Lecture 17 Measuring and Evaluating Transaction Costs

1. Lecture 17Measuring and Evaluating Transaction Costs

2. Quantitative Methods • Methods for Measuring Transaction Costs • Econometric Analysis of Contracts and Organizations

3. Problems of measuring transaction costs (Benham und Benham 2000) • Problem of definition: different definitions of transaction costs exists • Problem of separation: transaction costs are sometimes difficult to separate from other costs, such as production costs, transportation costs • Problem of missing observations: if transaction costs are very high no transaction can be observed • Problem of subjectivity: estimations of transaction costs are often subjective • Measurement costs: measuring transaction costs is often costly

4. Boundary issue of TC (McCann et al. 2005)

5. Methods of Transaction Costs Measurement • Indircet measurement • Difference between buying and selling price • Observed behavior • Direct measurement • Process (contracting) • Interviews • Experiments • Budget (organization) • Accounting • Interviews (Employees) • Prices for transaction services • Service fees

6. Measuring Transaction Costs • Market transaction costs • Mediator, broker, stock exchange • Difference between buying and selling price • Advertisement • Transaction costs of firms • Management • Administration, Accounting • Political Transaction Costs • Parliament, government, bureaucracy, courts, police • parties, interest groups

7. Measurement methods (McCann et al. 2005)

8. Whom to ask? (McCann et al. 2005)

9. Measurement of TC – What to ask? (McCann et al. 2005)

10. Process Costs - Regulation of Entry (Djankow et al. 2001)

11. Process Costs - Regulation of Entry (Djankow et al. 2001) II

12. Measuring transaction costs – the example of agricultural policy (Rorstad et al.2005) I

13. k k1 k2 0 Asset specificity, governance structures and transaction costs TC Hybrid Market Hierarchy Asset specificity

14. Measuring transaction costs – the example of agricultural policy (Rorstad et al.2005) II

15. Measuring transaction costs – the example of agricultural policy (Rorstad et al.2005) III

16. Measuring transaction costs – the example of agricultural policy (Rorstad et al.2005) IV

17. Econometric Analysis of Contracts and Organizations Analyzing Effects or Causes? Alston (1996) Effects = f (Contracts, Organizations, ...) Contracts, Organizations = f (Causes, ...)

18. k k1 k2 0 Asset specificity, governance structures and transaction costs TC Hybrid Market Hierarchy Asset specificity

19. Econometric Analysis of Contracts and Organizations Analyzing Effects or Causes? Transaction Costs = f (Market, Hierarchy, Specificity...) Market, vs. Hierarchy = f (Specificity, ...)

20. Models I (Sykuta 2005) • Probit and Logit • Y = 1/0 (e.g., contract, yes/no)

21. Models II (Sykuta 2005) • Ordered Logit, Probit • Y = 0,1,2 (e.g. Market, Hybrid, Hierarchy)

22. Models III (Sykuta 2005) • Poisson, count data • Y = 0,1,2, ,, (e.g. Number of trading partners)

23. Models IV (Sykuta 2005) • Tobit Regression, censored data • Y ≥ 0; 1≥ Y ≥0, ,, (e.g. Share of hired labor)

24. Problems and Limitations • Self-selection and endogeneity • Data limitations (measurement, variance) • Difficult to address innovations and change • Limited to standardized contracts, organizations • Formal features may be misleading

