One Reason Why Economics is Challenging

Published February 10, 2018

Nineteenth Century poet Christina Rossetti asked, “Who has seen the wind?” Neither you nor I have, but we know that the wind can blow down trees and buildings. Transaction costs in economics are similarly invisible and probably impact our lives even more than the wind.

Transaction costs are the costs of making and carrying out deals and trades. They include transportation costs, the time required for shopping, the cost of writing contracts, and the potential for people to take advantage of other parties. The time needed to read and understand the fine print for everything we buy would be a transaction cost.

As economist Ronald Coase first understood, transaction costs explain the existence and size of businesses. They help answer questions like: Why do businesses contract for cleaning and lawn mowing? Why do rental car damage waivers cost so much? And, why are law firms organized as partnerships?

Lowering transaction costs increases prosperity. Lower transportation costs make global businesses possible, and telecommunications helps manage these enterprises. eBay and Amazon Marketplace allow used items to be sold for much more than garage sale prices. New ways to organize businesses, like the traditional corporation and the benefit corporation, also reduce transaction costs. Economic historian Douglas North attributed much of modern prosperity to transaction cost reductions enabled by the institutions of the market economy.

Still, many economists overlook transaction costs in spite of the work of Nobel Prize winners Coase, North, and Oliver Williamson. The core economic models generally ignore transaction costs, which are sometimes viewed as no more than friction. Frictionless pulleys and tables make physics problems much easier. The frictionless world of physics homework, though, still teaches students a lot about the real world.

In economics, transactions costs significantly affect how we interpret the world. How so? A couple of years ago, my flight back to Atlanta was delayed because a flight attendants fell prior to boarding, hit her head, and likely suffered a concussion. Fortunately, an off-duty flight attendant was on the next flight arriving from Atlanta; if he agreed, he could work our flight for overtime pay. Tension was high as we awaited his arrival.

Professor Coase in “The Problem of Social Cost,” one of the most important economics papers of the 20th Century, explained what we passengers should have done: take up a collection to offer the flight attendant a bonus. One passenger indeed asked a gate agent if we could each give $1 as an extra incentive. The agent responded that an extra $150 would certainly make her more likely to work overtime!

We did not take up a collection, and the flight attendant decided to work our flight for the overtime pay. Our failure to offer a payment could have produced inefficiency if the flight attendant was unwilling to work for just overtime but would have for a bonus. We would have valued getting on with our trips enough to make it worth happening, and yet have remained in Oklahoma City.

The cost of organizing a group of strangers in an airport to make a payment, however, may be quite high. The other passengers might have dismissed a solicitation by a fellow passenger, or presumed that the organizer would just pocket the money. Our value of traveling may not have been enough to cover the bonus and the cost of organizing, making it efficient that we stay in Oklahoma overnight.

My travel dilemma resembles the challenge of public policy: is the market or government more efficient? We could try using voluntary contributions to pay for, say, national defense. The cost of organizing 320 million people to raise nearly a trillion dollars a year for defense seems impossibly high. Having government to tax us and spend on our behalf may be a better option.

Yet representative democracy is also imperfect, due in part to – transaction costs. Disagreements about the role of government often turn on whether transaction costs are higher in politics or in markets. Given that we cannot see transaction costs (or the wind), disagreement among economists about government policy seems unavoidable.