Encyclopedia of Law & Economics - 0740 TRANSACTION COSTS

0740

TRANSACTION COSTS

Douglas W. Allen

Associate Professor

Department of Economics - Simon Fraser University

© Copyright 1998 Douglas W. Allen

Contents

Abstract  
1. Introduction  
2. A Tale of Two Histories, Part A: The Property Right Approach  
3. The Tale of Two Histories, Part B: The Neoclassical Approach  
4. The Distribution of Property Rights vs. The Volume of Trade  
5. The Causes of Transaction Costs  
6. Modelling Transaction Costs, Part A: Neoclassical Modelling  
7. Modelling Transaction Costs, Part B: Property Rights Modelling  
8. Direct Empirical Work  
9. Conclusion  
 
Bibliography on Transaction Costs (0740)  



Abstract  

This article addresses the history, use, and significance of the term transactioncosts. Few words in the economic language have been more abused or foughtover, and this is shown to result from the emergence of two distinct definitionsand uses. The "Neoclassical" definition rests on the costs of trading across amarket, while the "property rights" definition centers on the costs ofestablishing and enforcing property rights. In articulating these two separatedefinitions, and in demonstrating their relationship and separate uses, it is hopedthat more progress can be made in the field of transaction cost economics.

JEL classification: K0, L0, L2, D0, D8

Keywords: Transaction Costs, Property Rights, Coase Theorem

1. Introduction  

Transaction costs. Do another two words exist in the economic lexicon thatgenerate as much friction? Conceptually introduced in Coase's 1937 paper "TheNature of the Firm" as simply "the cost of using the price mechanism" ( Coase p.38, 1988 ), the words "transaction costs" have evolved to the point where someskeptics claim they include any cost that is convenient and elusive enough toavoid critical examination ( Niehans 1987, p. 678 ). Advocates, on the other hand,have hailed the recognition of these costs as revolutionary, and as importantconceptually as "marginalism" and "substitution" ( Cheung 1983, p. 21 ).

The ambiguity that surrounds the concept of transaction costs stems, inlarge part, from the existence of two literatures simultaneously claimingownership over the term. The "property rights" literature, begins with Coase,and has consistently focused on the role transaction costs play in determiningthe distribution of property rights, broadly defined as all laws, rules, socialcustoms, and organizations that generate incentives for behavior. This literaturehas called into question fundamental concepts like efficiency and the nature ofproduction. Though based in neoclassical economics, this literature has evolvedbeyond the neoclassical model and has produced the new sub-fields of "law andeconomics", the "new economic history", and the "new institutionaleconomics". Though this field, through Coase, claims the discovery and rightfultitle to "transaction costs", ironically the words are conspicuously absent frommany of its titles. Indeed this literature is mostly responsible, though not solely,for the plethora of terms that either substitute for or refine the notion oftransaction costs.

The "neoclassical" literature on transaction costs begins in the early 1950s,although some might argue that it starts with Hicks (1935) or even Coase (1937) .This literature defines transaction costs more narrowly, generally models themmore explicitly and often analytically identical to transportation charges or taxes.The correspondence with familiar costs carries over to the types of issuesexamined, such as, the effect of transaction costs on the volume of trade,abilities to arbitrage, the bunching of transactions, intermediation, and theexistence and efficiency of equilibrium --- all standard neoclassical fare.Sometimes this literature examines issues of property right determination, suchas the role of middlemen and the medium of exchange. In addition to the differentapproach and definition, the conclusions are often opposite from the propertyrights literature as well. This is especially true over questions of efficiency, andthis has increased the level of belittling rhetoric between the two camps. Forexample, it is common in the neoclassical literature, when reference is made to theCoase theorem --- the cornerstone of the property rights literature --- to say "theso-called Coase theorem" [See Niehans, 1987 p. 678 , for an example]. Theproperty rights literature is just as aggressive, claiming that the neoclassicalcamp often wants their cake and eat it too. For example, early criticisms over themonopoly model almost mocked the inconsistency of having a monopolist knowits demand curve at zero costs, yet find it prohibitively costly to pricediscriminate [See Demsetz (1969) or Barzel (1977) for examples].

The likely cause of this dichotomous literature is twofold. First, there is theearly introduction of costly transacting by Coase (1937) in the explicit context ofinstitutional choice, at a time when the profession had little interest or ability tograpple with the issue. As Coase (1972) noted, his 1937 paper on the firm wasoften cited, but was little used. Second, there is Coase's failure in 1937 to definetransaction costs with any precision, using instead the phrase "the costs of theprice mechanism". At the same time, though Coase uses examples that suggestmore than just the market is involved in transaction costs, he ultimately leavesthe issue open for interpretation. As such, the property right literature did nottruly begin until 1960, with Coase's publication of "The Problem of Social Cost".This latter article provided the necessary elaboration of Coase's 1937 publicationin order to tie many existing ideas together and to provide a property rightsresearch agenda [See Barzel and Kochin (1992) or Medema (forthcoming) forelaborations on this point]. In the intervening years, economists did what theycould with the term transaction costs, and the neoclassical approach was born.

The purpose of this essay is to provide a broad picture of transaction costs:its history, definition, foundation, use, measurement, and implications. As such,it is often necessary to sacrifice detail, and the reader is directed to explore thereferences for further treatment. A theme throughout the essay is thedichotomous use of the term "transaction costs" in the two streams of literaturealready mentioned. It is ironic that a disagreement over ownership should engulfa term so closely related to property rights. Unfortunately, as with all cases ofdisputed ownership, useful output is lower for lack of definition.

