Transaction cost

Last updated

In economics and related disciplines, a transaction cost is a cost in making any economic trade when participating in a market. [1] Oliver E. Williamson defines transaction costs as the costs of running an economic system of companies, and unlike production costs, decision-makers determine strategies of companies by measuring transaction costs and production costs. Transaction costs are the total costs of making a transaction, including the cost of planning, deciding, changing plans, resolving disputes, and after-sales. Therefore, the transaction cost is one of the most significant factors in business operation and management. [2]


Oliver E. Williamson's Transaction Cost Economics popularized the concept of transaction costs. [3] Douglass C. North argues that institutions, understood as the set of rules in a society, are key in the determination of transaction costs. In this sense, institutions that facilitate low transaction costs, boost economic growth. [4]

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 of ideological 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, is market size, which affects the partiality or impartiality of transactions. [4]

Transaction costs can be divided into three broad categories: [5]

For example, the buyer of a used car faces a variety of different transaction costs. The search costs are the costs of finding a car and determining the car's condition. The bargaining costs are the costs of negotiating a price with the seller. The policing and enforcement costs are the costs of ensuring that the seller delivers the car in the promised condition.

History of development

The pool shows institutions and market as a possible form of organization to coordinate economic transactions. When the external transaction costs are higher than the internal transaction costs, the company will grow. If the internal transaction costs are higher than the external transaction costs the company will be downsized by outsourcing, for example. Market-Hierarchy-Model.png
The pool shows institutions and market as a possible form of organization to coordinate economic transactions. When the external transaction costs are higher than the internal transaction costs, the company will grow. If the internal transaction costs are higher than the external transaction costs the company will be downsized by outsourcing, for example.

The idea that transactions form the basis of an economic thinking was introduced by the institutional economist John R. Commons (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 thought to have been coined by Ronald Coase, who used it to develop a theoretical framework for predicting when certain economic tasks would be performed by firms, and when they would be performed on the market. However, the term is actually absent from his early work up to the 1970s. While he did not coin the specific term, Coase indeed discussed "costs of using the price mechanism" in his 1937 paper The Nature of the Firm , where he first discusses the concept of transaction costs. This is the first time that the concept of transaction costs has been introduced into the study of enterprises and market organizations, but "transaction cost" as a formal theory started in the late 1960s and early 1970s. [6] And refers to the "Costs of Market Transactions" in his seminal work, The Problem of Social Cost (1960). The term "Transaction Costs" itself can instead be traced back to the monetary economics literature of the 1950s, and does not appear to have been consciously 'coined' by any particular individual. [7]

Arguably, transaction cost reasoning became most widely known through Oliver E. Williamson's Transaction 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 of buying and selling, but also day-to-day emotional interactions, informal gift exchanges, etc. Oliver E. Williamson, one of the most cited social scientist at the turn of the century, [3] was awarded the 2009 Nobel Memorial Prize in Economics. [8]

According to Williamson, the determinants of transaction costs are frequency, specificity, uncertainty, limited rationality, and opportunistic behavior.

At least two definitions of the phrase "transaction cost" are commonly used in literature. Transaction costs have been broadly defined by Steven N. S. Cheung as any costs that are not conceivable in a "Robinson Crusoe economy"—in other words, any costs that arise due to the existence of institutions. For Cheung, if the term "transaction costs" were not already so popular in economics literatures, they should more properly be called "institutional costs". [9] [10] But many economists seem to restrict the definition to exclude costs internal to an organization. [11] The latter definition parallels Coase's early analysis of "costs of the price mechanism" and the origins of the term as a market trading fee.

Starting with the broad definition, many economists then ask what kind of institutions (firms, markets, franchises, etc.) minimize the transaction costs of producing and distributing a particular good or service. Often these relationships are categorized by the kind of contract involved. This approach sometimes goes under the rubric of new institutional economics.

