Thursday, January 13, 2005

Transaction Costs Explained

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Transaction costs refer to the extra costs associated with getting a finished good or service from the producer to the consumer. Transaction costs consist of things like the cost of physically moving the good or service from the seller to the consumer, commissions and fees to third parties who facilitate the sale, information cost, search costs, etc.

The services associated with transaction costs add value in the sense that, without the added value, the consumer could not utilize the product, but the added value is not needed in order to produce the good or service.

I remember taking a Spanish class while in graduate school and listening one day to the instructor lament about the injustice of the large price difference between what a coffee grower in Venezuela received for a pound of freshly harvested coffee beans and what a consumer in Milwaukee paid for a pound of coffee in the store. I quickly pointed out to him that pound of green coffee beans sitting on a farm in Venezuela did nothing for a consumer in Milwaukee wishing to have a cup of coffee in the morning for breakfast. He acknowledged that roasting, grinding and packaging was necessary and would add to the price but it was those other things like “shipping, insurance, commissions to coffee brokers, etc.” that drove the price up unnecessarily.

Shipping, insurance, commissions to brokers, etc. are examples of transaction costs. They are not a part of the production process as the Venezulean farmer could roast, grind and package the coffee grown on his farm. But a can of ready to use coffee in Venezuela is still of no use to a consumer in America. Think about how much time and money you, a coffee drinking consumer, would have to spend trying to find tropical farmers with coffee which they have grown, roasted, ground and packaged or small companies in the tropics who have purchased, roasted, ground and packaged the coffee. Conversely, think about how much time and expense these tropical farmers or small local coffee processors would have to go to in order to find you.

Enter the wholesalers (both in the tropics and here in America), shippers, business and customs brokers, insurers, bankers, etc. who provide the services that enable the coffee growers to concentrate on growing coffee and getting paid as soon as the harvest is in and, at the same time enable you and me to acquire all of the ready to brew coffee we want with a simple trip to the nearest grocery store. Wholesalers buy the freshly harvested coffee and arrange for transport to the nearest port. Business brokers find the best prices and line up wholesale buyers in the consuming countries while shippers transport the coffee from the producing to the consuming country. Customs brokers at each end facilitate the paper work needed to move the coffee between nations while wholesalers in the consuming nation arrange for distribution to stores conveniently located near coffee drinking consumers. Meanwhile, bankers provide the financing that enables entities at each stage of the process to be paid immediately and not wait for purchase by the final consumer while insurers insure against the financial loss that would result if the product were damaged, distroyed or stolen during its long journey from producer to final consumer.

Transaction costs add value to the final product and they are the price we pay for the high degree of specialization that enables our economy to produce the vast array of affordable goods for us.

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