Hey Kids! Transactions Costs!

by Will Wilkinson on March 3, 2009

In this macro-brutalizing post, William Buiter lays down many passages I agree with. I don’t believe it was offered in this spirit, but I think Buiter does a servicable job of explaining why my fave econ gurus — F.A. Hayek, James M. Buchanan, Douglass North, and Vernon Smith — will make you smarter than your local macro textbook. Buiter:

[M]ost of the New Classical and New Keynesian macroeconomics assumes away the problem of contract enforcement.  This problem is especially acute in trade over time or intertemporal trade, where the net value to each party to a contract of fulfilling the terms of the contract varies over time and can change sign.  In a world with selfish, rational, opportunistic agents, able and willing to lie and deceive, only a small set of voluntary transactions will ever be observed, relative to the universe of all potentially feasible transactions.

The first set of voluntary exchange-based transactions we are likely to see are self-enforcing contracts – those based on long-term relationships, repeated interactions and trust.  There are some of those, but not too many.  The second are those voluntarily-entered-into contracts that are not self-enforcing (say because interactions between the same sets of agents are infrequent and market participants have a degree of anonymity that prevents the use of reputation as a self-enforcement mechanism) but are instead enforced by some external agent or third party, often the state, sometimes the Mafia (sometimes it’s hard to tell who is who).  Third party enforcement of contracts is again often complex and costly, which is why it covers relatively few contracts.  It requires that the terms of the contract and the contingencies it contains be third-party observable and verifiable.  Again, only a limited set of exchanges can be supported this way.

The conclusion, boys and girls, should be that trade – voluntary exchange – is the exception rather than the rule and that markets are inherently and hopelessly incomplete.  Live with it and start from that fact.  The benchmark is no trade – pre-Friday Robinson Crusoe autarky.  For every good, service or financial instrument that plays a role in your ‘model of the world’, you should explain why a market for it exists – why it is traded at all. Perhaps we shall get somewhere this time.

[...]

The future surely belongs to behavioural approaches relying on empirical studies on how market participants learn, form views about the future and change these views in response to changes in their environment, peer group effects etc. 

Yeah! Do some real science, economists!

Let me point out that Buiter badly oversteps his line of reasoning when he says that voluntary exchange, as such, is the exception rather than the rule, because trade is in fact a ubiquitous feature of human society. The baseline is not “no trade” but the far from negligible level of exchange in hunter-gatherer societies. What Buiter might have said had he not himself wasted so much time with macroeconomics textbooks is this: There are transactions costs. These limit the trades it makes sense to make. But a vastly greater number of trades can be made (and vastly greater gains from exchange realized) when transactions costs — such as the costs of enforcing complex contracts — fall. The complex order of spatially and temporally extended impersonal exchange is the exception, not the rule. And that’s why almost all of humanity has been poor for almost forever.

But the main idea here is right, and it’s good to see a central banker grasp it: economics that leaves out transactions costs simply assumes what humanity has only rarely managed to approximate. Modern economies are weird, pulsing, unsteady achievements of ongoing cultural evolution. Economies certainly aren’t machines governed by physics-like regularities. Nor is “an economy” the creature of specious nationalist bookkeeping studied in textbooks. There are lots of things we need to grasp if we are to “get somewhere this time.”

  • David Jinkins
    For all the economist bashing, we do need models that simplify reality to understand the world. In order to tease out the factors that are important in certain situations, neo-classical and Keynesian economists do ignore transaction costs and a whole lot of other things. In some situations, certainly, it is ok to ignore transaction costs. In other situations, transaction costs are a major issue. Some Economists have spent careers studying transaction costs. The very fact we are talking about "transaction costs" is due to Coase, for instance.

    People often cite behavioral economics as the future of the general field. Without downplaying the interesting results of behavioral economics, in order to make sense of empirical results we still need theories which will simplify reality in many, many ways. How else will we understand in which situations the results are applicable, or even what the results are.

