An Econ Test Question We Shouldn't Get Wrong

At the end of the first year of graduate school in economics, they make you take long tests on micro- and macroeconomics. My micro test lasted five hours, and I still remember a question I missed. It was about transaction costs: It asked what happened if buyers and sellers had to row from island to island in order to exchange their goods. It turned out that this so-called transaction cost, even though it was tiny, made the market break down -- no one bought or sold anything.

As I learned that day, transaction costs are very important -- so important that they change our basic understanding of economics. But many economists ignore them when creating their models. And the basic mental frameworks that most of us use to understand the economy -- for instance, good old supply and demand -- leave out transaction costs.