Transactions cost economics
"Ronald Coase began his 1960 essay by arguing that when it is costless to transact, the efficient neoclassical competitive solution is obtained. This is so because the competitive structure of efficient markets leads the parties to arrive costlessly at the solution that maximizes aggregate income, regardlesss of the institutional arrangements.
This scenario is mimicked in the real world in situations where competition is strong enough via arbitrage and efficient information feedback to approximate the Coase zero-cost transaction conditions and the parties can realize the gains from trade inherent in the neoclassical argument.
In the real world, however, informational and institutional requirements necessary to achieve and realize the gains are stringent:
1. Players must not only have objectives, they must also know the correct way to achieve them, and it is through the instrumental rationality assumption that players know the correct way to achieve their objectives. The assumption states that even though the actors may have diverse and erroneous models, the informational feedback process and arbitraging actors will correct initially incorrect models, punish deviant behavior, and lead surviving players to the correct models.
2. An even more stringent implicit requirement of the discipline-of-the-competitive-market model is that when there are significant transaction costs, the consequent institutions of the market will be designed to induce the actors to acquire the essential information that will lead them to correct models. The implication of this is that not only are institutions designed to achieve efficient outcomes, but they can be ignored in economic analysis because they play an independent role in economic performance.
Both of these discuss stringent requirements that are realized only very exceptionally. The truth is:
1. Individuals typically act on incomplete information.
2. Individuals act with subjectively derived models that are frequently erroneous.
3. The information feedback is typically insufficient to correct individuals' subjective models.
Perhaps more significant, institutions are not necessarily, or even usually, created to be socially efficient. Rather they, or at least the formal rules, are created to serve the interests of those with bargaining power to create new rules.
In a zero-transaction cost world, bargaining strength does not affect the efficiency of outcomes; but in a world of positive-transaction costs, it does. Bargaining strength thus shapes the direction oflong-run economic change."
Economics of political markets
"I is exceptional to find economic markets that approximate the conditions necessary for efficiency. It is impossible to find political markets that do. This is because it is the polity that defines and enforces property rights. It is therefore not surprising that efficient economic and political markets are exceptional; in other words, inefficient markets are common.
Once an economy is on an "inefficient path" that produces stagnation, it can persist (and historically has persisted) because of the natrue of path dependence. Institutional path dependence exists because of the network externalities, economies of scope, and complementaries that exist with a given institutional matrix. The individuals and organizations with bargaining power, as a result of the institutional framework, have a crucual stake in perpetuating the system.
Institutional path dependence do get reveresed, but this reversal is a difficult process about which we know all too little. The reason is that we still know all to little about the dynamics of institutional change and particularly the interplay between economic and political markets."
Source:
Douglass North. 1993. "The new institutional economics and development"
May 31, 2008
May 18, 2008
Founders of New Institutional Economics: Douglass North (Part 1 of 2)
"The new institutional economics (NIE) builds on and modifies the neoclassical theory of economics. What is builds on is the funamental assumption of scarcity--hence competition. It views economics as a theory of choice subject to constraints. It employs the price theory as an essential part of the analysis of institutions. In particular, it sees changes in relative prices as a major force inducing change in institutions.
What NIE modifies in the neoclassical theory is the instrumental rationality assumption. In a world of instrumental rationality, there is perfect information. Economic and political markets are naturally efficient. Hence, institutions are unnecessary; ideologies don't matter.
The fact is, however, people have incomplete information and limited mental capacity by which to process information. In consequence, human beings impose contraints on human interaction in order to structure exchange. This implies that the consequent institutions inherent in the intrumental rationality assumption is not necessarily efficient. In the real world, ideologies actually play a major role in choices. Markets are not inherently efficient because the act of making an exchange has a cost. Transaction costs result in imperfect markets. And so NIE adds institutions as a critical constraint and analyzes the role of transactions costs as the connection between institutions and costs of production. It extends economic theory by incorporating ideologies into the analysis. More importantly, it models the political process as a critical factor in the performance of economies, as the source of the diverse performance of economies, and as the explanation for "inefficient" markets.
...
First, it must be remembered that individuals enter into economic exchange using mental models they use to interpret the world around them. These mental models are, in part, culturally derived. In another part, they are acquired through experience which is local to the environment where the individual is situated. Naturally, mental models vary widely with different environments and so there is immense variation in mental models. As a result, there are different perceptions about how people look at the world and the way the world "works." Even the formal learning that individuals acquire from educational institutions frequently consists of conflicting models by which the world around is interpreted.
Now as indicated, individuals entering into economic exchange make choices based on their mental models. The incomplete information and limited mental capacity by which to process information determines the cost of tranacting. The costs of transacting arise because information is costly and are assymetrically held by the parties to exchange. Transactions costs are determined by the costs of measuring multiple valuable dimensions of the goods and services exchanged, or of the performance of agents, and the costs of enforcing agreements.
This underlies the formation of institutions. Institutions are formed to reduce the costs of transactions (the uncertainty in human exchange). Together with the technology employed, they determine the costs of transacting and producing.
It should be remembered that at issue is not only the rationality postulate, but the specific characteristics of transacting that prevents the actors from achieving a joint maximization result of the zero-transactions cost model of neoclassical theory. The neoclassical result of efficient markets is only obtained when it is costless to transact. When it is costly to transact, institutions matter.
Because a large part of a country's national income is devoted to transacting (the act of making the exchange), institutions (especially property rights) are crucial determinants of the efficiency of markets."
