The Answer Is Transaction Costs

The Devil Went Down to Grievance: Tuh, Taxes, and HOAs

• Michael Munger • Season 1 • Episode 15

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Are HOAs an argument for anarchy, or an example of it?
Ex post recontracting as a form a of aggression, when the enforcer of contracts is also a party to the contract.
And of course the TWEJ

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You can follow Mike Munger on Twitter at @mungowitz


Speaker 1:

This is Mike Munger of Duke University, the knower of important things Homeowners, associations or clubs are they like states? What would Buchanan and Tullock say about that? And who is Tuh? And why would we worry about him? Also, twedge and this week's letter Straight out of Creedmoor. This is Tidy C.

Speaker 1:

I thought they'd talk about a system where there were no transaction costs. It's an imaginary system. There always are transaction costs. When it is costly to transact, institutions matter and it is costly to transact. Last week's letter asked I have a disability under control now on a drug trial Doing great.

Speaker 1:

I found myself quickly unable to perform routine home care and maintenance, so I traded my toolkit for a checkbook. When I moved to a condominium, my neighbors would complain about our HOA fees. I thought I'd won the lottery. Look, I give you $200 a month and you mow the lawn, shovel the walks, fix the roof, paint the garage, pay my water and trash bill and I get a swimming pool. Shared resources helps, but it occurs to me that a big part of this bargain is transaction costs. Just one contract for 500 lawn sections, one contract for 500 sidewalk segments, going super macro, would you extend this as an argument against anarchy? One could individually contract for all these services that has high transaction costs, or subscribe to a big Randy Barnett style super HOA that would have fewer transaction costs, but it might start to resemble a government as it grows to cover more services. My HOA is a bargain, but it's not utopia. They tell me how many plants I get to have on my patio.

Speaker 1:

Yes, the stoplight that you talked about in an earlier episode in Desert Town is the heavy hand of the state. But as Desert Town aficionados have accepted the intrusion of the stoplight over negotiating every intersection, I suggest that the bundling of sometimes inferior services provided by government might, like the stoplight, end up being preferable To superior services that required research and procurement. I'm a menarchist somewhere twix, nozick and Russ Roberts, with many anarchist friends. Anyway, that's what I was wondering. All the best, jk. This is a really interesting point. I always want to start by asking this utopia thing of which you speak when can I find it? But in fact, that is actually exactly JK's point. He's rather deftly making the case for anarchy, and he knows it, but he's also raising an important question At what point does a private club take on the bad aspects of the state, which is exactly what we're trying to avoid.

Speaker 1:

Isn't that really a problem of ex-post-recontracting, a standard category of transaction costs? The economies of scale in having public goods provided in a club setting, because that's what HOAs are, they're excludable and locally non-rival those economies of scale are enormous. They come with some inconveniences, but if you'd wanted to have a standalone house and mow your own lawn, mine your own sidewalks and have plants on your patio, that was available. If you chose a neighborhood with an HOA as a package, that must have been better. You had two different, non-utopian choices and you chose, in this case, sensibly, the one with the HOA. Now, if utopia had been an option, you would have picked it. Why is utopia not an option? Well, the answer is transaction costs. It's actually an example of T-Bow sorting. There weren't enough different HOAs to compete along all the dimensions that you might want, so you have to pick bundles and compare them to other neighborhoods with no HOA.

Speaker 1:

But there is a larger question, and that's really JK's point, which is a smart point to make. Look, the usual argument for the baseline state is that markets cannot provide security because it's a public good, non-excludable and non-rival, as was discussed earlier. That means that the state can tax your wealth because you wouldn't have that wealth if it weren't for the state protecting it. Your wealth is created in partnership with society and with the government, particularly the police, courts, military. All of those things make the protection and enjoyment of that wealth possible. Now the flaw in that argument is that providing security is actually not all that expensive. We could all pay a sum for the service, like tickets to the opera. Now maybe it costs 10 times as much to protect 10 times as much wealth. That's not how it works. We want the rich to pay a higher proportion of their wealth. Does that make sense? Many social contract theorists say yes, since wealth was formed in partnership with society, the rules of the contract require the wealthy much more because they benefited more from the partnership.

Speaker 1:

Let's pursue that line of reasoning as if a contract were in fact. What's going on? Imagine that I'm building a new house and I want a toilet. I contact a plumber, we negotiate a contract, I choose a toilet installed in a particular way as part of the contract and we agree on a price. Now, any voluntary agreement on price logically implies a disagreement about value. Let me say that again. I've said it before, but it's important Now. Any voluntary agreement on price logically implies a disagreement about value.

