EC516 Contracts and Organisations for Research Students: Lecture 2 Leonardo Felli LSE, D6 26 February 2009
Transaction Costs EC516 Contracts and Consider now a different cause for the failure of the Coase Organisations for Research Theorem: the presence of transaction costs. Students: Lecture 2 Leonardo Felli Of course for this to be an interesting argument we need to Transaction abstract from other sources of failure of the Coase Theorem Costs Outline such as asymmetric information. Numerical Example What are transaction costs? SImple Theorem (Strong version of the Coase Theorem) negotiation Coasian solution Continuous The Coase theorem guarantees efficiency: (1) regardless of the Costs Alternating way in which property rights are assigned, and (2) whenever the Offers Bargaining Robustness mutual gains from trade exceed the necessary transaction costs.
EC516 Contracts and Organisations We are going to show that this is not necessarily the case. for Research Students: The reason is the strategic role of transaction costs. Lecture 2 Leonardo Felli Key factor: some transaction costs have to be paid Transaction Costs ex-ante , before the negotiation starts. Outline Numerical Example What are transaction These ex-ante transaction costs generate an inefficiency costs? SImple usually known as a hold-up problem . negotiation Coasian solution Continuous Costs Alternating Offers The hold-up problem yield an outcome that is constrained Bargaining Robustness inefficient .
Numerical Example EC516 Contracts and Organisations Potential Surplus = 100, for Research Students: Lecture 2 Ex-ante cost to each negotiating party = 20, Leonardo Felli Transaction Distribution of bargaining power = (10%, 90%), Costs Outline Numerical Example Ex-ante Payoff to party A = (10% 100 − 20) = − 10, What are transaction costs? SImple negotiation Ex-ante Payoff to party B = (90% 100 − 20) = 70, Coasian solution Continuous Costs Alternating Social surplus = 60. Offers Bargaining Robustness Coasian negotiation opportunity is left unexploited.
EC516 Contracts and Organisations Natural question: whether it is possible to find a Coasian for Research solution to this inefficiency. Students: Lecture 2 Leonardo Felli In other words we are asking whether the parties can agree Transaction ex-ante on a transfer contingent on each party entering a Costs Outline future negotiation. Numerical Example What are transaction costs? We are going to show that under plausible conditions a SImple negotiation Coasian solution of this form may not be available. Coasian solution Continuous Costs Alternating Offers The reason is that any new negotiation may itself be Bargaining Robustness associated with (possibly small) ex-ante transaction costs.
EC516 Contracts and In the Numerical Example above Party B makes a transfer Organisations for Research to party A contingent on the cost of 20 being paid by A . Students: Lecture 2 Leonardo Felli Assume that B makes a take-it-or-leave-it offer to A , Transaction Costs Outline Ex-ante costs to each party associated with this Numerical Example ‘agreement contingent on future negotiation’ = 1, What are transaction costs? SImple negotiation A accepts the agreement if B accepts it and: Coasian solution Continuous Costs Alternating 10% 100 − 20 + x ≥ 0 , Offers Bargaining Robustness or x ≥ 10.
EC516 Contracts and Organisations There always exists an equilibrium in which x = 10. for Research Students: Lecture 2 Leonardo Felli Ex-ante payoff to party A Transaction Costs π A = 10% 100 − 20 + 10 − 1 = − 1 Outline Numerical Example What are transaction costs? SImple negotiation No negotiation (contingent or not) will take place. Coasian solution Continuous Costs Alternating Offers Bargaining A Coasian solution is not available. Robustness
What are the transaction costs? EC516 Ex-ante transaction costs: Contracts and Organisations for Research Students: time to arrange a meeting, Lecture 2 Leonardo Felli time and effort to conceive and agree upon a suitable Transaction Costs negotiation language, Outline Numerical Example time and effort to collect information about the legal What are transaction costs? environment in which the agreement is enforced, SImple negotiation Coasian solution Continuous time to collect and analyze background information for the Costs Alternating negotiation, Offers Bargaining Robustness time and effort to think about the negotiation at hand.
