Transaction Cost Economics (TCE): the Theory and Example
In almost every organization, the same question is asked at some point: are we going to do it ourselves, or are we going to have someone else do it? At first glance, this sounds simple, but there is often much more to this choice than meets the eye. Collaboration, procurement, or outsourcing always costs time and money. Think, for example, of consultations, making agreements, or checking results. The theory of Transaction Cost Economics (TCE) helps to better understand such choices.
This article explains what Transaction Cost Economics is, where it comes from, and how you can use it in practice. It also provides an example that shows how this theory helps you make smart choices about collaboration, doing things yourself, and outsourcing.
What is Transaction Cost Economics (TCE)?
The origins of Transaction Cost Economics (TCE) and its way of thinking/approach were conceived by Ronald Coase in 1937. In his article The Nature of the Firm, he posed the key question: “Why do companies exist if the market can do the same thing?” His answer was: “Because transactions via the market entail additional costs (searching, negotiating, checking).” This was the basic idea behind transaction costs.
The core of the theory states: “Every transaction costs something extra.” An organization always looks for ways to keep those costs as low as possible. Sometimes it is cheaper to do something yourself, but in other situations it is cheaper to outsource or collaborate.
Later, Oliver Williamson further developed the theory, based on Ronald Coase’s theory. He added important behavioral factors that often influence practice. The following are the adjustments that were made.
- Opportunism: People may act in their own interests, which can pose risks during collaborations.
- Bounded rationality: Organizations cannot foresee all risks and scenarios in advance.
- Asset specification: Some investments or resources are unique to a single collaboration and therefore difficult to replace.
These three factors together determine how high the transaction costs of an activity are. The essence of this theory is therefore to minimize transaction costs by finding the right balance between the market and hierarchy.
TCE is therefore all about transaction costs: Transaction costs are all visible and hidden costs that arise when entering into and managing collaborations, whether internal or external.
Frequency and uncertainty
- Frequency: TCE also distinguishes transactions based on frequency. One-off transactions are often easier to outsource, while recurring transactions can yield economies of scale and long-term relationships, which reduces transaction costs in the long run.
- Uncertainty: (Unexpected) market developments, technical complexity, or changing circumstances can increase and influence transaction costs.
Forming governance
Organizations can execute transactions in various ways, namely:
- Via the market: Outsource completely to an external party.
- Through hierarchy: Carry out internally, within the organization.
- Via a hybrid method: Combination of both, for example via long-term contracts or joint ventures.
Transaction Cost Economics (TCE) states that this choice depends on transaction costs and risk factors such as opportunism, asset specificity, and uncertainty. Here are some concrete examples
Opportunism
A supplier delivers lower quality than agreed or deliberately delays delivery in order to increase the price.
Asset specificity
Outsourcing special software or machinery that is unique to a particular organization can be risky because the supplier can misuse the investment.
Bounded rationality
An organization cannot foresee all scenarios in advance, which means that contracts are never complete and unexpected costs may arise.
How do you apply Transaction Cost Economics?
You can use the theory of Transaction Cost Economics to make better choices in your make-or-buy strategy. The theory helps you to look not only at the price, but also at the hidden costs involved in a collaboration.
In practice, you can apply the theory in five simple steps. The following steps are not an integral part of transaction cost economics theory. However, they are a practical translation of how different organizations make decisions based on the theory of Coase and Williamson.
Depending on the phase a company is in, make-or-buy decisions may differ (Organizational Life Cycle).
Step 1. Clearly identify the activity or activities
First, identify the activity and the steps involved as clearly as possible. Transaction Cost Economics theory provides a number of important concepts to keep in mind, such as search costs, negotiation costs, and enforcement costs. By conducting research , you can quickly see where the transaction costs lie and which factors (opportunism, asset specificity, bounded rationality) can cause costs to rise. You can use the following questions to help you with this.
What is the goal?
What does the organization want to achieve with the activity or product? For example, is it about saving costs, improving quality, or saving time?
How often does it occur?
Is it a one-off event or does it occur regularly?
