Transaction costs

Transaction costs represent the economic losses that can result from arranging market relationships on a contractual basis. The study of transaction costs originates from economics’ aggregative social modeling arising from individuals operating under competitive self-interest. At the highest level of abstraction, there are only markets, and everyone is free to enter into contractual relations with everyone else. Under this view, the firm is seen famously as a nexus of contracts. But proponents of the approach expect that contracts will be violated not occasionally, but whenever the parties to them find it possible. One theoretical line that emerges from this approach is agency theory, which sees firms in terms of contractual relations. But a different tactic has been transaction cost economics, which focuses on the limitations of contractual relationships. It consists of four main elements: 1. The world is uncertain and therefore unpredictable. 2. Small numbers bargaining and asset specificity make it costly for parties who enter into economic relationships to leave them. 3. Bounded rationality limits individuals’ opportunities to scan the environment for all possible options. 4. The inherent opportunism of individuals in economic relationships makes contractual enforcement over a long-term period difficult. Together, these four factors make it difficult to contract at low costs and create frictions (i.e., transaction costs) in the marketplace. The capitalist solution is to integrate up and down the production chain by buying out suppliers and the people one sells to. Variations in the way the four factors affect different economic relationships determine the degree to which an industry is concentrated or not. Extracted from Bevir, M. (2007).