EC516 Contracts and Organisations for Research These costs can be monetized through the hiring of an Students: Lecture 2 outside party: typically a lawyer. Leonardo Felli Transaction Costs The problem does not disappear if the lawyer needs to be Outline paid independently of the success of the negotiation: no Numerical Example What are contingent fees. transaction costs? SImple negotiation Coasian solution Continuous Indeed, monetizing the costs may increase the magnitude Costs Alternating of the inefficiency: moral hazard. Offers Bargaining Robustness
Simple Coasian Negotiation: EC516 Contracts and Consider the following simple coasian negotiation: Organisations for Research Students: Lecture 2 two agents, i ∈ { A , B } ; Leonardo Felli Transaction share a surplus, Costs Outline Numerical Example What are size of the surplus normalized to one, transaction costs? SImple negotiation Coasian solution parties’ payoffs in case of disagreement to zero. Continuous Costs Alternating Offers Bargaining Robustness Each party faces ex-ante costs: ( c A , c B ).
EC516 Contracts and Organisations Assume that ( c A , c B ) are: for Research Students: Lecture 2 Leonardo Felli complements: each party i has to pay c i for the negotiation to be feasible; Transaction Costs Outline Numerical Example What are affordable: party i ’s endowment covers c i ; transaction costs? SImple negotiation Coasian solution Continuous Costs efficient: c A + c B < 1. Alternating Offers Bargaining Robustness
EC516 Timing: Contracts and Organisations for Research Students: Lecture 2 Simult. Decisions Leonardo Felli on ( c A , c B ) Contract Transaction Costs enforced Outline Contract Numerical Example Negotiated What are transaction costs? SImple negotiation Coasian solution Continuous Costs Alternating ✲ ✲ Offers Bargaining s s s Robustness t = 0 t = 1 t = 2
EC516 Contracts and Organisations for Research We solve the model backward. Students: Lecture 2 Leonardo Felli Transaction We start with a simple bargaining rule: Costs Outline Numerical Example What are transaction Let λ be the bargaining power of A . costs? SImple negotiation Coasian solution Continuous Costs The division of surplus at t = 1 is then ( λ, 1 − λ ). Alternating Offers Bargaining Robustness
EC516 Result Contracts and Organisations For any given λ there exists a pair ( c A , c B ) of affordable and for Research Students: efficient ex-ante costs such that the unique SPE is Lecture 2 Leonardo Felli ( not pay c A , not pay c B ) Transaction Costs Outline Numerical Example What are transaction costs? Result SImple negotiation Coasian solution For any pair ( c A , c B ) of affordable and efficient ex-ante costs Continuous Costs there exists a value of λ such that the unique SPE is Alternating Offers Bargaining Robustness ( not pay c A , not pay c B )
EC516 Proof: The ‘reduced form’ of the two stage game is: Contracts and Organisations for Research Students: pay c B not pay c B Lecture 2 pay c A λ − c A , 1 − λ − c B − c A , 0 Leonardo Felli not pay c A 0 , − c B 0 , 0 Transaction Costs Outline Numerical Example What are A pays c A iff λ ≥ c A and B pays c B , transaction costs? SImple A does not pay c A if B does not pay c B , negotiation Coasian solution B pays c B iff 1 − λ ≥ c B and A pays c A , Continuous Costs Alternating B does not pay c B if A does not pay c A . Offers Bargaining Robustness Therefore the result holds when λ < c A or 1 − λ < c B .
EC516 Contracts and Assume now that ( c A , c B ) are: Organisations for Research Students: Lecture 2 substitutes: either party has to pay c i ; Leonardo Felli Transaction affordable: party i ’s endowment covers c i ; Costs Outline Numerical Example efficient: min { c A , c B } < 1 . What are transaction costs? SImple negotiation Coasian solution Continuous Result Costs Alternating Offers Both results above hold. In the second result only one type of Bargaining Robustness inefficiency may occur.
EC516 Contracts and Proof: The reduced form game is now: Organisations for Research Students: Lecture 2 pay c B not pay c B Leonardo Felli pay c A λ − c A , 1 − λ − c B λ − c A , 1 − λ Transaction Costs not pay c A λ, 1 − λ − c B 0 , 0 Outline Numerical Example What are transaction costs? SImple A pays c A iff λ ≥ c A and B does not pay c B , negotiation Coasian solution A does not pay c A if B pays c B , Continuous Costs Alternating B pays c B iff 1 − λ ≥ c B and A does not pay c A , Offers Bargaining Robustness B does not pay c B if A pays c A .
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