E
Economic Organization
and Transaction Costs
Steven N. S. Cheung
One important extension of the Coase Theorem
states that, if all costs of transactions are zero, the
use of resources will be similar no matter how
production and exchange activities are arranged.
This implies that in the absence of transaction
costs, alternative institutional or organizational
arrangements would provide no basis for choice
and hence could not be interpreted by economic
theory. Not only would economic organization be
randomly determined; there actually would not be
any organization to speak of: production and
exchange activities would simply be guided by
the invisible hand of the market.
But organizations or various institutional
arrangements do exist, and to interpret both their
presence and their variation, they must be treated
as the results of choice subject to the constraints of
transaction costs.
In the broadest sense transaction costs encom-
pass all those costs that cannot be conceived to
exist in a Robinson Crusoe economy where nei-
ther property rights, nor transactions, nor any kind
This chapter was originally published in The New
Palgrave: A Dictionary of Economics, 1st edition, 1987.
Edited by John Eatwell, Murray Milgate and Peter
Newman
# The Author(s) 1987
Palgrave Macmillan (ed.), The New Palgrave Dictionary of Economics,
DOI 10.1057/978-1-349-95121-5_375-1
of economic organization can be found. This
breadth of definition is necessary because it is
often impossible to separate the different types
of cost. So defined, transaction costs may then
be viewed as a spectrum of institutional costs
including those of information, of negotiation, of
drawing up and enforcing contracts, of delineating
and policing property rights, of monitoring per-
formance, and of changing institutional arrange-
ments. In short, they comprise all those costs not
directly incurred in the physical process of pro-
duction. Apparently these costs are weighty
indeed, and to term them ‘transaction costs’ may
be misleading because they may loom large even
in an economy where market transactions are
suppressed, as in a communist state.
By definition, an organization requires some-
one to organize it. In the broadest sense, all pro-
duction and exchange activities not guided by the
invisible hand of the market are organized activi-
ties. Thus, any arrangement that requires the use
of a manager, a director, a superviser, a clerk, an
enforcer, a lawyer, a judge, an agent, or even a
middleman implies the presence of an organiza-
tion. These professions would not exist in the
Crusoe economy, and payments for their employ-
ment are transaction costs.
When transaction costs are defined to include
all costs not found in a Crusoe economy, and
economic organizations are defined equally
broadly to include any arrangement requiring the
service of a visible hand, a corollary appears: all
organization costs are transaction costs, and vice
2 Economic Organization and Transaction Costs
versa. That is why during the past two decades
economists have striven to interpret the various
forms of organizational arrangements in terms of
the varying costs of transactions.
Some obvious examples will illustrate the
point. A worker in a factory (an organization)
may be paid by a piece rate or by a wage rate. If
the costs of measuring and enforcing performance
(one type of transaction cost) are zero, then either
arrangement will yield the same result. But if
these costs are positive, the piece-rate contract
will more likely prevail if the costs of measuring
outputs are relatively low, whereas the wage con-
tract will more likely be chosen if the costs of
measuring hours and enforcing performance are
low relative to the costs of measuring outputs. As
another example, some restaurants (again an orga-
nization) measure the quantity of food sold; others
serve buffet dinners, allowing customers to eat as
much as they please at a fixed price per head. The
cost of metering and quantifying food consump-
tion relative to the basic cost of the food will
determine which arrangement is chosen. In the
total absence of transaction costs, the factory or
the restaurant would not exist in the first place,
because consumers would buy directly from the
input owners who produce the goods and services.
As early as 1937, R.H. Coase interpreted the
emergence of the firm (an organization) in light of
the costs of determining market prices
(transaction costs). When these costs are substan-
tial because of the difficulties of measuring sepa-
rate contributions by workers and of negotiating
prices for separate components of a product, a
worker may choose to work in a factory (a firm);
he surrenders the right to use his labour by con-
tract and voluntarily submits to direction by a
visible hand, instead of personally selling his ser-
vices or contributions to customers through the
invisible hand of the market. The firm is therefore
said to supersede the market. As the supersession
progresses, the saving in the costs of determining
prices will be countered by the rising costs of
supervision and of management in the firm. Equi-
librium is reached when, at the margin, the cost
saving in the former equals the rising cost in the
latter.
