11Transactions/Agency Transactions/Agency CostsCosts

Economics Economics

22Perfect CompetitionPerfect Competition

When studying idealized perfect When studying idealized perfect competition (when the invisible hand competition (when the invisible hand theorem applies), these assumptions are theorem applies), these assumptions are mademade 1) There are many buyers and sellers, each 1) There are many buyers and sellers, each

with a “small” share of the total market size.with a “small” share of the total market size. 2) The product of each firm is homogeneous.2) The product of each firm is homogeneous. 3) Buyers and sellers have perfect information.3) Buyers and sellers have perfect information. 4) There is free entry and exit in markets.4) There is free entry and exit in markets. 5) There are no transactions costs.5) There are no transactions costs.

33RealityReality

Though they facilitate analysis, each of the above Though they facilitate analysis, each of the above assumptions can be challenged on how it reflects assumptions can be challenged on how it reflects reality.reality.

We will deal with the violation of assumption 1) We will deal with the violation of assumption 1) elsewhere.elsewhere.

Violation of 5) is frequent. It is often caused by Violation of 5) is frequent. It is often caused by violations of 2), 3), or 4), but may be due to other violations of 2), 3), or 4), but may be due to other reasons.reasons.

Violation of 5) will be the subject matter of this Violation of 5) will be the subject matter of this section.section.

44DefinitionDefinition

Defn: Transactions costs are costs associated Defn: Transactions costs are costs associated with acquiring an input that are in excess of with acquiring an input that are in excess of the amount paid to the input supplier (Coase).the amount paid to the input supplier (Coase).

Obvious examples: Insurance, freight, Obvious examples: Insurance, freight, damage, own time.damage, own time.

Other important examples: cost of searching Other important examples: cost of searching for a supplier willing to sell a specific input, for a supplier willing to sell a specific input, negotiations costs incl. legal costs, costs of negotiations costs incl. legal costs, costs of maintaining assets required to engage in the maintaining assets required to engage in the transactions.transactions.

55At Arm’s LengthAt Arm’s Length

Defn: An arm’s length transaction occurs when Defn: An arm’s length transaction occurs when autonomous parties exchange goods or autonomous parties exchange goods or services with no explicit or implicit agreement services with no explicit or implicit agreement that the relationship will continue into the that the relationship will continue into the future.future.

Examples: Purchasing at WalMart, staying at Examples: Purchasing at WalMart, staying at Best Western for a night.Best Western for a night.

66ContractsContracts Defn: A contract is a legal agreement which defines the Defn: A contract is a legal agreement which defines the

conditions of an exchange or series of exchanges.conditions of an exchange or series of exchanges.

Examples: Bank loan, futures contract, marriage, etc.Examples: Bank loan, futures contract, marriage, etc.

Defn: An incomplete contract is one in which not all Defn: An incomplete contract is one in which not all contingencies have been explicitly accounted for (note, contingencies have been explicitly accounted for (note, a contract is like a computer program, with if-then-else a contract is like a computer program, with if-then-else statements). It might also be thought of as a statements). It might also be thought of as a mathematical “function.”mathematical “function.”

Examples: Disputes in contract law, hedge-to-arrive.Examples: Disputes in contract law, hedge-to-arrive.

77Specialized Specialized InvestmentsInvestments

Defn: A specialized investment is an expenditure that Defn: A specialized investment is an expenditure that is made to allow two parties to make exchanges, but is made to allow two parties to make exchanges, but has less value in alternative uses.has less value in alternative uses.

Examples: Insuring assets (life or crops) when taking Examples: Insuring assets (life or crops) when taking out a loan, building trust with a supplier/customer, out a loan, building trust with a supplier/customer, quality control investments required to access quality control investments required to access international markets (food, toys, etc.).international markets (food, toys, etc.).

Defn: A relationship-specific exchange is one that Defn: A relationship-specific exchange is one that occurs when both parties to the exchange have occurs when both parties to the exchange have made specialized investments. These investments made specialized investments. These investments are called relationship-specific investments (RSIs).are called relationship-specific investments (RSIs).

