a) Please, give two examples of transactions that you know from experience that are governed by different governance structures, either market, hybrid, or hierarchy. Please, identify precisely what the transaction is that you study in each case. (6 pts.)
Transaction 1: On-line Purchases (eBay), in this transaction, there exists a client and a merchant utilizing a virtual market interface as a substitute to an actual market with physical goods. Since the transaction has a perceived inherent risk of defaults, Paypal was introduced as a form of electronic payment from buyer to merchant where it charges a transaction fee once a transaction was made successful. Moreover, it also provides possibility of reimbursement once the items purchased were no delivered from merchant to buyer. In this case, you assume a transaction cost equivalent to the amount charged by Paypal which streamed-lined the market process while reducing the uncertainty of the transaction and its asset specificity is very low considering the investment made by the client are not transaction specific or even not existent providing a market governance structure under a spot contract.
Figure 1: Transaction 1 Figure 2: Transaction 2
Transaction 2: Consider the case of an iPhone App Developer and its client Apple. In order to make an iPhone App, the developer is required to use the Software Development Kit as a standardization requirement and buy Publishing Licenses in order to legally publish iPhone Apps exclusively under Apples website. This move allows a bilateral agreement over two companies wherein Apple technically integrates the developer into a vertical arrangement through a contract granting partial ownership right to the iPhone App with a corresponding revenue sharing agreement. Frequency of transaction as designated by the contract agreement as specified in the license usually having a minimum contract period of 12 months. While uncertainty is given by time which is technically high risk given the fact that developer are often independent in nature and usually constitute other projects that may override the delivery of the iPhone Apps. As for the asset specificity, it is perceived to be low as the investments on transaction specific assets are not substantial as the SDK are available for free. Thus, it is safe to say that the given is under a hybrid governance structure allowing contracts and vertical integration.
b) Please, review the three main hypotheses of Williamson regarding what factors determine transaction costs and the choice of governance structure and discuss if these hypotheses seem to be valid for the examples you chose. Explain why a specific hypothesis may not hold true or why you are unable to assess it. Try to draw comparisons between the two transactions and the way they are governed. Methodologically, how would you go about studying the different types of transaction costs involved? What problems do emerge in the context of such a study? (14 pts.)
Williamson (1985) dimensions or variables used to characterize or determining any kind of transaction cost and the choice of governance structure wherein transaction can be (1) frequent or rare; (2) have high or low uncertainty; (3) or involve specific or non-specific assets.
Frequency is straight-forward that it is usually omitted in the discussion. However, the effect of frequency on transaction costs is very strong.
Uncertainty notes the probability dynamics that eventualities might occur during the course of the transaction. Time, for example, is factored in wherein uncertainty is relatively low when one doesnt have to predict the future which usually the case for spot markets. Conversely, transaction that involve a commitment over time have some inherent uncertainty built in to them as the completion of a long term contract may be jeopardize one in the instance when bounded rationality and opportunism is subjected.
Asset specificity involves assets that are only valuable (or are much more valuable) in the context of a specific transaction, transaction costs will tend to be reduced by vertical integration. Also, when transactions involve highly specific assets, transaction costs are likely to be lower in a hierarchy than in a market.
Consider the case of the two previous transaction, where in it manage to provide the necessary variables needed to determine the kind of transaction cost and the choice of governance structure. The classification and explanation of these dimensional variables has been extensively explained the previous answer since the governance structure is needed to define. However, it came to a conclusion that both has a different governance structure wherein Transaction 1 is given by the market characterized by the spot contract while Transaction 2 is given by a hybrid governance structure given by a combination of contract and vertical integration. Spot contract are characterized by one time contract between two entities doing a transaction with no substantial uncertainty and non-existing need for transaction specific assets. Conversely, hybrid which is a combination of a contract and vertical integration which is characterized by a continuous transaction engagement of both parties within the arranged time frame with a substantial uncertainty in the full delivery of the contract with an existing need for transaction specific assets since it is usually the case that the companies align their production into the acceptable standards as specified by the contracting company or entity.
Methodologically, there should start the agents, their relationships, specification of a transaction, determination of the kind of transaction cost, and choice governance of the structure. Once everything is defined, we can analyze the estimation of the actual cost function of such transaction to further provide quantification of such.
