Measurement Costs and Economic Calculation
In a previous post, I attempted to demonstrate how transaction costs—the costs of defining and enforcing property rights—modify and enrich the standard (and important!) Econ 101 analysis. In this post, I want to show how transaction cost analysis benefits from incorporating the most important Austrian contribution to economic science: economic calculation. What follows provides a practical example of how Austrian and transaction cost analysis can complement one another, as many scholars have argued they ought.
Measurement Costs and the Organization of Markets
Transaction costs arise when exchanging parties take steps to mitigate the threat of opportunistic behavior. As Barzel notes, a buyer has an interest in inspecting a good’s “attributes”—its size, quality, freshness, color, or similarity to other units—in order to verify that what is given up in exchange is perceived as less valuable than what is gained. (Resources that consumers perceive as having different attributes are different goods in the Mengerian approach). However, “measurement” of a good’s attributes is costly. The “problem” with measurement is that its costliness, unlike the money price, does not accrue to the exchange partner’s benefit. Relative to a perfect, Nirvana world where measurement is unneeded, measurement costs are pure waste! This suggests that buyers and sellers could affect exchanges at a higher net price if they could agree to a low-cost means of rendering measurement activity superfluous. Sellers would gain by receiving a higher money price; buyers would gain if the increase in the money price is less than the reduction in measurement costs. How then can exchange partners reduce measurement costs and enjoy these gains?
One possibility is for sellers to do something which makes it in the buyers’ best interests to refrain from expending resources on measurement. Perhaps counterintuitively, one way to achieve this goal is to raise a buyer’s cost of measuring, so that less of it is undertaken. Barzel offers a few illuminating examples. DeBeers, once the owner of a large majority of the world’s diamonds, interacts with its distributors only on a somewhat curious, “take-it-or-leave-us” basis. After having assessed a potential diamond dealer’s request, DeBeers will present the distributor with a package of diamonds that roughly matches the description. Next, the buyer is asked to make a choice: Make the purchase or forgo dealing with DeBeers ever again. Instead of seeing nefarious market power inherent in the “take-it-or-leave-us” offer, Barzel argues that this practice reduces the sorting and negotiation costs that buyers would otherwise incur. To convince buyers to consent to such seemingly slanted terms, sellers invest in brand name capital which they forfeit should they behave opportunistically toward buyers. The discipline of continuous dealings therefore constraints potential opportunism. Similar arguments can make sense of the way that perishable food items, such as tomatoes, are packaged and sold.
Barzel extends this analysis by noting that, in some markets, sellers will tend to be the least cost “measurers,” while buyers will tend to be so in other contexts. Under large-scale production of durable goods, for example, buyers will tend to be the least-cost inspectors, since each unit tends to be examined only once—by the buyer when he attempts to use it. In such contexts, sellers usually offer warranties, which reduce the costs associated with each buyer being forced to measure separate units at the point of sale. This lowers the overall costs stemming from measurement and allows the seller to receive a higher money price.
Calculation and the Organization of Markets
During the Socialist Calculation Debate, first Ludwig von Mises and then F.A. Hayek convincingly demonstrated that a consumer-satisfying allocation of resources is impossible under pure socialism, a system where the state owns all factors of production. Without the exchange of productive factors, there are no market prices for them, and without market prices, there is no way to perform profit and loss calculations. Lacking measures of profit and loss, there is no non-arbitrary means of assessing whether a production process has created or destroyed value. According to this argument, an institutional environment characterized by private property rights is necessary and sufficient for capital goods to be continuously re-allocated to their highest valued uses.
Since the original contributions of Mises and Hayek, the calculation argument has been extended (including by Mises himself), most notably to argue that interventionism’s fundamental flaw is that it causes “false” prices to inform economic calculation. More recently, Piano and Rouanet have extended the calculation argument into the organization of markets themselves. Without re-hashing their argument, they show that “primary calculation” occurs within a given set of institutional rules, but that “secondary calculation” governs the decision of what institutional arrangement to adopt. For example, the fundamental Coasean question about whether to use a market or a firm is regulated by secondary calculation.
Along the same lines, in free markets, the decision about whether to implement a measurement cost reducing arrangement is also subject to economic calculation. Certainly, the opportunity to participate in exchanges where the distribution of goods’ attributes is narrower is a benefit to buyers who can spend less time and fewer resources inspecting. Just because something is a benefit, however, does not mean the benefit exceeds associated costs. You may consider an anti-theft device to be a beneficial ad-on when purchasing a car. But if you live in a low-theft region and rarely drive your car into other areas, you may view the benefit of the ad-on to be less than the cost.
