Economic Theory

Economists need to look beyond their fancy models, and study transaction costs

If you were to ask an economist why financial institutions or food retailers exist, I wonder if the answer would go beyond that which would be offered by a random person travelling on the Tube. Answers might include “to provide bank loans, insurance and savings products” and, in the case of food retailers, “to provide food efficiently”. But this is merely stating the obvious.

If we cannot articulate the fundamental functions of these important sectors of the economy, we are unlikely to understand the circumstances in which they will cease to exist – an important skill for business strategists. Economists may struggle to predict – even in outline – fundamental economic change.

Financial institutions exist to reduce transactions costs. Without them, somebody saving money for a rainy day or for their pension would have to seek out and assess the creditworthiness of a vast number of individuals or companies before lending them money. And, without securities markets and banks providing on-demand deposits, the cost of individuals realising their investments at convenient times would be huge.

Supermarkets and shops also exist to reduce transactions costs. In their absence, we would have to go to a market gardener to buy vegetables, to a chicken farmer to buy eggs, and to a pig farmer to buy bacon, and so on. Supermarkets provide a central place to which producers sell produce and where consumers come and buy things, hugely reducing the cost of doing business. They don’t actually produce anything physical. Their service simply reduces the costs of everyday living.

The major changes that are happening before our very eyes and that will transform the economy beyond all recognition over the next generation are arising because technology is reducing the transactions costs of different ways of doing business.

Airbnb can thrive because the internet means that those who wish to rent out rooms temporarily don’t have to group them altogether in one building in a permanent business. The transactions costs obstacles to renting out one room for one day every week have disappeared.

Peer-to-peer lending radically simplifies the “middle-man” in credit transactions; and other innovations are on their way in finance. In China, 2,000 platforms intermediate £100bn of peer-to-peer lending. And a combination of the development of drones, the internet and modern computerised logistics means that Amazon provides services from a warehouse in Dundee to people who have never heard of Dundee.

Conventional economics as taught in universities prefers to use models that are mathematically neat, but which often miss the big conceptual picture. That is ironic because universities themselves largely exist because of transactions costs.

Those with the knowledge come to one place and are joined in that place by those who want to know more. In theory, students could interact with all their lecturers separately, attending different classes organised by their lecturers in different places and organise study groups with fellow students. But, it is cheaper for everybody to be brought to one place and contract with one organisation – the university.

What if technology were to change all this? A combination of MOOCs (massive open online courses), online materials, chat forums, Skype, professional and learned bodies and think tanks bringing together students and academics in different ways, and so on, might provide much of what a university offers today.

Of course, some students and lecturers might value the collegiate environment in and of itself, and there might be some benefits from it. But radical change in how over-16s learn is not beyond the bounds of possibility.

If you want to predict major developments in business and commerce, you should look at how technology will change transactions costs. It is quite possible that banks will go the way of department stores. And many universities may do so too. It would be ironic if this happened while university economists and business school professors were poring over their equations.


This article was first published in City AM.

Philip Booth is Senior Academic Fellow at the Institute of Economic Affairs. He is also Director of the Vinson Centre and Professor of Economics at the University of Buckingham and Professor of Finance, Public Policy and Ethics at St. Mary’s University, Twickenham. He also holds the position of (interim) Director of Catholic Mission at St. Mary’s having previously been Director of Research and Public Engagement and Dean of the Faculty of Education, Humanities and Social Sciences. From 2002-2016, Philip was Academic and Research Director (previously, Editorial and Programme Director) at the IEA. From 2002-2015 he was Professor of Insurance and Risk Management at Cass Business School. He is a Senior Research Fellow in the Centre for Federal Studies at the University of Kent and Adjunct Professor in the School of Law, University of Notre Dame, Australia. Previously, Philip Booth worked for the Bank of England as an adviser on financial stability issues and he was also Associate Dean of Cass Business School and held various other academic positions at City University. He has written widely, including a number of books, on investment, finance, social insurance and pensions as well as on the relationship between Catholic social teaching and economics. He is Deputy Editor of Economic Affairs. Philip is a Fellow of the Royal Statistical Society, a Fellow of the Institute of Actuaries and an honorary member of the Society of Actuaries of Poland. He has previously worked in the investment department of Axa Equity and Law and was been involved in a number of projects to help develop actuarial professions and actuarial, finance and investment professional teaching programmes in Central and Eastern Europe. Philip has a BA in Economics from the University of Durham and a PhD from City University.

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