Transaction costs and market failures

The very basis of Coase’s 1937 article on the theory of the firm - that is, transaction costs in the functioning of the price mechanism - becomes central to Coase’s 1960 seminal contribution on the problem of social cost.

The notion of transaction costs has had a peculiar development in the history of economic thought. Almost every term adopted by economic sci­ence has in time assumed a precise, mathematically definable, content. The notion of transaction costs has never been defined in an equally rigorous fashion.⁹⁰

Much of the secondary literature on the Coase theorem has directly or indirectly dealt with the content of this concept. In its narrow sense, the term ‘transaction costs’ contemplates material expenses and the opportunity cost of the time and energies necessary to reach an agreement on the transfer of a right.⁹¹ To these factors, one should add the various costs necessary for the preparation, strategic implementation and execution of the agreement, in­cluding information costs, and all the costs necessary for an effective monitoring of the other party’s performance.⁹²

The normative Coase theorem

If the sum of the various transaction costs exceeds the net benefit of the contract, no exchange will take place in the market. For a right to be ex­changed it is necessary that transaction costs be less than the difference between the demand and supply prices.

In the face of a similar clarification, one must question the relevance of Coase’s analysis when the assumption of no transaction costs is relaxed.⁹³ According to Coase’s prediction, without transaction costs, the final alloca­tion of scarce resources would coincide with the use that an individual who is the single owner of different activities would make of his/her endowments. Moving into a more realistic environment with positive transaction costs, however, an exchange will be pursued only to the point at which its marginal benefit equals the marginal cost of the transaction.

In this phase of the analysis, the positive transaction costs of Coase’s model play a role analogous to transportation costs in international trade or more generally, to the contracting costs in the economics of exchange.⁹⁴ This conclusion is rather obvious and consonant with criteria of economic ration­ality, but, as Demsetz notes, the question cannot be reduced merely to this observation.⁹⁵ It is necessary, in fact, to keep in mind that the positive Coase theorem indicates the market as a general cure for inefficient allocations of property rights. To recognize that the reallocation may not take place in the presence of positive transaction costs means to concede that the market solution postulated by Coase may fall short of rectifying the inefficiency in the case at hand. This would yield to other remedies of a public nature, addressing the problem through legislative, judicial or governmental inter­vention, models of taxation, or other structural corrections of the system.

The effect of positive transaction costs on the Coase theorem has been extensively examined by the secondary literature. The following is a classic illustration.⁹⁶ The smoke of a factory soils laundry which is line drying on five neighbouring properties.

Relaxing the initial assumption of no transaction costs, the initial alloca­tion of property rights is no longer immaterial.⁹⁷ Imagine that each owner has to face a cost of $120 in order to negotiate the contract with his/her neigh­bours and with the owner of the industrial plant. If the right is assigned to the industry, each landowner will have to choose whether to bear the loss of his/ her soiled laundry for $150, to acquire the electric dryer for $100, or, finally, to undertake the negotiation process for a total pro-quota cost of $180. Considering these alternatives, each rational landowner will choose to ac­quire his/her own dryer, generating a socially non-optimal outcome. By relaxing the no transaction cost assumption, thus, the choice of legal regimes appears capable of affecting the final equilibrium. In this particular case, the assignment of property rights to the neighbouring residents, rather than to the polluting industry, would minimize the effect of positive transaction costs, since the industry will have incentives to install the filter, without any need for Coasean bargaining with the neighbours.⁹⁸ The original formulation of Coase’s proposition, thus, can be restated as a normative theorem, by main­taining that, in the presence of positive transaction costs, the efficiency of the final allocation is not independent from the choice of the legal rule, and that the preferable initial assignment of rights is that which minimizes the effects of such transaction costs.⁹⁹

Coase on the issue of transaction costs

Coase’s positive theorem shows that, in a world with no transaction costs, the parties will reallocate rights among themselves, to maximize their aggregate welfare.

In his retrospective analysis, Coase explains that ‘The problem of social cost’ was developed as an economic essay aimed at economists.¹⁰¹ Coase intended to carry the standard economic assumption of no transaction cost to its logical extreme, demonstrating the inconsistency of the generally accepted idea that government intervention was necessary to improve the working of the economic system.¹⁰² But, according to Coase, this argument was only ‘a preliminary to the development of an analytical system capable of tackling the problems posed by the real world of positive transaction costs’.¹⁰³ With a rather telling consistency, Coase has attempted to correct what he perceives to be a general error in the understanding of his theorem, refuting the gener­alized identification of his own model with an imaginary universe of transactions without costs:

The world of zero transaction costs has often been described as a Coasian world. Nothing could be further from the truth. It is the world of modern economic theory, one which I was hoping to persuade economists to leave. What I did in The Problem of Social Cost was simply to bring to light some of its properties.¹⁰⁴

Already in his early writings, Coase revealed a mature understanding of the crucial role played by positive transaction costs in the economic system. As early as 1937, Coase had shown that, in the absence of transaction costs, there would be no economic basis for the existence of a firm.¹⁰⁵ Following the same logic, his work on the problem of social cost showed that, in the absence of transaction costs, it does not matter what the law is, since indi­viduals will contract with each other to an optimal allocation of legal entitlements.¹⁰⁶

None of his works, however, merely stop at the investigation of the proper­ties of an abstract world without transaction costs, and Coase clearly restates that it is necessary to introduce positive transaction costs explicitly into the analysis, in order to understand the functioning of the real world: ‘Without the concept of transaction costs, which is largely absent from current eco­nomic theory, it is my contention that it is impossible to understand the working of the economic system, to analyze many of its problems in a useful way, or to have a basis for determining policy’.¹⁰⁷ According to Coase, this important part of his argument has systematically been overlooked by the numerous commentaries to his theorem.

