Economics 103

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Economics 103

• Lecture 18
• Transaction Cost Economics

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Weve examined a powerful model, but there are
some unanswered questions.
When I go skiing at Cypress Bowl, how come I face
A line up means there is excess demand. Why does
the price not increase?
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Weve mentioned before, every classroom has
Unemployed, or underemployed, resources imply a
surplus, why dont prices adjust in order to
eliminate the surplus?
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Weve seen how great prices are in allocating
resources and explaining behavior, but think of
all the times prices are NOT used.
You dont bid for
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When you go work for a firm, your boss isnt
going to use prices to tell you what to do.

Professors can only wish grades were
distributed this way.
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There are just lots of instances in life where
we either ban the use of prices (kidneys) or we
simply choose not to use them.
What explains this?
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Finally, we all know that in life cheating
happens all the time.
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People goof off at work.
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The point is, in the model weve examined so far,
these types of things should never happen.
Weve been assuming prices work for free.
A theoretical device is to assume there is an
imaginary auctioneer out there who knows
everything, and calls out all the magic prices
to equate Supply and Demand.
But we are really assuming that everyone knows
everything.
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So, what happens, if we dont know everything?
Lets start by looking at an implication of
Omniscience.
Suppose a rancher and a farmer know everything.
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Unfortunately, even though they know everything,
they havent figured out how to build a fence
yet.
So the problem is the cattle tend to trespass
on to the corn farm and eat the corn.
Suppose there are two worlds
World 1 The rancher is liable for the damage.
World 2 The rancher is not liable for the
damage done by the cattle.
Will the number of cattle be different in either
world?
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The amazing answer is . NO!
Suppose the relation between Cattle and crops is
given by
Suppse the rancher is not liable, and decides
to have 6 cows.
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So we would end up with 3 / 4 cows.
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But what if the rancher was liable, and the
farmer got to decide how many cows should be on
the ranch. He might decide only one should be
there.
So once again you end up with 3 / 4 cows.
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Maximizers, when they know everything (namely the
table), maximize wealth, regardless of the rule
of liability.
3 / 4 cows gives the highest joint wealth.
So in our neoclassical model, the rule of law is
irrelevant. The allocation of cows is
independent of the liability.
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Weve actually seen this argument several times
this semester
As long as MC and MV are different, people
will trade, and they end up at the equilibrium
where wealth is maximized
The only thing that matters is the direction of
the payments.
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It turns out that this result is completely
general, and it has a name.
To translate into our cow case we would say the
number of cows doesnt depend on who is liable,
if they both know everything.
Clearly we have to define what we mean by
property rights and transaction costs.
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The Coase Theorem is named after the brilliant
economist, Ronald Coase.
The key to understanding the significance of the
Coase Theorem, is to understand the ideas of
property rights and transaction costs.
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Before we do this, however, lets do another
example in the context of our neoclassical model.
Married couples fight, and sometimes the
disagreements end in divorce.
Prior to 1968 fault divorce / mutual.
After 1968 no-fault divorce / unilateral.
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Some would consider the following grounds for
divorce.
However, in Canada, the grounds were just
abandonment, criminal behavior, and adultery.
In two provinces you needed an act of Federal
Senate.
After 1968, one of the parties could just leave.
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What would the Coase theorem predict should have
happened to the divorce rate.
Consider the following stylized example
Nothing.
Who wants to divorce?
Should they divorce?
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Under the old fault/mutual law, the husband would
have the right to decide if the divorce takes
place.
Under the new no-fault/unilateral law, the wife
would have the right to decide if the divorce
takes place.
What is the outcome, if they can freely bargain?
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But what actually happened?
USA
CANADA
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Clearly, the Coase Theorem is empirically
incorrect.
This was the point Coase was trying to make.
Clearly, the condition for this to hold, ZERO
TRANSACTION COSTS, must be violated.
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The rules of the game matter.
- property game.
Rules matter because transaction costs are
positive.
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But what are transaction costs?

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Why might a marriage break down? Ie. why might
the couple not be able to negotiate around
problems?
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These issues are examples of transaction cost
problems.
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Lets start by asking What are Property Rights.
A)
B)
C)
Different people use the phrase PR in different
ways.
They certainly are not the same thing.
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I like to think about them in terms of the
following diagram
A breathing air
B - abortion
C Sik right to concealed weapon polygamy
in bountiful
D walking in central park 1am. not to be
date raped.
E drive a stolen car stealing my
textbook!
F abortion in PEI
G sell pot in store in Vancouver
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Think of all the different choices you might make
with respect to an asset.

A property right is a bundle of these decisions.
The extent of your PR depends on what is in the
bundle, and how effective you are at carrying
out your choice.
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If you have perfect property rights to something,
then you can freely and effectively make all
the decisions wrt the asset.
But we never have perfect property rights.
Do you remember
Who owns this body?
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Think about something you consider you own.
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Why are your property rights not perfect?
1. Because someone else owns the right.
2. Because it isnt worth it to police the
right you legally have.
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Two Key Points

1. No Property Rights ?

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2. Perfect Property Rights ? Coase Theorem ?
Wealth maximized.
- this is what weve been assuming all along.
So we have a spectrum of rights
We always want to establish and maintain Property
Rights as long as the Benefits gt Costs.
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Think of all the ways you try to protect and
maintain your PR.
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So, we are finally ready to define Transaction
Costs.