/
Information Costs, Property Rights and Markets II Information Costs, Property Rights and Markets II

Information Costs, Property Rights and Markets II - PowerPoint Presentation

ellena-manuel
ellena-manuel . @ellena-manuel
Follow
386 views
Uploaded On 2017-07-27

Information Costs, Property Rights and Markets II - PPT Presentation

Yoram Barzel 11 th Conference on Planning Law and Property Rights Hong Kong February 23 2017 Preliminary PreHistory In 1924 Knight introduced property rights into economics ID: 573468

attributes cost rights costs cost attributes costs rights free model property transaction contract information seller priced restaurants disputes good

Share:

Link:

Embed:

Download Presentation from below link

Download Presentation The PPT/PDF document "Information Costs, Property Rights and M..." is the property of its rightful owner. Permission is granted to download and print the materials on this web site for personal, non-commercial use only, and to display it on your personal computer provided you do not modify the materials and that you retain all copyright notices contained in the materials. By downloading content from our website, you accept the terms of this agreement.


Presentation Transcript

Slide1

Information Costs, Property Rights and Markets II

Yoram

Barzel

11

th

Conference on Planning, Law and Property

Rights

Hong Kong

February

23, 2017

PreliminarySlide2

Pre-History

In 1924,

Knight introduced “property rights” into

economics.

In

1937, Coase

introduced “transaction

costs” into economics.

Nothing else of significance was written on these two topics until the 1950s.Slide3

Pre-History

In

the

1950s

Aaron Director started asking questions

such as:

Why

would a maximizing business firm adopt practices such as “retail price maintenance” (also called “fair trade”) or vertically integrate?

In traditional price theory, commodity information was assumed to be costless, so it couldn’t respond to

these

questions. Director

developed “costs

of

transacting” tools for this purpose

. Slide4

Pre-History

In 1959,

Coase reintroduced

the idea of “property rights” in his paper, “

The Federal Communication Commission,” and

he then

elaborated and generalized

the idea with his revolutionary paper, “

The Problem of Social Cost” (1960).

Both papers were published in

The

Journal of Law and Economics,

first edited by Director and later by Coase, and both Director and Coase

lived to be over 100. Slide5

Pre-History

In

the

1960s,

Armen Alchian brought

“property rights” into the forefront of economic thinking as

an operational

concept.

Neither

transaction costs

nor

property rights

, however,

was uniquely defined,

and the

relationship between

them remained unclear.

Slide6

ObjectiveTo construct a model that, layer by layer, analyzes

transaction costs

and

property rights

.

The development is rigorous and includes a formal

model.

The

usefulness of the concepts is demonstrated by

deriving empirical

implications from the

model.

These are implications that the Walrasian model cannot

derive.

Some

major differences between the approach here and

that of much

of the literature are also

addressed.

As I see it, this paper is an extension of Coase, as well as of

Cheung.Slide7

Literature

Not

much has been written about approaching the cost of transacting from the informational

viewpoint that focuses

on measurement costs and free

attributes.

The exceptions are

primarily my own paper, “Measurement

Costs and the Organization of

Markets”

(1982

), my book,

Economic Analysis of Property Rights

(1997

),

and Allen and Lueck, “The Nature of the

Farm,"

JLE

(1998).

Note, however,

that I may

have overlooked other contributions.Slide8

The Examples

The

examples I use here are chosen primarily from areas

with which most

of us are

familiar,

such as automobile ownership, produce sold at

supermarkets, commercial parking, and

restaurant operations.

Using automobiles as

an example

is especially useful in that it brings out the distinction between economic

rights and

legal rights.

I also use the example of farm tenancy that Cheung’s groundbreaking analysis of share tenancy (1968) made famous.

I now proceed with the main discussion.Slide9

Relationship Between Property Rights and

Transaction Costs

Property rights

By

the definition adopted here, which is common to the literature,

economic property rights

(as distinct from legal property rights) indicate what people are

able

to do with property, or

assets,

that is, the ability to exclusively use and exchange

them.

As elaborated

here,

economic property rights

are

never

complete.

Transaction costs

T

ransaction costs

as defined here are the

(minimal) costs incurred in maximizing the value of economic rights.

