Question

. “When transaction costs are zero, property rights do not affect income distribution.” True or False? Discuss carefully.

Answer 1

True, When transaction costs are zero, property rights do not affect income distribution.

Explaination: One important extension of the Coase Theorem states that, if all costs of transactions are zero, the use of resources will be similar no matter how production and exchange activities are arranged. This implies that in the absence of transaction costs, alternative institutional or organizational arrangements would provide no basis for choice and hence could not be interpreted by economic theory. Not only would economic organization be randomly determined; there actually would not be any organization to speak of: production and exchange activities would simply be guided by the invisible hand of the market.

But organizations or various institutional arrangements do exist, and to interpret both their presence and their variation, they must be treated as the results of choice subject to the constraints of transaction costs.

In the broadest sense transaction costs encompass all those costs that cannot be conceived to exist in a Robinson Crusoe economy where neither property rights, nor transactions, nor any kind of economic organization can be found. This breadth of definition is necessary because it is often impossible to separate the different types of cost. So defined, transaction costs may then be viewed as a spectrum of institutional costs including those of information, of negotiation, of drawing up and enforcing contracts, of delineating and policing property rights, of monitoring performance, and of changing institutional arrangements. In short, they comprise all those costs not directly incurred in the physical process of production. Apparently these costs are weighty indeed, and to term them ‘transaction costs’ may be misleading because they may loom large even in an economy where market transactions are suppressed, as in a communist state.

By definition, an organization requires someone to organize it. In the broadest sense, all production and exchange activities not guided by the invisible hand of the market are organized activities. Thus, any arrangement that requires the use of a manager, a director, a superviser, a clerk, an enforcer, a lawyer, a judge, an agent, or even a middleman implies the presence of an organization. These professions would not exist in the Crusoe economy, and payments for their employment are transaction costs.

When transaction costs are defined to include all costs not found in a Crusoe economy, and economic organizations are defined equally broadly to include any arrangement requiring the service of a visible hand, a corollary appears: all organization costs are transaction costs, and vice versa. That is why during the past two decades economists have striven to interpret the various forms of organizational arrangements in terms of the varying costs of transactions.

Some obvious examples will illustrate the point. A worker in a factory (an organization) may be paid by a piece rate or by a wage rate. If the costs of measuring and enforcing performance (one type of transaction cost) are zero, then either arrangement will yield the same result. But if these costs are positive, the piece-rate contract will more likely prevail if the costs of measuring outputs are relatively low, whereas the wage contract will more likely be chosen if the costs of measuring hours and enforcing performance are low relative to the costs of measuring outputs. As another example, some restaurants (again an organization) measure the quantity of food sold; others serve buffet dinners, allowing customers to eat as much as they please at a fixed price per head. The cost of metering and quantifying food consumption relative to the basic cost of the food will determine which arrangement is chosen. In the total absence of transaction costs, the factory or the restaurant would not exist in the first place, because consumers would buy directly from the input owners who produce the goods and services.

Traditional economic analysis has been confined to resource allocation and income distribution. Contractual arrangements as a class of observations have been slighted in that tradition. In a world complicated by transaction costs, this neglect not only leaves numerous interesting observations unexplained, but actually obscures the understanding of resource allocation and income distribution. The economics of organization or institution or, for that matter, the workings of various economic systems, were never placed in the proper perspectives under the traditional approach. For generations students were told that various kinds of ‘imperfections’ were the cause of seemingly mysterious observations: policies were ‘misguided’, or antitrust specialists were barking up the wrong trees.