88Usefulness of SIsUsefulness of SIs SIs generally promote economic efficiency (increase SIs generally promote economic efficiency (increase

the welfare of society) in that they identify the welfare of society) in that they identify collaborations between firms that reduce the cost of collaborations between firms that reduce the cost of producing the same amount of goods producing the same amount of goods oror increase the increase the amount of goods produced by the same level of amount of goods produced by the same level of resources resources oror do a bit of both (supply/demand graphs). do a bit of both (supply/demand graphs).

They are probably good for the firms in question They are probably good for the firms in question because the firms would likely not make the because the firms would likely not make the investment otherwise.investment otherwise.

Problems may arise because SIs create vulnerability.Problems may arise because SIs create vulnerability.

8a8aForms of Forms of Specialized Specialized

Investments (SI)Investments (SI) Site specificity: Here, assets are situated side-by-Site specificity: Here, assets are situated side-by-

side.side.

Examples: Grain elevators and rail-spurs, coal Examples: Grain elevators and rail-spurs, coal mines and power plants, processes in steel or wine mines and power plants, processes in steel or wine production.production.

Physical asset specificity: Here, the physical/ Physical asset specificity: Here, the physical/ engineering/chemical properties of the asset are engineering/chemical properties of the asset are tailored to a given set of transactions.tailored to a given set of transactions.

Examples: Dyes and molds, some genetically Examples: Dyes and molds, some genetically modified organisms, software products.modified organisms, software products.

99Forms of Forms of Specialized Specialized

Investments, Investments, Cont’dCont’d

Human asset specificity: Here, the SI is human in Human asset specificity: Here, the SI is human in nature.nature.

Examples: Skill acquisitions, building trust.Examples: Skill acquisitions, building trust.

Dedication is another dimension to SI. A dedicated Dedication is another dimension to SI. A dedicated asset is one that would be a complete write-off it the asset is one that would be a complete write-off it the transactions in question were cancelled.transactions in question were cancelled.

Example: “ISU Big 12 Champs 2000” printed before Example: “ISU Big 12 Champs 2000” printed before the final if we lost.the final if we lost.

There are other types of specificities, and some There are other types of specificities, and some investments may express multiple forms.investments may express multiple forms.

1010Rent and Quasi-Rent and Quasi-RentRent

Defn: Economic rent (i.e., economic profit) is the Defn: Economic rent (i.e., economic profit) is the difference between the profit a party to an exchange difference between the profit a party to an exchange actually receives and the profit the party must receive to actually receives and the profit the party must receive to make the exchange economically profitable (accounting make the exchange economically profitable (accounting for owned resources opportunity costs).for owned resources opportunity costs).

Defn: Quasi-rent is the difference between the profit a Defn: Quasi-rent is the difference between the profit a party to an exchange receives and the profit she must party to an exchange receives and the profit she must receive in order for her to remain in the exchange (think receive in order for her to remain in the exchange (think of sunk costs here).of sunk costs here).

These may arise when contract renegotiations directly These may arise when contract renegotiations directly benefit one party at the expense of other parties (over a benefit one party at the expense of other parties (over a barrel), or when conditions change.barrel), or when conditions change.

1111Example: A Example: A StatisticianStatistician

A statistician writes a module for a A statistician writes a module for a computer software package, which is computer software package, which is upgraded every two years.upgraded every two years.

Statistician cost data areStatistician cost data are Fixed one-time setup costsFixed one-time setup costs $20,000 $20,000 Updating costs every two yearsUpdating costs every two years

$8,000$8,000 Interest rate per yearInterest rate per year 12% 12%

1212Statistician CostsStatistician Costs

On an annual basis, we haveOn an annual basis, we have Capital opportunity costsCapital opportunity costs

$2,400 $2,400 Upgrade costsUpgrade costs $4,000$4,000 Reward required to enter contractReward required to enter contract $6,400$6,400

If the software company offers If the software company offers $7,000/year in perpetuity, then economic $7,000/year in perpetuity, then economic rent (economic profit) is $600/year.rent (economic profit) is $600/year.

Fixed costs are a specialized investment.Fixed costs are a specialized investment.

