Importance of Transaction Cost
What is Transaction Cost
In 1937, Ronald Coase published one of the most cited papers in economics, The Nature of the Firm. He introduced the concept later known as “transaction cost” – the cost of carrying out an economic exchange.
Coase’s thesis: a firm’s size is determined by the choice between (a) buying a service on the market or (b) producing it in‑house. A company will internalise a service if its transaction cost of doing so is lower than the cost of purchasing it externally.
Real‑World Example: Café Illustrations
A cafe owner orders illustrations and graphics from a freelance designer five times a month. As the café grows into a ten‑location chain, that demand jumps to a hundred orders per month. At that scale, the transaction costs skyrocket:
- Waiting for the freelancer to finish other jobs
- Finding and negotiating with extra designers
- Assigning tasks and reviewing drafts
- Processing payments
At this volume, it’s far more efficient to hire an in‑house designer—drastically reducing transaction cost while delivering the same quality.
Transaction Cost in Product Development
Transaction cost is unique for each product. It includes:
- Earning & spending money: effort to earn the funds required to pay for the solution.
- Search & selection: finding options, comparing features and prices, and choosing the best one.
- Onboarding & execution: learning how to use the solution, placing orders, waiting for delivery, setup, etc.
- Troubleshooting & emotional toll: dealing with hiccups, returns, customer support, unexpected fees, and the stress they cause.
When I was buying a new phone in 2024 prior to my trip to Bali, Apple offered AppleCare insurance with Theft protection for 15 percent of the phone’s price. I’d broken screens before, and my friends had their phones stolen in Bali, so the warranty would likely pay for itself – I agreed.
Previously, I’d abandoned the idea of insuring my phone because:
- Researching and comparing plans took too much time,
- Reading fine print felt like a torture,
- Ordering online and activating coverage required extra steps.
The energy investment outweighed the benefit, until insurance was offered during the phone purchase. Suddenly, the delta between value (peace of mind) and energy spent (one decision) was huge in the context. I signed up.
The Brain, Energy, and Product Success
In Seven and a Half Lessons About the Brain, Lisa Feldman Barrett describes the brain’s core function: managing allostasis – predicting energy needs before they arise to ensure survival.
“The brain’s primary role is not thinking, but managing a complex organism by investing energy where it expects the greatest return.”
—Lisa Feldman Barrett
Because the brain is constantly investing energy in anticipation of a return, whenever someone has a problem to solve and they learn of an alternative solution that promises to complete that job with less energy investment, they will become interested—and if the energy savings are significant enough, they’ll break through their habits and switch to the new solution.
Since Transaction Cost is a function of a specific solution, the product‑development algorithm is always about comparing and managing the dynamic between the Transaction Cost of your solution versus a competitor’s—or between your current version and a possible improvement.
In other words, given two solutions for the same problem, the customer will choose the one with the lower Transaction Cost.
- To win customers, you must undercut competitors’ transaction costs.
- To retain customers, you must continually reduce your own transaction cost or risk being overtaken.
References
- Coase, R. H. (1937). The Nature of the Firm – https://www.jstor.org/stable/2626876
- Barrett, L. F. (2021). Seven and a Half Lessons About the Brain – https://www.penguinrandomhouse.com/books/667490/seven-and-a-half-lessons-about-the-brain-by-lisa-feldman-barrett/