Ineconomics, atransaction cost is acost incurred when making an economictrade when participating in amarket.[1]
The idea that transactions form the basis of economic thinking was introduced by theinstitutional economistJohn R. Commons in 1931.Oliver E. Williamson'sTransaction Cost Economics article, published in 2008,[2] popularized the concept of transaction costs.[3]Douglass C. North argues thatinstitutions, understood as the set of rules in a society, are key in the determination oftransaction costs. In this sense, institutions that facilitate low transaction costs can boosteconomic growth.[4]
Alongsideproduction costs, transaction costs are one of the most significant factors in business operation and management.[5]
Williamson defines transaction costs as a cost innate in running an economic system of companies, comprising the total costs of making a transaction, including the cost of planning, deciding, changing plans, resolving disputes, and after-sales.[6] According to Williamson, the determinants of transaction costs are frequency,specificity, uncertainty, limited rationality, and opportunistic behavior.
Douglass North states that there are four factors that comprise transaction costs – "measurement", "enforcement", "ideological attitudes and perceptions", and "the size of the market".[4]Measurement refers to the calculation of the value of all aspects of the good or service involved in the transaction.[4]Enforcement can be defined as the need for an unbiased third party to ensure that neither party involved in the transaction reneges on their part of the deal.[4] These first two factors appear in the concept ofideological attitudes and perceptions, North's third aspect of transaction costs.[4] Ideological attitudes and perceptions encapsulate each individual's set of values, which influences their interpretation of the world.[4] The final aspect of transaction costs, according to North, ismarket size, which affects the partiality or impartiality of transactions.[4]
Dahlman categorized the content of transaction activities into three broad categories:[7][8]
Steven N. S. Cheung defines transaction costs as any costs that are not conceivable in a "Robinson Crusoe economy"—in other words, any costs that arise due to the existence ofinstitutions. For Cheung, term "transaction costs" are better described as "institutional costs".[9][10] Many economists, however, restrict this definition to exclude costs internal to an organization.[11]
The idea that transactions form the basis of an economic theory was introduced by theinstitutional economistJohn R. Commons in 1931. He said that:
These individual actions are really trans-actions instead of either individual behavior or the "exchange" of commodities. It is this shift from commodities and individuals to transactions and working rules of collective action that marks the transition from the classical and hedonic schools to the institutional schools of economic thinking. The shift is a change in the ultimate unit of economic investigation. The classic and hedonic economists, with their communistic and anarchistic offshoots, founded their theories on the relation of man to nature, but institutionalism is a relation of man to man. The smallest unit of the classic economists was a commodity produced by labor. The smallest unit of the hedonic economists was the same or similar commodity enjoyed by ultimate consumers. One was the objective side, the other the subjective side, of the same relation between the individual and the forces of nature. The outcome, in either case, was the materialistic metaphor of an automatic equilibrium, analogous to the waves of the ocean, but personified as "seeking their level". But the smallest unit of the institutional economists is a unit of activity – a transaction, with its participants. Transactions intervene between the labor of the classic economists and the pleasures of the hedonic economists, simply because it is society that controls access to the forces of nature, and transactions are, not the "exchange of commodities", but the alienation and acquisition, between individuals, of the rights of property and liberty created by society, which must therefore be negotiated between the parties concerned before labor can produce, or consumers can consume, or commodities be physically exchanged".
— John R. Commons,Institutional Economics, American Economic Review, Vol.21, pp.648-657, 1931
The term "transaction cost" is frequently and mistakenly thought to have been coined byRonald Coase, who used it to develop a theoretical framework for predicting when certain economic tasks would be performed byfirms, and when they would be performed on themarket. While he did not coin the specific term, Coase indeed discussed "costs of using the price mechanism" in his 1937 paperThe Nature of the Firm, where he first discusses the concept of transaction costs, marking the first time that the concept of transaction costs was introduced into the study of enterprises and market organizations. The term "Transaction Costs" itself can be traced back to the monetary economics literature of the 1950s, and does not appear to have been consciously 'coined' by any particular individual.[12]
Transaction cost as a formal theory started in the late 1960s and early 1970s.[13] And refers to the "Costs of Market Transactions" in his seminal work,The Problem of Social Cost (1960).