The firm superseding the market may be
regarded as a factor market superseding a product
market. If all costs of transactions were zero, the
two markets would be inseparable in that a pay-
ment made by a customer to the owner of a factor
of production would be the same as payment
made to a product seller. In such a world it
would be a fallacy to speak of the factor market
and the product market as coexisting entities.
The presence of transaction costs is a prelude
to separate the factor market from the product
market. However, in some arrangements, such as
the use of certain piece rates, it may become
impossible to separate the one market from the
other. Therefore, instead of viewing the firm as
superseding the market, or the factor market as
superseding the product market, it is more correct
to view the organizational choice as one type of
contract superseding another type. In these terms,
the choice of organizational arrangements is actu-
ally the choice of contractual arrangements.
When organizational choices are viewed as
contractual choices, it becomes evident that it is
often impossible to draw a clear dividing line
separating one organization from another. Take
the firm, for example. It is often the case that the
entrepreneur who holds employment contracts
(and it is not clear whether it is the entrepreneur
who employs the workers or the workers who
employ the entrepreneur) may contract with
other firms; a contractor may subcontract; a sub-
contractor may sub-subcontract further; and a
worker may contract with a number of
‘employers’ or ‘firms’. If the chain of contracts
were allowed to spread, the ‘firm’ might encom-
pass the whole economy. With this approach the
size of the firm becomes indeterminate and
unimportant. What are important are the choice
of contracts and the costs of transactions that
determine this choice.
Traditional economic analysis has been con-
fined to resource allocation and income distribu-
tion. Contractual arrangements as a class of
observations have been slighted in that tradition.
In a world complicated by transaction costs, this
neglect not only leaves numerous interesting
observations unexplained, but actually obscures
the understanding of resource allocation and
Economic Organization and Transaction Costs
income distribution. The economics of organiza-
tion or institution or, for that matter, the workings
of various economic systems, were never placed
in the proper perspectives under the traditional
approach. For generations students were told that
various kinds of ‘imperfections’ were the cause of
seemingly mysterious observations: policies were
‘misguided’, or antitrust specialists were barking
up the wrong trees.
The costs of introducing new and more valid
ideas must have been enormous. Even today text-
books still discuss marginal productivity theory
only with reference to fixed wage and rental pay-
ments. Yet economists have known all along that
(for labour alone) payments may be in the periph-
eral forms of piece rates, bonuses, tips, commis-
sions, or various sharing arrangements; moreover,
even wage rates may assume a number of forms.
Each type of contract implies different costs of
supervision, of measurement, and of negotiation,
and the form of economic organization, along
with the function of the visible hand, changes
whenever a different contractual arrangement is
chosen.
The choice of contractual arrangements is not,
of course, confined to the factor markets. In the
product markets, pricing arrangements such as
tie-in sales, full-line forcing, or membership fees
associated with clubs, may similarly be
interpreted in light of transaction costs. Further,
business organizations in mergers, franchises, and
various forms of integration are now beginning to
be viewed as transaction-cost phenomena. Indeed,
close inspection of department stores and shop-
ping centres reveals pricing and contractual
arrangements between a central agent and individ-
ual sellers, as well as among the sellers them-
selves, which could not be explained by
textbook economics.
Transaction costs are often difficult to measure
and, as noted earlier, difficult to separate by type.
However, the measurement problem can be
avoided if only we are able to specify how these
costs vary under different observable circum-
stances, and their different types are separable if
viewed in terms of changes at the margin. These
two conditions are requisite in the derivation of
3
testable implications for the interpretation of orga-
nizational behaviour.
The use of transaction costs to analyse institu-
tional (organizational) choice is superior to three
other approaches. One approach would focus on
incentives. However, incentives are not in princi-
ple observable, and we will do better in deriving
testable propositions if the same problem is
viewed in terms of the costs of enforcing perfor-
mance. A second approach adopts risk. However,
it is difficult to ascertain how risk is altered under
different circumstances. Many risk problems,
such as the uncertainty of whether an agreement
will be honoured, are also problems of transaction
costs, and it is easier to deal directly with those.
