Transaction Costs and Property Rights

Economic organization cannot be understood without grasping the role of transaction costs and their relation to property rights. Transaction costs are not simple market frictions like transportation fees or taxes; they are the costs of establishing, maintaining, and defending property rights. These rights, defined as the ability to exercise choices over resources, are rarely perfect. Most assets are governed by imperfect property rights, which exist along a continuum from zero to one. Individuals naturally seek to improve their control over resources—by theft, by self-defense, by capturing unowned goods, or through cooperation. All these actions entail costs. Some are dissipative (like rent-seeking), others create new wealth (like joint production). These are the true transaction costs: the economic sacrifices made to create and secure entitlements over goods and services.

The logic of organizational forms emerges from this framework. Since stronger property rights enhance expected wealth, individuals and firms weigh the marginal benefit of perfecting rights against the marginal cost. The result is an equilibrium level of imperfect rights, where the cost of further perfection exceeds its benefit. This deviation from perfection gives property rights their allocative importance: when transaction costs exist, the distribution of rights shapes outcomes. Coase’s theorem applies only in the limit of zero transaction costs, where the allocation of rights becomes irrelevant. But this condition is exceptional. In most real-world settings, property rights are costly to enforce, and their distribution matters. The key implication is that all forms of organization aim to maximize wealth net of these transaction costs. Therefore, understanding institutions, firms, or governance arrangements requires focusing on how they define, allocate, and protect property rights under conditions of imperfection.

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