2. A Tale of Two Histories, Part A: The Property Right Approach  

In the beginning Coase created transaction costs. His critics might continue:"And the term was formless and void, and darkness was over the surface of theterm." For the believers in the property right approach, however, Coase (1937) is seminal. As an advanced undergraduate perplexed by economic's ability toconceptually organize the economy around prices, Coase was troubled that therewas no room for any form of direct cooperation or direction. In his words "wehad a factor of production, management, whose function was to coordinate.Why was it needed if the pricing system provided all the coordinationnecessary?" [ 1992, p. 715 ]. His solution was to recognize that there are "costsof using the price mechanism." When prices allocate resources at a cost, thenthey compete with other allocating mechanisms like firms and governments.Coase argued that, at times, firms and direct management supersede the market,while at other times market prices are used in directing goods and services.Readers interested in the genesis and a detailed account of the history ofCoase's first great work are directed to Williamson and Winter eds. (1991) .

In this simple argument a charitable reading finds some basic elements thatdistinguish the property rights literature. First, all methods of allocatingresources have costs and benefits, and no single mechanism works for free anddominates all others --- in modern language, all allocation mechanisms are"second best". Second, it is argued that "rules", "organizational forms", and"methods of payments" are subject to economic analysis. Although it has beenargued that Frank Knight (1921) indirectly made a similar case [see McManus(1975) and Barzel (1987) ], Coase explicitly addressed this issue. And finally,Coase implicitly argues that positive transaction costs were both necessary andsufficient for an explanation of the firm.

Coase provides examples of what he meant by the costs of the pricemechanism: discovering what the prices are, negotiating and closing a contract;and he hints at problems of enforcement, but he stops short of any definition.In fact, throughout all of his writings, Coase never goes beyond providingexamples of transaction costs. Barzel and Kochin (1992, p. 25) have noted that"the discussion of transaction costs in that [1937] paper is brief and cryptic",and even the most sympathetic reader would have to agree. Though the words"transaction costs" are never used in his first work, Coase is still correct when,in his Nobel address, he states that: "What I think will be considered in thefuture to have been the important contribution of this article is the explicitintroduction of transaction costs into economic analysis." [ 1992, p. 716 ].

It remains a strange fact of economic history that after the publication of"The Nature of the Firm", neither Coase, nor any other writer in the professionpicked up the joint theme of transaction costs and property rights. Finally, in"The Federal Communications Commission," Coase (1959) returns to the themeof the influence of transaction costs on property rights, and this article providesthe motivation for "The Problem of Social Cost" [See Kitch (ed.) (1983) or Stigler(1988) for discussions of how Coase came to write his most famous paper].Ironically, even Coase did not appreciate his accomplishment at the time ofwriting:

I should add that in writing this article I had no such general aim in mind. Ithought that I was exposing the weaknesses of Pigou's analysis of the divergencebetween private and social products, an analysis generally accepted byeconomists, and that was all. It was only later, and in part as a result ofconversation with Steven Cheung in the 1960's that I came to see the generalsignificance for economic theory of what I had written . . . [ 1992, p. 717 ]

A tremendous amount has been written regarding "The Problem of SocialCost" and the literature it instigated. For friendly discussions of "The Problemof Social Cost" see Cheung (1983) , Barzel and Kochin (1992) , Coase (1988) , (1992) or Medema (1994 , 1996a) . For less friendly ones see Cooter (1982) , Donohue (1989) , Kelman (1979) and Samuels (1974) . Regardless, for the purposeshere, only two points require elaboration --- namely, that Coase explicitly makesa connection between transaction costs and property rights in the context of thecommon law of liability, and that Steven Cheung (1969) generalized thisargument to the context of contracts and contract choice.

Cheung has made many contributions to the property rights literature ontransaction costs, but perhaps his most significant is generalizing Coase'soriginal argument. The importance stems from the fact that Coase never definedtransaction costs and has often used examples that suggest transaction costsarise only in market exchanges. Cheung, in analyzing share tenancy andproviding the first contractual example of the Coase theorem, explicitly arguesthat contract choice depends on the transaction costs of the different contracts.These transaction costs are clearly internal and not just market costs. Cheung'swork inspired Stiglitz (1974) and begins the principal agent literature, but it alsoestablishes the precedent of thinking of transaction costs across markets and internal to the firm --- a theme that is strongly articulated in Williamson (1975 , 1979 , and 1985) . This connection between transaction costs and property rightsis summarized in "the Coase theorem", which is defined as follows:

Coase Theorem: In the absence of transaction costs, the allocation ofresources is independent of the distribution of property rights.

There are many attacks and defenses of the Coase theorem, none of which aredealt with here [See Shapiro (1974) for an example of an attack, Allen (1997) fora defense, and Zerbe (1980) for a survey]. The point is that for all property rightapproaches to transaction costs, the two concepts of property rights andtransaction costs are fundamentally inter-linked. In fact, it will be shown thatthey are two sides of the same coin, and that this linkage distinguishes theproperty right approach from the neoclassical approach to the study oftransaction costs.

Property Rights and Transaction Costs

The delineation of ownership is as old as human written records. The Mosaiclaws as described in the Ten Commandments or the laws on takings in Exodus22:1-15, as well as the host of other Levitical laws throughout the first five booksof the Old Testament are all attempts to legally define ownership. From theHammurabi code to the English common law the notion of legal ownership, orlegal rights, to property is well defined. In the words of Blackstone: "The thirdabsolute right; inherent in every Englishman, is that of property: which consistsin the free use, enjoyment, and disposal of all his acquisitions, without anycontrol or diminution, save only by the laws of the land." [ 1803, p. 138 ]

