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

2. 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

3. 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.

4. 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.

5. 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.

6. 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?

7. 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)

8. 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

9. 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

10. 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

11. 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

12. 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

13. 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

14. 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

15. 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

16. 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

17. 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

18. Choice of governance structure

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

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

21. 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

22. 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

23. 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

24. 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

25. 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

26. 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

27. 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

28. 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

29. 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

30. 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

31. 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.

32. 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

33. 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

34. 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