economics Economics () is the social science that studies the Production (economics), production, distribution (economics), distribution, and Consumption (economics), consumption of goods and services. Economics focuses on the behaviour and intera ...

and related disciplines, a transaction cost is a

cost In production, research, retail, and accounting, a cost is the value of money that has been used up to produce something or deliver a service, and hence is not available for use anymore. In business, the cost may be one of acquisition, in which ...

in making any economic

trade Trade involves the transfer of goods and services from one person or entity to another, often in exchange for money. Economists refer to a system or network that allows trade as a market. An early form of trade, barter, saw the direct excha ...

when participating in a

market Market is a term used to describe concepts such as: *Market (economics), system in which parties engage in transactions according to supply and demand *Market economy *Marketplace, a physical marketplace or public market Geography *Märket, an ...

Oliver E. Williamson Oliver Eaton Williamson (September 27, 1932 – May 21, 2020) 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 Ostro ...

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.

's ''Transaction Cost Economics'' popularized the concept of transaction costs. Douglass C. North argues that

institution Institutions are humanly devised structures of rules and norms that shape and constrain individual behavior. All definitions of institutions generally entail that there is a level of persistence and continuity. Laws, rules, social conventions a ...

s, 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 Economic growth can be defined as the increase or improvement in the inflation-adjusted market value of the goods and services produced by an economy in a financial year. Statisticians conventionally measure such growth as the percent rate of ...

.North, Douglass C. 1992. “Transaction costs, institutions, and economic performance.” San Francisco, CA: ICS Press. Douglass North states that there are four factors that comprise transaction costs – "measurement", "enforcement", "ideological attitudes and perceptions", and "the size of the market". ''Measurement'' refers to the calculation of the value of all aspects of the good or service involved in the transaction. ''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. These first two factors appear in the concept of ''ideological attitudes and perceptions'', North's third aspect of transaction costs. Ideological attitudes and perceptions encapsulate each individual's set of values, which influences their interpretation of the world. The final aspect of transaction costs, according to North, is ''market size'', which affects the partiality or impartiality of transactions. Transaction costs can be divided into three broad categories: * '' Search and information costs'' are costs such as in determining that the required good is available on the market, which has the lowest price, etc. *''Bargaining and decision costs'' are the costs required to come to an acceptable agreement with the other party to the transaction, drawing up an appropriate

contract A contract is a legally enforceable agreement between two or more parties that creates, defines, and governs mutual rights and obligations between them. A contract typically involves the transfer of goods, services, money, or a promise to tran ...

and so on. In

game theory Game theory is the study of mathematical models of strategic interactions among rational agents. Myerson, Roger B. (1991). ''Game Theory: Analysis of Conflict,'' Harvard University Press, p.&nbs1 Chapter-preview links, ppvii–xi It has appli ...

this is analyzed for instance in the

game of chicken The game of chicken, also known as the hawk–dove game or snowdrift game, is a model of conflict for two players in game theory. The principle of the game is that while the ideal outcome is for one player to yield (to avoid the worst outcome if ...

. On asset markets and in

organizational economics Organizational economics (also referred to as ''economics of organization'') involves the use of economic logic and methods to understand the existence, nature, design, and performance of organizations, especially managed ones. Organizational eco ...

, the transaction cost is some function of the distance between the

supply and demand In microeconomics, supply and demand is an economic model of price determination in a Market (economics), market. It postulates that, Ceteris paribus, holding all else equal, in a perfect competition, competitive market, the unit price for a ...

. * ''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 The contemporary national legal systems are generally based on one of four basic systems: civil law, common law, statutory law, religious law or combinations of these. However, the legal system of each country is shaped by its unique history an ...

) if this turns out not to be the case. 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 idea that transactions form the basis of an economic thinking was introduced by the institutional economist

John R. Commons John Rogers Commons (October 13, 1862 – May 11, 1945) was an American institutional economist, Georgist, progressive and labor historian at the University of Wisconsin–Madison. Early years John R. Commons was born in Hollansburg, Ohio on ...

(1931). He said that: The term "transaction cost" is frequently thought to have been coined by

Ronald Coase Ronald Harry Coase (; 29 December 1910 – 2 September 2013) was a British economist and author. Coase received a bachelor of commerce degree (1932) and a PhD from the London School of Economics, where he was a member of the faculty until 1951. ...

