The Answer Is Transaction Costs

Packing Out Your Trash, Brown M&Ms, and $100 Bills on the Sidewalk

• Michael Munger • Season 1 • Episode 13

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How do you trade off your own interests against the interests of others? And what role do transaction costs play? A discussion of our "interest" in the welfare of others,  and the complexity that adds to economic indifference curves.

Things take an interesting turn, going toward how transaction costs can shape our institutions and preferences, ranging from  a marine fishery to a bowl of M&M's.

And TWEJ. Always, TWEJ.

Some Resources:

Gary Lynne, on Dual Interest Theory:   https://journals.sagepub.com/doi/abs/10.1177/02601079231172366?journalCode=jiea

Neo(Classical) and Rama-Kandra, on caring about others: 
https://www.imdb.com/title/tt0242653/characters/nm0924502

On Coase, Olson, and the Problem of Encompassing Institutions:

On Brown M&Ms:


If you have questions or comments, or want to suggest a future topic, email the show at taitc.email@gmail.com !


You can follow Mike Munger on Twitter at @mungowitz


Michael Munger:

Hello, this is Mike Munger of Duke University, the knower of important things the acceptance of the fact that people are both interested in themselves and in others. How is that mediated? By transaction costs and brown M&Ms, twedge and this week's letter Straight out of Creedmoor. This is Tidy C. I thought they'd talk about a system where there were no transaction costs, but it's an imaginary system. There are always no transaction costs when it is costly to transact, institutions matter and it is costly to transact. Here's the letter from last week. I read most of it last time, so I'm just going to read an excerpt.

Michael Munger:

Transaction costs arise in the context of shared interest among people In dual interest theory and meta-economics. Transaction cost is represented in the other interest, a shared interest that is internalized within the own self-interest Institutions, as argued by institutional economists going back at least to Veblen. Representing the shared other interest matter because institutions, culture, both formal and informal, rules, including the enforceable and the unenforceable, affect the cost of achieving the shared other interest as well as the cost of achieving the self-interest. The shared other interest in the institution gives context to and tempers self-interest. In other words, humans pursue a complex balance in a joint self and other interest. Well, that's the end of the letter. There's a lot there.

Michael Munger:

I have to put up a link to a paper written by the author of the letter, professor Lin, which was just published, which is more theoretical. It was in the Journal of Interdisciplinary Economics. Perhaps the most important corrective that the work of Dr Lin offers is that he's pointing out that the cost of negotiation, enforcement and coordination do not arise solely from the fact that I'm self-interested and you're self-interested and we're trying to cheat or manipulate the other party into a transaction. We are self-interested but we're also interested in the welfare of others, and that also means that we may have difficulty negotiating mutually beneficial transactions, as Adam Smith put it. Well, that's from theory of moral sentiments. What Professor Lin and others who work on dual interest theory have done is to take this part of Smith seriously. I think a lot of economists are uncomfortable with this being part of economics. What's strange is that it ever stopped being a part of economics. Adam Smith, in the theory of moral sentiments, correctly said this is a big part of human motivation and for some reason, because it was difficult to model mathematically we have not kept to that kind of vision. It's easier to model singular self-interest on the part of all individuals. But what Professor Lin and others have done is to try to take that part of Smith seriously.

Michael Munger:

Suppose I could do X which would benefit me. No one will see me or know if I did X, but suppose that X would substantially harm someone else. If I care about others even a little bit, there are likely to be things I will not do, even though those things would benefit me. And our economist would say that the choice should come down to preferences, relative prices and income. Those are the things that we use to explain people's choices preferences, relative prices and income. It's then possible and I'm simplifying, of course to illustrate the trade-offs using the orthodox representation of indifference curves. A lot edge worth to consider those trade-offs. I might well choose to benefit someone else, even if it cost me something, if the transaction cost of doing that are not too high.

