It takes resources to define and protect property rights and to enforce agreements. Institutions together with the technology employed determine those transaction costs. It takes resources to transform inputs of land, labor, and capital into the output of goods and services and that transformation is a function not only of the technology employed, but of institutions as well. Therefore, institutions play a key role in the costs of production.

In previous chapters I specified why it is costly to transact and examined the variety of forms that institutional constraints take in constraining human interaction. Still ahead (in Chapter 9), I shall explore the way by which learning and organizations can modify and alter the relationship between institutions and transaction costs (and transformation costs as well). But first, I simply wish to pull together the threads of the argument so far.

A hierarchy of rules – constitutional, statute law, common law (and even bylaws) – together will define the formal structure of rights in a specific exchange. Moreover, a contract will be written with enforcement characteristics of exchange in mind. Because of the costliness of measurement, most contracts will be incomplete; hence informal constraints will play a major roles in the actual agreement. These will include reputation, broadly accepted standards of conduct (effective to the extent that the conduct of the other parties is readily observable), and conventions that emerge from repetitive interactions.