According to Coase, the insistence upon the no transaction cost assump­tion risks undermining the normative significance of the theorem for real-world problems. The normative Coase theorem addresses the problem of positive transaction costs as the origin of a failure in the spontaneous contracting of the parties. Coase remembers: ‘Law came into the article because, in a regime of positive transaction costs, the character of the law becomes one of the main factors determining the performance of the economy’.¹⁰⁹ It is, in­deed, by relaxing the assumption of zero transaction costs, that Coase’s analysis offers the most valuable insight on the effective potential of contrac­tual arrangements in the correction of inefficient allocations of property rights.¹¹⁰ The Coase theorem considers the effect of positive transaction costs. In its normative version, the theorem indicates that legal rules that minimize the effects of such costs are to be preferred for being relatively more efficient.¹¹¹ In its more complex formulation, the Coase theorem pro­vides, indeed, a guide for such a choice.

Coase is wary, however, of simplistic generalizations, noting that no single universal formula exists for the creation of an optimal system of incentives:

The result brought about by different legal rules is not intuitively obvious and depends on the facts of each particular case. It may be for example, as was shown earlier in this section, that the value of production will be greater if those generat­ing harmful effects are not liable to compensate those who suffer the harm they cause.¹¹²

Coase theorem and other market failures

Two further situations, both related to the general notion of market failure, have been indicated as potential obstacles to the working of Coase’s model.

Economists describe this category of commodities as private goods. Diffi­culties arise, however, when the object of the Coasean bargaining is an entitlement which has the nature of a public good (that is, a situation in which third parties cannot be excluded from the enjoyment of that right, with no feasible way to require them to share in the costs of that resource).¹¹⁴ The market may fail to cure a non-optimal allocation of rights that falls within this category.¹¹⁵ In order to understand this point, consider a scenario in which the object of the Coasean negotiation consists of a non-excludable right, such as the right to enjoy pollution-free air in a residential environ­ment. Imagine the legal limit of air emissions in that area to be fixed at twice the optimal level. In this situation, it will be the legal rule, and not the outcome of an ideal negotiation between the interested parties, that will determine the actual amount of emissions. Clean air is, in fact, a public good in the sense described above. The benefit derived from the reduction of industrial emissions is, on the one hand, non-consumable - or, more properly, not subject to rivalry in use - and, on the other hand, non-excludable.¹¹⁶ It is non-consumable because the normal enjoyment of a unit of clean air by one resident does not reduce the possibility of enjoyment from others; it is non­excludable because the reduction of pollution provides a benefit to all the residents, with no feasible way to exclude those who did not agree to pay for the reduction of the industrial emissions.

When non-excludability and absence of rivalry in use prevail in the charac­terization of the right, the possibility of costless exchange of individual entitlements on the market is unlikely to cure a non-optimal initial assign­ment of property rights. Individuals will not reveal their own preferences through the price system, placing public goods among those cases that are most recidivistic to the Coasean antidote.

A second obstacle results from the absence of any barrier to the entry of new operators in the market (in economic jargon, ‘ease of entry’). It is necessary to keep in mind that ease of entry is one of the characterizing features of a competitive market. The discussion that follows, therefore, far from being a mere theoretical speculation, directly regards the market struc­ture that serves as the ideal scenario for the Coasean negotiation.

In order to more fully understand the effect of ease of entry on the Coasean model, consider the hypothesis in which the exchange of rights takes place, according to Coase’s prediction, so that the ranchers agree, upon compensa­tion, to reduce the dimension of the herd until a point of Pareto efficiency is reached. If such an agreement is reproduced on a large scale, the total quan­tity of meat produced in the market will fall and, given the usual negative slope of the demand curve, the price of the meat will rise. If this occurs, the agreement between the ranchers and the farmers will be short-lived. The high price of meat will attract new enterprises interested in exploiting the new potential for profit in the industry. These entrepreneurs will immediately jeopardize the stability of the initial agreement by disturbing the momentary equilibrium reached through Coasean negotiation. The farmers, in order to reduce the damage to their crops, will be forced to pay the newly entered ranchers to limit the size of their cattle herds as well. This phenomenon would recur in cycles, rendering any further agreement useless. A static analysis of the equilibrium appears incapable of weighing the applicative significance of Coase’s theorem, in which the dynamic adjustments of the initial equilibrium risk corroding the holding structure of his model.

Described in these terms, however, the problem risks overstatement. One needs, in fact, to observe that the absence of barriers to the entry of new enterprises into the market does not represent, by itself, an obstacle to the functioning of Coase’s model. The problem arises only when the same trans­fer of rights occurs on a large scale, thus influencing the prices of the market.¹¹⁷ The individual rancher who reduces the dimension of his/her own herd is unlikely to influence the price of meat on the market. No dynamic adjust­ments will, therefore, take place in the equilibrium reached through the initial agreement, nor will there be new entries in the market. In spite of the absence of barriers, Coase’s analysis would thus remain a sound prediction of indi­vidual behaviour.