Speaker 1:

If I'm willing to pay the plumber $1,500 for the parts, equipment and labor to have the water lines, sewage line and toilet installed, I must value it more than $1,500. Actually, I'd probably value it a lot more, maybe $10,000. A house without a toilet is not very good. By contrast, the plumber is a very efficient work. She can obtain the parts and equipment for $300, which means she makes $1,200 for the six hours of labor that are required to install those parts in the toilet. That's $200 per hour, which is decent pay. I'm benefiting $8,500 because I value the toilet at $10,000, but I only have to pay $1,500. Well, that's the nice thing about markets. The plumber would have liked to charge more. I would have liked it if the plumber had charged less, but there's a competitive market for expert plumbing services. If I had tried to offer less or if she had tried to charge more than a different contract would have taken place. Anyway, the plumber does the work, the toilet works and looks good. I pay her the $1,500 and we're all happy.

Speaker 1:

But the next day the plumber knocks on my door. She says hey, bud, that's how plumbers talk. Hey, bud, hey bud. I was thinking your house is worth much more with a toilet than without. I created a lot of value for you by doing my job. After thinking about it, I decided that you should pay me more, since the toilet is so useful. Well, this is an attempt at ex-post-recontracting. The plumber could have tried it with the job half done and one of the pipes spewing water all over the floor. Pay me another $500 or I walk. Well, I point out that in a competitive marketplace, the price of a service is generally based on how much it costs to produce, not how valuable the service is, and a reputation for doing the job for the agreed price is an important part of the solution to the asymmetric information problem that the plumber faces to get future jobs. So, no, I'm not paying more, and if the plumber doesn't stop bugging me, I'm going to change my positive review on Craig's List. The plumber's angry, but she goes away.

Speaker 1:

My house is now nearing completion and I realize that having security protection will, like the toilet, make the house much more valuable. Being able to live in the house without fear of being attacked or robbed is something I'm perfectly willing to pay for. How much should this service cost? Well, if it were private security. It would be pretty expensive, but security services are a public good, meaning that providing security for the entire neighborhood is relatively cheap on a per household basis. Just like JK's point, we have one contract for security for 500 houses. It's not much more expensive to have security for 501 or 520 houses.

Speaker 1:

So I contract with a local security firm, tuz Security. The motto of Tuz Security is our bite is worse than our bark. Now it turns out that Tuz is a big, dumb, strong dog. But Tuz doesn't need to be smart, because security, like plumbing, is actually not that complicated. It takes some experience and it pays well because you have to do it right, but once you learn the craft it's not that difficult. Tuz signs a contract. He commits to bite anyone who breaks the law, takes property or threatens violent. I pay the first monthly installment for security services and everything's going great. My house is worth quite a bit more because now I have a toilet and security services.

Speaker 1:

One day, though, I come home and there's Tuh sitting on my couch, drinking my best scotch and watching English Premier League soccer on the Peacock Network on my big-screen TV. This is upsetting because I don't actually subscribe to the Peacock Network. Taa must have added it to my cable package. I yell Taa, taa, bad, dog, bad, get off my couch. And how dare you add channels to my cable package using my credit card? I don't want that. Taa doesn't move, but he looks at me. Then I notice that he's cleaning my Kalashnikov, my AK-47. Apparently he's pried open my gun cabinet.

Speaker 1:

Things get quiet. Then Taa says look, I was thinking, your house is worth much more with security than without, so I created a lot of value for you by doing my job. After thinking about it, I decided that you should pay me more, since protecting your wealth is so useful to you. I try to be patient. Taa, after all is not very bright. The plumber had tried to make this same argument. The fact that the contracted service provides me with a lot of value doesn't mean that I owe more for security than it costs to provide in a competitive market. And since security is actually a public good, it's cheaper than private goods such as a toilet, as long as it's also being provided to many other people at the same time. So no, I'm not going to pay Taa anymore, just like I'm not going to pay the plumber anymore, even though Taa is right that I value his service more than I paid for it. As Don Draper said, that's what the money is for. And again, I demand that Taa get his dirty dog butt off the couch. That's private property.

Speaker 1:

This time, taa has reassembled the AK-47. He's good with stuff like that, though, again, like plumbing, it's really not all that complicated. Anyone could do it with some training. I hear him chamber around in the Kalashnikov Ka-chunk. I say Taa, what are you doing? Taa says in a quiet but firm voice.

