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Understanding Transaction Costs

Every financial transaction involves some degree of extra cost, from researching competing products to broker fees to insurance. The degree of cost will depend on the type of transaction, so how can you plan for these in your budget? Here’s what to consider when breaking down cost per transaction.

What are transaction costs?

We’ll start by answering the basic question – what are transaction costs? The meaning of transaction cost refers to any money spent during the trading process, whether buying or selling, in addition to the cost of the asset itself. This could include concrete expenses like:

  • Bank fees

  • Broker fees

  • Legal fees

  • Underwriter fees

  • Insurance costs

Transaction costs also include more abstract costs, such as the difference between what the dealer and buyer paid for a specific security. They also include the money spent researching and discovering a product, as well as the cost of labour required to bring a product to the market. In real estate, the cost per transaction includes added fees like stamp duty, additional taxes, and agent commissions. Naturally, all these transaction costs should be considered when pricing a good or service.

What is transaction cost theory in economics?

When looking at the meaning of transaction cost it’s also important to consider its place in economic theory. The transaction cost theory was devised by economists Ronald Coase and Oliver Williamson to explain why markets need companies.

How does this work exactly? In an ideal world, markets wouldn’t require companies. The market forces would provide all the conditions needed for production. However, in the imperfect markets of the real world, companies need to exist. They use their authority to allocate resources efficiently and ensure production.

According to this theory, there are four main elements of transaction cost to consider:

  1. The world is unpredictable and filled with uncertainty.

  2. It can be expensive for organisations to leave transactions or contracts due to bargaining.

  3. Individuals are only able to process limited information due to limited rationality, which means transactions are also based on bounded rationality.

  4. Due to opportunistic behaviour and bounded rationality, it’s difficult for contracts to be enforced over time.

If you follow the line of thinking of these four transaction theory elements, the conclusion is that it’s difficult to maintain contracts in business. This is what creates transaction costs, which include the cost of services of professionals like lawyers and underwriters to enforce contracts. At the same time, large companies don’t need to enforce contracts because they have other methods of control like company incentives and employee monitoring.

Types of transaction costs

For the purposes of looking at real-world transaction costs, we can break them down into three main categories.

1. Search and information costs – finding out more information about a transaction

  • Meeting with agents

  • Stockbroker fees

  • Consultant fees

  • Cost of comparing products

  • Identifying stakeholders

2. Bargaining costs – coming to a mutually agreeable contract

  • Cost of drawing up a contract

  • Time spent at meetings

  • Cost of written and verbal negotiations

3. Policing costs – enforcing the terms of the contract

  • Lawyer fees

  • Auditor costs

  • Time spent monitoring

  • Employing external monitor

Cost per transaction example

To calculate the cost per transaction, consider all the costs we’ve mentioned above. For example, imagine that you’re interested in purchasing a property. You’ll first need to consider search and information costs such as the time spent investigating available properties, employing an agent to assist you with your search. Bargaining costs will include the time and cost of negotiating a deal with the seller, along with practical issues like stamp duty and broker commission fees. Policing costs include the cost of disbursements and any additional legal fees that arise. These should all be added onto the cost of the property itself – and because they’re transactional, they’re sunk costs that you won’t recover.

Before beginning any transaction, you should look not only at the headline price but also consider the wide range of transaction costs involved. These will be higher when trading complicated securities or purchasing real estate, so must be factored into any budget.

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