Transactions Costs

As noted already, Babbage regarded his identification of the cost of verifying that an article was what it professed to be as one of his important contributions to human knowledge (Babbage 1864 [1991]: 329-330). He accepted that the classical theory according to which market prices were determined by the proportion between supply and demand and natural prices by the cost of production including normal profits was broadly speaking true. However, there were two circumstances in which this required some modification: (i) where the whole supply was in the possession of one person, and (ii) where the quality of an article could not be determined easily on inspection. The latter tended to give rise to considerable variation in the prices at which exchange took place. Moreover, the cost of the article to the purchaser was not just the price he paid for it but also the cost of verifying its quality (Babbage 1832 [1835]: 134-135).

Babbage noted that the transactions costs arising from the need to verify quality could be an important determinant of the decision to make or buy a particular product. For example, while it was a general maxim that government could purchase most articles at a cheaper rate than that at which it could manufacture them itself, it might still be more economical to set up its own operations when account was taken of the cost of verifying the quality of each unit purchased and in devising methods of detecting the new modes of adulteration which were constantly resorted to (ibid.). Babbage quoted extensively from House of Commons Select Committee discussions of quality issues relating to clover seed, the Irish flax trade, the lace trade, the stocking trade, and the watch trade. Based on these reports and other instances with which he was familiar, he argued that since the majority of purchasers lacked the skill to verify the quality of products, it was necessary for them to pay a higher price to some person with the skill and integrity to furnish articles of the required quality (ibid.: 139-140).

Another alleged consequence of poor quality was the collapse of trade. A report investigating the grievances of framework knitters had noted that differences in the quality of lace were not visible to the naked eye but that the inferior product deteriorated rapidly on washing. It was claimed that where the inferior product was sold as first quality, it led to a subsequent collapse of the demand for any sort of lace from the district in question (ibid.: 137-138). In watchmaking, it was alleged that the marks and names of respectable manufacturers were forged by producers of inferior goods who sold these in foreign markets, thereby leading to the collapse of orders. Such products were also sold in the countryside by pedlars who had departed by the time the fraud became known.

Having discussed a number of other examples including drugs and harness, Babbage turned his attention to the quality of services. Here he argued that there was scope for fraud in the charging for services, such as the conveying of parcels, because it was difficult for the customer to verify the appropriateness of a charge and it was extremely costly to recover any excess charges that had been paid. For this reason, Babbage suggested that it would be worth experimenting with government conveyance of parcels along the same lines as the post was already conducted (ibid.: 144).

Whereas in the EMM, Babbage focused on the costs associated with ascertaining quality, in The Exposition of 1851 (Babbage 1851 [1968]) his focus was on the lack of price information. This arose because the organising committee of the exposition refused to allow prices to be posted on the various exhibits. Babbage argued that this had the consequence of defeating the effects of competition and imposing search costs in terms of a loss of time on both buyers and sellers. Babbage also claimed that it led to price dispersion, increased prices, and reduced demand (ibid.: 67-69).

The evolution of market days and regular markets was also discussed in The Exposition. These institutions increased competition and reduced price variability but, according to Babbage, their greatest benefit was in terms of reducing the cost of transacting by saving time for all the participants involved (ibid.: 73-74). As more regular markets evolved to facilitate the trade of merchants, larger dealers, and international exchanges, a class of men emerged whose business it was to buy and sell on commission and whose presence provided a means of reducing the cost of obtaining market information. As Babbage explained, in a market with 100 purchasers and 100 sellers, each purchaser has to ask each seller at least two questions, namely what is the price and what quantity have you for sale at that price? This would give 20,000 questions in all whereas if there is a broker in the market each agent provides the information on prices and quantities only to his own broker, making 400 questions in all. Brokers may then meet together to pool information and arrange the necessary exchanges. Babbage was clear, however, that the need for brokers arose because individuals did not have perfect information. Referring to this discussion, Romano (1982: 401) argues that, for Babbage, the establishment of market exchange was facilitated by a reduction in transactions costs. This is certainly true but Babbage also recognised that market exchange could take different forms and that the forms which were successful at any point in time were likely to be those which best succeeded in reducing the cost of transactions.

