Transaction cost

In economics and related disciplines, a transaction cost is a cost in making any economic trade when participating in a market.[1]

In Transaction Costs, Institutions and Economic Performance (1992), Douglass C. North argues that institutions, 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.[2]

Douglass North states that there are four factors that comprise transaction costs – "measurement," "enforcement," "ideological attitudes and perceptions," and "the size of the market."[2] Measurement refers to the calculation of the value of all aspects of the good or service involved in the transaction.[2] 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.[2] These first two factors appear in the concept of ideological attitudes and perceptions, North's third aspect of transaction costs.[2] Ideological attitudes and perceptions encapsulate each individual's set of values, which influences their interpretation of the world.[2] The final aspect of transaction costs, according to North, is market size, which affects the partiality or impartiality of transactions.[2]

Transaction costs can be divided into three broad categories:[3]

  • 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 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.

History of development

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, Vol.21, pp.648-657, 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.[4]

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, one of the most cited social scientist at the turn of the century,[5] was awarded the 2009 Nobel Memorial Prize in Economics.[6]

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".[7][8] But many economists seem to restrict the definition to exclude costs internal to an organization.[9] 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.

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.[10] Enforcement, the second of North's factors of transaction costs, is exemplified in Diego Gambetta'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.[11] Measurement and enforcement comprise North's third factor, ideological attitudes and perceptions – each individual's views influence how they go about each transaction.[2]

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:

ItemNeoclassical microeconomicsTransaction cost economics
Behavioural assumptions[12]Assumes hyperrationality and ignores most of the hazards related to opportunismAssumes bounded rationality
Unit of analysisConcerned with composite goods and servicesAnalyzes the transaction itself
Governance structureDescribes the firm as a production function (a technological construction)Describes the firm as a governance structure (an organizational construction)
Problematic property rights and contractsOften assumes that property rights are clearly defined and that the cost of enforcing those rights by the means of courts is negligibleTreats property rights and contracts as problematic
Discrete structural analysisUses continuous marginal modes of analysis in order to achieve second-order economizing (adjusting margins)Analyzes the basic structures of the firm and its governance in order to achieve first-order economizing (improving the basic governance structure)
RemediablenessRecognizes profit maximization or cost minimization as criteria of efficiencyArgues 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
Imperfect MarketsDownplays the importance of imperfect marketsRobert Almgren and Neil Chriss, and later Robert Almgren and Tianhui Li, showed that the effects of transaction costs lead portfolio managers and options traders to deviate from neoclassically optimal portfolios extending the original analysis to derivative markets.[13][14]

Game theory

In game theory, transaction costs have been studied by Anderlini and Felli (2006).[15] 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 powers 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.[16][17]

See also


  1. Buy-side Use TCA to Measure Execution Performance, FIXGlobal, June 2010
  2. North, Douglass C. 1992. “Transaction costs, institutions, and economic performance.” San Francisco, CA: ICS Press.
  3. Dahlman, Carl J. (1979). "The Problem of Externality". Journal of Law and Economics. 22 (1): 141–162. doi:10.1086/466936. 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.
  4. Robert Kissell and Morton Glantz, Optimal Trading Strategies, AMACOM, 2003, pp. 1-23.
  5. Pessali, Huascar F. (2006). "The rhetoric of Oliver Williamson's transaction cost economics". Journal of Institutional Economics. 2 (1): 45–65. doi:10.1017/s1744137405000238. ISSN 1744-1382.
  6. 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
  7. Steven N. S. Cheung "On the New Institutional Economics", Contract Economics
  8. L. Werin and H. Wijkander (eds.), Basil Blackwell, 1992, pp. 48-65
  9. Harold Demsetz (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
  10. Olson, Mancur (September 1993). "Dictatorship, Democracy, and Development". The American Political Science Review. 87 (3): 567–576. doi:10.2307/2938736. JSTOR 2938736.
  11. Gambetta, Diego (1996). The Sicilian Mafia: the Business of Private Protection. Harvard University Press. p. 15. ISBN 978-0674807426.
  12. Pessali, Huascar F. (2009-09-01). "Metaphors of Transaction Cost Economics". Review of Social Economy. 67 (3): 313–328. CiteSeerX doi:10.1080/00346760801933393. ISSN 0034-6764.
  13. R.Almgren and N.Chriss, "Optimal execution of portfolio transactions" J. Risk, 3 (Winter 2000/2001) pp.5–39
  14. Robert Almgren; Tianhui Li (2016). "Option Hedging with Smooth Market Impact". Market Microstructure and Liquidity. 2: 1650002. doi:10.1142/S2382626616500027.
  15. Anderlini, Luca; Felli, Leonardo (2006). "Transaction Costs and the Robustness of the Coase Theorem*". The Economic Journal. 116 (508): 223–245. doi:10.1111/j.1468-0297.2006.01054.x. ISSN 1468-0297.
  16. Müller, Daniel; Schmitz, Patrick W. (2016). "Transaction costs and the property rights approach to the theory of the firm". European Economic Review. 87: 92–107. doi:10.1016/j.euroecorev.2016.04.013.
  17. Schmitz, Patrick W. (2016). "The negotiators who knew too much: Transaction costs and incomplete information". Economics Letters. 145: 33–37. doi:10.1016/j.econlet.2016.05.009.


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