Michael Munger:

Doug North always used the example of a wine bottle on a mountain hike. So I'm going up to the top of a mountain, I've got a small backpack. I have packed in there a bottle of wine and an opener. I get to the top, we have a lovely picnic, we drink the wine. If there's a recycling container up there at the destination, then after I drink the wine, I'm likely to dispose of the bottle there rather than leaving it on the ground on top of the mountain. Even if I never expect to climb that mountain again, I will make some effort to make sure that that bottle is disposed of properly. But what if there is no recycling container up there? Will I pack it back down the mountain? I have a preference for my own convenient, and the bottle is heavy. Besides, I might fall and get caught by the broken glass. Yes, that was also true on the way up, but there was wine in it then. So be serious, I have a preference not to harm others, and leaving the bottle at the top of the mountain is unsightly, and I will know that I did it, even if no one else knows that I did it. So the trade-off between these two leaving the bottle at the top of the mountain, knowing that I will never be there again and it will not disturb my vision of the beauty of the mountain, or carrying it back down.

Michael Munger:

I consider the costs. Now, remember, to the consumer. All costs are transaction costs and in this case I might be consuming my taste for benefiting others and not littering. I'm not being asked to pay to dispose of the bottle. But it's inconvenient. I don't have to pay any money price, but I do have to pay some transaction cost to put it in my pack and schlep it back down the mountain. My decision whether to pack the bottle back down the mountain depends on the cost of disposal and transportation.

Michael Munger:

Ronald Kos argued that if there were two firms or two people that are in conflict, one solution is for one to buy the other out. Which well, whichever arrangement creates more value, because that creates a surplus out of which the purchase price can be taken. Consider an example. This is called a holdup problem in transaction cost theory. A large company needs to do a big print order in a small town in the Midwest. The local copy and print company would have to buy a much larger machine and sorter to fulfill the job because they don't have that kind of capacity on the timeframe that the big company wants.

Michael Munger:

Well, the two company. They agree on three cents per page for printing, sorting and binding, plus a fee for covers. The small companies are very excited. They order the machine, get it installed and they start printing. But then the large company says look, we're only going to pay you two and a half cents per page. Yeah, I know we agreed on three cents per page but we're only going to pay two and a half cents per page. You can sue, but you're going to go bankrupt because the payments for the loan on that huge printer sorter binder are going to eat you up and we have lawyers on retainer so we can drag this out for years.

Michael Munger:

Of course the small company knows in advance that this kind of hold up or post-contract negotiation is possible, so they don't do the deal in the first place. But then a contract that would have benefited both parties cannot be negotiated and enforced, which is a classic transaction cost problem. Because they're not really able to trust each other, they're not able to consummate what would be a mutually beneficial transaction. The solution is that the large company could buy the small company or the large company could buy the expensive equipment and then lease it to the small company for the duration of the job. This solution, where a merger or acquisition of a supplier is motivated by transaction cost problem, is very common and a big part of the reason why standard antitrust approaches fail to understand the problems of transaction costs, because some of the benefits to mergers and acquisitions can be their reduction, not of cost, but of transactions, cost of exposed renegotiation and hold up. I cannot become one with everyone else though. So companies can merge, but individual human beings cannot. Now we have mergers like marriage or connections with family or teams, and those can reduce the cost of me feeling as if I care about others in my group.

Michael Munger:

Menser Olsen famously wrote about what he called encompassing institutions. Encompassing institutions give us an identity that is shared, that is, we're all in this together. Robert Cohan, in an article in 1988, said institutions do not merely reflect the preferences and power of the units constituting them. The institutions themselves shape those preferences and that power. That's why institutional economics and the study of where preferences come from has to rely on institutions in the study of transaction costs. If I have a sense of trust in other people, and that trust is generally vindicated by the fact that people act in the way that I expect, then we have overcome a lot of transaction costs that we might not even think about because it's only operating in the background. That's why Professor Lin and other institutional economists care about preferences and where they come from. Our preferences are not fixed in exogenous, but they come from the institutions we grow up in.

