Understanding The Importance Of Transaction Costs

Michael Munger recently spoke with Russ Roberts on EconTalk about (what else) transaction costs. Exciting, I know, but everyone can learn from what Munger says transaction costs address: Triangulation, transfer, and trust.

Triangulation is figuring out what we’re considering trading. “I need this. Who has it?”

Transfer is how we’re going to do it. “I can pay $x for that.”

Trust is why we’re going to engage with whomever we’re going to engage with. “I’m happy to buy this from you.”

Don’t be put off by the economics-speak, once we grasp the basic model we can and will see it everywhere. We should care about Munger’s model because it’s literally where all value emerges from, in any business or relationship. It also helps to keep in mind that costs don’t just refer to dollars and cents, but to time, preferences, and lots of other squishy, emotional feelings.

For a real-world example, imagine: a baby cries, a mother prepares the bottle, and the baby gets fed. Mom triangulated the market problem (lazy father isn’t going to take this shift and baby needs to eat), she grabs the bottle (how the service will be transferred), and both parties trust the other to deliver the product and service (they each satisfy their end of the bargain). This process beats baby screaming in the wilderness and mother wondering why the kid doesn’t just grow up already. Every time. 

In the professional world, anytime we provide a shorter path to answer any question a client has, we are reducing a form of a transaction cost. Creating value requires someone else to realize that we can make their life easier. In the most rudimentary sense: firms form so babies get bottles from people they can trust. Firms form because we can show that it’s better to ask us than to just google it. Firms form because once the car has been invented, horses and buggies seem so passé.

It takes effort to continuously think broadly about our businesses in terms of transaction costs. Maybe I need to write “triangulation, transfer, and trust” down somewhere and put it in my office. Everything we do should be reducing some transaction cost in the relationship where we are trying to create value.