Based on Williamsons theory there are a few problems needed to be mentioned; (1) separation of production and transaction costs doesnt always hold while the measurement of transaction cost is very difficult even if it was already defined, (2) bounded rationality is not sufficient when it comes to the conflict of interest as agents interest may not be perfectly aligned, and (3) reputation and trust are not considered since transaction are treated as though they occur without any reference of the previous transactions that the parties engaged.
Task 2: Economic Theory of Democracy
c) What are the basic assumptions of the Economic Theory of Democracy and the main insights derived from this theory which, for example, can be demonstrated by means of spatial models? Which phenomena are addressed by the terms centripetal and centrifugal forces? Please use graphs. (20pts)
Anthony Downs (1957) in his Economic Theory of Democracy provided us with 3 major theoretical claims:
First, the median voter model wherein candidates must locate themselves at the median of a normally distributed voters in order to maximize their chances of being elected. Failure to position could risk being outflanked by another candidate who takes a position between the first candidate and the median voter. Such model assumes Arrows problem by supposing that all policy issues aggregately reduced to a single left-right dimension.
Second, it was claimed that the voters actually have little incentive to vote as they cannot expects to have any impact on the outcome of the said election. Since, they have a very little impact that any cost of voting negates any direct benefit from such action. This was later generalized by Mancur Olson (1965) in his logic of collective action.
Third, which is sub-divided into two claims, (1) is that individual citizens has no incentive even to learn enough to be able to vote intelligently and (2) that gaining such knowledge entails some costs.
Furthermore, as the main insight which acts as a precursor for a spatial model, Downs uses the assumption under the classical democracy theory wherein people seek their self-interest in politics. In this case, voters are only concerned about the policies that the government will implement wherein these policy choices involve trade-offs which can be represented as a single dimension. Each voter has spatial preferences over an issue, characterized by a policy that the individual most prefers, deviations from which lead to less good outcomes for such voter. Conversely, politicians seek to win public office while parties (treated as teams of politicians) seek to win control of the government. The electoral politics will provide a menu of policy promises that candidates and parties offer to implement if elected while voters choose the candidate closest to their ideal policy. Based on such, competition for office will lead candidates and parties to represent public policies that mostly appeal to the median voter.
Under the median voter theorem seen in Figure 1, there exist two politician given by A and B wherein there is a normally distributed voting population where each voter is represented by a point in a single dimension. Then politician A and B would, under all circumstances, try to position its policy platform in reflective to the preference of the median voter. In this case, A would move aggressively in order to increase its votes from a0 to a1 which is then followed incrementally by B moving from b0 to b1, respectively. This creates a Nash Equilibrium effect providing a common convergence on the ideal point of the median voter creating a centripetal tendency forming the rationale for real-world election under plurality. In this case, voters being indifferent between politicians since both now have equal probability in receiving votes; a deviation to commit a different policy position would lead to decrease in the probability of receiving such vote.
Figure 3: Median Voter Theorem Figure 4: Formation of Extremist Politician/Parties
Following the median voter theorem, Figure 2 exhibits the countervailing centrifugal effects. In this case, C emerges having a role of political activist in the sense that it pushes a far-leftist policy as compared to A & B which already met in the previously optimal median point. In this sense, a multiple politician/party system election tends to reinforce the divergence from overall voter median mainly due to the restricted enrollment in the primary electorate as disproportionate participation by hard-core supporters of the politician/party and the tendency to select candidates reflecting the views of those voters. This provides for the existence of geographically based differences in party support and political attitudes, and the presence of policy-motivated goals of elected politicians. Furthermore, such divergence of C from the median allows to catch votes equivalent to c which is greater than a and b providing a distinct advantage.
d) What is particular regarding the party preferences of farmers and what has shaped their party preferences? What conclusion can be drawn regarding the coordination capacity of elections for the agricultural sector? Please explain the following statement: For an agricultural politician who behaves in a rational way, favoring farmers by means of redistribution policies will cause too high opportunity costs in terms of votes. (20pts)
Picking from the previous discussion, self-interested citizens, make electoral choices and take actions, such as voting or reading about politics, to maximize the expected benefits of a given action net the cost of those activities. A utility maximizing citizen will choose a level of political activity, such that the marginal expected benefit of the activity equals the marginal cost. Thus, farmers are specifically concerned about the agricultural policies that the politician/party wished to implement whilst they behave completely neutral on other political problems. Since theyre only interested on the evaluation supply of agricultural policies which is formed by the responses of the agricultural politician to policy demands. Furthermore, Farmers often fall into four categorical voting behavior types namely; median voters, floating voters, regular voters, and extreme voters.
