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Transaction Costs

In economics, a transaction cost is a cost incurred in making an economic exchange. For example, when buying a good, the cost paid integrates not only the price of the product itself, but also the energy and efforts required to find out which variety is preferred, where to get it and at what price, its cost of travelling, the cost of making a legal contract and so on. All of these costs, except for the price of the product itself, represent transaction costs.

For ecological economics, an important focus is placed on the role of transaction costs when discussing Coasian bargaining, and in general in the management of emissions trading and in the use of incentive mechanisms for environmental protection.

Environmental governance typically involves administrative transactions rather than market transactions. Here are some examples of well known transactions:

  • Search and information costs: costs associated with market research.
  • Bargaining costs: costs of making an acceptable agreement with the other party.
  • Policing and enforcement costs: costs of making sure the other party sticks to the terms of the contract and of taking appropriate actions, mainly through the legal system, if this is not the case.

For example, McCann and Easter (1999) measure the magnitude of transaction costs associated with four different policies to reduce non-point source (NPS) pollution. In their study, transaction costs integrate information collection and analysis, enactment of enabling legislation including lobbying costs, design and implementation of policy and support and administration of on-going programmes, monitoring/detection, and persecution/inducement costs. They directly measure through interviews with program staff and others the amount of labour input required, which then is translated into monetary costs. The results show that the tax on fertilizer has the lowest transaction cost and the expansion of a permanent conservation easement program has the highest transaction cost.

Conservation easement programs are those in which ownership rights to land are transferred to a private charitable conservation organization or government agency without transferring ownership of the land. The organization or agency then holds those rights (the easement) in perpetuity, even if the land is sold or bequeathed by the landowner to another party).

Various emissions trading systems have been increasingly used to replace traditional command-and-control approach in environmental regulation. However, transaction costs are generally high in some marketable permit programs. As a consequence potential gains from trade are far from being realized. Several factors have been identified as contributors to high transaction costs in emissions trading:

  • the inability in some programs of buyers and sellers to identify each other;
  • regulatory approval is costly and lengthy;
  • firms face enormous uncertainty in anticipating how regulators would determine their baseline emission levels and emission reduction.

For individual products traded in markets, transaction costs are relatively low and sufficiently overcome by the agents performing the transaction to complete an exchange. But in reality, transaction costs are likely to be very important each time an externality affects more than a very few agents, which is frequently the case. For example, a farmer who pollutes his water supply may be one of numerous upstream farmers affecting thousands of downstream neighbors. Bringing all the relevant agents to the negotiating table would be almost impossible, and even if it could be achieved, free-riding could become a problem. For example, if a person lives on the banks of a stream polluted by farmers and if her neighbors agree to pay to reduce pollution, she would prefer that level of reduction for free to even more reduction at a positive cost to herself.

Beside the lack of a standardized definition, another shortcoming comes from the difficulty in estimating transaction costs. This is namely because production and transaction costs are jointly determined, so that it is hard to estimate transaction costs separately. In empirical studies, a direct measurement of transaction costs is simply the economic value of resources used for locating trading partners and executing transactions, but it can also be measured by calculating the difference between the price paid by the buyer and the one received by the seller.


Coase, R. (1961) The problem of social cost. Journal of Law and Economics, 3, 1-44

Colby, B. (1990) Transaction costs and efficiency in western water allocation‖, American Journal of Agricultural Economics, 72, 1184-92.

McCann L., Easter, K.W. (1997) Transaction costs of policies to reduce agricultural phosphorous pollution in the Minnesota River, Land Economics, 75 (3), 402-414.

This glossary entry is based on a contribution by Tom Bauler

EJOLT glossary editors: Hali Healy, Sylvia Lorek and Beatriz Rodríguez-Labajos

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