Transactions Costs

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Transactions Costs

Changes in transactions can explain why trade was so limited prior to the last few hundred years and why the quality, complexity, and extent of trade have grown so rapidly over the past few centuries.

Generally we think of production in terms of the inputs—capital, labor, and natural resources. If you want to produce more bread, you need to grow more grain. But in the exchanges that result in bread arriving at your table, more is involved. Sometimes dozens of middlemen, various lawyers, numerous civil agencies, and other public authorities play a role in moving and permitting the "simple" trade of food for goods between two nations. These costs above and beyond the pure costs of production, which have to do with the measurement of the characteristics of the exchange, the costs of transportation, and the enforcement costs surrounding the creation and fulfillment of exchange contracts (whether formal or informal, explicit and written, or implicit and verbal), constitute transactions costs.

Trade throughout history has involved overcoming the problems posed by climate and geography. Much of the reduction in transactions costs hindering trade can be attributed to technological changes. Improved transport mechanisms, from the wheeled cart to the automobile and from the horse to the jet plane, have made possible and profitable the greater volumes of trade that most countries today take for granted. Similarly, improvements in storage and preservation have contributed to our ability to deal with the high transactions costs of exchanging goods between regions with different climates or separated by great distances. Improved communications technologies have also contributed by allowing us to know what is available and from whom.

Price and quantity as conventionally discussed are simplifications of the infinity of characteristics of real-world goods and services that make comparison difficult and hence limit exchange. Physical goods that are otherwise identical are not economically identical if the associated characteristics of their purchase or delivery are not similarly identical. For example, two pairs of pants may be virtually identical in cut, material, size, and brand, but if one is available for immediate purchase in a local store and the other must be ordered and sent from a warehouse 5,000 miles away, the two are not really the same goods. The costs of transportation and delivery obviously account for many of these differences. Sometimes information itself about a product's existence and the actual price it sells for is costly. And if the goods are not physically homogeneous, the complications of exchange are multiplied. Consider the difference between comparison shopping for a new car and comparison shopping for a used car: the latter trade is complicated by the fact that used cars from the same company and of the same vintage may be wildly divergent in condition, much more so than for new cars. Of course, the simplicity of a car purchase is a result of the success of modern-day procedures of standardization and quality control. It is important to remember that in earlier time periods with more primitive institutions of production and exchange, almost all transactions were at least as complicated, if not more so, than purchasing a used car is today.

To take a contemporary example, consider how the internet and the rise of online auction houses such as eBay have turned the neighborhood garage sales of yesteryear into national and even international phenomena, with tens of thousands of items a day being bought and sold. In this case, the rise of the World Wide Web has lowered the transactions costs of many exchanges to the point that there now exist markets that would have been unthinkable as recently as the early 1980s.

Many transactions costs are difficult to reduce because of social and institutional problems, including the uncertainty and unreliability of contracts and their enforcement. Absent a good system of property rights and a reliable mechanism of enforcement, trade between strangers historically has been understandably limited. Many governments lacked the power to guarantee contracts or to enforce and maintain law and order. Most trade throughout history has centered on personal exchange. Knowing the right people, or signaling that you knew the right people, affected both the profitability and the viability of even the most basic trades. Trade between kinsmen or people of the same religion, ethnicity, nationality, or race were commonplace because societies and individuals often had few other options for guaranteeing the reliability and regularity of exchanges.

Most rulers and states—always eager for revenue—saw trade as something to be taxed or regulated for their benefit, thus depressing or even eliminating these trades. One of the paradoxes explored by economists and economic historians has been the problem of credible commitment involved in the provision of public goods. For instance, a king needing money in times of war might seek to borrow funds from private citizens, but a king too weak to survive would be a poor risk. Conversely, a king strong enough to be certain of winning was often strong enough to renege on a contract and refuse to pay. The most successful nations have developed laws and institutions that curb such opportunism and hence lower transactions costs for all people through a variety of constitutional and legal checks and balances.

In today's world the difficulties of the poorest populations usually stem from the lack of the most basic legal and social institutions in their countries. The populations of the worst-off nations must struggle with extremely high transactions costs cutting them off from trades with people even in the same nation or region, and defeating individual efforts to rise out of poverty and misery. Technology can sometimes overcome the problem of inadequate institutions, but for the most part, the lack of effective institutions constitutes the continuing impediment to further material progress and often generates corrupt relations between individuals by destroying trust and making it impossible for strangers to participate easily. In contrast, the wealthiest nations have prospered by creating systems of anonymous exchange that allow people to conserve our personal relations for those situations we value most, while extending the benefits of commerce to the widest range of people possible.

SEE ALSO Market Integration.


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Williamson, Oliver, and Masten, Scott, eds. The Economics of Transactions Costs. New York: Edward Elgar, 1999.

John V. C. Nye