Why do firms exist?
A fundamental question every young MBA should ponder is, “Why do firms exist?” This query has been explored by various scholars, and one particularly persuasive answer stands out: Firms exist to minimize transaction costs.
The question we then ask is, “what are these transaction costs?”.
Transaction costs are the costs associated with making an economic exchange. These costs can be divided into three main categories:
- Search and Information Costs: These are the costs of finding the right products, services, or partners. For example, if you want to buy a new phone, you might spend time and money researching different models, comparing prices, and reading reviews.
- Bargaining and Decision Costs: These are the costs involved in negotiating and making decisions. For instance, if you’re buying a car, you might spend time negotiating the price with the dealer and deciding on the best financing options.
- Policing and Enforcement Costs: These are the costs of ensuring that the terms of an agreement are upheld. For example, if you sign a contract for a rental apartment, there might be costs associated with ensuring that the landlord maintains the property and that you follow the lease terms.
Imagine you’re planning a road trip with friends. Here are some transaction costs you might encounter:
- Search and Information Costs: You need to find a rental car. This involves looking up different rental companies, comparing prices, and reading reviews to ensure you get a good deal and a reliable vehicle.
- Bargaining and Decision Costs: Once you find a car, you might negotiate the rental price or the terms of the rental agreement. You also need to decide on things like insurance coverage and whether to add additional drivers.
- Policing and Enforcement Costs: After renting the car, you need to ensure it’s returned in good condition to avoid extra charges. If something goes wrong during the trip, like a breakdown, you might incur additional costs to resolve the issue.
Businesses are also very similar. They want to minimize these transaction costs and focus on their core activities, improve efficiency, and increase profitability.
Now, let’s say one of your friends has a car - assuming he’s a good friend, you already have clear information about the car, and don’t have to bargain for the price. In all likelihood, you get the car for free. In other words, based on the transaction costs, you can make a critical decision - rent from an external agency or borrow for free from a friend.
Businesses are also very similar. They want to minimize these transaction costs and focus on their core activities, improve efficiency, and increase profitability. This concept helps explain why some companies choose to be vertically integrated (controlling multiple stages of production and distribution) while others focus on a specific niche within the value chain.
Remember the ridiculous example we spoke about in class to make this memorable?
Here’s a fun cartoon I drew just to drive home the point:
Imagine you wanted to buy some wood to make a chair. One way to approach the problem could be to go to the market and get some wood. Another way to do this could be to plant seeds, and wait 50 years before you can cut the tree and make your own wood (This is not an endorsement for deforestation - no real trees were harmed during this thought experiment :-P)
Well, understanding transaction costs is critical to grasping the essence of business models. A firm can choose to be completely vertically integrated or specialize in a small segment of the value chain to add value. This was precisely our focus in the Hilton case study that we delved into in this week’s MM1 classes.
Hilton’s operations can be viewed through the lens of three distinct business models (Direct ownership, management of property, and franchising), each representing different forms of firm structure. Clearly, the level of transaction costs are different in each of them. And one of the technologies that Hilton pioneered using was it’s Management Information Systems (MIS).
Hilton leveraged a sophisticated application that gathers all necessary details to provide their customers with a consistent and seamless experience. This is something that customers find most useful.
By employing this technology, Hilton can lower transaction costs significantly, allowing them to manage their business efficiently without the need for owning extensive real estate. This strategic use of technology not only enhances their profitability but also showcases the importance of MIS in modern business operations.
For those interested in diving deeper into the topic, you can read more about transaction costs here.
There was also a little trick that we picked up in this particular class. Do not limit yourself to the datasets provided; often, you need to augment them with additional data to gain a comprehensive understanding. Sometimes, this may be as simple as making joint use of two datasets that are provided in the exhibit to infer deeper insights. In other cases, this might meal taking advantage of other freely available datasets from the public domain to make our understanding clearer.
Until next class folks!