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 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 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. 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:

Item Neoclassical microeconomics Transaction cost economics
Behavioural assumptions[12] Assumes hyperrationality and ignores most of the hazards related to opportunism Assumes bounded rationality
Unit of analysis Concerned with composite goods and services Analyzes the transaction itself
Governance structure Describes the firm as a production function (a technological construction) Describes the firm as a governance structure (an organizational construction)
Problematic property rights and contracts Often assumes that property rights are clearly defined and that the cost of enforcing those rights by the means of courts is negligible Treats property rights and contracts as problematic
Discrete structural analysis Uses 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)
Remediableness Recognizes profit maximization or cost minimization as criteria of efficiency Argues 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 Markets Downplays the importance of imperfect markets Robert 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. ^ a b c d e f g h 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.


  • North, Douglass C. 1992. “Transaction costs, institutions, and economic performance.” San Francisco, CA: ICS Press.
  • Cheung, Steven N. S. (1987). "Economic organization and transaction costs". The New Palgrave: A Dictionary of Economics v. 2: 55–58.
  • Commons, J.R (1931). "Institutional Economics". American Economic Review. 21: 648–657. Retrieved February 8, 2013.
  • Douma, Sytse; Schreuder, Hein (2012). Economic Approaches to Organizations (5th ed.). London: Pearson. ISBN 9780273735298.
  • Klaes, M. (2008). "transaction costs, history of," The New Palgrave Dictionary of Economics, 2nd Edition. Abstract.
  • Niehans, Jürg (1987). “Transaction costs," The New Palgrave: A Dictionary of Economics, v. 4, pp. 677–80.
  • Pierre Schlag, The Problem of Transaction Costs, 62 Southern California Law Review 1661 (1989).
  • Coase, Ronald (1937). "The Nature of the Firm". Economica. 4 (16): 386–405. doi:10.1111/j.1468-0335.1937.tb00002.x.
  • Coase, Ronald (1960). "The Problem of Social Cost". Journal of Law and Economics. 3: 1–44. doi:10.1086/466560.
  • 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.
  • _____ (2002). "The Theory of the Firm as Governance Structure: From Choice to Contract," Journal of Economic Perspectives, 16(3), pp. 171-195.
  • 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. ISBN 978-0-13-224650-7.

External links

Bid–ask spread

The bid–ask spread (also bid–offer or bid/ask and buy/sell in the case of a market maker), is the difference between the prices quoted (either by a single market maker or in a limit order book) for an immediate sale (offer) and an immediate purchase (bid) for stocks, futures contracts, options, or currency pairs. The size of the bid-offer spread in a security is one measure of the liquidity of the market and of the size of the transaction cost. If the spread is 0 then it is a frictionless asset.

Bilateral monopoly

A bilateral monopoly is a market structure consisting of both a monopoly (a single seller) and a monopsony (a single buyer).

Chihong Zinc and Germanium

Yunnan Chihong Zinc and Germanium Company Limited (SSE: 600497) is the state-owned enterprise engaged in the processing, extracting and prospecting and trading of zinc, lead, germanium and sulphuric acid products.The company was founded in Qujing, Yunnan, China in 2000. It was listed on the Shanghai Stock Exchange in 2004.

In 2010, Chihong's Canadian subsidiary, Chihong Canada Mining, closed a joint venture with Selwyn Resources Ltd. for the development of a zinc-lead mining operation in the Yukon. The transaction cost CDN$100 million to complete.

External financing

In the theory of capital structure, external financing is the phrase used to describe funds that firms obtain from outside of the firm. It is contrasted to internal financing which consists mainly of profits retained by the firm for investment. There are many kinds of external financing. The two main ones are equity issues, (IPOs or SEOs), but trade credit is also considered external financing as are accounts payable, and taxes owed to the government. External financing is generally thought to be more expensive than internal financing, because the firm often has to pay a transaction cost to obtain it.

Possible ways are "Peer to peer funding", "Business angels", "Crowfunding" or "Loans".

Interaction cost

Interaction cost can comprise work, costs, and other expenses, required to complete a task or interaction. This applies to several categories, including:

Economy: the interaction cost of a purchase includes the requirements to complete it, and differ in costs for customers and vendors. Method of payment offered may factor into both transaction cost and interaction cost. Reducing steps for customers can be a service offered by the vendor. Interaction cost should be considered when clients choose vendors. Customers prefer to have choice about their interactions cost. In self-checkout, work is moved to the customer.

