Real world examples of cost theory
Here you will find some examples of cost theory application in real life. If you start a new firm one day, this page may contain some valuable lessons .
Let's start with Coase Theorem...
The Times of India group is a corporation. Many of us would have ready answers to why the group is in the business of publishing newspapers; to make profits, to spread social, political awareness, etc. To publish newspapers, the group needs, among many things, access to a printing press, services of reporters, editors and authors like me. It is plausible to argue that the Times group is a 'bigger' corporation with its own printing press than it would be without its own printing machines, other things remaining the same. Similarly, it is bigger with reporters and editors as its employees than without them.
Why has the Times group chosen to be big? Can they not carry out their business better by hiring the services of independent printers, reporters, and editors? The answer may not be terribly clear to readers but, of course, all newspaper publishers know the answer! However, the answers provided by the TCT of firms can be informative even for publishers. Indeed, the theory offers important insights on the size and internal organisation of firms, the institutions of capitalism.
According to the theory, the firm size is determined by transaction costs of doing business. What are the transaction costs? Imagine a world in which the Times group decides to publish its newspapers without owning a printing press. In that case, it can enter into a formal (market) contract with a printer. Such a contract can specify several aspects of the intended transaction; such as, per page price, number of copies, quality of paper to be used, etc. However, it invariably will leave many ambiguous terms.
For example, it may not be specific about what happens if the publisher decides to change the template of the front page, the number of monthly supplements, etc. The publisher decides on these matters depending on how the future unfolds in terms of the marketing strategies of the competition, political turmoil, epic success or tragic loss gripping the entire nation, etc.
Such contingencies are hard to predict and even harder to negotiate a priori into the printer-publisher contract, making it 'incomplete'. When contracts are incomplete, re-negotiations become inevitable. For example, the publisher and the printer will have to re-negotiate the contract whenever the publisher wants to publish an un-contracted supplement. But, the printer may or may not be ready to publish the supplement at a short notice. Or, he/she could demand an unacceptably high price. In sum, he may 'hold-up' the publisher.
In contrast, if the Times group owns the printing press (through vertical integration), then the manger of the press is its employee and there will be little hold-up. So, for the publisher, the transaction costs of doing business are lower when it owns the printing press than without it. A similar argument applies to reporters and editors as well.
*Note that even if the publisher and printer are independent, renegotiation will either be not needed or be costless if the publisher can replace the printer costlessly; just as they can replace one author with another.
**Part of this article is taken from The Economic Times.
Let's start with Coase Theorem...
The Times of India group is a corporation. Many of us would have ready answers to why the group is in the business of publishing newspapers; to make profits, to spread social, political awareness, etc. To publish newspapers, the group needs, among many things, access to a printing press, services of reporters, editors and authors like me. It is plausible to argue that the Times group is a 'bigger' corporation with its own printing press than it would be without its own printing machines, other things remaining the same. Similarly, it is bigger with reporters and editors as its employees than without them.
Why has the Times group chosen to be big? Can they not carry out their business better by hiring the services of independent printers, reporters, and editors? The answer may not be terribly clear to readers but, of course, all newspaper publishers know the answer! However, the answers provided by the TCT of firms can be informative even for publishers. Indeed, the theory offers important insights on the size and internal organisation of firms, the institutions of capitalism.
According to the theory, the firm size is determined by transaction costs of doing business. What are the transaction costs? Imagine a world in which the Times group decides to publish its newspapers without owning a printing press. In that case, it can enter into a formal (market) contract with a printer. Such a contract can specify several aspects of the intended transaction; such as, per page price, number of copies, quality of paper to be used, etc. However, it invariably will leave many ambiguous terms.
For example, it may not be specific about what happens if the publisher decides to change the template of the front page, the number of monthly supplements, etc. The publisher decides on these matters depending on how the future unfolds in terms of the marketing strategies of the competition, political turmoil, epic success or tragic loss gripping the entire nation, etc.
Such contingencies are hard to predict and even harder to negotiate a priori into the printer-publisher contract, making it 'incomplete'. When contracts are incomplete, re-negotiations become inevitable. For example, the publisher and the printer will have to re-negotiate the contract whenever the publisher wants to publish an un-contracted supplement. But, the printer may or may not be ready to publish the supplement at a short notice. Or, he/she could demand an unacceptably high price. In sum, he may 'hold-up' the publisher.
In contrast, if the Times group owns the printing press (through vertical integration), then the manger of the press is its employee and there will be little hold-up. So, for the publisher, the transaction costs of doing business are lower when it owns the printing press than without it. A similar argument applies to reporters and editors as well.
*Note that even if the publisher and printer are independent, renegotiation will either be not needed or be costless if the publisher can replace the printer costlessly; just as they can replace one author with another.
**Part of this article is taken from The Economic Times.
Let's see a quick example of application of economies of scale...
"The Eleonora Maersk and the other seven ships in her class are among the biggest ever built: almost 400m long, or the length of four football pitches, and another half-pitch across. The ship can carry 7,500 or so 40-foot containers, each of which can hold 70,000 T-shirts. On the voyage your correspondent took, the Eleonora was carrying Europe's New Year celebrations: 1,850 tonnes of fireworks, including 30 tonnes of gunpowder." (Economist.com)
"The Eleonora Maersk and the other seven ships in her class are among the biggest ever built: almost 400m long, or the length of four football pitches, and another half-pitch across. The ship can carry 7,500 or so 40-foot containers, each of which can hold 70,000 T-shirts. On the voyage your correspondent took, the Eleonora was carrying Europe's New Year celebrations: 1,850 tonnes of fireworks, including 30 tonnes of gunpowder." (Economist.com)
What does this mean? Well it means that "...a T-shirt made in China [can] be sent to the Netherlands for just 2.5 cents."(Economist.com). This economy of scale allows Maersk Line to compete with others by delivering goods cheaper because they reduce transportation cost PER UNIT. We hope that now you are understand the basic cost analysis into what Maersk is trying to do by running such big ships.
Works Cited For this page
The Economic Times (2003) Transaction cost theory carries the day. [online] Available at: http://articles.economictimes.indiatimes.com/2009-10-14/news/29403848_1_printing-press-theory-reporters-and-editors [Accessed: 29 Dec 2012].
The Economist (2011) Economies of scale made steel. [online] Available at: http://www.economist.com/node/21538156 [Accessed: 28 Dec 2012].
The Economist (2011) Economies of scale made steel. [online] Available at: http://www.economist.com/node/21538156 [Accessed: 28 Dec 2012].