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  The Transaction Costs Paradigm:

  1998 Presidential address Western
  Economic Association


    Steven N. S. Cheung


    Though the idea can be traced to David Hume and Adam Smith, the
    path breaking first economic analysis of transaction costs did not occur
    until 1937, when Ronald Coase published "The Nature of the Firm."1
    Stigler and Boulding perspicaciously reprinted Coase's paper in the
    famous AEA Readings in Price Theory {1952}, but for a quarter of a
    century it had no real impact on the profession. In the 1940s two
    significant works were published which touched on transaction costs, but
    these sparks did not ignite a fire.2

    The transaction costs paradigm began to blossom in the early 1960s.
    Again it was Coase who supplied the premium mobile-his great paper on
    social cost was published in early 1961, though Aaron Director dated
    that issue of Journal of Law and Economics as 1960. Ronald had
    company this time: George Stigler's article on information cost came out
    later the same year, and Kenneth Arrow's work on the appropriability of
    returns to inventions appeared in 1962.3

    The combined wisdom of three brilliant men would perhaps not have
    been enough, except that by the early 1960s science was on their side.
    Jargonistic articles on economic development flooded the journals
    throughout the 1950s, but by 1960 economists were beginning to question
    the explanatory power of this kind of economics. After the clarion call of
    Friedman's work on the consumption function (a few years earlier, in
    1957), the great methodological debate began.4 The demand for testable
    implications was becoming more vociferous by the day, and the tendency
    for economists to be policy oriented was losing hold as the Keynesian
    revolution waned.5 The tide of economic explanation was beginning to
    swell, and the transaction costs paradigm was the beautiful goddess who
    emerged from the foam.

    I began graduate work at UCLA in 1961, and after my MA a year later
    I turned to audit the price theory lectures of Jack Hirshleifer and Armen
    Alchian. The straight As student who knew by heart everything about
    market imperfections was told that this kind of knowledge did not count!

    By 1963, graduate students at UCLA's Department of Economics were
    all talking property rights and transaction costs. Now I knew Coase and
    Stigler by heart, and could even handle the questions on pricing behavior
    and mergers at the end of Friedman's Price Theory {1962}. Moreover, I
    was the luckiest of the lot because in late 1963 Armen gave me a copy
    of a manuscript by Harold Demsetz.6 One of the great expositors of our
    time, Harold wrote about property rights and transaction costs with such
    clarity and force that I decided then and there to work on these topics
    for my doctorate. Since that time, my research has all been on the same

    In this address, I shall confine discussion of the transaction costs
    paradigm to my own involvement. This limitation is imposed by
    necessity. I like to sail the strange seas of thought alone, and have
    seldom read other people's publications with the seriousness they
    deserve after I left Chicago in 1969. From 1976 to 1982, I spent my time
    on contracts in the petroleum industry, and from 1982 to now, my
    research has concentrated on economic reforms in China. Although
    these works are all transaction-costs oriented, the former is not in print
    because it is proprietary, while the latter has mostly been published in
    Chinese. After more than half a lifetime on the seashore, however, I feel
    it is time to share my small collection of pebbles with colleagues in the
    WEA. Still, you would not be wrong if you feel that I am addressing the
    subject as if I were a stranger returning from another planet.


    "Transaction costs" must be defined to be all the costs which do not exist
    in a Robinson Crusoe economy. This broad definition is necessary,
    because it is often impossible to separate one type of transaction cost
    from another: the toll collector of a bridge serves not only transacting
    customers but also police against trespassers. What is important is that
    inseparability does not hinder the derivation of testable hypotheses.
    Indeed, it is isomorphic to the case of joint production with variable
    proportions where average costs are not separable but marginal costs
    are, and so long as marginal costs are separable testable hypotheses may

    I have suggested, with the full approval of Coase, that transaction cost
    should actually be called "institution cost." An economy of more than one
    individual would necessarily contain institutions,8 but the costs that arise
    as a result may entail no transactions at all. For example, during the
    cultural revolution in China there were hardly any transactions in the
    market, but the political costs of memorizing Mao's slogans, establishing
    connections and so on were enormous. These costs certainly cannot
    exist in a Robinson Crusoe economy. They arise only where there are
    institutions, or in a "society" in the plain sense of the term. But changing
    household terminology is nearly impossible, so "transaction costs" stays
    even though it is not strictly correct and may even be misleading.

