Transaction Cost Economics: Applications

The applications of transaction cost economics sketched here are developed more extensively in later chapters. The object is merely to motivate the proposition that transaction cost economics makes useful contact with many of the issues of central interest to applied microeconomics.

1. Vertical Market Restrictions 

Whereas it was once common to approach customer and territorial restrictions and related forms of nonstandard contracting as presumptively anticompetitive, transaction cost economics maintains the rebuttable presumption that such practices have the purpose of safeguarding transactions. The contracting schema in section 4 discloses that firms in which specific assets are placed at hazard (k > 0) have an incentive to devise protective governance (s > 0), thereby to locate at node C. Many of the nonstandard practices, of which customer and territorial restrictions are examples, serve precisely this purpose.

Thus suppose that a firm develops a distinctive good or service and distributes it through franchisees. Assume further that the incentive to pro- mote’the good or service experiences externalities: Some franchisees may attempt to free-ride off of the promotional efforts of others; or franchisees that serve a mobile population may cut costs, allow quality to deteriorate, and shift the reputation effect onto the system. Franchisors thus have an incentive to extend their reach beyond the initial franchise award to include constraints on the condition of supply.

Transparent though that may be, it was not always so. Consider the position of the government in arguing the Schwinn case before the Supreme Court: A “rule that treats manufacturers who assume the distribution function more leniently than those who impose restraints on independent distributors merely reflects the fact that, although integration in distribution sometimes benefits the economy by leading to cost savings, agreements to maintain resale prices or to impose territorial restrictions of limited duration or outlet limitations of the type involved here have never been shown to produce comparable economies.”31 The clear preference for internal over market modes of organization is consonant with the then prevailing preoccupation with technological features and the associated disregard for the benefits of contractual safeguards. In terms of the contracting schema set out in Figure 1-2, the government implicitly assumed that all trades were of a node A kind—whence any efforts to impose restrictions were presumptively anticom- petitive.

2. Price Discrimination

The Robinson-Patman Act has been interpreted as an effort “to deprive a large buyer of [discounts] except to the extent that a lower price could be justified by reason of a seller’s diminished cost due to quantity manufacture, delivery, or sale, or by reason of the seller’s good faith effort to meet a competitor’s equally low price.” Again, this assumes a node A transaction. If, however, a seller is operating on the k > 0 branch and is selling to buyers one of which offers a contractual safeguard while the other refuses, it Is unrealistic to expect that product will be sold to both at an identical price. Instead, the node B buyer must pay a premium (p¯ > pˆ) to reflect his refusal to safeguard the hazard.

3. Regulation/ Deregulation

Monopoly supply is efficient where economies of scale are large in relation to the size of the market. But, as Friedman laments, “There is unfortunately no good solution for technical monopoly. There is only a choice among three evils: private unregulated monopoly, private monopoly regulated by the state, and government operation” (1962, p. 128).

Friedman characterized private unregulated monopoly as an evil because he assumed that private monopoly ownership implied pricing on monopoly terms. As subsequently argued by Demsetz (1968b), Stigler (1968), and Posner (1972), however, a monopoly price outcome can be avoided by using ex ante bidding to award the monopoly franchise to the firm that offers to supply product on the best terms. Demsetz advances the franchise bidding for natural monopoly argument by stripping away “irrelevant complications”— such as equipment durability and uncertainty (1968b, p. 57). Stigler contends that “customers can auction off the right to sell electricity, using the state as an instrument to conduct the auction. . . .The auction …. consists of [franchise bids] to sell cheaply” (1968, p. 19). Posner agrees and furthermore holds that franchise bidding is an efficacious way by which to award and operate cable TV franchises.

Transaction cost economics recognizes merit in the argument but insists that both ex ante and ex post contracting features be examined. Only if competition is efficacious at both stages does the franchise bidding argument go through. The attributes of the good or service to be franchised are crucial to the assessment. Specifically, if the good or service is to be supplied under conditions of uncertainty and if nontrivial investments in specific assets are involved, the efficacy of franchise bidding is highly problematic. Indeed, the implementation of a franchise bidding scheme under those circumstances essentially requires the progressive elaboration of an administration apparatus that differs mainly in name rather than in kind from the sort associated with rate of return regulation. It is elementary that a change in name lacks comparative institutional significance.

This is not, however, to suggest that franchise bidding for goods or services supplied under decreasing cost conditions is never feasible or to imply that extant regulation or public ownership can never be supplanted by franchise bidding with net gains. Examples include local service airlines and, possibly, postal delivery. The winning bidder for each can be displaced without posing serious asset valuation problems, since the base plant (terminals, post office, warehouses, and so on) can be owned by the government, and other assets (planes, trucks, and the like) will have an active secondhand market. It is not, therefore, that franchise bidding is totally lacking in merit. On the contrary, it is a very imaginative proposal. Transaction cost economics maintains, however, that all contracting schemes—of which franchise bidding for natural monopoly is one—need to be examined microanalytically and assessed in a comparative institutional manner.

Source: Williamson Oliver E. (1998), The Economic Institutions of Capitalism, Free Press; Illustrated edition.

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