Median voters follow the pure allocation model often voting ones who provide the preservation of agricultural structures resting on the guarantee of private property in production factors. Floating Voters follow the optimal distribution strategy under the pure democracy wherein maximum favors for a minimum majority and maximum burdens for a maximum minority. Floating voters are often captured through additional gains by means of policy measures that redistribute income. Regular voters are the ones who rely on party competition requiring long-term maintenance of respective party identification which is decided by the basis of the general party program but not for particular agricultural policies. Extreme voters are often created when the agrarian minority are radicalized through legitimate crises in agricultural policy wherein they feel that the traditional state actors didnt prioritize their interest resulting into crises which threatens their economic existence (see: CDU/CSU as the majority) or through the ideological instrumentation by groups and organizations which are close to agriculture but come from urban society (see: NSDAP/Nazi Party from 1928 to 1933). In all of these behaviors, the farmer exemplified the classical democracy theorem which allows them to maximize their benefits based on their individual interest.
In the case of coordination capacity of election, that resolves the paradox of non-participation through 3 possibilities that needs a certain degree of coordination.
First, was the introduction of duty to vote (Riker and Ordeshook, 1968) wherein the incorporated a constant term that captures a citizens sense of duty to vote. Individuals with sufficiently high duty to vote will vote, and those with a low sense of duty will not vote.
Second, was through the consumption motivation of expressive voting wherein people who care more about the outcome in the sense of having a greater utility differential in their assessments of the candidates will be more likely to vote (Schuessler 2000).
Third, was to embed individuals within social groups wherein Harsanyis notion of rule utilitarianism was further developed by Coate and Conlin (2002) the notion of group rule utilitarianism. A rule utilitarian solution holds that all would be better off if everyone voted than if no one voted, so the group has an incentive to create a mechanism which induces all to vote.
Furthermore, it assumes that the utility derived from electoral participation and electoral choice is strictly consumption which is waged over a spatial dimension, with a valence component or to assume that there exist mechanisms for coordinating groups of individuals to political action and such as churches, unions, political parties, and other social organizations.
For an agricultural politician who behaves in a rational way, favoring farmers by means of redistribution policies will cause too high opportunity cost in terms of votes specifically means that optimal redistribution strategy characterized by maximum favors for a minimum majority results to maximum burden on a maximum minority wherein one party strategy will constantly countermined by the promises of another one leading to unstable political conditions. This is the usually the case wherein redistribution schemes induce political fragmentation as there arise political disagreement between voters in different region. Such increases the possibility of wasteful rent seeking. Further, a minimum majority is characterized by 51% of the voting public while maximum minority is about 49% of the voting public wherein 2% of the voting public can be separated through special favors leading to rent seeking.
Task 3: Organization and Influence of Interest Groups
e) Please describe and explain the Economic Theory of Collective Action developed by Mancur Olson. Which groups and determinants does he distinguish as regards the emergence and feasibility of collective action? Please use graphs. (20pts)
Olson(1965) and his economic theory of collective action discuss the provision of public goods (and other collective consumption) through the collaboration of two or more individuals, and the impact of externalities on group behavior. This explores the market failures where rationality of individual consumer and firms’ profit-seeking do not lead to efficient provision of the public goods, wherein another level of provision would provide a higher utility at a lower cost.
Moreover, it also develops a theory of political science and economics of concentrated benefits versus diffuse costs. Wherein he noted two things; (1) if everyone in a group has interests in common, then they will act collectively to achieve them, and (2) in a democracy, the greatest concern is that the majority will tyrannize and exploit the minority. It also argues that individuals in any group attempting collective action will have incentives to “free ride” on the efforts of others if the group is working to provide public goods. Individuals will not free ride in groups which provide benefits only to active participants.