1313Holdup/OpportunismHoldup/Opportunism

After fixed costs are sunk, the statistician must After fixed costs are sunk, the statistician must receive $4,000/year to justify doing the upgrade.receive $4,000/year to justify doing the upgrade.

If the software company offers $4,000/year, then If the software company offers $4,000/year, then the economic profit is -$2,400/year.the economic profit is -$2,400/year.

At $7,000/year, the quasi-rent is $600 + $2,400 = At $7,000/year, the quasi-rent is $600 + $2,400 = $3,000/year. Knowing the statistician won’t $3,000/year. Knowing the statistician won’t leave, the software company can renegotiate to leave, the software company can renegotiate to appropriate this quasi-rent.appropriate this quasi-rent.

This is what is called opportunism or holdup.This is what is called opportunism or holdup.

1414Holdup, more Holdup, more FormallyFormally

Defn: Hold-up involves opportunistic behavior by Defn: Hold-up involves opportunistic behavior by one party to an exchange who tries to extract one party to an exchange who tries to extract the quasi-rents of another party.the quasi-rents of another party.

Quasi-rents arise from specialized investments, Quasi-rents arise from specialized investments, and creates ties between parties.and creates ties between parties.

Examples: Bauxite ore is refined to alumina near Examples: Bauxite ore is refined to alumina near a mine (site specificity). After a refinery is put a mine (site specificity). After a refinery is put near a mine, the mine owner may increase ore near a mine, the mine owner may increase ore prices to extract the quasi-rents. Kids and prices to extract the quasi-rents. Kids and candy at store. Rock and hard place.candy at store. Rock and hard place.

1515Fundamental Fundamental TransformationTransformation

Defn: A fundamental transformation is the change Defn: A fundamental transformation is the change in the nature of a relationship that arises when in the nature of a relationship that arises when specific investments change the situation from a specific investments change the situation from a “large bidding” situation to a “small number “large bidding” situation to a “small number bargaining” situation.bargaining” situation.

Example: For an independent food store or hog Example: For an independent food store or hog producer, this may happen when it enters into a producer, this may happen when it enters into a contract. The contract may relieve a party of contract. The contract may relieve a party of some duties (e.g., marketing) and these functions some duties (e.g., marketing) and these functions may decay over time until the firm is not may decay over time until the firm is not confident about being independent again.confident about being independent again.

1616Notes on ContractsNotes on Contracts

They are almost essential for a private ownership They are almost essential for a private ownership economy to work. In E. Europe, establishing economy to work. In E. Europe, establishing contract law was a critical issue post 1991.contract law was a critical issue post 1991.

They promote efficiency by reducing the risks They promote efficiency by reducing the risks that resource owners face when doing business. that resource owners face when doing business. This encourages useful investments.This encourages useful investments.

They facilitate sequential activities. Often in They facilitate sequential activities. Often in business, things do not occur simultaneously, business, things do not occur simultaneously, e.g., costs arise before consumers buy the e.g., costs arise before consumers buy the product. Hold-up may result without contracts.product. Hold-up may result without contracts.

1717Notes on Contracts, Notes on Contracts, Cont’dCont’d

For contracts to work well, the Judiciary For contracts to work well, the Judiciary must not be either corrupt or incompetent.must not be either corrupt or incompetent.

To the extent that contracts are limited by To the extent that contracts are limited by law, the law should be geared (at least law, the law should be geared (at least partly) to promote economic efficiency partly) to promote economic efficiency (Coase, Posner, Bork, Breyer). Insider (Coase, Posner, Bork, Breyer). Insider trading example. trading example.

Especially outside the U.S., laws are often Especially outside the U.S., laws are often insensitive to economic implications.insensitive to economic implications.

1818Incomplete ContractsIncomplete Contracts

Complete contracts eliminate the possibility Complete contracts eliminate the possibility of holdup.of holdup.

Often where contracts are silent, contract Often where contracts are silent, contract law applies. These are standard law applies. These are standard assumptions about profit, asset ownership, assumptions about profit, asset ownership, liability, etc. In all states but Louisiana, the liability, etc. In all states but Louisiana, the Uniform Commercial Code (UCC) tries to fill Uniform Commercial Code (UCC) tries to fill in incomplete contracts. in incomplete contracts.