How much time does it take up for the organization?
When making a decision, mistakes are often made here, such as search costs, negotiation costs, enforcement costs/control. If a task requires a lot of attention within the organization, this can significantly increase hidden costs and make the decision to outsource it more attractive. Structure and division of roles within an organization also influence how efficiently internal activities can be carried out, as explained in Max Weber’s bureaucracy theory.
What knowledge, materials, or resources are needed?
If the necessary resources are not available internally, the investment costs may be higher, which is part of asset specification.
- Knowledge: Is the necessary knowledge already available within the organization, or do you need to call in external specialists?
- Materials: Are the right materials/tools available? Or do they need to be purchased?
- Resources: Is the right software, machinery, or space available to perform the tasks properly?
Step 2. Calculate the internal costs (make)
Transaction Cost Economics states that internal organizational structures (such as hierarchical management) can keep transaction costs lower, but also entail their own costs.
Therefore, it is important to identify not only the direct transaction costs, but also the indirect ones. When identifying internal costs, consider Lean manufacturing, for example, as this can reduce transaction costs. Answering the following questions will give you a better picture of the internal transaction costs.
Labor and time
How many hours are needed to perform the tasks? And what does that cost in terms of wages and productivity? Don’t forget to include the time needed to explain the tasks, consult between different departments, and make schedules.
Materials and resources
Make an overview of the materials and resources that still need to be purchased, such as materials, software programs, and/or raw materials.
Supervision and control
How many hours are approximately needed to manage the process and monitor quality?
Risks and errors
Analyze where risks and errors may occur. Also take limited rationality into account; you can never accurately predict everything in advance.
Step 3. Calculate the external costs (buy)
After completing the previous step, you know exactly what it costs to do the work yourself. Now it’s time to look at what it costs to outsource the activity to an external organization. Many organizations only look at what is stated in the quotation, but there are always additional costs and risks that are sometimes overlooked.
Opportunism also plays a role here. A supplier may act in its own interest, for example by charging higher prices or delivering lower quality than agreed. These types of risks increase transaction costs, so it is extremely important to make clear agreements and to keep a close eye on control.
The following points not only help to identify the costs, but also to limit the risks and keep transaction costs low.
- Searching for a supplier: It takes time to find a good supplier to work with.
- Negotiating and making agreements: Once a suitable supplier has been found, negotiations will take place regarding price, quality, delivery time, and responsibilities.
- Implementation and monitoring: When work is outsourced, the organization remains responsible for the end result.
Step 4. Compare costs, risks, and control
Now that you have an overview of the different costs of the two options, you can compare them and then make a decision. According to TCE, the optimal choice is the one with the lowest total transaction costs. When comparing the internal and external options, it is therefore important to look beyond just the price:
Costs
Take everything into account, not only the direct costs but also the hidden costs. “Cheap is sometimes expensive”.
Risks
What could go wrong? Consider, for example, dependence on a supplier.
Control
How do you want to control quality and planning? Doing it yourself often provides more certainty, but it does cost more money.
By carefully considering these points, you will be able to see more quickly and clearly which choice is best for your organization in the long term.
Step 5. Make a decision and evaluate
Now that you have all the necessary information that influences the decision, you can make a choice: will you outsource or do it yourself?
Choose what is most efficient in the long term and not just what seems cheapest now.
Transaction Cost Economics emphasizes that market conditions and internal structures are constantly changing. Therefore, a decision is never final: the relationship between internal and external transaction costs can change.
Therefore, regularly evaluate whether the choice you have made still results in the lowest transaction costs. If prices rise or the collaboration proves to be ineffective, it may be wise to review your decision.
Brief conclusion after following the 5 steps
The make-or-buy decision is therefore essentially a practical translation of Transaction Cost Economics. It is not just about money, but about smart organization: who does what, at what cost, and with how much control? By following these steps, it becomes clear where collaboration is the better choice and where it is more efficient to keep the work in-house.
