2 Perfect 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.
3 Reality ¯ 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.
4 Definition 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.
5 At Arm’s Length Defn: An arm’s 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.
6 Contracts 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.
7 Specialized Investments Ã Defn: A specialized investment is an expenditure that is made to allow two parties to make exchanges, but has less value in alternative uses. Ã 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.). Ã 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).
8 Usefulness 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.
8a Forms 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.
9 Forms of Specialized Investments, Cont’d X Human asset specificity: Here, the SI is human in nature. X Examples: Skill acquisitions, building trust. X 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. X Example: “ISU Big 12 Champs 2000” printed before the final if we lost. X There are other types of specificities, and some investments may express multiple forms.
10 Rent 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.
11 Example: A Statistician < A statistician writes a module for a computer software package, which is upgraded every two years. < Statistician cost data are
"name": "11 Example: A Statistician < A statistician writes a module for a computer software package, which is upgraded every two years.",
"description": "< Statistician cost data are
12 Statistician Costs < On an annual basis, we have
"name": "12 Statistician Costs < On an annual basis, we have
13 Holdup/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 won’t leave, the software company can renegotiate to appropriate this quasi-rent. This is what is called opportunism or holdup.
14 Holdup, 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.
15 Fundamental 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.
16 Notes on Contracts R They are almost essential for a private ownership economy to work. In E. Europe, establishing contract law was a critical issue post 1991. R They promote efficiency by reducing the risks that resource owners face when doing business. This encourages useful investments. R 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.
17 Notes on Contracts, Cont’d G For contracts to work well, the Judiciary must not be either corrupt or incompetent. G 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. G Especially outside the U.S., laws are often insensitive to economic implications.
18 Incomplete Contracts A Complete contracts eliminate the possibility of holdup. A 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. A So why are contracts incomplete?
19 Why 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.
20 Incompleteness: 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?
22 Problems 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
23 Information 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 doesn’t ask (caveat emptor).
24 The UCC (Filling Gaps) f The UCC provides default specifications for many items that might be omitted in contracts. However, fit is often vague. What is reasonable or acceptable? fwhen applied, it can be unfair to a party in those particular circumstances frecourse to it often reduces trust. For dynamic reasons, firms may avoid it even if they gain in that instance.
25 Example: 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.
26 Example, Cont’d f Either party may leave if negotiations become too difficult, but neither wishes to unless there are good alternatives. f Bargaining may be fierce as both parties try to ‘snatch’ quasi-rents. f Information is power, and suppliers may be reluctant to give cost information to the auto- maker. Information may be used in bargaining. f But coordination is difficult without trust.
27 Holdup 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
28 Holdup 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).
29 Effects 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.
30 Contract 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.
31 Contract Length: Graphs, Cont’d B Assume, reasonably, that the marginal cost of writing a contract increases with duration. B It is harder to stylize marginal benefits. Let’s say they are constant. B Then we have the usual supply/demand situation, Baye TM 82. B Now what if the product requires more RSIs? The marginal benefit would increase, Baye TM83.
32 Contract Length: Graphs, Cont’d 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.