The transaction cost theory was introduced by Coase (1937) who argued that in considering the acquisition of products and services, firms must consider much more than the mere price of those products and goods. In fact, other costs are factored in: information, search, bargaining/negotiations, trade secrets and monitoring/enforcement costs (Coase, 1937). The theory of transaction costs can, therefore, be used to understand organization decisions such as long-term contracts and vertical integration. The theory of transaction costs can also be used to explain and understand the role of hold-ups in the decision to opt-out of a long-term contract and into vertical integration.
Transaction costs theory can arguably explain the primary motivating factors for vertical integration (Levy, 1985). Using transaction cost theory it can be argued that decisions for vertical integration arise out of a need for and a corresponding lack of “supply reliability” and the desire to obtain “risk reduction” and to ensure greater certainty relative to future “events” (Levy, 1985, p. 443). In other words, applying transaction costs theory, a firm’s decision to engage in vertical integration may follow from a need to respond to competitive and market threats and are therefore not always purely profit-driven decisions.
. .Klein (1980) also argues that since contracts are imperfect and cannot guarantee economic gains for all parties, long-term contracts often engage transaction costs analyses. . Contracts do not always anticipate each and every contingency and as a result, unanticipated events will expose the weaknesses of contractual arrangements and the vulnerability of one party to exploitation by the other contracting party. Quite often all of the rights and obligations of parties are not always accounted for in the context of a contract or some of the rights and obligations may be unclear or open to interpretation.