Transaction

Cost
&
Sunk Cost
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Transaction Cost History
 Report Outline

When would Why is it Do's and

they perform beneficial? Don’t’s
in the market
 Transaction History

The term "transaction cost" is frequently

The term "Transaction Costs" itself can
thought to have been coined by Ronald Coase,
instead be traced back to the monetary
who used it to develop a theoretical framework
economics literature of the 1950s, and does
for predicting when certain economic tasks
not appear to have been consciously 'coined'
would be performed by firms, and when they
by any particular individual.
would be performed on the market.
However, the term is actually absent from his early work
up to the 1970s. While he did not coin the specific term,
Coase indeed discussed "costs of using the price
mechanism" in his 1937 paper The Nature of the Firm,
where he first discusses the concept of transaction costs,
and refers to the "Costs of Market Transactions" in his
seminal work, The Problem of Social Cost (1960).
 Conclusion

At least two definitions of the phrase

"transaction cost" are commonly used in
literature.

Transaction costs have been broadly defined by

Steven N. S. Cheung as any costs that are not
conceivable in a "Robinson Crusoe economy"—in
other words, any costs that arise due to the
existence of institutions
For Cheung, if the term "transaction costs"
were not already so popular in economics
literatures, they should more properly be
called "institutional costs"
Transaction Cost
“A cost in making any economic trade when
participating in a market.”
- Ronald Coase in “The Nature of the Firm” (1937)
Ronald Coase used transaction
costs to examine firms’ choices
between purchasing goods and
services through contract and
integration of the firm.
 The transaction costs can include
managing and monitoring
personnel and procuring inputs
Transaction cost economics (TCE) focuses and capital equipment.
on the organization of transactions that
occur whenever a good or service is
transferred from a provider to a user Transaction costs are
across a technologically separable significant and have a major
interface. impact on economic
efficiency.
 ELIMINATION OF TRANSACTION COSTS

When transaction costs diminish, an economy

becomes more efficient, and more capital and
labor are freed to produce wealth. A shift of this
nature does not come without growing pains, as
the labor market must adjust to its new
environment.
 Specialized equipment
Dedicated capacity
or
tooling Brand name
Specific skills
Site specificity or knowledge or reputation

CHARACTERISTICS OF TRANSACTIONS CAN AFFECT TRANSACTION COSTS

• Investments in transaction-specific assets improve the efficiency of some transactions
• If parties behave opportunistically, they can capture the value of investments made by others
• Bounded rationality limits the ability of both managers and contracts to control incentives
 Types
of
Transaction Cost
 They are the costs associated with looking for relevant

Search and information costs information and meeting with agents with whom the transaction
will take place.

They are the costs related to coming to an agreement that is

agreeable to the parties involved and drawing up the contract. Bargaining costs
Bargaining costs can either be very cheap or can be very
expensive.

Policing and enforcement costs
They are the costs associated with making sure that the parties in the
contract keep up their word and do not default on the terms of the
contract.
In the real world, people often deviate from the contract, and thus
enforcement costs are incurred while governing contracts.
 What affects transaction cost?

1. There is a lot of uncertainty and unpredictability in the world.

2. With bargaining and asset specificity, organizations

that enter into transactions find it expensive to leave
them.
3. The inherent opportunistic behavior of individuals in an
economy makes it harder for contractual agreements to be
enforced after a long period of time
 What affects transaction cost?

4. Individuals possess limited rationality, meaning they obtain and process

limited information, and hence, have fewer options to choose from.
Economic transactions are not based on pure rationality but bounded
rationality. Bounded rationality is a form of rationality where a person’s
decision-making and rationality is limited by the amount of information
available to them and the finite amount of time that they need to decide.
Problems

Solutions
Sunk Cost
 History

Daniel Kahneman’s book, Thinking Fast and Slow, he writes about how he and his colleague
Amos Tversky through their work in the 1970s and ‘80s uncovered the imbalance between
losses and gains in your mind.

Kahneman explains that since all decisions involve uncertainty about the future the human
brain you use to make decisions has evolved an automatic and unconscious system for
judging how to proceed when a potential for loss arises.
 Sunk Cost
Sunk cost, in economics and finance a cost that has already been incurred and that
cannot be recovered. In economic decision making, sunk costs are treated as bygone and
are not taken into consideration when deciding whether to continue an investment
project.

