Those Pesky Transaction Costs

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When teaching students supply and demand in their introductory economics courses, the most interesting thing to discuss is disequilibrium. This might seem odd. After all, equilibrium is the “solution” and the concept of equilibrium makes for simple questions on problem sets, quizzes, and exams. Furthermore, students have been trained to look for the correct answer. Given sufficient information, it is easy to learn how to solve for the equilibrium price and quantity in a market.

However, to fully grasp equilibrium as a concept, one needs to understand what is happening away from equilibrium. A lot of the important insights about how markets work come from understanding the incentives that market participants face when they are out of equilibrium.

There are two ways that people tend to discuss disequilibrium. The first is to focus on price. If the price is “too high” (above the equilibrium price), there will be excess supply. Sellers will therefore tend to lower the price of their product. If the price is “too low” (below the equilibrium price), there is excess demand. Buyers will tend to bid up the price toward the equilibrium price.

The second approach is to focus on quantity. Start with a quantity that is “too low” (the quantity is below the equilibrium quantity). At this quantity the willingness to pay for another unit of the good is greater than the marginal cost of producing the good. There are gains from trade to be had. Thus, the quantity will increase toward the equilibrium quantity.

These explanations are two sides of the same coin. I tend to discuss both of these versions of the equilibrating process when I teach supply and demand. However, my personal preference is to focus on the latter approach. The reason that I focus on the latter approach is that it tends to emphasize exchange and that is what markets are really all about.

Focusing on exchange really helps to determine what is going on in a market. In addition, this focus on exchange is useful when discussing the role of taxes and subsidies and tax incidence. Similarly, this focus on exchange helps to introduce the role of transaction costs. [A quick aside. People have different definitions of transaction costs. I’m using transaction costs in the broadest sense of the word to include costs associated with information, measurement, etc.]

This emphasis on gains from trade allows one to take steps beyond the basic model to think about the real world. When we first introduce supply and demand, we abstract from particular problems. For example, in the real world, sometimes people have different information sets. Other times, goods might be hard to measure.

If you don’t think that goods are hard to measure, you should hang out in the produce section of the supermarket. You can always find a few people doing weird things to the fruit to see if it is any good. I have no idea if any of these techniques work. I’m also not sure if anyone else knows if these techniques work. But the reason that people are squeezing and bouncing the fruit is that they are trying to discern quality without destroying the fruit. Measurement of the quality of fruit can be difficult without taking a bite — and supermarkets tend to frown upon you putting the fruit back after taking a bite.

Differences in information are also important — and sometimes can be related to measurement. If my neighbor offers to sell me a diamond, it is likely that he has better information about whether this thing he is offering is actually a diamond and, if so, the quality of that diamond.

If we think about exchange and we think about gains from trade, then information costs, measurement costs, and other similar costs can best be thought of as driving a wedge between the price the buyer pays and the price the seller actually receives. For example, if I am willing to pay $1,000 for the diamond (at its true quality) offered to me by my neighbor and researching the quality of the diamond is going to cost me $300, then the maximum amount my neighbor will receive from me is $700. If my neighbor is unwilling to sell it for less than $800, then no trade will take place.

There are a couple of important implications here. The first is that solutions tend to emerge when gains from trade are possible. For example, someone who knows a lot about diamonds might choose to specialize in either inspecting diamonds or buying and selling them. If this specialist can inspect the diamond for $200 or less, my neighbor and I will be able to trade. In fact, my neighbor might just sell the diamond to the specialist for $800 and then turn around and sell it to me for $1,000. Both me and my neighbor are better off. So is the specialist. Competition among specialists will tend to close the gap between the price I pay and the price my neighbor receives.

Second, it is important to recognize the proper counterfactual when doing welfare analysis. People love to say “let’s cut out the middleman.” This seems quite intuitive. If you compare the world with the middleman to a world in which everyone has perfect information, that makes sense! After all, if I just bought the diamond from my neighbor for $900, I would be better off and so would my neighbor. However, given our different information sets and given the measurement costs, that solution isn’t feasible. The middleman is actually making us better off!

This second point is important because “cut out the middleman”-type arguments tend to pop up a lot in policy discussions. A number of policy proposals seem to amount to “let’s eliminate transaction costs.”

While proposals to get rid of the middleman or eliminate certain transaction costs might sound great, it is important to consider the relevant counterfactual. This means that we have to ask why the transaction costs exist in the first place — and that requires thinking carefully about exchange and the gains from trade.