(Bloomberg Opinion) -- On my graduate school preliminary exams, one question that stumped me. It was about people living on two different islands, trying to trade with each other. The problem was that they had to pay a small cost: rowing back and forth. Because economics classes had taught me that the market always finds a way, I couldn’t see the answer that was staring me in the face — that this tiny cost of doing business made productive trade between the islands impossible.
In the real world, islands trade with each other plenty. But transaction costs, as economists call them, really do interfere with the way markets work. Anyone who trades financial securities is already well aware of the problem; many a strategy that looks world-beating on paper ends up making little or no profit once trading costs are factored in. Those costs can include the expense of executing a trade, the bid-ask spread or the amount the price changes when one tries to buy or sell.
Beyond the simplified world of financial markets, transaction costs are even more complex and hard to grasp. Most of the biggest economic decisions we ever make involve a plethora of costs. Buying a house involves conducting an extensive search, paying a real estate agent and lender, educating yourself about real estate and the local market, driving a bargain and being ready to sue if someone tries to cheat you. Getting a job also requires huge amounts of searching, bargaining, learning and monitoring to make sure you get what you were offered.
Economists have long used transaction costs to explain why the economy doesn't behave like the frictionless market that students learn about in class. As far back as the 1930s, Ronald Coase argued that transaction costs are the reason that companies exist in the first place; producing goods and services with ever-shifting, ad-hoc, arms-length arrangements would be prohibitively expensive. About the same time, John Commons used transaction costs as the basis for creating the field of institutional economics. Oliver Williamson shared the 2009 Nobel prize for using transaction costs to explain why a lot of business is managed through long-term informal relationships, such as the ties between a company and its suppliers.
But modern institutions seem to be forgetting the pernicious power of transaction costs. Regulators, lawmakers and companies seem disturbingly content to force average Americans to endure an ever-growing variety of headaches to carry out daily life. Those costs are making the basics of an advanced society harder to maintain.
Just one example is the earned income tax credit. Because benefits depend on income, poor people have to claim the EITC through the tax system. But learning about the credit and filing tax forms are huge ordeals, which probably explains why many people who could be getting the benefit don’t claim it. But it’s not just the EITC — complexity pervades the American style of governance, a phenomenon that political scientist Steven M. Teles calls “kludgeocracy.”
The U.S. health-care system provides another example. You know those repetitive forms you have to fill out every time you go to a new care provider? That’s because there are so many different players in the system and they don’t share information -- much less have it online. Of course, those forms are just one small example of how the fragmented system raises administrative costs, which is one reason some economists think national health insurance could save the country hundreds of billions of dollars a year.
The high costs of infrastructure and housing in the U.S. also are partly due to transaction costs. Economist Leah Brooks and law professor Zachary Liscow found that legal challenges by wealthy homeowners force highways to take inefficient winding routes that drive up the cost of construction. Long approval processes, onerous regulations and the ease of halting construction with various legal objections drive up housing construction costs, making it hard to build affordable housing and contributing to spiraling rents and homelessness.
Transaction costs fall hardest on the poor and most vulnerable in society. When you don’t have much money, any small hassle -- a traffic stop, a late fee, a parking ticket — looms large compared with your scant resources. Economist Sendhil Mullainathan has done research suggesting that these aggravations and risks force poor people into a mindset of short-term desperation that makes it very difficult to escape poverty.
There’s no simple solution to transaction costs. Shifting away from capitalism offers no guarantee that life will be streamlined; governments are notorious for creating mountains of red tape, as anyone who has been to the Department of Motor Vehicles knows all too well, and any socialist system would involve large amounts of regulation. Nor does technology offer a silver bullet; the computerization of everything makes each individual hoop easier to jump through, but that encourages companies and governments to create new ones.
The only real solution to transaction costs is to draw more attention to the phenomenon. Instead of viewing each kludge as its own separate problem, policy makers need to think of them as one unified menace. Simply reframing the problems of modern American life under this single concept will enable a sustained, all-encompassing pushback against the hassles that are slowly making modern society unlivable.
To contact the author of this story: Noah Smith at email@example.com
To contact the editor responsible for this story: James Greiff at firstname.lastname@example.org
This column does not necessarily reflect the opinion of Bloomberg LP and its owners.
Noah Smith is a Bloomberg Opinion columnist. He was an assistant professor of finance at Stony Brook University, and he blogs at Noahpinion.
©2020 Bloomberg L.P.