By

these

definitions,

property rights

and

transaction costs

are

functionally

related. Indeed,

they are the two sides of same

coin.Slide10

Transaction Costs

The notion of transaction costs is brought to the forefront by

focusing on

unpriced

attributes;

attributes

which

are present in every exchange. These are costly to

produce, but not priced on the margin

.

As

a buyer’s marginal

cost

of using them is zero, buyers use them as if their cost

were zero

.

Examples of

unpriced attributes

:

The services that department stores’

salespeople

provide.

The quality

of non-uniform produce sold at

supermarkets,

which is selected by buyers and sold at a uniform price.

Soil

nutrients

in

a fixed-rent

farm contract.

Salt in

restaurants.Slide11

Transaction Costs

The

cost of information

is at the heart of the relationship between transaction costs and property rights.

One cannot obtain

information about the attributes of

an asset without incurring this cost.Slide12

Pricing of Attributes

Not all attributes are explicitly priced.

Information about goods is costly to obtain.

Goods and services have many attributes and measuring each of them so as to price them individually is prohibitively costly.

Examples

of

unpriced attributes

in a restaurant: salt, ketchup

, time

spet

there,

lighting, restrooms.

The

menu items are explicitly

priced.

A

seller who does not delineate an attribute places it in the public

domain, turning it into an

unpriced attribute.

Because such attributes are free to them, b

uyers

will

over-consume

them.Slide13

Steps Sellers Take to

Reduce

the

Cost

of

Overconsumption

The seller (free attribute provider)

takes steps to make consumption

of free attributes costly

to the

consumer.

Two examples of costs that free attribute providers

impose

on

consumers:

Restaurants’ use of

napkin

dispensers.

Such

dispensers are not used at

home.

2. More dramatic, and most appropriate in Hong

Kong,

where

space

is very valuable:

In crowded

restaurants, patrons who are waiting for a table

are admitted into restaurants’

interior.

They hover over those eating, imposing a cost on them which induces them to finish

faster

.

This reduces the

over-consumption

of

space

, which is a

free attribute

to patrons.

Slide14

Overpricing of

Priced

A

ttributes

The s

eller must recover the cost of the free attributes he is supplying; otherwise he would not survive under competition.

He

overprices

the priced attribute in order to recover the cost of the unpriced one.

So, along with the over-consumption

of the free

attributes,

we have the additional result of the

under-consumption

of the priced

attributes.

The

over- and

under-consumption

and the

associated dissipations

are illustrated in the following diagrams.Slide15

Dissipation Resulting from Unmeasured AttributesSlide16

Transaction Costs Arising from

Free Attributes

The high cost of measuring the unpriced attribute results in four types of transaction costs

:

Costs to the seller trying to curtail

over-consumption (effort to remove napkins from dispensers).

Costs to the buyer trying to capture the free attribute

(waiting time in

movie

theater where seats are unassigned).

Remaining

over-consumption

of the unpriced

attribute.

Resulting

under-consumption

of the priced

attribute.

These are all welfare

dissipations. (The

diagrams

display only points

3 and

4). Slide17

Dissipation Resulting from Unmeasured AttributesSlide18

Where Does this

Dissipation

O

riginate

?

Were the

attribute

priced

, there would be no

dissipation.

But the attribute is too costly to price, because it is too costly to measure and meter.

Here

the dissipation is minimized, and the outcome is always first

best.

Note that the term “dissipation” applies only in comparison with the Walrasian, zero transaction costs model. Slide19

The Walrasian Model

Diagram depicts

marginal value to the consumer (v) and marginal cost to the seller (c)

If there are no costs to obtaining information then welfare is maximized: Consumer Surplus is the red area and Producer Surplus is the blue area. Slide20

The question arises: What do the seller and buyer own to begin with?Slide21

What do the seller and buyer own to begin with?Because of transaction costs, buyers and sellers own the areas in the diagram on the right. Buyers own the (smaller) blue area. Sellers own the (smaller) red area.Slide22

The ModelI next introduce a simple mathematical model to formalize the role of transaction costs in the context of a good, attribute A, which may

be:

Offered for free

to buyers of a

complementary

good

(e.g., ketchup

when buying

French

fries

).