    "Transaction costs" thus broadly defined are huge indeed. Variations
    cover the incomes of lawyers, financial institutions, policemen,
    middlemen, entrepreneurs, managers, clerks, civil servants, ... just about
    all the conceivable costs in society except those associated with the
    physical processes of production and transportation. In today's Hong
    Kong, for example, when nearly all factories have moved north to the
    mainland, at least 80% of GDP derives from transaction costs, mainly as
    a result of servicing economic activity in China. In agricultural and
    non-politicized countries, transaction costs as a proportion of income
    would of course be less. But in the modern world, it would be difficult to
    find a rich country where transaction costs sum to less than half of
    national income.

    A question that must then be raised is why, given the magnitude of
    transaction costs, the subject could have been ignored by economists for
    so long? I believe there are two reasons.

    The first is that before the 1960s, with the single exception of Ronald
    Coase, economists tended to think of transaction cost as similar to
    transportation cost, or similar to a tariff or a commission. Students of my
    generation are all too familiar with the empty boxes we played with.
    Since Marshall's time economists did not, and many still do not, like to
    tackle a problem unless it fitted nicely into geometry or algebra or
    calculus. As traditionally understood, transportation cost, tariffs or
    commissions would not produce observations other than those pertaining
    to resource allocation and income distribution. For analytical
    convenience, therefore, deleting such price components would involve
    nothing more than a simplifying assumption. Thus it transpired that the
    followers of Walras adopted the convention, under which the auctioneer
    supplies services free of charge.

    The truth of the matter, of course, is that transaction cost is not the same
    thing as transportation cost. Changes in transaction costs, in one
    dimension or another, would generally lead to changes in the contractual
    or organizational structure. This is so because it may be possible to
    reduce transaction costs by rearranging institutions: the society we live in
    and the way we conduct economic activities depend upon the magnitude
    and type of cost which govern institutions in its numerous forms. You
    may recall that the Walrasian equations proceed in terms of n
    commodities and n-1 relative prices. The glaring hiatus in this approach
    is that the number n cannot be determined without introducing
    transaction costs, which however Walras assumed away.

    A second reason for economists' long neglect of transaction costs is that
    the concomitant constraints cannot be properly specified without
    knowing a lot about what is going on in the real world. This,
    unfortunately, is routinely difficult and exhausting. Transaction cost
    economics is real-world economics, and the real world is too often a
    place where academic economists fear to tread. Who would want to
    commit two years to studying an antitrust case, with an uncertain
    prospect of eventual publication? Pauca sed matura is a motto only a
    Gauss can afford.

    It was most unusual that it took only three months for me to complete an
    investigation of the constraints underlying beehive rentals, and write a
    paper everybody was keen to print.9 I also had luck with landlords and
    tenants (four years)10 and petroleum contracts (six years). But in patent
    and trade secret licenses, I ended up almost empty-handed after five
    years of trying. Transaction costs is not a subject a young economist
    seeking tenure should go into!

    It has been argued that it is fruitless to study transaction costs, because it
    is frequently impossible to measure them. This view is wrong.
    Fundamentally, measurement involves an assignment of numbers for the
    purposes of ranking, and precision in measurement can only be judged by
    the extent of agreement among different observers. To say that cost is
    measurable, or measurable precisely, does not necessarily mean it is
    measurable in dollars and cents. If we are able to say, ceteris paribus,
    that a particular type of transaction cost is higher in Situation A than in
    Situation B, and that different individuals consistently specify the same
    ranking whenever the two situations are observed, it would follow that
    transaction costs are measurable, at least at the margin. Testable
    propositions may then be obtained, and that is the important thing.


