Efficient outcome with Zero Transaction
Costs
Pappu, Sastry
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Table of Contents
Abstract ........................................................................................................... 2
Efficient outcome with Zero Transaction Costs ................................... 3
Introduction .................................................................................................... 3
Transaction Costs ...................................................................................... 4
Application in Shipping Industry ........................................................... 5
Conclusions ................................................................................................. 8
References ...................................................................................................... 9
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Abstract
This is the answ er to the question of how an efficient outcome is ensured w ith
negotiating aw ay the Transaction Costs in a ‘Coasean’ w orld. The intention is
to identify the Transaction Costs (TC), relate economic theories to the Shipping
industry, appreciate the factors that increase the TC, inv estigate the factors
that could help reduce the TC, and analyze how the outcome could be an
efficient one w ith Zero TC.
Keywords: Transaction Cost, Coasean World, Economics in Shipping
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Efficient outcome w ith Zero Transaction Costs
The main references are made from Besanko et al. (2010) to w orks of
Nobel laureates British Economist R.H. Coase and American Economist Oliv er. E.
Williamson. “Coasean” is a w ord coined around the Theory of the Firm by R.H.
Coase (1937). Coase questioned the economics w ithin the organization. His
arguments gained much traction w ith the discussions brought forw ard by
Williamson in his w orks regarding the Transaction Cost Economy (TCE) (Bylund,
2015).
Introduction
The theory put forw ard by Coase (1937 & 1988), w as ground breaking
w herein he questioned that, if there is a production possible w ithout an
organization, w hat could be the circumstances for hav ing an organization to
start w ith? He defined a “Firm” as an organization w ith a nexus of contracts,
both internal and external so as to balance the capabilities and costs. Such a
‘Coasean Theorem’ w as the basis for w orks of O.E. Williamson (1979 & 1981) who
discussed the factors determining the TCE.
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Transaction Costs
Transaction cost (TC) is a cost associated w ith the time, effort and resources
that are incurred for activ ities of acquiring the necessary know ledge,
negotiating contracts, monitoring outputs and liabilities thereof. According to
Coase (1937 & 1988) if it is know n w hich party is eligible for the rights under a
contract and if TC is Zero, then the output w ill be most efficient for the society
but not before one party is made better off at the cost of another to reach the
equilibrium. Coase used simplified examples and idealistic organization
structures to focus on the output being efficient for the society only in monetary
terms.
The truth of today is how ever that not many idealistic organizations exist, there
are many large firms w ith lean structures, there is efficient communication that’s
taken for granted, TC is seldom Zero in practice and there are many game
theories that dictate market strategy and firms now focus on obscure goals
instead of just the efficient outcome in monetary terms alone. Ev en though
simply put by Coase (1988), the fact remains true that the firm size is determined
by the number of contracts. A larger firm w ill hav e lower costs in increasing the
number of transactions it performs, possibly because it may be hav ing existing
systems in place to do so. When there are more transactions, the expertise and
precedence of terms may bring TC close to Zero.
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Application in Shipping Industry
This is an attempt to look at these economic theories in the context of Shipping
industry w here the complexity of the contracts is tremendous. Figure – 1 below
show s the simplified version of Ship Ow ning model that requires the contracting
out of activ ities (mentioned in ov als) to counterparts (mentioned in rectangles).
Fig – 1: Simplified version of Complexity of Contracts in Ship Owning
(Reproduced by the Author from experience, with assistance of Pranav P.)
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Most of the ow ning firms in commercial Shipping are SPVs (Single Purpose
Vehicles) and thus can be considered as lone standing firms w ith no employees
but only contracts. The usual practice is that the ‘beneficial ow ner’ w ill set up
SPV for Ship Ow ning, get finance from Banks for the SPV, procure a ship w ith the
help of brokers and sign a ‘management agreement’ w ith a professional thirdparty Ship Manager. Ship Ow ners then hav e v arious functions that still require
counterparts and the Ship Managers hav e their ow n set of functions for w hich
they engage w ith other counterparts; reason being circumstances similar to
that of Bounded Rationality (Williamson, Transaction Cost Economics: The
Gov ernance of Contractual Relations, 1979). Thus, the costs handled by the
Ship Ow ner can be considered as internal costs and that handled by the Ship
Manager could be termed as external costs, though all costs are incurred on
account of the Ship Ow ners. Ship manager’s function is the informed
coordination w ith various parties for running the ship so it is alw ays possible that
many more of the functions of the Ship Ow ner in Figure – 1 are also giv en to
managers.
