Transaction Costs

Foundations of Transaction Cost Economics

Transaction cost economics started with the 1937 article by Ronald Coase on the firm and continued with his 1960 article on social costs. Economic life is replete with different forms of contracts, whose shape transaction cost theory helps explain. Thus, in the Coasean tradition, internal firm organization with long-term contracts presents a mechanism to reduce transaction costs when relying on massive short-term contracting in the market. This 1937 insight received a much needed elaboration by Oliver E. Williamson, underlining the implications of transaction costs for both hierarchies and markets. In the Williamson tradition, minimizing transaction costs is of paramount importance in economic life where strong forces like opportunism and asymmetric information with economic agents, especially when possessing asset-specific knowledge, are conducive to economic inefficiency, such [Page 2649]as monopoly. The 1960 Coase article broadened transaction cost economics to the domain of public policy and externalities, arguing that with zero transaction costs, external effects and market failures could be handled by means of bargaining and compensation. This claim about the ability of market forces to allocate responsibility for external costs is known as the Coase theorem. It anticipated recent debates about extending the “polluter pays” idea to a global ecology policy to reduce carbon emissions. In general, institutional economics (new or neo-institutional) combine the insights from both Coase and Williamson, emphasizing that economic evolution aims at minimizing transaction costs (Oliver Williamson & Scott Masten, 1997). No similar teleology concerning a fundamental drive to develop institutions that minimize transactions is to be found in politics, however.

Transaction Costs in the Political Sphere

In politics, transaction cost arguments are primarily found in the theory of voting and the public choice school. Transaction costs arise in any political group taking decisions by some mechanism of voting, whether the group be a domestic one like the national assembly or an international organization like the World Bank, the United Nations, or the International Monetary Fund. In a group of choice participants—political parties, legislators, state representatives, faculty members, and club members—any decision or collective action will result from the summation of the preferences of the participants according to some mechanism of aggregation. Alternative social choice mechanisms—majoritarian techniques, proportional methods, utilitarian scoring, positional techniques—result in varying transaction costs for the group as a whole.

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