Transaction Costs

1. Frictionlessness

Kenneth Arrow has defined transaction costs as the “costs of running the economic system” (1969, p. 48). Such costs are to be distinguished from production costs, which is the cost category with which neoclassical analysis has been preoccupied. Transaction costs are the economic equivalent of friction in physical systems. The manifold successes of physics in ascertaining the attributes of complex systems by assuming the absence of friction scarcely require recounting here. Such a strategy has had obvious appeal to the social sciences. Unsurprisingly, the absence of friction in physical systems is cited to illustrate the analytic power associated with “unrealistic” assumptions (Friedman, 1953, pp. 16-19).

But whereas physicists were quickly reminded by their laboratory instru- ments and the world around them that friction was pervasive and often needed to be taken expressly into account, economists did not have a corresponding appreciation for the costs of running the economic system. There is, for example, no reference whatsoever to transaction costs, much less to transaction costs as the economic counterpart of friction, in Milton Friedman’s famous methodological essay (1953) or in other postwar treatments of positive economics.7 Thus although positive economics admitted that frictions were important in principle, it had no language to describe frictions in fact.

The neglect of transaction costs had numerous ramifications, not the least of which was the way in which nonstandard modes of economic organization were interpreted. Until express provision for transaction costs was made, the possibility that nonstandard modes of organization—customer and territorial restrictions, tie-ins, block booking, franchising, vertical integration, and the like—operate in the service of transaction cost economizing was little appreciated.nlnstead, most economists invoked monopoly explanations—be it of the leverage, price discrimination, or entry barriers kinds— when confronted with nonstandard contracting practices (Coase, 1972, p. 67). Donald Turner’s views are representative: “1 approach customer and territorial restrictions not hospitably in the common law tradition, but inhospitably in the tradition of antitrust.”10 As discussed below, the research agenda and public policy toward business were massively influenced by that monopoly predisposition. The prevailing view of the firm as production function was centrally implicated in that situation.

2. Explication 

Transaction cost economics poses the problem of economic organization as a problem of contracting. A particular task is to be accomplished. It can be organized in any of several alternative ways. Explicit or implicit contract and support apparatus are associated with each. What are the costs?

Transaction costs of ex ante and ex post types are usefully distinguished. The first are the costs of drafting, negotiating, and safeguarding an agreement. This can be done with a great deal of care, in which case a complex document is drafted in which numerous contingencies are recognized, and appropriate adaptations by the parties are stipulated and agreed to in advance. Or the document can be very incomplete, the gaps to be filled in by the parties as the contingencies arise. Rather, therefore, than contemplate all conceivable bridge crossings in advance, which is a very ambitious undertaking, only actual bridge-crossing choices are addressed as events unfold.

Safeguards can take several forms, the most obvious of which js-com- mon ownership. Faced with the prospect that autonomous traders will experience contracting difficulties, the parties may substitute internal organization for the market. This is not, to be sure, without problems of its own (see Chapter 6). Moreover, ex ante interfirm safeguards can sometimes be fashioned to signal credible commitments and restore integrity to transactions. The study of “nonstandard” contracting is centrally concerned with such matters.

Most studies of exchange assume that efficacious rules of law regarding contract disputes are in place and are applied by the courts in an informed, sophisticated, and low-cost way. Those assumptions are convenient, in that lawyers and economists are relieved of the need to examine the variety of ways by which individual parties to an exchange “contract out of or away. from” the governance structures of the state by devising private orderings/ Thus arises a division of effort whereby economists are preoccupied with the economic benefits that accrue to specialization and exchange, while legal specialists focus on the technicalities of contract law.

The “legal centralism” tradition reflects the latter orientation. It maintains that “disputes require ‘access’ to a forum external to the original social setting of the dispute [and that] remedies will be provided as prescribed in some body of authoritative learning and dispensed by experts who operate under the auspices of the state” (Galanter, 1981, p. 1). The facts, however, disclose otherwise. ‘Most disputes, including many that under current rules could be brought to a court, are resolved by avoidance, self-help, and the like (Galanter, 1981, p. 2).

