1Transactions/Agency Costs Economics

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1Transactions/Agency Costs Economics
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2Perfect Competition

• When studying idealized perfect competition (when
  the invisible hand theorem applies), these
  assumptions are made
• 1) There are many buyers and sellers, each with a
  small share of the total market size.
• 2) The product of each firm is homogeneous.
• 3) Buyers and sellers have perfect information.
• 4) There is free entry and exit in markets.
• 5) There are no transactions costs.

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3Reality

• Though they facilitate analysis, each of the
  above assumptions can be challenged on how it
  reflects reality.
• We will deal with the violation of assumption 1)
  elsewhere.
• Violation of 5) is frequent. It is often caused
  by violations of 2), 3), or 4), but may be due to
  other reasons.
• Violation of 5) will be the subject matter of
  this section.

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4Definition

• Defn Transactions costs are costs associated
  with acquiring an input that are in excess of the
  amount paid to the input supplier (Coase).
• Obvious examples Insurance, freight, damage, own
  time.
• Other important examples cost of searching for a
  supplier willing to sell a specific input,
  negotiations costs incl. legal costs, costs of
  maintaining assets required to engage in the
  transactions.

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5At Arms Length

• Defn An arms length transaction occurs when
  autonomous parties exchange goods or services
  with no explicit or implicit agreement that the
  relationship will continue into the future.
• Examples Purchasing at WalMart, staying at Best
  Western for a night.

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6Contracts

• Defn A contract is a legal agreement which
  defines the conditions of an exchange or series
  of exchanges.
• Examples Bank loan, futures contract, marriage,
  etc.
• Defn An incomplete contract is one in which not
  all contingencies have been explicitly accounted
  for (note, a contract is like a computer program,
  with if-then-else statements). It might also be
  thought of as a mathematical function.
• Examples Disputes in contract law,
  hedge-to-arrive.

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7Specialized Investments

• Defn A specialized investment is an expenditure
  that is made to allow two parties to make
  exchanges, but has less value in alternative
  uses.
• Examples Insuring assets (life or crops) when
  taking out a loan, building trust with a
  supplier/customer, quality control investments
  required to access international markets (food,
  toys, etc.).
• Defn A relationship-specific exchange is one
  that occurs when both parties to the exchange
  have made specialized investments. These
  investments are called relationship-specific
  investments (RSIs).

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8Usefulness of SIs

• SIs generally promote economic efficiency
  (increase the welfare of society) in that they
  identify collaborations between firms that reduce
  the cost of producing the same amount of goods or
  increase the amount of goods produced by the same
  level of resources or do a bit of both
  (supply/demand graphs).
• They are probably good for the firms in question
  because the firms would likely not make the
  investment otherwise.
• Problems may arise because SIs create
  vulnerability.

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8aForms of Specialized Investments (SI)

• Site specificity Here, assets are situated
  side-by-side.
• Examples Grain elevators and rail-spurs, coal
  mines and power plants, processes in steel or
  wine production.
• Physical asset specificity Here, the physical/
  engineering/chemical properties of the asset are
  tailored to a given set of transactions.
• Examples Dyes and molds, some genetically
  modified organisms, software products.

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9Forms of Specialized Investments, Contd

• Human asset specificity Here, the SI is human in
  nature.
• Examples Skill acquisitions, building trust.
• Dedication is another dimension to SI. A
  dedicated asset is one that would be a complete
  write-off it the transactions in question were
  cancelled.
• Example ISU Big 12 Champs 2000 printed before
  the final if we lost.
• There are other types of specificities, and some
  investments may express multiple forms.

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10Rent and Quasi-Rent

• Defn Economic rent (i.e., economic profit) is
  the difference between the profit a party to an
  exchange actually receives and the profit the
  party must receive to make the exchange
  economically profitable (accounting for owned
  resources opportunity costs).
• Defn Quasi-rent is the difference between the
  profit a party to an exchange receives and the
  profit she must receive in order for her to
  remain in the exchange (think of sunk costs
  here).
• These may arise when contract renegotiations
  directly benefit one party at the expense of
  other parties (over a barrel), or when conditions
  change.

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11Example A Statistician

• A statistician writes a module for a computer
  software package, which is upgraded every two
  years.
• Statistician cost data are
• Fixed one-time setup costs 20,000
• Updating costs every two years 8,000
• Interest rate per year 12

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12Statistician Costs

• On an annual basis, we have
• Capital opportunity costs 2,400
• Upgrade costs 4,000
• Reward required to enter contract 6,400
• If the software company offers 7,000/year in
  perpetuity, then economic rent (economic profit)
  is 600/year.
• Fixed costs are a specialized investment.

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13Holdup/Opportunism

• After fixed costs are sunk, the statistician must
  receive 4,000/year to justify doing the upgrade.
• If the software company offers 4,000/year, then
  the economic profit is -2,400/year.
• At 7,000/year, the quasi-rent is 600 2,400
  3,000/year. Knowing the statistician wont
  leave, the software company can renegotiate to
  appropriate this quasi-rent.
• This is what is called opportunism or holdup.

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14Holdup, more Formally

• Defn Hold-up involves opportunistic behavior by
  one party to an exchange who tries to extract the
  quasi-rents of another party.
• Quasi-rents arise from specialized investments,
  and creates ties between parties.
• Examples Bauxite ore is refined to alumina near
  a mine (site specificity). After a refinery is
  put near a mine, the mine owner may increase ore
  prices to extract the quasi-rents. Kids and
  candy at store. Rock and hard place.

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15Fundamental Transformation

• Defn A fundamental transformation is the change
  in the nature of a relationship that arises when
  specific investments change the situation from a
  large bidding situation to a small number
  bargaining situation.
• Example For an independent food store or hog
  producer, this may happen when it enters into a
  contract. The contract may relieve a party of
  some duties (e.g., marketing) and these functions
  may decay over time until the firm is not
  confident about being independent again.

