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Transaction Costs and Information Technology

written by: •edited by: Bill Bunter•updated: 6/18/2010

The article links transaction costs with information technology and its consequences on each another.

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    Definition of Transaction Costs

    TC Transaction costs are expenses of trading with others beyond the actual worth. These costs are those that are incurred apart from the production cost, when an economic exchange takes place.

    Coase contends that without considering transaction costs, it is unfeasible to understand the proper working of the economic system. Transaction costs are generally defined as:

    • costs of gathering information
    • negotiating costs
    • evaluating alternative options
    • cost of physical transaction
    • cost of uncertainty related

    Coase’s contribution was to focus on the overhead cost of searching, bargaining, and governing exchanges of value. He reasoned that when transaction costs are low, markets would form and find great prices, but the high transaction costs would be a forecaster of market breakdown. Arrow defined transaction cost, “as the costs of running the economic system" while Barzel defined it as “the cost associated with the transfer, capture, and protection of rights."

    Transaction costs are accepted as the hub of the new institutional theory of organizations by Groenewegan. In perfect markets, transaction costs would be zero. However, the real world is not where information is perfect and therefore certain key factors lead to the existence of these costs. The key environmental factors are uncertainty, frequency, asset specificity, and number of firms along with human factors such as bounded rationality and opportunism.

    - Bounded rationality: Is the limited human capacity to foresee or resolve complex problems. It is behaviour that is meant to be rational only in a limited way and involves cognitive and perceptive limitations and language limitations. Humans have limited memories and limited cognitive processing power to integrate all the information we have and perfectly workout its consequences, as there are many options and competitor actions that are unpredictable.

    - Opportunism: Includes guile in quest of one’s own interests. It refers to the possibility that people will act in a self-interested way with intelligence as they would not be completely honest and truthful about their intentions and would want to take advantage of exploiting another party when possible by referring to incomplete or distorted information.

    - Uncertainty and frequency: Transactions can be recurrent or rare, have high or low uncertainty, and involve specific or non – specific assets.

    - Asset specificity: This relates to the extent of value of a good or service. It refers to the extent to which non–fungible assets are tied to particular transactions specified by contracts and commitment. For instance, a house in LA is site specific to that particular location, a lot of Christmas trees is time specific, loyal customers of Coke are brand specific, etc.

    - Number of firms: Higher number of firms leads to higher uncertainty.

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    Link Between Information Technology on Transaction Costs

    Information Technology refers to electronic processing, storage and communication of information. By transaction costs, are meant the sum of production cost, the effort, and cost incurred to find and negotiate for the goods. Transaction costs include both internal and external coordination costs as well.

    Information technology has vague effects on overall transaction costs. Information technology externalities have both helpful and unhelpful effects on synchronization and transaction costs. Galbraith (1977) argues that larger the vagueness of task, higher is the amount of information that must be processed between decision makers during execution of task to achieve a level of performance.

    Thus, in general, information technology is seen as a prevailing tool that can trim down the costs of transacting by giving more information to decision makers. This results in reducing uncertainty and improving the functioning of the market. (Ciborra, 1993).

    Lewis argues, “professional and personal survival in modern society clearly depends on our ability to take onboard vast amounts of new information. Yet that information is growing at an exponential rate." With the adoption of IT, a number of communication channels drastically increase. IT networks are organized so that the number of possible interactions is almost unlimited and cost of interaction is negligible. (Fowler 1997).

    However, the contradicting view to this theory states that the usage of IT leads to more information that may lead to information overload, leading to higher processing costs, and eventually leading to higher TC. If information available would be reduced, complexity would decline leading to lower coordination and transaction costs. (Palme 1984).

    Although, this market efficiency of too much information could be fixed by efficiently supporting the IT by improving information processing capabilities and reducing the number of coordinating activities which don’t contribute to the value of the organization. Further, firms could reduce this uncertainty by better planning and coordination, often by forming rules, hierarchy, or goals. The above-mentioned views/strategies cannot be substituted but could co – exist.

    The theory of institutional economics states that increasing the complexity of transactions will result in the failure of the coordination mechanisms within a market because transaction costs will be too high. Therefore, as exchange related complexity increases, it becomes more efficient to use IT.

    Thus, to conclude, on one hand IT gives more and better information, making communication easier and on the other hand, increased amount of information has to be processed in order to coordinate the organizational activity, therefore, it can result in lower or higher coordination costs to the organization.