Small Business Doctor

What Are Transaction Costs?

Transaction costs are often overlooked in economics and textbook finance. In real life economics, however, they play a very significant role. In corporate finance, you can see many of a company’s transaction costs located in the selling and administrative categories within the Selling, General and Administrative (SG&A) section of their Income Statement. In social life, people who work in fields like corporate law, accounting, finance, HR, marketing, sales, security, quality control, PR, administration and management can thank transaction costs for providing the need for their jobs.

Transaction costs are the costs paid during a transaction that do not flow from the buyer to the seller. They go elsewhere. Economists refer to them as a wedge between buyer and seller.

A good example is buying a house. Things like house inspections, sales commissions and title insurance are transaction costs. They are costs related inextricably to the house buying transaction, but they are not part of the value assigned to the house.

Inside of a company, these are expenses that are not directly related to the products or services they company offers. These are the costs of doing business like liability insurance, sales commissions, inspectors and security staff as well as the managers who oversee it all.

Transaction costs primarily arise due to lower social trust in the economic environment and often involve an information asymmetry between buyer and seller. They have steadily risen from 1870 to 1970 to today. Transaction costs were about 22% of the American economy in 1870. By 1970 they had risen to 47%.

Then as now, most of the transaction costs in the economy are from the trade industry sector. In 1970 this accounted for almost half of all transaction costs in the economy. These are the wholesalers and retailers who market and sell goods and services in the marketplace. Between 1870 and 1970, the trade industry sector grew only 13% as a fraction of the American economy.

The real growth in transaction costs within the American economy came from what I refer to as SG&A workers and the FIRE (finance, insurance and real estate) industry sector. These grew 381% and 190% respectively. In 1870, these two sources were responsible for only 28% of transaction costs. By 1970 they were responsible for more than 55% of the transaction costs within the American economy.

Private Sector Transaction Costs

Within the private sector of the American economy there are three beneficiaries of transaction costs. The first and largest is the trade industry. While this segment has not grown appreciably, by 1970 it still accounted for about 45% of transaction costs in the private sector of the American economy. Basically, these are wholesale and retail stores.

The next largest segment of these three is the FIRE industry segment. The finance, insurance and real estate industry grew by 190% from 1870 to 1970. By 1970 it accounted for about 30% of private sector transaction costs.

The smallest but by far the fastest growing segment of transaction costs is SG&A employees and professional firms. These are the lawyers, accountants, HR departments, managers and security staff. In the American economy, these workers grew by more than 380% between 1870 to 1970 and in 1970 accounted for 25% of transaction costs in the private sector of the American economy.

Public Sector Transaction Costs

The public sector of the American economy is more difficult to assess because its defense spending is not particularly transparent. Basically, we don’t actually know what taxpayers are spending their tax dollars on when it comes to defense spending.

So, there are two estimates. One is a good faith estimate of transaction costs that include defense spending. This estimate soars from WW2 onwards.

The second estimate does not include this defense spending. This should be understood as a lower bound, a floor for the amount of spending on transaction costs by the federal government.

The difference between these two estimates by 1970 is from 6% and 14% of the American economy. So it is not insignificant at all, but it is contestable. The preceding graph of transactions costs in the American economy uses the more conservative estimate that does not include defense spending.

The numbers from the private sector alone are shocking enough. That so much of our economic activity is consumed by transaction costs in both sectors should be impetus enough to merit notice and hopefully social changes.

Transaction costs do not flow from producer to consumer in the form of improved products or services. They do not make either producers or consumers better off. They are parasitical burdens due to low levels of social trust within value chains and social networks. High transaction costs are signs of a sick society in need of healing and change.

SG&A Workers

From 1870 to 1970 the transaction costs that arose from SG&A employees went from about 5% to almost 25% of the entire American economy. As you can see in the SG&A Transaction Costs graph, since WWII there has been a spike in governmental spending on SG&A workers that leveled off by 1960.

The real growth driver in SG&A worker payments, however, is in the private sector. Payments to private sector SG&A workers grew by 381% during this period while the public sector grew by a smaller but still substantial 286%. To put this growth into some perspective, the growth rate of private sector SG&A workers is double that of FIRE industry workers.

The growth of these SG&A workers within the American economy over the past 150 years is the largest single contributor to the growth of transaction costs.

This post is based on the important work of John Wallis and Douglass North in their chapter titled “Measuring the Transaction Sector in the American Economy, 1870-1970” from the 1986 economic history book edited by Stanley Engerman and Robert Gallman Long-Term Factors in American Economic Growth.