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16Notes on Contracts

• They are almost essential for a private ownership
  economy to work. In E. Europe, establishing
  contract law was a critical issue post 1991.
• They promote efficiency by reducing the risks
  that resource owners face when doing business.
  This encourages useful investments.
• They facilitate sequential activities. Often in
  business, things do not occur simultaneously,
  e.g., costs arise before consumers buy the
  product. Hold-up may result without contracts.

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17Notes on Contracts, Contd

• For contracts to work well, the Judiciary must
  not be either corrupt or incompetent.
• To the extent that contracts are limited by law,
  the law should be geared (at least partly) to
  promote economic efficiency (Coase, Posner, Bork,
  Breyer). Insider trading example.
• Especially outside the U.S., laws are often
  insensitive to economic implications.

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18Incomplete Contracts

• Complete contracts eliminate the possibility of
  holdup.
• Often where contracts are silent, contract law
  applies. These are standard assumptions about
  profit, asset ownership, liability, etc. In all
  states but Louisiana, the Uniform Commercial Code
  (UCC) tries to fill in incomplete contracts.
• So why are contracts incomplete?

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19Why Incompleteness?

• To complete it, parties must
• a) be able to identify all relevant possibilities
  during the duration, then
• b) agree on what action to take, and by whom, in
  each possible scenario, then
• c) be able to outline what constitutes
  satisfactory performance, and
• d) measure that performance, and
• e) enforce the contract.
• On e), crime organizations have very effective
  informal contracts.

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20Incompleteness Examples

• Example A fruit grower contracts to deliver x
  apples/year at y/box for five years. Then the
  EPA bans azinphosmethyl, a very important
  insecticide in many regions.
• Is it reasonable to expect to be able to foresee
  all such events?
• If renegotiations do not raise the price, the
  supplier may go bankrupt. Might the packer be
  willing to renegotiate?

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21Biotech Litigation

• See overhead.

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22Problems with Achieving Completeness

• Bounded rationality The world is complex and
  stochastic. Parties cannot identify all
  contingencies.
• What is deemed satisfactory? Measurement issues.
• Asymmetric information Not all parties have
  equal access to information
• hidden action problems
• hidden information problems

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23Information Asymmetry

• Hidden actions (moral hazard) arises when a party
  in a relation cannot observe all relevant actions
  of the other parties
• health insurer and exercise/drinking,
• landlord and cost sharing with a sharecropper.
• Hidden information (adverse selection) arises
  when a party in a relation does not know all
  relevant information
• life insurer and family health history,
• rare species on your land, so you sell.
  Purchaser doesnt ask (caveat emptor).

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24The UCC (Filling Gaps)

• The UCC provides default specifications for many
  items that might be omitted in contracts.
  However,
• it is often vague. What is reasonable or
  acceptable?
• when applied, it can be unfair to a party in
  those particular circumstances
• recourse to it often reduces trust. For dynamic
  reasons, firms may avoid it even if they gain in
  that instance.

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25Example Transformations and Specific
Investments

• U.S. Auto companies outsource many parts.
  Contracts are often annual, and renegotiated
  annually.
• Fixed costs of design and molding man be high.
• Specific investments for both parties increase
  over time.
• These investments tend to bind companies
  together. There may be a fundamental
  transformation.

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26Example, Contd

• Either party may leave if negotiations become too
  difficult, but neither wishes to unless there are
  good alternatives.
• Bargaining may be fierce as both parties try to
  snatch quasi-rents.
• Information is power, and suppliers may be
  reluctant to give cost information to the
  auto-maker. Information may be used in
  bargaining.
• But coordination is difficult without trust.

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27Holdup and Transactions Costs

• If the potential for holdup exists, then
  renegotiations become more detailed, protracted,
  expensive. Care about contingencies clauses.
• There will be (socially unproductive) investments
  to improve ex-post bargaining positions.
• Dairy farmers and back-up generators
• Thatcher and the miners, key pro-athletes

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28Holdup and Investments

• We have noted that Holdup discourages RSIs
  because RSIs create quasi-rents that are
  vulnerable to appropriation.
• So RSIs fall but unproductive investments rise.
  There is too much of the wrong and too little of
  the right type of investment.
• The problem could be removed by vertical
  integration (making).

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29Effects of Vertical Integration (VI)

• It alters control structures. Hidden information
  and hidden action problems are reduced.
• Repeated interactions improve trust and
  coordination.
• The integrated firm has a common set of goals.
• But remember the problems with making.

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30Contract Length Graphs

• Good contracts reduce transactions costs, holdup
  risks, and unproductive investments. They
  encourage RSIs.
• Contracts of long duration encourage more RSIs,
  but are more difficult to write because it is
  harder to specify all contingencies, e.g., oil
  price rise, new technology, etc.
• Thus, there is a RSI/complexity trade-off.

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31Contract Length Graphs, Contd

• Assume, reasonably, that the marginal cost of
  writing a contract increases with duration.
• It is harder to stylize marginal benefits. Lets
  say they are constant.
• Then we have the usual supply/demand situation,
  Baye TM 82.
• Now what if the product requires more RSIs? The
  marginal benefit would increase, Baye TM83.

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32Contract Length Graphs, Contd Further

• What if there is an increase in the complexity of
  the environment because of technical changes? In
  biotech, this might have been the case recently
  Baye, TM 84.
• Suppose that the contracting environment is very
  complex. Contract duration may be very short.
  The cost of rewriting may be large, and so may
  RSI inefficiencies. VI may then be preferrable.
• The decision process might be as follows, Baye TM
  85.