Transaction Costs and Market Structure

The ubiquitous existence of transactions costs in the real world determines both the institutional structure within which prices are set and the level of prices.

In economics textbooks, the market is usually pictured as where the demand curve intersects the supply curve. It is simply a price-making mechanism without any institutional structure.

In the real world, the market consists of middlemen whose job is to reduce the transaction costs of producers directly dealing with consumers. Without the market, producers would have to sell directly to consumers. Assuming producers enjoy comparative advantage in producing than in selling, the consequent loss of output due to reduced specialization may result in lower income to producers and higher price to consumers. The fact that middlemen can increase efficiency by increasing producers’ income and lowering prices to consumers, however, does not guarantee that a market would exist because its provision is costly and requires entrepreneurial efforts.

A Tale of Two Fishing Villages

That a market does not always spontaneously emerge can be illustrated by the different experience of two fishing villages in China. Two fishing villages (DV and WV) are located on the north side of a lake while the city fish market is located on the south side of the lake. But only one fishing village (DV) enjoys a thriving fish market due to lower transaction costs. One reason for the lower transaction costs is the shorter distance between DV and the city market. The shorter transportation time reduces capital investment needed to preserve the fish during transportation. The other village (WV) is much farther away from the city market than DV. The boat trip from WV to the city takes four times as long and is much less frequent. Fish bought from WV must be better protected to preserve their freshness, thus requiring higher capital investment for any potential middlemen.

High transportation costs make WV less attractive to middlemen, but this does not necessarily prohibit them from going there. If a middleman is able to buy fish at a sufficiently low price at WV to compensate for the high transportation costs, there is no reason for him not to visit WV. Yet this scenario does not unfold. When there are few middlemen competing with each other, the middleman is more likely to over-report the cost of transportation and under-report the price of fish in the city. With few middlemen to choose from, the fishermen become highly skeptical of the price information conveyed by the middlemen, and they tend to bargain cautiously to avoid being cheated. This suspicion is abetted by the fact that fish prices tend to fluctuate from day to day. These two conflicting tendencies often tear bargaining apart. Hence a pricing mechanism cannot be established and the market fails to emerge. As a result, fishermen at WV sell their fish directly to the city market across the lake.

Thus, one initial higher transaction cost (i.e., transportation costs) compounds another transaction costs (i.e., agreement costs) leading to the virtual disappearance of specialized middlemen.

On the other hand, the initial lower cost of transporting fish from DV to the city encourages more middlemen to enter the business due to lower capital investment. The competitive bidding for fish among the many middlemen forces the fish prices in the city market to be accurately and quickly revealed to the fishermen. Transactions are quickly consummated as middlemen and fishermen can reach a mutually beneficial settlement price quickly in the absence of mistrust.

While the existence of any middlemen reduces transaction costs, these costs can be further reduced when middlemen are differentiated into moving and sitting types. For example, it does not pay the moving middleman to retail fish in the city market. If he retails fish occasionally in the city market, he must pay higher sales tax. And without a permanent space, he cannot establish his reputation. Also, he must invest in special capital investment (e.g., fish containers). Lastly, he would not be as visible or as knowledgeable about the wholesale marketplaces that he usually visits. On the other hand, the existence of sitting middlemen encourages the building a permanent physical space for transactions to take place and the assignment of permanent booths in which reputation to be rooted. By specifying rights and obligations, government regulation and enforcement further reduce the risk of transaction fraud.

When consumers and producers can freely meet each other to execute transactions at no cost, the market becomes a mere price-determining mechanism as modeled by neoclassical economics, and its institutional setting becomes irrelevant. The ubiquitous existence of transactions costs, however, means that the institutional structure of exchange does matter.