Hart on Transaction Costs

9 April 2008 at 12:02 am Peter G. Klein Leave a comment

| Peter Klein |

In a new paper, “Reference Points and the Theory of the Firm,” Oliver Hart reflects on the progress economists have made on the theory of the firm since 1937. He argues that despite many advances, economists still have difficulty operationalizing Coase’s notion of transaction costs, or “haggling costs,” as Hart calls them. Why, he asks, can’t managers strike efficient bargains — call them Coasian bargains, ironically, after Coase 1960 — with managers of other firms?

The transaction cost literature . . . has implicitly assumed the existence of haggling (or rent-seeking) costs: it has not confronted the issue of how to model them. The more formal property rights approach has sided with Coase (1960), thereby avoiding haggling costs. In a typical model the parties bargain costlessly ex post, and the focus is on ex ante investment inefficiencies. I have argued elsewhere (Hart and Moore (2007)) that, while such an approach can yield useful insights about optimal asset ownership, it is unlikely to be helpful for studying the internal organization of large firms. Specifically, in a world of Coasian bargaining, it is hard to see why important aspects of organizational form such as authority, hierarchy, and delegation matter. Why wouldn’t the parties simply bargain about everything all the time, using monetary sidepayments?

The answer, Hart suggests, lies in the concept of “reference points,” discussed here (and later published here). Drawing on concepts from behavioral economics, Hart argues that parties enter transactions with some notion of fairness, and renege on commitments or shirk on performance to the extent that they feel aggrieved, or shortchanged relative to this reference point.

The short, non-technical paper is based on the inaugural Coase Lecture, given by Hart at the London School of Economics in February 2007. It nicely summarizes Hart’s work in this area.

As an aside, I think Hart errs in contrasting the positive-transaction-cost emphasis of Coase (1937) with the zero-transaction-cost emphasis of Coase (1960). In the latter case, the assumption of costless bargaining is made to prove a point, namely that court ordering is necessary (according to Coase) precisely because parties cannot reach efficient bargains. Coase put it this way in “The Nature of the Firm: Influence” (1988): “Transaction costs were used in the one case [‘The Nature of the Firm’] to show that if they are not included in the analysis, the firm has no purpose, while in the other [‘The Problem of Social Cost’] showed, as I thought, that if transaction costs were not introduced into the analysis, for the range of problems considered, the law had no purpose.”