What is a Transaction Cost
Defining the base function of economic exchange
This blog has discussed the concept of transaction costs frequently, without ever having explained the term — this entry will remedy that mistake.
The analysis of the transaction cost must begin with the first principle — the transaction. The study of economics is the study of human interaction through mutual exchange. This foundation levels the base unit of economics to be not commodities or prices, but the transactions itself.
“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.”
The transaction is a product of context. The most thorough economic analyses are ones where the situational context of transactions between individuals, groups or firms is considered.
This is a difficult task for any research to undertake. Even the most simple scenarios are actually complex. Consider the case of two individuals attempting to exchange a laptop computer for an undecided sum of money. The conditions for an exchange to occur have much more depth than to simply say, “one wants to sell and one wants to buy.”
For that laptop computer to be sold, it must first be assumed that the seller possesses the proper freedom and right to sell the laptop. Further, there must exist an institutional structure such that the physical taking of the laptop by the purchasing party without proper compensation will be punished above the value of the laptop to the potential purchaser. Here again, we encounter an assumptive value whereby the nominal value of the punishment for stealing must exceed the maximum price a buyer would be willing to pay for the laptop when the act of stealing the laptop is already under consideration.
This is just the institutional support for exchange. Absent these considerations, for both parties to agree to exchange the laptop, there must necessarily be a disagreement on the value of the laptop itself. This is the assumption of mutual benefit in economics.
For the laptop to be exchanged, the price the buyer is willing to pay must exceed the value of the seller continuing to use the laptop for his or her own. on the other side of the transaction, the price the buyer would be willing to pay for the laptop will be equal or lower than the value the laptop has to the buyer. Each individual must perceive themselves as the surplus holder within the transaction for an exchange to take place.
This is yet another example of subjective value at work. The price agreed upon between two parties is both relatively high and low at once. If the price were equal between the two parties, the transaction would not occur — each party would think they are getting the short end of it.
All of this is to suggest that, as a base unit of analysis, the transaction is complex and subjective in at least two perspectives. This complexity requires that any analysis of a market boil down to one question: what are the conditions for free exchange to occur in this market?
Those conditions, whatever they may ultimately be, are subject to their own set of conditions, and those their own, and so on. What becomes clear rather quickly is that, for any exchange to occur, certain conditions must exist both internal and external (institutional context) to the exchange itself. Because those conditions are varying degrees of malleable, and because any of those potential conditions may destabilize a given exchange, there exists some situational cost for every transaction.
This situational cost is, essentially, the cost of participating in the market. These are transaction costs. What exactly transaction costs are and what their normative value is must be discovered on a case-by-case basis, but speaking generally, transaction costs are ancillary items that concern the means of acquiring or offering any good or service rather than the final price itself. That final price is a product of the transaction costs present in an exchange, but not necessarily derivative of it. Final prices are a function of the subjective valuations of the parties engaged in an exchange, but transaction costs may impact each subjective valuation independently, and therefore may impact final prices while not acting as an effective predictor of final prices.
“It was to realize that there were costs of using the pricing mechanism. What the prices are have to be discovered. There are negotiations to be undertaken, contracts to be drawn up, inspections to be made, arrangements to be made to settle disputes, and so on. These costs have come to be known as transaction costs.”
Markets are dynamic, they tend toward an equilibrium state as Wile E. Coyote tends toward the roadrunner. To continue the analogy, prices and constant subjective valuations are the tools at Wile E.’s disposal. Transaction costs are the rules the writers are subject to. That institutional structure outlining the interactions that may take place and the speed or ease at which our conniving coyote may pursue his elusive meal. Some of that structure is malleable, some of that structure is baked in, all of it impacts Wile E. Coyote.
In a sense, transaction costs describe the context of any given exchange. Because these are situational, any given transaction cost has many potential derivatives. Legal fees for contract writing are a transaction cost. But those fees are dependent on the hours it takes for lawyers to research and write the contract. Those hours are dependent on the knowledge and experience of any given firm’s lawyers. The exact legal fees are a product of the research and selection process an individual or firm undertook to select the law firm. And on it goes.
This domino-style consideration of transaction costs is why they are so difficult to encapsulate numerically. Even the most rigorous investigation into the potential transaction costs for any given exchange is likely to be incomplete. Instead, the consideration of transaction costs ought to be one of general awareness and the exploration of how any institutional action may impact them. And why legislatures should be extraordinarily cautious when considering regulations that may positively impact transaction costs.
Transaction costs are everywhere because they define the very contexts markets exist in and the potential exchange conditions for each party in a given transaction. They are potentially incalculable, and may therefore be incredibly large. Within the market, they are lubricants when controlled and abrasives when left unchecked. Because transactions are the basis of economic analysis, implicit or explicit consideration of transaction costs is vital to substantive research — and ought to be assessed more often in policy discussions.