    Ricardo and Mill were only half right in their conclusions about
    specialization and comparative advantage. Comparative advantage, no
    doubt, promotes specialization, but it is not a necessary condition for
    specialization to occur. Even if everybody were born with identical genes
    so that we all possessed equal natural advantages, I doubt that there
    would be very much less specialization in the world. Rather,
    specialization sharply reduces the cost of learning. In addition to
    comparative advantage, the gain from specialization would therefore far
    exceed what Adam Smith envisioned with his story of the pin factory.

    An example may illustrate the point. A ball-point pen has a retail price of
    25 cents, and of this sum the manufacturer receives no more than a
    nickel. The pen consists of metal, plastic, petrochemicals, in addition to
    design and the great invention of the rolling ball. If none of these
    materials and technologies were known and one were required to
    manufacture a ball-point pen from scratch, the cost would be at least one
    billion times higher.

    Gains from specialization in Adam Smith's time were nowhere near as
    large as they are now. Specialization not only goes hand-in glove with
    physical production, but more importantly, it does so in the production of
    ideas. Ideas and innovations are indestructible and accumulate over time;
    they are also amenable to concurrent usage. Specialization in production
    reinforced with innovations fully explains why Malthus was miles off in
    his dismal prognosis of human livelihood.

    Adam Smith was also half right in saying that specialization is limited by
    the extent of the market. As I will elaborate below, though specialization
    requires the support of exchange, market transactions merely comprise
    one form of exchange. Because the gains from specialization are
    enormous, there is room to accommodate very large transaction costs
    from exchange in all of its variations, and still have resources a-plenty
    left over for all to enjoy. In this way, transaction costs as a proportion of
    gains from specialization provides a critical measure which, in my view,
    very largely explains observed differences in the wealth of nations.

    Economists have long been baffled by these differences. In particular,
    they have been intrigued by the fact that some societies have managed
    to do extremely well despite poor endowments in natural resources. The
    argument that different economic systems--different property rights
    systems-matter is of course correct, but it is incomplete. What is
    essential is the recognition that under different systems transaction costs
    differ as a proportion of gains from specialization, and if this ratio is
    reduced just a little, a significant increase in wealth would follow.

    My favorite example is China under communism, especially during the
    Great Leap Forward and the Cultural Revolution. There was hardly any
    market, but exchange did occur through a central distribution system.
    With exchange there would be specialization, but to realize the gains one
    had to contend with huge transaction/institution costs, leaving very little
    afterwards. In other words, under the communist regime transaction
    costs as a proportion of gains from specialization was very large. This, I
    believe, is why the Chinese were so poor in their communist days.


    It was Coase who suggested that in the presence of transaction costs
    Pareto optimality requires reinterpretation11; Demsetz reinterpreted it
    brilliantly;12 I went so far as to say that in the real world the Pareto
    condition is always satisfied.l3 Under the postulate of constrained
    maximization, in a one-man system economic inefficiency is, by
    definition, impossible. Robinson Crusoe may starve to death because he
    is constrained by incompetence, but there is nothing "inefficient" about it.
    The riddle then is why economists have been so prone to suggest the
    frequent occurrence of inefficiency in a society, in which Pareto's
    condition is claimed to be violated? My answer is that a violation of this
    nature can occur only if certain constraints are neglected or ignored.

    A self-service buffet dinner provides a good illustration. An individual
    paying a lump-sum and free to eat as much as he pleased will consume
    to the point where the marginal benefit from the last mouthful reaches
    zero. The marginal cost of producing that last mouthful, however, is
    positive. Conclusion: the Pareto condition is violated. However, the
    picture changes if we ask why the buffet dinner is served as such. The
    answer, of course, is that it saves the costs of waiting upon customers
    and of metering the food each consumes. These transaction-cost savings
    must be larger than the "waste" generated by on the limit consumption,
    and once we take them into account the Pareto condition would be

    Here there are two observations which require explanation. One is the
    eating behavior of buffet customers; the other is the choice of the buffet
    dining contract. To explain the former, there is no need to introduce the
    costs of serving and metering, and this omission leads to a conclusion of
    economic waste. To explain the latter serving and metering costs must
    be brought in, after which the waste disappears. Some economists tend
    to think that if the buffet customers behaved themselves and ate
    Pareto-optimally, a great deal of food will be saved and the price of
    dinners would accordingly be reduced, to the benefit of all. How nice
    would it be if the restaurant owner merely posted the marginal costs on
    the wall, and all customers would follow by eating equi-marginally? Yes,
    Sir Thomas More, the world would be a better place if we do not shirk,
    cheat, lie, or steal.

