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Introduction

Supply chain management is a rapidly evolv-

ing area of interest to academics and business

management practitioners alike. Aspects of

marketing, economics, logistics and organiza-

tional behaviour are all important for develop-ing insights into how and why different supply

chain management arrangements emerge and

for understanding the consequences of these

arrangements for industry efficiency and

competitiveness. When undertaking any

analysis, it is helpful to have a framework

within which to work and from which testable

hypotheses can be drawn. A theoretical frame-

work enables predictions to be made about the

likely outcomes of different business strategies

and public policy initiatives. I t enables

observed business behaviour to be evaluated

and therefore provides better explanations of

the motivations for firms behaviour and the

consequences for efficiency within a supply

chain.

This paper discusses a theoretical frame-

work for the study of supply chain manage-

ment which is drawn from the economics

literature. Transaction cost analysis (TCA)

represents one possible approach to under-

standing and evaluating supply chain manage-

ment and has the potential to be combined inan interdisciplinary setting with the insights

provided by the marketing, logistics and

organizational behaviour literatures. The

purpose of this paper is to provide those inter-

ested in supply chain management, but who

are not familiar with TCA, with an overview

of this approach and to discuss methods of

applying the theory empirically.

Econom ics and supp ly chainmanagement

Business people, academics who teach and

study management and others interested in

the operation of supply chains often express

frustration with how few insights economics

appears to provide them. Although it is not

always obvious, the source of this frustration

lies in the assumptions underlying the ruling

neoclassical paradigm used in economic

analysis. Most economic studies of markets,

industries and firms use this theoretical

approach. Central to neoclassical theory is the

concept of a single product firm, operating in

a perfectly competitive industry with a large

number of competitor firms all producing the

15

Supply Chain M anagement

Volume 1 Number 2 1996 pp. 1527

M CB Un iv ersi ty Press I SSN 13 59 -8 54 6

Research pa perA t ransact ion costapp roach t o supply

chain m anagem entJill E. H obbs

The author

Jill E. Hob bs is based at Excellence in th e Pacifi c Research

Institute, University of Lethbridge, Lethbridge, Canada,

and Faculty o f M anagement, The University of Calgary,

Calgary, Canada.

Abstract

Observes that supply chain managem ent is a rapidly-

evolving subject w hich offers many insights into how

industries are organized and int o the effi ciency gains

w hich can be made under different organizational struc-

tures, pointing out t hat it is an interdisciplinary concept,

draw ing on aspects of m arketing, economics, logistics,

organizational behaviou r, etc. Presents a fram ewo rk from

the economics literature whi ch may be useful for those

interested in understanding and exploring th e concept of

supply chain managem ent. Describes the origins and

development o f transaction cost analysis and explains the

key concepts of the fram ewo rk. Discusses the potenti al

effects of transaction costs on vertical co-ordination w ithin

an industry and, hence, on supply chain management.

Finally, suggests methods for empiricizing transaction cost

analysis, result ing in recommendation s for closer co-

operation betw een researchers and business managers.

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same product under the same cost conditions

and all facing the same market demand curve.

(Of course, neoclassical theory has been

successfully extended to cover monopolies

and, with less success, to other intermediate

forms of industrial organization such as

monopolistic competition and oligopoly.)

The standard neoclassical transaction

involves the exchange of a homogeneous

product there are no quality variations

between products and consequently no costs

involved in measuring the value of a product.

Where products do exhibit quality differences,

they are regarded as distinct products serving

separate markets. Economic agents are

assumed to possess perfect information,

hence, there is no uncertainty regarding

prices, product characteristics, or the behav-iour of competitors and trading partners. The

neoclassical transaction occurs in the current

time period between multiple buyers and

sellers, thereby ruling out the possibility that

one firm could exercise market power over

others since many alternative buyers and

sellers exist. Neoclassical economic analysis

concentrates on equilibrium market out-

comes. T here is no consideration of how

business relationships arise. Instead, transac-

tions are treated as though they occur in a

frictionless economic environment, somewhat

analogous to the physicists perfect vacuum.

Somewhat ironically, the neoclassical theory

of the firm has little to say about the firm; it

does not provide a rationale for the existence

of firms, an explanation of the growth of firms

or an analysis of the internal organization of

firms[1-4]. The firm is instead treated as a

black box, a featureless production function

which turns inputs into outputs; as such it is a

component of the neoclassical explanation of

the workings of a competitive economy, butone which is little understood. When one

strips neoclassical theory down to its key

assumptions, it is not surprising that analysis

undertaken using its framework provides few,

if any, insights for those interested in supply

chain management.

New institut ional economics

Coase[2] identified some limitations to the

neoclassical paradigm for understandingrelationships between firms. These ideas later

became the foundation for new institutional

economics. Coase argued that in order to

understand what a firm does, one must first

understand why a firm exists and, therefore,

what forces govern the organization of eco-

nomic activity. Unlike standard neoclassical

economics, the Coasian approach recognized

that there are costs to using the market mecha-

nism. T hese include the costs of discovering

what prices should be, the costs of negotiating

individual contracts for each exchange trans-

action and the costs of accurately specifying

the details of a transaction in a long-term

contract. These costs were later termed

transaction costs[5].

The costs of using the market can be avoid-

ed if a firm becomes vertically integrated and

assumes the burden of co-ordinating econom-

ic activity internally through within-firm

managerial direction. However, this means

that a firm must assume the alternative costsof administering vertical flows of products and

organizing factors of production. Provided

that a firm can carry out these activities inter-

nally at a lower cost than would be the case if

the transaction were co-ordinated through an

open market, then one would expect, all other

things being equal, the organization of eco-

nomic activities to be carried out by a vertical-

ly integrated firm. Coase argued that:a firm will tend to expand until the costs of

organising an extra transaction within the firm

become equal to the costs of carrying out thesame transaction by means of exchange on the

open market or the costs of organising in anoth-

er firm[2, p. 395].

Hence, he provided a rationale for the exis-

tence of the firm which was based on the costs

of carrying out a transaction. T hese insights,

however, did not have a major impact on

economic thought until more than 35 years

later.

