Transactions Costs of Market
Exchange
Introduction
Using the market is costly
Imposes limits on the use of the market
Transactions costs arise because of
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mutual interdependence between upstream and
downstream units
inability to write complete contracts
incentives to cheat on the contract
 request a higher price if demand unexpectedly increases
 demand a lower price if the contract is to be renewed
 cheat on quality to increase profit margins
Contracts
Consider arms-length contracts
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no guarantee of renewal
essentially short-term
Important issues
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incompleteness
creation of relationship-specific assets
All transactions rely on some form of contract
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facilitates sequential trading
protects individuals from opportunistic behavior
Contractual incompleteness
A complete contract eliminates opportunistic
behavior
What does completeness require?
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identify all contingencies, the actions to be taken
in each case and agree outcomes
agreed forms of performance measurement
enforceable: observable and subject to rule of law
Contractual incompleteness
(cont.)
Incomplete contract leaves some
contingencies unidentified
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contingency cannot be imagined
cannot agree or articulate actions/responsibilities
All contracts are incomplete
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ambiguous language or open-ended
Three primary reasons
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bounded rationality
difficulties in performance measurement
asymmetric information
Bounded rationality
Individuals have limited ability to
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process information
deal with complexity
pursue rationality
Cannot imagine or identify all possible
contingencies
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complexity and information requirements are too
great
Performance measurement
Performance is not always easily measured
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processing speed on a computer
advertising quality
Input can be complex or subtle
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can involve trade-offs in particular dimensions
Ambiguity in language is inevitable
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“satisfactory”, “excess wear and tear”
can be circumvented by simple contracts
 Sage fishing rods
Asymmetric information
Parties to a contract not uniformly well informed
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private information
temptation to misrepresent or exploit private
information
Two basic forms
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hidden information: adverse selection
 information about cost, quality, performance e.g. used cars
 incentive to exclude reference to this from the contract
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hidden action: moral hazard
 actions that cannot be monitored but affect outcomes
 quality difficult to measure and affected by agents’ actions
Asymmetric information (cont.)
If quality cannot be measured and attention
to quality cannot be monitored: skimp on
quality
If quality is measurable but affected by
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buyer’s actions (installation)
random factors
Buyer has incentive to take less care if this is
unobserved
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car hire?
Cannot contract on unobservable
information/actions
Contract law
Underpins all contracts and recognizes
incompleteness: establishes general rules
But
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ambiguous and subject to interpretation
invoked by litigation: costly and loss of trust
has implications for reputation and future
contracts
 litigation-prone undermines reputation
Transactions with RelationshipSpecific Assets
A relationship-specific asset is created by an
investment intended to support a specific
activity
Transforms the relationship between the
parties
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ex ante: competitive bidding
ex post: bilateral bargaining
“fundamental transformation”: change from “large
numbers” bidding to “small numbers” bargaining
Asset specificity
At least four forms
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site specificity
 assets located side-by-side to increase efficiency
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physical asset specificity
 physical characteristics specifically tailored to the
transaction
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dedicated assets
 investment in plant and equipment to satisfy a particular
buyer
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human asset specificity
 individuals acquire skills, know-how specific to a
particular relationship
Rents and quasi-rents
Quasi-rent arises as a result of a relationshipspecific investment.
An example:
An example
A new factory is needed to supply a new client FlyByNight.
Cost of the factory:
I dollars per annum on mortgage: unavoidable cost
Capacity: 1 million units per annum
Unit cost of product C.
If contract falls through there is a bail-out option:
sell to TraderFred at price Pm.
Suppose Pm > C but 1,000,000(Pm - C) < I.
The factory should not be built unless the contract with FlyByNight is expected
to go ahead. Some of the investment is specific to this relationship.
Relationship-specific investment RSI = I - 1,000,000(Pm - C)
RSI is the amount of the investment that cannot be recovered if the contract
with FlyByNight does not go ahead.
Example (cont.)
Rent
Suppose FlyByNight contracts to buy 1 million units at price P* > Pm.
Rent = 1,000,000(P* - C) - I
Rent is just the annual profit expected if the investment goes ahead.
Rent and economic profit are synonymous.
Quasi-Rent
Suppose the contract with FlyByNight falls apart after the factory is built.
The product can be sold to TraderFred. Is this an option?
Yes, because Pm > C and so selling to TraderFred helps to defray the
sunk investment with its costs I.
Quasi-rent is difference between profit from FlyByNight and profit from
next best option: QR = 1,000,000(P* - C) - I - (1,000,000(Pm - C) - I )
= 1,000,000(P* - Pm)
The hold-up problem
Quasi-rents gives rise to a hold-up problem
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if there is no quasi-rent then the next best
alternative to the current contract offers the same
profit
if there is quasi-rent then the trading partner can
attempt holdup
attempt to renegotiate the terms of the contract
 because contracts are incomplete
 because the relationship-specific assets associated with
the contract create quasi-rents
The example (cont.)
Suppose: I = $8,500,000; P* = $12; Pm = $8; C = $3
Rent = 1,000,000(12 - 3) - 8,500,000 = $500,000 per annum
Quasi-rent = 1,000,000(12 - 8) = $4,000,000 per annum
Now suppose FlyByNight exploits a contractual loophole, after the
factory is built, to renegotiate the price down to $10
FlyByNight’s profits increase by $2,000,000, from the transfer of
quasi-rent.
The supplying firm is now making a loss of $1,500,000 but this is
still better than transferring to TraderFred.
But if the supplying firm anticipates the risk of hold-up then it may
decide not to enter into the contract in the first place.
The hold-up problem and
transactions costs
Holdup creates transactions costs
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contract negotiation and renegotiations
 initial negotiations will be time consuming
 remaining possibility of renegotiations with associated
costs and delay
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investment to improve ex post bargaining position
 acquire a stand-by facility
 second source
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distrust
 costly negotiation; underinvestment in the relationship
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reduced investment
 valuable exchange may not arise
Recap
Relationship-Specific Assets
Quasi-Rents
Holdup Problem
Transactions Costs
Transactions Costs and Vertical
Integration
Vertical integration (VI) is an alternative to
market contracts
Why should VI reduce the holdup problem?
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differences in governance
repeated relationship
organizational influences
Differences in governance
Powerful and flexible systems exist inside
firms to resolve disputes
Less formal contracting and more formal
authority
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management fiat
formal lines of control
Information is more extensive since it is
internal
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reduces problems of bounded rationality and
hidden information
Repeated relationship
Vertical relationship involves trading parties in
a repeated relationship
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less incentive for opportunistic behavior
 know that the relationship will continue
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more incentive to make relationship-specific
investment
 temptation to holdup is reduced
But not the only possibility:
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long-term contracting can achieve the same
benefits
Organizational influences
Common purpose across divisions
Creation of corporate culture
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teamwork
information sharing
Competition between divisions still exists
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adversarial relationships
competition for advancement
Senior management needs to balance
competition and cooperation between
divisions