The Transaction-cost Roots of Market Failure

Tamara TodorovaDepartment of EconomicsAmerican University in Bulgaria

“Social Sustainability through Competitivenesswith Qualitative Growth”16th International ConferenceSofia University18-19 October 2013, Sofia, Bulgaria

Market failure defined

Bator (1958) - “the failure of a more or less idealized system of price-market institutions to sustain “desirable” activities or to stop “undesirable activities” where by activities he means consumption and production.

studies market failure strictly from the viewpoint of Pareto efficiency.

The existence of market failure is thus seen as a possibility for improvement, i.e., making someone better off without hurting someone else.

Market failure defined

The failure of the market to allocate resources optimally, i.e. to their best use and best value, due to the presence of some inherent obstacles to or defects of market exchange.

Literature review

Coase (1937) – markets are not costless and transaction costs are always positive in the real world.

The very presence of transaction costs speaks for the imperfections and frictions of the market as a resource allocation system.

Firms are administrative structures which substitute the market when the costs of using it are excessively high.

Literature review

Firms serve to correct market failure. Coase (1937) explains:1) the monopoly firms based on private

property rights and managed administratively by the manager;

2) the state firm organized along public ownership and run by the government or a manager appointed by the government.

Literature review

Coase (1937) hints at market power in that large firms are associated with higher transaction costs, while small firms are associated with lower.

Coase (1960) reveals the problem of externality where there will be no externality problem in the absence of transaction costs.

Literature review

Arrow (1969) relates market failure to transaction costs.

“The distinction between transaction costs and production costs is that the former can be varied by a change in the mode of resource allocation, while the latter depend only on the technology and tastes, and would be the same in all economic systems.”

Literature review

Transaction costs vary from system to system.

Arrow (1969) stresses that collective action and the coercive power of the state can serve to economize on transaction costs;

hints at complete market failure where supply and demand cannot meet at all.

Literature review

Toumanoff (1984) relates market power and externalities to transaction costs but does not see market failure as an inefficiency of the market.

Correct on relating transaction costs to some types of market failure but wrong in the general treatment and understanding of market failure.

Literature review

Williamson (1971) – due to its “transactional failures” the market is substituted by vertically integrated firms.

Vertical mergers could result in market power.

Transactional opportunism leads to vertical integration and market power.

Literature review

Opportunism is a strong form of self-interest seeking in market dealings.

Williamson does not discuss opportunism as the general reason for complete market failure and a low-end equilibrium.

Transaction costs as the roots of market failure

All forms of market failure can be attributed to transaction costs as the costs of market operation.

The transaction-cost roots of market failure have been studied poorly and partially. No general transaction-cost theory of market failure.

Externality

Externality would not exist in the absence of transaction costs.

Sources of transaction costs in relation to externality:

1) impossibility to define property rights;

2) technical constraints in the process of negotiations;

3) immeasurability of externality.

Negative externality

Social costs exceed private costs. Equilibrium is on the right of Pareto

optimum. Difference represents transaction

costs. Society bears transaction costs at

the expense of the individual private agent.

Figure 1. Transaction costs under negative externality

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0

MBs

MCs

MCp

TC

Positive externality

Social benefits exceed private benefits.

Equilibrium is on the left of Pareto optimum.

Difference represents transaction costs in the form of exclusion costs.

The individual bears the transaction costs to the benefit of society. Society is a free rider.

Figure 2. Transaction costs under positive externality

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0

MBs

MCs

MBp

TC

Market power

Private monopoly:1) Organically grown monopolies2) Vertical mergers

State-owned monopoly

Market power

Coase (1937) explains all types of monopoly.

With zero transaction costs the market exchange would occur at the competitive outcome.

With significant transaction costs leading to private monopoly equilibrium is left of Pareto and the outcome is the monopoly outcome.

Figure 3. Transaction costs and market power

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P

0

MC

q*

MR

p*

D=MB

Market power

Transaction costs explain large firms, how they have grown naturally through the competitive market process.

Transaction costs explain state-owned monopolies – why the state undertakes to provide goods and services no private agent wants to provide because the market does not pay him to do so.

Both are forms of collective action. Both serve to save on transaction costs.

Market power

Natural monopoly and increasing returns to scale as a technical phenomenon (Arrow, 1969).

Natural monopoly does not seem to have transaction cost roots as it does not represent market failure.

Why is a natural monopoly state-owned in one country and privately owned in another?

Different resource allocation and property-right systems seem to be associated with different levels of transaction costs.

Market power

Too costly for customers to form a coalition and undertake collective action against an opportunistic monopolist.

Excessive deadweight social loss, monopoly rents, rent-seeking and opportunism with monopolies in high-transaction cost systems.

Market power

Transaction costs present, it is harder to regulate private monopolies.

The state and public ownership can save on transaction costs in societies faced with sizeable transaction costs. Alternative economic systems operate under different levels of transaction costs.

Complete market failure

Continuous contractual opportunism causes:

1) Vertical integration2) Low-end equilibrium – supply and

demand cannot meet at all because consumers lose all trust in the buyer and demand is insufficient (or absent).

Opportunism

Efforts to hide or distort information, mislead, disguise, obfuscate, or confuse the commercial partner on both sides of the transaction.

Opportunism

Self-interest seeking:1) weak – obedience, altruism2) semi-strong – simple self-interest

seeking, ordinary market game and favorable behavior

3) strong – opportunism, excessive, appropriating the quasi-rents of the partner taking advantage of his asset specificity, bounded rationality and uncertainty.

Asymmetric information

Misrepresented quality - the seller may convince the buyer that the product is of higher quality than it really is.

Adverse selection - “lemon” products drive good products out of the market.

Moral hazard – the probability of a party to a transaction to shirk, i.e. not observe the terms of exchange, once those terms are settled while the other party cannot observe that. Negligent and risky behavior.

Asymmetric information

Akerlof (1970) – bad-quality products drive good quality products out of the market causing thus complete market failure.

Barzel (1984) – costs are dedicated to measuring, testing and verifying quality. These are, in effect, transaction costs.

The costs of insuring against market risks, deviant behavior and transactional opportunism are essentially transaction costs.

Opportunism

Opportunism as a regional, racial or national trait – societies and cultures which are opportunistic and where self-interest seeking is excessive are more prone to market failure where market failure is the cause of economic underdevelopment.

There should be some trust in market dealings and self-interest seeking should be moderate in order for the market to function smoothly.

Market failure and economic development

Inability of neoclassical economics to explain market failures in EE and the failures of transition, as transaction costs are ignored.

New institutional economics and transaction-cost theory in particular help explain the misfortunes of transition.

Absence of a coherent theory of transitional failures.

Market failure and economic development

High Market EconomicTransaction Failure UnderdevelopmentCosts

Public goods, public ownership and the role of the state

Courts, in effect, allocate economic resources.

Indirect role of the state – defining and enforcing property rights.

Pigouvian approach to resolving externalities.

Direct role - the state as a sole owner of environmental, common-pool or common-access resources with negative externality.

Public goods – as a solution to positive externality and exclusion costs.

Public goods, public ownership and the role of the state

Public goods, public ownership and the role of the state

State ownership of natural monopoly in high-transaction cost systems.

State ownership of sectors, industries and spheres of life facing sizeable transaction costs.

Conclusions

Since private property is the instrument by which free markets work, all types of market failure can be attributed to private, rather than public, property.

All types of market failure can be traced to or explained with transaction costs.

Some economic systems are more prone to market failures than others due to higher transaction costs.