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THE TRANSACTION-COST APPROACH
I. Introduction: Up to now we have taken structure in the I-O and subsector approaches to be largely exogenously determined by things like scale economies and the nature of the regulatory framework. A. Given a certain structure, we have assumed that firms seek to optimize. B. When they attempt to modify the structure, we have assumed that it is to gain market advantage (e.g., market power) C. Transaction-cost approaches attempt to make structure endogenous to the model of economic optimization. I.e., it argues that the market structure that emerges may be the result of social economic optimization, not just private optimization-- that is, competitive forces may lead to the emergence of forms of economic organization that minimize total costs of production and exchange in the economic system.
- Note the contrast with the traditional I-O model that argues that deviations from atomistic competition reflect “imperfect competition” and may lead to inefficient pricing and output.
- TCE argues that market structure evolves in a way to minimize costs of production and transactions and hence represents attempts to gain efficiencies. D. More broadly, what transaction costs economics seeks to do is to include analysis of the costs of exchange (as well as “production”) into the study of how economic activities are organized. It argues that much of the structure of the economy (S in
The Transaction-Cost Approach Page 2 the SCP framework) can be explained by looking at the nature of transaction costs in society. E. This approach has become increasingly important over the past 20 years as structure of the economy (and food system) has evolved away from exchange through impersonal markets for commodities to personalized exchange for highly specific products (needed to assure quality). Big focus on structure of contracts (writ large) and how to make them efficient. How to align incentives in contract to get good performance. Very much tied to principal/agent problem. How does owner of one resource write contract to make user of that resource (agent) behave in a way consistent with desires of the owner? F. We will examine:
- How to Explain the Large Number of Ways of Vertically Organizing Transactions within a Subsector? a. Alternative Ways of Linking Stages of Production b. Why are there firms? (Coase) (1) Defining transaction costs (2) Range of vertical integration from spot market to total vertical integration, based on TCs. c. Williamson's analysis (huge literature beyond Williamson, but take him as starting point) (1) What gives rise to transaction costs?
The Transaction-Cost Approach Page 4
- Transaction costs = Costs associated with carrying out a transaction–Note, these are NOT costs of changing space or form utility (transformations), such as transport or processing costs, although some author’s (mistakenly) include them in transaction costs. a. Ex ante TCs (1) Cost of gathering information about the potential transaction (2) Costs of processing that information (3) Costs of coming to a decision (a) Within an organization (internal negotiation) (b) Between transaction parties (external negotiation). (c) Note that there may be third-parties that are indirectly parties to the transaction that also must be involved--e.g., government regulatory agencies. b. Ex post TCs (1) Cost of monitoring performance ( measurement ) (2) Costs of enforcement of the agreement, including costs of dispute resolution. c. Hence, the principal/agent issue we discussed earlier has a significant element of transactions costs in it (illustrate). Principal/agent problem (see reading by Caswell and Cotterill)
The Transaction-Cost Approach Page 5 (1) Note that simple micro theory of profit-maximizing firm is implicitly built upon model of entrepreneurial 1-person firm. Entrepreneur's goals are identical with firm's, so we can speak of "the firm seeking to maximize profits). (2) In reality, in most economic enterprises/undertakings, ownership is to some degree separated from control (3) E.g., in corporation: (a) Separation achieved through dispersed stock ownership and inside directors (b) Nominal control through the board of directors may not be effective. (c) This separation==>management having some scope to follow its own goals if firm possesses some degree of monopoly power. Principal/agent problem. Incentives facing manager (agent) may not be consistent with goals of principals (stock owners). Possible alternative goals of the agent: i) Firm growth/sales maximization ii) The quiet life (perks), combined with empire building
The Transaction-Cost Approach Page 7 (c) takeover bids--more common, especially in 1980s and early 90s--Restructuring to take out middle management (slack?) (4) Much of agency theory stresses the role of these other (internal) markets in disciplining the firm. c. Outside of corporation, have increasing use of contracting, e.g., in poultry. How does integrator make sure agent takes good care of resource.–General solution–Movement away from 1-part payment (proportional on output) to 2-part payment–Proportional and lump sum, with lump sum dependent on “good stewardship” of resource. d. Note that the origin of all TCs is human interdependence, in the sense that they arise only when people have to work together to benefit from: (1) Specialization and trade (2) Capturing economies of scale through cooperation (3) Because such cooperation is necessary to capture economies of size in new technologies, it is often difficult to clearly separate “transaction costs” from other production costs, as social cooperation is one of the prerequisites for adopting many forms of production technology.
