Property Rights and Transaction Costs: Understanding Exclusion, Security, and Economics, Slides of Institutional economics

Download Property Rights and Transaction Costs: Understanding Exclusion, Security, and Economics and more Slides Institutional economics in PDF only on Docsity! CHAPTER TWO KEY THEORETICAL AND ANALYTICAL CONSTRUCTS OUTLINE......: 2: Key theoretical and analytical constructs 2.1. Property rights 2.2. Transaction costs 2.3. Judicial decision making 2.4. Contracts 2.5. Markets and firms Cont'd... = Property rights are defined as the right to use an asset the right to derive an income from it and the right to transfe it to another party in the form of sell, gift or bequest. = Therefore, rights are not relationships between fhe righ holder and object, but rather are relations between #he righ holder and other people with respect fo the object. 2.1.2. Characteristics of Property Rights Universality: Property rights can be held by individuals, state, groups; the entitlements should be completely specified and enforced. Exclusivity: All benefits and costs are for the owner; their characteristic is concerned with durability, which is duration of these rights (a length of the entitlement). Transferability: All property rights can be transferred from one owner to another in a voluntary exchange; transferability is connected with divisibility. Security: Property rights should be secured from seizure. 2.1.3. Classification of Property Rights - Property rights are classified as absolute and relative. > Absolute righfs involving assignment of exclusive individual property rights to physical objectives. > Relative property rights related to contractual obligations and agreements. - Property rights can be held by individuals, groups and state. Property rights held by individuals are private property rights; by groups are co/lective property rights; by state — it is extended from of co//ective rights. Cont'd... > In the case of common property right, such as a lake or a forest, individuals have use rights but do not have the right to exclude others from using it. Example: irrigation systems, fishing grounds, common pastures, common wells, and common forests. Common-pool resources are generally subject to the problems of congestion, overuse, pollution, and potential destruction. 10 > A common-pool resource (CPR) is a particular type of good consisting of a natural or human made resource system, the size or characteristics of which makes it costly, but not impossible, to exclude potential beneficiaries from obtaining benefits from its use. > Common-pool resources are not necessarily governed by common property regimes, they may be owned by national, regional or local governments as public goods, by communal groups as Common property resources, or by private individuals or corporations as private goods. > Common Property is the private property of a group of co-owners. Common property regime refers to a particular social arrangement regulating the preservation, maintenance, and consumption of a common-pool resource. u Challenges in Using CPRs a) lack of Social Capital: individuals in rural communities sometimes are selfish and hence do not work in a cooperative way. 4) Heterogeneity: when members of the community have different economic interest and use perceptions of the resource, group members are restrained from to a common agreement. co) Rights Incongrvent fo Local Conditions: when users are not clear on how to use a common resource, they are more likely to deplete. d) Disharmony between Users and the Environment: we can think of the users of resources as living in harmony with the environment, but that is not always the reality. N Cont'd... 3. State Property: resources formally owned under state ownership. Resources are nationalized and citizens may have use rights, while the state has all forms of rights to the resources in question. » State property regimes fail due to:- a) Rigidity in application of rules, b) Ignorance or undermine of indigenous political structure and institutions, c) State agencies often lack the power, authority and/or will to implement rules prescribed at regional or national levels d) State employees who are responsible for the enforcement of resources use rules are often remunerated, legally or illegally through the collection of fines (e.g. corruption and bribes). 15 fo abd ‘Access: When resources are owned by no one or are used by all without any restriction. > Resources under open access are highly prone to overuse and degradation especially when population densities increase and a resource is valuable. > Lack of property regime leads to resource destruction often termed as tragedy of open access or tragedy of the commons. > Tragedy of the commons arises when it is difficult and costly to exclude potential users from common-pool resources that yield finite flows of benefits as a result of which those resources will be exhausted by rational, utility-maximizing individuals rather than conserved for the benefit of all. > Example; ocean, air, and open space. 