1.3 Transaction Costs and Institutional Analysis Flashcards Preview

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Flashcards in 1.3 Transaction Costs and Institutional Analysis Deck (14):

Please, define what an economic transaction is according to Williamson and what an economic transaction is according to Commons – what are the differences between the two definitions and what are the implications of either definition for the study of economics? (slides)

Market transaction costs consist mainly of information and bargaining costs!

NIE believe that economic transactions are a special kind of social transaction. Social actions are necessary for the formation and maintenance of the institutional framework in which economic activity occurs.

An economic transaction according to Williamson, “occurs when a good or service is transferred across a technological separable interface. One stage of activity terminates and another begins”.

According to that, a transaction is when resources are delivered and does not care if was a transaction with ownership or not. It is more related to the production concept. And because transactions imply interdependent but separable technology activities, there is a need for coordination (Institutions).

According to Commons, “transaction is the alienation and acquisition between individuals of the rights of future ownership of physical things”. A transfer of resources in the legal sense of transfer of property rights. That means that a transaction only occurs when there is transference of ownership.

There are implications of either definition for the study of economics. Williamson describes transactions in more general sense, but according to Connors a transaction occurs only if there is transfer of property rights. To value a transaction, it is important to recognise if its occurs or not and that also depends on the definition considerate.  It may be subjective than to evaluate if one transaction happened or not according to the definition assumed.

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Please, indicate which of these transactions are transactions according to Commons, and which ones are transactions according to Williamson, and which ones are both or no transactions at all. a. A farmer harvests hay and brings it into his warehouse to dehydrate it. b. A farmer sells corn to a buyer. c. A farmer applies fertilizer to his land d. A farmer rents his land to another farmer e. A farmer buys drought insurance for this harvest. (slides)

a. A farmer harvests hay and brings it into his warehouse to dehydrate it.

Transaction according to Williamson because the dehydration of the harvest is another stage in the production cycle.

b. A farmer sells corn to a buyer.

Transaction according to Williamson and Commons – there is production and transference of ownership

c. A farmer applies fertilizer to his land.

Transaction according to Williamson – related to the production and there is no property rights involved.

d. A farmer rents his land to another farmer.

Transaction according to Commons – there is transference of ownership.

e. A farmer buys drought insurance for this harvest.

This is a transaction according to both Williamson and Commons, because is represents a measure to minimize costs in the production and thus, directly impacts the production. On the other hand a service is purchased and thus property rights/ownership transferred


Please, define transactions costs. What are direct types of transaction costs, what are indirect transaction costs, what are variable transaction costs, what are fixed transaction costs? Please, provide several examples for each category. (slides)

There are many definitions for Transaction Costs. But they are basically the “resource spent on initiating, negotiating, safeguarding, monitoring, enforcing and adjusting transaction” (Dahlman, 1970). Transaction costs emerge because actors need to coordinate for production/consumption.

Variable transaction cost depends on the size and frequency of transaction.

Fixed transaction cost is the specific investments made in setting up and maintenance of institutional arrangements.


What are factors that influence the amounts of transaction costs of different types, ex-ante and ex-post? (slides)

The factors that influence the amounts of transaction costs are:


  • Search and information costs (supplies, customers, producs, …/ about quality, price…)

Depends on the function of the distribution of information and the information and communication technology available.

  • Negotiation and decision making costs (time and resource spend on decision making, cost of wrong decision – bounded rationality)

It will be influenced because there are differences in preferences, number of people involved and the decision make rule.


  • Monitoring and Enforcement Costs (identification of non-compliance with the rules)

It will be influenced by (has the function of) the measurability and verifiability of activities and the monitoring and enforcement technology.

  • Adjustment costs (endogenising institutional choice) – (adjusting the rules to changing environmental circumstances, costs of adaptation – losses/indirect TC)

It will be influenced (has the function of) uncertainty and the flexibility of rules.