Politics: Specific interaction cost can be increased by law for political gains.

User interface: In a computer menu with a graphical user interface, some designs require more clicks from the user in order to make a selection. With a dropdown menu, one click (or touch or hover) may reveal a hidden menu (sub menu), with a second click required to select the menu option. If the entire menu were displayed all along, as in a navigation bar, only one click would be required, but the menu would occupy more screen space. Sub-menus require even more care from the user to make a desired selection.

Internalization theory

Internalization theory is a branch of economics that is used to analyse international business behaviour.


In economics, internationalization is the process of increasing involvement of enterprises in international markets, although there is no agreed definition of internationalization. There are several internationalization theories which try to explain why there are international activities.

Market governance mechanism

Market governance mechanisms (MGMs) are formal, or informal rules, that have been consciously designed to change the behaviour of various economic actors. This includes actors such as individuals, businesses, organisations and governments - who in turn encourage sustainable development.

Market governance is characterized by high-powered incentives and adaptability (i.e. flexibility). An example of an alliance structured with a market governance mechanism is a legal agreement between two organizations to distribute, license or export a particular product. The rules governing the exchange are dictated by contract law where each party is highly incentivized to act in their best interest, with the nature of the relationship being adaptable, suggesting that the terms of the contract can be changed or renegotiated at minimal costs.Well known MGMs include fair trade certification, the European Union Emission Trading System and Payment for Ecosystem Services (PES).

MGMs, meanwhile, are not to be confused with market-based instruments. MGMs, as a group, includes command and control regulations as well as regulatory economics. As such, MGM is a broader classification.

The success and failure of market governance mechanisms is highly political, and is therefore likely to require more than just formal changes to rules and regulations. Sustained and inclusive progress requires transformative change reaching beyond legal frameworks into cultural domains, altering peoples’ perceptions of what is ‘the norm’ and establishing new moral frameworks to guide market activities.Market governance does not require such significant idiosyncratic investments from the buyers and sellers. Without investing sufficient resources, intent, and time, market governance is just a simple buyer-to-seller relationship that is relatively standardized and straightforward (Ring and Van de Ven, 1994; Larsson et al., 1998).

TCE (transaction cost economics) demonstrates that the governance between independent firms can be crafted by the degree of asset specificity (Ouchi, 1980; Williamson, 1985; Lai, 1990; Stump and Heide, 1996), that is, transactions of the high asset-specificity form should be governed by the hierarchy governance mechanism; transactions of the low asset-specificity type should be governed by the market governance mechanism.

Buyer-to-supplier governance alone is not sufficient to drive positive change of supplier’s social and ethical conduct. If only simply deploying code monitoring, buyers from AEs may defend their brands or reputation against NGO or customer criticism, but cannot actively pursue meaningful improvement of supplier’s compliance. The overall reliance on buyer-to-supplier governance may create a system in which a supplier’s main objective is to pass the audit, rather than address the substantive issues that are the focus of the audit. In market governance, opportunism in interorganizational relationships may be controlled through threats (Gundlach et al., 1995). Even though, as a result, buyers from AEs must be aware that an emphasis on market governance (i.e. threatening, monitoring, or inspecting) may actually be more costly in the long run (Roth et al., 2008).

The Trust and Tracing game is an operationalization of the theory on market governance in a new institutional perspective. It enables research into the interaction between the four levels of analysis of Williamson. It places participants in a serialized asynchronous Prisoners Dilemma-like situation. This situation is called the Trader’s Predicament. Netchains are another form of market governance.

If we treat organizational conventions as institutions and various types of market governance mechanism (trust and reputations, merchants' norms, third-party contract enforcement, "digital enforcement" and so on) as institutions arising in the commodity exchange domains, there may be complementary relationships between a certain pair of them.

Market microstructure

Market microstructure is a branch of finance concerned with the details of how exchange occurs in markets. While the theory of market microstructure applies to the exchange of real or financial assets, more evidence is available on the microstructure of financial markets due to the availability of transactions data from them. The major thrust of market microstructure research examines the ways in which the working processes of a market affect determinants of transaction costs, prices, quotes, volume, and trading behavior. In the twenty-first century, innovations have allowed an expansion into the study of the impact of market microstructure on the incidence of market abuse, such as insider trading, market manipulation and broker-client conflict.

