Transaction Cost Economics

In understanding why chaebol and keiretsu may be appropriate in some situations, and vertical integration in other situations we need to understand the costs of doing business within the corporation and between business units within the corporation.  These costs of doing business are called transaction costs and include search and information costs, bargaining costs and contract management costs. In a vertically integrated corporation these costs exist in the form of internal transfer pricing discussions and possibly service level agreements. But while the transaction costs are low, the lack of specialisation may cause individual business unit costs to be higher than the same service provided by equivalent external providers. Specialisation by single purpose companies allows lower operating costs, but buyers incur higher transaction costs to engage these providers. There is the cost of sourcing and evaluating the external service providers, negotiating terms and contractual agreements, and supervising and managing their performance.  The buyer might be better off if it could access the lower operating costs of specialist contractors, were it not for the additional transaction costs associated with dealing with third parties. If the search for a suitable contractor was narrowed down to one source, and the negotiation was simple and straightforward, and the pricing was based on open-book or transparent arrangements and the contract management was based on trust and co-operation, the transaction costs would be minimised.  In this case, the system as a whole would be better off.