Artificial markets and the theory of games
The concept of transaction costs is a common theme in most analyses of the phenomenon of market failure. Few economists would disagree with the abstract proposition that if there exist gains to be made from exchange, then in the absence of transaction costs private bargains will take place and exhaust all potential gain from trade. This proposition serves not only as a characterization of an ideal state of affairs, but as a guide to means by which specific cases of market failure could be remedied. It suggests, in particular, that reduction in transaction costs should be examined as a potential remendy. Since the nature and extent of transaction costs depend crucially on the institutional structure in which private bargains take place, the analysis of the relationship between institutions and transaction costs becomes a primary concern of policy for dealing with market failure.
© 1974 Center for Study of Public Choice Virginia Polytechnic Institute and State University. This article draws on material included in my doctoral dissertation, "Market Systems for the Control of Air Pollution," submitted to the Department of Economics at Harvard University. A lengthier version was presented at the Annual Meeting of the Public Choice Society in May 1972. I am indebted to Kenneth Arrow, Water Isard, James Krier and Charles Plott for suggestions and criticisms, and to the Environmental Quality Laboratory of the Calfornia Institute of Technology for research support.
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