In the 1970s, interest in transaction costs

increased. Pioneering work in the develop-ment of a theory of transaction costs was

carried out by Williamson[6,7]. Gradually, a

body of theories based on the concept of

transaction costs emerged; these include the

transaction cost economics of Williamson[7],

the property rights school[8-10], agency

theory[11], the economics of the multination-

al enterprise[12-14] and a transaction cost

approach to economic history[4,15].

Although focusing on separate economic

problems, these approaches all have their

roots in the original ideas of Coase[2] and use

the concept of transaction costs to explain the

organization of firms and the way in which

they interact along a supply chain. (For an

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Jill E. Hobbs


Volume 1 Number 2 1996 1527

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excellent summary of theoretical develop-

ments, empirical applications and a proposed

framework for synthesizing the transaction

and agency costs perspectives, see [16].)

Tran saction cost sTransaction costs are simply the costs of carry-

ing out any exchange, whether between firms

in a marketplace or a transfer of resources

between stages in a vertically integrated firm,

when the neoclassical assumption of perfect

and costless information is relaxed. They arise

wherever there is any form of economic orga-

nization, i.e. within a vertically integrated firm,

in a market or in a command economy (in

which market transactions are largely absent).

It should be noted that the word transactionis used in a broader context than the normal

English language usage which would not

consider the movement of a finished product

from a production line to the loading dock as a

transaction because it is co-ordinated within

the firm by managerial direction. The transac-

tion cost approach treats this as a within-

firm transaction. Unlike the frictionless

economic system implied by neoclassical

theory, T CA recognizes that transactions do

not occur without friction and labels the costs

which arise from the interaction between and

within firms as transaction costs.

It is useful to divide transaction costs into

three main classifications: information costs,

negotiation costs, and monitoring (or enforce-

ment) costs. Firms and individuals face costs

in the search for information about products,

prices, inputs and buyers or sellers. Negotia-

tion costs arise from the physical act of the

transaction, such as negotiating and writing

contracts (costs in terms of managerial exper-

tise, the hiring of lawyers, etc.), or paying forthe services of an intermediary to the transac-

tion (such as an auctioneer or a broker). M on-

itoring or enforcement costs arise after an

exchange has been negotiated. This may

involve monitoring the quality of goods from a

supplier or monitoring the behaviour of a

supplier or buyer to ensure that all the pre-

agreed terms of the transaction are met. Also

included are the costs of legally enforcing a

broken contract, should the need arise. I t

should be noted that the relaxation of neoclas-sical assumption of perfect and costless infor-

mation gives rise to all three types of transac-

tion cost (information, negotiation and moni-

toring costs). Information plays a key role in

all three cases, however, the lack of informa-

tion prior to a transaction is explicitly consid-

ered to be an information cost.

Transaction cost ana lysis ke y concept s

A number of other disciplines including

psychology, political science, economic histo-

ry and law have all contributed to the theo-

retical development of T CA. Drawn, in part,

from these associated disciplines, four key

concepts underpin TCA. T hey are bounded

rationality, opportunism, asset specificity and

informational asymmetry.

Bounded rationality

Bounded rationality means that although

people may intend to make a rational decision,their capacity to evaluate accurately all possi-

ble decision alternatives is physically limit-

ed[17]. A useful analogy is that of a chess

player who, although able to view the position

of all playing pieces on the chessboard, cannot

feasibly evaluate all potential outcomes of a

move, given an opponents counter-moves,

and given their own counter-counter moves,

and so on[18]. Bounded rationality poses a

problem only in situations of complexity or

uncertainty where the ability of people to

make a fully rational decision is impeded.

Opportunism

Opportunism has been defined by

Williamson[7, p. 234] as self-interest seeking

with guile. In other words, it recognizes that

businesses and individuals will sometimes

seek to exploit a situation to their own advan-

tage. T his does not imply that all those

involved in transactions act opportunistically

all of the time, rather, it recognizes that the

risk of opportunism is often present. T his riskis greater when there exists a small numbers

bargaining problem[7]. For example, the

fewer the number of alternative suppliers

available to a buyer, the more likely it is that an

existing supplier will act opportunistically to

alter the terms of the business relationship to

their own advantage, such as by demanding a

higher price than that previously agreed.

Asset specificity

Asset specificity arises when one partner to anexchange (firm A) has invested resources

specific to that exchange which have little or no

value in an alternative use. Examples might be

the installation of specialized machinery in a

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production plant or the development or pro-

motion of a product unique to one market.

Firm A faces the risk that its trading partner

(firm B) will act opportunistically by trying to

appropriate some of the rent from this

investment. (The term rent in this context

refers to the additional amount over and above

the minimum return firm A requires to induce

it to make the specialized investment.) K now-

ing that firm A has made a specialized invest-

ment, and is therefore locked-into the ex-

change, firm B could renege on the previous

agreement by offering firm A a lower price for

the product. Provided that this lower price

covers As operating costs and makes a contri-

bution towards the fixed cost of the investment,

A will have little choice but to accept Bs dis-

counted price offer[19]. Of course, in manycountries firm A would have recourse to con-

tract law to enforce this contract and could sue

for damages if the contract were reneged on.

However, firm A may incur legal costs and

faces uncertainty over the outcome of any

litigious action. The decision to apply the law

of contracts will probably depend on whether

the benefits to be gained from forcing firm B to

uphold its contractual obligations outweigh the

costs of legal action, allowing for the uncertain-

ty of the judicial process. T he economic rent

captured by firm B is known as specialized

appropriable quasi-rent. The opportunistic

behaviour displayed by firm B is termed post-

contractual opportunistic behaviour (PCOB)

or opportunistic recontracting.

Informational asymmetry

Transaction cost analysis also allows for

the relaxation of the full or perfect informa-

tion assumptions of neoclassical theory.

Drawing on the economics of information

literature[20-22], TCA recognizes that manybusiness exchanges are characterized by

incomplete, imperfect or asymmetrical

information. (Information incompleteness

and uncertainty refer to the situation where

all parties to a transaction face the same, but

incomplete, levels of information. Therefore,

they all face the same uncertainty. Informa-

tion asymmetry arises when there is public

information available to all parties but also

private information which is only available to

selected parties, so that all parties to thetransaction no longer possess the same levels

of information.) Informational asymmetries

can lead to opportunistic behaviour in two

ways. T he first involvesex anteopportunism

where information is hidden prior to a trans-

action. This is known as adverse selection

and was first defined by Akerlof in his 1970

seminal paper on the market for lemons.