Technologies associated with the Fourth Industrial Revolution such as, in particular, distributed ledger technology [12] and blockchains [13] are likely to reduce transaction costs comparatively to traditional forms of contracting.


A supplier may bid in a very competitive environment with a customer to build a widget. However, to make the widget, the supplier will be required to build specialized machinery which cannot be easily redeployed to make other products. Once the contract is awarded to the supplier, the relationship between customer and supplier changes from a competitive environment to a monopoly/monopsony relationship, known as a bilateral monopoly. This means that the customer has greater leverage over the supplier such as when price cuts occur. To avoid these potential costs, "hostages" may be swapped to avoid this event. These hostages could include partial ownership in the widget factory; revenue sharing might be another way.

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. Technologies like enterprise resource planning (ERP) can provide technical support for these strategies.

An example of measurement, one of North's four factors of transaction costs, is detailed in Mancur Olson's work Dictatorship, Democracy, and Development (1993) – Olson writes that roving bandits calculate the success of their banditry based on how much money they can take from their citizens. [14] Enforcement, the second of North's factors of transaction costs, is exemplified in Diego Gambetta's book The Sicilian Mafia: the Business of Private Protection (1996). Gambetta describes the concept of the "Peppe", who occupies the role of mediator in dealings with the Sicilian mafia – the Peppe is needed because it is not certain that both parties will maintain their end of the deal. [15] Measurement and enforcement comprise North's third factor, ideological attitudes and perceptions – each individual's views influence how they go about each transaction. [4]

Differences from neoclassical microeconomics

Williamson argues in The Mechanisms of Governance (1996) that Transaction Cost Economics (TCE) differs from neoclassical microeconomics in the following points:

ItemNeoclassical microeconomicsTransaction cost economics
Behavioural assumptions [16] Assumes hyperrationality and ignores most of the hazards related to opportunismAssumes bounded rationality
Unit of analysisConcerned with composite goods and servicesAnalyzes the transaction itself
Governance structureDescribes the firm as a production function (a technological construction)Describes the firm as a governance structure (an organizational construction)
Problematic property rights and contractsOften assumes that property rights are clearly defined and that the cost of enforcing those rights by the means of courts is negligibleTreats property rights and contracts as problematic
Discrete structural analysisUses 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)
RemediablenessRecognizes profit maximization or cost minimization as criteria of efficiencyArgues 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 MarketsDownplays the importance of imperfect markets Robert Almgren and Neil Chriss, and later Robert Almgren and Tianhui 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. [17] [18]

The transaction costs frameworks reject the notion of instrumental 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). [19]

Game theory

In game theory, transaction costs have been studied by Anderlini and Felli (2006). [20] 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-Moore theory of the firm. [21] [22]

Evaluative mechanisms

Oliver E. Williamson (1979) [23] stated that evaluative mechanisms consist of four variables, namely, frequency of exchange, asset specificity, uncertainty, and threat of opportunism. [24]