Priced individually

(soda

).

Not offered at all

(Tabasco

sauce

).

I am indebted to Aurora Stephany for developing the mathematical model.Slide23

The ModelConsider the problem a seller faces when deciding whether or not to offer a certain

attribute,

and if so

, whether to

charge for it explicitly or

to offer

it at no additional

charge with

the purchase of another (unit-priced) good.

For example, ketchup with fries.

We first need to look at consumer

behavior.Slide24

The Model: Consumer Behaviora is the amount of attribute being consideredv(a) is the marginal value function

e(a)

is the

buyer’s marginal

transaction

cost

of procuring amount

a

(wait in cashier line; look for parking spot

in

a garage).

If

the good is priced, the buyer will have to pay a unit price

p

.

Consumer surplus thus can be expressed as:

Slide25

The Model: Consumer Behavior

The

first order condition:

This is

the well-known result that the buyer will consume up to the point where his marginal value equals his marginal

cost.

However, in

this

case,

the cost

consists not

only

of the

price paid to the

seller,

but also

of the

effort it takes to procure the good. Slide26

The Model: Seller BehaviorIf good A were priced

,

the seller would receive

a

direct

revenue of

pa.

By

this model,

to be provided free of charge, good

A must

be

complementary

to a priced

good. (Otherwise, owners would not consider providing it

free of charge.

)

As A is complementary to the priced good, the

seller will

gain some

indirect revenue

(from selling more of

the priced good

)

.

We call this indirect marginal revenue

n(a). Slide27

The Model: Seller Behavior

We denote

c(a)

the

marginal cost of providing good

A.

m(a)

is

an additional marginal cost

for

metering and pricing

the good individually

(such as enforcement

cost when pricing movie seats individually).

The seller will incur this

latter

cost only if she decides to

charge for the good

instead of providing it

free of charge. Slide28

The Model: Seller Behaviorp

is

unit

price

n(x)

is

indirect

marginal revenue

c(x)

is

marginal

cost of provision

m(x)

is

marginal

cost of metering and

pricing

Naturally,

the seller will

choose the option that yields the largest PS, taking into account

buyer’s

behavior.Slide29

Graphical Representation of the Model

The blue line represents

marginal cost

c(a)

The green line is marginal cost minus the

indirect revenue

the seller will get if consumers obtain this good :

c(a) – n(a)Slide30

Graphical Representation of the Model

In the absence of any transaction costs, the seller will charge a unit price for good A, and as before, consumer surplus is the red area and producer surplus is the blue area. Slide31

Graphical Representation of the ModelBut

when priced, as a result of

the cost of pricing and metering the good,

m(a)

,

the

price is

higher

and welfare is

reduced. Slide32

Graphical Representation of the Model

If

m(a)

is large enough, it could become more profitable for

the

seller to simply offer the good

free

of charge:

Instead

of getting PS

that equals

the green area, they get the blue minus the

gray areas. Slide33

Graphical Representation of the ModelThe seller

may wish

to impose

restrictions

on

consumers

to reduce the overconsumption and get rid of the gray triangle. Slide34

Graphical representation of the modelHere, for example, the seller

imposes

some restrictions

on

consumers

to reduce

overconsumption

and

gets

rid of the gray triangleSlide35

Graphical Representation of the Model

One

of the contributions of

the

model

is that

it predicts that under certain circumstances, the seller would prefer to

reduce

buyers’

effort of acquiring the free attribute,

whereas the same seller, under

somewhat changed

conditions, will choose to

impose

costs

on the buyer

.Slide36

Graphical Representation of the Model

It is

also possible

that under certain circumstances, good A will

not be offered at

all

(even

though some people value it more than

its marginal

cost)

.Slide37

The ModelWe impose specific (linear) functional forms

on the elements (Aurora: parameters?)

in our model:

Buyer’s marginal

utility

v(a) = r –

qa

Buyer’s cost of effort

e(a) =

ε

Seller’s marginal

cost

c(a) = g + ha

Seller’s indirect revenue

n(a) = s - ta

Seller’s

metering cost

m(a) =

αSlide38

The Model

Solving the model

under these

functional forms, we obtain conditions under which the seller will: (1) choose to price good A individually; (2) offer it

free of charge

with the purchase of another good; or (3) not offer it at all.

