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

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