Though it is difficult to identify where one idea begins, the modern attemptto go beyond a legal delineation of rights and begin talking about "economicrights" seems to start with Alchian. Alchian's early work on tenure [ Alchian(1958) ], and the pursuit of individual utility within the context of regulated firms[ Alchian and Kessel (1962) ] hinge on the property right structures of theinstitutions in question. For example, managers and administrators of non-profitfirms and universities, he argues, face a lower relative cost of privateconsumption on the job than their counterparts in the private sector. Becausethese firms are constrained in their ability to show profit, they are able to survivewith higher costs. Alchian's insight was that the set of rules (the distribution ofproperty rights) determined the level of output of the firm because theydetermined the incentives of each individual. This theme is manifest throughoutAlchian's work, and culminates in his famous article with Demsetz [ Alchian andDemsetz (1972) ]. But perhaps Alchian's most significant contribution, articulatedmost clearly in Alchian (1965 and 1979) , is his emphasis on economic rather than legal rights. For Alchian, property rights are "the rights of individuals to the useof resources" [ p. 817, 1965 ]. Not just under the law, but in reality. He makes clearthat these rights are not solely dependent on the existence of the state, but thatthey depend on custom, reciprocity, and voluntary restraints. This notion is nowcommonplace in the modern property rights literature and is explicitly found in Ellickson (1991) and Landa (1994) . Although economic property rights areenhanced by the law, they are ultimately use rights, and the greater extent onecan exercise these uses and bear the consequences the greater are the propertyrights, regardless of the law. Property rights are therefore defined as:

Property Rights: the ability to freely exercise a choice over a good orservice.

The property rights literature argues there is a monotonic relationship betweenproperty rights and wealth. Given that trade is the transfer of property rights,there can be no trade (and hence no gains from trade) in the absence of propertyrights. Also, when property rights are perfectly defined, the Coase theoremstates that the gains from trade are maximized. Assuming there is a continuumbetween these two extremes, as property rights become better defined, the gainsfrom trade increase [see Anderson and Lueck (1992) for an empirical example].Other things equal, individuals prefer better defined property rights to poorerdefined ones because they prefer more wealth to less.

Increasing the ability to make choices of one individual can reduce the abilityto make choices for others. Generally speaking individuals increase theirproperty rights in three ways. First, the individual may steal the good inquestion. Second, the individual may privatize a good that was previously in thepublic domain. Finally, an individual may cooperate with other individuals withan agreement to divide the new wealth in some fashion.

When property rights are perfect, by definition no theft can take place, andas a result, no effort is made to protect the rights [a point made in Cheung (1974) and Barzel (1985) ]. However, when property rights are incomplete, individualsattempt to increase their ownership in an effort to increase their wealth. Thisattempt to capture property rights may be dissipating (as in the case of theft), ormay be wealth generating (as in the case of assets brought out of the publicdomain). When there is an opportunity for theft, there is also an opportunity forprotection. Hence, when property rights are incomplete, individuals are alwaysin the process of maintaining their existing property rights, and attempting toestablish new ones. This leads to the property right definition of transactioncosts.

Transaction Costs, #1: the costs establishing and maintaining propertyrights.

This definition is first articulated in Allen (1991) . Writers in the property rightsliterature have seldom defined transaction costs, relying mostly on examples ofinspection, enforcing, policing, and measurement which all hint at the protectionof property rights and implicitly recognize the threat of appropriation or theft.For similar, but informal, definitions, see Cheung (1969, p. 16) , McManus (1975,p. 336) , Jensen and Meckling (1976, p. 308) , Goldberg (1989, p. 22) , Barzel (1985,p. 8) , and Alchian and Woodward (1988, p. 66) .

Transaction costs include any direct costs, as well as any concomitantinefficiencies in production or misallocation that resulted from them. For example,consider the Klein and Leffler (1981) example of a firm investing in a sunk assetas a guarantee of product quality. The firm does this to protect the wealth of itscustomer and as such it is clearly an attempt to maintain property rights. Thetransaction costs would include the cost of the investment and any increases incosts of production that it may have caused.

The property rights definition of transaction costs respects no boundariesbetween firms, markets, households, or any other theoretical constructs. Whenproperty rights are protected and maintained in any context, transaction costsexist. By explicitly recognizing this relationship it is clear that statements like "ifwe assume zero transaction costs and complete property rights" are redundant.To say that a situation has zero transaction costs is to say that property rightsare complete, according to this definition. Cheung [p. 54, 1992] agrees with this,stating: "... the dual specifications of clearly delimited rights and zero transactioncosts are redundant. If transaction costs are truly zero, the delineation of rightscan be ignored.".

When it is costless to establish and maintain rights they are done soperfectly. If transaction costs are prohibitively high then property rights willneither be established nor maintained and property rights will be zero. Thereverse, however, is not necessarily true. If property rights are complete in somesituation, there are two possibilities, either transaction costs are zero, or costsmay have been incurred to guarantee the property rights simply because thebenefits of doing so exceed the costs --- in which case transaction costs arepositive. Further, when property rights are zero, transaction costs could also bezero. For example, if a property right could never be established, despite theresources devoted towards such a goal, no one would bother making anyexpenditures towards establishing property rights, and the good would remainunowned. For example, there are no property rights over the planet Venus, andno efforts have been made to establish any.

Transaction Cost Economics with the Property Rights Approach

An excellent survey of the property right literature is found in Eggertsson(1990a) , while an excellent textbook treatment of this approach is found in Milgrom and Roberts (1992) . Essentially the property rights literature ischaracterized by several features related to the above definition. First, the centralquestion is always "what explains the distribution of property rights?", wherethe "distribution of property rights" has a broad meaning and includes all setsof rules, governance structures, and organizations. Hence, families, firms,governments, non-profit institutions, contracts, are all viewed as sets ofproperty rights. Lawyers forming a partnership to split the residuals, a farmerrenting land from a landowner, or a judge deciding on a case, are all examples ofdifferent allocations of property rights. Every distribution of property rights haswith it a set of production costs and a set of transaction costs. The distributionof property rights that maximizes the gains from trade net of all costs is theoptimal distribution. This, in fact, is the grand hypothesis of transaction costeconomics under the property rights approach. An account of transaction costmethodology is beyond the scope of this paper, but see Williamson (1979 and 1985) for detailed accounts.

A second characterization is the reluctance to infer any policy implicationsfrom the analysis and to stress explanation. As stated earlier, this goes back toCoase's original idea that no single allocation mechanism dominates. Notions of"market failure" lose meaning when there is no reason for prices to allocateeverything. One might as well refer to "government failure" or "firm failure" incases where prices do allocate.

