Economists use the term transaction cost to refer to costs arising from actions that hinder the ability of two (or more) individuals to achieve mutually desirable objectives or resolve disputes. Originally conceived as the costs of conducting market transactions, recognition that exchange and cooperation also take place within firms (between employers and employees), within legislatures (among politicians trading votes over preferred legislation), and even within families has led to the broadening of the term to include costs incurred in interactions within any institutional or organizational setting.
Transaction costs have been described broadly as “the costs of running the economic system” (Arrow 1970) and have been compared to the frictions that occur in mechanical systems (Williamson 1985, p. 19). Examples include costs arising out of such activities as discovering or communicating opportunities for trade (information, search, and marketing costs), of reaching and describing agreements (bargaining and contracting costs), and of making sure that agreements are honored (monitoring and enforcement costs). The concept also includes costs of litigation (to enforce property rights or contracts or to determine liability for an accident, for example), lobbying (to influence legislation), and the management or administration of firms and government agencies. Although transaction costs are distinguishable from production costs, unnecessary or excessive production costs incurred to improve one’s bargaining position, or to protect oneself from losses that would result if a trading partner reneged on a deal, are also appropriately regarded as transaction costs.
The logic for focusing on transaction costs derives from an observation by 1991 Nobel laureate Ronald Coase (subsequently dubbed “the Coase theorem”) that, were it not for transaction costs, all possible gains from trade and cooperation would be achieved through voluntary agreements regardless of the particular institutions, legal rules, or organizational forms in place. It follows that if institutions and organizational forms do matter, it must be because transaction costs are significant. And because transaction costs reduce the gains from trade and cooperation available to transactors, institutions and organizational forms that generate lower transaction costs will generally be preferred to alternatives with higher transaction costs.
Early use of transaction costs to explain observed institutional and organizational arrangements were often criticized on the grounds that because transaction costs can be difficult to measure—and cannot be observed at all for institutions and organization forms that are not adopted— claims that observed arrangements minimized transactions costs were easy to make and impossible to refute. If companies are observed producing their own inputs, it must be because the transaction costs of procuring those inputs on the market are too high; if legislators enact strict liability standards for product liability, it must be because a negligence rule would generate excessive transaction costs.
Beginning in the 1970s, economists, led by Oliver Williamson (1985), began to address this criticism by relating the size of transaction costs under different forms of organization to observable characteristics of transactions such as the complexity of the transaction and the degree to which transactions require investments that are “relationship specific,” that is, are designed or located for use in a particular relationship and consequently have a lower value if used for some other purpose. Since then, transaction cost reasoning has been applied to a wide array of organizational forms and institutions. Although its most extensive development has occurred in the analysis of the boundaries of firms and the design of contracts, the theory of transaction costs has also been used to explain the evolution of political institutions and legal rules and the implications of those structures for the economic performance of nations (North, 1991).
SEE ALSO Coase, Ronald; Coase Theorem; Economics, Institutional; Neoinstitutionalism; Organization Theory; Organizations; Transaction
Arrow, Kenneth J. 1970. The Organization of Economic Activity: Issues Pertinent to the Choice of Market versus Non-market Allocation. In Public Expenditure and Policy Analysis, eds. R. H. Haverman and J. Margolis, 51–73. Chicago, IL: Markham.
Coase, Ronald H. 1937. The Nature of the Firm. Economica 4 (16): 386–405.
Coase, Ronald H. 1960. The Problem of Social Cost. Journal of Law and Economics 3: 1–44.
North, Douglass C. 1991. Institutions. The Journal of Economic Perspectives 5 (1): 97–112.
Williamson, Oliver E. 1985. The Economic Institutions of Capitalism: Firms, Markets, Relational Contracting. New York: The Free Press.
Scott E. Masten