, 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

. 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 "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. ...

'', 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. And refers to the "Costs of Market Transactions" in his seminal work, ''

The Problem of Social Cost "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 Coa ...

'' (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.

Robert Kissell The name Robert is an ancient Germanic given name, from Proto-Germanic "fame" and "bright" (''Hrōþiberhtaz''). Compare Old Dutch ''Robrecht'' and Old High German ''Hrodebert'' (a compound of '' Hruod'' ( non, Hróðr) "fame, glory, honou ...

and

Morton Glantz Morton may refer to: People * Morton (surname) * Morton (given name) Fictional * Morton Koopa, Jr., a character and boss in ''Super Mario Bros. 3'' * A character in the ''Charlie and Lola'' franchise * A character in the 2008 film ''Horton He ...

, ''Optimal Trading Strategies'', AMACOM, 2003, pp. 1-23. Arguably, transaction cost reasoning became most widely known through

'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 Trade involves the transfer of goods and services from one person or entity to another, often in exchange for money. Economists refer to a system or network that allows trade as a market. An early form of trade, barter, saw the direct exchan ...

and

selling Sales are activities related to selling or the number of goods sold in a given targeted time period. The delivery of a service for a cost is also considered a sale. The seller, or the provider of the Goods and services, goods or services, c ...

, but also day-to-day emotional interactions, informal

gift A gift or a present is an item given to someone without the expectation of payment or anything in return. An item is not a gift if that item is already owned by the one to whom it is given. Although gift-giving might involve an expectation ...

exchanges, etc. Oliver E. Williamson, one of the most cited social scientist at the turn of the century, was awarded the 2009

Nobel Memorial Prize in Economics The Nobel Memorial Prize in Economic Sciences, officially the Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel ( sv, Sveriges riksbanks pris i ekonomisk vetenskap till Alfred Nobels minne), is an economics award administered ...

. 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 Steven Ng-Sheong Cheung ( born December 1, 1935) is a Hong Kong-born 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 wi ...

as any costs that are not conceivable in a "

Robinson Crusoe ''Robinson Crusoe'' () is a novel by Daniel Defoe, first published on 25 April 1719. The first edition credited the work's protagonist Robinson Crusoe as its author, leading many readers to believe he was a real person and the book a tra ...

economy"—in other words, any costs that arise due to the existence of

s. For Cheung, if the term "transaction costs" were not already so popular in economics literatures, they should more properly be called "institutional costs".Steven N. S. Cheung "On the New Institutional Economics", ''Contract Economics''L. Werin and H. Wijkander (eds.), Basil Blackwell, 1992, pp. 48-65 But many economists seem to restrict the definition to exclude costs internal to an organization.

Harold Demsetz Harold Demsetz (; May 31, 1930 – January 4, 2019) was an American professor of economics at the University of California at Los Angeles (UCLA). Career Demsetz grew up on the West Side of Chicago, the grandchild of Jewish immigrants from central ...

(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 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,

franchise Franchise may refer to: Business and law * Franchising, a business method that involves licensing of trademarks and methods of doing business to franchisees * Franchise, a privilege to operate a type of business such as a cable television p ...

s, etc.) minimize the transaction costs of producing and distributing a particular good or service. Often these relationships are categorized by the kind of

involved. This approach sometimes goes under the rubric of

new institutional economics New Institutional Economics (NIE) is an economic perspective that attempts to extend economics by focusing on the institutions (that is to say the sociology, social and legal Norm (sociology), norms and rules) that underlie economic activity and ...

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

Examples

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 A monopoly (from Greek language, Greek el, μόνος, mónos, single, alone, label=none and el, πωλεῖν, pōleîn, to sell, label=none), as described by Irving Fisher, is a market with the "absence of competition", creating a situati ...

monopsony In economics, a monopsony is a market structure in which a single buyer substantially controls the market as the major purchaser of goods and services offered by many would-be sellers. The microeconomic theory of monopsony assumes a single entity ...

relationship, known as a

bilateral monopoly A bilateral monopoly is a market structure consisting of both a monopoly (a single seller) and a monopsony (a single buyer). Overview In a standard monopoly structure, the monopolist sells to multiple buyers with no market power, thereby giving t ...