Akerlof suggested that in a situation of asym-

metric information, a seller may possess

information about defects in a product (e.g.

a faulty second-hand car or lemon) that is

not available to the potential buyer. As a

result, the seller can act opportunistically by

failing to reveal these defects to the buyer

prior to the transaction. Buyers of second-

hand cars always face the risk that the seller

is acting opportunistically, trying to sell them

a lemon. Since buyers cannot tell the

difference between a good car and a lemon,

both cars must sell at the same market price.

At this price there will be a reduced incentivefor owners of good cars to sell them on the

second-hand market, whereas selling lemons

may still be a viable option. Lemons tend to

self-select the used car market and there is a

higher probability of purchasing a lemon in

this market. Akerlof used this reasoning to

explain why the price of new cars depreciates

so rapidly once they have been sold. Hidden

information can lead to adverse selection

and problems of opportunistic behaviour. In

some countries, contract law mitigates the

problem of adverse selection, providing

some protection to the buyer.

Moral hazard also arises from informational

asymmetry. This isex postopportunism which

occurs after a transaction because of the hidden

actions of individuals or firms. T hese parties

may have the incentive to act opportunistically

to increase their economic welfare because

their actions are not directly observable by

other parties. For example, insurance compa-

nies cannot observe the actions of their clients.

Once individuals have obtained fire insurancethey take less care in the prevention of fires,

thus leading to an increase in the incidence of

fires and an increase in insurance premiums.

Alternatively, they may act opportunistically to

damage items intentionally in order to collect

insurance payments. In either case, informa-

tion asymmetry exists because the actions (or

inaction) of the individuals are not directly

observable by the insurance provider.

The relationship bet w een t ransactioncosts and ver tical co-ord inatio n

Transaction costs are important because they

affect the organization of economic activity or

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vertical co-ordination. (Some writers refer

to this as the governance structure of con-

tractual relations, notably Williamson[6,7],

who invented the term.) According to M ighell

and Jones, vertical co-ordination:includes all the ways of harmonizing the

successive vertical stages of production andmarketing. The market-price system, vertical

integration, contracting, cooperation singly or in

combination are some of the alternative means

of coordination[23, p. 1].

Thus, there is always some kind of vertical co-

ordination if any production takes place. Of

course, vertical co-ordination is central to the

study of supply chain management.

Vertical co-ordination can be viewed as a

continuum. At one extreme lie spot markets

where goods are exchanged between multiplebuyers and sellers in the current time period,

with price as the sole determinant of the final

transaction. In other words, other aspects of

the transaction are non-negotiable the buyer

either accepts the product in its current form,

or does not purchase it. (Negotiation over

product quality, delivery schedules, etc. would

constitute a more formal exchange relation-

ship often resulting in some form of contract.)

Examples of spot markets are auction mar-

kets, stock markets and most consumer good

purchases (e.g. purchases of food in a super-

market). In a spot market transaction, man-

agement of the supply chain, in any formal

sense, is entirely absent. At the other end of

the vertical co-ordination spectrum lies full

vertical integration, where products move

between various stages of the production-

processing-distribution chain as a result of

within-firm managerial orders rather than at

the direction of prices.

In between the two extremes of spot market

transactions and vertically integrated firms liea myriad alternative ways of co-ordinating

economic activity, from strategic alliances and

formal written contracts, to vertical integra-

tion. These represent different degrees of

supply chain management some more for-

mal than others. A strategic alliance is an

agreement mutually entered into by two

independent firms to serve a common strate-

gic objective. I t is often more flexible than a

contract or full vertical integration. Central to

the success of a strategic alliance are trust

between firms and a strategy which is to the

mutual benefit of all the participants; some-

times the alliance may also place legal obliga-

tions on the parties. For example, a meat

processor might reach an agreement with a

group of pig producers to obtain finished pigs

of a certain quality, providing producers with

a list of acceptable breeders. A meat processor

might also introduce a high-quality packaged

pork product jointly developed with a major

retailer under a strategic alliance[24].

Under a contract, a firm usually devolves

control over various aspects of the supply

chain i.e. marketing and/or production of its

product to a buyer. Contracts can be classi-

fied into three broad groups[23]:

(1) Market specification contracts represent

an agreement by a buyer to provide a

market for a sellers output. T he seller

transfers some risk and the decisions over

when the product is sold and how it is

marketed to the buyer. Control over theproduction process, however, remains

with the seller.

(2) A production-management contract gives

more control to the buyer than a market-

specification contract. The buyer partici-

pates in production management through

inspecting production processes and

specifying input usage.

(3) Even more control rests with the buyer in

the case of resource-providing contracts in

which the buyer provides a market outletfor the product, supervises its production

and supplies key inputs. Often, the buyer

may own the product, with the seller paid

according to the volume of output. This is

the closest contractual arrangement to full

vertical integration. For example, a feed-

stuffs manufacturer might contract with

pig producers, supplying feedstuffs, over-

seeing production methods and market-

ing the finished pigs.

Quasi-vertical integration refers to a relation-ship between buyers and sellers that involves a

long-term contractual obligation where both

parties invest resources in the relationship. It

differs from full vertical integration because

the arrangement ceases at the end of an agreed

period of time and the firms remain indepen-

dent of one another. A joint venture is one

example of quasi-integration. Participants

share the costs, risks, profits and losses of the

venture. Franchises and licences are other

examples of quasi-vertical integration.

Tapered vertical integration occurs when a

firm obtains a proportion of its inputs through

backward integration with a supplier. For

example, a beef processing firm integrated

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backwards into beef production could obtain a

proportion of its beef supplies from its own

farms with the remainder procured from

auction markets or direct from beef produc-

ers. Alternatively, a firm could transfer a

proportion of output forward through its own

distribution network with the remainder sold

on the open market.

