Transaction Costs and Institutions: Investments in Exchange∗

This paper proposes a simple model for understanding transaction costs – their composition, size and policy implications. We distinguish between investments in institutions that facilitate exchange and the cost of conducting exchange itself. Institutional quality and market size are determined by the decisions of risk averse agents and conditions are discussed under which the efficient allocation may be decentralized. We highlight a number of differences with models where transaction costs are exogenous, including the implications for taxation and measurement issues. JEL Classification: D02; D51; H20; L14.