The Transaction-Cost Approach Page 8 (4) As interdependence goes up, so do transaction costs as a percent of total costs. But this is offset (hopefully) by decreases in per-unit production costs brought about by technologies requiring greater interdependence.
- Institutions a. Rules under which society (economy) operates. The rules of the game. Includes: (1) Culture & Custom (2) Formal law (a) constitutional (b) common (c) statute law (3) Standard business practice (4) The preceding 3 in turn define: (a) Structure of property rights (needed to distinguish ownership from theft) (b) Rules of contract (5) Note that these differ across societies, so that same transactions may be handled differently in different societies. This calls for sensitivity in doing business cross-culturally. (Role of Social Capital)
The Transaction-Cost Approach Page 10 due to diseconomies of size in management). This is the essence of firms “make or buy” decisions.
- By logical extension, the question of which type of coordination tools is used and how they are linked becomes a function of the transaction costs involved in using each. (Illustrate with overhead on the organization of the beef subsector from Marion). III. Williamson, since the 1960s, has been building on Coase’s observations to analyze: A. What factors give rise to TCs--e.g., the characteristics of the investments necessary to produce a particular good (often a function of the characteristics of the good itself). B. How different types of TCs and their allocation among different economic actors (who bears them) influence the type of organization that arises to mediate a transaction (IOF, co-op, spot market, etc.). He calls these different tools to mediate transactions “governance structures.” C. Williamson investigates a whole gamut of governance structures that handle the relations among economic actors, from spot market through various forms of contracting to vertical integration via a hierarchy.
- In Williamson’s perspective, there exists no dichotomy between the market and a hierarchy (or the market versus a corporation or the state), but rather a range of organizations. Which type develops depends on the level and type of TCs it generates. In this view:
The Transaction-Cost Approach Page 11 a. TCs can be viewed as “friction” in an economic system, which tend to reduce exchange. b. In this sense, “market failure” is simply a case of prohibitively high TCs. (To what extent is this a “failure” of the market? It is a market that does not arise because the costs of trade exceed the potential benefits.) c. The type of governance structure that minimizes the sum of production and transaction costs will have an economic advantage and hence tend to dominate that activity. (1) Thus, institutional design (the design of governance structures) becomes part of the process of economic optimization, rather than an exogenous process. (2) E.g., it is no mistake that collection of milk from farmers in many countries is organized by farmer co-ops rather than IOFs (investor-owned firms). But there exist few cooperative steel mills. We can explain that by examining the nature of the TCs involved in producing and getting milk to consumers as compared with those involved in producing and distributing steel. (3) Note the link to New Institutional Economics. There is an analogy to natural selection here: the existing institutions
The Transaction-Cost Approach Page 13 for others to know his/her behavior (note link to agency problem). Includes: (1) Strategic lying, disguising information, not revealing information (2) Honest disagreements over promised performance. c. The combination of bounded rationality and opportunism imply that you have to protect yourself against potential exploitation by your trading partner in an exchange. You can’t anticipate all contingencies and if unexpected contingencies arise, your trading partner may try to take advantage of them to your disadvantage. D. Three major factors that affect TCs (e.g., the costs of relying on markets):
- Uncertainty - The greater the level of uncertainty surrounding a transaction, ceteris paribus: a. the less efficient and the more costly it is to rely on the spot market to mediate the transaction b. the greater the incentive to move to some form of contracting or integration (produce the goods yourself rather than trade for them). (1) E.g., circle of poverty of farmers in many poor countries. {DeJanvry and Sadoulet]
The Transaction-Cost Approach Page 14 (a) Markets for inputs and outputs (including food) are highly risky due to the thinness of the market and fluctuating S&D (b) Other TCs of using markets are high (lack of standard weights and measures, poor enforceability of contracts, etc.) (c) These combine to discourage specialization and its gains, and hence the household remains integrated in a very diverse set of activities.==>Definition of subsistence production (d) This integration in turn reinforces TCs by leading to small lots of highly dispersed production of individual products and hence: i) High per-unit assembly costs ii) Local markets that support only a few traders, which can lead to monopsony and hence high TCs (e) Lack of specialization leads to poverty. Cf. industrialized countries like the US, where only about 10% of the value added in food derives from the farm.