To illustrate the Buy v s Ow n dilemma (Besanko, Dranove, Shanley, & Schaefer,
2010), you could consider a management fee of USD 10,000 per month
charged by the Ship Manager to Ship Ow ner. The Ship Ow ners, say based in
Europe, w ill calculate a cost of USD 60,000 per month to hav e in-house staff and
resources to manage the ship themselv es. So, they w ill compare the internal
cost of performing the activ ity against cost of signing a management
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agreement w ith a third-party professional manager. I f the Ow ners w ill discover
that cost w ill only be USD 30,000 per month if their ow n management staff w ill
be stationed in I ndia, they could look at hav ing their ow n Ship Management
out of I ndia once they hav e a fleet of more than 3 ships, or could w ait to have
a fleet of ov er 6 ships so they can justify employment of additional staff w ithin
their Europe office to manage their ow n ships in-house.
Since professional Ship Managers have their own set of contracts with different
counterparts in place for v arious activ ities, their TC for getting more ships from
same ow ners w ill be negligible or absorbed w ithin existing pricing, thus Zero.
Ship Managers will have an increased TC if they w ill hav e to find a new Owner
for increasing the number of ships they manage. Ship managers w ho may have
expertise in managing large crude oil tankers of British Petroleum (BP) are
normally not geared for managing a Passenger ship if offered by Cunard. Many
professional managers are set up in such a w ay and at times create their own
competition because they are unable to manage all ships of an ow ner who
may hav e a div erse fleet. The conv erse is also true that larger Ship ow ners who
hav e a div erse fleet with several types of ships w ill find it more expensiv e to set
up ow n management in-house and so use third-party professional Ship
Managers w ith expertise in that type of ship so they w ould hav e a different set
of contracts for each of their SPVs.
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Conclusions
We can see that the Economic principles such as ‘Asset Specificity’,
‘Opportunism’ and ‘Trust’ play a role in the TC of Ship Managers and Ship
Ow ners. I t can also be seen that the outcome is efficient w ith Zero TC in an
existing relationship betw een a Ship ow ner and Ship Manager, not considering
externalities w hich arguably hav e a reciprocal nature (Coase, The Firm, The
Market and The Law , 1988). Similar to those suggested by Williamson (Bylund,
2015), there are factors in today’s corporate w orld too that cause a reduction
to bring the TC as close to Zero as practically possible. Many modern firms
believ e in a lean structure w ith only experts and critical staff for coordination on
full time employment – similar to SPVs ow ning Ships. They rely on third-party
serv ice providers through a netw ork of contracts. Such a model, as seen w ith
relationship betw een Ship Ow ners and Ship Managers, can result in increased
efficiency w ith better communication, something that’s easier and cheaper
now than ev er before.
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References
Besanko, D., Dranove, D., Shanley, M. & Schaefer, S., 2010. Economics
of St rategy. Singapore: John Wiley & Sons.
Bylund, P. L., 2015. Signifying Williamson's contribution to the Transaction
cost approach: An agent based simulation of Coasean
transaction cost and specialization. Journal of Management
St udies, January, 52(1), pp. 148-174.
Coase, R., 1988. The Firm, The Market and The Law. Chicago: The
University of Chicago Press.
Coase, R., 1937. The Nature of the Firm. ECONOMICA, November, 4(16),
pp. 386-405.
Williamson, O. E., 1981. The Economics of Organization: The Transaction
Cost Approach. Amercian Journal of Socioogy, November, 87(3),
pp. 548-577.
Williamson, O. E., 1979. Transaction Cost Economics: The Governance of
Contractual Relations. Journal of Law & Economics, October,
22(2), pp. 233-261.