Transactions Costs of Market Exchange

Introduction Using the market is costly Imposes limits on the use of the market Transactions costs arise because of mutual interdependence between upstream and downstream units inability to write complete contracts incentives to cheat on the contract  request a higher price if demand unexpectedly increases  demand a lower price if the contract is to be renewed  cheat on quality to increase profit margins

Contracts Consider arms-length contracts no guarantee of renewal essentially short-term Important issues incompleteness creation of relationship-specific assets All transactions rely on some form of contract facilitates sequential trading protects individuals from opportunistic behavior

Contractual incompleteness A complete contract eliminates opportunistic behavior What does completeness require? identify all contingencies, the actions to be taken in each case and agree outcomes agreed forms of performance measurement enforceable: observable and subject to rule of law

Contractual incompleteness (cont.) Incomplete contract leaves some contingencies unidentified contingency cannot be imagined cannot agree or articulate actions/responsibilities All contracts are incomplete ambiguous language or open-ended Three primary reasons bounded rationality difficulties in performance measurement asymmetric information

Bounded rationality Individuals have limited ability to process information deal with complexity pursue rationality Cannot imagine or identify all possible contingencies complexity and information requirements are too great

Performance measurement Performance is not always easily measured processing speed on a computer advertising quality Input can be complex or subtle can involve trade-offs in particular dimensions Ambiguity in language is inevitable “satisfactory”, “excess wear and tear” can be circumvented by simple contracts  Sage fishing rods

Asymmetric information Parties to a contract not uniformly well informed private information temptation to misrepresent or exploit private information Two basic forms hidden information: adverse selection  information about cost, quality, performance e.g. used cars  incentive to exclude reference to this from the contract hidden action: moral hazard  actions that cannot be monitored but affect outcomes  quality difficult to measure and affected by agents’ actions

Asymmetric information (cont.) If quality cannot be measured and attention to quality cannot be monitored: skimp on quality If quality is measurable but affected by buyer’s actions (installation) random factors Buyer has incentive to take less care if this is unobserved car hire? Cannot contract on unobservable information/actions

Contract law Underpins all contracts and recognizes incompleteness: establishes general rules But ambiguous and subject to interpretation invoked by litigation: costly and loss of trust has implications for reputation and future contracts  litigation-prone undermines reputation

Transactions with Relationship- Specific Assets A relationship-specific asset is created by an investment intended to support a specific activity Transforms the relationship between the parties ex ante: competitive bidding ex post: bilateral bargaining “fundamental transformation”: change from “large numbers” bidding to “small numbers” bargaining

Asset specificity At least four forms site specificity  assets located side-by-side to increase efficiency physical asset specificity  physical characteristics specifically tailored to the transaction dedicated assets  investment in plant and equipment to satisfy a particular buyer human asset specificity  individuals acquire skills, know-how specific to a particular relationship

Rents and quasi-rents Quasi-rent arises as a result of a relationship- specific investment. An example:

An example A new factory is needed to supply a new client FlyByNight. Cost of the factory: I dollars per annum on mortgage: unavoidable cost Capacity: 1 million units per annum Unit cost of product C. If contract falls through there is a bail-out option: sell to TraderFred at price Pm.Pm. Suppose Pm Pm > C but 1,000,000(P m - C) < I. The factory should not be built unless the contract with FlyByNight is expected to go ahead. Some of the investment is specific to this relationship. Relationship-specific investment RSI = I - 1,000,000(P m - C)C) RSI is the amount of the investment that cannot be recovered if the contract with FlyByNight does not go ahead.

Example (cont.) Rent Suppose FlyByNight contracts to buy 1 million units at price P* > P m. Rent = 1,000,000(P* - C) - I Rent is just the annual profit expected if the investment goes ahead. Rent and economic profit are synonymous. Quasi-Rent Suppose the contract with FlyByNight falls apart after the factory is built. The product can be sold to TraderFred. Is this an option? Yes, because P m > C and so selling to TraderFred helps to defray the sunk investment with its costs I. Quasi-rent is difference between profit from FlyByNight and profit from next best option: QR = 1,000,000(P* - C) - I - (1,000,000(P m - C) - I ) = 1,000,000(P* - P m )

The hold-up problem Quasi-rents gives rise to a hold-up problem if there is no quasi-rent then the next best alternative to the current contract offers the same profit if there is quasi-rent then the trading partner can attempt holdup attempt to renegotiate the terms of the contract  because contracts are incomplete  because the relationship-specific assets associated with the contract create quasi-rents

The example (cont.) Suppose: I = $8,500,000; P* = $12; P m = $8; C = $3 Rent = 1,000,000(12 - 3) - 8,500,000 = $500,000 per annum Quasi-rent = 1,000,000(12 - 8) = $4,000,000 per annum Now suppose FlyByNight exploits a contractual loophole, after the factory is built, to renegotiate the price down to $10 FlyByNight’s profits increase by $2,000,000, from the transfer of quasi-rent. The supplying firm is now making a loss of $1,500,000 but this is still better than transferring to TraderFred. But if the supplying firm anticipates the risk of hold-up then it may decide not to enter into the contract in the first place.

The hold-up problem and transactions costs Holdup creates transactions costs contract negotiation and renegotiations  initial negotiations will be time consuming  remaining possibility of renegotiations with associated costs and delay investment to improve ex post bargaining position  acquire a stand-by facility  second source distrust  costly negotiation; underinvestment in the relationship reduced investment  valuable exchange may not arise

Recap Relationship-Specific Assets Quasi-Rents Holdup Problem Transactions Costs

Transactions Costs and Vertical Integration Vertical integration (VI) is an alternative to market contracts Why should VI reduce the holdup problem? differences in governance repeated relationship organizational influences

Differences in governance Powerful and flexible systems exist inside firms to resolve disputes Less formal contracting and more formal authority management fiat formal lines of control Information is more extensive since it is internal reduces problems of bounded rationality and hidden information

Repeated relationship Vertical relationship involves trading parties in a repeated relationship less incentive for opportunistic behavior  know that the relationship will continue more incentive to make relationship-specific investment  temptation to holdup is reduced But not the only possibility: long-term contracting can achieve the same benefits

Organizational influences Common purpose across divisions Creation of corporate culture teamwork information sharing Competition between divisions still exists adversarial relationships competition for advancement Senior management needs to balance competition and cooperation between divisions