Oliver E. Williamson

Oliver Eaton Williamson (born September 27, 1932) is an American economist, a professor at the University of California, Berkeley, and recipient of the 2009 Nobel Memorial Prize in Economic Sciences, which he shared with Elinor Ostrom.


An organization or organisation is an entity comprising multiple people, such as an institution or an association, that has a particular purpose.

The word is derived from the Greek word organon, which means tool or instrument, musical instrument, and organ.

Parametric insurance

Parametric insurance is a type of insurance that does not indemnify the pure loss, but ex ante agrees to make a payment upon the occurrence of a triggering event. The triggering event is often a catastrophic natural event which may ordinarily precipitate a loss or a series of losses. But parametric insurance principles are also applied to Agricultural crop insurance and other normal risks not of the nature of disaster, if the outcome of the risk is correlated to a parameter or an index of parameters.


Peppercoin is a cryptographic system for processing micropayments. Peppercoin Inc. was a company that offers services based on the peppercoin method.

The peppercoin system was developed by Silvio Micali and Ron Rivest and first presented at the RSA Conference in 2002 (although it had not yet been named.) The core idea is to bill one randomly selected transaction a lump sum of money rather than bill each transaction a small amount. It uses "universal aggregation", which means that it aggregates transactions over users, merchants as well as payment service providers. The random selection is cryptographically secure -- it cannot be influenced by any of the parties. It is claimed to reduce the transaction cost per dollar from 27 cents to "well below 10 cents."Peppercoin, Inc. was a privately held company founded in late 2001 by Micali and Rivest based in Waltham, MA. It has secured about $15M in venture capital in two rounds of funding. Its services have seen modest adoption. Peppercoin collects 5-9% of transaction cost from the merchant. Peppercoin, Inc. was bought out in 2007 by Chockstone for an undisclosed amount.

Price discovery

The price discovery process (also called price discovery mechanism) is the process of determining the price of an asset in the marketplace through the interactions of buyers and sellers. The futures and options market serve all important functions of price discovery. The individuals with better information and judgement participate in these markets to take advantage of such information. When some new information arrives, perhaps some good news about the economy, for instance, the actions of speculators quickly feed their information into the derivatives market causing changes in price of derivatives. These markets are usually the first ones to react as the transaction cost is much lower in these markets than in the spot market. Therefore these markets indicate what is likely to happen and thus assist in better price discovery.

Steven N. S. Cheung

Steven Ng-Sheong Cheung (; born December 1, 1935) is a Hong-Kong-born American economist who specializes in the fields of transaction costs and property rights, following the approach of new institutional economics. He achieved his public fame with an economic analysis on China open-door policy after the 1980s. In his studies of economics, he focuses on economic explanation that is based on real world observation (an observation first approach). He is also the first to introduce concepts from the Chicago School of Economics, especially price theory, into China. In 2016, Cheung claimed to have written "1,500 articles and 20 books in Chinese" during his academic career.He obtained his PhD in economics from UCLA, where his teachers were the American economists Armen Alchian and Jack Hirshleifer. He taught in the Department of Economics at the University of Washington from 1969 to 1982, and then at the University of Hong Kong from 1982 to 2000. During this period, Cheung reformed the syllabus of Hong Kong's A-level Economics examination, adding the concepts of the postulate of constrained maximization, methodology, transaction cost and property right, most of which originate from the theories of the Chicago school.

Theory of the firm

The theory of the firm consists of a number of economic theories that explain and predict the nature of the firm, company, or corporation, including its existence, behaviour, structure, and relationship to the market.

Transaction cost analysis

Transaction cost analysis (TCA), as used by institutional investors, is defined by the Financial Times as "the study of trade prices to determine whether the trades were arranged at favourable prices – low prices for purchases and high prices for sales". It is often split into two parts – pre-trade and post-trade. Recent regulations, such as the European Markets in Financial Instruments Directive, have required institutions to achieve best execution. This has resulted in the emergence of a number of companies who make TCA a central offering, such as Investment Technology Group, Bloomberg, Trade Informatics, Markit, and many others.

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Schools (history)
of economic thought
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