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What Are Transaction Costs? A Beginner-Friendly Guide

7 Minute Read

Buying and selling products may seem straightforward: Pay the posted price to get the desired item. However, many complicated procedures are involved, and can include finding, transferring, and processing every economic exchange. These extra steps often result in "transaction costs" that can increase the final price. 

While transaction costs may not be easy to spot in day-to-day purchases, they significantly impact the economy. Learn what transaction costs are to better assess financial decisions.

What are transaction costs?

Transaction costs are fees that pay for the transfer or confirmation of an exchange. While the final price already includes these costs, they aren't a part of the underlying asset's market value. Also, transaction costs may not go directly to the seller. When you pay transaction costs, the money goes to third parties (e.g., banks or brokers) that help confirm your trade. 

Although transaction costs are commonly associated with fees paid in fiat currency, they can represent more abstract expenses. For instance, time, travel charges, and labor are transaction costs. A firm's expertise or legal authority could also be considered a transaction cost. 

Transaction costs incentivize users to build systems we leverage to exchange value. If there was no money to be made building these systems, less people would build them. However, the race to improve transactions and lower costs means they have generally decreased over time.

Types of transaction costs

There are countless examples of transaction costs, but most of these fees fall into one of three categories, which help explain the services firms provide for these fees.

1. Search and information

Search and information costs pay for services involved in finding and sharing relevant data with two parties. Brokers on exchanges such as the New York Stock Exchange (NYSE) provide this service whenever they match stock buyers with sellers. Real estate agents also charge search and info fees whenever they research properties for interested homebuyers.

2. Bargaining 

Buyers only need to purchase an item once they find a willing seller. During this phase, they can compare the costs of various products and negotiate their preferred rate. Third parties, such as stockbrokers or real estate agents, can charge "bargaining transaction costs" to find the best price. Comparing expense ratios at different mutual funds is an example of bargaining fees. 

3. Policing

The third aspect of transaction fees involves legal protections and enforcement costs. Policing fees protect buyers and sellers if either party fails to meet their end of the bargain. Examples include lawyer fees and insurance payments.

Why do transaction costs matter?

Inspired by the work of the 20th-century author Ronald Coase, more economists agree that transaction costs are a central aspect of financial decision-making. Before Coase published his economic theories, everyone viewed transactions as a "friction-free" experience. In this old view, buyers and sellers settled prices at a fixed and transparent price. Coase pointed out that the very process of transaction imposes unique costs on every financial exchange. In many cases, these transaction fees influence purchasing decisions more than an asset’s market price. 

As transaction costs rise, customers notice more friction when buying items and services. Even if the costs of goods remain stable, high transaction costs will decrease everyone's purchasing power. As people encounter more transaction costs, consumer confidence will likely plunge.  

Businesses and investors need to account for transaction costs when reviewing their expenses. If they don't factor in transaction costs, these fees could eat away their profits. Transaction costs can also impact an economy's entrepreneurial and investment activity. Low transaction costs improve people’s confidence to invest capital, while high transaction costs likely stunt economic growth.

Eliminating transaction costs

In the 20th century, economists such as Coase developed the Transaction Cost Economics (TCE) model to analyze the impact these fees have on the economy. A core tenet of TCE is that low transaction costs lead to more economic activity and efficiency. TCE supporters also believe organizations will always seek the lowest possible transaction costs.   

The field of "transaction costs analysis" is designed to help businesses eliminate transaction costs. Analysts assess a company’s estimated annual expenses and put together strategies to help clients minimize these fees. 

In addition to fields such as transaction costs analysis, many economists believe technological advancements will naturally decrease transaction fees. Most notably, the internet has significantly reduced transaction costs associated with search and information. Search engines such as Google find valuable information quickly and cost less. eCommerce sites and online trading platforms make it easier to connect buyers and sellers. All these innovations reduce total transaction costs. 

Also, automation can reduce transaction costs for various businesses. Developments in machine learning and artificial intelligence can reduce a manufacturing plant's labor costs, which will eventually cut the transaction fees on manufacturing. In finance, many trading firms have transitioned to automated high-frequency trading machines. Those who favor these trading technologies argue they reduce transaction fees by increasing market liquidity

While there's debate over whether new technologies will ever eliminate transaction fees, TCE economists believe lowering these costs is a net positive for the economy.

Are there transaction costs in crypto?

Although crypto doesn't have a central bank or government, you still need to pay transaction costs to transfer these coins. Blockchains such as Bitcoin (BTC) have built-in "network fees" that go to BTC miners. Since Bitcoin is a decentralized network, these crypto fees incentivize more people to use their computing power to validate BTC transactions. The higher the hash power is on the Bitcoin blockchain, the more resilient it is against hacks. 

Many other blockchains, such as Ethereum (ETH), charge transaction costs known as "gas fees." Similar to Bitcoin's network fees, these gas payments go to the node operators who confirm transactions on Ethereum's blockchain. 

Individuals must also pay transaction fees when using centralized crypto exchanges (CEXs). CEXs provide a centralized hub for buying and selling digital assets like stock brokerage websites. Every CEX has a different fee structure, but most charge commissions as well as withdrawal and deposit fees.

Wrapping up

It's easy to ignore transaction costs when making small purchases, but they’re a significant aspect of the financial ecosystem. Transaction costs can directly influence all facets of the economy, including consumer habits, business development, and investment activity. However, transaction costs have declined in many areas thanks to innovations such as the internet, automation, and blockchain technology. Lower transaction fees may open up new opportunities in the global economy. 

While cryptocurrencies aren't fee-free, they offer more people an affordable alternative to centralized payment services. At Worldcoin, we want more people to learn the potential benefits of crypto. Subscribe to our YouTube channel to learn more.