16 1 Cont... ‘Tragedy of the Commons is a situation when common resources lacking ownership were doomed to over exploitation. Example: overgrazing, overfishing, appropriation of irrigation water by head-enders, clearing of forests and so on. >» The overuse can endanger the sustainability of the resources. Individuals try to gain as much as possible in the short term without taking longer term needs of the community into perspective. > Open access should be nationalized or privatized in order to use it sustainably. 17 Rights 1) Access is the right to enter a defined physical property. Examples of access: hike, canoe, and sit in the sun. 2) Withdrawal: The right to obtain resource units or products of a resource system (for example, catch fish, appropriate water). 3) Management: The right to regulate internal use patterns and transform the resource by making improvements. 4) Exclusion: The right to determine who will have access rights and withdrawal rights, and how those rights may be transferred. 5) Alienation: The right to sell or lease management and exclusion rights. Property-rights systems that do not contain the right of alienation are considered to be ill-defined. SI ™N The actors in the administration of property rights ) 2) 3) 4) J) Authorized Entrant: An individual who have an entrant right. It includes most recreational parks but do not have a right to harvest forest products. Authorize User: An individual who has an access and withdrawal rights. Claimants: An individuals who possess the same rights as authorized users plus the collective-choice right of management. Managing a resource that includes decisions concerning the construction and maintenance of facilities and the authority to devise limits on withdrawal rights. Proprietors: Individuals who possess collective-choice rights to participate in management and exclusion. Owners: Possess the right of alienation the right to transfer a good in any way the owner wishes that does not harm the physical attributes. = NI Operational Vs. Collective-choice property rights > In regard to common-pool resources, there are two types of property rights. » They are operational level property rights and collective-choice property rights. 1) Operational rules are changed by collective-choice actions. Such actions are undertaken within a set of collective-choice rules that specify who may participate in changing operational rules. The most relevant operational level property rights are access and withdrawal rights. 2) Collective-choice property rights include management, exclusion, and alienation. 22 The Role of Property Rights on Economic Growth 1) 2) 3) 4) 3) Limiting Expropriation Risks: property rights promote production by enhancing investment incentives through limiting expropriation risk. Reduced Protection Costs: secure property rights mean that individuals can devote fewer resources to protecting their property. Facilitate Gains from Trade: Encourage economic growth through facilitating trade in assets. Ex. Land markets Transactions Facilitation: Formally defined property rights allow for the use of property in supporting other transactions by using it as collateral to raise resources on the financial market. Infernalize Exfernality: Externalities can be internalized if property rights are well established. 25 2.2. Transaction Costs 1) Definition of Transaction >» — As Williamson (1985) defined, a sransaction is a process by which a good or a service is transferred across technologically separable interface. > The substance of transactionis the ownership transfer not the object itself moves from one to another. > Therefore, definition given by Commons (1931), “sransaction is just the transfer and obtains of object future ownership between two persons” is relatively accepted. 26 Production Costs Vs. Transaction Costs © Transformation (production) costs are costs like incurred due to employment of /abour, land and capital. © Transaction cost economics is one of the branches of new institutional economics. © Transaction costs are cost of searching for market, screening costs, bargaining costs, transfer costs, monitoring costs, and enforcement costs. ©The founding father of transaction cost is a British economist called Ronald Coase, who, in 1937, wrote an article entitled fhe nature of the firm. "It was refined by American economist Oliver Williamson in 1975. 27 Transaction Costs = These show that transaction costs have 0 a common definition. In general it has defined as fhe costs that an actor bears in order to engage in exchange. These costs include those of information, negotiation, monitoring, coordination and enforcement of contracts. In the presence of transaction costs markets and prices are not sufficient to create neoclassical equilibrium. “Transportation and transaction costs seems similar but represent costs of different origins; while transportation costs represent fhe costs of transfer physically a good from one market to another, taking into account fuel, freight, taxes, tariffs, wages, fares, etc. Market transaction costs are linked essentially to information and bargaining costs. SI 9) Cont'd... ‘According to Coase (1937), transaction costs can be divided into three broad categories: 1. Search & Information costs 2. Bargaining costs, and 3. Policing & enforcement costs. > The cost listed under points “1” and 2” are called ex-ante costs p whereas policing and enforcement costs are ex-post costs. > Ex-ante means beforehand (before signing contract), and ex-post means afterwards. > An ex-ante costs and charges report is a reasonable estimate of costs before they are incurred, whereas an ex-post costs and charges report discloses the actual costs after they have been incurred within a portfolio. “ Cont'd... » Transaction costs can be categorized as fixed and variable costs. » Fixed transaction cost is the specific investments made in setting up and maintenance of institutional arrangements. »Variable transaction cost depends on the size and frequency of transaction. > Transaction cost = Fixed Costs + Variable Costs > Fixed Costs = commissions + transfer fees + taxes » Variable Costs = Execution Costs + Opportunity Costs 32 > Execution Costs = Price Impact + Market Timing Costs PREC Lem L LT) > Economic growth — investment (spend today for tomorrow return) constitutional guarantees. > It needs 1. Meaningful & enforceable laws 2. Enforceable contracts 3. Basic security 4 Access to justice > Judicial system should be 35 Cont'd... > Independent judicial system has two functions 1. It limits the power of government 2. It protects the rights of individuals > Three archetypical interaction situation in which Judicial independency is important can be distinguished: 1) In cases of conflict between citizens 2) Conflict between government and the citizens 36 3) Conflict between various government branches 2.4. Contracts ><A contract is an agreement between a buyer and a supplier in which the terms of exchange are defined by a triple: price, asset specificity and safeguards. > Long terms contracts are complex and incomplete and their enforcement cost could be higher, the source of incompleteness being ‘bounded rationality, and where we find limited cognitive competence. > With the given cognitive limits the complex contracts s are unavoidably incomplete. o Cont'd... > Asymmetric Information: When one party does not have complete knowledge of actions or characteristics of the other party. > Moral hazard refers to hidden action not perfectly observed by the principal (ex. car insurance market). » Adverse Selection refers to hidden information where the type of agent is unknown to the principal (ex. the market of Lemon, health insurance and credit market). » Adverse selection is a form of market failure resulting when products of different qualities are sold at a single price because of asymmetric e e So information. Cont'd... > Principals: Owners (shareholders) of a firm. > Agents: People hired by owners to run the firm (manager and workers). 4] FORMS OF CONTRACT Oliver Williamson (1975, 1981) identified three fundamental forms of transaction governance and the conditions when they’re likely to occur: Market: Autonomous parties’ exchanges are governed by prices in supply-demand equilibrium Hierarchy: (Formal org) Transactions among parties occur under a unified owner, who settles disputes by administrative fiat Hybrid: “Long-term contractual relations that preserve [parties’] autonomy, but provide added transaction-specific safeguards as compared with the market.” EX: United Way and social service agencies Strategic alliances; agricultural cooperatives Networks of small-medium suppliers and manufacturers TRANSACTION ECONOMIZING — GOVERNANCE Williamson's key claim: Variations in exchange governance forms result from efforts to economize on transaction costs His three transaction costs dimensions align efficiently with transactors’ choices among the three ideal forms of governance: Market Hybrid Hierarchy Uncertainty LOW MIDDLE HIGH Frequency LOW MIDDLE HIGH Asset LOW MIDDLE HIGH Specificity MAKE-OR-BUY? Transaction cost theory examines the conditions under which organizations chose to internalize some functions (hierarchy) or to purchase them on the market (e.g., relational subcontracting) EX When should a firm or agency train its own employees, hire external vendor (college or commercial), or create a jointly staffed program? * Are employee job skill requirements changing rapidly & unpredictably? * How often must newly hired or promoted workers be (re)trained2 * Would org’s own training staff have to invest heavily in asset-specific facilities, such as simulation labs? * Is org’s own training staff more knowledgeable than external trainers about firm-specific and tacit skills needed by employees? * Are external vendors competent, reliable & cost efficient? MORE TC APPLICATIONS TC theory can be applied to explain diverse org’l phenomena: * Difficulties in establishing micro-credit lending associations * Unionization drive successes or failures * Creation of “company towns” for miners, loggers * Diffusion of conglomerate, M-form corporate structures * Mergers-acquisitions vs. technology transfers among alliance partners * Quarrels over which members own a defunct rock band’s name (Pink Floyd, Yes, Flying Burrito Brothers) (Cameron & Collins 1997) * Band names are asset-specific capital for re- releases of oldies that fans will buy * Reincarnated inferior group