This document provides an overview of transaction cost economics (TCE) and its application to the boundaries of the firm. It discusses how TCE, pioneered by Oliver Williamson, explains why firms vertically integrate to bring production stages in-house in order to reduce transaction costs, especially when asset specificity is present. The document also briefly describes alternative formal approaches to firm boundaries based on incomplete contracts, like the property rights theory of Grossman, Hart, and Moore, and relational contract theories.

1. Transaction Cost Economics and the Boundaries of the Firm Peter G. Klein Contracting and Organizations Research Institute Division of Applied Social Sciences University of Missouri, USA June 2006

8. Ex-ante versus ex-post analysis TCE as the “governance approach” to the science of contract

10. The stages of production

14. Perfect competition, shutdown, and quasi-rents p 3 p 2 p 1 quasi-rent rent

16. Discriminating alignment: one independent variable

17. Discriminating alignment: two independent variables