A research project supported by the European Commission
FP5: Energy, Environment and Sustainable Development
Key Action 4: City of Tomorrow and Cultural Heritage
Thematic Priority 4.1.2: Improving the quality of urban life
Contract No: EVK4-2002-0095
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Transaction Cost Theory: a literature review
Author:
Institution:
Date:
Judit Péter
PSIRU
31/03/2003
Work Package: 1
Deliverable no.: 4
The transaction cost theory is based on Ronald H. Coase’s paper (1937) on ’The Nature of the
Firm’. In this paper, he asks that if resources can be effectively allocated by the price mechanism
then why should resource allocation be planned within firms. Then he suggests that the reason
behind it is probably the cost accrueing to using the price mechanism; thus it is profitable to
establish a firm. This cost may occur with regard to discovering prices and to negotiating and
concluding contracts. Consequently, in his view the price mechanism and entrepreneurial control
are alternative methods of organising production and are both mainly centered around the problem
of co-ordinating resource allocation.
Transaction cost economics has elaborated on Coase’s paper. The most important contributions to it
were O. Williamsons’ works (Markets and Hierarchies 1975, The Economic Institutions of
Capitalism 1985) both of which made a significant impact on the theoretical development of
transaction cost economics. Following Williamsons’ works orthodox microeconomic theory of the
firm-as-production-function is very much criticised by the transaction costs economists and is
replaced by the theory of the firm-as-governance-structure. The theory of the firm-as-governancestructure is based on the notion that due to the existence of transaction costs, economic institutions
develop in order to economise on such costs.
Transaction costs are considered as ex ante and ex post. Ex ante transaction costs include costs of
drafting, negotiating and safeguarding an agreement. Ex post transaction costs include
maladaptation costs incurred in case of non-compliance with requirements, haggling costs incurred
if bilateral efforts are made to correct ex post misalignments, set-up and running costs associated
with the governance structures to which the disputes are referred, bonding costs effecting secure
commitments.
It is mainly accepted that the existence of transaction costs depends on three factors: bounded
rationality, opportunism, asset specificity. If none of them exist then it means that there are no
WaterTime partners:
PSIRU, School of Computing and Maths, University of Greenwich, UK
ERL, Universidad Complutense de Madrid, Spain
Tampere Institute of Environmental Engineering and Biotechnology (IEEB), Finland
International Water Affairs, Hamburg, Germany
Nomisma, Bologna, Italy
Eötvös József College, Hungary
Coordinator: PSIRU, CMS (M257), University of Greenwich, Park Row, London SE10 9LS, U.K.
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transaction costs. Transaction cost economics claims to be able to specify the governance structure
that can efficiently manage economic activity in any situation. It argues that different structures of
governance will be best suited to the different combinations of the above mentioned factors.
Bounded rationality refers to the fact that individuals can not gain all relevant data that is necessary
to calculate probabilities and cause-effect relationships. It means that economic actors are faced
with incomplete information; that is, informational uncertainty exists.
Opportunism is based on the assumption that if bounded rationality exists then parties will attempt
to gain advantage over others in the hope of achieving more favourable contract terms. Given
bounded rationality it is very difficult to uncover untrustworthy individuals ex ante. In order to
safeguard against such behaviour, parties select from the various institutional arrangements to
mitigate the expected costs.
Transaction costs appear when asset specificity is high. In cases of non-specific assets, markets can
efficiently allocate resources, because it is easier to enter to the market. High asset specificity
makes it difficult to use the asset for other purposes than for which its specific nature is designed.
When investments become more specific, the danger of opportunism becomes more relevant. In
order to avoid or mitigate the costs related to opportunism with regard to highly specified assets and
when transactions are frequent, then it is probable that a specialized governance structure will
develop within a firm. With less specialized assets but with still frequent transactions, the form of
governance will become relational contracting (the trading partner remains independent but
commiting itself to long-term relationship). With the help of transaction cost economics, it is easier
to understand why it is that under different circumstances different forms of governance prevail,
from contracts and transactions on the market to a hierarchical form, vertical integration.
The transaction cost economics and organization theory have great influence on each other.
Organization theorists accept that transaction cost economics point out some of the attributes of the
firm that was not analysed by them before. Also, it is acknowledged that the model used by
transaction economics is better for understanding the integration of production in big companies
than by other theories. However, it is argued that transaction economics cannot overtake
organization theory for it has limitations that are inherent in its assumptions, and approach.
The empirical researches of transaction cost economics are mainly different analyses of the various
determinants of transaction costs and their impact on the firm. In the majority, three organizational
modes are identified: market, hierarchy, hybrid and intermediate modes, that serve as dependent
variables in the model. Transactional properties such as asset specificity, transferability of assets
subject to a given transaction to a different use or different user, and other control variables serve as
independent variables. Some of the studies are related to a single industry and some examine crossindustry issues. There are various methodological approaches that are used: two-stage estimation of
organisation mode and performance; panel data estimation; history/analysis of joint ventures etc.