Full vertical integration occurs when one

firm carries out two or more consecutive

stages of the production-distribution chain. A

firm can be integrated forwards (downstream)

into distribution or retail functions or back-

wards (upstream) into supply functions.

According to TCA, one of the determi-

nants of vertical co-ordination is the nature

and level of transaction costs, wherein a

change in the transaction costs arising fromthe exchange of a product may lead to a

change in the management of that supply

chain[25]. In this context, the key characteris-

tics of transactions are:

the degree of uncertainty surrounding the

transaction;

the degree of asset specificity; and

the frequency of the transactions[7].

A low level of uncertainty lends itself to spot

market transactions. When aspects of the

transaction (such as quality characteristics)are highly uncertain, a more formal type of

vertical co-ordination where one party has

more control over the outcome of the transac-

tion may result, e.g. a strategic alliance, a

contract or some form of vertical integration.

Goods which are non-specific in nature, or

produced with non-specific assets, have many

alternative uses and would tend to be sold in a

spot market. As asset specificity increases, we

move along the spectrum of vertical co-ordi-

nation towards a more formal type of supplychain management such as vertical integra-

tion. Whether the result is a strategic alliance,

a long-term contract or full vertical integra-

tion may depend on whether one party, or

both, make an asset specific investment[26].

When transactions are carried out fre-

quently, both buyer and seller will probably

value repeat business and will not wish to

tarnish their reputations by acting opportunis-

tically. Frequent transactions also provide

buyers and sellers with information about one

another. For these reasons, transactions

repeated frequently tend to be carried out in

the spot market. As transactions become more

infrequent, however, the incentive to act

opportunistically and to exploit any informa-

tional asymmetries that may be present

increases and we move further along the

continuum of vertical co-ordination towards

the extreme of vertical integration.

The economic theory underlying TCA

provides considerable insights for supply

chain management. A large number of

testable hypotheses regarding supply chain

management can be devised using the theoret-

ical framework of TCA. Testable hypotheses,

however, require information about transac-

tion costs. L imited information has inhibited

the use of T CA in the study of supply chains.

M et hodo logical issues in measuring

transaction costsOne of the problems with TCA is that suc-

cessful measurement of transaction costs has

not kept pace with theoretical developments.

This is perhaps not surprising, since, unlike

production costs, transaction costs the costs

of economic organization are neither easy to

separate from other managerial costs nor

readily measurable. (T he problem is analo-

gous to the difficulty accountants have in

assigning costs of jointly used assets to indi-

vidual enterprises in a multiple enterprisefirm.) T he complex nature of companies and

market institutions means that the costs of

their operation are not easy to quantify and

the data which one might use to measure

transaction costs are not usually collected by

governments or by the standard accountancy

practices of firms. Although one can recognize

that there are indeed costs involved in valuing

a good or in monitoring the actions of a buyer

or seller, it is difficult to measure these costs in

financial terms. Until, and indeed if, the datanecessary for this type of estimation are ever

recorded by firms, an accounting approach to

empiricizing the transaction cost approach is

impractical.

Economists have turned instead to other

ways of measuring transaction costs. These

applications can be divided into three broad

types, each representing different methodolo-

gies with different data requirements and each

varying in the type of information which they

provide about transactions:

(1) those that evaluate the effect of transac-

tion costs on vertical co-ordination (pri-

marily vertical integration) across indus-

tries using secondary data sources;

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(2) industry-specific investigations of the

impact of transaction costs on vertical co-

ordination using secondary data; and

(3) industry-specific investigations of the

impact of transaction costs on vertical co-

ordination using primary data.

The discussion that follows is intended to be

indicative of the types of analyses carried out

rather than a comprehensive review of all

applications of TCA. (M ahoney[16] discusses

several examples of empirical research into the

vertical integration decision and summarizes

the methodologies used to measure vertical

integration, uncertainty and asset specificity.)

M ulti- industry evaluations of vert ical

co-ordina tion using secondary dat a

In an assessment of the transaction cost

approach to vertical integration, L evy[27]

presents a multi-industry study. Using a

sample of 69 firms from 37 different industries

over a four-year period, the author hypothe-

sizes that vertical integration, as measured by

the ratio of value-added to sales, is determined

by the costs of transacting through markets as

well as the costs of management. Levy is

forced to use proxy measures of transaction

costs; for example, a variable measuring theintensity of research and development expen-

ditures is used to proxy asset specificity. T he

minimum efficient plant scale relative to

industry sales, a four-firm concentration ratio

and the degree of diversification of the firm

are other examples of variables used to explain

vertical integration. M any of the variables

used by L evy only indirectly measure transac-

tion costs. Although the results indicate a high

degree of explanatory power for the model,

because many of the explanatory variables aremeasures of the degree of imperfect competi-

tion rather than measures of transaction costs,

the only conclusion that can be drawn is that

transaction costs are one of a number of fac-

tors that can lead to vertical integration.

An empirical analysis of the effect of

transaction costs on vertical co-ordination in

US food industries is provided by Frank and

Henderson[28]. (T here is a growing litera-

ture discussing the concepts of vertical co-

ordination and transaction costs in relation

to agriculture and food markets see [24,29-

31] however, there have been few attempts

to empiricize these insights.) Working at a

fairly disaggregated level across several food

industries, they develop a vertical co-ordi-

nation index to measure the extent of verti-

cal co-ordination in an industry. T he index

has two parts. F irst, it includes an input-

output transactions matrix to calculate inter-

dependencies between firms in an industry.

Second, it includes a measure of the degree

of administrative control over transactions.

This is measured by the percentages of farm

commodities procured through spot mar-

kets, through market specification, produc-

tion management and resource providing

contracts as defined by M ighell and

Jones[23] or through vertical integration.

The resulting vertical co-ordination index

ranges from zero (spot markets) to one (ver-

tical integration).

The index is regressed against proxy mea-surements of transaction costs divided into

four categories: uncertainty, industry concen-

tration, asset specificity and the costs of

administering vertical co-ordination:

(1) As uncertainty rises we expect vertical

integration to increase because it is no

longer possible to specify fully all contin-

gencies in a contract. T he uncertainty

surrounding food manufacturers input

supply is measured by the percentage

change in farm output supply between1981 and 1982.