    The best way to look at economics is as a "soft science" like biology. There is never going to be a law or model which completely describes human behavior the way a physicist describes thermodynamics. The world is just too complex. We can, however, use simplified models to gain insight about how the world works in certain situations.
  • dere
    Raivo Pommer
    raimo1@hot.ee

    ING-DiBa krise

    Vor einer Falle beim Vergleich von Kreditangeboten warnt die ING-DiBa: Unter Umständen droht eine Herabstufung der Bonität durch die Schufa, die Schutzgemeinschaft für allgemeine Kreditsicherung. Das kann zur Folge haben, dass ein Kreditantrag abgelehnt wird oder der Kredit nur zu einem höheren Zinssatz zu erhalten ist.

    Keine Gefahr besteht nach den Angaben der Experten, wenn eine Bank Einheitskonditionen für alle Kreditnehmer ausweist und beim Angebotsvergleich keine persönlichen Daten angegeben werden müssen. Aufpassen sollten Verbraucher bei der Jagd nach Kreditschnäppchen hingegen bei Banken, die den Zins von der Bonität des Kunden abhängig machen.

    Erkennen lassen sich solche Angebote daran, dass kein fester Zinssatz ausgewiesen wird, sondern mit Begriffen wie beispielsweise "Ratenkredite ab 6,9 Prozent" geworben wird. Um ein konkretes Angebot zu erhalten, müssen Verbraucher bei solchen Geldinstituten ihre Adressdaten sowie weitere Angaben zur Einkommens- und Vermögenslage hinterlassen. Um den bonitätsabhängigen Zins zu ermitteln, fragt dann die Bank auf Basis dieser Daten bei der Schufa an
  • Paul G. Brown
    I'd quibble with "[M]ost of the New Classical and New Keynesian macroeconomics assumes away the problem of contract enforcement. "

    My Macro 301 course the problem of price stickiness--necessary to much of the Keynesian machinery--was explained as an artifact of contracts and transaction costs. It costs time & money to find cheaper, to relabel goods. Administrating auction markets costs even more.

    But after that it all becomes much more reasonable. Real human beings aren't very good at rationality. Begin there. And construct a theory of markets based on assumptions of error, bias, mistakes and subsequent correction.
  • Jess Austin
    Your critique of Buiter's hypothesized baseline is a little too structuralist for my taste. The noble savages were humans just like us. They had the same intelligence and basic goals, even if they lacked particular customs and institutions. Even more so than for us in the civilized world, any interaction with other parties, including trade, involved a great deal of risk. The tribe down the river might want to sell us some flea-ridden hides, or maybe they just want to see the stuff we have and steal it from us while killing four adults and kidnapping a couple of preteens. Maybe you call that a "transaction cost", but my tribe sees it as more of an existential threat. We'll just shiver through this winter using the hides we have, thanks. Our baseline is to throw rocks at anyone outside the tribe.

    Even this sort of prehistoric scenario planning is unnecessary, though. If we really want to do science (that's gonna be a stretch for most economists, but let 'em try), then we're talking about models and hypotheses, not "the truth". It may be easier to work with a baseline of zero than a baseline of epsilon. If the resulting theory allows us to make falsifiable predictions of future observations, then we have something we can use. If not, back to the drawing board. As my own little structuralist interlude above was meant to demonstrate, the less our economic theories depend on fevered aetiological imaginings of the state of nature, the better.
  • Excellent point. Transaction costs affect everything. That's why so many tax rules, and so many regulations, are much more troublesome than their authors realize. These things aren't self-enforcing. They require lawyers, accountants and so on to comply with the regulations or to follow tax provisions, not to mention the time involved on the part of those regulated and taxed. These are real and often expensive transaction costs, and they don't show up in the regulating agency's budget.
  • Transaction costs matter, which is why we should all go an read Yoram Barzel.

    My nomination for the most disastrously misleading metaphor in the entire history of economic thought would be John Locke saying that a hunter in a state of nature "mixes his labour" with what he catches. No he doesn't he takes control of it. Locke's metaphor encouraged economists to see exchange as the end point of a process of production (which it may or may not be) rather than a purposive act, which it always is. Lock's mistaken metaphor led to all sorts of bad places, not merely the most famous analytical dead end.
  • "The earliest known oil wells were drilled in China in 347 CE or earlier. They had depths of up to about 800 feet (240 m) and were drilled using bits attached to bamboo poles"

    Wikipedia is your friend.
  • forkthis
    I think that's Will's point alphie. To my mind, mobilizing the capital necessary to exploit those resources as we do today (DMonteith's 25,000 man hours) is only possible in modern economies, hinging entirely on the ability to enforce long-term contracts.

