Transaction Costs Theory:

'The TCT assumes that there is always some efficiency rationale behind the evolutionary process of institutions in an economy. These institutions aim at reducing the transaction costs for the different economic agents in the economy. North defines institutions as a set of rules designated to constrain the behavior of individuals in the interest of maximizing the wealth or utility of' principals. The dynamics of the theory derives from the continuous tension between the gains from specialization in economic activities and the increasing costs that arise from the same process of specialization. Such costs include information costs, agency costs, costs of shirking and opportunism, costs arising from uncertainty, costs of measuring quality of the goods and quality of the output. costs of enforcement of property rights, costs of compliance and costs of detecting violations. These costs have a dynamics of frequent change necessitating, in turn, changes in the structure of the social, political. and economic institutions over time. Such costs are therefore going to constantly redefine the rules of the transactions generating a virtuous cycle of competition and institutional growth. Political process is identified as the main medium by which the process of institutional growth is brought about. It is the costliness of economic exchange owing to the sheer dynamism of ever increasing transaction costs that distinguish the TCT from the traditional theories. For this reason, North asserts that economic history conceived as a theory of the evolution of constraints, should not only explain the past economic performance but also explain the current performance of the political-economic system.

North builds on Coase's transaction costs theory by pointing out that the important elements in such costs arise from both formal and informal constraints. With regard to formal constraints (which refer to political, judicial. and economic rules) North underlines their function in facilitating exchange and reducing transaction costs. Coase had defined transaction costs as the cost of running the economic system. Williamson compares such costs as being equivalent to 'friction' in physical terms. He builds on the Coase's definition by providing a distinction between ex-ante transaction costs (e.g. drafting a document or contract, negotiating and safeguarding an agreement. etc.) and ex-post transaction costs (e.g. mal-adaptation costs, misalignments, etc.). Informal constraints are recognized by North as an important source of institutional stability having great survival tenacity as they succeed in resolving basic exchange problems among the participants at the social, political and economic levels. North had earlier advanced the theory that competitive pressures would lead to the elimination of inefficient institutions.

However, based on later views developed he attributed the presence of inefficient institutions (continuing through centuries) to the changing incentive structures generated by the institutions. Such incentive structures are manipulated by influential segments which is a nexus needing to be broken by efficient institutional arrangements/developments. TCT brings about institutional change/development by resulting in two type of economic progression viz. (i) increasing returns via organizations acquiring feedback about the continuous changes between them and other institutions i.e. learning by doing and increasing profits as a consequence; and (ii) by affecting the behavior of agents to acquire ideologies developed as a consequence of improving upon the imperfect markets (characterized by incomplete information) through exchange of transactions.