As noted already, Babbage held that outsourcing was most likely ‘where there exists a sure and quick method of ascertaining that the terms of the contract had been fulfilled’ (Babbage 1832 [1835]: 213). Babbage also noted that the move from cottage to factory production in the calico trade led to the demise of a class of middlemen and to a reduction in the need to monitor the measure and quality of cloth. In the old situation, Babbage argued, each cottager had an incentive to cheat in the absence of monitoring provided that any fraud on his part, even if detected, did not become known to other buyers. However, once the institutional setting became one involving the merchant and a single great manufacturer, there was no longer an incentive to cheat because the parties to the transaction will know that any gains from doing so would be more than counterbalanced by losses arising from the injury to the manufacturer’s reputation (ibid.: 218-219):

The value of character, though great in all circumstances of life, can never be so fully experienced by persons possessed of small capital, as by those employing much larger sums: whilst these larger sums of money for which the merchant deals, render his character for punctuality more studied and known by others. Thus it happens that high character supplies the place of an additional portion of capital; and the merchant, in dealing with the great manufacturer, is saved from the expense of verification, by knowing that the loss, or even the impeachment, of the manufacturer’s character, would be attended with greater injury to himself than any profit upon a single transaction could compensate (ibid.: 219).

Babbage argued that well-grounded confidence in the character of its merchants and manufacturers was an important advantage that an old manufacturing country always possessed over its rivals. As a consequence of this confidence, in some of the largest English towns, sales and purchases on an extensive scale were made daily without any of the parties ever exchanging a written document (ibid.: 219-221).

The idea that repeated transactions and the expectation of further dealing could provide a mechanism for ensuring honesty in commerce was not in itself new (Geary and Prendergast 2008). What was new was Babbage’s explicit linking of the issue of honest dealing with the use of modern factory- based organisational forms and his idea that the value of reputation was linked to firm size. Babbage also understood that well-grounded confidence in the character of merchants had a wider social value in reducing the transactions costs associated with trade.

Reviewing EMM for the Edinburgh Review, McCulloch dismissed Babbage’s discussion of quality arguing that adulteration was not carried out to the extent that was commonly supposed and that in any case it could not be eliminated by regulatory intervention since the corruption of the regulators was just as likely as the fraud of the vendors (McCulloch 1833: 320-322). Mill was more appreciative of Babbage’s contribution. In Principles of Political Economy he argued that the labour expended in verifying that people fulfilled their engagements is ‘so much withdrawn from the real business of production’ (Mill 1848 [1973]: 111). He elaborated to the effect that the support of those who lived by pillaging or overreaching other people was a direct burden on society. The police and the whole apparatus of justice was a second burden rendered necessary by the first. This, in turn, was far outweighed by the immense increase in produce which would be obtained if labourers honestly performed what they undertake ‘and by the increased spirit, the feeling of power and confidence, with which works of all sorts would be planned and carried on by those who felt that all whose aid was required would do their part faithfully according to their contracts’ (ibid.). Several of Babbage’s examples were then cited both to illustrate the waste occasioned to society through the inability of members to trust one another and, more positively, to show the ‘substantial advantage derived in business transactions from proved trustworthiness’ (ibid.: 112). Mill, however, neglected to provide any analysis of the institutional basis which helped to sustain trust and confidence. Given Mill’s importance to nineteenth century economics, his failure to carry forward Babbage’s insights may help to explain their subsequent neglect. It is also possible that the increasing coordination of production by firms and the centralisation and mechanisation of production contributed to the loss of interest in organisational solutions to problems of quality. As Babbage himself noted, one of the greatest advantages of mechanisation was ‘the check which it affords against the inattention, the idleness, or the dishonesty of human agents’ (Babbage 1832 [1835]: 54).