See also


  1. Buy-side Use TCA to Measure Execution Performance, FIXGlobal, June 2010
  2. Young, Suzanne (2013). "Transaction Cost Economics". Encyclopedia of Corporate Social Responsibility. Springer Link. pp. 2547–2552. doi:10.1007/978-3-642-28036-8_221. ISBN   978-3-642-28035-1 . Retrieved 2020-11-01.
  3. 1 2 Pessali, Huascar F. (2006). "The rhetoric of Oliver Williamson's transaction cost economics". Journal of Institutional Economics. 2 (1): 45–65. doi:10.1017/s1744137405000238. ISSN   1744-1382. S2CID   59432864.
  4. 1 2 3 4 5 6 7 8 North, Douglass C. 1992. “Transaction costs, institutions, and economic performance.” San Francisco, CA: ICS Press.
  5. Dahlman, Carl J. (1979). "The Problem of Externality". Journal of Law and Economics. 22 (1): 141–162. doi:10.1086/466936. ISSN   0022-2186. S2CID   154906153. 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.
  6. Ketokivi, Mikko; Mahoney, Joseph T. (2017). "Transaction Cost Economics as a Theory of the Firm, Management, and Governance". Oxford Research Encyclopedia of Business and Management. doi:10.1093/acrefore/9780190224851.013.6. ISBN   9780190224851 . Retrieved 2020-11-01.
  7. Robert Kissell and Morton Glantz, Optimal Trading Strategies, AMACOM, 2003, pp. 1-23.
  8. Special Issue of Journal of Retailing in Honor of The Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel 2009 to Oliver E. Williamson, Volume 86, Issue 3, Pages 209-290 (September 2010). Edited by Arne Nygaard and Robert Dahlstrom
  9. Steven N. S. Cheung "On the New Institutional Economics", Contract Economics
  10. L. Werin and H. Wijkander (eds.), Basil Blackwell, 1992, pp. 48-65
  11. Harold Demsetz (2003) “Ownership and the Externality Problem.” In T. L. Anderson and F. S. McChesney (eds.) Property Rights: Cooperation, Conflict, and Law. Princeton, N.J.: Princeton University Press
  12. Roeck, Dominik; Sternberg, Henrik; Hofmann, Erik (2019). "Distributed ledger technology in supply chains: a transaction cost perspective". International Journal of Production Research. 58 (7): 2124–2141. doi: 10.1080/00207543.2019.1657247 . ISSN   0020-7543.
  13. Lumineau, Fabrice; Wang, Wenqian; Schilke, Oliver (2020). "Blockchain Governance—A New Way of Organizing Collaborations?". Organization Science. 32 (2): 500–521. doi: 10.1287/orsc.2020.1379 .
  14. Olson, Mancur (September 1993). "Dictatorship, Democracy, and Development". The American Political Science Review. 87 (3): 567–576. doi:10.2307/2938736. JSTOR   2938736.
  15. Gambetta, Diego (1996). The Sicilian Mafia: the Business of Private Protection. Harvard University Press. p. 15. ISBN   978-0674807426.
  16. Pessali, Huascar F. (2009-09-01). "Metaphors of Transaction Cost Economics". Review of Social Economy. 67 (3): 313–328. CiteSeerX . doi:10.1080/00346760801933393. ISSN   0034-6764. S2CID   18240827.
  17. R.Almgren and N.Chriss, "Optimal execution of portfolio transactions" J. Risk, 3 (Winter 2000/2001) pp.5–39
  18. Robert Almgren; Tianhui Li (2016). "Option Hedging with Smooth Market Impact". Market Microstructure and Liquidity. 2: 1650002. doi:10.1142/S2382626616500027.
  19. North, Douglass C. (1990-10-01). "A Transaction Cost Theory of Politics". Journal of Theoretical Politics. 2 (4): 355–367. doi:10.1177/0951692890002004001. ISSN   0951-6298. S2CID   154451243.
  20. Anderlini, Luca; Felli, Leonardo (2006). "Transaction Costs and the Robustness of the Coase Theorem*" (PDF). The Economic Journal. 116 (508): 223–245. doi: 10.1111/j.1468-0297.2006.01054.x . ISSN   1468-0297. S2CID   3059129.
  21. Müller, Daniel; Schmitz, Patrick W. (2016). "Transaction costs and the property rights approach to the theory of the firm". European Economic Review. 87: 92–107. doi: 10.1016/j.euroecorev.2016.04.013 .
  22. Schmitz, Patrick W. (2016). "The negotiators who knew too much: Transaction costs and incomplete information". Economics Letters. 145: 33–37. doi: 10.1016/j.econlet.2016.05.009 .
  23. Williamson, Oliver E. (1979). "Transaction-Cost Economics: The Governance of Contractual Relations". The Journal of Law and Economics. 22 (2): 233–261. doi:10.1086/466942. ISSN   0022-2186. S2CID   8559551.
  24. Young, Suzanne (2013), "Transaction Cost Economics", in Idowu, Samuel O.; Capaldi, Nicholas; Zu, Liangrong; Gupta, Ananda Das (eds.), Encyclopedia of Corporate Social Responsibility, Berlin, Heidelberg: Springer, pp. 2547–2552, doi:10.1007/978-3-642-28036-8_221, ISBN   978-3-642-28036-8 , retrieved 2020-11-01
  25. Coggan, Anthea; van Grieken, Martijn; Jardi, Xavier; Boullier, Alexis (2017). "Does asset specificity influence transaction costs and adoption? An analysis of sugarcane farmers in the Great Barrier Reef catchments". Journal of Environmental Economics and Policy. 6 (1): 36–50. doi:10.1080/21606544.2016.1175975. ISSN   2160-6544. S2CID   168172769.