    We discovered oil thousands of years ago. Only recently have we made significant use of it (by minimizing transaction costs through state recognition of contracts).

    This does, however, strike me as beside the point of the article.
  • Oil has been exploited by mankind for at least 4000 years, fork.

    And I'm not arrogant enough to speculate on what did or didn't happen during prehistoric times.

    How about Social Security as an example of what a modern economy is capable of?
  • forkthis
    Burning oil for light is not exploiting it as we do today (nor does it save 25,000 man hours). Derricks, pipelines, refineries, and distribution requires massive capital investments that would not occur but for the ability to enforce long term contracts. Do you really dispute this point?

    Yes, most modern economies can support some form of social security. And that's relevant how?
  • I was lucky enough to take my first Macro class from the late Paul Heyne.

    What a great econ teacher he was, his "The Economic Way of Thinking" is worth a look if you have $100 bucks or so to spare.

    I remember the first thing he told my class 30 or so years ago was, "Making lunch for 4 people isn't the same thing as making lunch for 400 people."

    But, I don't think mankind has really come up with anything that impressive in the past 100 years or so.

    Powered flight, automobiles, calculating engines etc. were all developed long ago.

    Middle management isn't really that great of an achievement, fork.

    The Chinese digging oil wells 800 feet deep 2000 years ago impresses me.

    The corrupt operation going on in Sarah Palin's Alaska these days, not so much.
  • Prakash
    How about public key cryptography, the only known way to transmit messages without sharing a key in advance, and video conferencing (scary magical technology that only wizards could have imagined earlier)
  • forkthis
    No great achievements in the 20th century? You're a hard guy to impress.

    However, who said state recognition/enforcement of private contracts developed in the past 100 years? And, to Will's post, this is only one example of decreased transaction costs. Adoption of the uniform commercial code (1952), and the internet (Al Gore - late '90s), are pretty good examples too.
  • Name one modern invention society values higher than indoor plumbing or the light bulb.

    Seems we've decreased our transaction costs but lost our capacity for true innovation, fork.

    Now it's just a question of how long we can milk the innovations of our great grandparents.
  • Paul G. Brown
    The diesel powered generator, and television.

    Really. Visit some slums. They may not have running water, and they will often depend on kerosene lights. But they will have a TV.
  • Greg N.
  • Right
  • And all that oil had been sitting there all that time and no one did anything with it? Why not?
  • DMonteith
    I'm sure the pharoes, who had access to an equivalent amount of energy (the old fashioned way!) didn't worry too much about transaction costs either.

    I'm not arguing that "the complex order of spatially and temporally extended impersonal exchange" isn't exceptional, I'm saying that it owes its existence to our exceptional current levels of wealth rather than the other way around.
  • forkthis
    How do you suppose that wealth was created? Fall out of the sky or something?
  • DMonteith
    Population growth creates wealth the same way that discovering and exploiting oil does. It just takes a lot longer. You do the math.
  • Which would not doubt be why India is so rich. And Switzerland so poor.
  • forkthis
    So, forget the Uniform Commercial Code and just have more babies?
  • DMonteith
    I apologize if my posts have been too parsimonious for you to follow. If, however, you are in fact following my logic, do you have anything more to contribute beyond "You're wrong!! Neener neener!!!"?
  • forkthis
    I am, in fact, not following your logic.

    Your first post suggests that this "complex order of spatially and temporally extended impersonal exchange" is possible because of oil. Your second post asserts that it's possible because of "wealth." Your third post suggests that it's possible because of increased population. I'm sorry for the flippant replies, but these suggestions strike me as increasingly obtuse.