Michael Munger:

The word we use for this is culture, but that's really just a name. It's like that scene from the Matrix. There's two characters, ramakandra and Neo-classical economist. The Neo-classical economist says I just have never, and Ramakandra says, heard an economist speak of culture. And the Neo-classical economist says real economists don't talk about that, it's a Human emotion. And Ramakandra says no, it's a word. What matters is the connection that the word implies. I see that you care about others. Can you tell me what you would give up to hold on to that connection? And the neoclassical Economist says well, it depends. Actually, the answer depends on transaction costs. And Ramakandra says then perhaps the reason that we're here is not so different from the reason that I'm here. Well, I may rewritten that a little bit, but that's how it should have been written in the first place, because the answer to all questions is transaction costs.

Michael Munger:

So institutions evolve to reduce transactions costs, or institutions differentially survive if they're created for some other reason, but Institutions happen to reduce transaction costs. But then those institutions create a setting where preferences are induced. The next generation grow up in a setting where they take those institutions for granted. People are not selfish or other regarding exclusively Transaction costs make them so. Institutions create our preferences and that trade-off between selfishness and being other regarding.

Michael Munger:

Imagine that there's a large marine fishery full, for now, of Pelagic fish that fish out in the open ocean, that move around. If there are no property rights, then over a fishing or the tragedy of the commons will occur. No way to create private property because it's out in the open ocean. The transaction cost of exclusion are too high. But it's possible to create an institution for managing the common pool resource. Remember, common pool resources are rival but not excludable. By organizing an encompassing institution, all the signatory should be able to create a body of enforceable rules and quotas for fishing. If the transaction costs are not too high, then the entities that own some quota will have an incentive to defend that quota and to defend the whole system or the share of the common pool against unauthorized intrusion by outsiders. In effect, it's the Olsen solution again. We're a merger of the interest of those most directly affected creates a new entity, one that has other regarding preferences Rather than purely narrowly selfish interests. The difference is, rather than one company acquiring another, we need an institutional solution where everyone feels that they're part of the same culture, by far the lowest transaction cost.

Michael Munger:

Way to solve collective action problems is to rearrange institutions to create incentives for being concerned about the property value or welfare of others. Doing it by law or external constraint Always has higher transaction costs than by changing incentives if you can get people to buy into the system. There's another problem, one we've already discussed but which is important in this setting. If someone says they care about you and they want to make sure you're prosperous and healthy, that could be true, but humans differ in this sentiment, this caring about others, just like in all other tastes and that's what that actually is is a taste. The indifference curves that depict the tradeoff between my welfare and your welfare are idiosyncratic, very particular to the setting and to the individual.

Michael Munger:

The role of transaction cost and revealing type and giving costly signals is central to many Activities. When you think about it, if someone says I care about you and I want to make sure you're healthy, it could be true, but it might not. You need some way of getting them to reveal their type. This is often an unintended, even emergent, consequence of some accidental rule that happens to produce good outcomes and is Elevated to real doctrine, as in the case of the word of wisdom that we talked about before. There's a famous example where the sorting of type using transaction cost was clearly intentional. It was not emergent, it was intentional.

Michael Munger:

And that's the strange case of the brown M&M's. Now, in a rock show, all promoters are going to tell you that they're going to be careful and do a good job because they love you, they love your work, you. But will they Do they? We think of rock stars as spoiled divas constantly making excessive, unreasonable demands. You know, like Jacob Levy at McGill University in Montreal, just impossible to deal with a real primadonna. Well, the rock band Van Halen had a diva demand like that one, one that was oddly specific. Their backstage dressing room had to have a big bowl of M&M candies with all the brown ones removed. So big bowl of M&M candies is in the contract, and then buried in the contract is a provision or writer saying that all of the brown M&Ms have to be removed from the big bowl. For years this was seen as complete folly. The band was making a ridiculous demand of concert organizers simply because they could get away with it, but the seemingly ludicrous request was actually a way to use transaction cost to get information.

