Essential Coase: Transaction Costs & Institutions

Welcome to the essential ideas of Ronald Coase.

In a previous video, we explored the  importance of the costs incurred when

goods and services are exchanged, such as the  time it takes to find a person to exchange with,

the time and costs to negotiate a deal, and  the costs of enforcing the sales agreement.

Coase called these “transaction costs.” But he not only identified the importance

of transaction costs, he also understood the  way they shaped how the entire economy works.

As Coase explained, it's important to keep  transaction costs low so that more economic

exchanges can occur, which makes people better  off. But when transaction costs are too high,

they impede economic activity. For example, imagine if the legal and

regulatory steps required to buy a house—hiring a  realtor and a lawyer and changing titles with the

land registry office, and so on—were also required  when you bought a bike. No one would ever buy a

bike because the transaction costs are too high. However, for a major and costly purchase like a

house, the higher transaction costs don't impede  exchange. Or imagine if bikes were only allowed to

be sold in separate parts. You have to buy the  frame from one store, the tires from another,

the gears and brakes from another, and the  accessories from yet another. The time,

energy and costs involved would likely prohibit  almost everyone except the most ardent cyclists

from buying bikes. Simply put, the transaction  costs involved in buying a bike would be too high.

Given that there are transaction costs for every  exchange we make, and because it's so important

to keep them as low as possible, many of the  institutions we see in the economy emerged to

do exactly that—minimize transaction costs. Take the banking industry, for example,

whose entire reason for being is to  conveniently –and at a low cost—bring

together savers and borrowers. Without banks, the  transaction costs for borrowing money would be

much higher because it would mean borrowers would  have to spend a lot of time and money to find

other people interested in lending their savings. A more modern example is internet search engines,

which reduce transaction costs by making it  easier to find shops and sellers who offer

what you're looking for. Online reviews,  too, reduce transaction costs because they

help would-be buyers identify better, potentially  more trustworthy sellers and service providers.

Coase not only identified the importance of  transaction costs, but also how businesses

and institutions designed to lower the  costs of exchange are all around us today.

For more information on Ronald  Coase visit EssentialCoase.org,

and to learn about more essential  scholars, visit EssentialScholars.org