Source:
Douglass North. 1993. "The new institutional economics and development"
What NIE modifies in the neoclassical theory is the instrumental rationality assumption. In a world of instrumental rationality, there is perfect information. Economic and political markets are naturally efficient. Hence, institutions are unnecessary; ideologies don't matter.
The fact is, however, people have incomplete information and limited mental capacity by which to process information. In consequence, human beings impose contraints on human interaction in order to structure exchange. This implies that the consequent institutions inherent in the intrumental rationality assumption is not necessarily efficient. In the real world, ideologies actually play a major role in choices. Markets are not inherently efficient because the act of making an exchange has a cost. Transaction costs result in imperfect markets. And so NIE adds institutions as a critical constraint and analyzes the role of transactions costs as the connection between institutions and costs of production. It extends economic theory by incorporating ideologies into the analysis. More importantly, it models the political process as a critical factor in the performance of economies, as the source of the diverse performance of economies, and as the explanation for "inefficient" markets.
...
First, it must be remembered that individuals enter into economic exchange using mental models they use to interpret the world around them. These mental models are, in part, culturally derived. In another part, they are acquired through experience which is local to the environment where the individual is situated. Naturally, mental models vary widely with different environments and so there is immense variation in mental models. As a result, there are different perceptions about how people look at the world and the way the world "works." Even the formal learning that individuals acquire from educational institutions frequently consists of conflicting models by which the world around is interpreted.
Now as indicated, individuals entering into economic exchange make choices based on their mental models. The incomplete information and limited mental capacity by which to process information determines the cost of tranacting. The costs of transacting arise because information is costly and are assymetrically held by the parties to exchange. Transactions costs are determined by the costs of measuring multiple valuable dimensions of the goods and services exchanged, or of the performance of agents, and the costs of enforcing agreements.
This underlies the formation of institutions. Institutions are formed to reduce the costs of transactions (the uncertainty in human exchange). Together with the technology employed, they determine the costs of transacting and producing.
It should be remembered that at issue is not only the rationality postulate, but the specific characteristics of transacting that prevents the actors from achieving a joint maximization result of the zero-transactions cost model of neoclassical theory. The neoclassical result of efficient markets is only obtained when it is costless to transact. When it is costly to transact, institutions matter.
Because a large part of a country's national income is devoted to transacting (the act of making the exchange), institutions (especially property rights) are crucial determinants of the efficiency of markets."
Source:
Douglass North. 1993. "The new institutional economics and development"
May 8, 2008
Founders of New Institutional Economics: Ronald Coase
In a first of a three-part series, I will write something about the about who I consider the three major founders of the new institutional economics--the Triumvirs if you will. You see, I think of myself as a new institutional economist, and what better to revitalize this blog than by gracing it first with the main teachings of the Triumvirs and how they introduced this dynamic field. First off--Ronald Coase.
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Coase attributes the term "new institutional economics" to Oliver Williamson (another Triumvir). The term was intended to differentiate the relatively new field with another already existing economic field: the (old) institutional economics.
The economists from the old school were also, of course, men of great intellect. Coase pointed out, however, that the major weakness of the old school is that it does not have theoretical foundations that bind together the facts collected by the old school. The new school does, and the following is what Coase considers to be the basic theoretical framework within which the new school uses economic tools to study all the economic systems.
1. The welfare of the human society depends on the flow of goods and services.
2. The flow of goods and services depends on the productivity of the economic system.
3. Adam Smith also figures importantly in the new school. He explains that the productivity of the economic system depends on the division of labor (specialization).
4. Specialization is only possible if there is exchange.
5. The lower the cost of exchange, the more specialization there will be. This will also lead to greater productivity of the system.6. Finally, the cost of exchange depends on the institutions of a country. The institutions are either the legal system, the political system, the social system, the educational system, culture, etc.
So Coase stated it so clearly and precise:
"In effect, it is the institutions that govern the performance of an economy."
Of course, when we talk about performance of an economy, economic development is not far behind. The next Triumvir that I will discuss is Douglass North, and he has some excellent take on the new institutional economics and economic development.
Source:
Ronald Coase. 1998. "The new institutional economics."
********
Coase attributes the term "new institutional economics" to Oliver Williamson (another Triumvir). The term was intended to differentiate the relatively new field with another already existing economic field: the (old) institutional economics.
The economists from the old school were also, of course, men of great intellect. Coase pointed out, however, that the major weakness of the old school is that it does not have theoretical foundations that bind together the facts collected by the old school. The new school does, and the following is what Coase considers to be the basic theoretical framework within which the new school uses economic tools to study all the economic systems.
1. The welfare of the human society depends on the flow of goods and services.
2. The flow of goods and services depends on the productivity of the economic system.
3. Adam Smith also figures importantly in the new school. He explains that the productivity of the economic system depends on the division of labor (specialization).
4. Specialization is only possible if there is exchange.
5. The lower the cost of exchange, the more specialization there will be. This will also lead to greater productivity of the system.6. Finally, the cost of exchange depends on the institutions of a country. The institutions are either the legal system, the political system, the social system, the educational system, culture, etc.
So Coase stated it so clearly and precise:
"In effect, it is the institutions that govern the performance of an economy."
Of course, when we talk about performance of an economy, economic development is not far behind. The next Triumvir that I will discuss is Douglass North, and he has some excellent take on the new institutional economics and economic development.
Source:
Ronald Coase. 1998. "The new institutional economics."
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