Michael Munger:

The clause remove all the brown M&Ms was buried in the contract and required that someone actually get the M&Ms and then go through and remove all the brown ones Sort of like the tedium of cutting coupons Only. More so, the requirement was completely pointless. There was no instrumental reason to do it, but it was easily checked by looking at the bowl and pawing through it for just a few seconds. There either will be or there will not be brown M&Ms. The contract writer, remember, was buried in the middle of the contract and it says that if there's no M&Ms, or if there are M&Ms but there's brown ones mixed in, then the promoter would forfeit the entire show at full price. They didn't really put it in there in order that provision in there in order to get to trick promoters into forfeiting the entire price of the show. They were trying to do is to. So it wasn't a trick. They weren't trying to get paid, they were trying to survive. Lead singer David Lee Roth explained in a 2012 interview the bowl of M&Ms was a signal about whether the concert promoter had actually read the band's complicated contract. Let me read, quoting from David Lee Roth Van Halen was the first to take 850 par lamp lights Huge lights around the country At the time it was the biggest production ever.

Michael Munger:

Now par is parabolic aluminized reflector lights. They're very bright, they're very hot. It's like a car headlight, only even more so. Each of these bulbs was a thousand watts and there were 850 of them, plus an enormous power hungry set of amps and speakers, a lot of complex pyrotechnics and movement of stage elements. This was dangerous. Many venues were too outdated or inadequately prepared in order to be able to get this kind of sophisticated stage set up. Their electric circuitry might not be powerful enough, it might be unstable, meaning it could blink off during the show, and the construction of the stage itself might be unstable. Quoting David Lee Roth again, if I came backstage, having been one of the architects of this lighting and staging design, and I saw brown M&Ms on the catering table, then I guarantee that the promoter had not read the contract writer, which means that the promoter had not read the rest of the contract either, and we had to do a serious line check of the entire stage set up. End quote. That's pretty impressive. If there were no brown M&Ms, that was a pretty good sign that the promoter had actually read the entire contract carefully. And if the promoter was willing to do something stupid like pay somebody to remove all of the brown M&Ms from a large bowl, which would take a few minutes. The promoter is probably also willing to have checked the electrical and movement of stage elements parts of the show so that they weren't dangerous.

Michael Munger:

The interesting thing about thinking in terms of transaction cost is you end up seeing explanations for things that otherwise make no sense. It's fascinating. Whoa. That sound means it's time for the twedge.

Michael Munger:

An economist and a stockbroker are walking along a street and the economist looks ahead and sees a hundred dollar bill on the sidewalk. And the stockbroker says look at that, a hundred dollar bill just lying on the sidewalk. You know, we both saw it. I tell you what We'll split it, we'll each take $50. And the economist said well, that's the stupidest thing I've ever heard. We all know that in equilibrium there couldn't possibly be any $100 bills lying on sidewalks. People picked them up. That's what equilibrium means. So this is not happening. Stockbroker says okay, suit yourself. And picks up the hundred dollars and puts the entire thing in his pocket. The economist waits for a second and then says see, see, I told you there's no $100 bill. Somebody would pick it up. Well, as far as I know that last bit is my own invention, or at least I came up with it independently.

Michael Munger:

There is a sense in which the economist is correct In equilibrium things are efficient, but there need to be institutions and norms in place to support that equilibrium. In fact, there are $100 bills everywhere just lying around waiting to be picked up. It's one thing to say that, as a result of entrepreneurial awareness, many of these $100 bills are found and that there's not that many left, but it's an entirely different thing to say that there's no $100 bills in the first place. That's what's so confusing about the neoclassical model of economics based on equilibrium. It's confusing the thing and the model of the thing. The fact is there's $100 bills everywhere. That's what motivates a lot of economic activity. If you look after, the economic activity has taken place. Yes, prices have been generated and the $100 bills have been picked up, but that's missing the point. That's not what economic activity was about in the first place.

Michael Munger:

This week's letter is from DY. I moved to South Carolina some years ago. Our liquor stores are called red dot stores. Why Does any other state do that? I've asked some people here why they have red dots and the answer vary. Some say it's because South Carolinians are illiterate, but then why not have blue dots for groceries? Some say it's a symbol of the sun, because liquor is only sold in the daylight hours. Seems like this is more expensive than just having a sign. And how do people know what the red dots mean, especially if they're from out of state? What's up with the red dots? End of letter. Well, thanks for listening. We'll work on that puzzle. Have another hilarious twedge and more next week on Tidy C.