How does the proposition of achieving optimal search and monitoring activities relate to other ideas about how institutions structure human interaction, e.g. bounded rationality? (slides)

Achieving optimal search and monitoring activities is related to the costs for the search for information and the monitoring activities. They will be influenced by the distribution of information, the communication and technology available, how they can be measurable, verified and the use of enforcement technology. The concept of bounded rationality is present, because are cost for making the wrong decisions, being wrong or having just part of the information (if the information is incomplete there will be market uncertainty, that will also influence on the decision making process, and there will be costs).

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Please, provide examples of categories of transaction costs, i.e. market, firm’s and political transaction costs. How do they interrelate, if they do? Do they depend on each other? Why? (slides; Furubotn et al. 2003)

There are three different categories of transaction costs:

Market Transaction Cost

Are the costs of market organization - include the searching and information costs; preparation, bargaining and decision; supervision/monitoring/controlling; enforcement; adjustment.

Transaction costs in firms (managerial TC)

Are the fixed and the variable transaction costs.

Fixed: Costs of firm organization and change, personnel management, investments in information technology, lobbying, public relations…

Variable: Costs of running organization  - Information costs (decision making, monitoring, execution of orders)

- Coordination costs of transferring semi-finished products within firm (Williamson): intra-firm transport, “just-in-time”, quality control…

Political transaction costs

– Costs of supplying public goods; e.g. costs of the establishment and maintenance of a political order (legal framework, administrative structure, the judiciary…)

– Costs of running a polity: Decision making, implementation, administration, enforcement by administration; also costs of political parties, labor unions, employer‟s associations, pressure groups.. 

The transaction costs are, essentially, the costs of specialization and the divisor of labour. The resources needed for transaction purposes have to be financed and transaction costs bind financial capital. All the three categories will be included on the this transaction capital - because the capital investments required for the setting up of markets, forms and polities required for the running of the market and political systems (Furubotn et al. 2003).

To a certain extent, both managerial and political transaction costs can be interpreted as agency costs, or the costs that arise in a principal-agent relationship. And assuming that opportunism behaviour exist, the agent will no always act fully in the interest of the principal. In the three levels, it will also depends on the behaviour of individuals. That means that social morality, confidence, trust and the institutional framework are all interrelated (Furubotn et al. 2003).


Why do we want to measure transaction costs? (slides)

We want to measure transaction costs because they affect the existence and intensity of exchange on the market and high transaction costs policies may need to be further scrutinized (better evaluated) on the policy making process.

  • ­ transaction costs affect the existence and intensity of exchange in the market
  • ­ in policy making policies with high transaction costs may need to be further scrutinised

Transaction costs affect markets, reduce market inefficiency (existence and intensity of exchange). Some transactions may not take place because of high costs. High transaction costs in policy making have to be further analyzed. Basis for changing something in the policy or in the value chain of a firm. Measurement forces to examine which are transaction costs and which are not. According to the economic theory welfare is maximized when consumer and producer surplus is maximized. This is the case when marginal cost of a good is equal to the marginal benefit of a good. If we do not know the Tc it is not possible to identify the efficient outcome since we don’t know the exact prices or values of various goods. And since theory is the basis for policy we cannot apply the appropriate policies.

Market TC: Brooke, stock exchange, difference in selling and buying price

Advertisement TC of firms: Management, administration accounting

Political TC: government, courts, police, interest groups


How can we measure transaction costs? Please, explain direct and indirect ways to measure transaction costs and use examples. (slides)

For measuring  transaction costs we can use direct and indirect ways.