So why are contracts incomplete?So why are contracts incomplete?

1919Why Incompleteness?Why Incompleteness?

To complete it, parties mustTo complete it, parties must a) be able to identify all relevant possibilities during a) be able to identify all relevant possibilities during

the duration, thenthe duration, then b) agree on what action to take, and by whom, in b) agree on what action to take, and by whom, in

each possible scenario, theneach possible scenario, then c) be able to outline what constitutes satisfactory c) be able to outline what constitutes satisfactory

performance, and performance, and d) measure that performance, and d) measure that performance, and e) enforce the contract.e) enforce the contract.

On e), crime organizations have very effective On e), crime organizations have very effective informal contracts.informal contracts.

2020Incompleteness: Incompleteness: ExamplesExamples

Example: A fruit grower contracts to deliver Example: A fruit grower contracts to deliver x apples/year at $y/box for five years. Then x apples/year at $y/box for five years. Then the EPA bans azinphosmethyl, a very the EPA bans azinphosmethyl, a very important insecticide in many regions.important insecticide in many regions.

Is it reasonable to expect to be able to Is it reasonable to expect to be able to foresee all such events?foresee all such events?

If renegotiations do not raise the price, the If renegotiations do not raise the price, the supplier may go bankrupt. Might the supplier may go bankrupt. Might the packer be willing to renegotiate?packer be willing to renegotiate?

2121Biotech LitigationBiotech Litigation

See overhead.See overhead.

2222Problems with Achieving Problems with Achieving CompletenessCompleteness

Bounded rationality: The world is complex Bounded rationality: The world is complex and stochastic. Parties cannot identify all and stochastic. Parties cannot identify all contingencies.contingencies.

What is deemed satisfactory? What is deemed satisfactory? Measurement issues.Measurement issues.

Asymmetric information: Not all parties Asymmetric information: Not all parties have equal access to information;have equal access to information; hidden action problemshidden action problems hidden information problemshidden information problems

2323Information AsymmetryInformation Asymmetry

Hidden actions (moral hazard) arises when a party Hidden actions (moral hazard) arises when a party in a relation cannot observe all relevant actions of in a relation cannot observe all relevant actions of the other parties;the other parties; health insurer and exercise/drinking,health insurer and exercise/drinking, landlord and cost sharing with a sharecropper.landlord and cost sharing with a sharecropper.

Hidden information (adverse selection) arises Hidden information (adverse selection) arises when a party in a relation does not know all when a party in a relation does not know all relevant information;relevant information; life insurer and family health history,life insurer and family health history, rare species on your land, so you sell. Purchaser rare species on your land, so you sell. Purchaser

doesn’t ask (caveat emptor).doesn’t ask (caveat emptor).

2424The UCC (Filling Gaps)The UCC (Filling Gaps)

The UCC provides default specifications for The UCC provides default specifications for many items that might be omitted in many items that might be omitted in contracts. However,contracts. However,

it is often vague. What is reasonable or it is often vague. What is reasonable or acceptable?acceptable?

when applied, it can be unfair to a party in when applied, it can be unfair to a party in those particular circumstancesthose particular circumstances

recourse to it often reduces trust. For dynamic recourse to it often reduces trust. For dynamic reasons, firms may avoid it even if they gain in reasons, firms may avoid it even if they gain in that instance.that instance.

2525Example: Example: Transformations and Transformations and Specific InvestmentsSpecific Investments

U.S. Auto companies outsource many parts. U.S. Auto companies outsource many parts. Contracts are often annual, and renegotiated Contracts are often annual, and renegotiated annually.annually.

Fixed costs of design and molding man be high.Fixed costs of design and molding man be high.

Specific investments for both parties increase Specific investments for both parties increase over time.over time.

These investments tend to bind companies These investments tend to bind companies together. There may be a fundamental together. There may be a fundamental transformation.transformation.

