Transaction costs 2

Peter Klein over at the Organisations and Markets blog asks What Are “Transaction Costs” Anyway? He writes,

A friend complains that management and entrepreneurship scholarship is confused about the concept of transaction costs. Authors rarely give explicit definitions. They conflate search costs, bargaining costs, measurement costs, agency costs, enforcement costs, etc. No one distinguishes between Coase’s, Williamson’s, and North’s formulations. “Transaction costs seem to be whatever the author wants them to be to justify the argument.”

It’s a fair point, and it applies to economics (and other social sciences and professional fields) too. I remember being asked by a prominent economist, back when I was a PhD student writing under Williamson, why transaction costs “don’t simply go to zero in the long run.” Indeed, contemporary organizational economics mostly uses terms like “contracting costs,” and since 1991 Williamson has tended to use “maladaptation costs” (while retaining the term “transaction cost economics”).

Klein also usefully points us to two articles on transaction costs: Doug Allen’s essay from the Encyclopedia of Law and Economics and Lee and Alexandra Benhams’ more recent survey from the Elgar Companion to Transaction Cost Economics.

But not only do we have the problems of defining transaction costs we also have to worry about, when it comes to the theory of the firm, the difference between the transaction costs, property rights and reference point models each of which claims to use some concept of "transaction costs". As I have written before:

Hart (2008, p. 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, pp. 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, pp. 605–606) 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, p. 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, p. 294) points out ‘[...] is a significant departure from the standard contracting literature. The literature usually assumes that trade is perfectly enforceable ex post (for example 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, p. 4). Hart’s interpretation of the reference point theory is ‘[i]n a sense, this work can be viewed as a “merger” of the transaction cost and property rights literatures’. (Hart, 2011b, p. 106).

Also the reference point approach differs from the property rights theory in that it does not require an assumption of the use of relationship-specific investments as is standard in the property rights theory. Relationship-specific investments can be introduced to the reference point theory, Hart (2011a) is an example where this is done, but, in general, the reference point theory does not rely on such investment.

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, pp. 61–63) 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 et al., 2009, p. 562). This is an idea which finds experimental support: see Fehr et al. (2009), Fehr et al. (2011) and Hoppe and Schmitz (2011).

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, p. 283) notes that ‘[...] it may be that Hart and Moore’s (2008) “reference points” approach is a productive path. Time will tell [...]’. Hart (2011b, p. 106) concludes ‘[w]hether this merger [resulting in the reference point theory] will be successful remains to be seen’.