Sunday, 17 November 2013

7. Transaction costs

Transaction costs are costs of relations in general and markets in particular. They affect decisions to do things inside or outside the organization, and they affect the position of small relative to large firms. They are important for economics in general, but in innovation there are special features.

Between organizations there are transaction costs in different stages of  a relation: costs of contact and contract prior to a transaction and costs of control afterwards, in the execution of agreements.

Costs of contact are costs of searching for customers or suppliers and of judging their quality and reliability. Costs of contract are costs of coming to an agreement, whether formal, in a contract, or informal. Costs of control are costs of monitoring compliance, renegotiation, haggling, intermediation, and possibly litigation.

Costs of evaluation of quality vary between the following categories of products:
-          search goods: quality can be judged prior to use. Examples are cars, houses, appliances, etc.
-          experience goods: quality is judged during use. Examples are restaurants, performances,
       holidays, etc.
-          credence goods: even after use quality still cannot be judged. Examples are consultants, doctors,
       garages, etc. If one had the knowlwdge and skill to judge their work one would not have needed
       them in the first place.

Often there is a mix. Education is primarily a credence good: one can judge quality only later, in the practice of what is learned. However it is also an experience good in the skill and enthusisiasm of a teacher and conditions of class. Attempts are made to reduce transaction costs by turning it into a search good, by means of scores of graduation success and teacher evaluation. There is a danger here of reducing evaluation to what is readily measurable, even if the most important dimensions are difficult to measure.

In innovation transaction costs are particularly high due to the uncertainties of innovation. It is difficult to judge the quality and reliability of a product or a firm that is still under development, to specify contractual conditions under uncertain prospects, and to judge performance for which there are not yet any standards or benchmarks.  

An important point in the present context of comparing large and small firms is that there are economies of scale in transaction costs, both for a small firm and for others dealing with small firms. To judge a small firm and make agreements there are set-up costs (or threshold costs, see the preceding item in this blog on economies of scale) of a visit, acquaintance, evaluation and contracting that are relatively expensive when small volumes of business are involved. Furthermore, in small business much information is tacit, buried in the mind of the entrpreneur and not available in accessible documents, which are often available in larger firms. This is related to the condition that in small firms there is direct, visual control by the entrepreneur, so that costs of setting up and operating formal control systems may be saved. However, to judge the firm one needs to somehow pry the informal, tacit information from the entrepreneur, which is costly and imperpect.

For judging others, a small firm lacks the knowledge and expertise (technical, commercial and legal) for finding and judging opportunities and setting up agreements and monitoring. For this, it must employ third parties, who in their turn need to be judged, contracted and evaluated, which yields second order transaction costs.

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