This transaction cost approach dominates what is now called the "NewInstitutional Economics", so named because it provides a theoretical frameworkand emphasis of testability to the institutional traditions of Veblen andCommons. Oliver Williamson is considered the founder of this literature, bothin terms of vocabulary and content, and he is one of the strongest proponentsof applying the notion of transaction costs ubiquitously. His notion of a"governance structure" as a distribution of property rights providingappropriate incentives to govern a relationship, is intended to apply within andoutside firms. Williamson (1971) is the first to note the role sunk costs can playin causing contracting problems and incentives to vertically integrate. This ideais popularized in Klein, Crawford and Alchian (1978) and in Klein and Leffler(1981) . The role of asset specificity and idiosyncratic capital is so attached to thename of Williamson that for many, transaction costs means little else. AlthoughWilliamson's understanding of the relationship between transaction costs andproperty rights is consistent with what is presented here, he also distinguishesbetween the "property rights approach" and the "transaction cost approach" toorganizational problems. For Williamson, a property rights approach deals withgrand private environmental rules, while the transaction cost approach dealswith private incomplete contracts [see Williamson (1990) for a discussion].

3. The Tale of Two Histories, Part B: The Neoclassical Approach  

Although, Coase (1937) provides mostly market exchange examples and couldbe argued as the founder of the neoclassical approach to transaction costs, itcould be better argued that this approach begins with Hicks' (1935) publicationof "A Suggestion of Simplifying the Theory of Money", which predates Coaseby two years. In his paper, Hicks begins what is known as a transaction demandfor money, although he never calls it as such. For him, there are frictions in theeconomy and these apply to buying and selling capital assets yielding positivereturns. When the returns were small, at the margin, relative to the costs oftrading, individuals rationally hold cash balances yielding no return. In hiswords:

The most obvious sort of friction, and undoubtedly one of the most important,is the cost of transferring assets from one form to another. This is of exactly thesame character as the cost of transfer which acts as a certain impediment tochange in all parts of the economic system; it doubtless comprises subjectiveelements as well as elements directly priced. Thus a person is deterred frominvesting money for short periods, partly because of brokerage charges andstamp duties, partly because it is not worth the bother. [ 1935, p. 6 ]

Since money is used to facilitate exchange, and since an exchange that needs"facilitating" must be subject to transaction costs, it is not surprising that thoseconcerned with money dealt with these costs. Indeed, Baumol (1952) and Tobin(1956) elaborate on the transaction demand for money, and again treattransaction costs as the costs of trading. The first explicit statement oftransaction costs as the cost of trading comes from Demsetz (1964) where hestates that "Transaction cost may be defined as the cost of exchangingownership titles" [ 1988, p. 64 ]. Although this type of definition refers to propertyrights, transaction costs only arise when an exchange of property rights takesplace. This leads to the neoclassical definition of transaction costs:

Transaction Costs #2: the costs resulting from the transfer of propertyrights.

This is a shortened version of the definition later given in Niehans (1987) . Theneoclassical approach to transaction costs dominates in finance and puretheory. The following is a partial list of papers that utilize a neoclassicalapproach: Brennan and Copeland (1988) , Constantinides (1986) , Dermody andPrisman (1993) , Dumas and Luciano (1991) , Fisher (1994) , Gennotte and Jung(1994) , George, Kaul, and Nimalendran (1994) , Guia-Abiad (1993) , Hirshleifer(1973) , Huberman (1990) , Jouini and Kallal (1995) , Lund (1993) , Pesaran andTimmermann (1994) , Shaffer (1989) , Stavins (1995) , Wagner and Schulman (1994) , Wilcox (1993) , and Young (1989) . A typical definition of transaction costs foundin these papers would be as follows:

In general, transaction costs are ubiquitous in market economies and can arisefrom the transfer of any property right because parties to exchanges must findone another, communicate, and exchange information. There may be a necessityto inspect and measure goods to be transferred, draw up contracts, consult withlawyers or other experts, and transfer title. Depending upon who provides theseservices, 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 andselling price of a commodity in a given market. [ Stavins 1995, p. 134 ]

In the neoclassical approach, enforcement-type costs within firms are not transaction costs. Transaction costs consist of those costs that occur betweenfirms or individuals from the process of market exchange. Hence, an economymade up of one giant firm, or a state run economy, would be a zero transactioncost economy by this definition. Because these transaction costs are just thecost of exchange, they are modeled in a more recognizable fashion, often in theform of a "transaction function" [see Constantinides (1979) for an example].These functions are similar to other neoclassical production functions, and areusually assumed to depend on labor inputs. These functions may haveincreasing, constant, or decreasing returns to scale. Further, the transaction costfunctions may have fixed or variable components. Although the analogy is notcomplete, in many ways transaction costs play a role very similar totransportation costs and taxes, and according to Niehans: "transaction costs areanalytically analogous to transportation costs."

Being analytically similar means that many of the impacts of transactioncosts are similar as well. Consider, for example, the impact of transaction costson the volume of trade. If transaction costs increase with the quantity traded,this has the impact of increasing the relative price of the commodity beingpurchased. Since this holds for goods, in effect the budget constraint becomeskinked at the endowment point, and as a result, individual demands become lessresponsive to price changes and the volume of trade falls. These are often called"proportional transaction costs" in the literature, and their effect on multiperiodinvestment and consumption has also been examined. [See Constantinides(1976) , Eppen and Fama (1969) , Kamin (1975) , Magill and Constantinides (1976) , Bensaid, et al . (1992) , Davis and Norman (1990) , Boyle and Vorst (1992) , and Leland (1985) ]. Other similar results follow as well. Like per unit taxes, frictionalper unit transaction costs drive a wedge between buying and selling prices,although neoclassical transaction costs are not necessary to explain pricespreads. Glosten and Milgrom (1985) , based on Copeland and Galai (1983) ,provide an adverse selection explanation for bid-ask spreads that assumestraders have zero friction costs.

