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Definition of Transaction Costs:
include costs to identify, negotiate or execute a purchase or sale.
Have you ever purchased or sold a home? If so, then you probably understand the concept of transaction costs. A buyer or seller may negotiate a purchase price of $200,000. But by the time the buyer pays all the transaction costs, the home may cost $205,000. The seller may only receive $188,000 after paying to prepare the home for sale and a real estate commission. The mentioned costs do not include nonmonetary transaction costs such as the stress, time and energy it takes to close a sale.
Transaction costs are generally broken into three categories.
Before a trade can occur, a person must identify what will be purchased or sold and the party with whom the transaction will be made. Identifying a good or service to buy frequently requires an investment in time and money. For example, most homebuyers do extensive research before purchasing their home. What are other similar homes in the area selling for? Is the house in a good school district? Can the buyer secure a mortgage with an acceptable payment? These are a few of the most common questions buyers research before visiting any potential homes. The quest of driving and touring each home can be time-consuming and stressful.
A seller also incurs expenses to find the right buyer. For example, the seller may need to make some repairs or cosmetic improvements prior to putting a home on the market. An ad needs to be placed in local publications or listing services. Arrangements may need to be made to vacate the home when an interested buyer wants to visit.
This includes the cost of negotiating a deal. Few homes are sold for the listing price, or the suggested price when a house is initially placed on the market. There can be a great deal of time, stress, and patience in negotiating the price and terms of a purchase agreement. In a seller’s market, a buyer may offer a price above the listing price to solidify a deal. In a buyer’s market, the listing price may be discounted. The seller may pay the buyer’s closing costs.
There is frequently a cost to verify that the terms of an agreement have been met. Common terms include that the house is structurally sound, and the utilities are in good working order. Another stipulation may be that acceptable financing can be secured. The lender will require an appraisal and may charge processing fees. The costs incurred for an inspection and financing are examples of transaction costs. The buyer normally pays these fees.
Legal fees are also transaction costs, which could be paid by the buyer and seller. Real estate commissions are another transaction cost. Commissions are normally paid by the seller in the United States. However, they may be paid by the buyer if a buyer retained the services of an agent.
The seller may continue to be involved in a transaction after title is transferred. Time and money may be required to monitor an agreement after it has closed.
Most economic theory assumes that transaction costs are zero. However, many potential transactions never occur because the transaction costs are too high. I may be willing to pay $75 to see a rock band but choose not to purchase a ticket when I consider the traffic and trouble of getting to and from the concert.
High transaction costs are frequently a problem when there are externalities and the costs and benefits are borne by many individuals making it difficult to negotiate an agreement to internalize the cost. For example, assume that Factory A pollutes a lake. The equipment to clean up the pollution costs $100,000. Assume there are no government regulations and Factory A continues to pollute. However, Factory A would be willing to install and maintain the equipment if another party paid for it. Suppose there are 20,001 unidentified fishermen who would be willing to contribute $5 for the equipment to clean up the lake. Here there is a possibility to enter a contract to solve the problem. Sadly, the transaction cost of identifying and collecting $5 from each fisherman is probably too high. If so, the pollution would continue. A government frequently enters the market in circumstances like this where the transaction costs of finding a contractual solution are too high.