Transaction costs and institutions

1. Transaction costs and institutions

2. A revolution over the dinner party. • Coase’s critic of Pigou’s analysis of externalities. • Pigouvian approach: • If there is an externality, inefficient decisions with respect to production and consumption will be made (because not all costs of the action are accounted by a decision-maker); • Inefficiency can be corrected by charging the external costs back to a decision-maker (through Pigouvian tax, internalizing externality). • Coase’s conjecture: • Externalities are not a problem for efficiency but transaction costs are. • The central idea:the problem of externalities is reciprocal. • The existence and size of externalities depends on decisions made by both, a “producer” of the externality and a “victim” of externality. • If I light a cigarette in this conference room your lungs are affected. • It’s true that if I weren’t here with my stinking cigarette there would be no externality. • But it is also true that if you were not in this room there still would be no problem. • Since we are both responsible for this nuisance it looks somehow suspicious that the way to correct it has always something to do only with one of us, a “polluter”.

3. Let us assume that my smoking imposes $20 of damage on my roommate and I could walk to smoke outside which costs me $10. • Assume that my roommate could leave a room at cost tohim of $5. • First suppose the building manager works out a scheme by which I’m fined $20 if I smoke in the room (it’s so called Pigouvian tax, equal to the external cost). • The problem is solved – I go outside, pollution is eliminated at cost of $10. • But suppose the building manager has no such power, and no action against me can be taken. • In this case my roommate goes out – the problem is again eliminated, this time at cost of $5. • The solution with a Pigouvian tax is inefficient, and the solution without a Pigouvian tax is efficient. • If a government taxes all the polluters (even if a tax can be calculated correctly), it can go either way, efficiency enhancing of efficiency diminishing. • The Pigouvian tax (even if correctly calculated and effectively enforced) efficiently corrects externality only if it happens to be imposed on the agent who can eliminate the externality at the lowest cost. • Obviously, there is no reason on Earth to believe that such “low-cost” person is always a polluter.

4. Now let us make it a bit more realistic and assume that I pay a fine for my smoking only in case if my roommate does complain to the building manager. • If I want to light up a cigarette I offer my roommate $6; he takes it and happily goes for a walk. • In fact, we assigned property right over clean air to the roommate. Externality is eliminated at cost $5 (and there is a transfer $6 from me to the guy). • On the other hand, assume I have the right to do whatever I want. I light up a cigarette; the comrade goes for a walk even without receiving any bribe (this time he’s not happy at all). • Externality is again eliminated at cost $5. • Although externality is present, neither regulation no tax is needed to achieve efficient outcome. • This result is usually referred as Coase Theorem – if transaction costs are zero, then any initial allocation of property rights leads to an efficient outcome. • Unregulated markets (laissez-faire) do work – in the first case, rights were worth more to me, so I bought them from my roommate; in the second case rights still were worth more to me, so the fellow did not buy them. • Rights are bought and sold as any other commodity and end up in possession of whoever values them most. • The outcome is always efficient. • Actions of the government do not matter as efficiency is concerned (they do matter for welfare distribution, but it is not relevant here).

5. The efficiency in the previous example depends on inability of the manager to fine me without a report from my roommate. • But suppose the government is good in detecting felony. • The fine, if imposed, goes (as it usually happens) not to the roommate but to the manager (government). • Consider the following situation. • Damage to the roommate from my smoking is still $20, but my cost of going out is $30 and his cost of going out is $30. • It is efficient to smoke inside since the cost of elimination of pollution is greater than harm. • I will pay the fine and continue to intoxicate the guy who does not leave the room either. • He, then, offers me a deal – he would give me $15 to go out. • Obviously, I start smoking in the back yard – pollution is eliminated at cost that is higher than damage is worth. • Mere presence of the benevolent and informed government with its attempt to correct externality creates inefficiency even though tax is never collected. • The polluter gets too much of incentive to reduce pollution – one from the government and one from the victim. Instead of overproducing he under-produces. • The idea?: since free markets produce efficient outcome, the government has no business trying to enhance efficiency. • The idea is wrong. • Some people claim Coase is the major authority whose work supports the idea of laissez-faire. • Exactly the opposite is true, Coase’s work justifies non-market allocations wherever it exists. • In all the previous discussion, free markets work under an assumption of zero transaction costs. • We’ll have to take closer look at the transaction costs.