Indirect measurement

– Difference between buying and selling price (e.g., SO2 markets, stock markets)

 – Difference between production costs per unit and selling price

– Differences of prices across countries for identical products 

Direct measurement (it also allows for non-market TCs)

– Aggregated level (Wallis & North): distinction between transaction (commercial banking, real state, legal, technical, information management services…) and productive sectors 

– Micro level (Benham & Benham, Soto)

• Market prices for legal, financial, accounting, information management services

• Price of information (commercials, contact databases…)

• Interviews with contracting parties, employers, employees

• Experiments

• Budget (organization): Focus on specific accounting lines that are associated to transaction costs (legal, financial, technical service fees, information gathering and management expenditures,  

• Costs of entry (setting up a business)


What may be problems of taking the difference between buying and selling price (e.g. for product that is marketed by a retailer) as transaction costs? (slides plus your own, well-justified arguments)

The problems of taking the difference between buying and selling price are related of the problem of subjectivity. The transactional costs will be a perceived or a real. The perception of individuals is different and that affects the measurement of costs. For example the farmer who sells wheat will report the transaction costs or who is buying it?

Estimation is problematic because production and transaction costs are jointly determined. This leads to formidable difficulties in estimating transaction costs separately.  Economic theory suggests that changes in transaction costs have a first order impact on the production frontier.  Lower transaction costs mean more trade, greater specialization, changes in production costs, and increased output.  Changes in production costs likewise have an impact on transaction costs (Benham et al. 2000).


What may be problems in observing behavior and deriving transaction costs from this observation? How to reach a cost category based on observation? (slides plus your own, well-justified arguments)

Problems in observing behaviour and deriving transaction costs are related to a very high transaction costs. If an individual misses an observation, there will be no transaction observable.  There will be sunk costs and a dependency on existing institutions (and an efficient setting is often not possible).


What are problems of transaction costs measurement? (slides; McCann et al. 2005; Benham et al. 2001)

  • Problem of definition: different definitions of transaction costs exists
  • Problem of separation: transaction costs are sometimes difficult to separate from other costs, such as production costs, transportation costs
  • Problem of missing observations: very high transaction costs > no transaction observable, ex post sunk costs and dependency on existing institutions (efficient setting often not possible)
  • Problem of subjectivity: measure real TCs or perceived TCs?. Buckley and Chapman (1997): „Perception is everything, and never more so than in TCs„. Measurement costs: Precision vs. cost of measurement
  • Learning: start of a policy versus some years after 


How do transaction costs change production and market transaction costs in the neoclassical model? Please use graphs to convey your explanation (slides, Furubotn et al. 2003)

In the neo-classical model transaction costs are included in the standard model of perfect competition by adding the
activity “transactions” to the system as though it were analogous to the activity “production”.
• helps to explain the spread between the producer’s price for a commodity and the final price paid by the
consumer (trade margin) or the difference between interest on bank loans and deposits (interest margin).
• It disregards the link between transaction costs and the information status of decision makers.

Graph 1: If we consider two individuals - a
producer and a consumer- who trade a
commodity for money the initiation, conclusion,
monitoring and enforcement of this purchase
contract produces transaction costs. The
activity “transaction” can be represented by a
transaction function.
The distance from the origin to A is the amount
of the commodity sold by the producer also
called transaction input. The distance AB is the
corresponding amount purchased by the
consumer, the transaction output. The
transaction costs are represented by the
distance BD. The transaction curve must lie
below the 45 degree line if there are positive
TCs. The slope of the transaction curve is the
marginal productivity of the transaction
process. The marginal productivity declines as
the volume of transaction increases.

Graph 2: it is assumed that a special transaction
firm (a commercial enterprise) buys the
commodity from the producer and sells it to the
The graph shows that the consumer pays more
than the producer receives. The difference is due
to transaction costs. The decreasing returns to
scale of the activity “transactions” , there exists
an optimal size for the individual transaction firm.

Graph 3: The activity “transaction” could also be
integrated into the production firm or into the
household of the consumer. The situation can be
assessed by deduct ing the appropr iate
transaction costs from the maximum gross
product achieved by the firm. The curve of net
production would lie below the gross production
curve. This is always the case when you have
positive TC. It implies that the producer who
wants to sell OB units cannot achieve this goal if
he produces only OA units (O=origin). This is
because he has to spend BD units on transaction
costs. This means that the producer has to
produce OE units to be able to deliver OB units.
The slope of the net curve (net marginal
productivity) at each input Z is smaller than the
corresponding gross marginal productivity. The
net production curve lies further below the gross
curve the less efficient the coordination of
economic activities in society is.