The solution allows

us to predict when the seller will attempt to impose

costs on buyers

and when he will, instead, take measures to reduce

buyers

costs

. Slide39

Pricing ConditionsGood A is not offered at all

And

Or if

And

 Slide40

Pricing Conditions

Good

A is offered

free of charge if

AndSlide41

Pricing ConditionsGood A is offered at a unit price:

And

And the unit price is: Slide42

Economic Property RightsAs stated, economic property rights

are distinct from

legal property rights

.

Legal property rights

refer to what the State helps legal owners maintain.

Economic property rights

indicate

what people are able to do with property or assets; that is, the ability to exclusively use and exchange

them.

E

conomic

rights

are

never

complete, however (neither

are legal

rights); at

any

time,

some rights lie in the public

domain.Slide43

Example I: Ownership over carsBuyers

find

it very expensive

to

determine

the

condition of a

car

that is

offered for sale.

This results in low offer prices as buyers fear that the car may be a “lemon.” So ownership is

incomplete in that most owners receive offer prices below the “true” value of their cards.

Ownership is also incomplete in that you can’t do much with “your” car when it is stolen.

Having legal title to, i.e., legal property rights over, cars is not very useful when they are stolen.

No less important, ownership is incomplete in that the benefit from renting out the cars while they are not in use is foregone because of the costliness of “protection” from, among other things, careless use. Slide44

The Cost of

Establishing

Property Rights

In

order to maximize utility, people maximize the value of rights over their assets, net of the cost of establishing these

rights.

Transaction costs are the costs incurred in establishing the optimal level of economic property

rights.Slide45

Delineation of Property RightsAssets have multiple attributes, and it’s prohibitively costly to specify

all of them in

any given

transaction.

Throughout this talk, I revisit this idea because

I approach the problem from different

angles.

Delineating all

attributes

,

especially those that seem unimportant at contract

time,

is not worth the cost.

But some of the undelineated attributes may gain in importance within the

contract

period. This may become a source of dispute.Slide46

Example II: Farm Rental ContractProblems

in delineating

contracts

We expect the farm rental contract to cover

both the

more important attributes and

the

more

likely

contingencies

.

Because

each farm is unique,

the

contract

would

have to be drawn up specifically for each

farm to

be “

complete.

It is too costly, however, to delineate every

attributes and contingency,

so the agreement may

become

subject to dispute.Slide47

Delineation and the Coase Theorem

If a number of farms were identical

to each other, it would

be

necessary to delineate the attributes

only once

for all of them. The larger the number of identical farms, the lower the delineation cost per

farm.

Complete delineation would have met the condition of the

“Coase

Theorem

.”

But complete delineation is prohibitively

expensive.

Still

, the economies of scale in delineation are

evident.Slide48

FuturesFutures transactions provide an illustration both of the economies of scale and of the costliness of

delineation.

Futures contracts for each commodity

transacted in futures markets are

very numerous, so they are

well

delineated.

Part of the cost of transacting

these contracts consists

of the spread in trading them, which indeed is very

small.Slide49

Futures But

futures are

subject to another transaction cost.

Suppliers have no incentive to supply a

ny attribute not delineated in the contract, even if it is valuable.

For that reason, the

quality of futures commodities is sometimes characterized as “junk

”.

Thus

,

commodity traders seldom

trade the commodities underlying the

futures contracts

.Slide50

Economies of Scale in Delineating Chain Restaurants

By operating

chains of restaurants,

and

offering

similar services in multiple restaurants (e.g., placing condiments in same location, using the same quality napkins

),owners

can

also exploit

scale economies in

the delineation of their services.

This

enables owners to capture a larger fraction of the value of their services, and

leaves

fewer

services in

the public domain.

Thus they delineate some

of the attributes

that

stand-alone

restaurants offer free of

charge.

