Transaction Cost: The Hidden Payment You Always Make

Transaction costs are costs incurred when making an economic trade. They underline economic thinking as a whole. Society behaves on the basis of transaction costs. They are the expenses incurred when buying or selling a product or service that are outside the cost of the product or service itself. Transaction costs are one of the most significant factors in business operation and management. They comprise every cost of making the transaction itself: planning, deciding, changing plans, resolving disputes.

Some scholars state that transaction costs involve four main variables: measurement, enforcement, attitudes and perceptions, and the size of the market. Measurement refers to the calculation of value of aspects of a good or service. Enforcement can be defined as the need for an unbiased third party to ensure neither party engaged in the trade is unfair. Then attitudes and perceptions encapsulate an individual’s values and how they see the world. Last there is market size, which affects how impartial transactions are. Put simply, the more effort we put into a purchase, independent of how costly it is, the higher the transaction cost.

Everything beyond the price of a product or service is a transaction cost. The administrative, informational, and operational overhead. Expenses associated with finding the right product, service, or partner, and gathering necessary information. Costs in negotiating terms, reaching agreements, and making decisions. Expenses to monitor performance and enforce contracts. Costs related to organizing, managing, and communicating between parties in a transaction. From the time and money spent on researching suppliers and reading reviews, to the cost of negotiating a contract with a vendor and legal fees, is a transaction cost.

They matter because lower transaction costs result in more efficient markets. When the cost is high, trade is discouraged, and pricing and organizational structure are affected. For example, a company would opt for in-house production rather than outsourcing to contracts if transaction costs are high. Even if the economy is less efficient this way. Markets fail because of this reason: since mutually beneficial trades do not occur. Comparative advantages are left underutilized.

Real-world implications of transaction costs:

• E-commerce: the scenario: an online marketplace like eBay or Amazon reduces transaction costs by providing a centralized platform that handles search, payment processing, and distribution; the impact: buyers and sellers are able to trade more efficiently, which helps the platform scale and attract more users, forming a positive cycle;

• Real estate: the scenario: buying or selling real estate involves high transaction costs, such as agent commissions, legal fees, and time delays, and these costs affect the genuine value realized in these transactions;

• Financial services: the scenario: banks offer services that reduce transaction costs for customers, such as automated payment systems and online banking, and lowering these costs encourages frequent and efficient economic activity;

• Supply chain: the scenario: a company that produces its own components internally might do so to avoid the high transaction cost of negotiating contracts and finding external suppliers, reshaping the organization’s fundamental structure.

How you might employ transaction costs as a mental model: (1) implement technology, integrating automation, digital platforms, and information systems to reduce the time and resources to make transactions; (2) standardize processes, like by establishing standard contracts, protocols, and procedures to streamline negotiations and reduce uncertainty in each transaction; (3) build relationships, trust, and reputation, as these lower negotiation and enforcement costs between parties, reducing the need for extensive monitoring and protective measures; (4) in some cases, you might choose to internalize a process to avoid the transaction costs of dealing with external parties, like by manufacturing products in-house to ensure smooth operations.

There are limitations to transaction costs however. Not all of them are immediately visible. Some emerge over time. Think the costs of maintaining relationships or updating technology. Internalizing processes gives you control, but it reduces your flexibility: you are only so powerful when you decide to do everything yourself. Balance staying innovative and independent. Lowering immediate transaction costs is not always the best strategy long-term.