Lecture 17Measuring and Evaluating

Transaction Costs

Quantitative Methods

1. Methods for Measuring Transaction Costs

2. Econometric Analysis of Contracts and Organizations

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

Boundary issue of TC (McCann et al. 2005)

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

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

Measurement methods (McCann et al. 2005)

Whom to ask? (McCann et al. 2005)

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

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

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

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

Asset specificity, governance structures and transaction costs

0 kk1 k2

TC

Asset specificity

Market Hybrid Hierarchy

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

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

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

Econometric Analysis of Contracts and Organizations

Analyzing Effects or Causes?

Alston (1996)

Effects = f (Contracts, Organizations, ...)

Contracts, Organizations = f (Causes, ...)

Asset specificity, governance structures and transaction costs

0 kk1 k2

TC

Asset specificity

Market Hybrid Hierarchy

Econometric Analysis of Contracts and Organizations

Analyzing Effects or Causes?

Transaction Costs = f (Market, Hierarchy, Specificity...)

Market, vs. Hierarchy = f (Specificity, ...)

Models I (Sykuta 2005)

• Probit and Logit

• Y = 1/0 (e.g., contract, yes/no)

Models II (Sykuta 2005)

• Ordered Logit, Probit

• Y = 0,1,2 (e.g. Market, Hybrid, Hierarchy)

Models III (Sykuta 2005)

• Poisson, count data

• Y = 0,1,2, ,, (e.g. Number of trading partners)

Models IV (Sykuta 2005)

• Tobit Regression, censored data

• Y ≥ 0; 1≥ Y ≥0, ,, (e.g. Share of hired labor)

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

Some Examples

• Choice of Contract Types

• Hired Labor

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.

Lecture 5

Explaining and Evaluating Institutional Change

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

Institutional Change

L1

L2

L3

L4

often noncalculative, spontaneous10² to 10³

Embeddedness:Informal Institutions, Customs,

Tradition,Norms,Religion

Social Theory

FREQUENCY (YEARS)

PURPOSELEVEL THEORY

10 to 10²

get the Institutional Environment right, 1st order economizing

Institutional Environment:Formal Rules of the Game – esp.

Property (Polity, Judiciary, Bureaucracy)

Economics of Property Rights

1 to 10get the Governance structure right, 2nd order economizing

Governance:Play of the Game – esp. Contract

(aligning Governance Structures with Transactions

Transaction Cost Economics

Resource Allocation and Employment

(Prices and Quantities, Incentive Alignment) continuous

get the marginal conditions right, 3rd order economizing

Neoclassical Economics/Agency Theory

METHODS

(Historical) NarrativesCase studiesSimulations

Historical NarrativesCase studies

(Econometrics)

Case studiesEconometrics(Experiments)

EconometricsExperiments

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

Intentional Institutional Change

• Efficiency– Transaction cost reducing– Adoption to changing technology

• Interest and Values– Distributional advantages– Power– Preferences– Knowledge

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

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

Theories of Institutional Change

Evolutionary theories (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)

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.

Technical and Allocative Efficiency

Environmental goods

Production Possibility Frontier (PPF)

Consumables

Social Welfare FunctionA

BC

D

Pareto-Efficiency

Utility B

Utility Possibility Frontier (UPF)

Utility A

A

BC

DPareto-Improvement

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

„Invisible Hand“Emergence of Property Rights

MC

Specification of Property Rights

MB

MC

MB1

MB2

z.B. Demsetz (1967)

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)

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 DemocracyEconomic Theory of Collective ActionEconomic Theory of Bureaucracy

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

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.)

„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)

Normative Aspects of Economics

Distribution and Social Welfare

Institutions define what becomes Pareto-efficient I

Source: Vatn (2005, p. 215)

Institutions define what becomes efficient II

Source: Vatn (2005, p. 215)

Institutions define what becomes efficient III

Source: Vatn (2005, p. 215)

Institutions define what becomes efficient IV

Source: Vatn (2005, p. 215)

Institutions define what becomes efficient V

Source: Vatn (2005, p. 215)