25. Some Examples • Choice of Contract Types • Hired Labor

26. Literature • Alston, L. J. (1996). Empirical Work in Institutional Economics: An Overview. Empirical studies in institutional change. L. J. Alston, T. Eggertsson and D. C. North. Cambridge England ; New York, NY, Cambridge University Press: 25-30. • Macher, J.T. and B.D. Richman (2006). Transaction Cost Economics: An Assessment of Empirical Research in Social Sciences.Research Paper No. 115, Duke Law School. • McCann, L., B. Colby, et al. (2005). "Transaction Cost Measurement for Evaluating Environmental Policies." Ecological Economics 52: 527-542. • Rorstad, P. K., A. Vatn, et al. (2005). Transaction Costs and Agricultural Policy. Discussion Paper, Department of Economics and Resource Management, Norwegian University of Life Sciences. • Sykuta, M. E. (2005). New Institutional Econometrics: The Case of Contracting and Organizations Research. Working Paper No. 2005-4, CORI - Contracting and Organizations Research Institute, University of Missouri – Columbia. • Masten, S. E. and S. Saussier (2002). Econometrics of Contracts: An Assessment of Developments in the Empirical Literature on Contracting. In: The Economics of Contracts. Theories and Application. Edited by E. Brousseau and J.-M. Glachant. Cambridge, Cambridge University Press: 273-292.

27. Lecture 5 Explaining and Evaluating Institutional Change

28. Explaining Institutional Change • Spontaneous institutional change • Bottom-up process • Incremental evolutionary changes • Changing equilibrium in repeated games • Intentional institutional change • Efficiency enhancing • Reducing transaction costs • Interest and value driven • Unintended consequences

29. LEVEL FREQUENCY (YEARS) PURPOSE THEORY Embeddedness: Informal Institutions, Customs, Tradition,Norms, Religion Social Theory often noncalculative, spontaneous 10² to 10³ L1 Institutional Environment: Formal Rules of the Game – esp. Property (Polity, Judiciary, Bureaucracy) get the Institutional Environment right, 1st order economizing Economics of Property Rights L2 10 to 10² Governance: Play of the Game – esp. Contract (aligning Governance Structures with Transactions get the Governance structure right, 2nd order economizing 1 to 10 Transaction Cost Economics L3 Resource Allocation and Employment (Prices and Quantities, Incentive Alignment) Neoclassical Economics/Agency Theory get the marginal conditions right, 3rd order economizing L4 continuous Institutional Change METHODS (Historical) Narratives Case studies Simulations Historical Narratives Case studies (Econometrics) Case studies Econometrics (Experiments) Econometrics Experiments

30. Spontaneous Institutional Change • Institutions are the product of human action not human design (Hayek) • Equilibrium in repeated games (evolutionally game theory) • Step-by step changes through natural and artificial selection • Learning and copying replaces the natural selection in biology • Path dependencies possible

31. Intentional Institutional Change • Efficiency • Transaction cost reducing • Adoption to changing technology • Interest and Values • Distributional advantages • Power • Preferences • Knowledge

32. Long-term causes of institutional change • Changing price relations (scarcity), e.g. scarcity of land because of growing population • Changing technologies (reduction of production or transaction costs), e.g. changing information and communication technology create new markets • Changing knowledge (stock of knowledge , experiences) on the functionality of institutions • Changing preferences or norms and values • Changing power relationships

33. Mechanism of change • Competition: Change occurs if more efficient institutions emerge ( mutation) and crowd out less efficient institutions (selection) (natural selection/invisible hand) • Power: Change occurs if those that intent change are more powerful than those that oppose change • Negotiation: Change occurs if actors mutually agree upon

34. Theories of Institutional Change • Evolutionarytheories (Alchian, Hayek, Sudgen) • Neoclassical theories (Demsetz, Hayami und Ruttan) • Transaction cost theories (North, Eggertson, Williamson) • Marxist theory (Marx, Engels) • Public Choice Theory (Olson, Downs, Tullock) • Distributional theories (Knight, Libecap)

35. Concept of Efficiency • Technical Efficiency (max. output given the input, min. input given the output, related to productivity, e.g. GDP per capita) • Allocative Efficiency (cost minimizing, benefit maximizing combinations of inputs and outputs) • Pareto-Efficiency: Impossibility to make somebody better off without making somebody else worse off.

