Basic Predictions of Transaction Cost Economics

Transaction Cost Economics (TCE) provides a framework to explain how firms choose among governance structures—markets, hierarchies, or hybrids—based on the characteristics of transactions. The core insight is that transactions differ in ways that affect the efficiency of different governance modes. Two attributes stand out: asset specificity, which refers to how tailored an asset is to a particular relationship, and appropriability, the risk of knowledge leakage. When asset specificity is low, spot markets are efficient: they involve low setup costs, allow for strong performance incentives, and are easy to exit. But as specificity increases, parties become vulnerable to opportunism, and market governance becomes costly and risky. In such cases, vertical integration—governing the transaction within the firm—offers more secure coordination. The same logic applies to situations of high uncertainty or transaction frequency, which amplify contractual hazards and justify internal governance. TCE predicts a shift from market to hierarchy as these factors rise.

Beyond the make-or-buy decision, TCE has been extended to corporate diversification, multinational expansion, and strategic alliances. In each case, the theory predicts that firms will internalize activities when contracting exposes them to significant hold-up risks or when proprietary knowledge is at stake. Intermediate forms of governance—like alliances—arise when asset specificity and coordination needs are neither low enough for markets nor high enough to justify full integration. The more complex or knowledge-sensitive the transaction, the more alliance structures resemble firm hierarchies, sometimes even forming joint ventures. Empirical studies across industries consistently support TCE’s core predictions, showing that organizations adapt governance structures in a cost-minimizing and discriminating manner.

[https://www.learnioe.org/video/basic-predictions-of-transaction-cost-economics](See more...)