Private versus Public
The most important implication of integrating economic calculation with a theory of market organization is that transaction cost arguments do not apply with equal weight to both private and public institutional arrangements. To illustrate this point, I draw on an example that Barzel offers in his 1985 paper, “Transaction Costs: Are They Just Costs?” In discussing institutions which serve to reduce the variance of goods’ attributes and therefore to reduce measurement costs, Barzel writes: “Occupational licensing may serve a similar purpose. Consumers will view licensed professionals as more uniform when some minimum qualifying criteria are imposed. They would spend less on search and would be willing to spend more on the service itself,” (p. 15).
Barzel is contending that licensing necessarily reduces the quality variance among sellers. Buyers, knowing this, expend fewer resources sorting between labor sellers, and therefore pay higher prices for the laborer’s service. Of course, virtually all economists believe that licensing leads to a higher money price, but Barzel here argues that it is lower than the full price, inclusive of measurement costs, that would be incurred without licensing. In Barzel’s approach, the higher price is a boon to consumers because they are simply paying a premium to avoid sorting. Elsewhere in the paper, Barzel makes similar remarks about government interventions which would force grocery stores to remove expired milk from the shelve. Similarly, for Barzel, the American Medical Association’s regulation of doctors reduces physician variance and thus may confer net benefits on consumers.
However, we might wonder if there is there truly symmetry between private institutional arrangements that reduce measurement costs and public institutional arrangements purported to do the same. Barzel moves seamlessly from examples of sellers voluntarily suppressing expiration dates to government occupational licensing. A key difference between the two cases, though, is that private institutions designed to lower measurement costs are subject to profit-and-loss discipline, while publicly imposed constraints are not.
The reduction of measurement costs is itself a goal that demands someone expend resources to achieve it. When resources are devoted to this task, we must ask whether the resources used to achieve this goal might have been used to satisfy other, more intensely desired ends. For example, suppose that the measurement costs associated with buying tomatoes are minimized when they are sold in a specialized plastic carton. Further, suppose the benefits that exchange partners receive from this reduction in measurement costs are trivial, but that the plastic used to make the cartons is intensely demanded in some other use. The profit-and-loss system assures that the plastic is bid away from its measurement cost reducing role to satisfy some other end.
This logic is also applicable to the labor market example that Barzel supplies. In an unhampered labor market, there would likely be a larger range of quality among labor sellers than in a market restricted by licensing. Yet, an entrepreneur who perceives gains from reducing measurement costs could introduce a new institutional configuration in the form of (say) an association which certifies the quality of its members’ work. Another solution is individual certification by a third-party. In both cases, measurement costs are reduced, as buyers can come to rely on the brand name of the association or the third-party certifier. However, such arrangements will only arise if consumers value the reduced variance in seller quality sufficiently to pay the higher price that comes with “association” or “certified” labor.
Additionally, the reduction of measurement costs is clearly not the singular objective of exchange parties. Yes, some sellers may find it profitable to suppress information about expiration dates, while relying on reputation to assuage suspicions of their opportunism. Other sellers, of course, find that the benefits consumers derive from knowing this information outweigh the gains associated with reducing measurement costs. Which consideration ultimately prevails in any given context can only be determined in the presence of profit and loss feedback.
It follows that a persistent private institutional arrangement that reduces measurement costs can be taken as evidence that it confers net benefits. If it did not, firms employing this technique would earn losses and be forced to implement an alternative arrangement. The same cannot be said of public policies that reduce measurement costs. They may confer net losses on market participants yet persist because the public agency operates in the absence of disciplining losses. For examples of persistent public institutions, which nonetheless failed to achieve even their stated ends, see here.
Ultimately, the notion that occupational licensing works to benefit consumers by shrinking labor market variance is a subset of the idea that the state’s primary role is to reduce a society’s transaction costs. Certainly, more exchanges will occur should the state depress transaction costs. This is because transaction costs are a “brake” on the number of mutually beneficial exchanges which can occur. To point this out, however, is only to note that transaction costs are like all costs in this regard. Costs are barriers to action. If the state subsidized steel production, we would doubtless consume more steel, yet no economist reasons from this fact alone to conclude that steel subsidies are therefore justified. By the same token, transaction cost reducing innovations ought themselves to be left to the realm of economic calculation—if our goal is the most efficient use of society’s scarce resources.