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Analysis of Dynamic Capabilities and Transaction Cost

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Transaction Cost Theory
Underlying and Related Theories
Conceptualization of Transaction Cost
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Transaction Cost Theory


The transaction cost theory accounts for a longer history and a more established concept than the dynamic capabilities theory. Nevertheless, this theory has strongly been criticized for its logic. Such criticism, among others, addresses the lack of dynamism. This paper, first, discusses the intellectual roots of the transaction cost theory. The analysis of the theory is continued by discussing its major elements and selected principles, which are exposed to a particularly strong criticism and, as a result, are continuously refined.

Underlying and Related Theories


Over the past 30 years, the predominant theoretical explanation of the choice of the boundaries between the market and hierarchy was developed by a transaction cost theory (Williamson, 1975; 1991; 1996; Madhok, 2002), which to a large extent modified and refined the previously formulated principles (Williamson, 1985; 1998). Interestingly, while the transaction cost theory is associated with the industrial economics stream of research, the major intellectual antecedents of this theory comprise conceptualizations provided by prominent contributors to the theory of the firm (Williamson, 1999).

The most influential conceptualization, which predefined the emergence of the transaction cost theory, is the classical work of Ronald Coase, “The nature of the firm” (1937). Coase’s unconventional approach was to define the firm, not as an economic production function mechanism, but as a part of a dichotomy of the firm and market, where the choice between these two alternative forms of governance is dominated by the difference in the transaction cost. In his later articles, Coase (1960; 1992) elaborated on the notion of the zero transaction cost but still emphasized that choices always have to be made between feasible alternatives. This emphasis means that the analysis of the institutional actions has to be made considering existing transaction costs.

Similarly, John Commons has stressed the importance of analysis of the economics of the organization and defined a transaction as a unit of such an analysis: “The ultimate unit of activity … must contain in itself the three principles of conflict, mutuality, and order. This unit is a transaction” (1932: 4).

Chester Barnard has similarly insisted on the importance of organization and its underestimation in economic theory. In his book, “The functions of the executive” (1938), Barnard argued that cooperative adaptation is a central problem of economic organization. He further described such adaptation as, “conscious, deliberate, purposeful” (ibid: 4), which could be achieved by the administration of a firm. While Barnard’s ideas were fundamental to the development of the organization theory (Simon, 1947; 1957; Cyert and March, 1963), they also influenced the formation of the transaction cost theory (Williamson, 1999).

Another contributor to the development of the transaction cost theory is Kenneth Arrow (1962). He suggested that the market failure is a relative category which could be more accurately described by employing the category of transaction cost as they are able to explain the impediment or blocking of market formation. In this way, he has located the concept in economic theory.

Alongside with rationalizing the existence of transaction costs, these and other related concepts have proposed that there are multiple sources and aspects of such costs. For instance, Coase (1937, 1988) emphasized the ‘frictional’ costs, such as those of identifying a potential supplier, negotiating, drafting a contract, and monitoring it. Later, Williamson (1975, 1985) transformed the subject by shifting attention to the costs of transactional hazards and of governance arrangements to limit such hazards. His focus is on the tendency of transactions to attract difficulties for reasons associated with bounded rationality and opportunism. In this concept, the frictional costs differ from the transaction costs due to their quality to be present even when things go well.12

Despite the prominent antecedents, the concept of transaction cost remained “vague and elastic” for a long time (Williamson, 1999: 1088). Its excessive degrees of freedom allowed almost any outcome to be rationalized by one of the specifications of the transaction cost (Fischer, 1977). As late as in 1970s, the refinement and full-speed operationalization of the concept has begun. Since then transaction cost theory has gone through informal, preformal, semiformal, and fully formal modes of analysis (Williamson, 1996: 18-20).

