Transaction costs can be defined as the costs that would go away if you were dealing only with yourself. They apply to market transactions but also to transactions within organizations. “Cash” transaction costs comprise the costs of searching for, negotiating, monitoring, and enforcing agreements. Legal, cost accounting, sales, merchandising, purchasing, financing, auditing, and mediation by the boss are all cash transaction costs. If you built your own house instead of buying it, you would still need to buy the wood and the nails (direct production costs), but you wouldn’t need to pay the fees for the real estate broker, title insurer, or lawyer (direct transaction costs). But the direct production costs themselves include the indirect transaction costs incurred upstream. The transaction cost embedded in the price of the nails, for example, itself includes almost the entire cost-added of the retailer, since merchandising, advertising, displaying, sales help, and billing would all disappear if you “sold them to yourself.” Transaction costs are thus the price we quite sensibly pay for the benefits of division of labor: we incur transaction costs in order to lower production costs.
In the aggregate, we spend more on negotiating and enforcing agreements than on fulfilling them. And as the exhibit on page 4 shows, transaction costs are not only surprisingly large but also rising. This may be counterintuitive, since we can all think of examples where technology has dramatically lowered transaction costs—for example, the efficiencies of e-procurement or the substitution of electronic payments for paper. What has happened is that the cheaper unit costs of transacting have more than proportionately increased the number of transactions, so the total cost of transacting has gone up, not down. As the division of labor deepens and integrated value chains “deconstruct,” production costs fall, transactions proliferate, and transaction costs preponderate.
There is a second important kind of transaction cost: the “opportunity cost” of mutually beneficial agreements forgone. This is the value lost because the parties could not find each other or did not trust each other sufficiently to make a deal, or to make the best deal. “Cash” transaction costs and “opportunity” transaction costs tend to substitute for each other: in most cases, the more cash the parties spend on search, negotiation, monitoring, and enforcement, the nearer they approach an “efficient” transaction in which no opportunity costs are forgone.