PrintWhen we assume no transaction costs, what are we implying?
Okay, back to business! In our simplified model, we assumed no transaction costs. By doing this, what were we leaving out? Remember, transaction costs are the costs incurred to overcome market imperfections. By assuming no transaction costs, we implied the following:
Potential buyers do not waste resources on information discovery and verification. For example, suppose you are shopping for a car and you know that you can purchase one of two types; fuel efficient or fuel inefficient. If all other attributes of the cars are identical, the fuel efficient car should be more valuable because it is relatively inexpensive to operate. In a world without transactions costs, you costlessly distinguish between these two cars.
Firms can costlessly and effectively provide employees the incentives necessary to maximize firm value/profits. For example, suppose you own a full-service gas station. In order to maximize the profitability of your business, you've determined the optimal amount of effort to expend on various tasks - sweeping floors, washing windshields, and assuring customers get the gas they want, regular when they pay for regular and premium when they pay for premium. In a world without transacitions costs, you can costlessly create the employment contracts and monitoring and enforcement mechanisms necessary to elicit this optimal level of effort from your employees.
All parties affected by an exchange can costlessly participate in the exchange. The “affected parties” include parties that are external to the transaction itself (parties other than the producer and consumer). Consider our gas station example. But now, you are a bystander experiencing the external (to the gasoline sale/purchase) cost of breathing pollution emitted by the driver's exhaust. Your displeasure provides an incentive to mitigate the consequences of the exhaust. You could pay the driver to take a route outside your neighborhood. If the driver's cost of the detour is lower than your displeasure from the exhaust, then there is a transfer payment that makes you better off without making the driver worse off. And because contacting and enforcement is costless, you will establish property rights to clean air in your neighborhood. Alternatively, if the driver's cost of the detour is greater than your displeasure, the driver can compensate you for tolerating the dirty air. In this case, the driver will have established property rights to foul the air, again, because contracting and enforcement is costless. In either case, the parties can effectively exchange through markets to optimize the resource allocation (i.e., gasoline, money, air quality, time spent driving).
Of course, in the real world, parties to an exchange (producers, consumers and external parties) do incur transaction costs. Parties external to the transaction may be affected. These nonmarket "externalities" will be the subject of our next lesson.