What Are Transaction Costs? Definition, How They Work and Example

What Are Transaction Costs?

Transaction costs are expenses incurred when buying or selling a good or service. Transaction costs represent the labor required to bring a good or service to market, giving rise to entire industries dedicated to facilitating exchanges. In a financial sense, transaction costs include brokers' commissions and spreads, which are the differences between the price the dealer paid for a security and the price the buyer pays.

Key Takeaways

  • Transaction costs are the payments that banks and brokers receive from buyers and sellers for their roles.
  • Transaction costs are one of the key determinants of net returns.
  • Different asset classes have different ranges of transaction costs; investors should select assets with costs that are at the low end of the range for their types.

What Are Transaction Costs?

Understanding Transaction Costs

The transaction costs to buyers and sellers are the payments that banks and brokers receive for their roles. There are also transaction costs in buying and selling real estate, which include the agent's commission and closing costs, such as title search fees, appraisal fees, and government fees. Another type of transaction cost is the time and labor associated with transporting goods or commodities across long distances.

Transaction costs are important to investors because they are one of the key determinants of net returns. Transaction costs diminish returns, and over time, high transaction costs can mean thousands of dollars lost from not just the costs themselves but also because the costs reduce the amount of capital available to invest. Fees, such as mutual fund expense ratios, have the same effect. Different asset classes have different ranges of standard transaction costs and fees. All else being equal, investors should select assets whose costs are at the low end of the range for their types.

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.

One type of transaction cost is a barrier to communication. When an otherwise perfectly matched seller and buyer have absolutely zero means of communication, the transaction costs of a deal are too high to be overcome. A bank serves the role of the middleman by connecting savings with investments and a prosperous economy justifies the income of the bank for the transaction cost of compiling information and linking parties.

However, the Age of Information, specifically the influx of the Internet and telecommunications, has greatly reduced barriers to communication. Consumers no longer need large institutions and their agents to make educated purchases. For this reason, the survival of the insurance agent is being jeopardized by a wide range of technology startups that run websites either selling or promoting insurance policies. The easy access to information and communication that the Internet provides has also threatened the livelihood of jobs, such as the real estate agent, stockbroker, and car salesman. It is considered to be what destroyed Scottrade.

In essence, the prices of many goods and services have lowered due to a reduction in barriers to communication between everyday individuals. Retailers and merchandisers serve the role of middlemen as well, by pairing consumers with manufacturers. The retailing industry has also been shaken up in recent years, with e-commerce company Amazon.com passing traditional giants such as Kohl's and Macy's in a composite score based on assets, revenues, and market value.

Example of Transaction Costs

The average annual transaction cost for a mutual fund in the U.S. was 1.44%, according to a study by researchers Roger Edelen, Richard Evans, and Gregory Kadlec. The first of these costs is brokerage commissions from when a fund manager buys or sells a stock. Lower-turnover funds will pay fewer brokers' fees, though they may pay more than individual investors.

A large mutual fund may also incur market impact costs, where the fund's sizable purchase of stock artificially drives the price higher. Some managers diminish these costs by spreading their purchases over longer periods of time. Last, the mutual fund will encounter spread costs, which can be greater when the manager trades stocks across global exchanges or those with less liquidity. 

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  1. Typepad. "Scale effects in mutual fund performance: The role of trading costs," Page 37. Accessed Jan. 18, 2021.

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