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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).[1]

Transaction costs can be divided into three broad categories:[2]

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

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[edit]

The pool 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 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. CommonsInstitutional 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.[3]

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 Memorial Prize in Economics[4]

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".[5][6] But many economists seem to restrict the definition to exclude costs internal to an organization.[7] 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 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.

Differences from Neoclassical Microeconomics[edit]

Williamson argues in The Mechanisms of Governance (1996) that Transaction Cost Economics (TCE) differs from neoclassical microeconomics in the following six points:

  • Behavioral assumptions: whereas neoclassical theory assumes hyperrationality and ignores most of the hazards related to opportunism, TCE assumes bounded rationality.
  • Unit of analysis: whereas neoclassical theory is concerned with composite goods and services, TCE analyzes the transaction itself.
  • Governance structure: whereas neoclassical theory describes the firm as a production function (a technological construction), TCE describes it as a governance structure (an organizational construction).
  • Problematic property rights and contracts: whereas neoclassical theory often assumes that property rights are clearly defined and the cost of enforcing those rights by the mean of courts is negligible, TCE treats property rights and contracts as problematic.
  • Discrete structural analysis: whereas neoclassical theory uses continuous marginal modes of analysis in order to achieve second-order economizing (adjusting margins), TCE analyzes the basic structures of the firm and its governance in order to achieve first-order economizing (improving the basic governance structure).
  • Remediableness: whereas neoclassical theory recognizes profit maximization or cost minimization as criteria of efficiency, TCE insists 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.

See also[edit]


  1. ^ Buy-side Use TCA to Measure Execution Performance, FIXGlobal, June 2010
  2. ^ 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." 
  3. ^ Robert Kissell and Morton Glantz, Optimal Trading Strategies, AMACOM, 2003, pp. 1-23.
  4. ^ 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
  5. ^ Steven N. S. Cheung "On the New Institutional Economics", Contract Economics
  6. ^ L. Werin and H. Wijkander (eds.), Basil Blackwell, 1992, pp. 48-65
  7. ^ 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


External links[edit]

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FX Week (subscription)

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The need to demonstrate best execution has increased attention on the price paid by buy-side customers to their banks and brokers for executing orders, and while the idea of transaction cost analysis (TCA) originates from equity markets is fast gaining ...

Economic Times

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Tue, 22 Jul 2014 06:18:45 -0700

"We certainly feel that through this agreement, we will be able to see a significant reduction in the transaction cost involved in trading across borders. This is good for both trade and enterprise in India and we expect the government to take a ...

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Thu, 31 Jul 2014 15:07:30 -0700

... remittances due to poor money transfer infrastructure adding: "The Financial Action Task Force upgraded the country's anti money laundering and counter terrorism finance regime two months ago. "Country risk is a major contributor to high ...

Financial Express

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Ahead of a meeting that is likely to decide on India's stand on World Trade Organisation (WTO) Bali agreement, industry body Federation of Indian Chambers of Commerce and Industry (Ficci) on Tuesday said the pact will sharply lower transaction cost for ...

Times of India

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Thu, 10 Jul 2014 16:03:45 -0700

The government on Thursday announced measures to reduce transaction cost for exporters but stopped short of restoring the much-anticipated tax benefits for special economic zones. The finance minister promised quicker cargo clearances by extending the ...

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