The unreality of the assumptions of legal centralism can be defended by reference to the fruitfulness of the pure exchange model. Thgti^ ngtdisputed here. My concern is that the law and economics of private ornering hfave been pushed into the background as a consequence. That is unfortunate, since in “many instances the participants can devise more satisfactory solutions to their disputes than can professionals constrained to apply general rules on the basis of limited knowledge of the dispute” (Galanter, 1981, p. 4).

The issues here are akin to those that were of concern to Karl Llewellyn in his discussion of contract in 1931 but have been systematically evaded since. But for the limitations of legal centralism, the ex post side of contract can be disregarded. Given the very real limitations, however, with which court ordering is beset, the ex post costs of contract unavoidably intrude. Transaction cost economics insists that contracting costs of all kinds be accorded parity.

Ex post costs of contracting take several forms. These include (1) the maladaption costs incurred when transactions drift out of alignment in relation to what Masahiko Aoki refers to as the “shifting contract curve” (1983), (2) the haggling costs incurred if bilateral efforts are made to correct ex post misalignments, (3) the setup and running costs associated with the governance structures (often not the courts) to which disputes are referred, and (4) the bonding costs of effecting secure commitments.

Thus suppose that the contract stipulates x but, with the benefit of hindsight (or in the fullness of knowledge), the parties discern that they should have done y. Getting from x to y, however, may not be easy. The manner in which the associated benefits are divided is apt to give rise to intensive, self- interested bargaining. Complex, strategic behavior may be elicited. Referring the dispute to another forum may help, but that will vary with the circumstances. An incomplete adaptation will be realized if, as a consequence of efforts of both kinds, the parties move not to y but to y’.

A complicating factor in all of this is that the ex ante and ex post costs of contract are interdependent. Put differently, they must be addressed simul- taneously rather than sequentially. Also, costs of both types are often difficult to quantify. The difficulty, however, is mitigated by the fact that transaction costs are always assessed in a comparative institutional way, in which one mode of contracting is compared with another. Accordingly, it is the difference between rather than the absolute magnitude of transaction costs that matters. As Herbert Simon has observed, the comparison of discrete structural alternatives can employ rather primitive apparatus—“such analyseircan often be carried out without elaborate mathematical apparatus or marginal calculation. In general, much cruder and simpler arguments will suffice to demonstrate an inequality between two quantities than are required to show the conditions under which these quantities are equated at the margin” (1978, p. 6). Empirical research on transaction cost matters almost never attempts to measure such costs directly. Instead, the question is whether organizational relations (contracting practices; governance structures) line up with the attributes of transactions as predicted by transaction cost reasoning or not.

 3. The Larger Context 

This book concentrates on transaction cost economizing, but the costs need to be located in the larger context of which they are a part. Among the relevant factors—to which I sometimes (but not continuously) refer—are the following:

  1. Holding the nature of the good or service to be delivered constant, economizing takes place with reference to the sum of production and transaction costs, whence tradeoffs in this respect must be recog-nized.
  2. More generally, the design of the good or service to beMelivered is a decision variable that influences demand as well as costs of both kinds, whence design is appropriately made a part of the calculus.
  3. The social context in which transactions are embedded—the customs, mores, habits, and so on—have a bearing, and therefore need to be taken into account, when moving from one culture to another.
  4. The argument relies in a general, background way on the efficacy of competition to perform a sort between more and less efficient modes and to shift resources in favor of the former. This seems plausible, especially if the relevant outcomes are those which appear over inter-vals of five and ten years rather than in the very near term.14 This intuition would nevertheless benefit from a more fully developed theory of the selection process. Transaction cost arguments are thus open to some of the same objections that evolutionary economists have made of orthodoxy (Nelson and Winter, 1982, pp. 356-70), though in other respects there are strong complementarities (pp. 34- 38).
  1. Whenever private and social benefits and costs differ, the social cost calculus should govern if prescriptive treatments are attempted.

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

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