Business, Legal & Accounting Glossary
Transaction costs are costs incurred to complete a financial transaction. In financial markets, the primary transaction costs are commissions paid to brokers for trade execution. Other transaction costs include paying the spread, or the difference between what it costs to buy an asset and what the asset can be sold for. Transaction costs become increasingly important the shorter the holding time of an investment.
Many market models ignore transaction costs, assuming instead that markets are frictionless. While not strictly true, for many applications transaction costs are low enough that they can be ignored. The lower the transaction costs, the more efficient a market is said to be. Stock and foreign exchange markets have the lowest transaction costs of any major asset class.
In economics and related disciplines, a transaction cost is a cost incurred in making an economic exchange. 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 travel from your house to the store and back, and the time waiting in line, and the effort of the paying itself; the costs above and beyond the cost of the banana as the transaction costs. When rationally evaluating a potential transaction, it is important not to neglect 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, who 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, etc.. 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.
The term “transaction cost”, frequently thought to have been coined by Ronald Coase, who used it to develop a theoretical framework for predicting when certain economic tasks would be performed by firms, and when they would be performed on the market, is actually absent from his early work up to the 1970s. The term can instead be traced back to the monetary economics literature of the 1950s and does not appear to have been consciously ‘coined’ by any particular individual.
Arguably, transaction cost reasoning became most widely known through Oliver Williamson’s ‘Transaction Cost Economics’. These days, Transaction Cost Economics is used to explain a number of different behaviours. Often this involves considering as “transactions” not only the obvious cases of buying and selling but also day-to-day emotional interactions, informal gift exchanges, etc.
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This glossary post was last updated: 20th February, 2020