Transactions Costs of Market Exchange

1. Transactions Costs of Market Exchange

2. 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

3. 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

4. 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

5. 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

6. 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

7. 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

8. 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

9. 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

10. 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

11. 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

12. 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

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

14. 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. Suppose Pm > C but 1,000,000(Pm - 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(Pm - C) RSI is the amount of the investment that cannot be recovered if the contract with FlyByNight does not go ahead.

15. Example (cont.) Rent Suppose FlyByNight contracts to buy 1 million units at price P* > Pm. 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 Pm > 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(Pm - C) - I ) = 1,000,000(P* - Pm)

16. 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

17. The example (cont.) Suppose: I = $8,500,000; P* = $12; Pm = $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.

18. 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

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

20. 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

21. 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

22. 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

23. 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