Government Supply

Drawing Organizational Boundaries

By David L. Weimer & Aidan R. Vinning
Policy Analysis

Fahmi Rohman Bimantoro | Ni Putu Akira | Donny Octaviano

New Institutional Economics (NIE)

The purpose of NIE is two-fold:

Explain (opposed to describe) the
1 determinants of institutions and
analyze the institutional change;
2 Evaluate impact on economic
efficiency and distribution.

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 New Institutional Economics (NIE)
 NIE is the framework for social
New Economic History
scientists that puts institutions and
(North, Fogel)
transactions costs on the forefront of
Public Choice and Political Economy
analysis.
(Buchanan, Olson)
 NIE is evolutionary and rapidly
developing being focused on
New Social Economics

NIE Social Capital institutional change (dynamics).

Transaction Costs Economics
Property rights literature
 NIE is very good in empirical testing
(Coase, North, Williamson)
and analysis; however:
Theory of Collective Action
Economics of information
(Akerlof, Stiglitz, Stigler)
 Is the forum for scientists with different
background to “de-isolate” knowledge.
(Ostrom, Hardin)

Law and Economics  Major weaknesses are associated with

methodologies and thinness of empirical
application
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Economic Organization Theories
• Economic Organization Theories is the mix of
economy and organizaiton theories (Also called
as Transaction Cost).

• İt is the area where ECT stadies conjunct the

rational concepts of classical theories, ecological
approach and the economic perspectives of the
organizational structure.

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Transaction Cost Theory
• Transaction costs: the costs of
negotiating, monitoring, and governing
exchanges between people
• Transaction cost theory: a theory that
states that the goal of an organization
is to minimize the costs of exchanging
resources in the environment and the
costs of managing exchanges inside the
organization
• Transaction cost economics is
concerned mainly with the governance
of contractual relations
• Oliver Williamson has big
influence on development of this
theory.
• He accepts this approach as an
open system and mostly focuses
on the process of the output
production and service that is
exchanged by the people outside
of the system rather than the
technology and and production
system of the organizaiton.
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Transaction Cost

The main theme of this approach:

• Organizations try to organize the change in

their products and services in the most
economic way.
• This change, on one side, is influenced by the
bounded rationality of the decision-makers and
on the other side influenced by the self benefit
behaviors of the people involved in change.

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Transaction Cost

• Ronal Coase set out his theory of the

firm in 1937, making it one of the first
(neo-classical) attempts to define the
firm theoretically in relation to the
market.
• The Nature of the Firm (1937) was a
brief but highly influential essay in
which Coase tries to explain why the
economy is populated by a number of
business firms instead of consisting
exclusively of a multitude of
independent self-employed people who
contract with each other.
• Why and under what conditions should
we expect firms to emerge?

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Sources of Transaction Costs
• Environmental uncertainty and
bounded rationality
• Bounded rationality: refers to
the limited ability people have to
process information
• Opportunism and small numbers –
attempt to exploit forces or
stakeholders
• Risk and specific assets
• Specific assets: investments that
create value in one particular
exchange relationship but have
no value in any other exchange
relationship

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Production Costs, Bargaining Costs and Opportunism Costs

Production Opportunism
Cost & Bargaining

Transaction cost of
Goods and Services
Governance

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Production Costs, Bargaining Costs and Opportunism Costs

Production Cost Bargaining Cost Opportunism Cost

• Unrealized economies of • Low task complexity so • Low task complecity so
scale so opportunities for relative certainty and relatively little
gains in allocational less costly monitoring information asymmetry
efficiency • High contestability so les and ore effective
• Lack of competition for bargaining leverage for monitoring
agency product so contractee • Low task complecity so
opportunities for • Low asset specificity so production ecternalities
reductions in X- less need to compensate less likely
inefficiency contractee for risk • High contestability so
• Inflexibility in use of less post contract
inputs in-house so leverage for contractee
opportunities for • Low asset specificity so
reductions in X- less risk of hold-up
inefficiency problem

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Production Cost
• Production costs are the opportunity costs of the real
resources—land, labor and capital— actually used to
produce something, measured in terms of the value of
things that these resources would have produced in
their next best alternative use.

• Production costs are likely to be lower with competitive

contracting out and there is considerable empirical
evidence from a range of government activities that
contracting out by government to private suppliers
generally lowers production costs.

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Bargaining Costs

Bargaining costs include the following

components:
• the costs arising directly in negotiating contract details
• the costs of negotiating changes to the contract in the
postcontract stage when unforeseen circumstances arise
• the costs of monitoring whether performance is being
adhered to by other parties
• the costs of disputes that arise if neither party wishes to
utilize pre-agreed resolution mechanisms

Bargaining costs arise when both parties act with self-interest, but in good faith.

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The Costs of Opportunism
• Opportunism is behavior by a party to a transaction
designed to change the agreed terms of a transaction to be
more in its favor. Opportunism costs arise when at least one
party acts in bad faith.

• Opportunism is more likely in the context of contracting out

than in agency production, because the question of who
gets rents is more relevant in the nonhierarchical
relationships between organizations.

• Opportunism is more often considered to occur after

contracting has taken place, but some behaviors prior to
contracting have opportunism-like characteristics.
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Predicting Bargaining and Opportunism Costs
• Task Complexity:
• Task complexity is the degree of difficulty in specifying and monitoring the
terms and conditions of a transaction.

• Contestability:
• A contestable market is one in which even if only one organization is
immediately available to provide a service, many others would quickly become
available if the price offered by contact exceeded the average cost incurred by
contractees.
• If the market for the activity is contestable, then opportunism is reduced at the
contract stage and potentially at the execution stage.

• Asset Specificity:
• An asset is “specific” if it makes a necessary contribution to the production of a
good or service and has much lower value in alternative uses.

• Assessing and Building Capacity:

• Public agencies may be able to make intraorganizational investments to
increase the range of services for which contracting is feasible.
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