Transaction cost analysis

A useful tool in analyzing the framework for private sector development within a local community is the analysis of transaction costs i.e. the costs of conducting business transactions. Costs incurred in the search for information on the price, quality and availability of goods and services, search for potential buyers and sellers, and the relevant information about their behavior and reliability, bargaining, making contracts, monitoring contractual partners, contract enforcement and the collection of damages for the violation of the terms of a contract, protection of property rights against third-party encroachment are all transaction costs.

In order to reduce transaction costs, institutions (sets of rules) are created. They lower uncertainty and risk because they limit the individual freedom of action. Thus, behavior of market participants becomes better predictable. Trustful relationships, strategic alliances, long-term contracts etc. reduce complete market competition. Therefore, durable business relations with suppliers and customers based on contracts may be more profitable than arms-length-relations. Companies set up a stable relationship with suppliers and customers in markets that are only partly determined by prices related to market information, and manage to decrease their transaction costs.

The nature and size of transactions costs can change over time: for example, new communications technologies may lower the costs of transacting with suppliers, and motivate leading firms to outsource activities previously handled internally.

What does all this have to do with local economic development? What is the role local governments are playing with regard to transaction cost analysis? In fact, the better the local environment for companies is the more easily the local economy will grow and create jobs. Governments trying to create a favorable environment for business play a key role when it comes both to creating and minimizing transaction costs, as summarized in the following table.

Government and transaction costs for business

	Reduce transaction costs	Increase transaction costs
General government activities	effective and efficient legal system good and efficient infrastructure efficient, high-quality education and health system	regulations permit requirements red tape incompetence and inefficiency corruption
Government investment promotion activities	tax incentives real estate development skills development preferential credit	cost of application long decision period on application lack of transparency on decision criteria

The upper row is of a more general nature, not exclusively shaped by local governments but also by federal and national authorities, whereas the lower row addresses more specific issues. The upper row is the one which has to be addressed first. For example, an efficient information system allowing easy access to information about possible business partners, chances to export goods and services, legal requirements etc. can contribute considerably to reduce transaction costs. If the balance tips to the right-hand side, i.e. if government is more into creating than alleviating transaction costs, it may still conduct the activities mentioned in the lower row, but they will not be particularly convincing and effective.

The following examples illustrate the handling of transaction costs in different settings and countries:

Italy is well known for its so-called industrial districts, comprising small and medium enterprises, most of them highly specialized and some of them world champions for a specific product. The business community is organized in a network-like manner that also includes local governments, technical schools, research institutions and other organisations. Within an industrial district, transaction costs are reduced through collaboration and partnership based on trust and reciprocity. Enterprises in these places work much more efficiently and productively than those elsewhere.

In transition economies in Eastern Europe, the rapid progress in establishing market-based institutions has reduced high transactions costs formerly caused by lack of knowledge about market mechanisms, unclear regulatory frameworks as well as an inexperienced bureaucracy, underdeveloped court system and corruption. Establishing new business relationships after dissolution of the centrally planned economy caused high transactions costs as former administrators without experience in a market context turned into independent economic actors, and Western businesses not only had difficulties in getting market information but also had to deal with partners that were inexperienced in business negotiations. Newly created supporting institutions managed to set up formal rules of the game, to reduce uncertainty and to establish a stable structure to facilitate interactions, to the benefit also of local areas.

A study about the first complete externalization of a local government - Technical Services in London - illustrates the difficulties that arise under local authority competitive tendering where the parties enter into an incomplete contract and rely on mutual goodwill to adjust the contract terms later. The contractor invested in a specific asset, the contract, from which there could be no withdrawal without significant cost. It could be confirmed that transaction costs can be pervasive in local government contracting, depending upon the nature of the contract and the associated organisational arrangements. Moreover, public sector contracts have an additional hazard, 'political risk', which is not well assimilated into transaction cost economics.

In general, one may conclude that the reduction of transaction costs is an important tool of creating competitive advantages for a local community, as it improves the competitiveness of local businesses.

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