Along with offering fewer free attributes, we also expect

chain restaurants to

lower the level of overpricing

their

priced items, and

to charge

a lower

real

price for their

services. Slide51

Scale Economies in Delineating

Chain restaurants’ Employment

Contract

The difficulty in

observing

labor effort

means

that

the

cost of measuring effort is

high

. Therefore,

it

is

difficult to perfectly delineate a labor

contract.

Because

of the costliness of delineating labor performance, scale economies in delineation

are important

.

For instance, s

cale

economies in delineating workers’ effort

may be exploited in chain

restaurants

.

Owners of chain restaurants can exploit

their scale by delineating their wage contracts in greater detail than stand-alone restaurants can

.

We expect owners to

pay their workers higher monetary (and real) wages because these are offered fewer free

attributes.

Owners

’ property rights have been

enhanced because of the superior delineation of their products and their labor services.Slide52

Scale Economies in Delineating Labor Performance

I propose

that

as large

firms

have many employees, they are

able to exploit

scale economies in delineating labor contracts,

and thus

to offer

fewer free attributes to their employees.

As

such employees

are offered fewer free attributes, they must receive higher wages than

do employees

of small firms.

This

observation might explain the prevailing wage disparity between small and large

firms.

Refutable implication: Large

firms whose labor force is concentrated in a single location

pay

their

wage workers

higher wage than

do large

firms whose

wage workers

are

dispersed.

(Concentrated large

firms,

for instance,

measure time on the job more accurately as they tend

to

have

more card punchers than do

dispersed firms

.)Slide53

Alternative Labor Contracts

Farm

workers may be employed on a wage contract basis, or

they may

operate independently as fixed rent tenants

(they may also operate as

share contractors, but this does not add to the

present discussion).

When

operating

on a fixed rent basis,

nutrients

in the soil become free attributes to them.

Thus,

they will extract

the nutrients

to

the point

at which the nutrients’ marginal

product is zero.

But when they operate

as wage workers,

they do not gain from extracting

such nutrients

, and thus, if anything, their employers are expected to instruct

them, at least indirectly,

to exploit the

nutrients (but

to the optimal

level).

The more fertile the soil, the more dissipating the fixed rent contract, and

the

more advantageous the wage contract.Slide54

Disputes

In

the absence of

measurement

costs, all property rights can be delineated and ownership is well established.

When

information is costless, the outcome of a dispute is known in advance, and

disputes are

unlikely to

erupt.

Since

in reality the

cost of measurement is positive,

property rights are incomplete, and disputes over them may

erupt.Slide55

Disputes

Disputes occur when valued rights to assets or to commodity attributes are not fully delineated, so the assets or attributes have no clear owner. When such rights are sufficiently valued, people compete to acquire rights over them.

People expend resources when they compete for the disputed rights.

Importantly, each

(maximizing) party

expends resources

to the point

at which the

expected gain is equal to the cost.Slide56

Dynamics of Disputes

At any given

moment,

there are no disputes because people have already acquired from the public domain what they thought was

worth acquiring.

Conditions, however, change constantly. As the information

that individuals

possess changes, their incentives change too.

Thus, a neighbor

who seemingly

“all of a sudden” claims part of “my”

property,

must have just acquired information making the claim worthwhile to him now,

whereas earlier he did

not realize it was

worthwhile. Slide57

Types of Dispute ResolutionDisputing parties may resolve their disputes in a variety of

ways; for instance:

By negotiation

(sometimes in

the shadow of the courts

).

By

fist-fighting.

By jumping

ahead in the

waiting

line.

By rushing to be the first to get apples from a

branch

hanging over the

sidewalk.

When

the dispute is contractual, by going to court to resolve it.

In

all

disputes,

the costs of their

resolution

are

dissipating

,

and

the disputing parties

optimize (Aurora: minimize?)

these costs.

The

resolution

of a

dispute, at a cost, brings to private ownership what was in dispute. Slide58

Contracts and Contract Disputes

A contract, whether written or oral, constitutes the voluntary exchange of legal property rights.

Contracts are enforced by the

state.

Contracts are needed when exchange is not instantaneous and where future (non-synchronous) transfers are anticipated

.