Relevance to water services
Transaction cost economics may point out several relevant questions in the field of water services.
It is undeniable that in the water services, bounded rationality exists, the assets are highly specific,
the number of economic actors are small and they are not ’faceless’, and thus the danger of
opportunism is high. Thus it is worth considering transaction costs, and how under different
conditions (legal, political, technical, cultural, etc.) they are economised.
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In most cases there are three aspects that could be analysed: a) the relationship between service
related to water and sewerage (both services provided by one or separate firms) from the service
provider’s point of view, b) the relationship between municipalities and the service provider; c) the
relationship between the service provider and the consumers. In all relationships transaction costs
might become very high but for different reasons.
The quality of the water provided through the system is dependent on several factors. However, the
most important ones are: what kind of water source is used (ground water and/or surface water) and
the technical conditions of the system itself. Most commonly, pollution of surface water occurs due
to direct emmissions of untreated sewage. This is one of those problems where transaction costs
may become prohibitively high and could force the service provider to reorganize its governance
structure resulting in a new form of governance.
Ground water pollution is caused mainly by other economic activities than the water service. It may
happen that the ground water that is used to satisfy water needs becomes polluted and cannot be
used at all, not even for watering flowers. (As recently was the case in one settlement in Hungary.)
The existence of such a threat to ground water may or may not be known to the service provider. In
cases where it is known, the transaction costs related to securing the quality of water and/or to
prepare for the use of alternative sources will affect the governance structure.
Technical conditions of the systems differ greatly. Quite often, information on the actual status of
the pipelines does not exist. Also, the technical conditions are not always in compliance with the
services to be used. In some cases, it is difficult to predict how demand for the service will change
over time, because there are several factors that might have a direct impact on it such as
employment prospects, age distribution of the population etc.
An analysis based on transaction cost economics could focus on which kind of organizational form
is used, what is the role of asset specificity, and how it is possible to overcome the problem of
bounded rationality.
There are various forms of relationship between the service provider and municipalities. Practice
shows that transaction costs accrued from bounded rationality and opportunism might be very high
on both sides. Thus it would be worthwhile to analyze the reasons and the type of transaction costs
that occur on each side and the safeguards (including legal, technical, procedural, etc.) that are used
to minimize them.
It has been suggested that the transaction costs related to the opportunism of consumers might be
very high. There is an ongoing debate on what kind of control should be introduced in order to
avoid or to mitigate it. However, there might be transaction costs on the side of the consumers that
are indirectly inflicted on them by the service provider. If due to sewage pollution the quality of
surface water deteriorates to such an extent that it cannot be used for bathing purposes, it means that
transaction costs are inflicted on the consumers by the service provider. Is there any way in which
consumers can minimize those costs?
Due to the various uses of water, consumers tend to use those resources that best suit the purpose;
for bathing, a natural watercourse gives different satisfaction compared to a bathroom tub, a well on
the property might be used for watering and other purposes. If the service is used for the same
purposes, the costs of using the sewerage system may be incurred compared to the zero cost of
using the well. Transaction cost theory could be used to point out the various costs (and their
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magnitude) that are likely to be incurred by either the service provider and/or consumers, and in
what framework those costs are dealt with.
Economic analysis of law
As the above mentioned examples indicate, the complexity of water service is great. Transaction
costs may become prohibitively high in a given situtation The legal environment may hinder or may
help to reach the best solution in economic terms. Some of the legal rules are stringent, some allow
flexibility. The very same legal provision may mean and allow different activities due to differences
in application of law or court practices. If transaction cost theory is to be applied in the Watertime
project it is important to review the legislation through the lens of that theory, as well. Otherwise
the chance of misinterpretation of the parties behaviour and the reasons behind transaction cost
could not be ruled out. (The following approach is the one that is taught at US law schools which
have been greatly criticized by Williamson.)
If there are zero transaction costs the efficient outcome will occur regardless of the choice of legal
rule. However, it does affect the distribution of income. If there are positive transaction costs, the
efficient outcome may not occur under all legal rules. In these circumstances the preferred legal rule
is the one that minimises the effects or transaction costs.
Standard assumptions of economic analysis that will be made in analysing the efficiency of legal
rules:
- common denominator: all benefits and costs can be measured in terms of a common
denominator. It is not essential to economic analysis and does not exclude considerations that might
be thought of as non-economic such as protection of life. However, to incorporate benefits and costs
that are not equivalent to a gain or loss of money would require the introduction of economic
concepts.