Fixed transaction costs tend to bunch transactions together and provide anexplanation for the demand for money [see Edirisinghe, et al . (1993) , for anexample]. Differences in transaction costs across individuals lead to somespecializing in the transaction function. Hence brokers and agents are thoseindividuals with low transaction costs. Alchian and Allen (1964) were probablythe first to note this [see also Niehans (1969) ]. Differences in the transactioncosts across commodities provide an explanation for why some commodities areused as currencies of exchange [ Niehans (1969) and Alchian (1977) ]. In these lasttwo cases, the question examined is close to the institutional type of questionaddressed by the property rights school. Neoclassical transaction costs havealso been used to analyze the equity premium. The real average returns on U.S.Treasury Bills is less than one percent, while for stocks it is closer to 7 percent.This difference is too large to explain with reasonable Arrow-Debreu models. Mehra and Prescott (1985) began a literature explaining this premium based onneoclassical trading costs. [See Aiyagari and Gertler (1991) for an example, anda survey of the literature.] Finally, all discussions of the existence of equilibriumwith transaction costs utilize a neoclassical definition [See Radner (1972) , Bergstrom (1976) , Heller and Starr (1976) , Hart and Kuhn (1975) , Kurz (1974b) , McKenzie (1981) , Foley (1970) , Hahn (1971) , and Repullo (1988) .]

Definitional Squabbles

For the most part, these two streams of literatures --- the property rightsapproach and the neoclassical approach --- flow independently. Those writingin the area of property rights follow the line of reasoning laid by Coase, Cheung,and Williamson, and use the broad notion of transaction costs. Those interestedin the neoclassical issues of volume of trade and equilibrium generally stick toan Arrow-Debreu based general equilibrium model, and use the narrow definitionof straight exchange costs.

The major exception is Harold Demsetz. Demsetz was an early contributor tothe theory of property rights and the role of enforcement costs in determiningthe distribution of property rights [See Demsetz 1964 , 1967 and 1972 ]. Ironicallythough, he was also the first to articulate the neoclassical definition oftransaction costs [ Demsetz, (1968) ]. For Demsetz, transaction costs remain "thecosts of coordinating resources through market arrangements" [ 1995, p. 4 ], andamong property right economists he remains a staunch, though perhaps lonely,proponent of this view. Demsetz (1964) is the first to deal with the breadth ofdefinition used for transaction costs. In Demsetz (1988) he acknowledges thatthis is mostly a question of semantics, since his collection of costs all fit underthe rubric of "governance" costs or the property rights definition. According toDemsetz, the clear meaning of transaction costs is the cost of transacting . Toapply the term more broadly threatens to make the term tautological and useless.This view is summarized by Schlag, "an overly expansive view of transactioncosts threatens to make the Coase theorem tautological. On the other hand, anoverly restrictive view of transaction costs can effectively invalidate thetheorem." [ 1989, p. 1675 ]

Demsetz (1988, pp. 144-150) argues that a broad definition of transactioncosts hinders any understanding of firms and markets. For example, Demsetz(1995) argues that the definition of a firm and its internal organization are twoseparate issues that have been confused since Coase. Demsetz defines the firmas a production unit, created to exploit gains from specialization. Since marketsonly transfer titles they complement firms, and the Coasean notion of firms andmarkets substituting for one another does not arise. This is exactly the oppositeway the property rights literature would define a firm. [See Barzel (1989) as anexample]. Coase has always put emphasis on the formal relations within a firm(e.g., employer vs. employee) as a possible means of reducing transaction costs. Alchian and Demsetz (1972) , on the other hand, downplay the role of authoritywithin the firm. [See Medema (1994) for a discussion of Coase vs. Alchian andDemsetz].

Demsetz, de facto , takes a property rights approach to the internalorganization of the firm, however. Demsetz (1995) discusses several transactioncosts (definition #1) arguments for the firm without using the term, including:shirking, Knightean uncertainty, reduction of coordination costs, and theagency problems from opportunism. Hence, in the end there is very little toquibble over, and the definition to be used depends on the problem beingaddressed. Clearly, all of the costs mentioned by Demsetz fall under the umbrellaof the property right definition of transaction costs, where a broad transactioncost definition is necessary in order to make clear that the Coase theorem doesnot apply.

4. The Distribution of Property Rights vs. The Volume of Trade  

The economics profession is littered with various assertions and theoremsstating that distributions of property rights do not matter. The Coase theoremis the most famous of these, but there are many others. For example, theModigliani/Miller theorem [ Modigliani and Miller (1958) ] is almost identical tothe Coase theorem. This proposition states that if capital markets are perfect andfirms and investors face the same rate of interest, then investors can unravel anycorporate structure chosen by the firm. This means that the ratio of debt toequity financing, as well as the form of debt and equity within the firm, isirrelevant to the firms value. A similar result is found in the RicardianEquivalence Theorem [ Ricardo (1951) ]. This theorem states that with perfectcapital markets, the government's choice over taxation and debt is irrelevant tothe level of household wealth, because taxpayers are able to unravel anyfinancing decisions of governments.

In addition to these, there are a host of equivalence results regarding taxes.The most famous being that it is irrelevant whether the consumer or the produceris taxed, the result is the same in terms of both resource allocation and incidenceof tax paid. Furthermore, both ad valorem and per unit taxes are equivalent interms of resource allocation. Finally, in trade policy and again in terms ofresource allocation, it is well known that tariffs and quotas can have identicaleffects.

All of these results are special cases of the Coase theorem because all taxes,debt obligations, equity shares, and other policy instruments are delineationsof property rights. A firm deciding on the optimal amount of debt versus equityis essentially assigning property rights over the stream of expected profits,including priority in case of unexpected shortfalls. A government deciding ona choice between taxation and debt is simply transferring property rights overtime. In all of these cases, only a different distribution of property rights exists,and given the Coase theorem, this does not alter the allocation of resources ---when, as Coase stated, transaction costs are zero.