A

dispute

over

an

agreement

may seem to be an

oxymoron.Slide59

Contract DisputesAs stated, contract

stipulations cover

only

attributes

which the

parties deem

to be worthwhile

stipulating

at

the contract

time.

The contracting parties

leave in the public domain other attributes relevant to the agreement because they view the cost of measuring and enforcing them to exceed the gain.

In

a farm

contract, for instance, they may ignore seemingly low value trees on the

property.

The value of an unassigned attribute can change

unexpectedly

(the trees are revealed to be valuable

),

and disputes regarding its ownership

may erupt.Slide60

Court Resolution of Disputes

I will dwell briefly on

court adjudication of disputes as it is well

understood.

Moreover,

the economic nature of the resolution of such disputes is readily apparent.

Suppose the dispute is over a monetary matter. Each side will employ lawyers and spend other resources

to the point

at which one

dollar spent yields

one

dollar in expectation

. Each

party takes

into account what it believes the other side

to be

doing. Each minimizes its expenditures to achieve its

objectives.Slide61

Court Resolution of Disputes

The nature of individuals’ maximization here is no different from how they normally maximize, for example, in

production, and

its nature is no different from what individuals do in resolving any

dispute.

All expenditures in dispute resolution,

however, are

dissipated.

But the

expected

dissipationis

necessarily less than the total value of the disputed amount.Slide62

Direct Transaction Costs

Direct transaction costs

include (1)

dissipation

from

overconsumption

of free

attributes; (2)

cost

of

arriving early to be at the

head of the line

in single-price

movie

theaters; (3)

cost

of negotiating disputes; and (4)

costs

incurred

from

building

fences

on properties

to reduce theft.

Slide63

Indirect Transaction Costs

Certain trades do not occur due to poorly delineated property rights.

The resulting welfare

losses

are

indirect

transaction

costs.

For example, if the overconsumption of a free attribute is significant enough and cannot be prevented, the unpriced attribute will simply not be

offered.

Some businesses would benefit from providing parking

space

for customers, but

they cannot

prevent

customers from overstaying

, or

non

-

customers from parking,

so they don’t offer the parking. The loss here is

an

indirect

transaction

cost.

Transaction costs (as defined here)

then may

be incurred even where there are no

transactions.Slide64

Testable Implications

The heart of the problem here is the costliness of information,

but it is difficult to measure the cost of information.

What we

need for testing,

however, is the

relative

cost of information.

Ordinary observations, then,

may

be

used for

testing the model.

The following is

predicted with the emergence of a

new minimum wage:

T

he

number of supervisors per employee

in large

firms will

increase. To employers, the cost of

employee shirking

has increased, and thus more resources will be spent to reduce it.

More

disputes will erupt. This is because the differential between market wage and the minimum wage lies in the public

domain.

Contracts

will contain more stipulations. This is because the value of adhering to them has increased.Slide65

Testable Implications

Each

of these

constitutes

a test of the costs of transacting, but

to perform the test, it is sufficient to observe variables

such as the number of stipulations in contracts.

Note that the Walrasian model is incapable of making these predictions

because prices

there

determine everything;

for instance, bread

in restaurants will

always be priced by the

piece,

and

will never be provided

free of charge.Slide66

Example: The Restaurant TransactionI will now illustrate some

of

the issues discussed earlier by considering ownership problems that are encountered with

additional discussion of restaurant

transactions.

Restaurants offer a

large

number of significant as well as insignificant commodity attributes. Owners

must

decide which of the attributes to delineate, and which not to. The ones delineated explicitly are

priced

on the menu.

Owners place

in the public domain attributes they do not

delineate,

such as salt and time spent in the restaurant

.

Both kinds of attributes must be produced.

Unlike free attributes, delineated

commodities must be measured, policed, and served.

But

pricing them prevents dissipation of value

associated with attributes that

otherwise would

be provided free,

left in the public domain.

Whereas

the undelineated free attributes are over-consumed, they incur low serving costs. Moreover, priced attributes come in sizes that fit the average patron, whereas free attributes are consumed at the desired quantity

.