    There is no doubt transaction costs would be far lower if we were all
    born with decent genes, as if we were congenitally disposed to obey the
    Ten Commandments, and we would all be richer as a result. But
    "indecent" behavior is the result of constrained maximization, and this
    postulate must be asserted as universal or there would be no economic
    science. Selfishness helps society; selfishness also harms society. We
    seek to reduce transaction costs, but we also behave to increase them.
    Under different institutional arrangements the distribution of these gains
    and costs will differ. Indeed, the Ten Commandments can be interpreted
    as an institution designed to reduce transaction costs.

    In the buffet dinner example, it is clear that the Pareto condition appears
    to be violated only because certain transaction cost constraints are
    omitted, and because it is not necessary to introduce such constraints to
    explain a certain kind of behavior. Specification of the constraints
    sufficient for interpreting a given observation may not suffice to produce
    an "efficient" outcome, but this must not be construed to mean that the
    Pareto condition would remain violated when all transaction/institution
    costs are taken into account.

    The buffet dinner argument may be generalized to all "inefficient"
    activities in society. Take price or rent controls, which yield the standard
    examples of economic wastage. Here again, transaction/institution costs
    which underlie the political and legislative processes of control have been
    ignored. If these costs are brought fully into consideration, the Pareto
    condition would be satisfied.

    My reinterpretation of Pareto optimality renders the condition worthless
    in welfare economics, but significantly enhances its role in positive
    analysis. In specifying constraints to derive testable propositions,
    whenever the Pareto condition fails to hold we would immediately know
    that some constraints are missing: it would then be up to us to decide
    whether the omitted constraints are relevant to the observations we are
    seeking to explain.

    Equilibrium, defined as a state in which there is sufficient specification of
    constraints to yield testable implications, must display transaction costs
    (if relevant) as a constrained minimum. Failure to do so would render the
    analysis empirically empty. A notable example is the literature on the
    dissipation of rent, in which rent without exclusive claimants is said to be
    dissipated to produce an equilibrium. Often what replaces the rent
    dissipated are transaction costs in some form or another. If these are not
    treated in terms of constrained minimization, we cannot find a way to
    predict the particular behavior through which rent would dissipate.

    Treating transaction costs as a constrained minimum is a requisite for
    treating dissipation of rent as a constrained minimum. This is absolutely
    essential, if the postulate of constrained maximization is to be
    consistently applied. As I have noted in a study of price control, one
    cannot predict whether it would lead to queueing, politicking,
    favor-currying, or violence, unless the dissipation of rent is treated in
    terms of constrained minimization. 14

    My prolonged research on China's economic reforms has added another
    insight to this view. In the real world, there is no such thing as a valuable
    resource open to unrestrained common exploitation. When private
    property rights are absent, some other rights must emerge to fill the void.
    These "other rights" are in a substantive sense exclusive, whether they
    are assigned by hierarchical ranking, political connection, or sex appeal.
    Which way depends on transaction/institution costs, in a manner that
    keeps the dissipation of rent to a constrained minimum.

    Under its earlier communist regime, China chose a complicated but
    ingenious hierarchical ranking system to assign rights over resources.
    Hunger was widespread, and yet the population exploded. This paradox
    may be explained by noting that hierarchical ranking is an effective way
    to reduce the dissipation of rent.