    You seem to imply that modern commerce is a byproduct of chance. To the contrary, modern commercial transactions are possible because of the rule of law, and state recognition/enforcement of private contracts (both of which significantly decrease transaction costs). These are deliberate (and brilliant) constructs which have generated massive wealth and well-being.

    I might also offer that it's not oil that makes us wealthy. Rather, it's commercial exploitation of oil (see exchange below). Again, commerce of this nature is only possible by lowering transaction costs in the manner I describe above.
  • DMonteith
    Here are some questions that point to what I'm getting at:

    Generally speaking, when in nature does the development of the complexity that leads to more
    efficient exploitation of a given resource precede the availability of the resource in question? Does a genetic

    mutation call into existence a heretofore unoccupied ecological niche? Which is the greater hurdle to the

    exploration of new territories, the lack of resources to expend on the project whatsoever, or the lack of systems to

    do it quickly and efficiently?

    When a resource becomes depleted doesn't the inevitable decision to no longer maintain the cultural and physical

    structures erected to exploit it indicate the order of dependencies here? What effect does the advent of the

    availability of 12 years of labor in a can for less than $50 have on the relative and absolute values of pre-

    existing transaction costs? Is the rule of law easier to enforce with posses on horseback or with helicopters and

    video cameras?

    Can you imagine a "complex order of spatially and temporally extended impersonal exchange" existing in a society

    that didn't have a whole bunch of energy (meaning wealth-- the connection/equivalence between the two should be

    obvious) to throw around to support the required complexity/specialization? Relatedly, if you lived on an agrarian

    planet with no fossil fuels and your goal is to maximize wealth within a couple hundred years, would you ask the

    genie in the bottle to eliminate transaction costs or would you ask him to create large (i.e. earth-like) deposits

    of oil and coal?

    What effect might a historically atypical but entirely plausible transition from a higher to a lower quality

    resource (from oil to solar for instance, as opposed to coal/whale oil to crude) have on transaction costs/overhead

    for society? How much of the "progress" we've seen rests on a historically contingent and inherently finite

    discovery and exploitation of increasingly space efficient energy resources? Was the much slower cultural progress

    from 1700 to 1800 really a reflection of much higher absolute transaction costs than existed between 1800 and 1900?

    I can't figure out what a series of coherent, reality based, answers to these questions that is compatible with the

    idea that transaction costs matter more to social wealth than the sheer amount of work an economy is capable of

    producing would look like. Then again, I'm not an economist.

    Just to be clear: I'm not denying that transaction costs are important. If you assume that natural capital does not exist as a factor of production it might even be as important as Will thinks it is, but then one is simply indulging in a different kind of potentially fatal abstraction away from reality that Will decries with regard to behavioral psychology.
  • DMonteith
    That said, in a strict sense, I don't think there is such a thing as "natural capital."

    Well there's your problem right there. If there's no fish in the sea, neither greater capital investments in fishing boats nor the application of harder or smarter labor are going to suffice to increase returns on investment in the fishing industry. In what "strict sense" can such a non-substitutable factor of production be claimed not to exist? How is "assume a healthy fish population" more intellectually defensible than "assume homo economicus" or "assume a can opener"?

    This is the crux of my disagreement with you. I applaud your project to bring behavioral empiricism to economics, but I suspect that your unwillingness to expand the purview of empiricism beyond the behavioral arena to be an illustration of Upton Sinclair's paycheck dependent thinking.
  • I really don't grasp your point, and don't understand your grounds for dismissing mine. Suppose there is a box at the bottom of the ocean that contains infinite energy, produces unlimited food, etc. However, getting to the box requires an immense, complex, cooperative effort. In what sense does the box count as capital if the social coordination required to reach it cannot be accomplished?
  • DMonteith
    If there were a magic treasure chest in a bank vault that remained full of money no matter how much you took out of it, would my inability to access the vault negate the treasure chest's existence? The nature of the value/capital in play here seems irrelevant.

    In this scenario, the existence of the magic box serves as an incentive to develop the necessary complex systems to access it. Access to the magic box is the "return" part of "return on investment". To turn this question around, how do these complex systems arise absent independently existing incentives? If access to the magic box is fully known in advance to be impossible, then the scenario is reduced to an observation that the absence of incentives is functionally equivalent to the absence of incentives.