When transaction costs are not zero, these equivalence results do not occur.For example, Barzel (1976) shows how the tax equivalent result is altered whentransaction costs are positive. When goods are complex bundles of commoditiesthey become difficult to define under tax legislation and some attributes arepossibly ignored. Under these conditions, taxes have the effect of altering therelative price of the taxed and untaxed attributes, and therefore alter the mix orquality of the item that is produced. Lump sum taxes tend to increase the qualityof good, while per unit taxes tend to lower quality. The result is that differentforms of taxation can have vastly different effects on resource allocation.Furthermore, differences in the ability to avoid taxation implies that tax revenueis not neutral with respect to the location of the tax.

All these examples explain why the property rights approach requires a broaddefinition of transaction costs. Given the Coase theorem, and all of its differentmanifestations, distributions of property rights are irrelevant. If we did live in aworld of zero transaction costs (definition # 1), then firms truly would toss coinsto decide debt levels, if indeed there were any firms, which would also bedecided by a coin toss. And so on for governments and all other institutions.The importance of the Coase theorem then is that it points to transaction costsas the necessary factor in any explanation of the distribution of property rights.The definition of transaction costs, therefore, must be those costs that cause theCoase theorem to not apply. This also seems to be the reason why theneoclassical approach never analyzes questions of economic organizationoutside of the choice of medium of exchange. They have selected a definition oftransaction costs that is too limited for this purpose. Many in the neoclassicalliterature have balked at this line of reasoning, suggesting that it is tautological.The difference of opinion stems from the different objectives each approach isinterested in.

5. The Causes of Transaction Costs  

Regardless of which stream of literature is examined, the underlying theme fortransaction costs is the notion of ignorance. Hence, even though its treatmentis different and the definition is narrower, the neoclassical approach still usesexamples of transaction costs that are similar to the property rights approach.Niehans states that parties must

find each other, they have to communicate and to exchange information . . . goodsmust be described, inspected, weighed and measured. Contracts are drawn up,lawyers may be consulted, title is transferred and records have to be kept. Insome cases, compliance needs to be enforced through legal action and breach ofcontract may lead to litigation. [ 1987, p. 676 ]

Negotiation, fraud, communication, and contract stipulation all come aboutbecause knowledge is incomplete and not common. Though its importance isrecognized by everyone, the role of information leads to a great deal ofconfusion in the discussion of transaction costs. Information costs are aprerequisite to transaction costs and are a necessary condition for theirexistence. Information costs, however, are not always transaction costs. StevenCheung once remarked that transaction costs are costs that do not exist in aRobinson Crusoe world (a definition consistent with definition #1). ClearlyCrusoe faced many information problems, but until Friday showed up, he had notransaction cost problems.

Barzel has been a strong proponent of the distinction between informationand transaction costs. Barzel (1977) states that "transaction costs include those[costs] required to formulate and to police contracts." ( 1977, p. 292 ), but goes onto point out that it is possible to have information problems resulting inspeculation, sorting, and signalling, which may appear to yield decreases insocial value, but that these reductions are impossible when transaction costs arezero. With zero transaction costs, contracting is a perfect substitute forinformation because contracts can always be made over all contingencies. Barzel(1982 , 1985) stresses that information costs are at the heart of transaction costsbecause they lead to measurement. Barzel (1977) notes that when the distinctionbetween information costs and transaction costs is made, several other pointsfollow rather obviously: costless information implies perfect property rights;individual honesty does not necessarily eliminate transaction costs; costlyinformation means transaction costs can explain self-imposed constraints; andtotal costs, not just transaction costs or information costs, are required to beminimized.

It is not always appreciated that information costs are not sufficient fortransaction costs. The mere presence of information costs lead to risky eventswhich can be eliminated through contingent claim contracts. In addition tocostly information a factor is required to eliminate the ability to write completecontingent claim contracts. There are several examples of what this factor mightbe. Knight was the first to suggest this with his distinction between risk anduncertainty. Uncertainty arising in situations where moral hazard preventedindividuals from assigning accurate probabilities to events, and therebyeliminating the ability to contract over the risk. Barzel (1989) and Allen (1991) have stressed the idea that goods are complicated bundles of attributes thatboth are variable in nature, and alterable by individuals. The inability to separatethe contributions to quality by nature and man allows for cheating to take placein equilibrium. Other attempts to add to information costs include the notion ofasymmetric information and opportunism [See Ackerlof (1970) and Williamson(1975 , 1985) ].

6. Modelling Transaction Costs, Part A: Neoclassical Modelling  

As may be expected, the two literatures have different methods by whichtransaction costs are modelled. In both cases, transaction costs considerablycomplicate the neoclassical model, and the level of mathematical sophisticationis quite demanding. The major point made here, however, is that neoclassicalmodeling is a direct extension of the Arrow-Debreu model, while property rightsmodeling involves some fundamental differences.

In an Arrow-Debreu world with complete contingent markets, trades onlytake place once. An early application of transaction costs in neoclassical modelsexplained why markets had a "sequence" over time --- the general idea being thatat any given time, a specific market may be too expensive to trade in, and thustrade is postponed until some future date.

There are two general types of approaches in modeling neoclassicaltransaction costs. The first, used by Foley (1970) , Hahn (1971 , 1973) , and Starrett(1973) , involves a central transactor who takes buy and sell orders from eachhousehold and carries them out. In order to pay for his services, the "broker"charges a margin between the buying and selling price for his efforts. Thesecond approach requires households and firms to directly use resources in thepurchase and sale of goods. Here the firms and households use some type of"transfer technology." [For early treatments, see Kurz (1974a) , Niehans (1971) or Ulph and Ulph (1977) . See Repullo (1988) for a later treatment using this style].Although the specific technologies are generally simple, they are usuallysufficient to complicate the analysis greatly.