Tip: Combine Transaction Cost Economics with the Blue Ocean Strategy principles: investigate whether you can reduce transaction costs or organize them differently through new market models or partnerships.
A detailed case study/practical example for recognition
Situation
The (fictional) company ‘IT-Beter service’ manages the IT and communication systems at various terminals in the ports of Rotterdam and Amsterdam. Due to the rapid growth this company is experiencing, the management team is faced with the following question: should we continue to manage the network ourselves or should we outsource part of it to an external IT partner?
Analysis according to Transaction Cost Economics
Step 1: Identify activities and costs
This involves various activities, namely daily network management, data security, and troubleshooting. The current IT team is very experienced, but when several companies experience a problem at the same time, this slows down solutions for the port companies.
Step 2: Identify internal costs (Make)
The average cost for internal IT staff is €48 per hour. 5 FTE means that this amounts to approximately €38,000 per month. When calculated with software licenses, additional fees for urgent jobs, and internal coordination, this amounts to approximately €43,000 per month.
Step 3: Identify external costs (buy)
The external party charges more for IT staff, namely 60 euros per hour. For the same amount of work as the internal staff, this will cost approximately 47,000 euros per month. On top of that, there are other transaction costs of around 3,000 euros per month. This amounts to approximately 50,000 euros per month.
Step 4: Compare costs, risks, and control
- Internal: more control and certainty regarding data security and quality.
- External: less control and certainty regarding data security and quality. This will require more monitoring.
Step 5: Decision
The costs are not far apart, but internal implementation offers more certainty and control over the quality delivered. As a result, the management team has opted for a hybrid approach: critical systems remain internal and standard/easier maintenance is outsourced. This provides greater certainty about the quality delivered by IT-better service.
What does the methodology or model offer?
Transaction Cost Economics theory helps organizations make more informed choices between doing something themselves or outsourcing it.
This is not just about the lowest price, but about the total picture: price, time, risks, trust, and control. By mapping out the various transaction costs, it becomes clear when something is better handled internally or when it is better to enter into a partnership.
This methodology gives organizations more insight into hidden costs and dependencies. This not only saves them money, but also helps them build better and more sustainable relationships with their suppliers and partners.
Practical Transaction Cost Economics checklist for better decisions and tips
Transaction Cost Economics only becomes interesting when you use it for real choices in your organization. This checklist helps you quickly identify where the largest transaction costs lie and which form of organization makes the most sense. By simply going through the questions honestly, you will quickly see how efficient or risky a collaboration or outsourcing actually is.
Start by looking at how much effort it takes to gather the right information. If you spend a lot of time searching, comparing, or assessing risks, your information costs are high and the process is unnecessarily cumbersome. Next, look at the agreements that need to be made. How much energy does it take to close a deal, properly establish terms and conditions, and get everyone on the same page? Finish with the costs of supervision: think of monitoring, quality control, and resolving issues if agreements are not met.
If one of these components takes a lot of time, stress, or money, it is often wiser to organize the activity internally or to work with a regular partner you trust. If the transaction costs are low, outsourcing is usually more efficient and flexible. By using this checklist regularly, you can make more informed choices and avoid surprises later on. This is good news for anyone responsible for strategy or business operations.
Tips for implementation
Below are a number of tips you can use when implementing this theory.
- First, map out all activities thoroughly and know exactly what needs to be done.
- Think beyond just the price; also consider time, communication, quality control, and dependencies.
- Avoid opportunism, make clear agreements about price, quality, and delivery times, and record these.
- Remain flexible; markets change, so be critical of the choices you make. Something may no longer be the best option in a year’s time.
Regularly evaluate suppliers and check whether the agreements made are being complied with.
Digital developments and their impact on transaction costs
Transaction Cost Economics is a classic model, but digitization has made it more relevant than ever. Many organizations no longer work with traditional chains, but with platforms, hybrid collaborations, and digital partnerships. As a result, transaction costs are constantly changing. Activities that used to be expensive and time-consuming are becoming much easier thanks to technology. Think of real-time data, automatic contract monitoring, or systems that immediately check whether agreements are being complied with.