    Your impressive knowledge (credit where due!) of the empirical blind spots of economics vis a vis behavioral psychology seems matched by a lack of knowledge concerning a similar inability of mainstream economics to integrate itself with the empirical findings ecological/geophysical experts. How convenient for you that this ignorance is justified by the triviality/nonexistence of the issue! You really should get your findings published in the Journal of Ecological Economics before they shutter their operations!

    The urge to snark would be easier to resist if you just claimed disinterest in the subject rather than offering such weak objections to to it's validity.
  • forkthis
    I don't buy it. By way of example (maybe not a great example, but I'm sure we could point to others), I'd highlight the wealth disparity between San Diego and Tijuana (or the United States and Mexico). I think most people would agree that the disparity has very little to do with access to natural resources, and far more to do with the social constructs that enable/strangle commercial exchange and innovation.

    That is, if the magic box is a given, it's these social constructs such as the rule of law and state recognition of contracts (enabling complex coordinated effort) that renders value from the magic box.

    You presume that all peoples will derive the same value from the magic box. On this count I believe that you (and Jared Diamond) are wrong.
  • forkthis
    Likewise. I should have probably stuck with "neener neener."
  • DMonteith
    "I'd say the wealth disparity between San Diego and Tijuana (or the United States and Mexico) has very little to do with access to natural resources, and far more to do with the social constructs that enable/strangle commercial exchange and innovation.

    You just destroyed that straw man there! Unlike you guys, I'm not claiming that the other side of the argument has no merit whatsoever. I would, however, point out that very small changes in historical contingency could easily have had us arguing in spanish about the poor anglos who just can't get their shit together. This bizarro world, however, would most likely sustain a "complex order of spatially and temporally extended impersonal exchange" funded in large part by astronomical surpluses provided by fossil fuels.

    You presume that all peoples will derive the same value from the magic box.

    Well, I actually presume that multiple iterations of our little thought experiment would result in historical accidents that lead to different peoples deriving somewhat different values from the magic box, but that the results: a)would be unpredictable from the starting conditions; b) would rarely repeat; and c) would reveal that the process of development of the complex structures required to exploit the box would would create more congruencies between the successful societies than differences. Thanks for asking.

    No more chance that our disagreement stems from an excessive love of parsimony on my part, huh?
  • Can we agree that neither complex cooperation nor nature is a sufficient condition for growth?
  • DMonteith
    This is a significant improvement over the claim that transaction costs represent the single greatest limiting factor for human welfare.
  • I think every credible economic history puts scientific discovery and innovation -- especially innovations in energy -- at the center of the era of modern growth. So I'm not sure what you think we're disagreeing about. Economic historians like Doug North and Joel Mokyr will say that the development of cooperation-enhancing institutions gave us science, which gave us big tech discoveries, which gave us immense productivity gains, etc.

    That said, in a strict sense, I don't think there is such a thing as "natural capital." Without the coordination necessary to do something productive with oil, it's not worth anything. The prior coordination problems have to be solved before oil becomes valuable.
  • "The bourgeoisie, by the rapid improvement of all instruments of production, by the immensely facilitated means of communication, draws all, even the most barbarian, nations into civilization. The cheap prices of commodities are the heavy artillery with which it forces the barbarians' intensely obstinate hatred of foreigners to capitulate. It compels all nations, on pain of extinction, to adopt the bourgeois mode of production; it compels them to introduce what it calls civilization into their midst, i.e., to become bourgeois themselves. In one word, it creates a world after its own image. "
    - Some German guy, 1848
  • AnotherGerman
    Marx was indeed one of the most compelling advocates of capitalism.
  • DMonteith
    And that’s why almost all of humanity has been poor for almost forever.

    I'm pretty sure that the fact that one barrel of oil has an energy equivalent to 25,000 man hours of labor (give or take) has a lot more to do with this than the cost of enforcing contracts, but I guess the only really important science for economist to grapple with is behavioral psychology, so whatever...
blog comments powered by Disqus

Previous post:

Next post: