Transactions and Institutions: The Building Blocks

1. Transactions and Institutions: The Building Blocks Chapter 2 (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

2. The Logic of Economic Value (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

3. The Benefits of Exchange The difference between the seller’s opportunity cost and the buyer’s valuation is known as the economic value the transaction can create. Here, $4 in economic value will materialize if we can reach an agreement. (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

4. What Matters and What Doesn’t Because of the potential for a gain by both parties from a transaction, it matters that a transaction occurs. What matters less to an economist is the exact price at which the exchange takes place. Whatever the price, $4 of gain is realized by the two parties. The distribution of the gain between the parties is a normative judgment, outside the domain of an economist to make. (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

5. Transactions Costs (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

6. Why Include Transactions Costs? Suppose that arranging for the transaction involves a transaction cost, like, the value of the time it takes to negotiate an agreeable price. Suppose that cost is $2. This will reduce the gains to be made from the exchange. (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

7. Why Include Transactions Costs? An Example East of downtown Los Angeles, the suburbs of the San Gabriel Valley have become home for upwardly mobile Hispanic and Asian families who have left the central city. The area is also home to many recent immigrants from the Middle East, the Near East, India, and elsewhere. For the past 20 years, Longo Toyota of El Monte has been the country’s largest Toyota dealer. Sixty members of Longo’s 80-person sales force are multilingual. Longo lowers transaction costs by hiring multilingual salespeople. (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

8. Making Transactions Materialize In this transaction, if transaction costs were $5, no transaction will occur because the transaction costs exceed the potential value of the exchange. If transaction costs could be reduced to less than $4, the transaction can occur. (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

9. Making Transactions Materialize - Sears Sears pioneered the mail order consumer goods business in the late 1800’s. Sears lowered a host of transaction costs, bringing profits to its shareholders and lower prices to its customers. (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

10. Choosing What to Produce: Specialization and Comparative Cost (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

11. Production Sets and Marginal Costs These production sets illustrate the number of bananas and anchovies that can be produced using available resources. (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

12. Production Sets and Marginal Costs The marginal cost of anchovies is the number of bananas sacrificed in order to produce anchovies. In this example, my marginal cost for anchovy production is ½ of a banana and your marginal cost is 1 banana. I am the more efficient anchovy producer. (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

13. Efficiency by Command If we start by both specializing in anchovies we can produce 9 anchovies but zero bananas. If we are commanded to collectively produce 1 banana and as many anchovies as possible, then you should produce the banana because we would only sacrifice 1 anchovy. Our most efficient collective production set is given by the red line. Combinations inside the red line are inefficient. (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

14. Efficiency by Trade I produce 2 anchovies and 2 bananas while you produce 2 anchovies and 1 banana. Because of the difference in marginal costs we decide that I should give you 1.5 anchovies in exchange for 1 banana. With this trade in mind, I produce 3.5 anchovies and 1.25 bananas and you produce 1 anchovy and 2 bananas. After we trade, I have 2 anchovies and 2.25 Bananas (a gain of 0.25 bananas) and you Have 2.5 anchovies and 1 banana (a gain of 0.5 anchovies). (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

15. Why the Example Matters The moral of the story is, I give you the anchovies not because I care about your well-being, but because I care about mine, and you have no charitable feelings toward me that lead you to send out the banana. When we trade we make each other wealthier. (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

16. NATIONS AND PERSONS (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

17. Ireland: What Happened to the Potatoes? In the twenty-first century, Ireland has replaced the United States as the world’s largest exporter of software. Land planted in potatoes fell from 1.8 million acres in 1867 to 30,000 in 2007. Ireland now imports most of its potatoes from the United States. As for the United States, it is still a net exporter of software, but imports have been rising rapidly relative to exports. The United States never imported many potatoes, but by 2004 it had become the world’s largest exporter of them. (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

18. Ireland: What Happened to the Potatoes? We can use the idea of the production set To explain this occurrence. The Diagram illustrates both Ireland’s and the Unites States’ production set for Potatoes and software. Between 1990 And 2004, the production sets shifted And the marginal costs changed Producing the production shifts described. (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

19. What Are Resources? Resources are whatever has value in the process of providing goods and services that people around the world value. Today oil is called a resource, though it took thousands of years before anyone discovered its uses as a fuel and a feedstock for chemicals. (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

20. ECONOMIC INSTITUTIONS (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

21. What Institutions Are Economic institutions define the environment in which we can trade. As an example, criminal law is one of many conditions that will affect the trades we can and cannot make. (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

22. Other Examples of Institutions - Contracting I may produce a good custom-built to your specifications that I can only sell elsewhere at a loss if you refuse to take delivery. Our contract (or a court) will probably require you to pay me the difference if you refuse the good. (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

23. Other Examples of Institutions – Market Protocols Buyers and sellers often agree to use market protocols to propose and make transactions. A protocol may be imposed from above, like the U.S. government’s systems for auctioning Treasury bills and telecommunications frequencies, or it may have evolved over time, like the practices automobile dealers use to buy and sell used cars among themselves. (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

24. Other Examples of Institutions - Etiquette Whether two strangers can arrange a transaction that benefits them both can depend on whether they meet each other’s expectations before the transaction. I may need to credibly show that I am likely to deliver as promised, and you must convince me that you are likely to pay the agreed-upon amount. (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

25. THE GOVERNANCE OF TRANSACTIONS (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

26. Three Forms of Governance - Markets A household buys vegetables and a business buys office supplies by selecting one of the alternative sellers in a market. We will soon define markets more precisely, but for now think of them as facilitating the purchase and sale of standardized goods or services, often in repeated transactions. (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

27. Three Forms of Governance - Contracts A contract is a set of promises intended to create economic value and enforceable by a court or some other agency, such as an arbitrator. Often a buyer and seller can increase the economic value they create by engaging in an unstandardized transaction. (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

28. Three Forms of Governance - Heirarchies Hierarchies are command-based systems in which prices usually play a relatively smaller role. You cannot order a seller in a market to deliver goods without an agreed-upon price, and unless both agree to a change the parties to a contract can trade only at prices specified in it. In a hierarchy, a superior can order a subordinate to do something without determining a price for that service. (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

29. The Dimensions of Governance – Trade-offs Choice of governance matters for many activities. For example, which parts of a firm’s legal work will be performed by inhouse lawyers and which by outside law firms? The best choice depends on accurately assessing the costs and benefits of the various modes of governance. (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

30. The Dimensions of Governance – Mixed Modes of Governance A given transaction can take place under a mix of governance modes. For instance, during a game a professional baseball player is a subordinate who takes orders from persons above him in a hierarchy. The team’s manager announces where he will bat in the lineup, and if he is running the third-base coach tells him whether to stop or try for home plate. A written contract that runs for several years outlines the basics of the relationship between the player and the team’s owners. At various points in his career the player participates in a market. Teams initially compete to sign him, and his contract will specify how soon he may become a free agent and negotiate with any interested team. (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.