How we change what others think, feel, believe and do

Transaction Cost

Explanations > Trust > Transaction Cost

The cost of distrust | Organizations as trust boundaries | So what

The cost of distrust

Whenever you interact with another person, then a certain amount of what you do before, during and after the interaction may well be directed at ensuring that you do not get deceived by the other person. This activity is effectively waste, as it does not directly create value for you or the other person. This is the transaction cost.

 For example if you are going to buy a television, there may be a small local shop that sells them, but you do not trust their prices, so you travel to a superstore. You still look up prices on the internet beforehand and also check the store's returns policy. At the store, there is a bit of a rigmarole whilst they check your credit and there is a security man on the door who checks your receipt as you leave.

Transaction costs include those around:

• Search and information: Finding products and appropriate suppliers.
• Bargaining and decision-making: Negotiating and establishing the agreement.
• Policing and enforcement: Ensuring the other person conforms with agreements.

When your work involves interaction with many people, the cumulative transaction cost can be a very significant part of the cost of doing business.

Organizations as trust boundaries

Transaction cost is a founding principle of economics and organizational theory. If you can build an organization within which transaction costs are lower, then you can operate at a lower cost than a set of individuals who are collaborating but who have a higher level of distrust with one another.

Organizations thus act as 'trust boundaries' where people inside will automatically give a level of trust to the people inside their company that they will not give to outsiders. Companies have the opportunity to extend these boundaries into customers and suppliers, reducing the transaction cost of the entire supply chain and thus create a highly competitive ecology.

So what?

So if you are running a company, work hard to develop trust within the company to reduce your transaction costs and hence the cost of operating your business. It is also worth spending time breaking down trust barriers to partners, customers and other stakeholders.

If you have any regular interactions with people, even on an individual basis, then increasing trust reduces the cost of those interactions (and vice versa), increasing their value to all concerned.

See also

Coase, Ronald H. (1937) "The Nature of the Firm," Economica, 4(n.s.), 1937, 386-405. Reprinted in R.H. Coase, Ronald H. (1988). The Firm, the Market, and the Law, Chicago: University of Chicago Press, 33-55

Transaction costs, trust and outsourcing