10. Transaction costs: the origin, nature, classification, measurement problems.

In economics and related disciplines, a transaction cost is a cost incurred in making an economic exchange (restated: the cost of participating in a market). For example, most people, when buying or selling a stock, must pay a commission to their broker; that commission is a transaction cost of doing the stock deal. Or consider buying a banana from a store; to purchase the banana, your costs will be not only the price of the banana itself, but also the energy and effort it requires to find out which of the various banana products you prefer, where to get them and at what price, the cost of traveling from your house to the store and back, the time waiting in line, and the effort of the paying itself; the costs above and beyond the cost of the banana are the transaction costs. When rationally evaluating a potential transaction, it is important to consider transaction costs that might prove significant.

A number of kinds of transaction cost have come to be known by particular names:

* Search and information costs are costs such as those incurred in determining that the required good is available on the market, which has the lowest price, etc.

* Bargaining costs are the costs required to come to an acceptable agreement with the other party to the transaction, drawing up an appropriate contract and so on. In game theory this is analyzed for instance in the game of chicken. On asset markets and in market microstructure, the transaction cost is some function of the distance between the bid and ask.

* Policing and enforcement costs are the costs of making sure the other party sticks to the terms of the contract, and taking appropriate action (often through the legal system) if this turns out not to be the case.

In financial economics, transaction costs are generally understood as the cost of investing in financial markets, including brokerage fees and ask-bid spreads

The idea that transactions form the basis of an economic thinking was introduced by the institutional economist John R.Commons (1931).

Institutions and market as a possible form of organization to coordinate economic transactions. When the external transaction costs are higher than the internal transaction costs, the company will grow. If the internal transaction costs are higher than the external transaction costs the company will be downsized by outsourcing, for example.

Why Difficult to measuer: Managerial perceptions matter, and transactions costs cannot be quantified or measured separately from these perceptions. Managers undertake a conscious (not random) selection from among arrays of potential transaction costs, and among the most important transaction costs are those which are avoided by this process. From the observer's point of view, transaction costs are thus difficult to measure in any objective fashion.

Measurement problems are clearly just a manifestation of bounded rationality, without which transaction costs cannot exist. So suggestion that local managers have better knowledge of local conditions may prevent a shadow price system operating effectively.

For example, transaction costs for institutional investors (mutual funds & pension funds) are the following: TC(transaction costs)=commissions + fees + taxes + execution costs + opportunity costs, where Execution costs=market impact costs + market timing costs. Market impact costs represents the cost resulting from the bid-ask spread; market timing costs represents the cost resulting from the adverse price movement during the transaction which cannot be attributed to the particular transaction. Therefore, the problem with measuring transaction costs is that they depend on the supply and demand conditions at the margin which is not always observable and predictable. The availability of high quality data has increased, thus the measurement of the true cost of transaction is improving.