The Economics of Transaction Costs: Theory, Methods and Applications (review)

Transaction cost economics (TCE), as P.K.Rao rightly points out is largely an unexplored area. The reasons for such a lackluster status of TCE are many: (1) apparent inflexibility of institutions and organizations on which the basic tenets of TCE depend; (2) apathy in developing stronger theoretical and quantifiable framework for analysis of TCE; and (3) the very existence of an imperfect assumption of rational choice in a less than perfect world. However, TCE has tremendous potential in advancing the economic science. In ten chapters Rao does a good job in highlighting both the theoretical underpinnings and the areas where TCE is either applied, or can possibly be applied. Where this book deviates from other books on TCE is that it illustrates how TCE can be applied, and/or fits in the core areas of economics. In particular, welfare economics, industrial organizations, market failure and externalities, law and economics, behavioral economics are some of the areas where TCE, as Rao suggests, is most suitable. What this book is lacking, however, is an objective assessment of applications of TCE in a variety of areas of economics, and other disciplines. In terms of TCE and its applications Rao has only looked into the economics literature while in recent years, TCE has gained popularity in other areas such as marketing, logistics, and management.

In chapter 1 the author discusses the fundamental concepts and assumptions of TCE. In defining transaction costs Rao aptly quotes from Arrow, Williamson and further elaborates what are the various components of it, and the examples from Egypt, Peru, and Singapore are excellent illustrations of how one can get a practical sense of what transaction costs are. In chapter 2 the core of TCE and its application in the economics of industrial organization is discussed. In developing the fundamental concepts of the theory of firm, specifically the boundaries of the firm, Ronald Coase, and then later on Williamson, Demsetz and others explicitly stated the role that transaction costs play in business transactions, e.g., outsourcing, vertical integration, adaptation, technical innovation etc. Principal-agent problems are pervasive in modern business transactions, and a deeper insight and understanding of the attributes of transaction costs and their presence or lack there of allow both theoreticians as well as practitioners to better grasp the complexities. Readers of Rao's book easily get the overall picture from this chapter.

Chapter 3 devotes to the problems that typically externalities (negative or positive) pose to any economic agent. By internalizing such externalities in the production, consumption, or distribution processes, as literature shows, optimal decisions including Pareto efficiency (first best or second best) are reached. However, such process of internalization involves full recognition and treatment of transaction costs. Rao elegantly argues extension of this line of work.

In chapters 4 and 5 two recently developed branches of economics: New-Neoclassical Economics, and New Institutional Economics are analyzed with the inherent roles played by transaction cost economics. First, in the New neoclassical setting the marginality principle, in the presence of transaction costs as a result of specific nature of institutions, and/or presence of certain types of assets, or the in-built rigidity in them, is somewhat different. In that the marginal rate of substitution is higher than that of the general case because of the presence of such transaction costs. As a result the optimal resource allocation will be different compared to the situation where TC is assumed away, or assumed to be zero. This fundamental departure in allocation principle in presence of TC is pivotal in achieving efficiency in decisions. This line of argument is consistent throughout the sections in this chapter such as in the economics of information, credit rationing, economic growth and development, hierarchical and decentralized management, the economics of free trade, structural adjustments, debt management and the like. In short, what Rao so very effectively argues is that the standard neoclassical...