The Transaction-cost Roots of Market Failure

1
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

2
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.

3
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.

4
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.

5
Literature review

• Firms serve to correct market failure.
• Coase (1937) explains
• the monopoly firms based on private property
  rights and managed administratively by the
  manager
• the state firm organized along public ownership
  and run by the government or a manager appointed
  by the government.

6
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.

7
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.

8
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.

9
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.

10
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.

11
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.

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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.

13
Externality

• Externality would not exist in the absence of
  transaction costs.
• Sources of transaction costs in relation to
  externality
• impossibility to define property rights
• technical constraints in the process of
  negotiations
• immeasurability of externality.

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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.

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Figure 1. Transaction costs under negative
externality
P
MCs
MCp
TC
MBs
0
q
16
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.

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Figure 2. Transaction costs under positive
externality
P
MCs
TC
MBs
MBp
0
q
18
Market power

• Private monopoly
• Organically grown monopolies
• Vertical mergers
• State-owned monopoly

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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.

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Figure 3. Transaction costs and market power
P
MC
p
DMB
MR
0
q
q
21
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.

22
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.

23
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.

24
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.

25
Complete market failure

• Continuous contractual opportunism causes
• Vertical integration
• Low-end equilibrium supply and demand cannot
  meet at all because consumers lose all trust in
  the buyer and demand is insufficient (or absent).

26
Opportunism

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

27
Opportunism

• 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.

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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.

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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.

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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.

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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.

32
Market failure and economic development

• High Market Economic
• Transaction Failure Underdevelopment
• Costs

33
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.

34
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.

35
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.

36
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.