Everything about Transaction Costs totally explained
In
economics and related disciplines, a
transaction cost is a
cost incurred in making an economic exchange. For example, most people, when buying or selling a
stock, must pay a commission to their
broker; that commission is a transaction cost of doing the stock deal. Or consider buying a banana from a store; to purchase the banana, your costs will be not only the price of the banana itself, but also the energy and effort it requires to find out which of the various banana products you prefer, where to get them and at what price, the cost of traveling from your house to the store and back, the time waiting in line, and the effort of the paying itself; the costs above and beyond the cost of the banana are the transaction costs. When rationally evaluating a potential transaction, it's important to consider transaction costs that might prove significant.
A number of kinds of transaction cost have come to be known by particular names:
- Search and information costs are costs such as those incurred in determining that the required good is available on the market, who has the lowest price, etc.
- Bargaining costs are the costs required to come to an acceptable agreement with the other party to the transaction, drawing up an appropriate contract and so on. In game theory this is analyzed for instance in the game of chicken.
- Policing and enforcement costs are the costs of making sure the other party sticks to the terms of the contract, and taking appropriate action (often through the legal system) if this turns out not to be the case.
History of development
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'd be performed on the
market. However, the term is actually absent from his early work up to the 1970s. While he didn't 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. The term "Transaction Costs" itself can instead be traced back to the monetary economics literature of the 1950s, and doesn't appear to have been consciously 'coined' by any particular individual.
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.
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. To Cheung, "transaction costs", if the term isn't so popular in economics literatures, should be called "institutional costs". But many economists seem to restrict the definition to exclude costs internal to an organization. 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.
A simple example
A supplier may bid in a competitive environment with a customer to build a widget. However, to make the widget, the supplier will be required to build specialized machinery which can't 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. Defence suppliers and the military appear to have the opposite problem, with cost overruns occurring quite often.
IT's relationship to transaction costs
Implementing a new
information technology is generally seen as a means for reducing the transaction costs of an
organization. However, in practice, implementing new
IT often results in higher transaction costs. This is because the amount of information that needs to be processed by the organization increases. This can result in
information overload.
Antonio Cordella and
Kai A. Simon call the cost of processing this information
coordination cost. If these costs exceed the benefits of IT, then the implementation becomes something negative and expensive
To reduce coordination costs, organizations can do one of two things:
Improve information processing capabilities. This can be done either through implementing new information systems or creating lateral relations.
Use IT to reduce the need for coordination through increased slack resources (which reduces the need for extreme precision) or increased reliance on self-contained tasks which provides more of the information to a single point of contact rather than requiring communications and coordination among multiple units. Notes
Further Information
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