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
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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.