Related Research Articles

Ronald Coase British economist and Nobel laureate (1910–2013)

Ronald Harry Coase was a British economist and author. He was the Clifton R. Musser Professor of Economics at the University of Chicago Law School, where he arrived in 1964 and remained for the rest of his life. He received the Nobel Memorial Prize in Economic Sciences in 1991.

In the social sciences, the free-rider problem is a type of market failure that occurs when those who benefit from resources, public goods, or services of a communal nature do not pay for them or under-pay. Free riders are a problem because while not paying for the good, they may continue to access or use it. Thus, the good may be under-produced, overused or degraded. Additionally, it has been shown that despite evidence that people tend to be cooperative by nature, the presence of free-riders cause this prosocial behaviour to deteriorate, perpetuating the free-rider problem.

Externality In economics, an imposed cost or benefit

In economics, an externality is a cost or benefit for a third party who did not agree to it. Air pollution from motor vehicles is one example. The cost of air pollution to society is not paid by either the producers or users of motorized transport. The concept of externality was first developed by economist Arthur Pigou in the 1920s.

Market failure Situation where the free market allocation of goods and services is not Pareto efficient

In neoclassical economics, market failure is a situation in which the allocation of goods and services by a free market is not Pareto efficient, often leading to a net loss of economic value. Market failures can be viewed as scenarios where individuals' pursuit of pure self-interest leads to results that are not efficient– that can be improved upon from the societal point of view. The first known use of the term by economists was in 1958, but the concept has been traced back to the Victorian philosopher Henry Sidgwick. Market failures are often associated with public goods, time-inconsistent preferences, information asymmetries, non-competitive markets, principal–agent problems, or externalities.

“The Nature of the Firm” (1937), is an article by Ronald Coase. It offered an economic explanation of why individuals choose to form partnerships, companies and other business entities rather than trading bilaterally through contracts on a market. The author was awarded the Nobel Memorial Prize in Economic Sciences in 1991 in part due to this paper. Despite the honor, the paper was written when Coase was an undergraduate and he described it later in life as "little more than an undergraduate essay."

Oliver E. Williamson American economist

Oliver Eaton Williamson was an American economist, a professor at the University of California, Berkeley, and recipient of the 2009 Nobel Memorial Prize in Economic Sciences, which he shared with Elinor Ostrom.

In law and economics, the Coase theorem describes the economic efficiency of an economic allocation or outcome in the presence of externalities. The theorem states that if trade in an externality is possible and there are sufficiently low transaction costs, bargaining will lead to a Pareto efficient outcome regardless of the initial allocation of property. In practice, obstacles to bargaining or poorly defined property rights can prevent Coasean bargaining. This 'theorem' is commonly attributed to Nobel Prize winner Ronald Coase.

Douglass North American economist

Douglass Cecil North was an American economist known for his work in economic history. He was the co-recipient of the 1993 Nobel Memorial Prize in Economic Sciences. In the words of the Nobel Committee, North and Fogel "renewed research in economic history by applying economic theory and quantitative methods in order to explain economic and institutional change."