6. Economic property rights • In most cases when talking about property rights one means essentially what the state assigns to a person. • These are “legal property rights”. • They are important but not directly relevant for the decision making. • Another concept is the rights to the property as the ability to enjoy a piece of property. • These are “economic property rights”. • We can define them as “the individual ability, in expected terms, to consume the good (or the services of the asset) directly or to consume it indirectly through exchange. … Economic property rights are the end (that is, what people ultimately seek), whereas legal rights are the means [and not even always essential means] to achieve the end.” • A person never has full property rights over a piece of property if there is any positive probability of dispossession (say, theft) or there are restrictions on its exchange. • Essentially, a person is an economic owner of a commodity or an asset whenever that person is a residual claimant to the services provided by the commodity or asset.

7. One otherwise excellent economist writes “the idea of a thing belonging to a person is fairly clear when the thing is an automobile or a pair of pants. It is less clear when the thing is a piece of land.” and then goes on discussing how a piece of land has many attributes and not all of them really belong to the legal owner of the plot. • Truth is, there is no essential difference between what he says about ownership over land attributes and ownership over automobile attributes. • It is not at all clear who owns the car. • First of all, the legal owner does not have full economic property rights. • Any automobile is at risk to be stolen or run into accident, which is going to decrease the value of its services. • There are also restrictions on its use. It is likely that the owner is prohibited from lending his car for the purpose of bank robbery no matter how much robbers offer him for such service. • More than that, he is not a sole owner of the automobile. Every thief that thinks about trying to steal it, is a partial owner. • Also, consider the case of waranty. If the car breaks, a seller or producer has to fix it up. So the seller or producer is a residual claimant to the stream of services that the automobile provides. He is a partial owner of the automobile. • Have you ever wondered how different parts of your refrigerator have different warranty duration? • As in case of an automobile a guarantor for a part of your fridge is a partial owner of that part. • As warranty expires, you become a sole owner of that part. • You don’t usually become a sole owner of a commodity right after you have made your payment and taken a thing home. Transfer of the property rights continues after the purchase and may take years to complete.

8. Goods we consume are not one-dimensional. • They can be described as vectors of attributes. • Say, such “very simple” good as an apple has many attributes: among them, color, brightness, sweetness, shape, size, ripeness, etc. • If people are able to distinguish between various attributes of a single good, they most certainly can use this ability and assign different attributes or their parts do different persons if it is beneficial to do so. • Consider a factory. • Shareholders are owners of the attributes that produce profits. • Management is a partial owner of those attributes, too. • If there is any debt financing (which almost certainly the case), creditors are partial owners. • Workers, who may steal something (not necessarily by taking things home but say, by shirking), are partial owners, too. • Fire insurance company is an owner of the attributes that produce burnt buildings. • The government is likely a partial owner of attributes that lead to bankruptcy, in which case the government has to pay unemployment benefits to the workers. • This goes on. • Even if there is a firm whose entire assets are this one factory, it is difficult to define the scope of such a firm. • We now know that people could distinguish among various attributes of a good and assign different attributes of a single good to different persons. Will they? Why?

