Transaction Costs Theory

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Summary of the theory behind Transaction Costs, by Manuel DeLanda:

"The origin of transaction cost economics may be traced to the work of Ronald Coase who, among other things, emphasized the role of legal considerations in economics. When people exchange goods in a market, not only physical resources change hands but also rights of ownership, that is, the rights to use a given resource and to enjoy the benefits that may be derived from it. These legal background conditions were then "expanded beyond property rights to include contract laws, norms, customs, conventions, and the like..." Collectively, these political, social and legal ground rules forming the basis not only for exchange, but also for production and distribution, are referred to as the "institutional environment" of an economy.

The coiner of the term, economist and economic historian Douglass North, believes that when market exchanges are conceived this way they can be shown to involve a host of "hidden" costs ranging from the energy and skill needed to ascertain the quality of a product, to the drawing of sales and employment contracts, to the enforcement of those contracts. In medieval markets, he argues, these transaction costs were minimal, and so were their enforcement characteristics: threats of mutual retaliation, ostracism, codes of conduct and other informal constraints sufficed to allow for a more or less smooth functioning of a market. But as the volume and scale of trade intensified (or as its character changed, as in the case of foreign, long-distance trade) new institutional norms and organizations were needed to regulate the flow of resources, ranging from standardized weights and measures, to the use of notarial records as evidence in merchant law courts. North's main point is that as medieval markets grew and complexified their transaction costs increased accordingly, and hence that without a set of institutional norms and organizations to keep these costs down the intensification of trade in the West would have come to a halt. Economies of scale in trade and low-cost enforceability of contracts were, according to North, mutually stimulating.

The other (and better known) New Institutionalist contribution is the idea that depending on the balance of different transaction costs different governance structures become appropriate (in terms of their relative efficiency) in an economy. As early as 1937, Ronald Coase convincingly argued that the traditional picture of a market, as a system in which without central control individual traders are collectively coordinated by the price mechanism, is only valid for a certain combination of transaction costs. For other combinations, firms (that is, more or less hierarchical institutional organizations) are a more efficient mechanism of coordination. As he puts it, "the distinguishing mark of the firm is the supersession of the price mechanism."

Coase goes on to argue that:

The main reason why it is profitable to establish a firm would seem to be that there is a cost of using the price mechanism. The most obvious cost of 'organizing' production through the price mechanism is that of discovering what the relevant prices are....The costs of negotiating and concluding a separate contract for each exchange transaction which takes place on a market must also be taken into account....It is true that contracts are not eliminated when there is a firm, but they are greatly reduced. A factor of production (or the owner thereof) does not have to make a series of contracts with the factors with whom he is co-operating within the firm, as would be necessary, of course, if this co-operation were a direct result of the working of the price mechanism. For these series of contracts is substituted one."

Firms are not, of course, all the same. In particular, they may differ in size and in the degree to which they possess market power. Coase also dreamt of giving the question of differences in size a more scientific treatment, arguing that the more transactions are conducted without the price mechanism, the larger a firm should get, up to the point where "the costs of organizing an extra transaction within the firm are equal to the costs involved in carrying out the transaction in the open market or the costs of organizing by another entrepreneur."

Since Coase first proposed these theses much work has been done in discovering transaction costs other than those he explicitly dealt with (information-gathering costs, contracting costs) and the list seems to still be growing. What this means is that, unlike the simple dichotomy of governance structures (markets coordinated by prices versus firms coordinated by commands) which results from including only a few transaction costs, the inclusion of a wider variety of costs leads to consider a host of hybrid structures between pure markets and pure hierarchies.23 (This is, in a sense, implicit in Coase, given that he does distinguish between an economy ran by hundreds of small firms, and one ran by a handful of oligopolistic large corporations.)" (


  1. 18. Oliver E. Williamson, Transaction Cost Economics and Organization Theory, Op. Cit. p210.
  2. Douglass C. North, Institutions, Institutional Change and Economic Performance, New York: Cambridge University Press, 1995, pp120-131.
  3. 20. Ronald H. Coase, 'The Nature of the Firm' in The Firm, the Market and the Law, Chicago: University of Chicago Press, 1988, p36.