Further advancement of the transaction cost theory is enhanced by joint analysis with related theories of the new institutional economics. In particular, empirical studies combining principles of transaction cost theory with those of property rights (Grossman and Hart, 1986; Hart, 1990; 1991) and agency theories (Jensen and Meckling, 1976; Harris and Raviv, 1978) have contributed to a better calibration of the instruments of the transaction cost theory. For instance, in his research on contractual governance of R&D projects, Ulset (1996) found that the combined approach of transaction cost theory and property rights theory provides a more precise description of governance tools (e.g. such as control and property rights). A wider range of control mechanisms is made available by the agency theory which offers an in-depth analysis of transaction-based agency relationships between independent market players (Jensen and Meckling, 1976). The costs of relationships, or agency costs, are comprised of expenses for monitoring and bonding mechanisms designed to reduce opportunism and unavoidable conflicts between principals and agents. Employed by the agency theory governance mechanisms include various forms of contracts, ranging in character from formal to informal, explicit to implicit, and objective to subjective (Barney and Ouchi, 1986). The strong focus of this theory on the interaction process between agents well complements a broader conceptualization of the choice of governance analyzed in the transaction cost theory.

A brief summary of major contributions to the development of the transaction cost theory are outlined in table 1.

Table 1: Principles Contributing to Transaction Cost Theory

Relevant Principles
Selected Contributors

Firm - market dichotomy

Differences in transaction costs

“Frictional” costs
Ronald Coase (1937)

Importance of economics of organization

Transaction as a unit of activity

John Commons (1932)

Economic theory underestimates organization

Functions of executive

Cooperative adaptation

Chester Barnard (1938)

Market failure

Transaction costs explain impediments and blockings of market formation
Kenneth Arrow (1967)

Transaction cost stems from difficulty to measure and monitor performance
Alchian and Demsetz (1972)

Transaction cost stems from inability to specify goods and services needed
Jacobides and Croson (2001)




Relevant Principles
Selected Contributors

Property Rights Theory

Control and property rights as governance tools

Grossman and Hart (1986); Hart (1990); (1991)

Agency Theory

Control mechanisms

Various forms of contracts

Jensen and Meckling (1976); Harris and Raviv (1978)

Source: Own analysis

Conceptualization of Transaction Cost


In this section the key elements of the transaction cost theory are analyzed and their interpretation of the specific assets, the issue central for the present study, is discussed. First, (a) the general logic of the theory regarding the governance of specific assets is outlined. Then (b) the dual concept of commodity goods (for which the price mechanism is efficient) and specific assets (for which the price mechanism is considered to be inappropriate) is presented. While specific assets are prescribed to be kept inside a firm, the theory does not specify the corporate mechanism for dealing with such assets and limits (c) the role of managers to passive decisions of allocating existing assets. Finally, the advancements of the transaction cost theory indicate that despite the role of the firm as (d) a value protecting mechanism, (e) the hybrid organizational forms could compromise the duality of the market vs. hierarchy mechanisms and exemplify an efficient mode for dealing with specific assets. Furthermore, the static nature of the transaction cost decisions is questioned with (f) a hypothesis of dynamic transaction costs.

(a) Governance of Specific Assets

In his work, Coase (1932) distinguished between governance in a hierarchy and market organizational modes. The choice between them is made so as to minimize the transaction cost which defines all organizational modes ranging from the market to internal coordination in the firm. In the latter, transaction costs form the boundaries of the firm, so that at the margin, the internal costs of organizing are equilibrated with the costs associated with transacting in the market. The boundary choices are driven largely by the specificity of assets involved in the exchange (Shelanski and Klein, 1995), which may trigger a threat of opportunistic behavior of companies involved in the exchange and require costly contractual safeguards, use of property rights, and sufficient incentives to deter participants from opportunism. According to the transaction cost theory, a vertical integration in the presence of exchange-specific assets, is a preferred governance solution (Hennart, 1991; Osborn and Baughn, 1990). It is accepted that it is useful to think of a firm and market as alternative modes of governance. Therefore, whether to use an internal mode of governance or a market mode of governance is dependent on the tradability of the assets in question.

(b) Price Mechanism and the Role of the Firm

The price mechanism means that a large portion of allocation of resources can take place via the market in a quick and efficient way.13 This is true for commodity markets, but a large portion of goods and most services are difficult to exchange in open, organized, and well-developed markets. Mutually beneficial transactions frequently do not happen if the object of the transaction is associated with property rights that are poorly defined, contain assets that are difficult to transfer, and have a value that is hard to measure.

