Transaction Cost

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Transaction costs are the time, money, and effort lost in obtaining what one wants. For example, in order to drive to the store and buy groceries, you must first spend effort and time to earn money, then you spend that money on gas to drive to the store and when you arrive on groceries, time is also spent driving to and from the store and shopping.

Common transaction costs are:

searching for information, such as where to buy something and where the best price is
bringing the parties together to negotiate, which can be difficult if there are many parties
bargaining for an agreement by both sides
enforcing the agreement and suing if necessary

It is debatable whether taxes qualify as a transaction cost. But in a paper by economists Collins and Fabozzi in 1991, they propose the following analysis of the transaction costs in stock trades:

Transaction costs = fixed costs + variable costs
Fixed costs = commissions + transfer fees + taxes
Variable costs = execution costs + opportunity costs
Execution costs = price impact + market timing costs

Professor Ronald Coase did not first coin the term "transaction cost," but he was its most informed scholar. He wrote in his famous papers of 1937 and 1961 that transaction cost is "the cost of using the price mechanism" or "the cost of carrying out a transaction by means of an exchange on the open market."

In his 1961 paper, Coase elaborated on the concept without using the term (p. 15):

In order to carry out a market transaction it is necessary to discover who it is that one wishes to deal with, to inform people that one wishes to deal and on what terms, to conduct negotiations leading up to a bargain, to draw up the contract, to undertake the inspection needed to make sure that the terms of the contract are being observed, and so on.

This became known as transaction costs.


Sources: Overview of definitions of transaction costs

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