Three general approaches are taken to model the transaction technology.The first simply assumes that some general transaction function T(x) exists [see Brennan and Copeland (1988) , for example]. This function is often assumed todepend on the volume of trade, cash flows, number of traders, and other suchvariables that reflect the "size" of the transaction. The second assumes thattransaction costs are fixed [see Leland (1974) , Mukherjee and Zabel (1974) , Brennan (1975) , Goldsmith (1976) , Levy (1978) , or Mayshar (1979 , 1981) forexamples]. Finally, proportional (or "iceberg") transaction costs k(x) areassumed, where k is a constant fraction and x again is a measure of the size oftransaction [see Gennotte and Jung (1994) or Constantinides (1986) forexamples]. All of these technologies make their way into standard objectivefunctions for firms and households. Though the subsequent analysis is usuallycomplicated, the results are most often exactly analogous to the effects oftransportation charges. Typically, these analyses show that the presence oftransaction costs reduces the frequency and volume of trade.

7. Modelling Transaction Costs, Part B: Property Rights Modelling  

The property rights approach to modeling is a vast, diverse, and technicallycomplex literature, well beyond the scope of this survey to treat it in any detail[see Holmstrom and Milgrom (1994) , or Hart and Moore (1990) ]. Unlike theneoclassical literature, where transaction costs enter and yield results which aresomewhat predictable, modeling the distribution of property rights isfundamentally different. Rather than entering through a transaction technology,transaction costs arise through changes in incentives, and manifest in changesin values in different property right distributions, with often surprising results.For example, Coase (1960) is perhaps the first surprising result, despite the lackof formalization. Cheung (1969) is another, and perhaps the first case of a formaltreatment of transaction costs from a property rights approach. Here twoexamples of property rights modeling are provided to highlight some differences.

The simple example of insurance, first discussed in Rothschild and Stiglitz(1976) , demonstrates some differences. Consider a world where there are twotypes of behavior: careful and uncareful, and all else equal, individuals preferbeing uncareful. Furthermore, there is the chance that a fire may occur, and theprobability of this event depends on the behavior of the individual. If insurancecompanies can fully observe behavior they offer a full insurance contract andeveryone takes it --- no one has an incentive to be careless.

Thus far, we have a standard neoclassical problem, and the introduction ofrisky events has changed little. Recall that the marginal rate of substitution ofthe individual for wealth in both states of the world is:

where a is the probability of fire in state ' a ', U the individual's affine utilityfunction, and W the wealth level in the two states. In the case of pureuncertainty the probabilities are determined by nature.

However, if the behavior of the individual is not observable, the probabilitiesare alterable by the individual and a transaction cost problem arises. As hasbeen noted above the transaction cost problem requires: 1) the presence ofuncertainty (here the probability of a fire), and 2) the ability of the individual tochange his behavior without costless detection. Since the firm cannot observebehavior, this implies individuals all become careless, which alters the marginalrate of substitution! The introduction of costly information leads to preferencesno longer being fixed and exogenous, and this is an example of a fundamentaldifference between the two types of models. [ Arnott and Stiglitz (1988) explorethe implications of shifting marginal rates of substitution].

The solution to this particular problem has the insurance company offeringan incomplete contract (an insurance contract with a deductible), which pointsto a second difference. Namely the possible non-existence of explicit transactioncosts in equilibrium. The insurance company, by offering an incentivecompatible contract, does not engage in any form of direct monitoring. Suchmonitoring is not necessary, and many property right models have no actualresources used to establish and maintain property rights in equilibrium. In thiscase, the transaction costs are simply the lost gains from trade that result fromthe incomplete contract.

As a second example, consider a variation on the principal-agent model firstintroduced by Stiglitz (1974) . In this model the effort of a risk averse agent isunobservable, and so a contract is reached that trades off incentives for riskavoidance. For example, consider the case of cropshare contracts, where a riskaverse farmer contracts with a risk neutral landowner [ Allen and Lueck (1995) ].For a plot of land, output is q=(e + ) , where e is the unobservable labor effortand is a random variable with mean 0 and variance Ó. Furthermore, assume thatthe farmer's income is Y = q + , and his utility is U=E(Y) + (r/2)Var(Y) , where r is a measure of risk aversion, is the share of output, and is a fixed sidepayment. Finally, assume that the cost of effort to the farmer is c 0 + c 1 e + ( c 2 /2) e 2 .

For a given output-share the effort which maximizes farmer utility is:

which represents the behavior of the farmer and becomes a constraint to thelandowner designing the optimal contract. This incentive compatibilityconstraint represents another example of a fundamental distinction in modelingproperty right distributions --- namely, the constraints often involve optimizationproblems. The next stage in this particular problem involves the landownermaximizing his expected income E [(1 - ) ( ê + ) + ] subject to the incentiveconstraint and a participation constraint.

Although the principal-agent model has been extended and broadly applied,[see Holmstrom (1979 , 1982) , Dewatripont (1989) , Freixas et al . (1985) , or Shavell(1979) for examples], it has recently fallen out of favor for models where allparties are risk neutral [see Grossman and Hart (1986) , Eswaran and Kotwal(1985) , Leffler and Rucker (1991) , and Allen and Lueck (1992a) for examples]. Holmstrom and Milgrom (1991) develop an explicit principal agent model whererisk aversion is not required. The great advantage of risk neutrality is that itallows for several margins over which transaction cost behavior can take place.However, though there remains no single way to model transaction costs in theproperty rights approach, the bottom line remains that it does involve somefundamental differences from putting a "T" in a cost function.

