Transaction cost

In economics and related disciplines, a transaction cost is a cost incurred in making an economic exchange. 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: [cite journal|last=Dahlman|first=Carl J.|date=1979|title=The Problem of Externality|journal=Journal of Law and Economics|volume=21|issue=2|pages=141–162|issn=00222186|quote=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.]
* "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.
* "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.

History of development

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. 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.Robert Kissell and Morton Glantz, "Optimal Trading Strategies", AMACOM, 2003, pp. 1-23.]

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.

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".Steven N. S. Cheung "On the New Institutional Economics", "Contract Economics"] L. Werin and H. Wijkander (eds.), Basil Blackwell, 1992, pp. 48-65] But many economists seem to restrict the definition to exclude costs internal to an organization.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] 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. Defence suppliers and the military appear to have the opposite problem, with cost overruns occurring quite often.

IT's relationship to transaction costs

Implementing a new information technology is generally seen as a means for reducing the transaction costs of an organization. However, in practice, implementing new IT often results in higher transaction costsCordella, A. & Simon, K.A. (1997), 'The Impact of Information Technology on Transaction and Coordination Cost', Conference on Information Systems Research in Scandinavia (IRIS 20), Oslo, Norway, August 9-12] Cordella, Antonio (2006). Transaction costs and information systems: does IT add up?, Journal of Information Technology, 21, 195–202 [http://www.palgrave-journals.com/jit/journal/v21/n3/abs/2000066a.html] ] . This is because the amount of information that needs to be processed by the organization increases. This can result in information overload. Antonio Cordella and Kai A. Simon call the cost of processing this information coordination cost.Cordella, A. (2001), 'Does Information Technology Always Lead to Lower Transaction Costs?', The 9th European Conference on Information Systems, Bled, Slovenia, June 27-29] If these costs exceed the benefits of IT, then the implementation becomes something negative and expensive. (For an alternative view of coordination costs, see Malone, Yates, and Benjamin, 1987.)Malone, T. W., J. Yates and R. I. Benjamin (1987), "Electronic Markets and Electronic Hierarchies," Communications of the ACM, 30, 484-497]

To reduce coordination costs, organizations can do one of two things:
# Improve information processing capabilities. This can be done either through implementing new information systems or creating lateral relations.Galbraith, J. A. (1973), Designing Complex Organizations, Addison-Wesley Longman Publishing Co., Inc., Boston, MA.]
# Use IT to reduce the need for coordination through increased slack resources (which reduces the need for extreme precision) or increased reliance on self-contained tasks which provides more of the information to a single point of contact rather than requiring communications and coordination among multiple units. The decreased amount of information to process means lower coordination costs and lower transaction costs.]

Technologies like enterprise resource planning (ERP) can provide technical support for these strategies.

Notes

References

* Cheung, Steven N. S. (1987). “economic organization and transaction costs," "The ", v. 2, pp. 55-58.
* Niehans, Jürg (1987). “transaction costs," "The New Palgrave: A Dictionary of Economics", v. 4, pp. 677-80.
* Coase, Ronald H. (1937). "The Nature of the Firm." "Economica", N.S., 4(16), pp. [http://www.cerna.ensmp.fr/Enseignement/CoursEcoIndus/SupportsdeCours/COASE.pdf 386-405.]
* _____. (1960). "The Problem of Social Cost," "Journal of Law and Economics", 3: pp. [http://www.sfu.ca/~allen/CoaseJLE1960.pdf 1-44.]
* Williamson, Oliver E. (1981). The Economics of Organization: The Transaction Cost Approach. "The American Journal of Sociology", 87(3), p [http://www.jstor.org/pss/2778934 p, 548] -577.
* _____. (1985). "The Economic Institutions of Cpitalism: Firms, Markets, Relational Contracting". [http://www.sp.uconn.edu/~langlois/Williamson%20(1985),%20chapter%201.pdf Preview to p. 25.] New York, NY: Free Press.
* _____. (1996). "The Mechanisms of Governance". [http://books.google.com/books?hl=en&lr=&id=meERBVysP6YC&oi=fnd&pg=PA3&dq=Williamson,+Oliver+E.++%22Mechanisms+of+Governance%22&ots=0qUSo2k08z&sig=lBumF_65WefRE_-rSV3SWDbT6ng#PPA16,M1 Preview.] Oxford University Press.

See also

* Switching costs
* Economic anthropology
* Property rights (economics)

External links

* [http://www.encycogov.com/B11TransactionCostEconomics.asp Transaction cost economics]
* [http://www.instant-science.net Coordination Costs (follow the "Publications" link, where you can download Reference 5)]
* [http://www.ecsocman.edu.ru/images/pubs/2003/03/14/0000065779/bibl_harvey.doc Annotated Bibliography on Transaction Cost Economics]