seeks undeserved “rents” from the reputations earned by their more talented predecessors PERFORMANCE INCENTIVES Monitoring Agent’s skills & activities is difficult, so Principal could use pay-for-performance incentives to encourage A’s risk-taking and make A more accountable in looking out for P’s interests EX: Make A’s compensation contingent on actual outcomes CEO bonus, stock options depend on annual share prices Teacher’s salary gains tied to her student’s test scores Problem: Org’s performance affected by many factors beyond agent's control (fickle consumers, govt regs, bad weather) In high uncertainty, tying compensation to performance may actually induce a risk-averse CEO to take timid, less-risky actions in effort to avoid a major loss to personal fortune Major corporate CEO pay-performance effect very weak: only $3.25 per $1,000 change in shareholder wealth = 1 week's pay ($9,600 in 1980s) This amount judged “small for an occupation in which incentive pay is expected to play an important role” (Jensen & Murphy 1990:227) Factors Affecting Effectiveness of Contracts > Factors of contracts are such as Asset specificity, safeguards, and extent of using private ordering. » Asset specificity: A specialized investment that cannot be redeployed (re- utilized) to alternative uses or by alternative users except at a loss of productive value. > Asset specificity arises in exchange where contracts require specific investments and/or where idiosyncratic knowledge is likely to be acquired in the course of contractual enforcement. > Specific assets give rise to bilateral dependency, which complicates contractual relations. 51 ASSET SPECIFICITY ° Investments on assets are of two types. Some investments are special purpose and others are general purpose. ° A specific purpose asset has little or no alternative use. Contracting around specific assets can be risky in that the specialized assets cannot be redeployed without sacrifice of productive value if contracts should be interrupted or prematurely terminated. ¢ Asset specificity arises in an intertemporal context. General purpose investments do not pose the same difficulties. ¢ For instance, one party may invest on durable specific assets on the agreement that a contracting party will use the specific assets. © Once the investment is made and if the contracting party terminated its contract, then the specific asset will have no value as it cannot be redeployed for some other purpose. ¢ This situation can provide the contracting party the incentive to threaten the party who invested on the specific asset. ow way Cont'd... > Safeguard is the added security features, if any, that are introduced into a contract in order to reduce hazards (due mainly to asset specificity) and to create confidence. > Safeguards can take the form of penalties, a reduction in incentive intensity, and/ or more fully developed private-ordering apparatus to deal with contingencies. » Extent of Using Private ordering: The self-created mechanisms to accomplish adaptive, sequential decision making between autonomous parties to a contract, including information disclosure, dispute settlement, and distributional mechanisms to deal with gaps, errors, | omissions, and inequities. " 2.5 Market & Firm > Transaction cost economics views firm and market organization as alternative modes of governance — where governance is the means by which to infuse order, thereby to mitigate conflict and realize mutual gains. » Market is coordinated by the price mechanism. Market is more decentralized forms of organization and supports high-powered incentives and display outstanding adaptability to autonomous disturbances, but they are poorly suited to cooperative adaption. »Firm (Hierarchy), by contrast, has weaker incentives and worse at autonomous adaptation but better at cooperative adaptation. 56 Market & Firm > A firm is defined as an integrated and durable organization of people devoted to the production of goods or services that are owned as property under law by the firm. > Within firm the market transactions are eliminated and substituted by the entrepreneur-coordinator. > The main causes of firm are a transaction failure and contractual incompleteness due to the conjugation of bound rationality, opportunism and asset specificity. > Firms emerge to economize on the transaction costs of market exchange and that the boundary/size of a firm depends on the magnitude of these ‘> treanenctinn cacte Cont'd... Market Firm Incentive intensity High Low Administrative control | Low High Adaption Autonomous More cooperative adaptation in response to changes in relative prices adaptations are needed Contract laws Legalistic and relies on court ordering Private ordering and settles disputes by fiat Technology General technology Special technology SI =) Cont'd... "Firms are used to achieving the benefits of collective action in situations:- i. Uncertainty and the inability to insure some risks (leading to incomplete markets), ii. Moral hazard (hidden action) — It is an ex post opportunistic behavior. iii, Adverse selection (hidden information) — It is ex ante opportunistic behavior. iv. Idiosyncratic assets 61 THANKS