Transaction Costs are the Costs of Engaging in Economic Calculation
This year marks the 100th anniversary of the publication of Ludwig von Mises’s seminal article, “Economic Calculation in the Socialist Commonwealth,” which marked the first salvo in what later became the socialist calculation debate. Though the contributions of F.A. Hayek to that debate, and to economic science more broadly, have been well recognized, what is somewhat forgotten today is that the fundamental contributions of another economist were also born out of the socialist calculation debate. I am referring to none other than Ronald Coase.
As Coase outlines in his Nobel Prize Address, he had been a student of Arnold Plant in the Department of Commerce at the LSE, who introduced him to Adam Smith’s invisible hand, and the role that the price system plays in coordinating the allocation of resources to their most valued uses without central direction. The insights of Coase, like Mises, were both motivated from the attempt by the Bolsheviks to implement central planning in Soviet Russia. As Coase writes, “Lenin had said that the economic system in Russia would be run as one big factory. However, many economists in the West maintained that this was an impossibility,” a claim first put forth by Mises in his 1920 article. “And yet there were factories in the West, and some of them were extremely large. How did one reconcile the views expressed by economists on the role of the pricing system and the impossibility of successful central economic planning with the existence of management and of these apparently planned societies, firms, operating within our own economy?” The answer put forth to this puzzle was what Coase referred to as the “costs of using the price mechanism,” (Coase 1992, 715). This concept, which later came to be known as “transaction costs,” was first expounded in his seminal article, “The Nature of the Firm” (1937) and later developed in subsequent articles, “The Federal Communications Commission” (1959) and “The Problem of Social Cost” (1960). But, it is interesting to note that Coase also states that “a large part of what we think of as economic activity is designed to accomplish what high transaction costs would otherwise prevent or to reduce transaction costs so that individuals can freely negotiate and we can take advantage of that diffused knowledge of which Hayek has told us” (1992: 716).
My point here is not to trace the historical origins of the parallel insights drawn by Mises and Coase, or other economists working in the Austrian tradition and the transaction-cost tradition for that matter. Rather what I wish to suggest here is that what Coase (not just Hayek) had been stressing in his insights learned from the socialist calculation debate cannot be fully appreciated without placing his contributions in the context of what Mises had claimed regarding the problem of economic calculation. Reframed within this context, I would argue that the concept of transaction costs can also be understood as the costs of engaging in economic calculation. However controversial my claim may seem, this reframing of transaction costs as the costs of associated with economic calculation has a precedent that can be found not only in Coase, but also in more recent insights made by economists working in the Austrian tradition (see Baird 2000; Piano and Rouanet 2018).
How do transaction costs relate to the problem of economic calculation? According to Coase, the most “obvious” transaction cost is “that of discovering what the relevant prices are” (1937: 390). The costs of pricing a good (i.e. transaction costs) are based, fundamentally, on the costs of defining and enforcing property rights in order to create the institutional conditions necessary for establishing exchange ratios, hence prices, in the first place. This also entails not only cost of negotiation and drawing up contracts between trading partners, but also discovering who are the relevant traders partners are, as well as discovering what are the actual attributes, such as quality, of the good or service being exchanged.
Carl Dalhman (1979) argues that all such transaction costs can be subsumed under the umbrella of information costs, but the nature of such information is not one that can be obtained only through active search per se, as if all such information is already “out there” and therefore acontextual. Rather, the very nature of such information is not just tacit and dispersed (Hayek 1945), but contextual (see Boettke 1998). The discovery of relevant trading partners, the valuable attributes of a good being exchanged, and the price to which trading partners agree, emerges only within a context of exchangeable and enforceable private property rights. This last point is precisely the argument that Ludwig von Mises had meant in his claim that economic calculation under socialism is impossible! Outside the context of private property, subjectively held knowledge cannot be communicated as publicly held information without first establishing the terms of exchange in money prices to allocate resources to their most valued uses.
In his Presidential Address to the Society for the Development of Austrian Economics, published in The Review of Austrian Economics as “Alchian and Menger on Money,” Charles Baird (2000) best illustrates the point I’m making here. Carl Menger (1892) and Armen Alchian (1977) had made distinct, though complementary stories as to why money emerges spontaneously, namely to reduce transaction costs. Menger argued that money emerges to avoid the costs associated with the double coincidence of wants between exchange partners. On the other hand, Alchian emphasized that money emerges to reduce the costs of calculating and pricing the value of the various attributes of a good, such as in comparing the quality of different diamonds. Money prices reduce the costs of pricing the quality of diamonds, thereby providing information, discovered by middlemen, to non-specialists about what kind of diamond they are purchasing (i.e. higher quality or lower quality). As Baird writes, “Menger’s story is incomplete. But so, too, is Alchian’s. On the other hand, both stories are complete on their own terms. Clearly what is needed is someone to put these two stories together” (2000: 119). Thus, reframing transaction costs from an Austrian perspective, money, firms and other institutional arrangements emerge to reduce the costs associated with economic calculation.
In a lecture written to honor F.A. Hayek in 1979, later published posthumously in The Review of Austrian Economics, James Buchanan boldly declared the following: “The diverse approaches of the intersecting schools [of economics] must be the bases for conciliation, not conflict. We must marry the property-rights, law-and-economics, public-choice, Austrian subjectivist approaches” (Buchanan 2015: 260). The link that “marries” these distinct schools, including the Austrian School, is the notion of transaction costs. However, this underlying link cannot be understood without first reframing, I would argue, the concept of transaction costs as the costs of engaging in economic calculation. The “marriage” of these intersecting schools, as Buchanan and others have suggested, highlights distinct aspects of the economic forces at work in the market process, as well as the alternative institutional arrangements that emerge to reduce the cost of transacting and thereby exploit the gains from productive specialization and exchange.
Rosolino Candela is a Senior Fellow in the F.A. Hayek Program for Advanced Study in Philosophy, Politics, and Economics, and Associate Director of Academic and Student Programs at the Mercatus Center at George Mason University
Alchian, Armen A. 1977. “Why Money?” Journal of Money, Credit and Banking 9(1): 133–140.
Boettke, Peter J. 1998. “Economic Calculation: The Austrian Contribution to Political Economy.” Advances in Austrian Economics 5: 131–158.
Buchanan, James M. 2015. “NOTES ON HAYEK–Miami, 15 February, 1979.” The Review of Austrian Economics 28(3): 257–260.
Coase, Ronald H. 1937. “The Nature of the Firm.” Economica 4(16): 386–405.
Coase, Ronald H. 1959. “The Federal Communications Commission.” The Journal of Law & Economics 2: 1–40.
Coase, Ronald H. 1960. “The Problem of Social Cost.” The Journal of Law & Economics 3: 1–44
Dahlman, Carl J. 1979. “The Problem of Externality.” The Journal of Law & Economics 22(1): 141–162.
Hayek, F.A. 1945. “The Use of Knowledge in Society.”
Menger, Karl. 1892. “On the Origin of Money.” The Economic Journal 2(6): 239–255.
Mises, Ludwig von.  1975. “Economic Calculation in the Socialist Commonwealth.” In F.A. Hayek (Ed.), Collectivist Economic Planning (pp. 87–130). Clifton, NJ: August M. Kelley.
Piano, Ennio E., and Louis Rouanet. 2018. “Economic Calculation and the Organization of Markets.” The Review of Austrian Economics, https://doi.org/10.1007/s11138-018-0425-4