The Transaction-cost Roots of
Market Failure
Tamara Todorova
Department of Economics
American University in Bulgaria
“Social Sustainability through Competitiveness
with Qualitative Growth”
16th International Conference
Sofia University
18-19 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
P
MCs
MCp
TC
MBs
0
q
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
P
MCs
TC
MBp
0
MBs
q
Market power

1)
2)

Private monopoly:
Organically grown monopolies
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
P
MC
p*
D=MB
MR
0
q*
q
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 propertyright 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 integration
2) 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

1)
2)
3)
Self-interest seeking:
weak – obedience, altruism
semi-strong – simple self-interest
seeking, ordinary market game and
favorable behavior
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
Transaction
Costs
Market
Failure
Economic
Underdevelopment
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.

Public goods, public ownership
and the role of the state



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
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.