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Transaction cost

transaction cost economics, transaction costs
In economics and related disciplines, a transaction cost is a cost incurred in making an economic exchange of some sort, or in other words the cost of participating in a market

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 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 On asset markets and in market microstructure, the transaction cost is some function of the distance between the bid and ask
  • 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

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


  • 1 History of development
  • 2 Examples
  • 3 Differences from Neoclassical Microeconomics
  • 4 See also
  • 5 Notes
  • 6 References
  • 7 External links

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

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, Vol21, pp648-657, 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, 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

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 was awarded the 2009 Nobel Memorial Prize in Economics

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" 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 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

Differences from Neoclassical Microeconomics

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

  • Behavioral assumptions: whereas neoclassical theory assumes hyperrationality and ignores most of the hazards related to opportunism, TCE assumes bounded rationality
  • Unit of analysis: whereas neoclassical theory is concerned with composite goods and services, TCE analyzes the transaction itself
  • Governance structure: whereas neoclassical theory describes the firm as a production function a technological construction, TCE describes it as a governance structure an organizational construction
  • Problematic property rights and contracts: whereas neoclassical theory often assumes that property rights are clearly defined and the cost of enforcing those rights by the mean of courts is negligible, TCE treats property rights and contracts as problematic
  • Discrete structural analysis: whereas neoclassical theory uses continuous marginal modes of analysis in order to achieve second-order economizing adjusting margins, TCE analyzes the basic structures of the firm and its governance in order to achieve first-order economizing improving the basic governance structure
  • Remediableness: whereas neoclassical theory recognizes profit maximization or cost minimization as criteria of efficiency, TCE insists 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

See also

  • Diseconomy of scale
  • Economic anthropology
  • Property rights economics
  • Herbert A Simon
  • Switching costs
  • Theory of the firm
  • Market maker
  • Transaction Cost Analysis
  • Market impact cost


  1. ^ Buy-side Use TCA to Measure Execution Performance, FIXGlobal, June 2010
  2. ^ Dahlman, Carl J 1979 "The Problem of Externality" Journal of Law and Economics 22 1: 141–162 doi:101086/466936 ISSN 0022-2186 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 
  3. ^ Robert Kissell and Morton Glantz, Optimal Trading Strategies, AMACOM, 2003, pp 1-23
  4. ^ 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
  5. ^ Steven N S Cheung "On the New Institutional Economics", Contract Economics
  6. ^ L Werin and H Wijkander eds, Basil Blackwell, 1992, pp 48-65
  7. ^ Harold Demsetz 2003 “Ownership and the Externality Problem” In T L Anderson and F S McChesney eds Property Rights: Cooperation, Conflict, and Law Princeton, NJ: Princeton University Press


  • Cheung, Steven N S 1987 "Economic organization and transaction costs" The New Palgrave: A Dictionary of Economics v 2,: 55–58 
  • Commons, JR 1931 "Institutional Economics" American Economic Review 21: 648–657 Retrieved February 8, 2013 
  • Douma, Sytse; Schreuder, Hein 2012 Economic Approaches to Organizations 5th ed London: Pearson ISBN 9780273735298 
  • Klaes, M 2008 "transaction costs, history of," The New Palgrave Dictionary of Economics, 2nd Edition Abstract
  • Niehans, Jürg 1987 “Transaction costs," The New Palgrave: A Dictionary of Economics, v 4, pp 677–80
  • Pierre Schlag, The Problem of Transaction Costs, 62 Southern California Law Review 1661 1989
  • Coase, Ronald 1937 "The Nature of the Firm" Economica 4 16: 386–405 doi:101111/j1468-03351937tb00002x 
  • Coase, Ronald 1960 "The Problem of Social Cost" Journal of Law and Economics 3: 1–44 doi:101086/466560 
  • Williamson, Oliver E 1981 "The Economics of Organization: The Transaction Cost Approach," The American Journal of Sociology, 873, 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, 163, pp 171-195
  • Milgrom, P, and J Roberts, "Bargaining Costs, Influence Costs, and the Organization of Economic Activity," in JE Alt and KA Shepsle eds, Perspectives on Positive Political Economy, Cambridge: University of Cambridge, 1990, 57-89
  • Milgrom, P; Roberts, J 1992 Economics, Organization and Management Englewood Cliffs, NJ: Prentice-Hall ISBN 978-0-13-224650-7 

External links

  • Transaction cost economics
  • Coordination Costs follow the "Publications" link, where you can download Reference 5

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