Arguably, transaction cost reasoning became most widely known throughOliver E. Williamson'sTransaction Cost Economics. Today, transaction cost economics is used to explain a number of different behaviours. Often this involves considering as "transactions" not only the obvious cases ofbuying andselling, but also day-to-day emotional interactions and informalgift exchanges. Williamson was one of the most cited social scientists at the turn of the century,[3] and was later awarded the 2009Nobel Memorial Prize in Economics.[14]
Technologies associated with theFourth Industrial Revolution such as distributed ledger technology[15] and blockchains may reduce transaction costs when compared to traditional forms of contracting.
A supplier may bid in a very competitive environment with a customer to build awidget. To make the widget, the supplier needs to build specialized machinery that cannot be used to make other products. Once the contract is awarded to the supplier, the relationship between customer and supplier changes from a competitive environment to amonopoly/monopsony relationship, known as abilateral monopoly. This means that the customer has greater leverage over the supplier. To avoid these potential costs, "hostages" may be swapped, which may involve partial ownership in the widget factory and revenue sharing.
Car companies and their suppliers often fit into this category, with the car companies forcing price cuts on their suppliers. Defense suppliers and the military appear to have the opposite problem, with cost overruns occurring quite often.
An example of measurement, one of North's four factors of transaction costs, occurs when roving bandits calculate the success of their banditry based on how much money they can take from their citizens.[16] Enforcement, the second of North's factors of transaction costs, may take the form of a mediator in dealings with the Sicilian mafia when it is not certain that both parties will maintain their end of the deal.[17]
Williamson argues inThe Mechanisms of Governance (1996) that Transaction Cost Economics (TCE) differs fromneoclassical microeconomics in the following points:
| Item | Neoclassical microeconomics | Transaction cost economics |
|---|---|---|
| Behavioural assumptions[18] | Assumeshyperrationality and ignores most of the hazards related to opportunism | Assumesbounded rationality |
| Unit of analysis | Concerned with composite goods and services | Analyzes the transaction itself |
| Governance structure | Describes the firm as aproduction function (a technological construction) | Describes the firm as a governance structure (an organizational construction) |
| Problematic property rights and contracts | Often assumes that property rights are clearly defined and that the cost of enforcing those rights by the means of courts is negligible | Treats property rights and contracts as problematic |
| Discrete structural analysis | Uses continuous marginal modes of analysis in order to achieve second-order economizing (adjusting margins) | Analyzes the basic structures of the firm and its governance in order to achieve first-order economizing (improving the basic governance structure) |
| Remediableness | Recognizesprofit maximization orcost minimization as criteria of efficiency | Argues that there is no optimal solution and that all alternatives are flawed, thus bounding "optimal"efficiency to the solution with no superior alternative and whose implementation produces net gains |
| Imperfect Markets | Downplays the importance of imperfect markets | Robert Almgren andNeil Chriss, and laterRobert Almgren andTianhui Li, showed that the effects of transaction costs lead portfolio managers and options traders to deviate from neoclassically optimal portfolios extending the original analysis to derivative markets.[19][20] |
The transaction costs frameworks reject the notion ofinstrumental rationality and its implications for predicting behavior. Whereas instrumental rationality assumes that an actor's understanding of the world is the same as the objective reality of the world, scholars who focus on transaction costs note that actors lack perfect information about the world (due to bounded rationality).[21]
In game theory, transaction costs have been studied by Anderlini and Felli (2006).[22] They consider a model with two parties who together can generate a surplus. Both parties are needed to create the surplus. Yet, before the parties can negotiate about dividing the surplus, each party must incur transaction costs. Anderlini and Felli find that transaction costs cause a severe problem when there is a mismatch between the parties'bargaining powers and the magnitude of the transaction costs. In particular, if a party has large transaction costs but in future negotiations it can seize only a small fraction of the surplus (i.e., its bargaining power is small), then this party will not incur the transaction costs and hence the total surplus will be lost. It has been shown that the presence of transaction costs as modelled by Anderlini and Felli can overturn central insights of the Grossman-Hart-Mooretheory of the firm.[23][24]
Oliver E. Williamson's[25] theory of evaluative mechanisms assess economic entitles based on eight variables: bounded rationality, atmosphere, small numbers, information asymmetric, frequency of exchange, asset specificity, uncertainty, and threat of opportunism.[26]
These, then, represent the first approximation to a workable concept of transaction costs: search and information costs, bargaining and decision costs, policing and enforcement costs.
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