2626Example, Cont’dExample, Cont’d

Either party may leave if negotiations become Either party may leave if negotiations become too difficult, but neither wishes to unless there too difficult, but neither wishes to unless there are good alternatives.are good alternatives.

Bargaining may be fierce as both parties try to Bargaining may be fierce as both parties try to ‘snatch’ quasi-rents.‘snatch’ quasi-rents.

Information is power, and suppliers may be Information is power, and suppliers may be reluctant to give cost information to the auto-reluctant to give cost information to the auto-maker. Information may be used in bargaining.maker. Information may be used in bargaining.

But coordination is difficult without trust.But coordination is difficult without trust.

2727Holdup and Transactions Holdup and Transactions CostsCosts

If the potential for holdup exists, then If the potential for holdup exists, then renegotiations become more detailed, renegotiations become more detailed, protracted, expensive. Care about protracted, expensive. Care about contingencies clauses.contingencies clauses.

There will be (socially unproductive) There will be (socially unproductive) investments to improve ex-post bargaining investments to improve ex-post bargaining positions.positions. Dairy farmers and back-up generatorsDairy farmers and back-up generators Thatcher and the miners, key pro-athletesThatcher and the miners, key pro-athletes

2828Holdup and InvestmentsHoldup and Investments

We have noted that Holdup discourages We have noted that Holdup discourages RSIs because RSIs create quasi-rents that RSIs because RSIs create quasi-rents that are vulnerable to appropriation.are vulnerable to appropriation.

So RSIs fall but unproductive investments So RSIs fall but unproductive investments rise. There is too much of the wrong and rise. There is too much of the wrong and too little of the right type of investment.too little of the right type of investment.

The problem could be removed by vertical The problem could be removed by vertical integration (making).integration (making).

2929Effects of Vertical Effects of Vertical Integration (VI)Integration (VI)

It alters control structures. Hidden It alters control structures. Hidden information and hidden action problems information and hidden action problems are reduced.are reduced.

Repeated interactions improve trust and Repeated interactions improve trust and coordination.coordination.

The integrated firm has a common set of The integrated firm has a common set of goals.goals.

But remember the problems with making.But remember the problems with making.

3030Contract Length: GraphsContract Length: Graphs

Good contracts reduce transactions costs, Good contracts reduce transactions costs, holdup risks, and unproductive holdup risks, and unproductive investments. They encourage RSIs.investments. They encourage RSIs.

Contracts of long duration encourage more Contracts of long duration encourage more RSIs, but are more difficult to write RSIs, but are more difficult to write because it is harder to specify all because it is harder to specify all contingencies, e.g., oil price rise, new contingencies, e.g., oil price rise, new technology, etc.technology, etc.

Thus, there is a RSI/complexity trade-off.Thus, there is a RSI/complexity trade-off.

3131Contract Length: Graphs, Contract Length: Graphs, Cont’dCont’d

Assume, reasonably, that the marginal cost Assume, reasonably, that the marginal cost of writing a contract increases with duration. of writing a contract increases with duration.

It is harder to stylize marginal benefits. Let’s It is harder to stylize marginal benefits. Let’s say they are constant.say they are constant.

Then we have the usual supply/demand Then we have the usual supply/demand situation, Baye TM 82.situation, Baye TM 82.

Now what if the product requires more RSIs? Now what if the product requires more RSIs? The marginal benefit would increase, Baye The marginal benefit would increase, Baye TM83.TM83.

3232Contract Length: Graphs, Contract Length: Graphs, Cont’d FurtherCont’d Further

What if there is an increase in the complexity of What if there is an increase in the complexity of the environment because of technical changes? the environment because of technical changes? In biotech, this might have been the case In biotech, this might have been the case recently: Baye, TM 84.recently: Baye, TM 84.

Suppose that the contracting environment is very Suppose that the contracting environment is very complex. Contract duration may be very short. complex. Contract duration may be very short. The cost of rewriting may be large, and so may The cost of rewriting may be large, and so may RSI inefficiencies. VI may then be preferrable.RSI inefficiencies. VI may then be preferrable.

The decision process might be as follows, Baye The decision process might be as follows, Baye TM 85.TM 85.