Transaction Cost

Updated on February 1, 2024
Article byNupur Chowdhury
Reviewed byDheeraj Vaidya, CFA, FRM

Transaction Cost Definition

Transaction cost is the expense one incurs by engaging in economic exchange of any kind. Any activities associated with a market generate transactional costs. They represent the trade expenses that one needs to cover for aiding the exchange of goods and services in a market. 

Examples of common transaction costs are labor, transportation, broker fees, bank charges, commissions, etc. The nature and magnitude of transaction costs vary in different business scenarios. Nevertheless, these costs play a huge role in business management and economic growthEconomic GrowthEconomic growth refers to an increase in the aggregated production and market value of economic commodities and services in an economy over a specific more.

Key Takeaways

  • Transaction costs are associated with facilitating a transaction in the market. Examples are a broker’s fee or an insurance company’s premiums.
  • There are three primary types of transaction costs: search and information, bargaining, and enforcement.
  • A person trying to buy a house incurs search costs when looking for a real estate agent, bargaining costs when looking through various houses to close a deal, and enforcement costs when hiring a lawyer to draw up the paperwork.
  • The transaction cost theory states that organizations always try to minimize transaction costs, either by managing resources internally or by outsourcing the service.

Transaction Cost

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How Does Transaction Cost Work?

To buy or sell any commodityCommodityA commodity refers to a good convertible into another product or service of more value through trade and commerce activities. It serves as an input or raw material for the manufacturing and production more in the market, a person needs to find a dealer who can provide the commodity. The person then negotiates the price they are willing to buy or sell the commodity, leading to a bargain. They finally agree on a price that is acceptable to both parties. The person will then need to draw up a contract for the sale and hire legal help to ensure that all parties abide by the contract terms.

Here, the transaction cost includes the expense for availing of the services of the dealer and the lawyer. It is an additional charge the buyer has to pay besides the commodity’s price. As such, these costs inflate the total cost involved in a purchase. They are also hidden costs because one often can’t see the results of these expensesExpensesAn expense is a cost incurred in completing any transaction by an organization, leading to either revenue generation creation of the asset, change in liability, or raising more in terms of a physical product or service. 

Hence, one can calculate the transactional cost of a particular purchase as the difference between the price a buyer paid and the seller received.

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Types of transaction costs

There are three main types of transaction costs. Let us explore each with the help of an example. Suppose a person is trying to buy a house. Here the transaction costs include

#1 – Search Costs

These are the costs of searching for information on sellers or availing services that can help a person find the best commodity. Some examples are communication and consulting fees, advertising expenses, travel expenses, etc. The individual trying to buy the house pays a real estate agent to help them find the perfect property. Here, they incur search costs to find the right commodity (a house).

#2 – Bargaining costs

These are the costs related to negotiation and conflicting interests regarding trading until the transacting parties agree. An individual has to spend time and labor looking at different houses and negotiating the price with the owners. Here they are incurring bargaining costs.

#3 – Enforcement costs

These are the expenses one incurs to verify and ensure that the parties involved in a contract comply with its terms. It relates to the time, money, and effort taken by a person to ensure that everyone meets the terms of the agreement. The person who is finally planning to purchase hires a lawyer has to draw up the paperwork for sale. In this case, they are paying for the enforcement costs.

To facilitate the original goal, the buyer has to sustain all these three types of costs, i.e., buying a house.

Types of transaction costs

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Let us understand this concept through two transaction costs examples.

A company needs clerical staff for their new office. Therefore, it hires a recruitment firm to find suitable clerks. Here, the company is the service buyer, while the clerks are the service’s sellers. The recruitment firm is the medium here. Hence, the money paid to the firm for recruiting clerks for the company is the transaction cost. 

Cryptocurrency is a real-life example to study the effect of transaction costs on global economics. Cryptocurrencies help cut out the middleman in any transaction between two parties by facilitating decentralized, cashless transactions over the internet. As there is no intermediary, the transaction costs are much lower than when they use fiat currency. 

Transaction Cost Theory in Economics

The transaction cost theory states that the goal of any organization is to minimize costs associated with transactions. Therefore, the organization will either choose to manage these resources externally or internally, depending on transaction costs.

For instance, the theory predicts that organizations would internalize most transactional activities within hierarchies when these costs are high. On the other hand, organizations would prefer to outsource the activity when the costs are low. It is because paying an external source to perform the activity would be cheaper.

According to this theory, all organizations encounter expenses with market transactions. Depending on whether these costs are high or low, organizations sometimes favor internal (or in-house) hierarchies or favor external markets as a structure for their economic governance. A third governance structure, known as relational or hybrid, is an intermediate mechanism combining the other two.

Let us look at a practical application of this theory. A company needs to hire 20 clerks for its new office. It can either recruit the clerks through its internal HR department or outsource the recruitment process to an external recruitment firm. Either way, the company would have to pay certain money associated with the recruitment. It would either have to pay salaries to those working in its internal HR department or pay a fee to the external recruitment firm. Whether the recruitment process is completed internally or externally will depend on which of these costs is lower.

If staffing an in-house HR department is cheaper in the long term than hiring an external recruitment firm, the company will complete the process internally. The opposite will be true if outsourcingOutsourcingOutsourcing refers to contracting out specific business processes to a third-party or specialized service provider, i.e., an individual or more is the more affordable option. 

Frequently Ask Questions (FAQs)

How to reduce transaction costs?

Depending on the type of transaction one is dealing with, they can reduce the transaction costs in many ways. Companies opting for work from home instead of running an office are good examples of reducing their transaction costs. Using digital media for common services is an effective way to reduce these costs. The internet and video calls have helped lower travel costs, search and information costs, and communication costs.

What is transaction cost analysis?

The study conducted by financial analysts is to understand whether an organization undertakes a trade at the least transaction cost possible. The analysis is undertaken before and after the trade, where all the transaction costs are recorded and studied.

What is transaction cost economics theory?

This theory states that any exchange in the market requires a transaction cost to be paid and that the goal of any organization or firm would be to reduce these costs.

This has been a guide to Transaction Cost and its Definition. Here we explain how transaction cost theory in economics works and its types and examples. You can learn more from the following articles –