Sankar Ray

TRANSACTION cost is a neglected concept among econometricians in India. In the West, as also in Hong Kong, there were attempts to rid it of unethical objectives that saw the growth of subterranean economies. In India, it remains hijacked by accountants and financial analysts. So the art of hiding costs has flourished so as to inflate expenditure. Credit for the theoretical foundation of transaction cost goes to Ronald Coase ( The Nature of the Firm in Economica (NS), November 1937). In August 1946, he fine-tuned the concept in a paper titled `The Marginal Cost Controversy'.

Economists differ on interpreting Coase's path-breaking work. In his presidential address to the Western Economic Association in 1998, Chinese economist Steven N. S. Cheung observed that Coase showed "in the presence of transaction costs Pareto optimality requires reinterpretation". And he sharply criticised economists for neglecting the issue. "Transaction cost economics is real-world economics, and the real world is too often a place where academic economists fear to tread."

Douglass C. North, who got the Nobel for his contribution on transaction cost and related topics, said that Coase in 1960 had identified "the crucial connection between institutions, transaction costs, and neo-classical theory. The neo-classical result of efficient markets only obtains when it is costless to transact. Only under the conditions of costless bargaining will the actors reach the solution that maximises aggregate income regardless of the institutional arrangements when it is costly to transact then institutions matter. And it is costly to transact."

North, along with Robert P. Thomas, caused a significant take-off in the concept in the 1970s. Beginning with their paper The Rise of the Western World: A New Economic History (Cambridge: Cambridge University Press, 1973), they gave it another interpretation in `A Transactions Cost Theory of Politics' published in the Journal of Theoretical Politics in 1990 and thus enriched the concept significantly. North, in his Stockholm oration, addressed the institutions as "humanly devised constraints that structure human interaction."

He dichotomised two types of constraints formal (rules, laws, constitutions) and informal (norms of behaviour, conventions, and self-imposed codes of conduct) and emphasised their enforcement characteristics. "Together they define the incentive structure of societies and specifically economies. Institutions and the technology employed determine the transaction and transformation costs that add up to the costs of production," North added. Perceptive cost accountants make no bones of unethical aspects of transaction cost, albeit infrequently.

Mr Siddhartha Sen, director (research), Institute of Cost and Works Accountants of India, drew attention to "not-so-visible and invisible elements associated with these transactions, giving rise to a variety of `hidden costs' which ultimately affect adversely, in the short or long run (for both), the cost of final product/output per unit." CMIE reports reveal that raw materials account for over 55 per cent of the cost of production. Mr Sen found that transaction cost is included therein. However, transaction cost as a tool of manipulation of cost of production on paper is not a monopoly of India, nor of any developing country. Even in the US, the transaction sector used to be 45 per cent of GNP in 1970, according to a paper North had written jointly with John Wallis in the Journal of Institutional and Theoretical Economics in 1999.

The state and watchdog bodies have a crucial role to play. The instrumental rationality is a necessity where economic and business models are diverse and erroneous models, but North stressed on "informational feedback process and arbitraging actors will correct initially incorrect models, punish deviant behaviour and lead surviving players to correct models."

Indian economists, particularly econometricians with an eye on behaviourism, ought to chip in and reposition it rather than allow its unethical use of transaction costs.

(The author is a Kolkata-based freelance writer.)

(This article was published in the Business Line print edition dated April 14, 2005)
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