaction, it is important to consider transaction

cost that prove significant. A manager would have to review both uncertainty
and transaction cost before he can make a decision whether to buy a product
that would benefit the company.
Discuss the relationship between economies of scale and scope and transaction
cost
Economies of scale are factors which lead to falling cost when scale of production
is increased. Economies of scale include technical, marketing, specialization, bulk
buying among others.
Economies of scale can be classified into either external EOS or internal EOS.
External economies of scale include the benefits of positive
externalities enjoyed by firms as a result of the development of an industry or
the whole economy. For example, as an industry develops in a particular region
an infrastructure of transport of communications will develop, which all industry
members can benefit from. Specialist suppliers may also enter the industry and
existing firms may benefit from their proximity. in the form of lower transaction
cost for searching and information.
Likewise, when a firm achieves larger cost savings through internal economies of
scale, bargaining, policing and enforcement costs are lowered too. As a big buyer
of inputs, the contract of the firm has would be more valuable, firm has more
bargaining power and there is more motivation for the terms and conditions in
the transaction are agreed upon.
Economies of scope are cost advantages from a providing a variety of products
rather than specialising in the production and delivery of a single product or
service. Economies of scope exist if a firm can produce a given level of input for
each product line more cheaply than a combination of separate firms, each
producing a single product at the given output level .Economies of scope can
arise from the sharing or joint utilisation of input and lead to reduction cost.
For economies of scope, the large variety of products a firm produces ensures
that the searching and information costs are minimised as comparison of prices
can be done within the scope of the products produced by the firm. Bargaining,
policing and enforcement costs can also lower when firm is the supplier of the
whole range of products to its clients and thus afford to cater to more flexible
terms.