Institutional Economics and Economic organisation Theory (IE&EOT) Chapter 5 Attributes of transactions and transaction cost economics

Overview Transaction cost theory Transaction cost economics; applying the basic elements Framework for transaction attributes decisive for choice of governance structures Determining transaction costs in practice Public and private transaction costs

Transaction costs (1) In classical article of Coase (1937) the fundamental question was raised: Why do organizations or firms exist? What is their economic function? What determines which transactions take place via the market? and which occurs via a formal organization such as a firm? The answer of Coase was: There are costs linked to carrying out transactions. The size of these transaction costs depends on the nature of the good, the nature of the transaction and the way in which it is organised. Costs linked to use of market mechanism consist of: Finding the relevant prices The costs of negotiating and the specification of the good to be transferred. The institutional arrangement to be used to specify and transfer the property rights of goods.

Transaction cost theory (2) Coase: Use of price mechanism involves costs (negotiations, signing contracts, inspections, agreements to sort out differences)  transaction costs Transaction costs implies other transaction mechanism than the market are preferable Reducing the costs of carrying out transactions via other mechanisms than the market explains  existing of firms. A firm as a planning unit can only exist  if it can carry out his co-ordination function at lower costs than that by market transactions.

Transaction cost theory (3) Why did it take such a long time before ideas of Coase became analyzed? Transaction costs are difficult to define. Alchian and Demsetz (1972) considered a firm as nexus of contracts → firm as a contractual structure They saw no difference between contracts via the market and between an employer and employee However, they assumed complete contracts, and worked out the ideas of Coase in terms of complete contracts In that case there are no differences between market-transactions and contracts, e.g. between employer and employee.

Transaction cost theory (4) Jensen and Meckling adopted the view of Alchian and Demsetz: organisations such as firms, non-profit institutions and governments agencies consist of a nexus of contracts (internal or external).  With an internal contract, the firm decides to provide the requirements from within the organisation.  With an external contract, provisions are delivered by a third party. This refers to the classical make or buy decision a choice a firm must make whether it should make an intermediate good in-house or secure it in some markets or via contacts make or buy decision also refers to the fundamental questions: Why do we have firms? How do they function?

Transaction cost theory (5) For answering these questions  two views Organizational mode view (see Chapter 9) A governance structure adds value by carrying out transactions takes care for the distribution of quasi-rents also focuses on ways of coordination and motivation, corporate status and legal entity (see Chapter 8) Transaction view What is the unit of analysis? Transaction (is synonymous with exchange)

Transaction cost theory (6) Most fundamental unit of analysis Transfer of goods and services from one individual to another Is synonym with economic concept of exchange Trade-off between performance and counter performance → quid pro quo Transaction should be organized as efficiently as possible In transaction view → transaction costs is at the centre Transaction cost economics sees problem of economic organization as a problem of carrying transactions

Transaction cost theory (7) Transaction costs approach is also related to contractual perspective on organisation TCE poses problem of economic organization as a problem of contracting the firm is perceived as an institutional solution for avoiding the costs of making use of the market as GS Most suitable GS depends on (Williamson): (1) characteristics of human decision makers (bounded rationality and opportunistic (strategic) behaviour) (2) environmental characteristics of the transaction Both determine the comparative advantages of transaction mechanisms such as markets, firms or hybrid forms

Transaction cost theory (8) (1) characteristics of human decision makers Bounded rationality: it may be too costly or impossible to consider all consequences of a decision and to use the market for carrying out transactions transaction costs of internal relationship (make) can be lower than of market transaction (buy) Opportunistic behavior A condition of seeking self-interest with guile According to Williamson opportunism also includes hidden information and hidden actions. In his view, it is expected that some agents will behave differently from what they appear to be doing

Transaction cost theory (9) (2) environmental characteristics of the transaction three aspects (influencing size and nature of transaction costs) are distinguished: Asset specificity Site specificity Physical asset specificity Human asset specificity Dedicated assets specificity Brand name capital specificity Uncertainty Frequency

