Element 1.5: Transaction Costs Are Obstacles to Trade

“A large part of what we think of as economic activity is designed to accomplish what high transactions costs would otherwise prevent.”

Voluntary exchange promotes cooperation and helps us get more of what we need, want, and value. Trade itself, however, is costly. It takes time, effort, and other resources to search out potential trading partners, negotiate terms, determine risks, and complete exchanges. Resources spent in these ways are called transaction costs, and they are obstacles to the creation of wealth. They limit both our productive capacity and the realization of gains from mutually advantageous trades.

Transaction costs are sometimes high because of physical obstacles, such as oceans, rivers, and mountains, which make getting products to customers difficult. Investment in roads, transportation, and communication improvements can reduce these transaction costs. In other instances, transaction costs may be high because of the lack of information. For example, you may want to buy a used car, but you don’t know someone willing to sell a reliable car at an attractive price. The time and energy spent searching for a car, assessing trustworthiness, and negotiating a price are part of your transaction costs. In still other cases, transaction costs are high because of political obstacles, such as taxes, licensing requirements, price controls, and tariffs. Regardless of whether the roadblocks are physical, informational, or political, high transaction costs reduce the potential gains from trade.

People who help others arrange trades and make better choices reduce transaction costs. They help promote economic progress. Such specialists are sometimes called middlemen. They include campus bookstores, real estate agents, stockbrokers, automobile dealers, and a wide variety of merchants. Many people claim that middlemen merely increase the price of goods and services without providing benefits. If this were the case, people would not choose to use their services. Transaction costs are obstacles to trade, and middlemen reduce these costs and benefit others through their services. This is why people value their services and are willing to pay for them.

The grocer, for example, is a middleman. Of course, today’s giant supermarkets reflect the actions of many people, but together their services are those of a middleman. Without the grocer, think of the time and effort involved in preparing even a single meal. You would have to deal directly with farmers when purchasing vegetables, citrus growers when buying fruit, dairy operators if you want milk or cheese, and ranchers or fishermen if you want to serve beef or fish. Grocers make these contacts for you and other consumers, place the items in convenient selling locations, and maintain reliable inventories. The services of grocers and other middlemen reduce transaction costs significantly, helping potential buyers and sellers realize gains from trade. These services increase the volume of trade, promote economic progress, and release resources for other uses.

The amazing growth of online marketplaces such as Amazon, Alibaba, AliExpress, Lazada, and others illustrate the importance of reductions in transaction costs. In just two decades, Amazon grew from a small online bookstore to the world’s largest retailer. Alibaba, in less than three decades, has emerged as one of the top ten most valuable companies globally. How was this achieved? The reduction in transaction costs is the key. These platforms, among others, have rapidly expanded by cutting down the costs associated with buying and selling. Customers no longer need to go from one physical store to another to find what they need. Instead, they can easily compare products, prices, and reviews online. With just a few clicks, their purchases are made and the products are shipped directly to their homes.

In recent years, technology has reduced the transaction costs of numerous exchanges. In a few swipes on a device, buyers can now acquire information about potential sellers of almost every product. Apps are routinely used to shop for groceries, clothing, household items, and homes. They locate hotel rooms and flights, obtain tickets for major events, and even share rides.

Similarly, technological improvements and discovery of better ways of doing things have vastly reduced the cost of shipping goods in recent decades. Adjusted for inflation, the cost of shipping per ton via both ocean and air is now less than 50 per cent of what it was the early 1970s. These reductions in transaction costs, including transport costs, have increased the volume of trade, expanded our production, and enhanced our living standards. They have played a central role in the worldwide rapid growth of per-person income and huge reductions in poverty.