Monitoring

Monitoring is the cost of observing and/or controlling the performance of a trading partner.34 Monitoring may take the form of audits, quality checks, computer system reporting, incentives, and so on.

Monitoring costs are created when bounded rationality, opportunistic behavior, and uncertainty are combined. Because a firm is unsure of whether the trading partner will behave honorably and managers cannot know all they need to in order to assure that the contract is being carried out as it should be, the need to monitor the trading partner is created.

When asset specificity is high, the need to monitor is more intense, causing higher transaction costs, whereas fewer specific assets decrease the need to monitor and results in lower transaction costs.

Risk preference will impact transaction costs because a risk-averse manager may feel the need to monitor the partner in order to reassure himself of the partner's behavior, whereas a risk-seeking manager may not see the need. Thus, a firm with risk aversion will have higher transaction costs, whereas the risk seeking will have lower costs.

Because frequent transactions in which the partner behaves properly may lead to trust, the more frequently the partners have traded, the lower the need for monitoring. Reputation may act as a substitute for trust, also lowering transaction costs.

A trading partner's high market power may also impact transaction costs because it creates a small numbers exchange when a trading partner is in a seller's position in the supply chain. The firm may feel it is in a "hostage" position in such a situation and thus, feel less need to monitor the partner. On the other hand, when the firm dominates market power, the trading partner may be in the hostage position. In such situations, the firm may not feel the need to monitor a supplier partner because it is important for the trading partner to maintain the relationship.

Information known to one partner may be costly to discover or to transfer. Thus, it is possible that information asymmetry can increase transaction costs if the firm decides that it is important to have the same information the partner has, and that the information is available through the monitoring function.

Compliance

Compliance costs are those that arise when a trading partner does not live up to the terms of the transaction (usually a contract) in terms of quality, deadlines, or other specifications. Enforcement costs are the costs of forcing a partner to comply with the terms of the transaction, proper usage of property rights, and handling intellectual property rights appropriately. These costs may be court costs, costs of having an employee at the partner's location, mediation, and so on and may affect either the trading party or the firm itself.35

Enforcement costs arise when uncertainty is combined with bounded rationality because contracts cannot be fully comprehensive. When assets are specific to the transaction, trading partners are more likely to behave inappropriately. Although incomplete contacts may allow for some adaptation that is beneficial to both parties, when a partner behaves opportunistically, the firm may have no recourse but to enforce the contact through third-party intervention. Bounded rationality also affects enforcement costs when that third party must interpret the areas of the contract that are incomplete.

One partner may comply with the contract, even to its detriment, because it hopes to have exchanges in the future that will bring greater benefits than noncompliance does. Thus, expectations of future exchange and frequency of exchange may lower the costs of enforcement.

Information asymmetries, especially in the area of intellectual property, can increase enforcement costs. Should either partner with proprietary or protected knowledge find that the information has leaked, it may use self-protecting measures to avoid completing the contract, thereby creating higher enforcement costs.