(2) Increasing concentration leads to a small

numbers bargaining problem. A four

firm concentration ratio measures concen-

tration in food manufacturing industries.

(3) As asset specificity rises, an increase in

non-market vertical co-ordination is

expected. Variables used to measure this

include an advertising to sales ratio and a

research and development expenditure to

sales ratio for food industries.

(4) As the costs of administering within-firm

vertical co-ordination rise, a reduction in

vertical integration is expected. The

authors identify a number of characteris-

tics of firms which affect the internaliza-

tion of transactions (e.g. capital intensity)

and use proxy measures of these charac-

teristics (e.g. a capital to sales ratio) to

measure the costs of administering verti-

cal co-ordination.

Although not all of the variables used were

significant, the authors conclude that transac-

tion costs are a primary determinant of verti-

cal co-ordination. Due to the lack of adequate

data for measuring transaction costs, Frank

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and Henderson[28] resorted to the use of

industry characteristics as indirect proxy

measurements of transaction costs. Conse-

quently, this approach was not able to mea-

sure directly the effects of specific transaction

costs on vertical co-ordination.

Industry-specific investigat ions oft ransaction cost s using seconda ry dat a

Lieberman[32] assesses demand variability

and transaction costs as factors jointly influ-

encing vertical integration. (When the fluctu-

ating demand of other buyers affects the price

of an input, firms with stable input require-

ments may integrate backwards to avoid

paying a premium for the input.) Although the

example used for the analysis is drawn fromthe chemical industry, the authors primary

concern is to provide insights regarding these

two causes of vertical integration which have a

wider applicability. Using regression analysis,

the dependent variable is a dummy variable

equal to one if the firm manufactures its pri-

mary input and zero if it does not. A number

of proxy measures of transaction costs and

demand variability are used as explanatory

variables. For example, the reciprocal of the

number of upstream firms is used to measure

supplier concentration (an indicator of the

small-numbers-bargaining problem outlined

by Williamson[7]); the total fixed investment

cost of the firms downstream plant is used to

proxy asset specificity, together with a dummy

variable to measure whether the upstream

input is a gas (since this would necessitate a

large fixed investment in a pipeline between

plants). The results indicate that both transac-

tion costs and demand variability can lead to

vertical integration.

Globerman and Schwindts[33] analysis ofthe organization of transactions in the Cana-

dian forest products industries avoids the

need to obtain actual measurements of trans-

action costs. M any transactions along the

chain from timber production to its various

end-uses such as construction, paper produc-

tion and newspaper production involve asset

specific investments a characteristic of

transactions which TCA indicates should lead

to within-firm hierarchical, rather than market

forms, of organization, i.e. to verticalintegration. Given the practical difficulties of

obtaining reliable measurements of transac-

tion costs, the authors adopt instead what

they call a more pragmatic inductive

approach[33, p. 201]. They examine the

organization of the forest products industries

to identify any anomalies between the

observed industry structure and the predic-

tions of TCA. All but one of Canadas 30

largest forest products enterprises were inte-

grated backwards into the ownership of

timber rights. T imber mills are a highly

dedicated asset, therefore mill operators are

vulnerable to post-contractual opportunistic

behaviour. Backward integration by mill

owners (the purchase of licences or of the

rights to log) is consistent with the TCA

model. Similar inductive reasoning suggested

that the vertical co-ordination arrangements

between pulp/paper making activities and

newsprint manufacturers were consistent with

the predictions of T CA. T he authors con-clude that the major vertical linkages within

the industry comply with the predictions of

TCA and that transactional considerations, in

particular asset specificity, are important

determinants of vertical co-ordination.

Industry-specific investiga tion s oftra nsaction costs using prim ary d at a

Evaluating the determinants of vertical co-

ordination at a general, multi-industry level isextremely difficult due to data limitations.

The available published data sources often

require the researcher to construct indirect

and potentially confusing proxy measures of

transaction costs. For this reason, most empir-

ical work regarding transaction costs has been

carried out on an individual industry level or

at an even narrower level on a case study

basis. However, this approach also faces data

limitations. In addition, it has been criticized

on the grounds that the results are not neces-

sarily representative of the wider economicenvironment[27,34]. However, for the devel-

opment of a credible empirical alternative to

the measurement of transaction costs, the

necessary transaction cost information would

have to be collected on a routine basis, which

it clearly is not. As Coase has lamented:just as important at the present stage would

be the gathering in a systematic way of new data

on the organization of industry so that we can

be better aware of what it is that we must

explain[35, p. 69).

Given the problems of using secondary data to

measure transaction costs, a more appropriate

approach would be to use data which specifi-

cally measure different transaction costs at the

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level of the individual firm. Unfortunately, the

accounting and management practices of

most firms do not routinely collect this type of

information. Thus, if researchers wish to

apply TCA without recourse to general indus-

try-level data to approximate transaction

costs, it is likely that they will have to collect

the data themselves through surveys of indus-

try participants. C learly the researcher faces a

trade-off: the use of surveys to collect primary

data about transaction costs would be time

consuming and resource intensive but should

allow a more accurate measurement of these

costs than the use of secondary data.

Using a case-study approach, H allwood[36]

presents a detailed study of the organization of

offshore oil production. One of the objectives

of this study was to determine whether theorganizational features of the industry are

consistent with the predictions of the transac-

tion cost paradigm. Data were collected

through a series of interviews with oil compa-

nies and offshore oil supply firms. Generally

speaking, oil companies are not integrated

backwards into input supply firms; instead, an

invited tender bid auction system is used by oil

companies to purchase most supply equip-

ment. Under this system, oil companies invite a

number of supply firms to submit sealed bids

for the provision of an intermediate good or

service; the bidder with the lowest price wins

the supply contract. Using data from the survey

of oil supply companies, Hallwood shows that

the nature of transactions in this industry, i.e.

their frequency, the potential for opportunistic

behaviour and the extent of information asym-

metry, affect vertical co-ordination in ways

which conform to the predictions of TCA.