The bounded rationality of involved actors and the incomplete information they possess contribute to an inadequacy of a market valuation of specific assets. Therefore, when specific assets are needed to support efficient production, the preferred organizational mode is a hierarchy. For the situations of thin or non-existent markets, transaction cost theory clearly favors allocation of assets inside the firm. Furthermore, the allocation of resources inside a firm not only substitutes but also complements the allocation of resources by markets as the latter possess no efficient mechanisms for trading thin assets.

While transaction cost theory has been used in empirical analysis of production and supply activities (Monteverde and Teece, 1982; Stuckey, 1983; Masten, 1984; Walker and Weber, 1984; Balakrishnan and Wernerfelt, 1986), as well as in marketing (Anderson and Schmittlein, 1984), its application to the research of specific assets (such as R&D) in the definition of a firm’s boundaries has been limited (Pisano, 1990). The rationale behind this lack of studies on specific assets is the accepted assumption that an internal organization possesses an ability to defeat opportunism and make specific assets work for the purposes of a firm. However, this assumption does not explain why it occurs. This treatment excludes any insights on process design, internal resource allocation, and asset alignment, as a set of factors explaining the performance of a firm. In other words, it leaves an explanation of how specific assets are handled beyond the scope of traditional transaction cost theory. The theory is, however, very efficient at explaining the treatment of commodity goods and low-specificity assets. It indicates that the market enables rapid adaptation with respect to assets which are actively traded using a price mechanism. If activities are done outside a firm, the emphasis is put on designing contracts that are efficient, in the sense that “hold up” or re-contracting costs are minimized or avoided. Therefore, the main emphasis in the transaction cost theory is put not on the selection of activities that are needed to be done or on the explanation of how these activities have to be done, but rather on the determination of where they are to be done. The mechanism provided by the transaction cost theory solely serves to avoid the negative consequences of opportunism in the case of a transaction. If the activity is done outside the firm, the emphasis is put on a contractual mechanism that helps to avoid “hold up” problems.

(c) Role of Management and Concept of “Fit”

The transaction cost theory leaves the role of management somewhat indistinctive. It limits managerial functions to making the choice of governance mode between market arrangement and internal organization. The managers do not necessarily have to understand what drives or should drive asset selection, configuration, or investment decisions. The theory conceptualizes managers only as cautious executives of the asset allocation decisions, and in this description the term “managerial discretion” emphasizes the passive role of a manager. However, in later refinements, the transaction cost theory revises this view and makes a claim that the role of management is “significant” in transaction cost theory (Williamson, 1999: 1001). Nevertheless, this only means that the role of a manager is limited to exercising organizational “fit” in a form of adaptive process of organization and reorganization of a firm’s existing resources.

(d) Firm as Value Protection Mechanism

The transaction cost theory focuses on the economizing on transaction costs with the emphasis put on how this mechanism is organized via the governance framework. The governance framework explains asset and value protection, but leaves unexplained the process of value creation. Therefore, the transaction cost theory reflects the static situation of choices between internalization and externalization. This is supported by the assumption that non-traded and thinly traded assets have to be organized internally. The transaction cost theory implies that both an evaluation and a choice of governance structure are situational decisions with a short-term orientation at best. Furthermore, though there is much utility and exploratory power in the transaction cost framework, the contractual scheme upon which it is built deals with existing resources and does not examine how new resources are discovered, how they are accumulated, and how a firm learns. Therefore, the structure and behavior of a modern firm cannot be fully explained by simply appealing to transaction costs. This is an important element of management, but it is not the main concern of management scholars or practitioners.

(e) Role of Hybrid Organizational Forms

Any advancement of the traditional transaction cost logic to justify the hybrid governance form of specific assets (such as R&D) is constrained by the previous assumptions of this theory. For instance, the transaction cost theory is quite pervasive at explaining why there should be no outsourcing of R&D. The reasoning is that the high degrees of complexity and uncertainty associated with such a transaction make contractual relationships difficult or impossible to negotiate. Under conditions of bounded rationality imposed by the complexity of the transaction, the bargainers are unable to define complete contractual agreements because neither all alternative features nor their corresponding prices can be determined (Williamson, 1975). Similarly, Ouchi and Bolton note in relation to R&D projects: “When the task in hand is complex or uncertain, contractual agreements will be difficult to specify and monitor, and post-contractual opportunism will be common” (1988: 12). Because of these reasons, the transaction-cost model rationalizes that R&D is impossible to trade in the market-mediated system, and it rather should be carried out within the firm.

