Submission
THE IMPORTANCE OF TRANSACTION COSTS
In his classic 1937 article The Theory of the Firm, Nobel Laureate Ronald Coase argued that the boundary of firms is determined by what have subsequently been labelled "transaction costs" -- search and information costs, bargaining and decision costs, policing and enforcement costs. (1) Coase argued that, if it was cheaper to organise something within the firm than purchase it on the open market, then production would take place within the firm.
The importance of transaction costs in understanding how well, or badly, societies work is increasingly clear. Economists such as Nobel Laureate Douglass North, Jack Powellson and Mancur Olsen have sought to explain long-run differences in economic performance between societies in terms of matters including how well their institutions reduce transaction costs.
Perhaps the most powerful single demonstration of the importance of differences in transaction costs has been from the work of Peruvian economist Hernando de Soto. De Soto conducted an exercise where graduate studies attempted to get the approvals to open up a small clothing factory in Lima, Peru (it took 290 days to get the relevant government approvals) and then repeat the exercise in Miami, Florida (a few hours). The comparison made it obvious where there was going to be more economic activity. It expresses with eloquent simplicity a key reason why the US is richer than Latin America. Higher transaction costs mean less transactions, which means less economic activity, which means a lower standard of living.
In Latin America, the privilege of legal operation in the economy has been handed out by the State, creating tight-knit groups of highly privileged elite "insiders". Regulatory complexity benefits the insiders, but impoverishes the society. Regulatory complexity is a direct tax on transactions -- it raises their cost and restricts their scope. Transactions are the fundamental building blocks of economic activity and thus prosperity. (2)
If the state increases the regulatory complexity, and thus raises the transaction costs, for a mode of employment -- such as permanent, full-time employment -- then that eats into the possible mutual gains of providers and users of labour. Both users and providers of labour services acquire an incentive to seek other modes of employment which avoid or lessen those costs. As such transactions costs rise, so does the attractiveness of means which allow the parties to avoid those costs, and so mutually appropriate the resulting gains.
Raising transaction costs of, for example, permanent employment not only leads to looking for other modes of employment, it may push labour services outside the firm. Restricting movement to other modes of employment does not solve the problem of high transaction costs, it merely reduces the capacity to evade the transaction costs, so will increase the overall depressive effect on employment activity.
Increasing transaction costs decreases economic efficiency, decreasing transaction costs increases economic efficiency. Given the long-term pressures on Australian governments, particularly the fiscal pressure from the expanding welfare state -- pressures became particularly strong in Victoria in the late 1980s and early 1990s -- any policy of increasing economic inefficiency in the most important single market in the economy has dubious long-term prospects precisely because it has real and immediate costs for economic activity, with consequent implications for government revenues and costs.
Graph S1
There are reasonable grounds for suspicion that the deterioration in Victoria's relative labour market performance from 1987 onwards, and its improvement since 1993, might have some connection with changes in relative transaction costs in the Victorian labour market as a result of regulatory changes.
Graph S2
Unfortunately for rational debate on these matters, drawing attentions to costs and difficulties gets in the way of the game many play in parading their "virtue" by their commitment to ever-wider legislation of rights and entitlements. In order to protect their moral assets, they seek to de-legitimate such discussion or contrary positions. But not only are such rights and entitlements not without their costs, using regulation to impose them itself has costs.
FALSE HISTORY
Another problem in these debates is the prevalence of false characterisations of recent history. While some will be genuine error, there is reasonable grounds for suspicion that others have sought to characterise events in ways that defend what might be called the writers' "moral assets" in upholding particular opinions. Sensible policy recommendations can only flow from an accurate understanding of the context policy must operate in, including the actual pressures policy makers have been under, and have sought to respond to.
(1) Empty Definitions of "Economic Rationalism"
In his Concise History of Australia, Professor Stuart McIntyre, Ernest Scott Professor of History and Dean of the Faculty of Arts at Melbourne University says of economic rationalism (pages 239-40) that it was
was remarkable not so much for devotees capacity to incorporate almost every form of human behaviour into its syllogisms as for the assumption that there could be no other form of reason than the logic of the market.
This is in a similar vein to the definition offered by Professor Michael Pusey, Professor of Sociology at the University of Sydney and author of Economic Rationalism in Canberra: A Nation-Building State Changes Its Mind:
Economic rationalism is a doctrine which says that markets and prices are the only reliable means of setting a value on anything and, further, that markets and money can always, at least in principle, deliver better outcomes than states and bureaucracies
I never encountered anyone in the Canberra bureaucracy who could be so described by either definition. Nor am I aware of having encountered such a person since. When Dr Michael Keating, then head of the Department of Prime Minister and Cabinet and econocrat par excellence, was asked at the conference in which Professor Pusey's paper was delivered if he had ever encountered someone in the public service who conformed to Professor Pusey's definition, he equally replied in the negative.
Changes in economic policy over the last 15 years have been responses to particular pressures, not some weird outbreak of economic fundamentalism that those of particularly high moral sensitivity and intellect easily (sic) see through.
(2) False Characterisations of Government Cutbacks
Professor Ron McCallum, Professor of Law at the University of Sydney, seems to share the common delusion that the last two decades have seen a shrinking of government activity, saying in his Whitlam Lecture that:
They [the economic reformers] advocated labour market flexibility at a time when federal and State governments were shrinking their public sectors and reigning in their spending. Governments bought the idea that greater labour market flexibility would limit unemployment. At this time, the social capacity of governments to cope with welfare programs and payments was diminishing, but if it would limit unemployment then deregulation was worth a try.
In fact, government outlays, including State Government outlays, have increased markedly.
Graph S3
The real issue has been the fiscal pressure from the expanding welfare State, and the varying ability or willingness to deal appropriately with that pressure, in the light of other constraints.
Graph S4
Graph S5
ENDNOTES
1. Dahlman, Carl J., "The Problem of Externality", The Journal of Law and Economics 22, no. 1 (April 1979): 148.
2. For example, Murphy, K., Shleifer A. & Vishny R. (1991) "The Allocation of Talent: Implications for Growth", Quarterly Journal of Economic 106: 503-30 found that a ten per cent increase in law graduates reduced economic growth by 0.3 per cent (by contrast, a ten per cent increase in engineering graduates increased economic growth by 0.5 per cent)
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