The Transaction-Cost Approach Page 16 b. Role of cooperatives in the US in the 1920s “open labeling” movement to assure quality fertilizer and animal feed. c. Increased vertical coordination (and in some cases integration) in the US pork subsector to assure a consistent quality for specific niche markets.
- Asset specificity - (See Klein, Crawford, and Alchian). The greater the transaction involves assets that are specific to a particular transaction, the less likely the transaction is to be efficiently mediated by spot markets. a. Asset specificity = value of an asset in its transaction-specific (“specialized”) use is greater than its use in alternative activities. (1) E.g., a milking parlor (2) Difference between value in specialized use and its next best use is called a quasi-rent (Marshall). (3) Asset specificity is the essential condition or inducement for teamwork. The value of assets of different participants are greater if they work together than the sum of their value in use separately. (a) E.g., value of a milking parlor + milk processing plant are greater when they work together than separately ==> teamwork between dairy farmer and milk processor (e.g., via a co-op).
The Transaction-Cost Approach Page 17 (b) Cf. the value of two separate milking parlors on separate farms. There is much less mutual interdependence, so we see much less horizontal integration farming operations. b. Types of asset specificity (see Masten) (1) Physical capital (a) Specialized use (b) Site-specific (c) Temporal -e.g., due to perishability of the product produced by the asset (2) Human capital, e.g.: (a) Specialized skills (b) Access to benefits from current institutions--e.g., one’s position in a bureaucracy may grant the individual to certain benefits (rents). This explains the reluctance of people in such positions to institutional reform. c. Incentive for non-spot-market governance of such transactions arises from the tendency of at least one party to a transaction to act opportunistically to try to appropriate the quasi-rent generated by
The Transaction-Cost Approach Page 19 (c) This creates an incentive to move towards more long-term contracts and vertical integration, especially where the commodity is perishable (and hence scope for holdup is greater). i) Cf. annual crops, especially storable ones that are not produced for a specific niche market (and hence for which there are more potential buyers). ii) In the U.S., there is much more co-op activity in processed fruits and vegetables than in grains. Co-ops are also prevalent in dairy, where milk perishability makers farmers particularly vulnerable to short-term holdups. (d) Failure to devise mechanisms to deal with this problem can lead to nobody making what otherwise would be a socially useful investment. This is a key development problem (some would say the development problem) in some low-income countries.
The Transaction-Cost Approach Page 20 (2) Moral hazard - Arises when one party relies on the behavior of another to realize the full return to a specific asset and that behavior is costly to observe and monitor (part of the principal/agent problem) (a) Temptation of user of the asset to use it to pursue her/his own goals--e.g., empire building by managers of firms or cooperatives. (b) Agent may simply not have incentive to maintain the asset or operate it in a way that minimizes costs (e.g., use of a piece of equipment by an employee). (c) Need to devise either ways of monitoring behavior of the agent (e.g., boards of directors) or incentive structures that reduce moral hazard (e.g., stock options, role of ideology and cultural norms). IV. Examples of aplications of TC economiocs to agriculture: 4 main uses. A. The approach is still relatively new. Its analysis is more qualitative than quantitative, although quantitative analyses are increasing (see Masten; Nabli and Nugent). B. 4 main uses of the approach:
- Explanation of types of governance structures that are likely to arise in situations involving certain types of transactions.
