Transaction Costs

What are Transaction Costs?

Transaction costs are costs incurred that don’t accrue to any participant of the transaction. They are sunk costs resulting from economic trade in a market. In economics, the theory of transaction costs is based on the assumption that people are influenced by competitive self-interest.

At the highest level, only markets exist, and people in the economy are free to enter into contractual agreements with each other. Under such a viewpoint, the company exerts full control over the contract, which led economists to believe that contracts would be violated by different parties when they find an opportunity to do so. The aim of the transaction cost was to limit the authority of contractual relationships.

What Affects Transaction Costs?

Transaction costs in economies aim to clarify why some markets are able to accommodate many organizations while others are dominated only by a few, which are known as hierarchies. Oliver E. Williamson, who won the Noble prize for Economic Science in 2009, made an argument for the transformation of economies based on small transactions into one made of large hierarchies that transact among themselves.

In today’s economy, organizational development is dominated by hierarchies as it is a more efficient way to build relationships. Transaction cost economies consist of four elements:

1. There is a lot of uncertainty and unpredictability in the world.
2. With bargaining and asset specificity, organizations that enter into transactions find it expensive to leave them.
3. Individuals possess limited rationality, meaning they obtain and process limited information, and hence, have fewer options to choose from. Economic transactions are not based on pure rationality but on bounded rationality. Bounded rationality is a form of rationality where a person’s decision-making and rationality is limited by the amount of information available to them and the finite amount of time they have to make a decision.
4. The inherent opportunistic behavior of individuals in an economy makes it harder for contractual agreements to be enforced after a long period of time.

The four factors above collectively make it difficult to enter into contractual agreements at low costs, which led to the creation of transaction costs in the marketplace. Transaction cost economics argues that large firms maintain substituted contractual relationships with authoritative relationships. Entrepreneurs of large hierarchical organizations don’t need contractual agreements because they use organizational policies such as coercion, monitoring, and incentives to maintain control.

Types of Transaction Costs

The three types of transaction costs in real markets are:

1. Search and information costs

These are the costs associated with looking for relevant information and meeting with agents with whom the transaction will take place. The stock exchange is one such example, as they bring the buyers and sellers of financial assets together. The stockbroker’s fee is a type of information transaction cost.

2. Bargaining costs

These are the costs related to coming to an agreement that is agreeable to the parties involved in drawing up a contract. Bargaining costs can either be very cheap, such as buying a newspaper, or can be very expensive, such as trading a basketball player from one team to another.

3. Policing and enforcement costs

These are the costs associated with making sure that the parties in the contract keep their word and do not default on the terms of the contract. In the real world, people often deviate from the contract, and thus, enforcement costs are incurred while governing contracts. Lawyer fees are an example of such a cost.

Transaction Cost Economics (TCE)

Economists Ronald Coase and Oliver Williamson are credited for introducing and popularizing the concept of Transaction Cost Economics (TCE). The TCE theory explains the need for companies in a market. If markets operated in a perfect world, companies would not be needed, as market forces would provide the coordination and incentives needed for production activities.

However, in a real market, companies exist with hierarchies and exercise authority that allocates resources efficiently. Markets, on the other hand, use their bargaining power to allocate resources. The TCE theory states that a hierarchy can allocate resources more effectively, or efficiently, than a market due to imperfect information and bounded rationality.

Other Resources

Thank you for reading CFI’s guide to Transaction Costs. To keep advancing your career, the additional CFI resources below will be useful:

• Corporate Structure
• Loan Covenant
• Market Economy
• Opportunity Cost
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