The expansion of a business enterprise is beneficial in terms of the economies of scale and scope, creation of market power, development and utilization of brand value, etc.
However, expansion of the business indefinitely is not a good idea, and there is a boundary to the expansion of the firm/enterprise. Such a boundary is created by the transaction cost of expansion. When an enterprise expands its size, it increases the internal transaction cost of the business in the form of managerial cost, bureaucratic cost, monitoring and supervision cost, etc.
It means that as the firm increases its size, it increases the number of departments, human resources, suppliers, and distributors, etc. This increases search cost, bargaining and negotiation cost, monitoring and supervision cost, etc.
For example, the firm has to search for the appropriate human resources, bargain, and negotiate for the salary and other benefits, develop the terms and conditions, and provide regular supervision on the performance of the hired manpower.
There may be conflicts between different individuals and departments, which increases the conflict resolution cost.
Similarly, at the large scale of business, the decision-making takes time, which is costly to the firm. All of these costs associated with expanding the business are internal transaction costs, and they are increasing as the business expands.
Similarly, if the enterprise purchases/outsource the product from the external party, there is some external transaction cost such as search cost, bargaining and negotiation cost, monitoring and supervision cost. Such per-unit external transaction cost declines as the volume of purchase or outsourcing increases.
So, the rational enterprise/firm compares the internal transaction cost of expanding business and the external transaction cost of purchasing or outsourcing the product. So, as long as the per-unit internal transaction cost is lower than the external cost, it is better to outsource or purchase the product instead of expanding the business by self-investment.
So, the boundary of expanding the firm is determined at a point where internal and external transaction costs are equal.
Here, the per-unit internal transaction cost increases as the size of the firm’s output increases. While the external per unit transaction cost is declining due to a larger quantity of purchases/outsourcing.
Both internal and external transaction costs are equal at “A”, which works as the boundary of the firm’s expansion.
So, the firm expands until the per-unit internal external transaction costs are equal.
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