Transaction Costs and the UCLA Brand of Price Theory
What makes the UCLA brand of price theory distinct?
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It has been some time since I wrote a big picture post. It seems past due. Thus, today seems like a good time to discuss the transaction cost approach to price theory.
This newsletter is about price theory. However, there are different brands of price theory. In particular, we tend to distinguish between the Chicago brand and the UCLA brand. People often ask what makes these brands different. As a result, I am always looking for a pithy way to differentiate the two approaches. Unfortunately, that hasn’t been as successful as I would like. I typically say something to the effect of “the Chicago School focuses on markets and the UCLA School focuses on exchange.” This typically leads to confusion. Isn’t exchange what takes place in a market? Well, yes. Nonetheless, I continue to believe that this distinction is important. However, I now believe that this distinct is also incomplete. I think the best way to describe the UCLA approach would be to say that it is the intersection of the transaction cost approach to economics and traditional price theory. Allow me to explain.
Transactions As the Central Focus
When I think of the UCLA brand of price theory, what differentiates them from others is their emphasis on institutions and transaction costs. Thus, rather than saying that their emphasis is on exchange, I think it would be more accurate to say that the UCLA approach to price theory is focused on transactions.
To see what I mean by this distinction, consider Ronald Coase’s famous paper on the firm. The language used to describe Coase’s motivating question is often a source of confusion, for much the same reason that my comparison of markets and exchange can be confusing.
Typically, when people teach Coase’s theory of the firm they begin by phrasing the central organizing question as a choice between allocation by a firm and allocation by a market. In my experience, students often find this type of phrasing confusing. Instead, I prefer to state Coase’s central question as asking why some transactions take place within the firm and some transactions take place between firms. After all, it is nature of the transaction that seems to matter given that Coase’s explanation is transaction costs.
Today, we think about Coase’s paper as foundational to the literature on firms. However, it is not clear that this was always the case. (Coase himself wrote a paper in 1972 arguing that his paper was widely cited, but little used.) In fact, one could argue that it was the subsequent work on transaction costs, firms, and institutions by the people at UCLA (and others) decades later that elevated that paper to its current position.
Some have argued that the reason for this is that a transaction cost explanation appears tautological. If one asks why a transaction takes place within the firm rather than between firms and the answer is that it was cheaper to do so, what do we learn?
To make a transaction cost argument, one needs the term “transaction cost” to be well-defined. In addition, any theory based on transaction costs should be able to predict the sort of decision-making we actually observe and allow for comparative institutional frameworks with testable predictions.
Property Rights and Transaction Costs
Armen Alchian’s work on property rights was an early step in this direction. The term “property rights” sounds like something that we all immediately understand, but as Alchian’s work demonstrated, the characteristics of property rights often differ. For example, property rights provide excludability to the owner in the sense that the owner can exclude others from the flow of benefits the property provides. Within that component of property rights, the owner gets to determine what to do with the property, or how to use and/or change the property. Another characteristic is alienability, which provides the owner with the right to transfer ownership to others.
Nonetheless, the choices are not always limitless. If I own a plot of land, I might want to turn that land into a farm or a gun range. In theory, it is my choice as the property owner. Nonetheless, there are often limits on how property can be used. Often, if land is located within a neighborhood, homeowners association agreements or city ordinances prohibit the use of firearms on one’s property. The same is true with regards to alienability. There can be restraints on alienation. Historically, it was common to have limits on the division of property.
This poses a number of questions. What effect do these restrictions have on decision-making? Why do these restrictions exist? Who decides?
This type of discussion inevitably leads to thinking about the nature of transactions and thus transaction costs. But one challenging question is how one defines transaction costs. Doug Allen, for example, notes that the term “transaction costs” is often quite vague. He defines transaction costs as “establishing and maintaining property rights.”
The Transaction Cost Approach
Once one starts thinking about the nature of transactions and transaction costs, a natural question to ask is just how much insight that one can get from this approach in comparison to others. Oliver Williamson argued that any economic problem that could be formulated as a contracting problem warranted using the transaction cost approach — the scope of which turns out to be quite broad!
But even within this transaction cost approach, there are distinct types of analysis. For example, following Alchian, there is a branch of transaction cost economics that focuses much of its attention on the role of property rights.
By contrast, Williamson’s description of the transaction cost approach is different. In addition to defining transaction costs more broadly (using Arrow’s definition as the “cost of running the economic system”), Williamson argues that the transaction cost approach is distinct. He argues that the property rights approach often takes legal institutions and dispute resolution as given, whereas his preferred definition of transaction cost economics is not only focused on the the contracting problem itself, but also the institutions that emerge to deal with the disputes and resolutions thereof. While this approach does not deny that issues of ownership are important, Williamson argues that the transaction cost approach tends to focus on issues related to governance or measurement.
Of course, it is hard to delineate all of these different approaches. For example, one could argue that what Williamson calls the measurement approach is actually just a version of property rights economics rather than a distinct approach. As a result, I tend to lump all of these approaches together under the broad umbrella of transaction cost economics.
It is important to note that Williamson was not part of the UCLA school. Nonetheless, he was engaged in a similar type of analysis. Yet this transaction cost framing is helpful in explaining what was unique about the UCLA brand. One might think of the key distinction of UCLA as being the intersection of traditional price theory with transaction cost economics. On the one side, transaction cost economics involves a lot of comparative institutional analysis and focus on transactions. On the other side, traditional price theory is about marginal analysis and focuses on markets. The diverse set of people who are identified with the UCLA brand — especially those like Alchian, Demsetz, Hirshleifer, Klein, and Thompson — did work at the intersection of these two approaches.
In my view, it is working at that intersection that made the UCLA approach unique. It also seems to explain the amount of insight that these economists were able to provide across a broad scope of topics.