893 0740 TRANSACTION COSTS Douglas W. Allen Associate Professor Department of Economics - Simon Fraser University Copyright 1999 Douglas W. Allen Abstract This chapter addresses the history, use and significance of the term transaction costs. Few words in the economic language have been more abused or fought over and this is shown to result from the emergence of two distinct definitions and uses. The ‘Neoclassical’ definition rests on the costs of trading across a market, while the ‘property rights’ definition centers on the costs of establishing and enforcing property rights. In articulating these two separate definitions and in demonstrating their relationship and separate uses, it is hoped that more progress can be made in the field of transaction cost economics. JEL classification: K0, L0, L2, D0, D8 Keywords: Transaction Costs, Property Rights, Coase Theorem 1. Introduction Transaction costs. Do another two words exist in the economic lexicon that generate as much friction Conceptually introduced in Coase’s 1937 paper ‘The Nature of the Firm’ as simply ‘the cost of using the price mechanism’ (Coase, 1988, p. 38), the words ‘transaction costs’ have evolved to the point where some skeptics claim they include any cost that is convenient and elusive enough to avoid critical examination (Niehans, 1987, p. 678). Advocates, on the other hand, have hailed the recognition of these costs as revolutionary and as important conceptually as ‘marginalism’ and ‘substitution’ (Cheung, 1983, p. 21). The ambiguity that surrounds the concept of transaction costs stems, in large part, from the existence of two literatures simultaneously claiming ownership over the term. The ‘property rights’ literature begins with Coase and has consistently focused on the role transaction costs play in determining the distribution of property rights, broadly defined as all laws, rules, social customs and organizations that generate incentives for behavior. This literature has called into question fundamental concepts like efficiency and the nature of production. Though based in neoclassical economics, this literature has evolved beyond the neoclassical model and has produced the new sub-fields of ‘law and economics’, the ‘new economic history’ and the ‘new institutional economics’. 894 Transaction Costs 0740 Though this field, through Coase, claims the discovery and rightful title to ‘transaction costs’, ironically the words are conspicuously absent from many of its titles. Indeed this literature is mostly responsible, though not solely, for the plethora of terms that either substitute for or refine the notion of transaction costs. The ‘neoclassical’ literature on transaction costs begins in the early 1950s, although some might argue that it starts with Hicks (1935) or even Coase (1937). This literature defines transaction costs more narrowly, generally models them more explicitly and often analytically identical to transportation charges or taxes. The correspondence with familiar costs carries over to the types of issues examined, such as the effect of transaction costs on the volume of trade, abilities to arbitrage, the bunching of transactions, intermediation and the existence and efficiency of equilibrium - all standard neoclassical fare. Sometimes this literature examines issues of property right determination, such as the role of middlemen and the medium of exchange. In addition to the different approach and definition, the conclusions are often opposite from the property rights literature as well. This is especially true over questions of efficiency and this has increased the level of belittling rhetoric between the two camps. For example, it is common in the neoclassical literature, when reference is made to the Coase Theorem - the cornerstone of the property rights literature - to say ‘the so-called Coase Theorem’ (See Niehans, 1987 p. 678, for an example). The property rights literature is just as aggressive, claiming that the neoclassical camp often wants their cake and eat it too. For example, early criticisms over the monopoly model almost mocked the inconsistency of having a monopolist know its demand curve at zero costs, yet find it prohibitively costly to price discriminate (see Demsetz, 1969, or Barzel, 1977, for examples). The likely cause of this dichotomous literature is twofold. First, there is the early introduction of costly transacting by Coase (1937) in the explicit context of institutional choice, at a time when the profession had little interest or ability to grapple with the issue. As Coase (1972) noted, his 1937 paper on the firm was often cited, but was little used. Second, there is Coase’s failure in 1937 to define transaction costs with any precision, using instead the phrase ‘the costs of the price mechanism’. At the same time, though Coase uses examples that suggest more than just the market is involved in transaction costs, he ultimately leaves the issue open for interpretation. As such, the property right literature did not truly begin until 1960, with Coase’s publication of ‘The Problem of Social Cost’. This latter article provided the necessary elaboration of Coase’s 1937 publication in order to tie many existing ideas together and to provide a property rights research agenda (see Barzel and Kochin, 1992, or Medema, forthcoming, for elaborations on this point). In the intervening years, economists did what they could with the term transaction costs and the neoclassical approach was born. The purpose of this chapter is to provide a broad picture of transaction costs: its history, definition, foundation, use, measurement and implications. 0740 Transaction Costs 895 As such, it is often necessary to sacrifice detail and the reader is directed to explore the references for further treatment. A theme throughout the chapter is the dichotomous use of the term ‘transaction costs’ in the two streams of literature already mentioned. It is ironic that a disagreement over ownership should engulf a term so closely related to property rights. Unfortunately, as with all cases of disputed ownership, useful output is lower for lack of definition. 2. A Tale of Two Histories, Part A: The Property Right Approach In the beginning Coase created transaction costs. His critics might continue: ‘And the term was formless and void and darkness was over the surface of the term’. For the believers in the property right approach, however, Coase (1937) is seminal. As an advanced undergraduate perplexed by economics’ ability to conceptually organize the economy around prices, Coase was troubled that there was no room for any form of direct cooperation or direction. In his words ‘we had a factor of production, management, whose function was to coordinate. Why was it needed if the pricing system provided all the coordination necessary’ (1992, p. 715). His solution was to recognize that there are ‘costs of using the price mechanism’. When prices allocate resources at a cost, then they compete with other allocating mechanisms like firms and governments. Coase argued that, at times, firms and direct management supersede the market, while at other times market prices are used in directing goods and services. Readers interested in the genesis and a detailed account of the history of Coase’s first great work are directed to Williamson and Winter (1991). In this simple argument a charitable reading finds some basic elements that distinguish the property rights literature. First, all methods of allocating resources have costs and benefits and no single mechanism works for free and dominates all oth