Social cost in neoclassical economics is the sum of the private costs resulting from a transaction and the costs imposed on the consumers as a consequence of being exposed to the transaction for which they are not compensated or charged. In other words, it is the sum of private and external costs. This might be applied to any number of economic problems: for example, social cost of carbon has been explored to better understand the costs of carbon emissions for proposed economic solutions such as a carbon tax.

The theory of the firm consists of a number of economic theories that explain and predict the nature of the firm, company, or corporation, including its existence, behaviour, structure, and relationship to the market.

In economics, the hold-up problem is central to the theory of incomplete contracts, and shows the difficulty in writing complete contracts. A hold-up problem arises when two factors are present:

  1. Parties to a future transaction must make noncontractible relationship-specific investments before the transaction takes place.
  2. The specific form of the optimal transaction cannot be determined with certainty beforehand.

Steven Ng-Sheong Cheung is an American economist who specializes in the fields of transaction costs and property rights, following the approach of new institutional economics. He achieved his public fame with an economic analysis on China open-door policy after the 1980s. In his studies of economics, he focuses on economic explanation that is based on real world observation. He is also the first to introduce concepts from the Chicago School of Economics, especially price theory, into China. In 2016, Cheung claimed to have written "1,500 articles and 20 books in Chinese" during his academic career.

New institutional economics (NIE) is an economic perspective that attempts to extend economics by focusing on the institutions that underlie economic activity and with analysis beyond earlier institutional economics and neoclassical economics. Unlike neoclassical economics, it also considers the role of culture and classical political economy in economic development.

Market (economics) System in which parties engage in transactions according to supply and demand

A market is a composition of systems, institutions, procedures, social relations or infrastructures whereby parties engage in exchange. While parties may exchange goods and services by barter, most markets rely on sellers offering their goods or services to buyers in exchange for money. It can be said that a market is the process by which the prices of goods and services are established. Markets facilitate trade and enable the distribution and resource allocation in a society. Markets allow any trade-able item to be evaluated and priced. A market emerges more or less spontaneously or may be constructed deliberately by human interaction in order to enable the exchange of rights of services and goods. Markets generally supplant gift economies and are often held in place through rules and customs, such as a booth fee, competitive pricing, and source of goods for sale.

Property rights are constructs in economics for determining how a resource or economic good is used and owned. Resources can be owned by individuals, associations, collectives, or governments. Property rights can be viewed as an attribute of an economic good. This attribute has three broad components and is often referred to as a bundle of rights in the United States:

  1. the right to use the good
  2. the right to earn income from the good
  3. the right to transfer the good to others, alter it, abandon it, or destroy it

Bargaining power is the relative ability of parties in an argumentative situation to exert influence over each other. If both parties are on an equal footing in a debate, then they will have equal bargaining power, such as in a perfectly competitive market, or between an evenly matched monopoly and monopsony.

"The Problem of Social Cost" (1960) by Ronald Coase, then a faculty member at the University of Virginia, is an article dealing with the economic problem of externalities. It draws from a number of English legal cases and statutes to illustrate Coase's belief that legal rules are only justified by reference to a cost–benefit analysis, and that nuisances that are often regarded as being the fault of one party are more symmetric conflicts between the interests of the two parties. If there are sufficiently low costs of doing a transaction, legal rules would be irrelevant to the maximization of production. Because in the real world there are costs of bargaining and information gathering, legal rules are justified to the extent of their ability to allocate rights to the most efficient right-bearer.

Market governance mechanisms (MGMs) are formal, or informal rules, that have been consciously designed to change the behaviour of various economic actors. This includes actors such as individuals, businesses, organisations and governments - who in turn encourage sustainable development.

Organizational economics involves the use of economic logic and methods to understand the existence, nature, design, and performance of organizations, especially managed ones.

In economic theory, the field of contract theory can be subdivided in the theory of complete contracts and the theory of incomplete contracts.