Theory of transaction costs

The Theory of Transaction Costs is an economics-based theory that examines the costs associated with conducting and executing economic transactions. It is based on the idea that all transactions incur certain costs, such as search costs, bargaining costs, and enforcement costs, which can be minimized through the utilization of various strategies.

• Search cost: These costs include the resources utilized to find the best-suited and most cost-effective products or services.
• Bargaining cost: These costs are incurred by the parties involved in a transaction during the negotiation process. This can include the time and money spent to reach an agreement.
• Enforcement cost: These costs are related to the enforcement of the agreement. This can include legal fees, arbitration, and other costs associated with making sure all parties involved adhere to the agreement.

Example of Theory of transaction costs

The Stigler-Savage model is an example of the Theory of Transaction Costs in action. This model is based on the idea that the costs of transactions are a function of the information available to the parties involved in the transaction. It suggests that when information asymmetry exists between the parties, the costs associated with the transaction will be higher.

This model suggests that transactions can be made more cost-efficient when both parties have the same level of information. To achieve this, the parties must invest in the process of obtaining accurate information, such as conducting research and obtaining expert advice, so that they are both on equal footing. Additionally, this model also suggests that parties should also invest in mechanisms that facilitate the enforcement of the transaction agreement, such as legal fees and arbitration services.

Formula of transaction costs

The formula for the Theory of Transaction Costs is given by: TC = SC + BC + EC, where TC stands for Total Transaction Costs, SC stands for Search Costs, BC stands for Bargaining Costs, and EC stands for Enforcement Costs. This formula helps to measure the cost of any transaction by taking into account the search, bargaining, and enforcement costs associated with it.

When to use transaction costs

The Theory of Transaction Costs can be used to analyze any transaction, from small everyday purchases to larger business deals. It is especially beneficial for businesses, as it can help them identify and reduce unnecessary costs associated with transactions. For example, a business could use the Theory of Transaction Costs to identify and reduce search costs by utilizing a more efficient method for finding the best-suited and most cost-effective products or services. It could also be used to identify and reduce bargaining costs by negotiating more efficiently or utilizing a third-party to facilitate the negotiations. Finally, it could be used to identify and reduce enforcement costs by finding cheaper and more effective ways to enforce the agreement.

Types of transaction costs

There are three main types of transaction costs that are commonly considered when analyzing and evaluating economic transactions: search costs, bargaining costs, and enforcement costs.

• Search costs: These costs involve the resources required to find and secure the most suitable and cost-effective product or service. This could include research and labor costs as well as the cost of any information or data required to make a decision.
• Bargaining costs: These costs involve the time and money spent to negotiate and finalize an agreement. This could include the cost of lawyers and other professionals utilized during the process.
• Enforcement costs: These costs are related to the enforcement of an agreement and involve the costs of making sure all parties comply with the terms of the agreement. This could include legal fees, arbitration, and other costs associated with enforcing the agreement.

Steps of transaction

The Theory of Transaction Costs outlines four steps to minimize the costs associated with economic transactions. These steps include:

• Identifying the transaction: In this step, the parties involved in a transaction must identify and define the transaction, as well as its purpose and objectives.
• Negotiating the transaction: This step involves the negotiation of the transaction, which includes the determination of the price and other terms of the transaction.
• Executing the transaction: This step involves the actual execution of the transaction, including the delivery of the goods or services, payment, and any other required steps.
• Monitoring and enforcing the transaction: This step involves the monitoring and enforcing of the agreement, which can include legal fees, arbitration, and other costs associated with making sure all parties involved adhere to the agreement.

Advantages of transaction costs

There are several advantages to using the Theory of Transaction Costs when conducting economic transactions. These include:

• Cost savings: Utilizing the strategies outlined by the Theory of Transaction Costs can help to reduce the costs associated with conducting and executing transactions, leading to cost savings for both parties involved.
• Efficiency: By utilizing the strategies outlined by the Theory of Transaction Costs, transactions can be conducted more efficiently and quickly, leading to increased productivity and economic growth.
• Risk reduction: Utilizing the strategies outlined by the Theory of Transaction Costs can help to reduce the risk associated with conducting transactions, leading to greater security and stability.

Limitations of transaction costs

The Theory of Transaction Costs has certain limitations that should be considered when using it to evaluate the costs associated with a particular transaction. These limitations include:

• Depending on the situation, the costs associated with a transaction may not be accurately captured.
• The theory does not account for the overall cost of a transaction, as additional costs such as taxes, fees, and interest may be incurred.
• The theory does not account for the potential benefits that may be derived from a transaction, such as increased efficiency or improved service.

Other approaches related to Theory of transaction costs

• The Coase Theorem: This theorem was proposed by Ronald Coase and suggests that when transaction costs are low, it is efficient for the parties to bargain and reach an agreement without the intervention of the government.
• The Williamson Model: This model was developed by Oliver Williamson and suggests that transaction costs should be taken into account when forming contracts. It proposes that firms should utilize specific strategies to minimize transaction costs.
• The Arrow-Debreu Model: This model was proposed by Kenneth Arrow and Gerard Debreu and suggests that when transaction costs are high, the government should step in to create a market for the transaction.

Theory of transaction costs — recommended articles

Transaction cost theory — Expected utility — Economic efficiency — Government procurement — Marginal cost of producing — Outsourcing and offshoring — Uncertainty and risk — Value engineering — Incremental analysis

References

• Williamson, O. E. (1989). Transaction cost economics. Handbook of industrial organization, 1, 135-182.