Kanishka Kacker
University of Maryland, Department of Agriculture and
Resource Economics
June 25 th 2010

• Joskow (1985): “Long-term (nominal) fixed-price contracts are simply not credible in a market like this, and I would not expect them to be used extensively”
• Hart (2009) Proposition 1: “(Price) Indexed contracts are strictly superior to nonindexed
contracts”
• “(This) result is consistent with Joskow’s finding that price indexation is a common feature of contracts between
suppliers and buyers of coal”

These assertions are contradicted
Coal transportation rate database, Energy Information
Administration, USA
In 1980 the dominant contract form specifies a
Base Price with escalation clauses built in …
…In 2000, this is no longer true
Fixed Price contracts account for approx 50% of contracts

• Are these buyers (Power Plants) and sellers (Coal
Mines) being silly?
– Herbert Simon (1951): “Human behaviour is
intendedly rational, but only limitedly so”
• Who cares about coal anyway?
– Wide variation in governance forms at a point in time
(Joskow, 1987)
– Environmental regulation  alters governance structure over time  underlying motivation

500 000
450 000
400 000
350 000
300 000
250 000
200 000
150 000
100 000
50 000
0
Production (thousand short tons) (y)
Appalachia
Interior
Western
1986 1991 1994 1997
…production of
Western Mines increases rapidly

Number of Mines (n)
4 500
4 000
3 500
3 000
2 500
2 000
1 500
1 000
500
0
1986 1991
Appalachia
1994
Interior Western
1997
…so average mine size increases overall, but the increase for Western mines is massive
350
300
250
200
150
100
50
0
…while the number of mines declines overall,
Appalachian/Interior mines fall by a greater amount…
7 000
6 000
5 000
4 000
3 000
2 000
1 000
0
Average Mine Size (thousand short tons) (= y/n)
1400
1200
1000
800
600
400
200
0
1986
Western
1991 1994
Appalachia
1997
Interior

• 1990 Clean Air Act Amendment
– Established permit trading program for Sulfur Di-
Oxide
– Total emissions capped
– Constraint set to bind in 2 phases
• Phase I (begins 1995) targets the dirtiest 110 coalburning power plants
• Phase II (begins 2000) new restrictions on cleaner plants, older restrictions tightened

– Given significant investment in relationship-specific capital, repeated bargaining is unattractive
– Hold-up problem: “Sunk” investments create opportunities for haggling ex-post
• Discourage investment ex-ante
– These opportunities need to be mitigated to allow for
(efficient) trade
– A long term contract is the instrument through which this mitigation is carried out

• Williamson (1985): governance form varies according to
– Asset Specificity
– Uncertainty
– Frequency

• Contract duration = F (Site Specificity, Physical Asset
specificity, Dedicated Assets)
Site specificity = “Mine-mouth” Power Plants
Physical asset specificity = Boiler specification for different kinds of coal
Dedicated assets = Coal quantity
Joskow interpretation: Williamson theory should predict F
1 inverse U shape
>0, F
2
>0, F
3
This is what he finds

Contract duration =
F ( Site Specificity , Physical
Asset specificity , Dedicated
Assets )
F
1
>0,
“Site
Specificity”
F
2
>0,
F
3 inverse U shape
“Dedicated
Assets”
Physical
Asset
Specificity

• Power plant engineers begin to alter boilers to burn
Western coal
• Changing boiler technology  asset more generic  decreased physical asset specificity  lessens incentive to engage in long-term contracts

Revisit earlier model: Does the prediction of declining asset specificity hold up?
• Contract duration = F (Site Specificity, Physical Asset
specificity, Dedicated Assets)
• Want a reduced coefficient for physical asset specificity…
• Will take data from 1990 to 2000, and divide into two time periods 1990 - 1995 and 1995 – 2000

Joskow: Mine

• We have evidence of a buyer (power plants) looking to alter a technology to accommodate a changing supplier (coal mine)
=> Following transaction cost theory (Williamson
1985), physical specificity is reduced  less incentive to engage in long term contract
• The only assessment allowed by this theory is a comparative static one

• Why is this important?
– Examine how contracts work , not “make or buy”
– Klein (2004) talks about examining changes in contractual arrangements to changing circumstances
– “Contracts as reference points” theory predictions flatly contradicted by data on coal contracts
• Most theorizing has taken a static viewpoint
– Che and Sakovics (2004) explicitly talks about a dynamic theory of hold-up
– Admitting dynamics, they find hold-up need not entail underinvestment
• Dynamics of contractual change need to be understood
• Through the effects of regulation on contractual arrangements

• Dataset of contracts that capture buyer-seller interaction at a time when both experience significant shifts
• Evidence of altered contractual arrangements in line with a comparative static prediction of transaction cost theory
• Explicit characterization of dynamics underlying contractual shifts (following from regulation) is what is needed