Transaction Cost Economics and Risk Management Principles
Transaction Cost Economics (TCE)
Transaction Cost Economics (Williamson) is a branch of economics that studies the solution to coordination and motivation problems using price and non-price mechanisms.
Core Principles of Williamson’s TCE
- i) It makes the transaction the basic unit of analysis.
- ii) Transactions differ in attributes that are relevant for the decision on how to govern them.
- iii) Contracts govern transactions, and the list of available contracts is much larger than the narrow view of pure market exchange contracts where buyers simply pay a price for a product or service.
- iv) The costs of transacting, when combining types of transactions and types of contracts, can be very different; therefore, the choice of the right contract for each transaction type is highly relevant.
- v) In the calculation of transaction costs, factors of “atmosphere” (environment) intervene and act as constraints in the choice of the contract.
- vi) From an efficiency point of view, the choice of the contract or institutional form for each transaction should be made under the criterion of minimizing transaction costs.
Types of Transactions
- Complete and Symmetric: All parties have the same information.
- Incomplete and Asymmetric: Characterized by hidden information (before the transaction) or hidden action (after the transaction).
- General: The value of the asset is similar in all uses.
- Specific: Involves the cost of specific assets (sunk costs).
Contractual Frameworks
Contract: Establishes the terms and conditions of the transaction between separable units; they are voluntary and set, among other things, how the potential gains from the transfer will be shared among the parties.
Types of Contracts
- Complete: Spells out all the terms of the exchange in all possible contingencies.
- Incomplete: Establishes a general framework for the transaction, but there are many possible contingencies not anticipated in the market.
Information Asymmetries and Moral Hazard
Information Asymmetries: These appear in exchanges where buyers and sellers have different information, with the buyer generally being less well-informed than the seller.
- Hidden Information: A situation of information asymmetry at the time of contracting, such as when the buyer (employer) does not know a relevant attribute of the product (employee’s hidden ability).
- Hidden Action: This asymmetry occurs after the contract is signed and affects the performance of the relationship between buyers and sellers over the time the contract is active. The joint interaction of states of nature and human actions determines that hidden actions derive into situations of moral hazard.
Hold-ups: Contracting situations where one or both parties cannot use the exit option to protect the value of their respective assets (v > I – C) in case of no agreement on the terms of the contract.
Ethics and Decision Making Under Uncertainty
Ethics: A branch of Moral Philosophy that provides standards of behavior from which a person can determine what is right or wrong from a moral point of view.
Decisions Under Uncertainty
These are situations where a decision-maker must make choices among alternatives without having certainty about the payoffs. Such payoffs depend on the chosen alternative and the state of nature actually occurring, which is unknown when making the choice.
Risk Management and Insurance
- Certainty Equivalent: A monetary payoff with probability one that makes the decision-maker indifferent between the lottery and the certain payoff.
- Risk Management: Actions that contribute to wealth creation by reducing the disutility produced by assuming risk.
- Risk Sharing: Reduces the disutility of assuming risk by replacing one investor with many investors.
- Diversification: Reduces the risk of a portfolio of investments relative to investing in a single asset.
- Insurance: The transfer of risk from a risk-averse party to a risk-neutral party for a price.