It is transaction costs all the way

In my last post (Transaction Costs — Part 1) I claimed that the fundamental role of ICT is reduction of transaction costs. What, you may ask, is transaction costs? The answer is this: pretty much everything is transaction costs, with a little bit of physical stuff thrown in.

In California, you can buy a loaf of bread for about $2. The basic materials that go into the making of the bread — wheat, primarily — is about $0.07. Then there is some energy required for baking it and transporting it. Add a dime for that. The total material cost is therefore about 17 cents. The difference between the cost of the inputs and the price of the product is the value added. In our case, it is $1.83. That is, about 92% of the price of the bread is value added.

How do you allocate the value added in this case? Most of it has to be assigned to services — from the marketing of the bread, to the stocking of it in the store shelf. The cost incurred in bringing a loaf of bread to the market (less the cost of the material, the fuel and labor involved in the baking and transportation) is transaction costs.

Of course, costs seen from a different angle are revenues and incomes. And part of revenues are profits (if prices exceed costs.) The generalization of these costs are transaction costs.

Transaction costs are ubiquitous. Consider what happens in any organization, say a car manufacturing firm. Cars are produced by people using machines to transform steel and other stuff. If you add up the costs — labor, material, and machines — the car would not cost all that much. But when you add the fact that there are other people employed by the car firm who have nothing to do with the manufacturing of cars, you realize that they represent transaction costs. For instance, you have managers, and accountants, and secretaries, and human resources divisions, … the list goes on. They all represent transaction costs. And the greater the transaction costs, the higher the cost of production. Why do firms exist? Because they reduce transaction costs.

Ultimately, one can explain pretty much all organizations as an attempt to systematically reduce transaction costs. Economies of scale, scope, and agglomeration themselves arise from the reduction of transaction costs.

Information and communications technologies reduce transaction costs. Here is a simple demonstration of that. The next time you make a phone call, ask yourself what it would have cost you if you could not have made that call.

For instance, I called the store to find out if they had indeed installed the AC in my apartment. (They had not.) If I could not have made the call, I would have had to spend at least two hours and a lot of money to travel to the store to find out that information.

I will continue to ramble on the transaction costs theory of the universe in the next few posts. As they say on the radio, stay tuned.

3 thoughts on “It is transaction costs all the way

  1. Nagendra Thursday November 13, 2003 / 1:37 am

    Hi Atanu Dey,
    Last three years I am telling my friends IT is a productivity tool and all this hype will go away soon.After the Dot com bubble most of them have realised it.
    After completing these articles can you elaborate on the cost of governments at Central, State and local bodies? Who is paying for those? How the huge govt expenditures are drag on the Economy.
    Similarly the cost of corruption and how it diverts the productive capital into unproductive expenditure by bureaucrats and politicians.
    These things don’t require any expenditure are technology. Without addressing these can we really make big progress.


  2. Gordon Dryden Thursday September 1, 2005 / 2:13 am

    Now relate all this to “education”, the Net and the open-source movement: it costs about 57 US cents to mass-produce each copy of a CD-rom. But Microsoft Office, the world’s biggest-selling software, sells (at recommended price) for between $400 and $500. Leaving aside pirated copies, SUN’s Star Office is under $100. But you can download Open Office free off the Internet. And you can download a Linux computer Operating System — also for nothing.
    Watch out, Bill: we’re gaining on you.

    Gordon Dryden (


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