Incurred Cannot be
changed
 Sunk Cost

IRRELEVANT
to decision
• High Sunk Cost, less contestable market

• High sunk cost act as barrier to

entry of new firms

• Low sunk cost, contestability is high

 The sunk cost effect is manifested in a
greater tendency to continue endeavor
once an investment in money, effort, or
time has been made.

Sunk Cost Fallacy

Loss Aversion
“The sunk cost fallacy sometime makes
us stay in things that` we might be better
off leaving.”
 Types of
Sunk Cost
 Sunk Cost is also known as unrecoverable cost as the
amount is not able to be recovered which has already
been spent on some business activities. Marketing
expenses also one of the best examples of Sunk Cost.

Marketing Study/Expense Almost all businesses spend on marketing and

advertisement to promote their products and services.
The amount which has already been spent on marketing
and advertisement, cannot be recoverable.

So, advertisement and marketing expenses should not

be considered in the future decision-making process.
This is one of the best examples of sunk
cost. Almost all industries will be having
Research and development expenses in Research And Development
their books and companies will be
spending huge money for research and
development purpose for their product
 Equipment Expenses

Cost for equipment’s whether small or big production machinery, tend

to become sunk cost over time. Most of the manufacturing companies
would have a huge product line in their portfolio, and most of them
are not similar.

Companies have to invest in different kind of machinery for different

products. Not a single machine can produce all kind of products.
Sometimes, most of the machinery which are old or the products
which they manufacture are not at all in fashion at the present time,
companies have to replace that machinery with new upgraded
 Payroll Expenses

Payroll Expenses includes salaries, employees’ benefits,

expenses on employee training, which would become sunk cost
always once the amount paid in payroll head.

The amount which has already spent on employees, whether

directly or indirectly, cannot be recoverable in any case, it does
not affect by the performance of the employee performance or
behavior in the organization.
 Sunk Cost as a Type of Expense

Some expenses are anticipated, such as next month's payroll or

an annual subscription fee that is coming due. Other expenses
are recoverable.

For example, you may buy a piece of office equipment that

comes with a 100-percent, money-back guarantee if you are not
satisfied with it; this is a recoverable expense. Money already
spent, but that is not recoverable, is a sunk cost. Some sunk costs
can be precisely stated.
 Example of
Problems and
Solutions
Sunk costs can also show up in your personal life. If you buy a ncaa finals ticket for P300
but realize you can't attend, the P300 is gone, a complete sunk cost.
Once again, even in your personal life many sunk costs are inevitable and not just a bad
decision.

In Business
A movie studio spends $50 million on making a movie and an additional $20 million on
advertising. But the film disappoints at the box office and grosses just $15 million. Any
of that budget that isn't getting recouped is a sunk cost, and the possibility of it not
getting recouped should be factored into other film production budgets even before it
becomes one.
A restaurateur is considering expanding his restaurant into a
chain. They spend $10,000 on market research, and using
that research determine that opening a new location in a
specific area isn't likely to be profitable. They don't move
forward with the expansion, and that $10,000 is a sunk cost.
 References

https://www.investopedia.com/terms/t/transactioncosts.asp
https://surface.syr.edu/cgi/viewcontent.cgi?article=1019&context=lawpub
https://www.sciencedirect.com/topics/economics-econometrics-and-finance/transaction-costs
https://www.sciencedirect.com/topics/social-sciences/transaction-cost
https://pdfs.semanticscholar.org/bf8d/8ac9ced35331220c08f393e2910609a33fb3.pdf
https://en.wikipedia.org/wiki/Transaction_cost
https://www.rand.org/content/dam/rand/pubs/monograph_reports/MR865/MR865.chap2.pdf
https://www.soas.ac.uk/cedep-demos/000_P538_MSA_K3736-Demo/unit1/page_16.htm
https://corporatefinanceinstitute.com/resources/knowledge/economics/transaction-
costs/?fbclid=IwAR2BzBKu0kvgscwHTxLYcmMf7M0aPLsuFmOSxLzEtR-D6Y_QsvA6evfU-T4