Now that we have covered the definition and the importance of coordination, let’s move on to the topic of efficient coordination. Consider the most basic form of coordination. Two firms engaged in a transaction. By “Transaction” we mean the transfer of goods and services from one firm to another. The study question we are considering is: “Is this transaction efficient?” To answer this question we need an efficiency criterion, something that helps us to understand when the transaction is efficient. We can say that a transaction is efficient if the outcome of the transaction is efficient. More formally, if the resulting allocation of resources is efficient. Economists use a clear and powerful criterion to assess the efficiency of allocations: the Pareto Principle. An allocation is efficient if, changing the allocation, we cannot benefit someone without harming someone else. This means that the economist is willing to move to a different allocation when the new distribution makes no one worse off (and at least no one better off). We call this efficient allocation because we cannot do better without harming someone. Please note that, the efficient allocation might include compensation. I change the allocation to favor Mr. X over Mr. Y, but then I require X to pay a fee to Y to compensate him for the disutility. If after the compensation, both X and Y have at least the same amount of utility as before the change in allocation, the new allocation is efficient. This is a fundamental principle in political economy. Also note that the Pareto principle has no ethical concerns. For example, a strict application of the principle says that it is inefficient to ask a multi-millionaire to pay €10 and buy a meal for a starving child, unless he/she obtains something in return. Clearly, the starving child needs the meal more than the multi-millionaire needs the €10, but still the latter is worse off. This is why we say that being efficient is not necessarily fair. Yet assessing fairness requires somehow measuring utility (or needs), which is something economists are not well-equipped to do. Now, let’s move forward and consider the following question: “What kind of institutions ensure efficient transactions?” By “institutions” we mean the set of laws, regulations, rules and coordination mechanism that are the framework within which the transaction takes place. Economists developed an efficiency principle answering this question. It is called the Efficiency Principle. It states that “If people are free to bargain effectively and can enforce their decisions, then the outcomes of the economic activity tend to be efficient”, according to a Pareto criterion. The keyword here is free bargain. In fact, free bargainers would never accept a transaction if the outcome makes them worse-off. Thus, if the deal is made, it is Pareto Efficient, as no one will be worse-off. Also, note the reference to enforcement. This means the outcome of free bargain can be efficient only if no one cheats. Good institutions must discourage bargainers from cheating. For examples, laws against commercial frauds can help efficiency. Finally, the principle uses the word “tend” to be efficient, meaning that free bargaining and effective enforcement might not be sufficient conditions. Other conditions such as information asymmetries or negotiation power can prevent an efficient outcome. This principle has deep implications. For example, it implies that the market, which is the decentralized coordination of freely bargaining firm tend to be efficient. In this context, the role of government is ensuring effective enforcement of decisions and removing other market imperfections. In one sentence: markets are efficient if institutions are efficient. The efficiency principle says that free bargaining tends to be efficient, under the appropriate conditions. But what about distribution? In our simple framework, a transaction is a change from an initial allocation to an outcome allocation of resources. Does the initial allocation of resources affect the outcome allocation? The Coase Theorem gives an answer to this question. If each party bargains freely and with the objective of maximizing his/her own utility, If they reach an agreement, then by the efficiency principle, the outcome tends to be efficient. Coase Theorem concludes that the outcome allocation is independent of the initial allocation of resources or bargaining power. The intuition is straightforward and relies on the possibility of compensation. The idea is that smart bargainers agree on making the pie as large as possible and they use compensations to make sure that no one is worse off. The exact amount of compensation depends on the distribution of bargaining power. Compensation must be high enough to make no one worse off. Yet, the stronger the firm is, the higher is the compensation. This proves Coase’s point. All firms agree on the efficient solution. They use their bargaining power to determine the amount of compensation. The initial distribution of bargaining power only determines the amount of compensation. (which is how they distribute the benefits) and does not affect the production choice. Again, the efficient outcome (choosing allocation) is not necessarily fair. An important condition for the Coase Theorem to work is the absence of Wealth Effects, which means that no bargainer is in a state of needs. If a bargainer is forced to accept an outcome because of external forces, the result is not necessarily efficient. Probably the first thing coming to an economist’s mind when free bargaining is mentioned is the spot market. The spot market is a distinctive form or coordination described by neoclassical economists such as Walras and Marshall. The key characteristic of the spot market is that the outcome allocation is achieved exchanging a minimum vector of information: prices and quantity for each product. Spot market is efficient in the use of information. Is it also efficient according to the Pareto criterion? We have two main approaches to this question. The first one is the theory of perfect markets describing the well-known perfect competition models. Under the listed assumptions, an economy organizing the allocation using the spot market achieves the social optimum. This is standard microeconomic theory and we do not cover it in this course. A second approach is the Transaction Cost Theory originally developed by Oliver Williamson in 1975. Consider this simple problem. A firm needs a production input. Should it buy it from the spot market? Or should it make it from scratch using its resources? If the firm buys it from the market, it pays a market price. If the firm produces the input, it pays a production costs. We can ask a Neoclassical economist following the perfect market theory and an Institutional economist following the transaction cost theory. The neoclassical economist says that the answer can be obtained comparing the production costs of the input with the market price. If markets are efficient and perfectly competitive, the production costs are always greater than the market price, because a specialized firm is more efficient than a non-specialized firm. In a perfectly competitive market, buying is more efficient than making. The Institutional economist says market price is not the only cost that a firm pays in order to participate in the market. There are other costs, the transaction costs, that need to be considered. Once you add market price and transaction costs and compare the sum with production costs, buying is not necessarily the best option. Production costs might be greater than market price, but if transaction costs are high enough, the market might not be the most efficient way to organize transactions. An alternative organization, Hierarchy, is more efficient and preferable. Transaction costs are a key concept in coordination studies. Let’s define them more precisely. Transaction costs are the cost of participating in a market. They include all costs that a firm bears to organize a transaction through the market, except for the market price that is paid for the goods or the service. There are several types of transaction costs. Search and information costs are the expenses that a firm bears to obtain the information needed to organize the transaction. They are paid before the transaction happens. Examples of search and information costs are the time spent finding the best price in the market, or learning the relevant information about each product in the market. If you ever shopped for a car or a house, you know very well this type of costs very well. Bargaining costs are the expenses that a firm bears to organize the transactions. They are paid during the transaction. For example, they include the time and work that is necessary to write a contract, the time spent to bargain over price. Enforcing costs are the expenses that a firm bears to make sure that the counterpart delivers what he/she has promised and/or reduce the damage in case he/she does not deliver. Usually (not always) they are paid after the transaction has been completed. They might include insurance fees, cost of lawsuits, monitoring costs, and so on. As you can see, transaction costs can be a non-negligible part of the total costs of buying any goods. In some cases, they can make the difference and push toward hierarchy as an efficient alternative to markets. Transaction cost economics suggests that a dominant way to coordinate transaction does not exist. If transaction costs are low, the spot market is preferable. If transaction costs are high, hierarchy is more efficient. The optimal form of coordination depends on the intensity of transaction costs in each particular transaction.