192 – Transaction costs

If I buy something, I have to pay the asking price, but I may also incur a range of extra costs. These might include things like time, stress and travel costs involved in making the purchase. Economists call these extra costs ‘transaction costs’. There are also transaction costs involved in establishing, running or participating in a government program. I’ve become very interested in how transaction costs affect environmental programs.

I’m visiting China in October, so this week I applied for a visa. When I pick it up next week, it will cost me $30. However, that’s not the only cost I will have borne to get it. They have a new rule that you can’t apply by mail; you have to make a personal visit to the consulate. So far I have had to:

  • complete the application form, which was not straightforward, requiring me to make two queries to the people who are organising the visit;
  • look up the location of the Chinese consulate in Perth;
  • drive about 10 km to where I thought (mistakenly) it was, involving costs of fuel, vehicle wear and tear, and time;
  • pay for parking;
  • spend time walking around the area looking for it, unsuccessfully;
  • look at the street directory again and realise I was about a kilometre from the right place;
  • drive to the right place;
  • pay for parking again;
  • walk to the consulate;
  • wait in a slow-moving queue for about half an hour; and
  • drive home (more petrol, depreciation and time).

When I go to pick it up, I’ll need to invest more time, fuel and vehicle wear and tear. By the time I get the visa, the $30 cash cost will be pretty minor compared to the rest of the costs.

Economists call these other costs ‘transaction costs’. They are costs, using the term broadly, involved in undertaking a transaction, other than the direct financial cost of the transaction itself. They may include costs associated with thinking, analysing, negotiating, monitoring, enforcing, administering, learning, and so on.

In simple text-book economics, transaction costs aren’t accounted for, but in recent decades, economists have paid more attention to them. There have even been a couple of Nobel prizes awarded to people whose work included an emphasis on transaction costs.

I’m interested in transaction costs in environmental policy. I’ve been amazed at how big they can be. For example, under the National Action Plan for Salinity and Water Quality (Pannell and Roberts, 2010), the approximate allocation of Australian government funds to projects was as follows:

Category Budget ($ million)
On-ground works 220
Capacity building 260
R&D 44
Administration, planning, monitoring and evaluation 120

The last category is clearly solely transaction costs involved in getting the program delivered. They are large, but this number greatly understates the total transaction costs of the program. For one thing, the Australian Government took a large slice off the top for its own administration costs (to get the program established and run it), and that’s not included in the above figures. Also, the numbers in the first three categories include significant transaction costs involved in running those individual projects. As a rough guess, I estimate that the share of the Australian Government’s money in the program that was spent on transaction costs could have been about 40 per cent. That’s a lot of money not being spent on managing salinity.

Elsewhere in government, there were four reviews of the program during its life: two by the Australian National Audit Office, one by a committee of the House of Representatives and one by a Senate committee. Each of these involved substantial costs. And there were transaction costs prior to the program being established, as governments around Australia negotiated, discussed, and argued about the shape, the size and the rules of the program.

On top of that were the transaction costs borne by farmers and other organisations who were engaged with the program. They had to incur transaction costs in the course of negotiating with their partners and collaborators about involvement in projects, completing project application forms, completing reports to satisfy accountability requirements, meetings of various sorts, phone calls, and so on. Some of them would have incurred transaction costs from lobbying the government during the period when the program was being developed, or attempting to change aspects of the program once it was up and running.

These are even more invisible than the transaction costs incurred by government, and they are probably even more likely to be overlooked when a program is being designed or implemented.

For example, the first full round of competitive funding for the Caring for our Country program in Australia received about 1300 project applications, of which less than 10% were actually funded. These applications can be quite time consuming and difficult to prepare, but more than 1200 applicants must have felt like they had borne those transaction costs for no benefit. If this had been considered, I think the process would have been designed differently.

Focusing on the transaction costs in environmental programs could be beneficial for various purposes, including:

  • identifying cases where they seem excessive, guiding efforts to reduce transaction costs;
  • designing programs in a way that limits transaction costs to participants;
  • guiding better choices about policy mechanisms;
  • understanding why some policies achieve less than intended; and
  • understanding why people are unwilling to participate in programs in some cases.

Well-conducted studies of transaction costs in environmental programs should ultimately contribute to greater achievement of environmental outcomes from those programs, by encouraging greater participation and leaving more money to be spent on the problem.

