Implications of transaction costs
Several important results follow from this analysis:
• The Failure of the Invariance Version of the Coase Theorem:
In the presence of per unit transaction costs, the invariance version of the Coase Theorem no longer holds. That is, the final level of production of Q depends on the initial legal regime.
- • The Failure of the Efficiency Version of the Coase Theorem: In the presence of per unit transaction costs, the efficiency version of the Coase Theorem no longer holds. That is, the total transactions costs and the size of the welfare gains which flow from the final choice of the level of production of Q depend on the initial legal regime.
- • The Efficient Legal Rule Minimises Aggregate Transaction Costs: Moreover - and more significantly - both the individual and aggregate gains from trade when the residents have the property right will, in general, differ from the outcome under a no liability rule. Since income effects are absent in both cases, and since the aggregate gains from trade in the absence of transaction costs are the same in each legal regime, the efficient legal rule minimises the aggregate transaction costs.
- • If Transactions Costs are High, Legal Rules Should Direct Individuals Away from Negotiated Outcomes: When transactions costs are high, it is better that they not be incurred at all. One way to ensure that transaction costs do not occur is to encourage individuals not to make those transactions at all. In other words, if the market mechanism is costly to use, individuals should be given an incentive not to use the market mechanism. For example, consider a rule of strict liability, where the factory can produce as much Q as it desires, with the proviso that it must compensate the residents. Then the factory will produce up to the point where its marginal gain equals the marginal loss to the residents, which is at the efficient point Q. But this transfer is an involuntary, non-market transaction: even though the residents are compensated (assuming that they win in court) they did not consent to the factory's production. Nevertheless, no transaction costs are incurred since the factory does not bargain with the residents. Hence the maximum welfare gains are realised, even though no market exchange has taken place. Here a rule of strict liability not only attempts to mimic or replicate the outcome that the parties would have arrived at but for the existence of high transaction costs. It also means that those transaction costs are not actually incurred.
- • The Economic and Legal Incidence of Transaction Costs: Notice also that the final outcome in each case only depends on the total per
unit transaction costs (which are equal to t = tR + tF under the no liability rule or t' = t'R + t'F when the residents have the property right). For the purposes of determining the final level of production and the total gains from trade, it matters not who bears those costs - what matters is the total transaction costs. In other words, the economic incidence of transaction costs (which determines the final outcome) is independent of the legal incidence (the identity of the party that bears those costs).