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argued that any analysis of economic organization must hinge on an examination of the
transaction costs involved. His argument is as follows: If transaction costs equal zero, then
property rights are perfect and organization does not matter; if these costs are not zero,
then the explanation of organization lies in transaction costs. The grand hypothesis of the
transaction cost approach is that contracts and organization are organized to maximize joint
wealth net of transaction costs.
All of this, of course, begs the question “What are transaction costs?"—a question that
is made more pressing given that Coase himself has never defined the term but instead
just provided examples. Indeed, the transaction cost approach has been hindered at times
by ambiguities in language and a general reluctance to define terms—especially the terms
“transaction costs” and “property rights." In fact, there are two well-developed concepts
of transaction costs in the economics literature. The first, developed by Demsetz (1968),
defines transaction costs as the costs of transferring property rights in a market exchange.
This is the definition found in the The New Palgrave Dictionary of Economics . 6 This
approach typically posits some type of “transaction technology” that taxes the transaction
and acts in many ways just like a tax. Because this notion of transaction costs was developed
to analyze the volume of trade, its major drawback is that it is not useful for examining
questions of contract and organizational choice. In another survey article, Allen (2000)
calls this the “neoclassical” definition of transaction costs because of its emphasis on the
volume of trade. 7
We do not use the neoclassical concept of transaction cost. Instead, we use what has
been called the “property rights approach” to transaction costs, where these costs are
defined as the costs of enforcing and maintaining property rights —regardless of whether
a market exchange takes place or not. Property rights, in turn, are defined as the ability to
freely exercise choices over the asset in question. Transaction costs include the deadweight
losses that result from enforcing property rights as well (Allen 1991, 2000; Barzel 1997). 8
As a result, transaction costs are more than the costs of a market exchange. That is,
property rights may be required to be enforced in a private contract, through courts or
other third party agencies, against thieves, or across market transactions. We employ this
concept of transaction costs throughout our topic because it is complete enough to explain
organizational choices and because it more closely aligns with the modern literature on
contracts and organization.
In order for transaction costs to exist, two conditions must be met. Information must
be costly to obtain, and assets must be variable in their quality or characteristics, and
alterable by man. That information must be costly is rather obvious. If everything is known,
then enforcing and maintaining one's claim to property is redundant. 9 That assets must be
both variable and alterable is perhaps less obvious. Essentially the only way someone can
systematically infringe on another's property rights, and therefore make necessary efforts
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