    What would things be like if transaction/institution costs were zero?
    There are a number of possibilities, but one thing we can be certain of is
    that in such a world property rights or institutional arrangements would
    not matter. Analyzing institutional change in China, I wrote in 1982.15

    If all transaction costs, broadly defined, were truly zero, it would have to
    be accepted that consumer preferences would be revealed without cost.
    Auctioneers and monitors would provide free all the services of
    gathering and collating information; workers and other factors of
    production would be directed freely to produce in perfect accord with
    consumer preference; and each consumer would receive goods and
    services in conformity with his preferences. The total income received
    by each worker (consumer), as determined costlessly by an arbitrator,
    would equal his marginal productivity plus a share of the rents of all
    resources according to any of a number of criteria costlessly agreed
    upon. In other words, production and consumption activities can in
    principle be carried out without a market, to produce the same result as
    though costless markets were in operation.

    An important implication follows: the market itself is an institution, which
    would not have emerged if transaction/institution costs were zero. Like
    any other institution, the market was created to reduce transaction costs,
    subject to other constraints.

    Now the Coase Theorem, in its earlier FCC version, states that private
    property rights is a necessary condition for the theorem of exchange to
    be operative. In Coase's own words: "The delimitation of rights is an
    essential prelude to market transactions."16 In essence this is an
    important and fruitful way to restate and apply the theorem of exchange,
    in which I can find no flaw.

    On the other hand, I am disturbed by the Coase Theorem in its later
    social cost incarnation. This popular version, sometimes referred to as
    the invariance theorem, states that if private property rights exist and if
    transaction costs are zero then resource allocation will be "invariantly
    optimal," regardless of how the rights are assigned. The Coase Theorem
    so stated must be fallacious, because logically private property rights
    cannot coexist with zero transaction costs.17

    Private property rights is itself an institution and, like any other institution,
    it arises because transaction costs are not zero. As with any institutional
    arrangement, choosing a system of private property rights depends on
    how far transaction costs are reduced subject to other constraints. This
    brings to mind an observation made by Friedman some forty years ago,
    when he said it is foolish to try to empirically estimate whether a firm's
    cost of production is the lowest, for it must always be so by definition.18
    Similarly, if an institutional arrangement is observed to lead to massive
    starvation, by definition the tragedy is the result of constrained
    maximization. The problem of economic science is to begin with such a
    tautology, and then to derive falsifiable propositions to test the
    explanation of what appears to be a stupid choice. In the process, we
    should remember that tautologies, assertions and identities always appear
    at the starting point of scientific analysis.

    When in 1966 I conceived the notion that contractual arrangements are
    determined by choice subject to transaction cost constraints,19 I thought
    I was on to something novel. A few months later I realized I was mining
    the same vein as Aaron Director's oral tradition on tie-in sales, and
    Ronald Coase's work on the firm. I did not know it when I worked on
    sharecropping for my doctoral thesis, but in retrospect there is no way I
    could have completed the thesis without Aaron's and Ronald's influence.

    There is no reason why we cannot or should not extend the analysis of
    pricing and contractual arrangements to problems of larger scale, in
    particular by treating the constitution of a country as a contract and the
    state as a giant firm.

    In 1981, employing a transaction costs approach, I predicted that China
    will go capitalist.20 Many friends demurred-some (particularly Theodore W.
    Schultz) even argued that economic analysis cannot be used to make this
    type of prediction, but I let the manuscript go into print because I was
    convinced the analysis was correct. In this I owe a great debt to my old
    friend and colleague Yoram Barzel. Yoram too was skeptical, but he
    was also firm that my reasoning was flawless and urged that I publish.
    Judging from what has happened in China, it is clear that we have here
    at least one example, which shows how changes in transaction cost
    constraints may be applied to explain the evolution of the state.


    Economic analysis seems to have become a great deal more complicated
    since my student days. I find this development disturbing. The world
    being such a complicated place, we would stand little chance of
    interpreting its institutional arrangements if complicated tools are used.
    The transaction costs paradigm in which I was brought up, and here I am
    sure Coase fully shares my view has the merit that it entails only the
    simplest of economic tools. In fact, this paradigm contains no new theory
    whatsoever to speak of.

