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Transaction Costs

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transactions costs
costs of buying or sellign a financial insturment
information costs
costs that savers incur to determine the creditworthiness of borrowers and to monitor how borrowers use the acquired funds
economies of scale
the reduction in transaction costs per dollar of transaction as the scale of transactions increases
adverse selection
a lender's problem of distinguishing the good--risk applicants from the bad-risk applicants before making an investment
moral hazard
a lender's verification that borrowers are using their funds as intended
free riders
individuals who gain access to the information without paying for it
property that is pledged to a lender to guarantee payment in the event that the borrower is unable to make debt payments **this type of debt is secured debt**
net worth
difference between assets and liabilities
shareholders who own the firm's net worth
managers who control the firm's assets
principal-agent problem
managers do not own much of the firm's equity and thus do not have the same incentive to maximize the firm's value as the owners do
restrictive covenants
long legal documents with provisions that restrict and specify certain activities that the borrower can engage in
venture capital firms
raise equity capital from investors and invest in emerging or growing entrepreneurial business ventures
corporate resturcturing firms
raise equity capital to acquire large blocks of the equity in mature firms to reduce free-rider problems
What are transaction costs
costs of using the market
Coase Theorem
Externalities are problematic because of TCs
Williamson's take on Coase Theorem
Developed General theory of vertical integration
Determinants of TCs
TCs result form opportunism, information asymmetry, risk/uncertainty, bounded rationality and small numbers bargaining
Bounded Rationality
Reflects the limits on our ability to process information
Self-seeking with guile (clever thinking, crafty behaviour)
information asymmetry
Parties do not have equal access to information
Small Numbers
When numbers of agents in the market place are limited
Asset Specificity
Generates quasi-rent: Once installed, a specific asset is worth more in specialised use than its next best use
Site Specificity
Forms of asset specificity
Physical Asset Specificity
Refers to assets whose Physical or engineering properties are specifically tailored to a particular reason
Dedicated Assets
an investment in plant and equipment made to satisfy a particular buyer
Human Asset Specificity
Refers to cases in which a worker, or group of workers, has acquired skills, know-how and information that are more valuable inside a particular relationship than outside
Profit you expect to get when you build the plant, assuming it all goes to plan
Extra profit you get if deal goes ahead as planned, versus the profit you would get if you had to turn to your next-best alternative
Holdup Problem
If an asset was not relationship-specific, the profit firm could get from using the asset in its best alternative and its next-best alternative would be the same
Coase 1960 showed that externalities
are problematic because of TC's
MC rises with additional input
Marginal Benefit (MB) falls with additional input
Optimal input not usually achieved
because TCs prevent bargaining outcomes
economise on TCs
Coase argued that firms exist to
short run contracts require
repeated search, negotiation, inhibit forms of investment i.e. firm-specific training
Williamson 1975 argued that if TC's are lower than
org costs, use market, if not use hierarchies and vertical integration
Williamson proposed TCs result from...
...opportunism, information asymmetry, bounded rationality, small numbers bargaining and the atmosphere/social relations surrounding the transaction affected its cost.
Vertical integration only if
contracts could not be cheaply written and enforced
Asset specificity gives rise to the small numbers condition Klein et al 1978. Asset specificity generates
quasi-rents - an asset that once installed is worth more in specialist use than a next-best use generates a stream of quasi-rents and threat of hold-up
Quasi rent example
2006 Coventry City moved to purpose built stadium, owned by separate company and leased to clue, 2012 team was relegated, club couldn't afford the £1.2m year rent, 2013 clue withheld rent and was put …
VI expected where
specificity makes hold-up threat
Williamson used the term 'fundamental transformation'
describe change from market outcome to bilateral monopoly when investment in specific asset occurs
Testing TC economics
with any evolutionary principle danger of tautology. later tests to identify determinants of TCs, then use ownership data to see if VI dominates where TCs should be high
A better test would use TC theory to
predict 'optimal' structure and then use performance data to see if departures from the optimal carries penalty
Masten 1984 Aerospace test
engineers classify components by complexity and specificity, found more complex components with high specificity more likely to be made in-house
Theory predicts fall in TCs, Why?
Outsourcing, swing towards in late 20th C...
Outsourcing facilitates
econs of scale, lowest cost locations
complex multi-product firms may experience
high org costs - TCs may be cheaper
Outsourcing example Oil and Gas production
oil companies traditionally undertook their own production/exploration.
costs change e.g. trucking
tech advances have made it easier to determine position, speed, work history of distant trucks giving owners greater control over drivers, encouraging owned fleets
vertical integration
the expansion of a firm into stages of production earlier or later than those in which it specializes
a firm buys inputs from outside suppliers
core competency
area of specialty: the product or phase of production a firm supplies with greatest efficiency
economies of scope
the ability to use one resource to provide many different products and services
winner's curse
the plight of the winning bidder who overestimates an asset's true value
asymmetric information
one side of the market has better information about the product than does the other side
hidden characteristics
one side of the market knows more than the other side around product characteristics that are important to the other side
hidden actions
one side of an economic relationship can do something that the other side cannot observe
principle-agent problem
the agent's objectives differ from those of the principal, and one side can pursue hidden actions
the amount of money borrowed in a loan of the amount of your money in savings account that is earning interest
a person or firm who is supposed to act on behalf of the principal
efficiency wage theory
the idea that offering high wages attracts a more talented labor pool and encourages those hired to perform well to keep their jobs
using a proxy measure to communicate information about unobservable characteristics
the process used by employers to select the most qualified workers based on observable characteristics, such as a job applicant's level of education and course grades
behavioral economics
an approach that borrows insights from psychology to help explain economic choices
mapping brain activity while subjects make economic choices; the goal is to develop better models for economic decision making