8. Direct Empirical Work  

The empirical work in transaction cost economics is very large. On the propertyrights side, studies have examined vertical integration [ Globerman (1980) , Globerman and Schwindt (1986) , Joskow (1985) , Masten (1984) , Masten,Meehan, and Snyder (1989 , 1991) , Monteverde and Teece (1982) , Levy (1985) , Anderson (1988) , Mahoney (1992) , and Fishback (1986 , 1992) ], long-termcontracts [ Crocker and Masten (1988) , Joskow (1985 , 1987) , Leffler and Rucker(1991) , Masten and Crocker (1985) ], franchising and share contracts [ Williamson(1976) , Lafontaine (1993) , Zupan (1989a , 1989b) , Allen and Lueck (1992a , 1992b , 1993) , Alston, Datta, and Nugent (1984) , Alston and Higgs (1982) , Datta, O'Hara,and Nugent (1986) ], marriage [ Allen (1990 , 1991) , Brinig (1990) , Brinig andAlexeev (1993) , Parkman (1992) ], wildlife [ Lueck (1991) ], horse racing [ Hall(1986) ], price adjustments [ Crocker and Masten (1991) , Goldberg and Erickson(1987) , Joskow (1988b , 1990) ], economic history [ North (1981) , North andWeingast (1989) , and North (1990) ], rate of return regulation [ Crew andKleindorfer (1985) ], and a host of other organizational issues [see Shelanski andKlein (1995) for a more complete listing of references to the empirical literature].

Studies in the neoclassical approach are also numerous, and mostly focus onasset arbitrage, the volume of trade, risk adjusted returns, and the bundling oftransactions [see Demsetz (1968) , Frenkel and Levich (1975) , Litzenberger andRolfo (1984) , Malkiel (1966) , Phillips and Smith (1980) , Protopapadakis and Stoll(1983) , Smiley (1976) , Schultz (1983) , Fisher (1994) , Pesaran and Timmermann(1994) ]. It should be stressed that the empirical transaction cost literatureseriously tests hypotheses, and therefore by its existence refutes the assertionthat transaction cost economics is tautological. However, most of property rightand neoclassical empirical studies are of the comparative static variety andattempt to test transaction cost hypotheses using various proxies for assetspecificity, uncertainty, measurement costs, friction, and other transaction costvariables in reduced form equations. There are only two studies that haveattempted to measure the level of transaction costs.

The first, and perhaps most ambitious of these is Wallis and North (1986) ,who attempt to measure the entire transaction sector of the economy over 100years. Understandably, the first problem they face is how to define transactioncosts. Their property rights background leads them to define transaction costsas "the resource costs of maintaining and operating the institutional frameworkassociated with capturing the gains from trade". In the end, however, theysimply separate resources devoted to transacting as their measure, and in doingso ironically come closer to a neoclassical definition. Although theyacknowledge the conceptual problems this definition has with respect to firms,they settle for the following compromise:

We divide occupations into those that provide primarily transaction services tothe firm and, by elimination, those that provide primarily transformationservices. The wages of employees in these "transaction occupations" constituteour measure of the transaction sector within firms. [ 1986, p. 100 ]

This compromise would require all protective services (police, courts, etc.)included in the non-transaction sector of the economy, which makes Wallis andNorth so uncomfortable, they switch its classification ( pp. 102-103 ). The analysisof Wallis and North concludes that the transaction sector accounts for asignificant part of the economy, and that this has grown form 25% to 40% overthe years 1870 to 1970.

Davis (1986) , however, has pointed out that this estimate is not robust foreven small changes in the line that separates "transactions" from "production".In the end, the problem of definition seems overwhelming. Is a farmer amanager/marketing agent, or a grain-growing field hand? All jobs have elementsof production and transaction in them, and it seems an impossible task toseparate them. This perhaps best explains why Wallis and North were both thefirst and the last to tackle transaction costs on such a grand scale.

A more sophisticated treatment of measuring the costs of organization isfound in Masten, et al . (1991) . They note that much of the empirical literatureproxies only "the hazards of market exchange", and ignores the internal costs ofgovernance. Reduced form estimates are unable to distinguish between internaland external Transaction costs.

Furthermore, attempts to directly measure transaction costs are subject to theproblems faced by Wallis and North. Finally, Masten, et al . recognize theselection bias that occurs since the efficient organization structure is chosen andthe other choices are not observed. Their solution is to utilize switchingregression techniques, and to adopt censured regression models used in laboreconomics. From this technique they obtain actual dollar estimates oforganization costs, and therefore can estimate the magnitude of individualcoefficients and not just their relative impact. Masten, et al . apply thismethodology to Naval shipyard contracts and find that overall organizationcosts amount to 14% of total costs. The estimate that if an incorrect contractualagreements is chosen that this would lead to increases in organizational costsof up to 70%.

9. Conclusion  

The essential element of transaction costs, that property rights must beprotected, is found in most fields of economics and throughout the discipline'shistory. Adam Smith, in discussing foreign trade, endowments, corporateownership structure, and non-profit organizations repeatedly exploits conceptsof costly information and the ability of individuals to exploit others ignoranceto their own advantage [see West (1990) for an account of Smith's anticipationof modern economic ideas like principal-agent relations]. In macro-economics thenotion of costly information lead to the rational expectations revolution andsubsequent real business cycle models based on search and the disincentivesfound in unemployment insurance programs. Public choice models are foundedon the premise that individuals can use the state as a mechanism to transferwealth to themselves. In game theory, the prisoner's dilemma and othernon-cooperative games are essentially transaction cost problems. And otherfields like industrial organization, international trade, development, and labor, allcontain ideas that hinge on the protection of property rights.

Given its long history and prevalence, it is ironic that the definition oftransaction costs would be so difficult to agree on. This paper has argued thattwo definitions prevail in the literatures: one that defines transaction costs asonly occurring when a market transaction takes place; the other definingtransaction costs as occurring whenever any property right is established orrequires protection. I have called these the neoclassical and property rightsdefinitions, and have argued that which definition is useful depends on whatquestion is being examined. Recognizing the distinction, though, is important forremoving ambiguity and animosity.

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© Copyright 1998 Douglas W. Allen