Chapter-6: Neoclassical economics versus transactions cost economics

Attributes of markets in neoclassical economics

o “mutuality of advantage from voluntary exchange is . . . the most
fundamental of all understandings in economics” then at least some of us
should be thinking of economics as the “science of exchanges”.
o Neoclassical economics takes the following assumptions as a starting
point.
 Decision makers to have perfect knowledge.
 Self-interested rational individuals attempt to maximize their utility.
 Neoclassical economics uses an ideal perfect competition as a
benchmark against which to develop and extend the theories to consider
real world situations and problems.
 Cont’d….
An approach focusing on:
Determination of goods, outputs and income distributions in markets
through supply and demand. Market price determined by both demand and
supply
By applying the principle of:
maximization of utility income-constrained consumers, and
maximization profits by firms facing production costs.
By employing available information and factors of production,
 in accordance with rational choice theory.
 Basic message of the school
 Enhancing economic efficiency and economic progress
 By ensuring that markets work freely and competitively
 Governments intervention can be justified to correct market failure
 Cont’d….
 Neoclassical economics starts with the development of basic theorems of
individual behavior and market interactions under controlled conditions in a
virtual laboratory provided by the assumptions of perfect competition.
Three basic assumption of the neoclassical economics
 Rationality: Allocate income/resource to maximize utility/profit
 Emphasis on equilibrium and equilibria (Profit and utility
maximization): These are the dominant objectives motivating producers and
consumers, respectively.
 Perfect knowledge: Full information with certainty. Economic actors
(individuals, households, firms, or government) have complete information
about all aspects of business profits and consumption utility, including
market opportunities, available technology, costs of production under
alternative production arrangements, prices, natural resources, quality of
goods produced…
 Cont’d….
Concept of transaction costs

 Initial Assumption of Coase: Production and exchange can be

solely carried out through the price mechanism.

 In the process of determining price rate, there is a cost of

discovering prices (Cheung 1983)

 The idea that “Perfect markets direct all production in the absence
of transaction costs (zero)” is a fiction, leading to the Coase
Theorem:
 Cont’d….
Coase (1937)
o Market exchange is not costless
o Firms emerge to economize on transaction costs
o Boundary of the firm determined by nature and extent of
transaction costs
 Therefore, TC are the costs that an actor bears in order to engage in
exchange (political, economic, social etc.).
 TC exist because info is costly to obtain as well as due to “bound
rationality”, cognitive limits and the opportunism (self-interested
individuals will not readily disclose the information about their
preferences).
 Cont’d….
Types of transaction costs

1. Search and information costs

o These are the costs associated with looking for relevant information and
meeting with agents with whom the transaction will take place.
o The stock exchange (የአክሲዮን ልውውጥ) is one such example, as they bring the
buyers and sellers of financial assets together. The stockbroker’s (የአክሲዮን ድለላ)
fee is a type of information transaction cost.
 Cont’d….
2. Bargaining costs
o These are the costs related to coming to an agreement that is
agreeable to the parties involved in drawing up a contract.
o Bargaining costs can either be very cheap, such as buying a
newspaper, or can be very expensive, such as trading a basketball
player from one team to another.
3. Policing and enforcement costs
o These are the costs associated with making sure that the parties in
the contract keep their word and do not default on the terms of the
contract.
o In the real world, people often deviate from the contract, and thus,
enforcement costs are incurred while governing contracts. Lawyer
fees are an example of such a cost.
 Cont’d….
Measuring transaction costs
 Market transaction costs
 Mediator, broker, stock exchange
 Difference between buying and selling prices
 Advertisement
 Transaction costs of firms
 Management
 Administration, accounting
 Political transaction costs
 Parliaments, government, bureaucracy, courts, police
 Parties, interest groups
 Cont’d….
Problems of measuring transaction cost
o Problem of definition: different definitions of transaction costs
exists
o Problem of separation: Transaction costs are some times difficult
to separate from other costs, such as production costs,
transportation costs…
o Problem of missing observations: if transaction costs are very
high no transaction can be observed
o Problem of subjectivity: estimation of transaction costs are often
subjective
o Measurement costs: measuring transaction costs is often costly
 Cont’d….
Determinants of transaction costs
 Cont’d….
The role of contracts on minimizing transaction costs
o 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,
where quality, quantity and duration are specified (Williamson, 1996,
p.377).
o Long terms contracts are complex and incomplete and their enforcement cost
could be higher, the source of incompleteness being ‘bounded rationality’,
where we find limited cognitive competence to store and process information.
o “Contractual incompleteness poses added problems when paired with the
condition of opportunism—which manifests itself as adverse selection, moral
hazard, shirking and other forms of strategic behavior” (Williamson 2000,
p.601).
o The basis for opportunism is information asymmetry.
 Cont’d….
Forms of contracts
o Markets are short term contracts (instantaneous) where identity is irrelevant
since a transacting party can go its own way at negligible cost to the other.
o Hierarchy Transactions that are placed under unified ownership (buyer and
supplier are in the same enterprise) and subject to administrative controls
(an authority relation, to include fiat) are managed by hierarchy. The
contract law of hierarchy is that of fore bearance, according to which
internal organization is its own court of ultimate appeal.
o Hybrid Long-term contractual relations that preserve autonomy but provide
added transaction-specific safeguards, compared with the market.
 Hybrid contracts and hierarchy emerge as asset specificity builds up and
identity matters.
የንብረት ልዩነት