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How are Transaction Costs and Division of labor related to each other? Using a graph is encouraged but not necessary. (slides, Furubotn et al. 2003)

Transaction Costs and Division of labor are direct related to each other, basically because an increasing division of work leads to increasing of costs. Division of labor for a better efficiency of transaction costs. Each individual’s labor productivity increases as she narrows down her range of production activities. Economics grow, more costs in communication and coordination, but still efficient?!

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How are neo-classical economics and Institutional economics approaches to the study of transaction costs different and why (assumptions)? (slides; Allen 2000)

The essential element of transaction costs, that property rights must be protected, is found in most fields of economics and throughout the discipline’s history. Two definitions prevail in the literatures: one that defines transaction costs as only occurring when a market transaction takes place; the other defining transaction costs as occurring whenever any property right is established or requires protection. I have called these the neoclassical and property rights definitions and have argued that which definition is useful depends on what question is being examined. Recognizing the distinction, though, is important for removing ambiguity and animosity (Allen 2000).


Institutional Economics

• defines TC more narrowly and models them more explicitly and often analytically identical to transportation costs and taxes.
• issues examined: the effect of transaction costs on the volume of trade, abilities to arbitrage, the bunching of transactions, intermediation and the existence of efficiency
• transaction demand for money: there are frictions in the economy and these apply to buying and selling capital assets yielding positive returns ⇢ treat transaction costs as the costs of production
• Arrow-Debreu: complete contingent markets, trades only take place once


the costs resulting from the transfer of property rights

• TC consist of those costs that occur between firms or individuals from the process of market exchange.
• never analyses questions of economic organisation outside of the choice of medium of exchange.
• most analyses show that the presence of TC reduces the frequency and volume of trade
• TC enter and yield results which are somehow predictable
• non-existence of explicit TCs in equilibrium


every distribution of property rights has with it a set
of production costs and a set of transaction costs. The distribution of property rights maximises the gains from trade net of all costs is the optimal distribution. —> no single allocation mechanism

Neoclassical Economics

• basic elements: (1) all methods of allocating resources have costs and benefits and no single mechanism works for free and dominates all the others (all allocation mechanisms are
second best) (2) rules, organisational forms and methods of payment are subject to economic analysis.
• positive TC are necessary for an explanation of the firm e.g. contract choice depends on the TC of the different contracts
• internal and not just market costs
• connection between TC and property rights (Coarse Theorem: In the absence of TC, the allocation of resources is independent of the distribution of property rights)

Definition: the costs establishing and maintaining property rights (when property rights are incomplete, individuals are always in the process of maintaining their existing property rights and attempting to establish new ones)

• include any direct costs as well as inefficiencies in production or misallocation that resulted from them
• no boundaries between firms, markets, households or any other theoretical constructs. When property rights are protected or maintained in any context, TC exist.
• TC arise through changes in incentives and manifest in changes in values in different property rights distributions
• TC problem requires (1) the presence of uncertainty, (2) the ability of the individual to change his behaviour without costless detection.
• The firm can’t observe behaviour: implies that individuals become careless; alters the marginal rate of substitution.
• the introduction of costly information leads to preferences no longer being fixed or exogenous.
• many property rights models have no actual resources used to establish and maintain property rights in equilibrium → TCs are lost gains from trade that result from the incomplete contract

Hypothesis: Because parties must find one another, communicate & exchange information they need to inspect and measure goods, draw up contracts, consult with lawyers or other experts. Transaction costs can take one of two forms, inputs or resources -including time- by a buyer and/or a seller or a margin between the buying and selling price of a commodity in a given market.