Transaction cost theory (10) Asset specificity (or transaction-specific investments) is the most critical dimension for describing transactions. asset specificity results in higher transaction costs (see Box 5.1) Uncertainty: possibilities or events which can be anticipated at high cost, events which cannot be anticipated or are difficult to anticipate. Frequency: the intensity with which transactions take place. Human and environmental characteristics  result in transactions taking place within a specific organisational relationship (e.g. firms, or hybrids) or a market

TCE: applying the basic elements (1) →Transaction is unit of analysis, while chosen GS depends on: environmental characteristics of transaction characteristics of human decision makers (1) and (2) are exogenous variables choice of GS is an endogenous variable Choice of a GS should taken into account Transaction view and Organisational view Transaction view Does not explain the initial GS→ only that they are different because of the transaction costs for carrying out transactions TCE assumes that an efficient GS is adopted and very inefficient ones would not exist/survive

TCE: applying the basic elements (2) A more appropriate view for initial reason of a GS is: it adds value by carrying out transactions it takes care for distribution of quasi-rents (see slide 7) transaction-specific investments are crucial elements in TCE they create quasi-rents when transaction-specific investments are involved → market is not the most preferable GS or organisational mode → role and type of GSs is very important Conclusion: (amount and distribution of) quasi-rent is an important element in TCE

Example (1) The (investing) party that is doing transaction-specific investments is tied to the relationship He/she is trapped quasi-rent is total value minus recoverable costs distribution of the quasi-rent depends on ex-post bargaining power Without opportunistic behavior both parties equally share the quasi-rent With opportunistic behavior The non-investing party exploit the relationship and reduce his price → capture a larger part of the quasi-rent The investing party is because of the sunk investment locked-in

Example (2) Williamson calls type of investment leading to ’being trapped’ or ’locked- in’→ fundamental transformation an original situation with a large number of potential transaction partners is transformed to into a situation with a small number of transaction partners; Ex-ante a large number of transaction partners and ex-post a small number of transaction partners The final situation can be a bilateral monopoly. Reasons why non-investing party can exploit the relationship: Asset specificity or sunk character of investment Opportunistic behavior and bounded rationality Contracts are incomplete →Unspecified contingencies

Example (3) Hold-up is an ex-ante problem Non-investing party may appropriate a high share of surplus of the investment (= quasi-rent) prospect of hold-up often results in no investments Lock-in is an ex-post problem non-investing party can exploit the relationship by claiming a large part of the quasi-rent non-investing party can improve its position at the costs of the other party Williamson: Ex-post haggling about quasi-rent = bargaining about quasi-rent → involves transaction costs

Choice of governance structure

Governance structure choice as a function of asset specificity and degree of uncertainty

Governance structure choice as a function of asset specificity and frequency.

Framework for transaction attributes decisive for choice of governance structure Framework of attributes consist of: level of asset specificity; degree of uncertainty; level of frequency and duration; difficulty of measuring performance of the transaction; level of connectedness of assets and co-specialized assets; non-excludability and non-rivalry of the goods. If these attributes occur complexity will crease  higher transaction costs transaction costs, level of quasi-rent and distribution of quasi-rent determine which governance structure is preferable

Asset specificity, hold-up and lock-in (1) Asset specificity is most important attribute Assets are specific for a certain use Degree of specificity: the fraction of its value that would be lost if it were excluded from its major use E.g. pipeline, railway and a stable for cows When an asset is specific  investing party can be held-up possibility of hold-up arises in every contractual relationship which is incomplete Fear of being held-up can prevent people from investments It will affect total welfare in a society  Real social costs of hold-up

Natural monopolies (NMs) (1) NMs are characterised by a large part fixed costs and a relative small part variable costs asset specificity is an important transaction attribute of NMs NMs often used as an application of TCE; Joskow NMs are a common phenomenon for provision of electricity, gas, water, and other network facilities Different modes of organisation are possible Government is legal owner and producer Government is legal owner of network and network is leased to private operators Franchising contracts as GS

Natural monopolies (2) Local government is owner and producer Local government is legal owner of network and network is leased to private operators Franchising contracts as GS Part of bundle of property rights of network is transferred to and operated by a franchisee The more stable the environment and the less specific the investment → the longer can be the duration of a franchise solution

