Transaction cost theory tries to explain why companies exist, and why companies expand or source out activities to the external environment. The transaction cost theory supposes that companies try to minimize the costs of exchanging resources with the environment, and that companies try to minimize the bureaucratic costs of exchanges within the company. Companies are therefore weighing the costs of exchanging resources with the environment, against the bureaucratic costs of performing activities in-house.
The theory sees institutions and market as different possible forms of organizing and coordinating economic transactions. When external transaction costs are higher than the company's internal bureaucratic costs, the company will grow, because the company is able to perform its activities more cheaply, than if the activities were performed in the market. However, if the bureaucratic costs for coordinating the activity are higher than the external transaction costs, the company will be downsized.
According to Ronald Coase (1937), every company will expand as long as the company's activities can be performed cheaper within the company, than by e.g. outsourcing the activities to external providers in the market.
According to Williamson (1981), a transaction cost occurs "when a good or a service is transferred across a technologically separable interface". Therefore, transaction costs arise every time a product or service is being transferred from one stage to another, where new sets of technological capabilities are needed to make the product or service.
transaction costs related to the exchange of resources with the external environment could be reflected by the following factors. The list is not exhaustive.
- Environmental Uncertainty
- Bounded Rationality
- Core company assets
The factors above will all potentially increase the external transaction costs, where it may become rather expensive for a company to control these factors. Therefore, it may very well be more economic to maintain the activity in-house, so that the company will not use resources on e.g. contracts with suppliers, meetings, supervision etc.
Therefore, if companies see the environmental uncertainty as high, they might choose to not outsource or exchange resources with the environment.
If a company is thinking about outsourcing its production of a given product, it may assess the costs related to such a transaction with the environment. If the company sees it as difficult to formulate a contract that controls the uncertainties related to the exchange, the company may regard it as to costly to outsource the production. This is because the transaction costs of monitoring the exchange are perceived to be higher, than the bureaucratic costs of performing the activity in-house.
Managers must therefore weigh the internal transaction costs against the external transaction costs, before the company decides whether or not to keep some activity in-house, or to e.g. outsource the activity to the environment.