Oliver Williamson and Transaction Cost Economics

The theories of Transaction Cost Economics originated in the paper “The Nature of the Firm” by Ronald Coase who was awarded the Nobel Prize in 1991. Coase wondered “if the price mechanism is the most efficient mechanism for allocating resources in a market economy, why do firms exist?” “why does a firm emerge at all in a specialized exchange economy”, and “why coordination is the work of the price mechanism in one case and of the entrepreneur in another”.
Coase’s answer was that economic agents incurred transaction costs when using the price mechanism. The greater the number, and the complexity, of transactions, the greater the costs involved in transacting. According to Coase, the firm should not be studied in isolation as a production function to be optimized. Instead, the transaction should be made the basic unit of analysis and the firm should be seen as one of several alternative ways of organizing transactions.
Williamson, following in Coase’s footsteps, elaborated on the reasons that transactions were costly. Uncertainty, complexity, informational asymmetry, and opportunism were inherent to transactions, which made it difficult to coordinate highly interdependent production and distribution processes through the market mechanism alone.
According to Williamson, firms emerged primarily to reduce the costs of transactions. Firms merge with other firms to bring more activities within one governance structure
Transaction costs consist of search costs, bargaining costs, contracting costs, risk costs, monitoring costs and enforcement costs. The basic premise of transaction cost analysis is that costs associated with transactions vary with the characteristics of the transaction, and different organizational forms are better suited to economize costs for transactions with different characteristics. Transaction cost economics is about finding the most economic organizational form given the characteristics of a transaction.
So viewed through the lens of transaction cost economics, outsourcing should take place when internal transaction costs for producing a good or a service are higher than the market costs, and should be outsourced to a vendor who has a relative advantage in delivering the service.