In this case, public goods are goods which are non-excludable and non-rival. Without selective incentives to motivate participation, collective action is unlikely to occur even when large groups of people with common interests exist.
Also, a large group has been noted that it will face relatively high costs when attempting to organize for collective action while small groups will face relatively low costs. While, individuals in large groups will gain less per capita of successful collective action; individuals in small groups will gain more per capita through successful collective action. Thus, in the absence of collective incentives, the incentive for group action diminishes as group size increases, so that large groups are less able to act in their common interest than small ones.
Furthermore, a collective action by large groups is difficult to achieve even when the interests are common, but it can occur that the minority bounded together by concentrated selective incentives can dominate the majority.
On the other hand, Olson made mention about the groups, namely; large, small, privileged, intermediate, and latent.
Large group is where each person gets proportionally smaller benefit from a collective good which in turn, the individual contributes little to the organization. A member in this group would rarely act to secure a collective benefit unless the individual return is sufficient to cover the individual cost of action. Since this group is broad, they provide sanctions and incentives to ensure the loyalty of members who might otherwise identify strongly with small groups. While it provides collective goods to their membership, they must also offer non-collective goods to attract new members.
Small Group is often more viable because the costs of organization are less, and each member receives a more substantial portion of the collective good. But this will not operate perfectly because the distribution goods and burdens between members will always be unequal. The collective good is provided by the voluntary, rational, and unilateral action of one or two members who find that their reward for providing the good is easily more than the costs they bear. And since any member can consume the good once it has been provided, some members see no incentive to provide the good where they end up exploiting the few members who bear the costs.
Privileged group a few of the members have an incentive to provide the collective good for all. No formal organization is needed because many different psychological, social, and economic incentives can motivate members.
Intermediate group there are so many members that a free-rider is not noticed and therefore no subgroup has an incentive to act on their own. Thus, institutions are necessary to help identify psychological, social, economic an psychological incentives for members to act.
Latent group there are so many members that neither the action nor inaction of any particular member would help provide the collective good. The only sets of incentives, if they ever appear, are economic in form and are rarely enough to motivate collective action.
Furthermore, the determinants for the provision of public goods are basically two things; (1) group size and (2) intensity of preference. In the case of large group, once the intensities of preferences are equal then voluntary provision of public good very unlikely but once the intensities of preferences are unequal then the provision on the collective good is not sure. Conversely, the case of small group, once the intensities of preferences are equal then voluntary provision of public good is not sure but once the intensities of preferences are unequal then the provision on the collective good is very likely.
f) Which mechanisms for collective action to come into being play a role in the Economic Theory of Olson? What mechanisms are used for organizing collective action in the case of the German Farmers Union and in the case of a drainage association at the coast of the North Sea, and why do they differ? (20 pts)
There are three mechanisms for the provision of collective good, namely; (positive) selected incentives, negative selected incentives or coercion, and irrationality.
Positive selective incentives allow paying members receive benefits or private goods wherein exclusion principle can be applied. Thus, non-paying members are excluded from such.
Negative selected incentives or coercion which often used by the government as it has the legitimacy to use a formal and physical power on the society wherein it delegates tasks to associations with compulsory membership and it is implied that there is no free exit.
Irrationality is due when the expressive interests are emphasized in public policy which ignores the important practical considerations despite the underlying economic costs in order to provide collective action. Caplan (2007) claimed that the voter choices and government are biased in favor for its irrational beliefs. This is then effectively subsidized by democracy wherein anyone who derives utility from potentially irrational policies (such as protectionism) can receive private benefits while imposing the costs of such beliefs on the general public.
Under the case of the German Farmers Union, it effectively uses the mechanism of negative selected incentives or coercion since it can legitimately use the power of the state granting that it has maintained a political monopoly through the prevention of the fragmentation of the agricultural association in Germany. Furthermore, GFU has the leadership and management of the Central Committee of German Agriculture even though there is perceived ideological discrepancies with the inclusion of the post-socialist farmer unions from Eastern Germany.
Conversely, the drainage association at the coast of the North Sea effectively uses positive selective incentives since it doesnt have a legitimate power to coerce the government in doing what they wished. Moreover, this case allowed excludability as only the stakeholders who are directly affected by the creation, operation, and maintenance of the drainage system could get the benefits of having such within their property.