Transaction costs

Definition – A transaction cost is any cost involved in making an economic transaction. For example, when buying a good or buying foreign exchange, there will be some transaction costs (in addition to the price of the good.)

The transaction cost could be financial, extra time or inconvenience.

Transaction costs could involve.

  • Paying a margin to an intermediary. For example, when buying foreign exchange a broker may take a commission of 0.5% of total purchase.
  • Search costs. When purchasing foreign exchange, you will look around for the dealer with best commission rate.
  • Contract costs. For transactions, you may need to sign a contract to specify what the parties need to stick to. This can involve bargaining to gain the best contract and ensuring the contract is honoured. If there is little respect for property rights, these transaction costs may be quite significant. (e.g. if you have to take a landlord to court to complete purchase of house)

In a simple barter economy, transaction costs will be greater because of problems, such as searching and finding someone to trade with. Money helps to reduce transaction costs.

An argument in favour of a single currency is that it reduces the transaction costs of exchanging foreign currency when moving between different European countries. (benefits of Euro)

Transaction cost theory

Transaction cost theory suggests that the growth of firms is partly explained by the desire to reduce transaction costs from the market mechanism and concentrate production within a firm.

Transaction costs and internet

The internet has helped to reduce transaction costs for firms. Markets are more competitive enabling firms to get lower prices from suppliers. It has also made it easier and more convenient to search price comparison sites.

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