Friday, 14 January 2011

Just for fun: reference points, property rights and transaction costs

Hart (2008: 406) argues that shading costs are akin to "haggling costs". The modelling of haggling costs can be seen as a move towards the modelling (however imperfectly) of transaction costs. Hart and Moore (2008: 4-5) argue that "[ ... ] the costs of flexibility that we focus on--shading costs--can be viewed as a shorthand for other kinds of transaction costs, such as rent-seeking, influence, and haggling costs." Exactly how similar the reference point and transaction-cost explanations are is, however, open to debate. There is also the question of the relationship between these two approaches to the firm and the property rights approach.

In a discussion of the differences between the Grossman-Hart-Moore (GHM) theory of the firm and the transaction-cost approach, Williamson (2000: 605-6) argues that the most important difference between them is that GHM introduce inefficiencies at the ex ante investment stage while the transaction-cost approach emphasises that ex post haggling and maladaptation drive inefficiencies. There are no ex post inefficiencies in GHM due to their assumption of common knowledge and ex post costless bargaining. Gibbons (2010: 283) explains it this way:
"[t]he model in question is Grossman and Hart's (1986), which explores an alternative to Williamson's (2000, p. 605) emphasis that "maladaptation in the contract execution interval is the principal source of inefficiency". Instead, in the Grossman-Hart model, there is zero maladaptation in the contract execution interval, and the sole inefficiency is in endogenous specific investments.

It is striking how different the logic of inefficient investment can be from the logic of inefficient haggling. In their pure forms envisioned here, the two can be seen as complements. For example, the lock-in necessary for Williamson's focus on inefficient haggling could result from contractible specific investments chosen at efficient levels. But by assuming efficient bargaining and hence zero maladaptation in the contract execution interval, Grossman and Hart focused attention on non-contractible specific investments and hence discovered an important new determinant of the make-or-buy decision: in the Grossman-Hart model, an important benefit of non-integration is that both parties have incentives to invest; in Williamson's argument, an important cost of non-integration is inefficient haggling. In short, the two theories are simply different."
This emphasis on ex post haggling and maladaptation can be interpreted as reflecting a view that internal organisation is better at reconciling the conflicting interest of the parties to a transaction and facilitating adaptation to changing supply and demand conditions when such cost are high.

The reference point approach can be seen as a movement away from the ex ante GHM approach and back towards transaction cost thinking in so much as contracting is not perfectly contractible ex post. This fact, as Hart (2008: 294) points out "[ ... ] is a significant departure from the standard contracting literature. The literature usually assumes that trade is perfectly enforceable ex post (e.g. by a court of law). Here we are assuming that only perfunctory performance can be enforced: consummate performance is always discretionary", and thus inefficiencies can arise ex post. The development of a tractable model of contracts and organisational form that exhibits ex post inefficiency is one of motivations for advancing the reference point approach in the first place. (Hart and Moore 2008: 4).

The reference point approach also highlights the importance of Williamson's notion of the "fundamental transformation". Hart and Moore argue that the move from an ex ante competitive market to an ex post bilateral setting--what Williamson (1985: 61-3) terms the fundamental transformation--provides a rationale for the idea that contracts are reference points. "A competitive ex ante market adds objectivity to the terms of the contract because the market defines what each party brings to the relationship. HM assume that the parties perceive a competitive outcome as justified and accept it as a salient reference point." (Fehr, Hart and Zehnder 2009: 562). This is an idea which finds experimental support: see Fehr, Hart and Zehnder (2008), Fehr, Hart and Zehnder (2009) and Hoppe and Schmitz (forthcoming).

But we must also be aware that important features of the transaction-cost theory may still have been left out. How fully shading costs capture the costs of ex post maladaptation and haggling is an open question. When discussing some opportunities for the future of transaction-cost economics, Robert Gibbons (2010: 283) notes that "[ ... ] it may be that Hart and Moore's (2008) "reference points" approach is a productive path. Time will tell [ ... ]".

  • Fehr, Ernst, Oliver D. Hart and Christian Zehnder (2008). `Contracts as reference points - experimental evidence', National Bureau of Economic Research, NBER Working Paper: 14501, November.
  • Fehr, Ernst, Oliver D. Hart and Christian Zehnder (2009). `Contracts, Reference Points, and Competition-Behavioral Effects of The Fundamental Transformation', Journal of the European Economic Association, 7(2-3) April-May: 561-72.
  • Gibbons, Robert (2010). `Transaction-Cost Economics: Past, Present, and Future?', Scandinavian Journal of Economics, 112(2): 263-88.
  • Grossman, Sanford J. and  Oliver D. Hart (1986). `The Costs and Benefits of Ownership: A Theory of Vertical and Lateral Integration', Journal of Political Economy, 94(4): 691-719.
  • Hart, Oliver D. (2008). `Economica Coase Lecture: Reference Points and the Theory of the Firm', Economica, 75(299) August: 404-11.
  • Hart, Oliver D. and John Moore (2008). `Contracts as Reference Points', Quarterly Journal of Economics, 123(1) February: 1-48.
  • Hoppe, Eva I. and Patrick W. Schmitz (forthcoming). `Can contracts solve the hold-up problem? Experimental evidence', Games and Economic Behavior.
  • Williamson, Oliver E. (1985). The Economic Institutions of Capitalism, New York: The Free Press.
  • Williamson, Oliver E. (2000). `The New Institutional Economics: Taking Stock, Looking Ahead', Journal of Economic Literature, 38(3) September: 595-613.

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