Limited Liability is a Cheap Call Option Factory

The Feynman Lectures on Physics opens with a wonderful, thought-provoking question: if you could compress as much human knowledge as possible into a single sentence, what would it be? What Feynman settles on is:

I believe it is the atomic hypothesis (or the atomic fact, or whatever you wish to call it) that all things are made of atoms — little particles that move around in perpetual motion, attracting each other when they are a little distance apart, but repelling upon being squeezed into one another. In that one sentence, you will see, there is an enormous amount of information about the world, if just a little imagination and thinking are applied.

If we were to perform the same exercise for economics, we’d probably go with: needs are infinite, wants are finite. But we’d have to elaborate a bit to get anywhere useful, as humans are more unruly than subatomic particles. Our first elaboration would sketch out the laws of supply and demand, both heavily-footnoted with exceptions. And then we’d spend the rest of the discussion talking about transaction costs.

Transaction costs are the bridge between Econ 101 and the real world. A huge majority of the violations of simple economic models boil down to the cost of actually buying or selling something.

One way to think about transaction costs is that they play the same role as the weak and strong atomic forces: the high cost of hiring people encourages individuals to form companies (you could run a store by…