Saving "the Market” out of Cambridge: “Transaction Costs”

 

“Theories are approximations. Nothing is completely anything,” or so does the Nobel-laurate Eugene Fama quip. He is very true: At best, laws, principles and theories in science are approximations across the space or tendency over the time.

            There are two great reasons for such incompleteness: one is difficulty in specifying and defining the environment; the other presence of frictions. In conjunction with our economic activities in general and market trade in particular, the one may be dubbed as “imperfect knowledge” and the other “transaction costs.”

            The law of one price is a rough, very rough, approximation. First, we do not have the complete knowledge conducting arbitrage, interspatial, intertemporal or inter-substitutive. For instance, we do not know for sure prices at Walmart, Trader Joe’s and the other alternative sellers. Moreover, we have to pay a traffic fare, among other costs, which eats an arbitrage benefit to a certain extent.

            More than clearly, such defects prevent the community from achieving Pareto optimality. The two of them must be Public Enemy #1 and #2. 

            We may think of various types of transaction costs including the following:

1)     We pay for information about possible means to the defined end. In addition we need detailed information on potential partners of trade.

2)     We pay for deal-making in spoken or written words and implementing a commercial transaction. These costs may be substantial depending upon nature of the transaction. Legal fees, if any, must be included in this category as well. In a war-torn economy, one might need a legion of mercenary for the implementation.

3)     We pay administration costs all through the process from the beginning to the end of transaction. According to certain economists, these costs are especially important in association with industrial transactions at the firm. “Moral hazard” or the “agency problem” is frequently cited.

4)     We pay transportation costs in time and money of the household, the object or both. We pay transformation costs including brokerage fees and banking costs to trade assets or financial instruments for money.

5)     We pay risk premiums. We can in no case remove uncertainties completely, and consequently we in risk management pay costs in time, money or both. These are particularly pertinent to inter-temporal arbitrage which involves the future of everyone’s non-surety.

Needless to say, the costs listed above are inter-substitutive. As a matter of course in everyday life, we sometimes interchange information, time, distance or money with one another.