9. Attributes are variable • Although an apple remains an apple, its ripeness change with time, its cells get damaged when the apple gets hit, and the longer it stays on a table, the more likely it starts to dry up or rot. • One can think about variability of the attributes as changes brought about by nature. • Attributes are alterable • One can think about alterability of the attributes as changes brought about by man. • One can carefully pick apples off branches of just shake the tree and then pick the apples from ground, and an apple would have altogether different characteristics in these two cases. • We can consider the taxonomy in the next table. Almost everything is composed of attributes that are both variable and alterable. • See Table:

10. Goods and their attributes Alterable Non-alterable Variable Almost Everything Earthquake Orbit of Mars Non-Variable Rose God Speed of Light

11. Information regarding the number and levels of each good’s attributes is not free • One is not born with absolute knowledge about goods attributes. • Or, even if one were, she’d need to continuously adjust this knowledge because of variability and alterability. • Any measurement is costly. • It consumes time, energy and resources that have alternative use. • And in most cases exact measurements are prohibitively costly. • As with any other activity, utility maximizing individuals are going to acquire additional information about the attributes right to the extent where marginal benefits from more precise measurements are equal to the marginal costs. • As a consequence, not only we don’t have full information about the attributes a priori but we also do not attempt to obtain full information at all. • As it comes to exchange, people purchase the goods they don’t have full information about. • But the willingness to pay for something is determined by the value of the good’s attributes to a buyer. • If information about the attributes is not perfect, prices do not exactly reflect values.

12. Some attributes belong to the “public domain” • Since some attributes are notmeasured, they cannot be priced. • It means than in every exchange these attributes can be captured by exchanging parties, that is, appropriated without paying for them. • One can say that a commodity lies in the “public domain” if the resources needed to acquire it accrue to no one. • When one spends resources to capture the attributes from the public domain, a seller does not receive what the buyer expends. • One simple and clear illustration of the phenomenon is rationing by waiting. • If a commodity is distributed at zero price to those who care spending some time in line, waiting time accrues to no one, so the commodity distributed in this way lies in the public domain. • Buyers spend resources to capture non-priced attributes from the public domain, sellers spend resources to prevent such capturing. • Exchange is costly because information is costly.

13. If information about the attributes were free, all characteristics of any good would be perfectly determined, public domain would be empty, all attributes priced, and resources to capture non-priced attributes would be zero. • So transaction costs are information costs. • But not all information costs are transaction costs. Those information costs that are independent of an exchange are not transaction costs. • The transaction costs arise only in relation to an exchange. • Their source is asymmetric information about the attributes of a commodity. • Not only the information is costly but also it is more costly for some to acquire than others. • In this case people attempt to use their informational advantages and capture the non-priced attributes from the public domain, which their trading partners cannot prevent because of their informational disadvantages. • Returning to the taxonomy in the table, it is necessarily that the commodity belongs in upper-left corner of the table, it is both variable and alterable. • Consider a case when a commodity is alterable but not variable. • So there is this generic product that a seller can alter say, in attempt to sell substandard piece, but such action cannot go without detection. • If a buyer knows what a generic product is, every time it is substandard a buyer knows it’s a seller’s fault. • Informational asymmetry can only arise if the exchanged commodity is both variable and alterable and the buyer cannot determine the source of variability.

14. What are transaction costs? • If the information about commodities’ attributes were perfect (costless to obtain), property rights would be perfect, too. • In such a case no capture of property rights would be possible, and no effort would be made to either capture or protect one’s property rights. • When information about the attributes is costly and asymmetrical, property rights are not fully delineated, utility maximizing individuals spend resources to further establish their property rights; resources are spent in attempt to capture some not yet delineated property rights and resources are spent in attempt to protect one’s property rights. • Transaction costs equal to the value of the resources used to establish and maintain property rights. It includes the resource used for capturing and protecting property rights, and also all deadweight costs that result from any potential or real protecting and capturing. • Not only capture and protection of property rights leads to loss of some surplus that is produced by exchange, it also reduces the volume of exchange. • If such capturing and protective activity were absent, total wealth would increase by the amount actually spent in transaction and the value of additional trade. • Since most commodities are both variable and alterable, transaction costs are ubiquitous.

