I have a long bus commute to work in Washington DC. Most mornings I am engrossed in reading the latest news or a scholarly article, but the other morning I was thinking about a knotty problem and found myself looking out of the window. The answer to the problem became apparent as I realized how many commercial vehicles there were out there, and that each one was engaged in an economic transaction of one kind or another. It’s all about transaction costs.
Nobel laureate Ronald Coase first brought transaction costs to our attention in the 1930s. His article, The Nature of the Firm, examined the role of what was then called “marketing costs” in allowing an economic transaction to take place, and the particular nature of the employment contract in reducing these costs.
A transaction cost is, at its simplest, a cost incurred in making an economic transaction such as buying a new phone, getting legal advice, or flying to Maui for a holiday. If the transaction costs are too high, the transaction doesn’t happen. Yet it is these transactions that are the basis of wealth creation. As David R. Henderson says, “The only way to create wealth is to move resources from a lower-valued to a higher-valued use. Corollary: Both sides gain from exchange.”
So if transaction costs are too high, resources remain at their lower-valued usage. I keep my money in my pocket rather than getting a new phone, the lawyer’s investment in his skills goes without a return, and planes fly with empty inventory. It is in all our interests to get transaction costs down. Technology has been a great enabler of this in the decades since Coase wrote that first paper. Yet there are other aspects to reducing transaction costs – such as the institution of the rule of law reducing the transaction costs of corruption.
Indeed, the vast wealth of America can be explained by how we have lowered transaction costs. The invention and adoption of the automobile, for example, lowered the transaction cost of distance. All those commercial vehicles flying by my bus were engaged in economic transactions that would not have been possible a hundred years ago.
Keeping Costs Low
That’s not all lowering transaction costs can do. In his second great article, Coase looked at “The Problem of Social Cost.” Coase’s insight here was that so-called economic “externalities” were not just a question of one party inflicting harm on another, but a conflict of interests that could be resolved by an economic transaction if transaction costs were low enough. Environmental regulations crowd out the possibility of running a crowdfunded campaign.
We now live in a world where Venmo makes settling debts for shared pizza purchases easy. Is it too hard to believe that environmental nuisance problems cannot be solved quickly and easily by appropriate cost-sharing mechanisms? While we may not be there yet, we are much closer than we were just a few years ago. As I have written about at length here, homesharing and ridesharing technologies have created new markets simply by lowering the transaction costs of putting people in touch with one another. It is plausible that new environmental markets could be created in similar ways.
Want to save the spotted owl? Using a crowdfunding platform, you could contribute to compensating the owner of the woodland who won’t be able to harvest lumber.
Unfortunately, while many transaction costs are trending down, some are veering up. That’s often because of regulation. Payment regulations could make apps like Venmo too expensive to use. Occupational licensing regulations could make trading your skills illegal unless you gain licenses requiring thousands of hours of study – and costing hundreds of dollars. Environmental regulations crowd out the possibility of running a crowdfunding campaign to save the spotted owl (the money goes instead to environmental pressure groups who simply lobby for more regulation).
That’s a problem because all that regulation is getting in the way of yet more wealth creation. It’s no coincidence that the much-ballyhooed income stagnation in America began at about the same time as regulation started to take off. Technology has kept us a few steps in front of some of the regulation, but we’d still benefit from much of that $1.9 trillion annual burden being lifted.
If we lift that burden, transaction costs will go down, and there will be even more commercial vehicles speeding down the highway. If you’re worried about the cost of congestion, well, autonomous vehicle technology and ridesharing could take care of that, as long as the transaction costs are low enough. Because, in the end, it’s all about transaction costs.
Originally posted to Foundation for Economic Education.