The invited tender bid system is the preferred

method of vertical co-ordination for many

intermediate inputs because of lower transac-tion costs, which include lower information

and monitoring costs. T he multinational

nature of the offshore oil supply industry is

also explained as an attempt by firms to mini-

mize transaction costs, particularly to guard

against the risks arising from a high level of

asset specificity.

An alternative to a descriptive case-study

approach is to survey industry participants to

identify individual transaction costs and then

measure the effect of these costs on the organi-zation of supply chains. The first step would

be to identify the industry participants and the

vertical co-ordination relationships which

exist. Are there separate firms carrying out

separate functions along the supply chain, or

are some stages conducted within a vertically

integrated firm? Do suppliers/buyers along the

chain transact through the use of open spot

markets, contracts, strategic alliances, joint

ventures, etc. or through a combination of

these? What are the characteristics of these

vertical co-ordination arrangements, for

example, do spot markets take the form of

auctions, electronic auctions or physical

marketplaces? Do government, quasi-govern-

ment institutions or marketing boards, etc.

play a role? A thorough profile of the industry

structure and the vertical co-ordination link-

ages between industry participants must be

developed before any analysis can be under-

taken.

Once an industry profile has been devel-oped, the potential transaction costs which

industry participants may face can be identi-

fied. T his process is often easier if the transac-

tion costs are separated into information,

negotiation and monitoring costs. A method-

ology for analysing the transaction costs must

then be chosen. Two such methodologies are

proposed here. The first is the more resource

intensive of the two but yields more detailed

information regarding transaction costs. An

in-depth survey of industry participants at one

or more levels (e.g. producers, processors

and/or retailers) can be carried out to identify

and measure the important transaction costs

facing those firms. T he challenge is to design

survey questions which accurately describe

the transaction costs, convey this information

clearly to survey respondents and obtain

responses which can be meaningfully

analysed.

This approach was used recently in an

analysis of the marketing channel alternatives

(live-ring auction sales, electronic auctionsales, direct sales to processor or sales through

a group marketing scheme) available to Scot-

tish farmers selling finished cattle[37]. For

each of the marketing channel options, a list of

possible information, negotiation and moni-

toring costs was compiled. Examples of infor-

mation costs incurred when selling cattle

through a live-ring auction were the costs of

obtaining information on likely auction prices

and the price uncertainty associated in selling

through an auction. Possible negotiation costsincluded the time and cost of transporting

cattle to the auction and attending an auction

sale. When selling cattle deadweight (direct to

an abattoir) a potential monitoring cost would

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be the grade uncertainty which farmers face as

they cannot know how their cattle will grade

before they are slaughtered. Also, there is a

degree of grade information asymmetry as

farmers may not trust the deadweight grad-

ing system. T hese, and the other transaction

costs identified, will influence the farmers

choice of marketing channel[38].

What type of information should be collect-

ed? How should this information be analysed?

Clearly, these questions are related. While it is

possible to obtain monetary valuations of

some transaction costs, e.g. transportation

costs to/from an auction mart, survey respon-

dents would find it difficult, if not impossible,

to provide monetary estimates of other trans-

action costs. Sometimes the analyst can imply

a monetary value, for example, a respondentcan provide an estimate of the time taken to

attend an auction sale and this can be assigned

a monetary value using a shadow wage for the

opportunity cost of the farmers time. Unfor-

tunately, monetary values cannot be assigned

to all transaction costs. The monitoring costs

involved in grade information asymmetry

would be extremely difficult to value in mone-

tary terms without detailed (and accurate)

information on the probability of an incorrect

grade being applied to a carcase and an esti-

mate of the average loss incurred by the

farmer for an incorrect grade evaluation.

Unless this type of information is routinely

collected by those carrying out the grading,

the data requirements become unrealistic.

Instead, transaction cost data can be used

in an econometric analysis of the choice of

marketing channel, where the vertical co-

ordination outcome is the dependent variable

and the dependent variables are transaction

costs. H obbs[37] collected data from a survey

of 110 farmers in NE Scotland, includinginformation on the proportion of a farmers

cattle sold through each marketing channel

over an 18-month period. T his was the inde-

pendent variable in the econometric analysis.

The dependent variables were various infor-

mation, negotiation and monitoring costs

arising from the use of each marketing chan-

nel, together with a number of socio-econom-

ic and farm characteristic variables. Although

it was possible to obtain direct approximations

for some transaction costs (e.g. distance to theauction mart or abattoir as a measurement of

transportation costs, percentage commission,

etc.) most were categorical variables. Respon-

dents were asked to rate whether different

transaction cost aspects of using a marketing

channel were a problem. A scale of 1 (not a

problem) to 5 (major problem) was used. For

example, farmers were asked whether it was a

problem that cattle may not grade as expected

when selling deadweight (a measure of grade

uncertainty); they were asked whether not

being present at the abattoir when cattle were

graded was a problem (a measure of grade

information asymmetry). T he time spent

attending an auction sale or obtaining price

information about auction and deadweight

markets was measured in hours. Data were

collected on 24 transaction cost variables.

This enabled a regression of the proportion of

cattle sold through live-ring auctions (versus

direct to abattoirs) against the transaction cost

and farm/farmer characteristic variables. Fivetransaction cost variables and three farm

characteristic variables were found to be

significant in determining the farmers choice

of marketing channel. (For further informa-

tion regarding these results or for copies of the

questionnaire, see Hobbs[37].)

The advantage of this methodology is that a

comprehensive analysis of a large number of

potential transaction costs is possible. The

important transaction costs can be identified

and the extent to which they influence vertical

co-ordination is indicated by the size of the

regression coefficient. The level of detail

required in the questionnaire means that

personal interview-style surveys may be the

only practical way of collecting these data.

This is relatively resource intensive. The

success of this method depends crucially on

the careful design of questions to elicit the

appropriate information from respondents.

A second analytical method which uses

survey data provides less detailed information

but is potentially less resource intensive. Thesupply channel (or marketing channel) options

available to a firm can be described in terms of

their key transaction cost attributes. Again, this

requires the analyst to have developed, through

consultation with industry representatives, a

detailed profile of the industry structure and its

vertical linkages. Having identified the key

transaction cost attributes of the supply (mar-

keting) channel, a series of hypothetical chan-

nel scenarios can be developed using different

combinations of these transaction cost attribut-es. Survey respondents are asked to rank or rate

the channel scenarios in terms of preference.