Finally, some recent advances in transaction-cost
analysis have called attention to the costs embod-
ied in dishonesty, cheating, shirking, and oppor-
tunistic behaviour. Yet these are loose terms and,
whatever they describe, to some extent are always
to be found. To the degree that we can identify the
particular costs of transactions that promote dis-
honesty, that shadowy explanation is no longer
needed. After all, in what sense can we say a
person is ‘increasingly dishonest’ or ‘increasingly
opportunistic’?
The transaction-cost approach to analysis of
economic organizations can be extended upward
from a few participants to the ‘government’ or
even the nation itself. At the lower level, the
owners of condominium units almost as a rule
form associations with specific by-laws and elect
committees to act on matters of common concern,
the decisions being determined by majority vote.
The transaction costs of ballot voting are less than
those of using prices and dollar votes in certain
circumstances, and trivial matters may even be
delegated to a ‘dictatorial’ manager to further
reduce the cost of voting. Similarly, residents in
a particular location may choose to incorporate
into a city, selecting their own mayor, with a
committee setting up the building codes, hiring
firemen and policemen, and deciding other mat-
ters of common concern.
Private property rights offer the unique advan-
tage of allowing individual property owners the
option of not joining an organization. This choice
is an effective restraint against the adoption of an
4 Economic Organization and Transaction Costs
organization with higher transaction costs. It is
true that a home-owner in a given region may,
by majority vote, lose his option of not joining
in a city corporation (unlike a worker who, in a
free enterprise economy, always has the option of
not joining a ‘firm’). But with private property
rights the majority vote aims at cost saving, and
a reluctant resident may exercise his own judge-
ment by selling his house and moving elsewhere.
Private property rights further reduce transac-
tion costs under competition. An entrepreneur or
agent who wants to recruit other resource owners
to join his organization must, under competition,
offer attractive terms, and this can be achieved
only if his organization can effectively reduce
transaction costs. On the other hand, the resource
owner competing to join an organization will be
more inclined to deliver a good performance when
at risk of losing his job.
The option of not joining an organization and
the cost-reducing function of competition are, of
course, restrained when an organization is
extended to encompass an entire nation. When
citizenship is dictated by birth, the option of not
joining is restrained, and competition among
nations to recruit members is decidedly less than
among organizations within a nation. This relative
lack of cost-reducing mechanisms is all the more
evident in a communist state, where a citizen does
not have the option of choosing an organization
within that state.
A communist state may be regarded as a
‘superfirm’ in which comrades lack the option of
not joining. Each worker is assigned to a particu-
lar job supervised and directed by the visible
hands of comrade officials of varying ranks. In
this aspect the communist state is remarkably
similar to what Coase calls a ‘firm’, where
workers are told what to do instead of being
directed by market prices. But the lack of market
prices in the communist state is not due to the
costs of determining prices; rather, in the absence
of private property rights market prices simply do
not exist, and visible supervision by a hierarchy
ranking becomes the remaining alternative to
chaos.
The transaction costs of operating an organiza-
tion are necessarily higher in a communist state
than in a free enterprise economy, due to the lack
of option of not joining and the lack of competi-
tion both to recruit members among organizations
and to induce members to perform well.
If the transaction costs of operating organiza-
tion were zero, resource allocation and income
distribution would be the same in a communist
state as in a free enterprise state: consumer pref-
erences would be revealed without cost; auction-
eers and monitors would provide freely all the
services of gathering and collating information;
workers and other factors of production would be
directed free of cost to produce in perfect accord
with consumer preference; each consumer would
receive goods and services in conformity with his
preferences; and the total income received by each
worker, as determined costlessly by an arbitrator,
would equal his marginal productivity plus a share
of the rents of all resources other than labour,
according to any of a number of criteria costlessly
agreed upon. But such an ideal situation is obvi-
ously not to be found.
We therefore conclude that the poor economic
performance of a communist state is attributable
to the high transaction costs of operating that
organization. Under the postulate of constrained
maximization, the communist state survives for
the same reason that any ‘inefficient’ organization
survives: namely, the transaction costs of chang-
ing an organizational (institutional) arrangement
are prohibitive. Such costs include those of
obtaining information about the workings of alter-
native institutions, and of using persuasive or
coercive power to alter the status of the privileged
groups whose incomes might be adversely
affected by the institution of a different form of
economic organization.
See Also
▶ Coase Theorem: Transactions Costs
▶ Vertical Integration
Economic Organization and Transaction Costs
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