Uncertainty (1) TCT: degree of uncertainty is a result of Incompleteness of contract Possibilities of ex-post renegotiations A way for organising a transaction is a concluding a contract transaction are not always simple → Contracts can be very complicated It is difficult to forecast and to take into account all possible events; How to deal with unforeseen contingencies? It is difficult to negotiate over so many possibilities It is very difficult to write it all down in an agreement  transaction costs would be very high  contracts are incomplete

Uncertainty (2) Which GS can reduce uncertainty? Generally: contracting become more complex when uncertainty increases The longer the time horizon the more trust is needed Relationship is often more important than content of contract Analysis with expected utility and loss aversion can be very useful Which GS can reduce uncertainty? Long term contracts supported with making use of common values and norms and reputation mechanism building-up of trust

Frequency and duration Some transactions are one-time affairs buying a house Transactions which occur infrequently → trilateral GS: makes use of external intermediator Parties who interact frequently → a mechanism specially designed for their relationship Parties involved in a long term and close relationship have to be aware The longer the time between performance and counter performance the more difficult to foresee all relevant contingencies More trust is needed Reputation can be a very effective control mechanism Cost savings as result of trust and reputation can be considerable

Difficulty of measuring performance It is often difficult or too costly to measure actual performance Measuring performance is important If you want to tie workers’ pay to their performance For the choice between in-house production and contracting out; this requires that you know what you want the quality of goods and services that you want are contractable Possible incentives are Rewards (carrot) Performance-based pay, career concerns, reputation building Punishment (stick) Performance-based pay When it is cheap to measure performance → Performance-based pay is a good solution We have take into account how people react on different incentives See Chapter 4 : knaves and knights

Connectedness and co-specialised assets Transactions differ in how they are connected with other transactions Assets can be strongly complementary A higher level of one increases the value of the other this gives rise to hold-up and lock-in problems, especially when assets are highly specific Investments could be mutually dependent What is in such cases the best GS? Connectedness can be result of people involved Human capital is a very important asset Co-specialized skills and knowledge are often characteristic for working in a team → team is organisational mode

Non-excludability and non-rivalry (1) Excludability and rivalry and are important concepts in: The classification of goods. Which GS is preferred? Excludability means: it is possible to exclude persons who do not want to pay for the use of the good. Non-excludability: it is impossible to exclude people from the use of a good → the benefits of the good are available to all, even on the same time. Non-excludability is due to the lack of property rights. Lack of property rights or degree of non-excludability is crucial factor in determining the most suitable governance structure Market as GS would involve too high transaction costs

Non-excludability and non-rivalry (2) Rivalry relates to the possibility that a good, factor of production or natural resource  can be used only by one individual at the same time . In case of non-rivalry a good can be used by several individuals at the same time. Multiple use or multiple consumption (use by several persons simultaneously) is possible. An important measure of rivalry is the marginal costs For the non-rival goods, marginal costs of the use are null.

Non-excludability and non-rivalry (2) For making use of market as GS Exclusion and rejection of goods should be possible Goods have private and transferable property rights The use of the goods is rivalry Goods are divisible in marketable units For pure public goods (non-excludable and non-rival) most suitable GS is: in-house production of the government sometimes contracts are possible For quasi-public and common goods Contracts between private firms and the government Clubs as GS

Determining transaction costs in practice Measuring transaction costs is not easy No standard terminology on transaction costs It is difficult to separate them from production costs If transaction costs are high, transaction will not take place, thus part of transaction costs is not observable Ways of measuring transaction costs using of demand and supply curves of goods using surveys or interviews for getting estimations of transaction costs carrying out simulation regarding all the steps of a transaction Transaction costs can be divided in Private transaction costs: for private persons or firms Public transaction costs: for the government

Transaction costs and transitions costs Are not the same TCE is a comparative static analysis Institutional environment is given Transitions costs includes e.g. cost of creating, building up or changing a institutional structure the institutional environment is not given, but is in transition or has to be adapted Box 5.5 gives classification of public and private transaction costs Quantitative estimations of transaction costs are rare; Section 5.5 gives a theoretical framework and an application Transaction costs are relatively high