Dear Amanda,

Some of the terms you are asking about are technical terms in
economics. They have specific meanings.

Transaction costs is such a term. The Dictionary of Economics from
Oxford University Press defines transaction costs as

“The cost incurred in undertaking an economic exchange. Practical
examples of transaction costs include the commission paid to a
stockbroker for completing a share deal and the booking fee charged when
purchasing concert tickets. The costs of travel and time to complete an
exchange are also examples of transaction costs. The existence of
transaction costs has been proposed as the explanation for many of the
economic institutions that are observed. For example, it has been argued
that production occurs in firms rather than through contracting via the
market because this minimizes transaction costs. Transaction costs have
also been used to explain why the market does not solve externality
problems . See also Coase theorem; transaction cost economics.”

Ronald Coase (1937, 1988) won the Nobel Prize in Economics in 1991 for
a 1937 article titled “The Theory of the Firm.” In this article., he
explained that nearly everything we do in business carries transaction
costs. When we buy and sell goods or services in the open market, these
transaction costs include gaining trust and knowledge, learning to work
together, moving goods back and forth, and so on. If we had to perform
all business in open markets, we would spend so much time on transaction
costs that the price of goods and services would soon outstrip our
ability to pay. Things simply wouldn’t be worth doing. In early human
communities – primarily agricultural – and in many rural farming
communities through the late 19th century, people would do everything
for themselves. We formed cities around markets to permit people to work
together for many purposes, buying goods and services in a trading
economy among them.

As humans began to create specialized labor markets, one question was:
“Is it cheaper and more reliable to make my own wagon wheel, blanket,
or pot, or do I do better to buy the good or service in the market?”
Another question was: “If I can buy goods and services in the market,
how do I know it will cost me less in my own labor while providing
better quality than I can get for myself?” If we specialize through
division of labor and increasing expertise, each of us will generally
produce better goods and services than if we attempt to make all things
– I provide expert services in my field, but I would likely make
extremely bad wagon wheels or automobile tires, and my blankets or pots
would not be what an expert can make. This suggests that markets have
reasonable functions. Then comes the price question, and transaction
costs make goods more costly or cheaper – as well as making it more or
less expensive for companies to produce them.

Now here is an example of transaction costs. I like to eat out these
days. Back home on our island in the Oslo Fjord, I loved cooking. But I
was often working at home, and I did most of the cooking as good
house-husband. These days, I work a long day on most days. By the time I
get home, I’m tired and too lazy to cook. My wife Ditte, on the other
hand, loves my cooking. It’s one reason she married me. (Of course, my
natural charm didn’t hurt, or the fact that she found a short, balding
man strangely attractive.) But it remains the case that she believes I
make better food than she can get in most restaurants. In my view, the
time for the shopping I used to love and the time for cooking it runs
the cost of my meals far higher than I prefer. I believe that the market
provides specialist labor food at a far better price than the cost to me
when I cook. For me, the transaction costs are high, while markets
provide better services at a lower cost.

Whenever people work together on projects, they incur transaction
costs, even when they do not spend money. This is why we see more
effective teams develop among colleagues who work on the same floor of a
building in adjacent offices. Productivity decreases if colleagues work
a floor apart, decreasing still further in separate buildings.
Interestingly, once colleagues work together to develop a sense of
coherence, they can work half a world apart using email and telephone.
The issue of patterning, learning, trust, awareness of work habits, and
the rest determine a great deal.

Transaction costs also play a role in other ways. In the days before
digital library collections, one company I knew was spending tens of
thousands of dollars on reference books for each researcher. To save
money, they consolidated all libraries on each floor of a ten-story
building so that every floor would have only one collection instead of
the equivalent of multiple sets. The time that researchers began
spending tracking down books and resources, waiting for copies of needed
books to become available, etc., reduced productivity so dramatically
that the company found it cheaper to return to the former practice of
buying multiple sets of books on each floor.

Transaction costs through brokerage do not necessarily lead to path
dependencies. Path dependencies are another issue entirely. I imagine
that one can find a case where brokerage leads to path dependencies, but
this is not a general issue. To understand transaction costs, I’d
suggest reading Coase and some of the more recent literature. You can
also Google Coase’s Nobel Lecture for an interesting view on these
issues.

Yours,

Ken

Professor Ken Friedman, PhD, DSc (hc), FDRS | University Distinguished
Professor | Dean, Faculty of Design | Swinburne University of Technology
| Melbourne, Australia

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References

Coase, R. H. 1937. “The Nature of the Firm.” Economica, New Series,
Vol. 4, Issue 16 (November 1937), 386-405.

Coase, R. H. 1988. The Firm, the Market, and the Law. Chicago:
University of Chicago Press, 33-55

Amanda Bill wrote:

—snip—

Not sure what you mean about transaction costs. Are you talking about
how the brokerage of design activity can result in path dependencies?

—snip—