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Power of Transaction Cost Economics on Outsourcing Decisions (Research Paper Sample)

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Paper on the theory of transaction cost economics and its influence on outsourcing decisions.

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The Power of Transaction Cost Economics on Outsourcing Decisions
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Date of Submission: The Power of Transaction Cost Economics on Outsourcing Decisions
Introduction
The increasing pressure on industries by forces of globalization and competition explain the growing role of transaction cost economics (TCE) in outsourcing decisions. The idea of transaction costs has gained much popularity over time as industry players seek to; identify and uphold dependable business partners, establish contracts and gain control over the business process. Transaction costs are a crucial part of every business and together with transport costs, they account for the largest part of the cost of a given contract. Currently, there is much research interest in the field of business outsourcing as firms seek to enhance their competitiveness and capacity through outsourcing. Research focus on various theoretical underpinnings that explain the issues surrounding outsourcing decisions has intensified. Such research is inspired by the intention to move from the largely descriptive nature of some published literature that only describe best practices for managers to conduct outsourcing operations (Vasiliauskiene & Snieska, 2009). Further, this literature lacks support from rigorous theoretical frameworks. On the same note, existing literature seems to lack in terms of coverage and only tends to focus on certain parts of the logistic chain. Outsourcing decisions are critical because the manner in which a firm makes them defines its boundaries. In this view, this research paper seeks to analyze the power of transaction economics in decision making for logistic outsourcing.
Transaction Cost Theory
The works of Coase (1937) are credited for the development of transaction costs theory. However, Williamson is credited for the development of the theory in his works, between 1975 and 1985 (Lynch, 2001). Hence, the development of the theory is attributed to a series of developments that occurred in the field of economics between 1930 and 1970. TCE has since become a central reference point for the study of organization. According to Vera and Yvette (2006), TCE has contributed immensely to the understanding of outsourcing decisions. From the transaction cost theory perspective, outsourcing decisions are mostly based on a firm’s ability to employ economies of scale to practice outsourcing (Mukherji & Ramachandran, 2007). Transaction costs theory provides an avenue through which the effect of transaction costs on the performance of economics can be assessed. The theory has contributed significantly to the understanding of the manner in which the relationships between buyer and suppliers are managed (Ambrose, Marshall & Lynch, 2010; Tadelis, 2002). The theory had not been exhaustively exploited until the last decade when business authors began paying keen attention to the field of business outsourcing. This development was also inspired by the growth of business outsourcing practices as the world was becoming more and more globalised.
TCE offers a reliable scientific perspective on an organisation’s outsourcing decisions. The major issue is minimization of both production and transaction costs. It is important to note that a variety of theoretical backgrounds have been developed to explain outsourcing decisions. These theories include co-ordination theory, core competency theory, unit of competitive advantage, power, agency theory, resource-dependence theory, game theory, resource-based theory and transaction cost theory (Ambrose, Marshall & Lynch, 2010). However, it is the transaction cost theory that has gained much popularity over time and in the current dispensation whenever businesses are seeking to redesign to match up to the trends in the world and to remain both profitable and relevant to their clientele.
Transaction cost theory contributes to the understanding of governance decisions within a firm and the efficient boundaries of an organisation. The concepts of opportunism and asset specificity are the major factors that influence governance decisions in the context of bounded rationality (McKinsey Global Institute, 2003). Williamson (cited in Wang, 2002) notes that transactions form the basis of organizational analysis in which a contract for the transfer of goods or services among parties is involved. This suggests why the theory has become common place in outsourcing decisions.
Transaction Costs
With increasing challenges and opportunities in business, it has become vital for firms seeking to engage in various transactions to focus on the development of relationships in which ongoing interaction is essential throughout the transaction. The idea of transactions as manifested in the transaction costs theory is that other than the basic market exchange of commodities and services, the continuity of the exchange relationship is vital (Geyskens, Steenkamp & Kumar, 2006; Weidenbaum, 2005). Other researchers support this argument with views that the “ultimate unit of activity” which refers to a transaction, has to have three principles including mutuality, conflict and order (Lynch, 2001). This is the fundamental challenge of economic organisation. The main ideology behind transactions is governance and it follows the most cost effective approach in which order can be realized, conflicts mitigated, and mutual gains realized. Transaction cost thus becomes the basic unit in the analysis of firm governance. They also are important avenues for the understanding of collaborative buyer-supplier relations which are key sources of competitive advantage for organizations today (Mankiw & Swagel, 2005).
Transaction costs can be characterized into three major categories as described (Craig & Willmott, 2005). One, bargaining costs which are costs arising due to negotiation and the establishment of a contract with focus on every possible future transaction situation. Two, information costs, these are associated with the process of finding information about potential partners. Three, enforcement costs, these encompass costs that are associated with the process of implementing partnerships and exercising control over performance, conflict resolution and renegotiation of contracts.
The extent of transaction costs therefore becomes an indicator of a firm’s decision to outsource (Vasiliauskiene & Snieska, 2009). That is, if transaction costs are low, a firm ought to outsource the activity or product but embark on in-house provision of the activity if outsourcing is expensive.
Characteristics of Transactions Costs
Williamson (2005), who is credited for development of TCE, holds the view that markets and firms exist as complements. This implies that a choice among firms and markets is solely influenced by the efficiency shown by each. This degree of efficiency however is based on the costs associated with coordination within an organisation as well as transaction costs. According to Williamson (cited in Wang, 2002), there exists five principal issues that affect transaction costs as illustrated in figure 1 below.

Figure 1: a representation of the five principal factors affecting transaction costs
Human Factors Affecting Transaction Costs
In view of human factors, bounded rationality implies that humans lack the ability to predict all possible future contingencies including the results of an occurrence in advance (Varadarajan, 2009; Drezner, 2004). However, irrespective of them having knowledge of computational limitations, humans tend to act in rational ways as possible.
Another aspect, opportunism is a crucial human aspect that helps understand the power of transaction cost theory in outsourcing decisions. In relation to economic theory, opportunism is associated with the marginal utility curve indicating the actions that make an individual feel better off (Whinston, 2000). This is based on the assumption that the behavior exhibited by people can be demonstrated on a utility curve. As such, self-interested actions dominate and therefore people tend to act opportunistically (Lynch, 2001).
Environmental Characteristics Affecting Transaction Costs
These constitute asset specificity and information asymmetry. Most transactions are characterized by a great level of complexity and/or involve uncertainty regarding certain factors hence difficult to comprehend in a contract. Further, some transactions in the market are characterized by few buyers and/or suppliers; such market lacks perfect competition. This is referred to as asset specificity and it influences the transaction cost negatively given that their value is based on a given transaction to its completion (Ambrose, Marshall & Lynch, 2010). The second environmental factor encompasses both uncertainty and opportunism. This characteristic is information asymmetry. Transaction costs are usually influenced by these five factors if human characteristics remain unchanged across various transaction types. In view of these five factors, it should be noted that in a situation where there is complexity, information asymmetry and a level of uncertainty, firms resolve to in-sourcing (McIvor, 2008).
Outsourcing
The term was introduced in the 1980’s in which it referred to the process of information systems contracting (Masten, & Stephane, 2000). However, various terminologies and phrases have since emerged and all address this aspect. Such include “integration vs. disintegration” and “make-or-buy decisions’(David & Han, 2004). The concept of outsourcing has been applied to fields other than information systems. However, one thing is crucial; that in outsourcing, it ought to be feasible for the specific business function to be contracted to an external provider. According to Varadarajan (2009), outsour...
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