36. Technical and Allocative Efficiency Consumables A D Social Welfare Function B Production Possibility Frontier (PPF) C Environmental goods

37. Pareto-Efficiency Utility A A D Pareto-Improvement B Utility Possibility Frontier (UPF) C Utility B

38. Efficiency Theories of Institutional Change • Changes in resource scarcities and competition between actors are seen as driving forces of institutional change • Actors adjust to new scarcities, being external factors to them, by seeking efficient institutional solutions • „Naive“ form of Property Rights Theory (Demsetz): transaction costs are considered the only determinants of institutional change, politics and policies are neglected • Institutional change then results from cost-benefit comparisons between different institutional arrangements • New or revised property rights are responses to (changing) positive or negative externalities to be internalized • North (1992: 112ff.): efficiency less relevant; three factors: transaction costs, ideology and path dependency

39. MB2 „Invisible Hand“Emergence of Property Rights MC MC MB MB1 Specification of Property Rights z.B. Demsetz (1967)

40. Demsetz (1967):Towards a Theory of Property Rights • „...property rights develop to internalize externalities when the gains of internalization become greater then the cost of internalization.“ (S. 350) • Example • „Before fur trade became established, hunting was carried out on primarily for purposes of food and the relatively few furs that were required for the hunter‘s family. The externality was clearly present. ... But these externality effects were of such small significance that it did not pay for anyone to take them into account. There did not exist anything resembling private ownership in land“ (S. 351-52) • „The lands of the Labrador Peninsula shelter forest animals whose habits are considerably different from those of the plains. Forest animals confine their territories to relatively small areas, so that the costs of internalizing the efforts of husbanding these animals is considerably reduced. This reduced cost, together with higher commercial value of fur-bearing forest animals, made it productive to establish private hunting lands.“ (p. 353)

41. Public Choice Theory of Institutional Change • Political actors offer institutional changes to clientele groups, for example, economic actors or groups of citizens • They are motivated to do so by self-interest: win elections, become leader of an association, a bureaucracy, etc. • Accordingly, this institutional change is a political process that changes formal institutions mostly by legislation • Bundle of approaches of Public Choice Theory: Economic Theory of Constitutions Economic Theory of Democracy Economic Theory of Collective Action Economic Theory of Bureaucracy

42. Distributional Theory of Institutional Change I (Jack Knight) • Distributional gains and losses of actors are relevant • Actors negotiate for institutional changes • Outcomes are not necessarily efficient • Power of actors involved as the main driving force • New rules reflect power asymmetries • Relevant sources of power asymmetries are availability of resources, capability to accept risk and time preferences • Include spontaneous and decentralize change of institutions • Emphasize informal networks of conventions, norms, rules • Institutions are a by-product of strategic interaction • Intended and non-intended outcomes

43. Distributional Theory of Institutional Change II (Jack Knight) „On this bargaining account, social institutions are a by-product of strategic conflict over substantial social outcomes. By this I mean that social actors produce social institutions in the process of seeking distributional advantage in the conflict over substantive benefits. In some cases they will create institutional rules consciously. In other cases the rules will emerge as unintended outcomes of the pursuit of strategic advantage. I each case the main focus is on the substantive outcome; the development of institutional rules is merely a means to that substantive end“ (Knight 1995: 1077f.)

44. „Objectives“ and „Results“ of Institutional Change May Differ! „Institutional change is an incremental process in which the short-run profitable opportunities cumulatively create the long-run path of change. The long-run consequences are often unintended for two reasons. First, the entrepreneurs are seldom interested in the larger (external to them) consequences. (...) Second, there is frequently a significant difference between intended outcomes and actual outcomes. Outcomes frequently diverge from intentions because of the limited capabilities of the individuals and the complexity of the problems to be solved“ (North 1997: 5)

45. Normative Aspects of Economics

46. Distribution and Social Welfare

47. Institutions define what becomes Pareto-efficient I Source: Vatn (2005, p. 215)

48. Institutions define what becomes efficient II Source: Vatn (2005, p. 215)

49. Institutions define what becomes efficient III Source: Vatn (2005, p. 215)

50. Institutions define what becomes efficient IV Source: Vatn (2005, p. 215)