Richard Ippolito

Economics for Lawyers

Think of transactions costs as those that are incidental to a good or service from which one derives utility. Bill lives in Washington, D.C. He likes baseball games. He is willing and able to pay $100 to see an Orioles game in Baltimore. The cost of the ticket is §40. The ticket cost embodies the cost of providing this service to whoever wants to attend. Think or this cost as production cost. It is the resource cost required to create a good or service that gives rise to utility.

Normally, production costs do not vary with the buyer's identity. Transactions costs tend to he idiosyncratic to the buyer. Bill's brother, Dan, lives right near Camden Yards. He attaches the same value to the game as Bill. He realizes the full $60 surplus from attending the game. Bill will sit right near him and derives the same utility from the game but enjoys less surplus. The reason is that Bill needs to incur resources costs to put him in proximity to the game. Suppose that the value of his driving time, gas expense, parking, and so on amounts to $35. These are transactions costs. Unlike production costs, transactions costs do not increase the utility he enjoys from the game. They merely reduce his surplus, in this case from $60 to $25. Transactions costs explain the difference in surplus enjoyed by Bill and Dan.

In an informal sense, we can think of transactions costs as those that are ancillary to the exchange that gives rise to utility. They are real costs, just as real as the resource cost to produce any good or service. In the transportation cost incurred by a consumer. Similarly, they almost always purchase a black suit for interviews at the law school. She knows from prior experience that of the fifty clothing stores that carry suits and are within ten miles of her home, only ten have a suit in stock that provides a nice fit.

Jane is willing to pay $1,000 for a black suit that fits her well. The price of black suits is about $200 just about everywhere. This is the resource cost of acquiring the materials, cutting and assembling the suits, transporting them to Jane's proximity, and making them available in retail stores, where they await her inspection. Like most other shoppers, Jane sets out on her mission one Saturday (perhaps choosing a rainy one, so as to reduce the opportunity costs of the search).

If she knew which ten stores had the suits that fit her well, she would pick out the closest one, buy the suit, and be back home within the hour. Transactions costs would be minimal, say $25, and so she would realize $775 in surplus. Undoubtedly, most readers at this point are saying to themselves, 'Yeah, right!' In reality, everyone knows from experience that it will likely lake several stores, many locations, and a significant chunk of Jane's life before the right suit appears. These are all transactions costs. None increase the value to Jane of having the nice suit, once discovered; they merely erode consumer surplus. Suppose that the transactions cost in this case turn out to be as high as the production cost. She still gets $600 in surplus. In the absence of transactions cost, she would enjoy $500 in surplus.

Jane's quandary is rediscovered in every corner of every market. To find a suitable job in the labor market, job seekers engage in lots of search, and companies invest large amounts of resources to learn more about the attributes of applicants. In the absence of transactions costs, all job seekers know about all job opportunities without expending any time and effort. Employers know everything about candidates' skills and abilities without expending any resources.

Similarly, to buy a car we spend time searching for information, test-driving cars, evaluating trustworthy dealers, and so on. These costs are in addition to the cost of the car itself. When transactions costs are high, it is easy to imagine that we might end up with a different contractor, job, or car than we would in a world of zero transactions costs; yet, sometimes it is useful to make the simplifying assumption that these costs are zero to make it easier to understand some underlying market behavior.