TRANSACTION COST

ECONOMICS

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Defining transaction costs
 Cost of screening and selecting a buyer or
seller
 Cost of obtaining information on the good
or service
 Cost of bargaining & negotiating a contract

 Cost of monitoring & enforcing the contract

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 Why does transaction cost
economics exist?
 Coase (1937)
 Markets do not regulate the whole of economic
life.
 Market exchange is not costless

 In a firm, the co-ordination mechanism is not the

price mechanism, but the firm itself.
 Firms emerge to economize on transaction costs
 Boundary of the firm determined by nature and
extent of transaction costs

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 why?
 Williamson (1996, 2000)
 Combines the concepts of bounded
rationality & opportunistic behavior to
explain contracts & ownership
structure of firms
 Continuum of organizational form
(from vertical integration to cash
markets) that depends largely on the
magnitude of transaction costs

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 why?
 North (1986, 1989, 1994)
 Institutions that evolve to reduce
transaction costs are key to the
performance of economies
 Not all institutions that emerge are
efficient
 Role of government is crucial in
specifying property rights and
enforcing contracts

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 why?
 North (1990)
“The inability of societies to develop
effective, low-cost enforcement of
contracts is the most important source
of both historical stagnation and
contemporary underdevelopment in the
third world.”

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How is transaction cost economics
relevant for agriculture sector in
developing countries?
Characteristics of rural agricultural-
economy in developing countries:
 Small farmers and traders face high
transaction costs resulting in thin markets
 Market failure in the provision of credit,
inputs, and services in remote areas
 Incomplete or imperfect land and labor
markets
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 how? (continued)

 The transaction costs literature will be

important in:
 Explaining the choice of contracts between
different market participants
 Analyzing the type of institutional
innovation needed to integrate small
farmers and the poor in the new
agricultural economy
 Understanding the role of the government
and the private sector in supporting the
development of these institutions
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Example 1: Contract farming

 Contract farming as a way to cut

transaction costs and include small
farmers in high-value markets (Minot 1986,
Delgado 1999)
 What are the conditions that make
contract farming sustainable and
beneficial to small and poor farmers?
 What is the role of the government in
improving those conditions?
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Example 2: Grades & standards

 Increasing demand for safe, healthy, and

high-quality food in the industrialized
countries are changing the nature of
international grades & standards
(Kherallah, 2000)
 How can developing countries respond?

 Do grades and standards act as a barrier to

trade to small farmers or do they create an
opportunity to enter high-value produce
markets?
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 Example 3: Transaction
costs and traders behavior
 How do traders respond to high
transaction costs in terms of screening
for trust-worthy partners, obtaining
information, and enforcing contracts?
(Gabre-Madhin, 1998)
 Is the institutional response of traders
efficient?
 What is the role of the government to cut
down on transaction costs and decrease
the riskiness of market exchange?
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Weaknesses & limitations of
transaction cost economics
 Better at describing behavior & providing
diagnosis than at predicting outcomes or
prescribing cures
 Measuring transaction costs is difficult
 Poor modeling of risk & uncertainty
 No unified framework or theory
 Still very ignorant about institutions

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Concluding Questions:

 How useful is transaction cost economics

to inform public policy beyond enforcing
property rights & contracts, improving
public market information, investing in
infrastructure, etc.?
 Is there a benefit to separating social
capital out, or should we just focus on the
individual mechanism being studied in
each case?

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NIE on Property Rights
and (a bit) on relevant
Legal Frameworks

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 Why Important?
 Property rights in productive resources –
land itself, trees, pasture, many water
sources, fish, etc. often characterized by
non-private property rights structures
 Substantial part of income generation, especially in
SSA
 Poor, and reliance on non-private resources as safety
net
 Almost all “big” environmental problems are a function
of resources under non-private, non-market property
rights (desertification, forest mgmt, soil erosion,
pollution, overfishing, overgrazing)
• Intellectual property rights
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 Property Rights
 With transactions costs, they matter for
efficiency; note: they matter for equity even in
absence of transactions costs
 Absolute PRs: Definition of the bundle of legal
interests in “resource”
 Relative PRs: Exchange. Contractual obligations
-- particularly when time is an important part of
the “transaction” -> monitoring and enforcement
of the contract.

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 Emergence of
Absolute Property Rights
 Demand Side
(Alchian, Demsetz)
Relative prices will
change so that
property rights will
emerge to more
efficiently allocate
resources. “Optimistic
View”
 Supply Side (North):
Existing power
structures matter,
changes will be costly,
not necessarily
“optimal”. Asset
specificity and Network
externalities.

• Methodologies for analysis still in infancy

• Almost all focus on “move to privatized”; little on operation
under non-private tenure or if non-private is “optimal”.

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 Relative Property Rights
 Focus on Contracts, bargaining and negotiation
 Asymmetric Information
 Asymmetric assets, risk-bearing mechanisms, etc.
 Incentives and Mechanism Design

 Very well-developed and rigorous (read: mathematical)

frameworks for analyses but:
 Emphasis on transactions in industrialized nations
with very strong legal institutions already
 Assume different power relations (maybe based on
asymmetries in assets/wealth etc.), or take as
exogenous, or assume away altogether

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 NIE, Law and PR
 Implies that making and monitoring agreements should
be decided at “local” level (information, moral hazard
et al. more easily gathered); formal law basically there
to provide credible enforcement
 However, once formalized, law can certainly change
bargaining position of participants –ex-ante and ex-
post consistency
 Credibility vs. Flexibility in legal regulations of
property “institutional” change; rent-seeking vs.
institutional adaptation to circumstances -- Devolution

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 Problems – Theoretical
(according to an NIE person)

 Basic proposition: cannot separate equity from

efficiency – immediate “problem” of developing
criteria for evaluation (remember: positive transactions
costs so “pareto” improvements in absence of costs may not be
“pareto” with them – valuation of change in equity is crucial).

 Bhardan article (WD,1989) articulating what he saw

as gaps in NIE; Furubotn & Richter (2000) conclude
their 481 page book with almost exact same gaps –
serious theoretical stagnation.

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 Problems -- Empirical
 Very difficult to “judge” even efficiency of
resource use under alternative PR regimes;
technical parameters often very difficult to
obtain – many studies have sketchy
information at best
 Methodologies for capturing qualitative
“institutional” aspects still very much in
their infancy – severe problems with proxies
(are lots of meetings a sign of “strong social
cohesion and organization” or weak and
inefficient organization?; tenure security –
title vs. traditional norms; insiders/outsiders)

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