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
buyers 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.
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.
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)
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; 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
FlyByNights 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