A regression analysis of the preference scores

against the scenario attributes indicates the

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extent to which respondents are willing to

trade-off levels of one attribute for another and

provides a measure of the relative importance

of each transaction cost. Results are available at

both an individual respondent level and for the

whole sample. T his approach is known as

conjoint analysis. (For more information about

the use of conjoint analysis, see [39-41].)

Hobbs[37] used conjoint analysis to

analyse the importance of key transaction

costs in determining the preferences of UK

meat processors for different beef supply

channels. Pre-survey interviews with industry

representatives enabled a list of possible trans-

action cost attributes to be reduced to four.

These were: continuity of supply (long-term

regular suppliers reduce a processors infor-

mation and monitoring costs); the transporta-tion of cattle to the abattoir (direct transporta-

tion from farm to processor reduces the

buyers monitoring costs, imposes less stress

on the animals and gives the processor greater

control over the timing of delivery); basis of

payment (if the processor pays on a per kilo

liveweight basis, it incurs the uncertainty that

cattle may not grade as expected, if payment is

on a deadweight carcase grade basis, the grade

uncertainty remains with the farmer); trace-

ability of cattle (easy traceability lowers moni-

toring costs for buyers). Scenarios were devel-

oped using different combinations of these

attribute levels and abattoirs were asked to

rate each scenario on a preference scale.

(Further details of the methodology, question-

naire and results can be found in [37].)

Similarly, conjoint analysis has been used

to assess the importance of key transaction

costs in determining the preferences of UK

supermarket beef buyers[37]. Three key

transaction costs were identified and com-

bined in scenarios along with an attributerepresenting price. T hese attributes were

chosen through pre-survey interviews with

industry representatives.

The results of both conjoint analyses pro-

vided information on the relative importance

of the transaction costs. Different supply

channels exhibit these transaction costs to a

greater or lesser degree. Predictions can be

made regarding the consequences for supply

chain management of changes in the market-

ing or policy environment which alter thesetransaction costs.

Conjoint analysis requires that a small

number of transaction cost attributes be used.

A large number of attributes would make the

survey respondents task of evaluating the

scenarios impossible. I t does not, therefore,

generate as much information about individ-

ual transaction costs as the econometric

methodology described earlier. However, it

enables an evaluation of the extent to which

industry participants will trade-off transaction

costs. Furthermore, it may be less resource

intensive because the surveys can be carried

out by mail or by telephone.

Neither of the econometric or conjoint

methodologies discussed above provides a

monetary or percentage measurement of the

size of individual transaction costs. Perhaps

this is not necessary. Perceiving transaction

costs as a measurable cost in the accounting

sense of the word, or as a margin analogous

to a marketing margin may be misguided. T henature of transaction costs is more subtle than

either of these two interpretations allow.

Instead, methodologies which identify the

significant transaction costs and measure their

importance (whether in absolute or relative

terms) may suffice. Certainly, this improves

our understanding of supply chain manage-

ment and can indicate which transaction costs

should be reduced in order to enhance the

efficiency of vertical co-ordination within

supply chains.

There are many potential pitfalls when

using primary data to measure transaction

costs. The subtle nature of these costs means

that great care must be taken in the design of

questions. Some industry sectors are highly

concentrated; this leads to additional prob-

lems. First, the confidentiality of survey

respondents must be protected; firms may be

unwilling to provide information which they

regard to be of a commercially sensitive

nature. Any reluctance to take part in surveys

could seriously damage the statistical reliabili-ty of the results, particularly if the industry

sector comprises a small number of firms.

Second, surveys of highly concentrated indus-

tries are necessarily based on the responses of

a very small number of firms, even if all firms

participated. T his is the case for analyses of

the UK supermarket retailing sector, for

example. T hese problems notwithstanding,

until the data which measure information,

negotiation and monitoring costs are routinely

collected by firms or by government agencies,analysts wishing to apply T CA to supply chain

management will probably have to collect

their own data through the use of industry

surveys.

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Conclusions

In order to further our understanding of the

intricacies of supply chain management we

need frameworks in which to test theories

about supply chain management. Drawing

from the new institutional economics litera-ture, transaction cost analysis may be one such

framework. I t provides an explanation for the

existence and structure of firms and for the

nature of vertical co-ordination within a

supply chain. Empirical measurement of the

effect of transaction costs on vertical co-

ordination appears to be rare in the main-

stream economics literature but even rarer in

the agricultural and food economics literature.

The insights which TCA provides into the

nature of vertical co-ordination need to be

empirically verified through micro-analytical

studies of supply chains. A convergence of

interests is thus suggested for joint research.

Transaction costs, and their reduction, lie

at the heart of the interest in supply chain

management. Proactive moves to enhance

management of supply chains are fundamen-

tally concerned with improving their efficiency

to gain competitive advantage. Adversarial

relationships along the supply chain increase

transaction costs. Co-operation, teamwork

and the rapid interchange of data amongcompanies in a supply chain will reduce trans-

action costs. To gain a better understanding of

how these new relationships reduce costs,

those who wish to undertake analyses of

transaction costs require information infor-

mation only firms can provide. If firms do not

collect information which can be used to

analyse transaction costs, then their co-opera-

tion in the collection of survey data is essen-

tial.

Here lies the challenge facing researchersand business practitioners alike to co-oper-

ate in carrying out applied research into

aspects of supply chain management. A few

successful attempts have been made to empiri-

cize the insights provided by TCA using data

collected from individual firms. Requests for

information from businesses need to be stated

clearly and be capable of being satisfied by a

reasonable amount of effort from a firms

managers.

The contribution of businesses to research

efforts relating to supply chain management

need not involve any proprietary or sensitive

information. It will, however, involve taking

time to answer questions, to provide input into

the research agenda itself and to understand

the requirements of those conducting the

research. Researchers, on the other hand,

must be sensitive to the concerns of those

providing information relating to their activi-

ties. In the past, this co-operation was not well

developed, meaning that empirical analysis

was confined to what was possible with pub-

lished information largely within the con-

straints of the neoclassical paradigm and

companies were frustrated with the types of

information available. Transaction cost analy-

sis appears to provide a means to bridge the

gap between those interested in the results of

research and those who can provide the

research.

