transaction coststhe costs associated with the activities of buying and selling in a MARKET system (see TRANSACTION). For example, firms incur costs in finding satisfactory input suppliers and distributors for their products and in negotiating, concluding and monitoring CONTRACTS with other firms. In some market situations, transaction costs may be inflated by the application of monopoly surcharges by powerful suppliers. Although a firm may avoid some transaction costs by VERTICAL INTEGRATION (i.e. performing some functions internally), these may well be offset by the higher administrative, stockholding and other costs involved in running a vertically integrated business. See AGENCY COSTS.
transaction coststhe costs incurred in the EXCHANGE of an INPUT, GOOD, SERVICE or ASSET between two or more individuals or firms. TRANSACTIONS can take place through a MARKET, which involves the ‘arm‘s-length’ buying and selling of inputs, goods, services and assets using the PRICE SYSTEM, or transactions may be ‘internalized’ through an internal ORGANIZATION, which involves the interchange of inputs, goods, services and assets between the various departments of a firm, often using an internal TRANSFER PRICING system.
The transaction costs of using the market include the ‘search’ costs of finding suitable input suppliers and distributors for the firm's output, the administrative and legal costs involved in drawing up CONTRACTS with suppliers/distributors, specifying terms and conditions of supply/delivery the costs of‘monitoring‘whether or not the terms and conditions of the contract have been adhered to, and the costs of dealing with non-compliance (e.g. the return of defective components). Where a firm deals with a multitude of suppliers/distributors, this takes up management time as well as involving substantial ‘policing’ costs. In addition, the firm may be faced by powerful input suppliers and distributors who are able to impose monopolistic surcharges on the terms of exchange and/or operate PRICE SQUEEZES, REFUSALS TO SUPPLY, etc.
For these reasons, a firm may seek to eliminate external transaction costs by engaging in self-supply of inputs and self-distribution of its products, thus substituting an internal organization for the market. It is important, however, to emphasize that the elimination of external transactions does not represent a ‘pure’ saving. By ‘internalizing’ transactions, the firm now incurs extra internal expenses - the greater administrative costs of running an enlarged operation - and it may encounter ‘agency’ problems (see AGENCY COSTS). See TRANSACTION for further discussion.
The Coase theorem suggests that the decision by a firm to use markets to undertake exchanges rather than to internalize such exchanges will be determined by the amount of transaction costs involved in undertaking any specific exchange. See INTERNALIZATION, OUTSOURCING.