David Pannell, The University of Western Australia

Further reading

Pannell, D.J. and Roberts, A.M. (2010). The National Action Plan for Salinity and Water Quality: A retrospective assessment, Australian Journal of Agricultural and Resource Economics, 54, 437-456. Journal web site here

2 Comments

  • 20 October, 2011 - 9:12 pm | link

    Having mulled over your TC piece a bit, it now seems to me that there’s an issue in simply identifying what the transaction costs actually are. Many of them (not all, of course), seem necessary in terms of information acquisition, verification and communication. There is a strong link between a sub-category of transaction costs and information costs (but also benefits). In many cases, transaction “costs” are better thought of as (informational) “investments”: they are “costs” only if these investments don’t deliver (discounted) benefits greater than (discounted) costs! I don’t know how well this relationship is understood today. This makes me think one could categorize transaction costs in these two categories:

    – those not in need of elimination

    – those in need of elimination.

    Of course, the first can be reduced: in this case we’re talking efficiency: how efficiently can we undertake these necessary information-related activities?

    The second are unlikely to be completely eliminated, but they can perhaps be substantially reduced: again, efficiency, but of a different kind: by how much can we reduce them? How close to zero can we get them?

    Following on from this, it may pay to consider transaction costs as an absolutely essential aspect of every economic activity, not as a residual or as an incidental. That’s the way I’m starting to think of them now. Which means that (except in special cases) transaction costs are not very different from any other economic costs. I think what’s specific about them is how difficult it is to measure or quantify them. Thus, in practice, transaction costs always come with an amount of uncertainty. When you factor in the informational component of transaction costs, you get a sort of Heisenberg “minimum uncertainty principle”: there is no way you can hope for not-uncertain transaction costs. You will always have some degree (often a large degree) of “scientific” uncertainty, just like for climate change, biodiversity, wildlife populations and the like. The transaction costs of acquiring information on transaction costs is, more often than not, just too great. Here’s a topic for further discussion. In addition, transaction cost information is often politically sensitive, so that there exist incentives for transaction cost-information holders to hold back that information and, in some countries, to imprison or kill anyone who tries too hard to measure them (sic!).

    Steve Schilizzi, University of Western Australia

  • 20 October, 2011 - 9:12 pm | link

    I read your recent article on transactions costs of environmental programs with interest. Having been a grass-roots community development worker for many years, then designing and running environmental programs within state and Commonwealth governments I am well aware of transaction costs and the need to make them visible and reduce them where possible.

    However, there is a flaw in your argument and an omission.

    The flaw is that you make a point that the $120 million for administration, planning, monitoring and evaluation are transaction costs. Sure, the administration is a transaction cost, but should you include planning, monitoring and evaluation? Are these not an essential part of a learning cycle within which we explore and hopefully adopt better science and practice? Given the challenge of ensuring that policy development is based on the best possible science, I would not like to see this effort further reduced because we are on a transaction cost economy-drive.

    The omission in your argument is an acknowledgement of the benefits accrued as a result of the transaction costs. The main one is capacity. As a community development worker I used to write funding submissions for little non-profit groups. This was a pain, but what was good about it was that it brought all sorts of people into my office that otherwise wouldn’t have come to the neighbourhood centre. Often, I could link them with other groups, or they would get interested and volunteer for something new. Because my knowledge was more extensive than theirs, I was often able to improve their idea and by making them sit with me when I scoped the submission, I tricked them into doing preliminary project planning which they wouldn’t have done otherwise and thus saved them from further transaction costs down the track.

    As a project manager in government, I saw the reporting and review processes as being vital to developing the capacity of the executive to tackle a range of issues and by improving their understanding, sometimes gained champions which came in handy. Furthermore, I deliberately designed the process of reporting to improve and extend community engagement and understanding, thus increasing the likelihood of practice uptake.

    The most significant benefit that transaction costs give us is accountability – both financial and to the environment. The financial one is very important. We are blessed with living in a country that has a low level of corruption and this is the result of having stringent (though painful) requirements to account for public funds. The lack of corruption is a fundamental basis for addressing environmental issues – just look around you at countries where corruption is rife – addressing environmental issues is so much more expensive and difficult. I spent two years mentoring Coordinators of Indigenous ranger groups to develop their management skills. Much of the work was associated with transaction costs which they found boring and frustrating. However, in the process, they were forced to understand their budgets and their improved financial management and reporting skills empowered them to tackle some systemic dysfunctional governance issues, resulting in more funds reaching the ground, vastly improved workflow and increased job satisfaction. The new skills they learned are also life skills which have improved their ability to manage transaction costs in their personal lives.

    Kate Eden, Australian Government Land and Coasts Joint Team

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