Owners take non-price steps to reduce the consumption of undelineated attributes, as with the seating practices in Hong Kong mentioned earlier. Slide67

Restaurants

Owners will place

attributes

complementary to the priced one

in the public domain because

the former increase

the demand for the

latter. That

increase must be

sufficient, though,

to

fully cover

the cost of the unpriced ones.

But to recover the cost of the free

attributes that owners

place in the public

domain

they charge extra for items on the menu.

Not all restaurants place the same attributes in the public domain. Bread and sodas are examples of attributes that are priced in some restaurants and free in others. Slide68

Restaurants

Two

refutable

implications here

are:

We expect e

xpensive

restaurants

to tend

to provide bread free of

charge to avoid the cost of metering it,

whereas inexpensive

restaurants to tend

to charge for bread by the

piece.

Otherwise

heavy users of bread will go to restaurants

simply to

consume the free bread.

Relatedly, in the

expensive

restaurants, free bread will be provided only

along with high-priced

menu items.

Slide69

RestaurantsRestaurants

that offer free bread must

overprice their

menu

items,

which results in their under-consumption.

High

prices deter consumers with a low demand for bread from eating there, forcing extra overpricing.

The overpricing

can lead

to the death-spiral,

just as it does with

insurance.

This

cycle may lead to the withdrawal

from the market of

the commodity

that is accompanied by free attributes.Slide70

Problems with the Literature

The

economics literature

, sometimes

implicitly,

assumes

that some information

is either

costless

or that it

is

prohibitively

costly

.

These assumptions lead to untenable implications.

In contrast, here

it is assumed that information is

always costly

, and

that although it is often

prohibitively so, its cost is not systematically prohibitive.

Slide71

Problems with the Literature

Three branches of the literature that are subject to

the

problem are (1) contract theory; (2) the theory of the firm; and (3) bargaining theory.

I consider here only contract theory and bargaining theory.

The critique of (essentially Hart’s) theory of the firm is a bit too convoluted to be exposed here.Slide72

Contract Theory

The c

ontract

theory literature deals with two

problems

; one of

moral hazard

and the other of

adverse selection

. The two share basic informational assumptions. I discuss only the adverse selection model, as the discussion of moral hazard adds little

here

.

Adverse selection.

The basic adverse selection model (Spence, 1973) analyzes a principal who employs two types of agents, high productivity and low productivity ones. Agents

know

their type.

Slide73

Contract Theory

I

focus on the notion that agents “know” their type. What does it mean to “know” something?

Although it

may not be obvious,

this claim

implies, as I now argue,

that the agents acquire the information at no cost.

Slide74

Contract TheoryOne informational

ingredients from elementary school is fluency in arithmetic.

Under the assumption just stated, agents know

,

at no cost

, that one plus one equals two, and that adding one more makes the sum equal to three, and so forth. This

ability may

appear trivial, but

in fact all computer operations are based on addition,

though

they do it extremely

fast, they incur

minute but positive costs in performing addition.

Because individuals

here incur zero cost in

performing addition

, it follows that they can

do it even better than

computers

can.

So

agents can perform any number of arithmetic operations instantaneously.

Slide75

Contract TheoryIn other words,

agents can

perform instantaneously all the operations computers can

perform, no

matter how roundabout a way is required for arriving at any

outcome. So

individuals can master virtually all quantifiable information at no cost, and thus there is no limit to their quantitative knowledge.

It follows that they will have acquired all past

information needed to know their type

at no cost and can retrieve it costlessly in the present.

The

assumption

that agents know their type, then, has

far-reaching implications:

they can

then obtain

all

relevant quantitative information at zero cost.

Such

an implication radically

alters the results

that are usually attributed to contract theory.

Among

other things,

it turns out that both

low and high productivity types know their type costlessly

,

so the

distinction between the two

vanishes.Slide76

Contract TheoryIt transpires that the seemingly innocent notion that anybody

simply “

knows” something at no cost is untenable. If individuals can obtain all the information underlying their type at no cost,

then

the most basic principal-agent model turns to be a useless tool

for analyzing

economic problems. Slide77

Contract TheoryA different interpretation of the question of how much it costs

to agents

to know their

type is that while it is not quite zero, it is “very low.”

The

view here is that agents have a

cost-of-information function

. Once

a change

in conditions is admitted, “very low”

simply becomes

a point on that function.