Notes and references

1 Cheung, S.N.S., On the new inst i tut ional economics ,

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2 Coase, R.H. , The natu re of the fi rm , Economica,

Vol. 4,1937, pp. 386-405.

3 Eggertsson, T. , Econom ic Behaviour and Institu tions,

Cambridge Surveys of Economic Literature, Cambridge

University Press, Cambridge,1990.

4 North, D.C., Inst i tut ions, t ransact ion costs and

economic growth , Economi c Inquiry, Vol. 25 No. 3,

1987, pp. 419-28.5 Arrow, K.J. , The organizat ion of economic act iv i ty:

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6 Wi l l iamson, O.E. , M arkets and Hierarchies: Analysis

and Ant i-Trust Implications: A Study in th e Economics

of Organization, Free Press, New York, N Y, 197 5.

7 Wil l iamson, O.E., Transact ion cost economics: the

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and Economics, Vol. 22, 1979, pp. 233-62.

8 Alchian, A.A. , Some economics of proper ty r ights ,

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9 Demsetz, H. , Toward a theory of proper ty rights ,

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Clarendon Press, Oxford, 199 1.

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14 Teece, D.J., Transaction cost economics and the

mult inational enterprise: an assessment , Journal of

Economi c Behavior and Organization, Vol. 7, 1986,

pp. 21-45.

15 North, D.C. and Thomas, R.P., The Rise of the W estern

World: A New Econom ic History, Cambridge University

Press, Cambri dge, 1973 .16 M ahoney, J.T. , The choice of organizat ional form:

vertical financial ow nership versus other meth ods of

ver t ica l in tegrat ion , Strategic M anagement Journal,

Vol. 13, 1992, pp. 559-84.

1 7 Si m on , H ., Adm inistrative Behavior, 2nd ed., M acmil-

lan, New York, NY, 196 1.

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Organizations, Prentice Hall International (UK), Hemel

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25 Note that t ransact ion costs are only one of a number

of pot ential determinant s of vertical co-ordination . For

example, the existence of econom ies and disec-

onom ies of scale influence wh ether it is econom ically

efficient for a fi rm to be vertically integrated. Also, the

capital investment requirements and addit ional r isks

involved in vertical integration could out w eigh any

transaction cost advantages of integration. Some-

tim es, firm s vertically integrate to reduce their taxa-

tion bu rdens or to circumvent restr ictive import

regulations. Although these other infl uences areimpo rtant, this paper deals w ith transaction cost

mot ivations for vertical co-ordination.

26 I f only one par ty (A) has made an asset specific

investment, it is probably party A that w il l vertically

integrate w ith th e other party (B) because of the r isk of

B practising PCOB. Wh ere both parties have made an

asset specific investment, either vertical int egration, a

long-term contract or a strategic all iance may result.

The outcome w ill depend on other features of the

transaction, such as the level of uncertainty.

27 Levy, D.T., The transactions cost approach to vertical

integrat ion: an empir ical examinat ion , Review of

Economi cs and Statist ics, Vol. 67, 1985, pp. 438-45.

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industr ies , American Journal of Agricultural Econom-

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food system , presented at the spring meeting of the

Federal Reserve System Committee on Agriculture andRural Development , Kansas City, M O, 20 M ay 1993.

30 Sonka, S.T. , New Industries in Agriculture: Concepts,

Issues and Oppo rtunit ies, mimeo, Department of

Agricultural Econom ics, University of I l l inois at

Urbana-Champaign, IL, 1992.

31 M asten, S.E. , Transact ion-cost economics and the

organization of agricultural transactions , presented

at th e NC-194 Wo rld Food Systems Project Sympo-

sium, Examin ing t he Econo mic Theory Base for Vertical

Coordination, Chicago, IL, 17-18 October 19 91.

32 Lieberman, M., Determinants of ver t ical in tegrat ion:

an empir ical test , The Journal of Industrial

Economics, Vol. 39 No. 5, 1991, p. 451-66.33 Globerman, S. and Schwindt , R., The organizat ion of

vertically related transactions in t he Canadian forest

products industries , Journal of Economic Behavior

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the sources of growth , The Econom ic Journ al, Vol. 96

No. 384, December 1986, pp. 903-18.

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research , in Fuchs, V.R. (Ed.), Policy Issues and

Research Opportun it ies in Industrial Organization,

Nat ional Bu reau of Econom ic Research, New York, NY,

1972, pp. 59-73.

3 6 Ha ll w oo d, Transaction Costs and Trade between

M ultinat ional Corporations: A Study of Offshore Oil

Production, Unwin Hyman, Boston, M A, 1990.

37 Hobbs, J.E., A t ransaction cost analysis of beef

marketing in t he UK , unpublished PhD thesis,

Department of Agriculture, University of A berdeen,

Scotland, 199 5.

38 Clear ly, other non- transact ion cost factors may

infl uence a farmers choice of marketing channel.

How ever, the purpose was to identify im portant

transaction costs. Also, the transaction costs incurred

by processors in purchasing fin ished beef catt le w il l

affect their choice of supply channel, thereforeinfl uencing vertical co-ordination in t he supply chain.

The same survey metho d could be used to id entify the

import ant transaction costs facing p rocessors.

39 Hair, J.F. Jr, And erson, R.E., Tatha m, R.L. and

Black, W.C., M ultivariate Data Analysis w ith Readings,

3rd ed., M acmillan, New York, NY, 1992.

40 Steenkamp, J.B.E.M., Conjo int measurement in ham

qual i ty evaluat ion , Journal of Agricultural Economics,

Vol. 38 No. 3, 1987, pp. 473-80.

41 Wit t ink, D.R., Vr iens, M. and Burhenne, W., Commer-

cial uses of conj oint analysis in Europ e: result s and

crit ical reflections , International Journal of Research

in Market ing, Vol. 11 No. 1, 1994, pp. 41-52.

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