    Only three fundamental propositions are present in the paradigm. First is
    the postulate of constrained maximization. Second is the downward
    sloping demand curve, which (because there is no need to separate
    consumption and investment activities) also covers diminishing marginal
    productivity. Third is the notion that cost is the highest-valued option

    In this tradition, the transaction costs paradigm concentrates on changes
    in constraints. Nothing is new in the theory, and the analytical tools are
    kept to the most elementary. The paradigm, however, is simple but
    difficult. The difficulty lies in the thorough empirical investigation required,
    from which we can (hopefully) garner insights on the nature and
    classification of transaction cost constraints in the real world.

    On a fundamental level, there are only three avenues through which we
    can obtain economic interpretation of observations. First is manipulating
    the utility function; second is manipulating the production function; third
    is manipulating the constraints. (Combinations are of course possible.)
    New theory may emerge along the first and second avenue, but never
    with the third. My stance, and no doubt it is a minority view, is that
    institutional economics should confine itself to the third avenue.

    Interpretations of institutional arrangements have been attempted
    through all three avenues, together with a variety of combinations. I
    harbor mixed feelings about a major work, to which I contributed orally.
    This is the now famous Alchian-Demsetz paper on economic
    organization.21 Two of the leading price theorists of our generation,
    Armen and Harold combined manipulations of transaction cost
    constraints as well as the production function. Their paper has become
    the headwater of the game theoretic approach to contracts. This
    paradigm is too complicated for my liking. In my view we still have to
    wait, to see what predictive powers the fashionable high theory may or
    may not display.


    1. Coase {1937}.

    2. See Hayek {1945} and Coase {1946}.

    3. See Stigler {1961} and Arrow {1962}.

    4. It was Alchian's classic article {1950} which started the whole thing,
    and after Friedman's equally classic {1953} defence of the use of
    behavioral assumptions in positive economics, pundits like Gordon
    {1955}, Becker {1962}, Nagel {1963} and Samuelson {1963} entered
    the fray.

    5. Robbins {1961} observed that classical economists were all
    policy-oriented. This tradition was continued by Pigou and Keynes, but
    not by Fisher and Knight.

    6. I believe this manuscript was later published as two papers, at the cost
    of some loss in forcefulness. See Demsetz {1964} and {1967}.

    7. Hirshleifer suggests that it is essential to distinguish between two
    types of transaction costs: those associated with "exchanges", and those
    associated with "commands from higher authority". This observation
    would seem to be in the same vein as Coase's {1937} treatment of the
    firm and the market. However, the inseparability problem does not
    disappear with this distinction. Indeed, I have argued that often there is
    no clear dividing line between the firm and the market. See Cheung

    8. The word "insitution" may seem vague, but I use it to simply mean any
    arrangement used to conduct economic activities which involve two or
    more individuals.

    9. See Cheung {1973}. When they saw the circulated manuscript, two
    editors (including the AER's) wrote to ask to publish it. But the paper
    was committed to Coase even before it was written down.

    10. See Cheung {1974}, {1975} and {1979}.

    11. Coase {1946} and {1960}.

    12. Demsetz {1969}.

    13. Cheung {1974} and {1982}.

    14. See Cheung {1974}.

    15. Cheung {1982}.

    16. Coase {1959, p. 27}.

    17. This argument promises to engender controversy in the future
    literature, because even at this stage Hirshleifer and Barzel have
    difficulty with it. I, of course, believe that my views will stand the test of
    time and debate.

    18. See Friedman {1962, p. 139 and if}.

    19. See Cheung { 1969}.

    20. Published as Cheung {1982}.

    21. Alchian and Demsetz {1972}.


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    * I am indebted to M.T. Cheung for assistance with the final four of
    seven drafts of this paper, and for this Michael was awarded the original
    handwritten draft. I have, after all, never touched a word processor.
    Among old friends and peers Milton Friedman, Jack Hirshleifer and
    Yoram Barrel all rushed to my aid-Milton by fax, Jack by e-mail, and
    Yoram by hand.


    10/01/1998 Economic Inquiry Page 514 Copyright UMI Company 1998. All
    Rights Reserved. Copyright Western Economic Association Oct 1998

    Copyright 1999 Dow Jones & Company, Inc. All Rights Reserved.

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