Digitization also allows us to determine more quickly and accurately which activities we should do ourselves and which we should outsource. Search and information costs are falling because everything is more transparent, negotiation costs are lower because contracts are more often standardized, and supervision costs are falling thanks to automatic monitoring and digital dashboards. As a result, the discussion is shifting not only to what it costs, but above all to how quickly we can switch and how much flexibility it delivers.
At the same time, technology brings with it new transaction costs. Think of security risks, dependence on external platforms, or the complexity of digital integrations. This makes the choice between organizing internally or collaborating with partners less black and white than it used to be. For modern organizations, it is therefore important not to view TCE as a theoretical model from the 1980s, but as a lens through which to understand how digitization is changing the rules of collaboration. It makes decisions faster, but also more strategic, which is exactly what leaders and entrepreneurs are dealing with today.
Recommended literature on Transaction Cost Economics (TCE) theory
This literature gives you everything at a glance: the classic basis of TCE, modern extensions, and practical translations to the real world. Short, powerful, and exactly what a Toolshero article needs to be immediately applicable.
- Avdasheva, S. B. (2025). Transaction cost economics (TCE) and the theory of governance structures. Russian Journal of Economics (forthcoming). → Recent insights into TCE within governance structures; keeps your article up to date and applicable.
- Berkery, D. (2023). The zero transaction cost entrepreneur: Powerful techniques to reduce friction and scale your business. New York, NY: McGraw-Hill. → Connects TCE directly to scalability, growth, and operational efficiency—ideal for entrepreneurs and professionals who want to understand how transaction costs can be strategically reduced.
- Groenewegen, J. (Ed.). (1995). Transaction Cost Economics and Beyond. Dordrecht: Kluwer Academic Publishers. → Collects extensions and critiques of TCE; ideal for adding nuance, depth, or discussion to your article.
- Hardt, L. (2009). The history of transaction cost economics and its recent development. Erasmus Journal for Philosophy and Economics, 2(1), 31-56. → Describes the history of TCE in an accessible way; good source for context.
- Ketokivi, M., & Mahoney, J. T. (2017). Transaction cost economics as a theory of the firm, management, and governance. Oxford Research Encyclopedia of Business and Management. → Combines TCE with organizational science and governance; useful for highlighting management applications.
- North, D. C. (1992). Transaction costs, institutions, and economic performance. San Francisco, CA: ICS Press. → Shows how transaction costs influence institutions and performance; perfect for the broader economic context.
- Peng, G. Z. (2021). Toward behavioral transaction cost economics: Theoretical extensions and an application to the study of MNC subsidiary ownership. Cham, Switzerland: Springer Nature. → Adds behavioral science to TCE (biases, decision-making, culture) and helps deepen your article with modern insights that go beyond the classical economic approach.
- Williamson, O. E. (1998). Transaction cost economics: How it works; where it is headed. In G. D. Libecap (Ed.), The economic institutions of capitalism: Firms, markets, relational contracting (pp. 391-418). New York, NY: Free Press. → Clear explanation of TCE by its founder himself; ideal for a robust foundation in your article.
- Williamson, O. E. (2010). Transaction cost economics: The natural progression. American Economic Review, 100(3), 673-690. → Describes the evolution of TCE and helps you outline its historical trajectory and development.
- Valentinov, V. (2024). The idea of adaptation in transaction cost economics. Society and Business Review, 19(3), 473-490. → Introduces adaptation concepts within TCE; a current and innovative angle for your article.
How to cite this article:
Jimmink, J. (2025). Transaction Cost Economics (TCE). Retrieved [insert date] from Toolshero: https://www.toolshero.com/strategy/transaction-cost-economics/
Original publication date: 11/23/2025 | Last update: 11/23/2025
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Job Jimmink
Job Jimmink is Content Manager at Toolshero. He focuses on writing articles and conducting research into management and strategy theories. He also studies at Rotterdam University of Applied Sciences (HES), where he further develops his project management and problem-solving skills. His specific interests lie in procurement management and strategy.