Cont’d….
Factors affecting effectiveness of contracts
o Asset specificity(የንብረት ልዩነት) A specialized investment that cannot
be redeployed to alternative uses or by alternative users except at a
loss of productive value.
 Asset specificity can take several forms, of which human, physical,
site, and dedicated assets are the most common.
 Specific assets give rise to bilateral dependency, which complicates
contractual relations.
o Safeguard 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.
 Cont’d….
 Safeguards can take the form of penalties, a reduction in incentive
intensity, and/ or more fully developed private-ordering apparatus to
deal with contingencies.

o 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.

Question: What other features affect contractual relations?

Chapter-7: Institutional performance and economic development
 institutions are humanly devised, Set constraints and Shape
incentives.
 Institutions can be developmental or predatory:
 Developmental institutions: encourage investment, growth and
productivity through incentives, human capital, entrepreneurship,
innovation, occupational choice, land ownership….
 Predatory institutions: extractive institutions that favor the few
 Development is the over all increment/improvement of social
wellbeing.
 Cont’d….
 Economic development is "a process of creating and utilizing
physical, human, financial, and social assets to generate improved
and broadly shared economic well-being and quality of life for a
community or region or country".
 It is employed to describe a change in a country’s economy
involving qualitative as well as quantitative improvements.
o Economic institutions are considered as the fundamental cause of
economic growth.

o Economic institutions affect economic growth through allocation of

resources like physical and human capital.
 Cont’d….
Institutions & Economic growth
Different empirical studies conducted:
o The study concludes that good economic institutions, private
investments, and government intervention by providing security,
economic and social infrastructural facilities are conducive for
economic growth. (African studies)

o The study recommended that more efforts be made at curbing

corruption in the region.
 Cont’d….
 Economic growth causes good economic institutions. Valeriani and
Peluso (2011)

 Acknowledged the bi-causality between economic institutions and

economic growth.

 The rationale for causality from economic growth to quality

economic institutions stems from the simple logic that economic
growth implies a high living standard with greater awareness.
 Cont’d….
Institutions and Environment

 Majority of studies reveal that a positive relationship between

different indicators of institutional quality, performance and
policy adoption.
 Impact of institutional quality on the outcomes for environment.
 Institutional quality for the quality of the environment.
 Institutional performance for the overall environmental
development.
 Cont’d….
Institutions & Development

o There is wide-ranging evidence that institutions matter a great deal

in determining the level of economic development of a country.

o Across-country analyses use indicators such as degree of protection

of property rights, the rule of law, and civic liberties and find that
they are strongly correlated to economic performance.
  Cont’d….
 Institutions which are conducive to development ensure greater self-
expression, allow the free flow of information and encourage the
formation of associations and clubs.

 Institutions strongly affect the economic development of countries and

act in society at all levels by determining the frameworks in which
economic exchange occurs.

 Institutions encourage trust by providing policing and justice systems

which adhere to a common set of laws leads economic development
 Cont’d….
 Institutions also determine the scope for oppression and
expropriation of resources by elites:

 unequal institutions which allow the dominance of powerful elites

over economic exchange strongly limit development, as can be seen
in the case of many ex-colonial countries.

 Lastly, institutions determine the degree to which the environment

is conducive to cooperation and increased social capital;
 Cont’d….
 inclusive and participatory institutions increase the flow of information and the
extent to which resources can be pooled to reduce risk and ensure sustained
levels of wealth.
 high quality institutions today are rooted in greater equality, political
competition and cooperative norms in the distant past.
 Institutions strongly affect the economic development of countries and act in
society at all levels by determining the frameworks in which economic
exchange occurs.
 They determine the volume of interactions available, the benefits from
economic exchange and the form which they can take.
 Cont’d….
 Institutions reduce the costs of economic activity. The costs include transaction
costs such as search and information costs, bargaining and decision costs,
policing and enforcement costs.
 In short, institutional quality directly affects income levels and promote
development through three channels:
 Reduced information asymmetries, as institutions channel information about
market conditions, goods, and participants;
 Reduced risk, as institutions define and enforce property rights
 Greater restrictions on the actions of politicians and interest groups, as
institutions make them (more) accountable to citizens.
 Cont’d….
Institutions and foreign aid
o Foreign aid, the international transfer of capital, goods, or services from a
country or international organization for the benefit of the recipient country or
its population. Aid can be economic, military …

o Aid may promote institutional quality through greater availability of financial

resources and technical assistance from official creditors and

o Aid may undermine institutional quality by encouraging budget dependency,

corruption and rent-seeking behaviour in recipient countries.
 Cont’d….
 Increased aid weakens government accountability, encourages rent-
seeking behaviors, instigates dispute over control of aid resources,
and reduces pressures to change inefficient government policies and
institutions – thereby undermining quality governance and public
sector institutions.

 Efficient institutions are essential to reducing the adverse effect of

aid and enhancing domestic and international competitiveness in
Africa.
 The End
Thank You for All