- consumer sovereignty: individuals themselves determine the cash values to place on their
benefits and costs.
- exogenous preferences: the values placed by individuals on their benefits and costs are
stable in the sense that these values are not affected by changes in public policy.
- utility (profit) maximization: maximize their benefits less their costs.
Efficiency refers to the relationship between the aggregate benefits of a situation and the aggregate
costs of the situtation. Pareto efficient or Pareto optimal: one allocation of resources is preferable to
another if, under the first allocation at least one person is better off than under the second while
noone else is worse off.
A distinction between the two aspects of Pareto efficiency can be made. Pareto optimality:
describes a state affairs such that it is impossible by any reallocation of resources to make anyone
better off without making someone else worse off; Pareto superiority: describes a relation between
two states of affairs A and B, such that A is Pareto superior to B if and only if, in A one person is
better off than he/she would be in B, while noone else is worse off. In that case it might be said that
a shift from B to A is a „Pareto improvement”.
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The distinction may be clarified by considering that one state (A) may be Pareto superior to another
(B) without being Pareto optimal, there might be another state (C) that is Pareto superior to (A).
One should also note that a Pareto suboptimal state (D) need not be Pareto inferior to a Pareto
optimal state (E): it may not be possible to move from (D) to (E) without making someone worse
off even though, once (E) is attained, it will be impossible by any further reallocation of resources
to confer additional benefits on anyone without imposing costs on someone else.
The Kaldor-Hicks efficiency (hypothetical compensation) is different from Pareto efficiency.
According to it, one allocation is preferable to another if under the first allocation some people are
so much better off than they would be be under the second that they could compensate those who
would be better off under the second allocation and still come out ahead. Note, that the
compensation need not actually be paid.
Based on the standard view regarding the relation of efficiency and utility is that efficiency is
preferable to inefficiency because it yields greater social utility. Thus the economic analysis of law
is a way in which the efficient rules could be determined.
In the Problem of Social Cost, Coase dealt with the actions of business firms that have harmful
effects on others, such as factory smoke, harmful to those occupying neighbouring properties.
The economic analysis of such situation has usually proceeded in terms of a divergence between the
private and the social product of the factory. The traditional approach of economists is if A inflicts
harm on B a decision has be made on how A should be restrained from such activity. According to
Coase the real question instead, is who should be allowed to harm the other, A or B, in order to
avoid the more serious harm. If the damaging business has to pay for all damage caused then the
pricing system works smoothly under the condition that the pricing system is without costs. The
parties could settle the case through bargaining. If the pricing system, the bargaining etc. have
transaction costs attached, then the efficient settlement will be reached when the transaction costs
are the lowest.
In relation to environment it is an everyday issue how it is possible to change the behaviour of the
business inflicting harm on the environment. The transaction costs related to bargaining is very high
since the number of those on whom the harm is inflicted on is usually high, thus the costs to
organize meetings to reach a common understanding of the problem and to reach a common
approach that unifies them in order to have one voice against the business is costly. For that reason,
there is an ongoing debate between economists working in the field of environment about the
internalization of the negative externalities (harming the environmnet) of business due to even
normal operation.
If simplified, there are two major approaches to how to overcome the problem of transaction costs
and of internalization of negative externalities: changing the price by using economic measures;
changing the operation of the business by introducing environmental management systems. It
means one approach is relying partly on the neo-classical economics, the other is on the new
institutional organizational movement.
References
- Boerner, Cristopher S.-McDonough, Robert e.: Transaction Cost Economics: An Assessment of
Empirical Research in the Social Sciences (http:/groups.haas.berkeley.edu/bpp/csb)
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- Williamson, Oliver E.: Why Law, Economics, and Organization? 2000 December
(http:/groups.haas.berkeley.edu/bpp/oew/wleaorg17b121800.pdf)
- Joskow, Paul L.: Transaction Cost Economics and competition policy October 2000 (http://econwww.mit.edu/faculty/pjoskow)
- Dietrich, Michael: Transaction Cost Economics and Beyond towards a new economics of the firm;
1994 Routledge, London
- Posner, Richard A. Economic Analysis of Law 3rd edition 1986. Little Brown, Boston
- Polinsky, A. Mitchell: An Introduction to Law and Economics 2nd. edition 1989. Little Brown,
Boston
- Kerekes, S.-Szlávik J.: A környezeti menedzsment közgazdsági eszközei (Economic tools of
environmental management 2nd edition1999. Közgazdasági és Jogi Könyvkiadó, Budapest
- Perrow, Ch: Szervezet szociológia (Complex Organizations); Budapest Osiris 1994
- Kieser, A: Szervezetelméletek (Organisationstheorien), Budapest Aula, 1995
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