SMALLHOLDERS’ PARTICIPATION IN HIGH-VALUE AGRICULTURAL MARKETS
2.3 Transaction costs in high-value agriculture
2.3.1 Transaction costs defined
Transaction cost economics (TCE) falls under the realm of New Institutional Economics (NIE), a body of theory embraced within the frame of neo-classical economics. The NIE, however, offers new insights of reality in relation to certain restrictive market assumptions
20 that are central to neoclassical economics (see Harriss et al., 1995, for details). The NIE evolved from Old Institutionalists (e.g. Commons, 1934), who dispute the notion that economic systems evolve as a result of the rational-maximising self-seeking behaviour of individuals. Instead, they contend that economic systems evolve as a result of adjustments to existing institutions prompted by technological change (Rutherford, 1994).
TCE has developed over a considerable period of time, having gained prominence from Ronald Coase’s study on the ‘Nature of the Firm’, where he acknowledged that the price mechanism cannot on its own co-ordinate production as there are other costs of using the price mechanism, i.e. transaction costs (Coase, 1937; 1998). Transaction costs include costs of discovering what prices should be, and negotiating contracts for exchange. The transaction cost phenomenon was given impetus by Oliver Williamson whose considerable contribution was to integrate the developing concepts with information asymmetry and property rights to formulate a predictive theory about the choice of organisational structure in an industry, given the optimising behaviour of firms and the limited cognitive capacity of individuals (Williamson, 1975). A further exposition of transaction costs is provided by Eggertson (1990) who highlights the thin line between information costs and transaction costs. He contends that transaction costs are not identical to information costs. Instead, when information is costly to attain and interpret, various activities related to the exchange of property rights between economic agents give rise to transaction costs.
Although perceived differently by scholars from various fields (see Allen, 1999), transaction costs are generally conceptualised as costs incurred for carrying out any exchange between firms in a market or a transfer of resources between stages in a vertically integrated firm, when the traditional neoclassical economic theory assumption of perfect and costless information is relaxed (Hobbs, 1996a; 1996b). In the field of marketing and trade, transaction costs relate to the costs incurred in searching for a partner with whom to exchange a product or service, screening potential trading partners to ascertain their credibility, bargaining with potential trading partners to reach an agreement, transferring the product or service, monitoring the agreement to ensure that its conditions are honoured, and enforcing the exchange agreement (Jaffee, 1995). These costs are classified in the literature based on whether they are incurred before (ex ante) or after (ex post) the actual exchange. They are further categorised into information costs, negotiation (bargaining) costs, and monitoring and enforcement costs (Williamson, 1985). Information
21 costs, which arise ex ante, include the costs incurred by economic agents in the search for information about products, prices, inputs, and trading partners (Key et al., 2000).
Negotiation costs include the costs of negotiating and drawing exchange agreements.
Monitoring and enforcement costs occur ex post and generally relate to the costs of ensuring that the pre-agreed terms of the transaction are fulfilled (Hobbs and Kerr, 1999).
Examples could be monitoring the quality of goods from a supplier or monitoring the actions of a supplier or buyer, and the costs of seeking restitution in instances where contract terms have been flouted by either party.
Others classify transaction costs according to whether they are tangible or intangible (e.g.
Loader and Hobbs, 1996). Tangible costs are those to which monetary values can be attached with relative ease. Examples include transfer costs, communication costs and legal costs, whereas intangible transaction costs arise due to adverse selection and/or moral hazard (Loader and Hobbs, 1996). Adverse selection arises as a result of the potential for ex ante opportunism because private information is hidden by one party prior to a transaction (Arrow, 1984). This may happen, for instance, in agricultural credit schemes where potential borrowers, who are most likely to produce an undesirable (adverse) outcome (i.e. the bad credit risks), are those who most actively seek loans and stand a chance to be selected as lenders may not have the full information in relation to their creditworthiness (Swinnen and Gow, 1999). Because of the unobservability of such pertinent private information, the lender ends up with a set of clients in which the high risk segment of the population is over-represented. As a consequence of this adverse (borrower) selection, the lender could be forced to raise interest rates, leading to another version of adverse effects as the institution may become unattractive even to average risk groups (Douma and Schreuder, 1992).
Moral hazard arises as a result of the potential for ex post opportunism because of information asymmetry or hidden actions of transacting parties (Douma and Schreuder, 1992). The anticipation that such hidden actions are possible may also prevent the transaction altogether. When the actions of one party (e.g. the agent) cannot be observed by another (e.g. the principal), yet these actions have a direct bearing on the economic returns of both, the former has an incentive to act opportunistically in attempting to capture any gains possible. The principal may incur transaction costs in monitoring the actions of the agent and enforcing the terms of a pre-agreed contractual arrangement (Hobbs and
22 Kerr, 1999). An example is cited by Smith and Godwin (1996), where they found that insured farmers have a tendency to undertake riskier production options than do uninsured farmers. Once the insurance company (principal) provides cover for possible accidents, there is an incentive effect on the behaviour of clients (agent) who may act with less caution, and in some instances with malicious intent (Sadoulet and de Janvry, 1995). For the insurance company, it becomes difficult and costly to investigate whether the damage was indeed caused by uncontrollable accidents or whether the behaviour of the insured had anything to do with the damage or loss.
Transaction costs can also be categorised based on whether they are proportional or fixed.
Proportional transaction costs change in accordance with how much the economic agent sells or buys (Key et al., 2000). An example could be transfer costs expressed on a per unit (of commodity) basis. Fixed transaction costs are independent of the quantities sold or bought, and examples include information, bargaining, and monitoring costs (Key et al., 2000; Alene et al., 2008). Another category identified by North (1987) is referred to as
‘non-market transaction costs’. This category includes resources spent in waiting, acquiring permits to engage in business, cutting through red tapes, and sometimes bribing officials while performing the exchange function.
Given the above discussion, it could be inferred that TCE is underpinned by bounded rationality, opportunism, and information asymmetry, all of which become more apparent in the presence of uncertainty or complexity (Jaffee, 1995; Hobbs and Kerr, 1999).
Bounded rationality postulates that while economic agents intend to make informed rational decisions, their ability to accurately evaluate alternative possible decisions is limited by their own cognitive powers (Williamson, 1985). Opportunism relates to economic agents seeking to exploit a situation to their own advantage in order to capture economic rents (Moschandreas, 1997). Worth indicating, however, is that TCE does not imply that all transactors always act opportunistically, rather, it acknowledges that the risk of opportunism is often present given the difficulty to distinguish ex ante honest actors from dishonest ones (Douma and Schreuder, 1992). In a world of perfect and costless information, the allocation of resources to enforce exchange agreements would be unnecessary. However, as observed by Stigler (1961), information is not costless, and because of the existence of information asymmetries, transaction costs arise either directly from these asymmetries or indirectly as a result of economic agents’ attempts to mitigate
23 them. The next sub-section identifies various socio-economic and institutional factors that give rise to transaction costs in the production and marketing of HVACs in developing countries.
2.3.2 Sources of transaction costs in the production and marketing of high value