Transaction cost economics

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Vertical chain and vertical integrated firms
Vertical chain is a process that starts with raw materials and ends with the final product, which can be either a product or a service.
The central issue that companies face is whether to integrate the vertical chain and become a vertical integrated firm, which means that all is done “in house,” or to use the market in order to carry out some or allthe different tasks into which the vertical chain is divided. One example of the vertical integration is most of the airline companies: they now internally carry out tasks traditionally linked to the travel agencies and have also vertically integrated suppliers’ tasks such as aircraft maintenance and catering.
How to resolve this dilemma? Companies have to compare the relation costs/benefitsof using the market to performing these themselves.
Market firms
When firms decide to outsource some their activities, they buy them from a market firm. Market firms are companies that are specialized and leaders in their areas (e.g. DHL in the logistics field or Oracle in the hardware and software solutions sector).
The main reason why companies decide to use market firms is to be able toproduce at lower costs (market firms may have special information and /or patents). Additionally, they could exploit economies of scale if the market firms accumulate the production of several firms. They also might take advantage of the learning economies by means of knowledge based on the experience of the market firms.

Some of the most descriptive examples of exploiting economies of scale byusing market firms are the transport companies: if all single producers have to assign resources for the product be delivered to different customers, it is less efficient than if one single intermediary (or market firm) using each shipment to deliver the products of several producers.
By using market firms, companies will also be able to get rid of the costs associated with the principal-agentrelationship (agency costs), the costs derived from influence activities (to try to convince the management of taking or don’t certain actions), together with the possible costs of the company’s bad decision internally. On the other hand, if companies use market firms, they are exposed to several costs derived from the lack of coordination, absence of information flow and transaction costs.Limitations of using market firms
Limitation of the contracts
The conditions under which two companies with a commercial relationship work are defined by the contracts.
Contracts are incomplete when they regulate imperfect commitments. A contract is incomplete when, due to the complexity of the transaction, the ambiguity of the context or just limitations of the human mind, all responsibilities andsanctions are not clearly specified. The information that we have about the future is incomplete so we cannot take into account all the possible situations. Therefore, in the real world, all contracts are incomplete. The case Cook Vs. Deltona Corp. (pp.132 of “Economics o Strategy.” Besanko) clearly illustrates this argument. When the contracts are incomplete, we can make use of contract law. Ifthe body of the law is well labored, it can help to make transactions easier, but contract law has a general language (e.g. reasonable time, reasonable quality) and trials may become costly. Therefore, it is not a substitute for incomplete contracts.

Design attributes
When using the market, coordination between the different companies in the vertical chain is exceptionally important. Actionsand decisions of one company must fit actions and decisions of the other. E.g. the keyboard must precisely fit in the opening of the mobile phone (size fit). Especially important are design attributes, which have to be connected to each other in an exact sequence. In the case that some maladjustment happens, small mistakes may be translated in high costs. The mobile keyboard, mentioned above, is...
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