Low

information cost, then,

turns

into a special case of positive information cost, as it is in reality, and as assumed

here.Slide78

Contract TheoryThus, agents as well as the principal

can get information about each other. They will meet the standard equilibrium condition in their decisions

about how

much information to acquire. So

interpreting the

assumption of zero information cost

as low information cost converts

the principal agent problems into standard micro economic ones

.

Similar considerations apply to the analysis of moral hazard, but I will skip that

discussion.Slide79

Conclusions about Contracts

The basic principal-agent model is based on the notion that individuals “know” their type at no cost (and

that

the

principals’ cost

to “know” agents’ type is prohibitive).

Demonstrated

here is that the entire edifice constructed on the basis of these informational assumptions simply crumbles. What transpires instead is that the analysis of the formation of contracts between agent and

principal

requires standard microeconomics analysis, where costs and gains are equated on the margin.Slide80

Disputes and Bargaining Power

The approach in much of the literature (Rubinstein excepted) is that when there is a pie

(a surplus) to

be divided, the parties use their bargaining power to determine their shares in it, and that they do

so costlessly.

It

is also assumed, but only implicitly, that besides using bargaining power, there exist

no

way

or no

margin

for the

parties

to exploit with which to

enhance their share in the

pie (or surplus).

It

is curious that unlike bargaining in the bazaar, the use of bargaining

power in bargaining theory

takes place without the parties dickering with each other and without use of resources. This result is presumably obtained because each of the parties knows (note that “knows” creeps in here too) precisely how much bargaining power the other has, and thus the outcome is determined without the use of resources.Slide81

Disputes and Bargaining Power

In my view, margins

that

the parties

can exploit to increase their

shares

in the pie are

always available (e.g., walking

away, pretending there are different

offers, estimating each other’s bargaining power)

.

This

act of exploitation consumes resources. Each party will spend so

much as

to maximize

his or hers share

, taking account of what he or she thinks the other will do.

Thus,

dispute resolution, as discussed earlier, is subject to standard analysis.

This implies that the

pie shrinks in the process of dividing it. The pie is in the public domain, and the resources spent to claim it constitute transaction costs, or dissipation.

Note

that bargaining power does not even appear in this

picture.Slide82

SummaryTransaction costs are the costs individuals incur

in order to maximize the value

of their

economic property rights, i.e.,

what

they can

do with properties. As enhancing these rights incurs

costs,

property rights are never complete. Commodities have numerous attributes, and delineating them all is prohibitively costly. Only a subset of attributes is delineated, and the rest are left in the public domain. What is in the public domain is consumed to the point

at which

its marginal

values

is zero

.

An example of an over-consumed attribute is the soil nutrients that fixed-rent farm tenants extract.

To

prevent

such over-consumption

, the landlord has the option of switching to

a wage

contract. Under the

latter,

workers have no incentive to over-exploit the nutrients.

Sellers use various inducements to encourage consumers to consume more of the priced

commodities.

To recover the cost of the undelineated attributes, the seller overprices the commodities he delineates, which are thus under-consumed.

The buyers’ and sellers’ equations developed here explicitly incorporate the costs of transacting. Slide83

SummaryDelineation

is subject to scale economies. Thus, chain restaurants delineate in greater detail than stand-alone restaurants

do both

the attributes of their offerings and their contracts with their

workers.

The competition

over

public

-domain attributes constitutes disputes. Contracts constitute what the parties agree to transfer to each other. Contract

disputes occur

when an unstipulated attribute becomes valuable enough for

parties

to compete

for.

People spend resources, which are transaction costs, to settle the disputes.

These expenditures

meet the conventional marginal

conditions

.

“Bargaining

power”

simply does

not enter

this

picture.

In

much of the

economic literature,

information costs are assumed to be either zero or prohibitively costly. These extreme assumptions lead to untenable conclusions in, among others, contract theory, the theory of the firm and

bargaining theory.

Moreover,

unlike the model developed here, these

models cannot deal with nuanced

real-world outcomes,

such as

the

expected increase in workers’ contract stipulations subsequent to the introduction of

a minimum

wage.