15. Allocation of property rights • If one is an inefficient owner of an attribute, that is, one’s utilization of the property rights over the attribute brings up less net benefits than somebody else’s, parties can benefit by transferring the attribute to the efficient person in exchange for an appropriate compensation. • Such a transfer is mutually beneficial. • Under wealth maximization, property rights to the particular attributes end up in possession of those who value them most. • Different persons can be most efficient owners of different attributes and it must be efficient when a commodity has many owners each maintaining property rights over subset of the commodity attributes. • As we earlier connected property rights to residual claim, in order to maximize the total value of rights, a person’s share in the residual should increase as his contribution to the mean output increases.

16. Institutions • One may reason as follows. • There are many ways to exchange. • One is laissez faire. • Another one is command. • Laissez faire is “good” – it does not require us to know about consumers’ preferences, their marginal values get reflected by prices, which thus convey information producer needs to know when making a decision to increase or decrease production. • Now we can also say that laissez faire is “bad” – resources are wasted in course of exchange. • On the other hand, command may be “bad” because of great requirements of costly information. • But it may also be “good” – transaction costs may be reduced. • In general, one cannot expect that either way to organize exchange is superior to other in all circumstances. It all depends on transaction costs – free markets may be efficient in some instances, firms (where exchange is organized by command) in other, yet a government (where decisions are made by central authority, or by voting) may be most efficient way to organize allocations in many cases.

17. Example of an institution: Slavery • Why was slavery abolished in the US? • A slave owner must be able to maintain his property rights over slave labor. • If slaves escape and cannot be caught, such property rights are lost. • Initially in the US slaves were easily identified by the color of their skin. • If a person was black, he was a slave. • Escaped slaves were captured at low cost – you see a black man who does not belong to anybody, you know he is an escaped slave. • The slave owners discovered long ago that they must satisfy inventive compatibility constraint to maximize their own benefits from slaves’ work. • Main consequence of this is that slaves receive a surplus, which they can accumulate and use to buy their freedom. • With time, population of free black people grows. • Eventually there are so many free Afro-Americans that it becomes too costly to try to identify an escaped slave among them. • The cost of maintaining property rights over slaves becomes so high that it is no longer beneficial to own them. • Slavery cannot be sustained as an efficient institution. • Additional support for this explanation is re-emergence of the institution under a new guise in late 19 century, when many Chinese workers were imported to the US and Canada for railroad construction. • Chinese were easily identified by their physical appearance. • As soon as number of Chinese who accumulated enough wealth and legitimately left railroad had grown large, the institution collapsed.

18. Voting • “Voting [is] a mechanism that explicitly bypasses the use of prices [in resource allocation]. Within voting organization, … individuals are subject to constraints imposed on them by fellow voters. Yet by their own behavior individuals demonstrate that they value some of these constraints even though they reduce their freedom of action.” • Voting is an imperfect mechanism to make decisions but we use it a lot.

19. Consider the case of monogamous marriage. • Most people probably believe that men are more inclined to seek multiple partners than women do. • Sometimes it is suggested that men would prefer polygamous society where women would be worse off. • I believe the opposite would be true. • If a man were allowed to marry many women there would be high degree of competition among men. • If polygamy were legal, women probably would still insist on monogamous marriages and we would have same situation as we presently have in terms of mating structure. • But women in such society would have much more bargaining power. If a wife is such society negotiates with a husband (on anything) she can always resort to the threat to leave the husband and marry a nice neighbor despite the fact that the neighbor already has few wives. • Follow Adam Smith: men, as any other economic actors, try to “end in conspiracy against the public”. • Think this way: men made a collusive agreement to limit their attention to one woman apiece. • Because there are so many men, such collusion would be impossible to enforce through the market mechanisms. • While you see many men fantasizing how great it would be if they were allowed multiple wives, they also make sure to vote for the legislators who support “good old family values” and prevent the others from cheating on the agreement.