It is transaction costs all the way – Part 2

In my last post 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.

Categories: Economics, Transaction Costs

6 replies

  1. No one needs to be convinced of the necessity of ICT in today’s world and the efficiencies brought about by its application in our day-to-day life are far too obvious for anyone to debate against it. Example of Chandrababu Naidu in AP comes easily to our minds as one of the proponents of this panacea for india’s ills. But then did that stop the farmers there from committing suicide in abject despondency. It didn’t and similarly the supposed panacea failed to stop him from getting swept away in the much touted anti-incumbency wave. Anyway thats a different story. The point I was intending to make was that there can but only be a limited use of ICT in the rural development theories discussed in this forum. As you yourself mentioned in one of your writings, that agricultural and manufacturing sectors have to prosper first to give services a chance to blossom. Blind adherence to ICT in all contexts can only bring about lopsided development where zero degrees humanity resides at the TRIPLE POINT of the world, to borrow a phrase from you.
    The silver lining in this dark cloud has been FM’s renewed emphasis on agriculture in this year’s budget. At least he seems to have his priorities correctly defined. Whether he delivers or not is another matter.


  2. Does anyone here know whether RISC pilot is being carried out? OR is it just a concept still.
    I am writing a report for a MBA class on Globalization from bottom-up, so please someone answer this.


  3. I was very inspired to read this RISC concept. However, few minutes later, skepcticism took over me – because Indians are very good at abstract thinking and theorizing but don’t seem to have the killer instinct/other skilles needed to get things done. Since some profile VCs and proven entreprenuers are involved I’m hoping that this may actually get implemented. Does anybody know what is the status of RISC pilot?


  4. Hi Atanu,
    I just had this observation made. plz let me know if the following is also a result of Transaction cost. I had to buy a cough syrup. a small bottle of 100 ml quantity costs Rs. 43 (around $1) in chennai. I guess this will be the price throughout India too. This syrup is one of the most recommended and i have seen kids too taking it. can poor afford to buy a small bottle of syrup for Rs. 43/-? don’t you think the high cost of commodities, especially medicines make it prohibitive for the poor to have access to it? many families’ daily income is Rs. 40 – 50 in India. What is the reason for keeping such necessities out of reach but allocating tax payer’s money in thousands of crores for the “alleviation” of poverty and for the “betterment” of poor? has this got anything to do with politics or drug research in India?Thanks, Venkat.



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