My theory of institutions is constructed from a theory of human behavior combined with a theory of the costs of transacting. When we combine them we can understand why institutions exist and what role they play in the functioning of societies. If we add a theory of production we can then analyze the role of institutions in the performance of economies.

The costliness of information is the key to the costs of transacting, which consist of the costs of measuring the valuable attributes of what is being exchanged and the costs of protecting rights and policing and enforcing agreements. These measurement and enforcement costs are the sources of social, political, and economic institutions. The rest of this chapter concentrates on economic exchange; in Chapter 6 I will build a model of political exchange from the same building blocks.

The costliness of economic exchange distinguishes the transaction costs approach from the traditional theory economists have inherited from Adam Smith. For 200 years the gains from trade made possible by increasing specialization and division of labor have been the cornerstone of economic theory. Specialization could be realized by increasing the size of markets, and as the world's economy grew and division of labor became ever more specific, the number of exchanges involved in the performance of economies expanded. But the long line of economists who built this approach into an elegant body of economic theory did so without regard to the costliness of this exchange process.