Transactions and Institutions: The Building Blocks Chapter 2 1 (c) 2010 Cengage Learning. All Rights...

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Transactions and Institutions: The Building BlocksChapter 2

(c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole

or in part.

(c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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The Logic of Economic Value


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The Benefits of Exchange

The difference between the seller’s opportunity cost and the buyer’s valuation is known as the economic value the

transaction can create. Here, $4 in economic value will materialize if we can reach an agreement.


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What Matters and What Doesn’t

Because of the potential for a gain by both parties from a transaction,it matters that a transaction occurs. What matters less to an economist

is the exact price at which the exchange takes place. Whatever the price,$4 of gain is realized by the two parties. The distribution of the gain

between the parties is a normative judgment, outside the domain of aneconomist to make.


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Transactions Costs


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Why Include Transactions Costs?

Suppose that arranging for the transaction involvesa transaction cost, like, the value of the time it takes tonegotiate an agreeable price. Suppose that cost is $2.

This will reduce the gains to be made from the exchange.


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Why Include Transactions Costs? An ExampleEast of downtown Los Angeles, the suburbs of the San Gabriel Valley have become home for upwardly mobile Hispanic and Asian families who have left the central city. The area is also home to many recent

immigrants from the Middle East, the Near East, India, and elsewhere. For the past 20 years, Longo Toyota of El Monte has been the country’s largest Toyota dealer. Sixty members of Longo’s 80-person sales force

are multilingual.

Longo lowers transaction costs by hiring multilingual salespeople.


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Making Transactions Materialize

In this transaction, if transaction costs were $5, no transaction willoccur because the transaction costs exceed the potential value of theexchange. If transaction costs could be reduced to less than $4, the

transaction can occur.


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Making Transactions Materialize - Sears

Sears pioneered the mail order consumer goodsbusiness in the late 1800’s. Sears lowered a host

of transaction costs, bringing profits to itsshareholders and lower prices to its customers.


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Choosing What to Produce: Specialization and Comparative Cost


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Production Sets and Marginal Costs

These production sets illustrate thenumber of bananas and anchovies that

can be produced using available resources.


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Production Sets and Marginal Costs

The marginal cost of anchovies is the number of bananas sacrificed in order to produce anchovies. In this example, my

marginal costfor anchovy production is ½ of a banana and your marginal cost is 1 banana. I am

the more efficient anchovy producer.


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Efficiency by Command

If we start by both specializing in anchovies we can produce 9 anchovies but zerobananas. If we are commanded to collectively produce 1 banana and as many

anchovies as possible, then you should produce the banana because we would onlysacrifice 1 anchovy. Our most efficient collective production set is given by the red

line. Combinations inside the red line are inefficient.


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Efficiency by TradeI produce 2 anchovies and 2 bananaswhile you produce 2 anchovies and 1banana. Because of the difference in

marginal costs we decide that I shouldgive you 1.5 anchovies in exchange for

1 banana. With this trade in mind, Iproduce 3.5 anchovies and 1.25 bananas

and you produce 1 anchovy and 2 bananas.

After we trade, I have 2 anchovies and 2.25Bananas (a gain of 0.25 bananas) and you

Have 2.5 anchovies and 1 banana (a gain of 0.5 anchovies).


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Why the Example Matters

The moral of the story is, I give you the anchovies not because I care about your well-being, but because I careabout mine, and you have no charitable feelings toward

me that lead you to send out the banana.

When we trade we make each other wealthier.


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NATIONS AND PERSONS


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Ireland: What Happened to the Potatoes?

In the twenty-first century, Ireland has replaced theUnited States as the world’s largest exporter

of software. Land planted in potatoes fell from 1.8 millionacres in 1867 to 30,000 in 2007. Ireland now imports

most of its potatoes from the United States. As for the United States, it is still a net exporter of software, but imports have been rising rapidlyrelative to exports. The United States never

imported many potatoes, but by 2004 it had become theworld’s largest exporter of them.


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Ireland: What Happened to the Potatoes?

We can use the idea of the production setTo explain this occurrence. The

Diagram illustrates both Ireland’s and theUnites States’ production set for

Potatoes and software. Between 1990And 2004, the production sets shifted

And the marginal costs changedProducing the production shifts described.


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What Are Resources?

Resources are whatever has value in the process

of providing goods and services that people around the world value. Today oil

is called a resource, though it took thousands of years before anyone discovered its uses as a fuel and a

feedstock for chemicals.


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ECONOMIC INSTITUTIONS


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What Institutions Are

Economic institutions define the environment in which we can trade. As an

example, criminal law is one of many conditions that will affect the trades we

can and cannot make.


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Other Examples of Institutions - Contracting

I may produce a good custom-built to your specifications that I can only sell

elsewhere at a loss if you refuse to take delivery. Our contract (or a

court) will probably require you to pay me the difference if you refuse the

good.


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Other Examples of Institutions – Market Protocols

Buyers and sellers often agree to use market protocols to propose and make transactions. A protocol may be imposed from above, like the

U.S. government’ssystems for auctioning Treasury bills and

telecommunications frequencies, or it may have evolved over time, like the practices automobile

dealers use to buy and sell used cars among themselves.


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Other Examples of Institutions - Etiquette

Whether two strangers can arrange a transaction that benefits them both can depend on whether they meet each other’s expectations

before the transaction. Imay need to credibly show that I am likely to

deliver as promised, and you must convince me that you are likely to pay the agreed-upon

amount.


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THE GOVERNANCE OF TRANSACTIONS


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Three Forms of Governance - Markets

A household buys vegetables and a business buys office supplies by selecting one of the alternative sellers in a market. We will soon

define markets more precisely,but for now think of them as facilitating the purchase and sale of standardized goods or

services, often in repeated transactions.


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Three Forms of Governance - Contracts

A contract is a set of promises intended to create economic value and enforceable by a

court or some other agency, such as an arbitrator. Often a buyer and seller can increase the economic value they create by engaging in

an unstandardized transaction.


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Three Forms of Governance - Heirarchies

Hierarchies are command-based systems in which prices usually play a relatively smaller role. You cannot order a seller in a market to deliver goods without an agreed-upon price,

and unless both agree to a change the parties to a contract can trade only at prices specified

in it. In a hierarchy, a superior canorder a subordinate to do something without

determining a price for that service.


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The Dimensions of Governance – Trade-offs

Choice of governance matters for manyactivities. For example, which parts of a firm’s

legal work will be performed by inhouselawyers and which by outside law firms? The best choice depends on accurately assessing the costs and benefits of the various modes of

governance.


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The Dimensions of Governance – Mixed Modes of Governance

A given transaction can take place under a mix ofgovernance modes. For instance, during a game a

professional baseball player is a subordinate who takes orders from persons above him in a hierarchy. The team’s manager announces where he will bat in the lineup, and if

he is running the third-base coach tells him whether to stop or try for home plate. A written contract that runs for

several years outlines the basics of the relationship between the player and the team’s owners. At various

points in his career the player participates in a market. Teams initially compete to sign him, and his contract will

specify how soon he may become a free agent and negotiate with any interested team.

Transactions and Institutions: The Building Blocks Chapter 2 1 (c) 2010 Cengage Learning. All Rights...

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