. 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 Enterprise resource planning (ERP) is the integrated management of main business processes, often in real time and mediated by software and technology. ERP is usually referred to as a category of Business management tools, business management ...

(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. Enforcement, the second of North's factors of transaction costs, is exemplified in

Diego Gambetta Diego Gambetta (; born 1952) is an Italian-born social scientist. He is a professor of social theory at the European University Institute in Florence, a Carlo Alberto Chair at the Collegio Carlo Alberto in Turin, and an official fellow at Nuffie ...

'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. Measurement and enforcement comprise North's third factor, ideological attitudes and perceptions – each individual's views influence how they go about each transaction.

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: The transaction costs frameworks reject the notion of

instrumental rationality "Instrumental" and "value rationality" are terms scholars use to identify two ways individuals act in order to optimize their behavior . Instrumental rationality recognizes means that "work" efficiently to achieve ends. Value rationality recogni ...

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).

Game theory

In game theory, transaction costs have been studied by Anderlini and Felli (2006). 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 power Bargaining power is the relative ability of parties in an argumentative situation (such as bargaining, contract writing, or making an agreement) to exert influence over each other. If both parties are on an equal footing in a debate, then they w ...

s 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 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. Firms are key drivers in econ ...

Evaluative mechanisms

(1979) stated that evaluative mechanisms consist of four variables, namely, frequency of exchange, asset specificity, uncertainty, and threat of opportunism. * Frequency of exchange refers to buyer activity in the market or the frequency of transactions between the parties occurs. The higher the frequency of transactions, the higher the relative administrative and bargaining costs. * Asset specificity consist of site, physical asset, and human asset specificity. The asset specific investment is a specialized investment, which does not have market liquidity. Once the contract is terminated, the asset specific investment cannot to be redeployed. Therefore, a change or termination of this transaction will result in significant loss. * Uncertainty refers to the risks that may occur in a market exchange. The increase of environmental uncertainty will be accompanied by the increase of transaction cost, such as information acquisition cost, supervision cost and bargaining cost. * Threat of opportunism is attributed to human nature. Opportunistic behavior of vendors can lead to higher transaction coordination costs or even termination of contracts. A company can use governance mechanism to reducing the threat of opportunism.

Notes

References

* North, Douglass C. 1992. “Transaction costs, institutions, and economic performance.” San Francisco, CA: ICS Press. * *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 An International Standard Serial Number (ISSN) is an eight-digit serial number used to uniquely identify a serial publication, such as a magazine. The ISSN is especially helpful in distinguishing between serials with the same title. ISSNs ...

2160-6544. * * *Ketokivi, Mikko; Mahoney, Joseph T. (2017-10-26). "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. Retrieved 2020-11-01. * Klaes, M. (2008). "transaction costs, history of," ''

The New Palgrave Dictionary of Economics ''The New Palgrave Dictionary of Economics'' (2018), 3rd ed., is a twenty-volume reference work on economics published by Palgrave Macmillan. It contains around 3,000 entries, including many classic essays from the original Inglis Palgrave Diction ...

'', 2nd Edition
Abstract.
* Niehans, Jürg (1987). “Transaction costs," ''The New Palgrave: A Dictionary of Economics'', v. 4, pp. 677–80. * Pierre Schlag
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62 Southern California Law Review 1661 (1989). * * * Williamson, Oliver E. (1981). "The Economics of Organization: The Transaction Cost Approach," ''The American Journal of Sociology'', 87(3), pp
548-577
* _____ (1985). ''The Economic Institutions of Capitalism: Firms, Markets, Relational Contracting''
Preview to p. 25.
New York, NY: Free Press. * _____ (1996). ''The Mechanisms of Governance''
Preview.
Oxford University Press. * _____ (2002). "The Theory of the Firm as Governance Structure: From Choice to Contract," ''Journal of Economic Perspectives'', 16(3), pp
171-195.
* Milgrom, P., and J. Roberts, "Bargaining Costs, Influence Costs, and the Organization of Economic Activity," in J.E. Alt and K.A. Shepsle (eds.), Perspectives on Positive Political Economy, Cambridge: University of Cambridge, 1990, 57-89. * *Young, Suzanne (2013). "Transaction Cost Economics". ''Springer Link''. doi:10.1007/978-3-642-28036-8_221. Retrieved 2020-11-01. {{Authority control Costs Production economics New institutional economics