Economics 103Lecture # 18

Transaction Cost Economics

We’ve examined a powerful model, but there are some unanswered questions.

When I go skiing at Cypress Bowl, how come I face

A line up means there is excess demand. Why does the price not increase?

We’ve mentioned before, every classroom has

Unemployed, or underemployed, resources imply a surplus, why don’t prices adjust in order to eliminate the surplus?

We’ve seen how great prices are in allocating resources and explaining behavior, but think of all the times prices are NOT used.

You don’t bid for:

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When you go work for a firm, your boss isn’t going to use prices to tell you what to do.

Professors can only wish grades were distributed this way.

There are just lots of instances in life where we either ban the use of prices (kidneys) or we simply choose not to use them.

What explains this?

Finally, we all know that in life cheating happens all the time.

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People goof off at work.

The point is, in the model we’ve examined so far, these types of things should never happen.

We’ve been assuming prices work for free.

A theoretical device is to assume there is an imaginary auctioneer out there who knows everything, and calls out all the magic prices to equate Supply and Demand.

But we are really assuming that everyone knows everything.

So, what happens, if we don’t know everything?

Let’s start by looking at an implication of Omniscience.

Suppose a rancher and a farmer know everything.

Unfortunately, even though they know everything, they haven’t figured out how to build a fence yet.

So the problem is the cattle tend to trespass on to the corn farm and eat the corn.

Suppose there are two worlds:

World 1: The rancher is liable for the damage.

World 2: The rancher is not liable for the damage done by the cattle.

Will the number of cattle be different in either world?

The amazing answer is …. NO!

Suppose the relation between Cattle and crops is given by

Suppse the rancher is not liable, and decides to have 6 cows.

172

114

66So we would end up with 3 / 4 cows.

But what if the rancher was liable, and the farmer got to decide how many cows should be on the ranch. He might decide only one should be there.

21048

6 6

So once again you end up with 3 / 4 cows.

Maximizers, when they know everything (namely the table), maximize wealth, regardless of the rule of liability.

3 / 4 cows gives the highest joint wealth.

So in our neoclassical model, the rule of law is irrelevant. The allocation of cows is independent of the liability.

We’ve actually seen this argument several times this semester:

As long as MC and MV are different, people will trade, and they end up at the equilibrium where wealth is maximized

The only thing that matters is the direction of the payments.

It turns out that this result is completely general, and it has a name.

To translate into our cow case we would say the number of cows doesn’t depend on who is liable, if they both know everything.

Clearly we have to define what we mean by property rights and transaction costs.

The Coase Theorem is named after the brilliant economist, Ronald Coase.

The key to understanding the significance of the Coase Theorem, is to understand the ideas of property rights and transaction costs.

Before we do this, however, lets do another example in the context of our neoclassical model.

Married couples fight, and sometimes the disagreements end in divorce.

Prior to 1968: fault divorce / mutual.

After 1968: no-fault divorce / unilateral.

Some would consider the following grounds for divorce.

However, in Canada, the grounds were just abandonment, criminal behavior, and adultery.

In two provinces you needed an act of Federal Senate.

After 1968, one of the parties could just leave.

What would the Coase theorem predict should have happened to the divorce rate.

Nothing. Consider the following stylized example:

Who wants to divorce?

Should they divorce?

Under the old fault/mutual law, the husband would have the “right” to decide if the divorce takes place.

Under the new no-fault/unilateral law, the wife would have the “right” to decide if the divorce takes place.

What is the outcome, if they can freely bargain?

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But what actually happened?

USA CANADA

Clearly, the Coase Theorem is empirically incorrect.

This was the point Coase was trying to make.

Clearly, the condition for this to hold, ZERO TRANSACTION COSTS, must be violated.

The rules of the game matter.

- property game.

Rules matter because transaction costs are positive.

But what are transaction costs?

Why might a marriage break down? Ie. why might the couple not be able to negotiate around problems?

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These issues are examples of transaction cost problems.

Let’s start by asking “What are Property Rights”.

A)

B)

C)

Different people use the phrase PR in different ways.

They certainly are not the same thing.

I like to think about them in terms of the following diagram:

A – breathing air

B - abortion

C – Sik right to concealed weapon – polygamy in bountiful

D – walking in central park 1am. – not to be date raped.

E – drive a stolen car – stealing my textbook!

F – abortion in PEI

G – sell pot in store in Vancouver

Think of all the different choices you might make with respect to an asset.

A property right is a bundle of these decisions.

The extent of your PR depends on what is in the bundle, and how effective you are at carrying out your choice.

If you have perfect property rights to something, then you can freely and effectively make all the decisions wrt the asset.

But we never have perfect property rights.

Do you remember:

“Who owns this body?”

Think about something you consider you “own.”

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Why are your property rights not perfect?

1. Because someone else owns the right.

2. Because it isn’t worth it to police the right you legally have.

Two Key Points:

1. No Property Rights

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2. Perfect Property Rights Coase Theorem Wealth maximized.

- this is what we’ve been assuming all along.

So we have a spectrum of rights

We always want to establish and maintain Property Rights as long as the Benefits > Costs.

Think of all the ways you try to protect and maintain your PR.

So, we are finally ready to define Transaction Costs.