This assumption could be relaxed by the fact that not all R&D has high degrees of uncertainty and complexity attached to it (Freeman and Soete, 1997). There are some kinds of R&D that have low levels of complexity (i.e. minor technological improvements and product differentiation) where market-mediated contracts can theoretically function.14

On the basis of this advancement of the transaction cost theory, several attempts were made to use the theory for explanation of a shift from the in-house provision of research toward a more market mediated approach. However, although useful as a general guide for such changes, transaction cost theory is difficult to apply for specific organizational contexts or more aggregated empirical surveys (Foss, 1996; Englander, 1988). This happened due to what Robins has termed “serious logical and empirical flows” (1987: 68) of the theory. However, there was also positive evidence of operationalization such as Brockhoff’s (1992) application of the transaction cost logic for the analysis of the R&D cooperation.

The recent developments in terms of the transaction cost theory further elaborate on hybrid forms of governance and explain them as able to cope with greater complexity in contractual and organizational forms, than the traditional market and hierarchical organizations (Williamson, 1996).

(f) Dynamic Transaction Cost

The proponents of the dynamic approach to the transaction cost theory argue that although the context in which the transaction cost decisions are made is fixed in the short term, it is subject to change in the medium term as firms make incremental adaptations and explore new directions in their search for profit. The slow evolving factors of dominating contracting norms, firm reputations, and transactions technology, as well as the on-going process of learning to contract determine the environment and its change (Mayer and Argyres, 2004). The environment is further altered by the change in the existing transactional “interfaces” that can support market exchange to a greater or lesser extent (Baldwin and Clark, 2003). Therefore, in the intermediate and longer terms a firm could influence the shape of the transaction cost context and the way the transactions are made evolves (Jacobides and Winter, 2005).

In summary, the recent efforts to extend the transaction cost theory, also including the explanation of placement specific assets outside the boundaries of the firm, are still in the process of development. Meanwhile, the transaction cost theory has the reputation of being a theory which best explains the mechanisms for allocating non-specific assets.

The role of management in the transaction cost theory is somewhat limited. The very nature of managerial activity expressed in the coordination and adaptation of non-traded or thinly traded assets (Cyert and March, 1963) is not elaborated in this theory. Because the question usually asked by managers in the transaction cost framework is “where” to allocate resources, the issues of “how” to exploit resources and, in particular, how to treat them under the condition of hierarchy, are not developed in this concept. While the transaction cost theory adequately explains the managerial role in arrangement of market contracts, it does not provide an equivalent explanation of any managerial role for the internal coordination of resources. This contradicts the concepts of the strategic management literature, which suggest that asset selection, development, and configuration, as well as further investment decisions, comprise the essence of managerial activities in the creation of strategic “fit” of a firm (Teece et al., 1997). Beside that, the static decision of boundary choice does not contain space for an option to learn and there is no managerial creativity left in the transaction cost theory.

Due to these conceptual weaknesses the opportunistic basis of the transaction cost theory has come up against wide-spread criticism. An accepted criticism is that the link between asset specificity and boundary choice has little to do with opportunistic behavior and failed markets (Foss and Foss, 2004a). The counter argument is that the increase in the specificity of activities does not trigger market failure but enhances the efficiency with which such activities are coordinated (Grant, 1996; Kogut and Zander, 1992; Coff, 2003).

The predominant concern of transaction cost theory with allocation decisions does not provide space for taking into account the value of creation. For instance, the focus of the transaction cost theory on finding the remedy from opportunism underemphasizes the fact that there could be a value in the co-specialization. Similarly, the fear of opportunism also extinguishes numerous opportunities available on the market. Other theories show that decisions regarding asset selection are not just driven by transaction costs and governance considerations but by a degree of value that has yet to be discovered (Langlois and Foss, 1999; Conner, 1991). The meaning of the assertion “price is what you pay, value is what you get” has yet to be recognized by the transaction cost theory.