Speaker 1:

Well, like I said, I've been thinking the social contract is different from private contracts. I have the gun, so I make the law. The law says you have to pay more and you have to keep paying as long as you have any wealth left. I'm not providing protection. I'm deciding how much wealth is beneficial for the society to allow you to keep. I speak for the society because I am security. Now I'm mad. There's no social contract here. Taa is just making that up.

Speaker 1:

I didn't consent to this change in status from a private contract to a social contract. This is just expost recontracting. In fact, if I pay Taa to enforce contracts, I expect him to enforce this contract, even though Taa is also a party to that contract. It had never occurred to me that this was a problem. Taa can enforce the contract with the plumber because he's outside that contract. Who's going to enforce the contract with Taa? There are special transaction costs when the enforcer is also a party to the contract. So while I'm thinking these deep thoughts, taa's getting mad. He starts to growl and he comes closer to me and I yell Taa stay, no, no, taa stay, stay, taa stay, taa stay, stay, dang. Taa has become the state. So here's the problem. Any decision rule has transaction costs.

Speaker 1:

Buchanan and Tulloch pointed out that there's actually two costs in decision the costs of excluding someone from having a voice in the decision and the decision costs themselves the negotiations of reaching an outcome. Unanimity imposes minimal exclusion costs. The undesirable solutions where someone is forced to do something against their will are reduced, but the decision costs of reaching unanimous agreement are really high. Now, in some ways, this is a problem for bilateral contracts also. Notice that my contract with the plumber was unanimous also, but there were only two of us. If we're talking about a unanimous agreement among 500 people or 5 million people, reaching unanimous consent is much harder and we have hold-up problems and other kinds of transactions costs.

Speaker 1:

Well, the story of TA illustrates a new transaction cost problem, one that highlights public choice, something we haven't talked much about on TIDC. The plumber might engage in ex-post-recontracting, but it's not catastrophic because you could enlist the aid of the enforcement agency against the plumber. But what if it is the enforcement agency itself that's engaging in ex-post-recontracting? Tuck can come back at any time and demand that you pay even more, and if you appeal to the enforcement agency to enforce the contract you agreed to, you're just asking Tuck to enforce that contract against itself. Hoas are a kind of middle ground. If you bought a house in that neighborhood, you consented to those rules. But then what if they changed the rules? The rules were that they could change the rules by majority vote, and you consented to that rule by buying the house. But is that the same thing Overall? Do HOAs increase or reduce the value of homes, or do they increase or decrease the variance of the value of homes in the neighborhood over time? Well, we'll talk about those questions again in a future TIDC. Whoa, that means it's time for the twedge.

Speaker 1:

This week we have three short ones on the public perception of economists and of economics. First, some people say that economic forecasters assume everything except responsibility. Second, economists are people who are too smart for their own good and not nearly smart enough for anyone else's good. Finally, on the first day, god created the sun. In response, the devil created sunburn. On the second day, god created sex. The devil laughed and created marriage. On the third day, god created rich, delicious food and the devil gleefully created heartburn and obesity. God kept on creating, but the devil hung right with him tit for tat. That was day 39. Answering each creation with its evil consequence. Finally, on the 238th day, god created an economist. The devil was stumped at first, but then he invented the union grievance, because God was poaching on the devil's turf.

Speaker 1:

The first letter we got was actually a correction from the twedge from last week. Mj writes if the economist for the Bureau of Labor Statistics can count but can't differentiate between a dog and a sheep, then he should have overcounted the sheep by one. So unless he knew that there was at least one dog in the group, because all shepherds have a dog, but didn't know enough to know which one was a dog and which one was a sheep, mj, end of letter. Well, that's absolutely right. If the economist could really count, he would have miscounted the number of sheep, adding one because he counted the dog. That's fine so far, but then why did the shepherd agree that the number of sheep was correct? It should have been one over, but the shepherd agreed with the count. Well, it's okay that the twedges are not funny that comes with the territory but in this case there was a logical problem. My mistake, and thanks, mj.

Speaker 1:

Now on to the letter that we'll take up next week. It's from KR. Kr writes that how do salad bars work? All of the items cost different amounts to the producer, but they charge a single by the ounce price, retail, to the customer. Why do they do that and what are the issues in deciding what price to charge? It seems like if you charge a high price you'll get adverse selection, with people only taking the expensive items and then mixing them later with the cheap items. Kr end of letter. Well, thanks for listening. We'll work on that puzzle. Have another hilarious twedge and more next week on Tidy Sea.