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In economics and related disciplines, a transaction cost is a cost incurred in making an economic exchange (restated: the cost of participating in a market). For example, most people, when buying or selling a stock, must pay a commission to their broker; that commission is a transaction cost of doing the stock deal. Or consider buying a banana from a store; to purchase the banana, your costs will be not only the price of the banana itself, but also the energy and effort it requires to find out which of the various banana products you prefer, where to get them and at what price, the cost of traveling from your house to the store and back, the time waiting in line, and the effort of the paying itself; the costs above and beyond the cost of the banana are the transaction costs. When rationally evaluating a potential transaction, it is important to consider transaction costs that might prove significant.

A number of kinds of transaction cost have come to be known by particular names:[1]

  • Search and information costs are costs such as those incurred in determining that the required good is available on the market, who 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.

Contents

History of development

The model 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 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.[2]

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 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. To Cheung, "transaction costs", if the term is not so popular in economics literatures, should be called "institutional costs".[3][4] But many economists seem to restrict the definition to exclude costs internal to an organization.[5] 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 simple example

A supplier may bid in a 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.

Notes

  1. ^ Dahlman, Carl J. (1979). "The Problem of Externality". Journal of Law and Economics 21 (2): 141–162. ISSN 00222186. "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.".  
  2. ^ Robert Kissell and Morton Glantz, Optimal Trading Strategies, AMACOM, 2003, pp. 1-23.
  3. ^ Steven N. S. Cheung "On the New Institutional Economics", Contract Economics
  4. ^ L. Werin and H. Wijkander (eds.), Basil Blackwell, 1992, pp. 48-65
  5. ^ 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

References

  • Cheung, Steven N. S. (1987), Economic organization and transaction costs, The New Palgrave: A Dictionary of Economics v. 2,, pp. 55–58  
  • Niehans, Jürg (1987). “Transaction costs," The New Palgrave: A Dictionary of Economics, v. 4, pp. 677–80.
  • Coase, Ronald (1937). "The Nature of the Firm". Economica 4 (16): 386-405.  
  • Coase, Ronald (1960). "The Problem of Social Cost". Journal of Law and Economics 3: 1-44.  
  • Williamson, Oliver E. (1981). The Economics of Organization: The Transaction Cost Approach. The American Journal of Sociology, 87(3), 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.
  • Milgrom, P., and J. Roberts, “Bargaining Costs, Influence Costs, and the Organization of Economic Activity,” in J.E. Alt and K.A. 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. http://books.google.com/books?id=cCi3AAAAIAAJ.  

See also

External links

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