Transaction Cost, Expected Cost and Externality

2.3.1 Notions o f cost, private cost and social cost: In its ordinary sense in economics,

the term cost means opportunity cost, i.e. alternative price or benefit foregone by

employing a resource in such a way that denies its use by someone else."*^ Opportunity cost

is what economists call social cost in the sense that it affects resource use and diminishes a

society's wealth. For instance, a loss to an individual of his leg in an accident is a social cost, since it necessitates compensation and denies society other uses o f the resources, and consequently reduces social wealth."*^ By contrast, purely pecuniary transactions such as transfer payments do not affect resource allocation."** Although transfer by taxation of a "*®. Cooter & Ulen, 45-48. Consider, e.g. such instances of the imperfect insurance market as limited coverage o f third-party liability insurance policies, general exclusion o f cover for the defendant's liability caused by his wilful misconduct, or the insurance company's inability to monitor exactly the behaviour o f his insureds and to adjust premiums accordingly.

"**. See Ramose, Consumer Protection, 38-39. "*^. Hart, n.6 above, 192; Calabresi, 24-26.

"*^. For Aristotle, justice meant not only the mechanic proportional allocation (commutative justice) but the restoring o f balance deficient in exchange (distributive or corrective justice). See Aristotle, The Ethics of Aristotle (trans J A K Thomson, London: Allen & Unwin 1953) Bk V, 1131a22, 1132a2-19, 1132al9-b3. "*"*. C G Veljanovski, The New Law-and-Economics: A Research Review, in Ogus & Veljanovski, 12, 23. ■*^. Both the terms effective and efficacious are defined as "producing the desired result or effect". See Longman Dictionar>^ o f Contemporary English (2d ed 1987).

Posner, 6-7; Cooter & Ulen. 35 & 45-6. T\pical examples of opportunity cost include the Coase Theorem and gratuitous actnities such as housework done by a spouse without any pecuniary reward. Sec 3.1 below.

"*^. Sec 4.1 below.

"**. The assumption is that the transfer is costless. For a detailed discussion o f the concept o f cost, see 0 Stigler, The Theoiy of Price (1966), ch 6. 104-14 & (1987) ch 7. W l f f

certain sum o f money from A to B would decrease A's purchasing power, this would

increase B’s by the same amount. This is a private cost incurred only to the individual A

and not to the society as such. Private cost merely rearranges wealth distribution between individuals and has little to do with social cost.

2.3.2 Transaction cost vs. administrative cost: The term transaction cost includes

information and enforcement costs incurred for the settlement o f a dispute between parties through bargaining.Transaction cost would be high and preclude the efficient outcome,

if there is a strategic behaviour by one party in the bargaining process (e.g. adopting 'hold­

out' tactics or threatening to resort to litigation rather than out-of-court settlement).^® When a dispute is up to the court, voluntary transactions are replaced with involuntary judgment. This involves the court's administrative cost incurred in the process o f legal proceedings, e.g. information, judgment and enforcement costs.A dm inistrative cost thus includes the court's expenditure for gathering information on relevant facts, seeking opinion from experts and assessing relevant risks involved to arrive at efficient decisions. When parties are risk averse, another important aspect o f administrative costs relates to

those incurred to the i n s u r e r .

2.3.3 Expected or average cost: The term expected cost (loss) means cost o f the

accident if it occurs, multiplied or discounted by the probability that the accident will

occur. Expected cost is most easily understood as average cost to be incurred over a

period o f time long enough for the predicted number o f accidents to be the actual n u m b e r . F o r instance, if the probability of an accident is 0.01 and accident losses if it occurs are £100,000, expected accident losses is £1,000. This is equivalent to saying that if one observes the carriage by air activity for a long period o f time, he will notice an average accident cost o f £1,000. To illustrate, suppose there occur 100 accidents per every 10,000 flights between London and New York (thus the accident probability on the London-New York route is 0.01). Total cost of these 100 accidents will amount to £10 million (£100,000 X 100) and average cost per flight will thus be £1,000 (the total cost of £10,000,000 divided by the total number of flights 10,000). This amount equals expected cost in this example and matches actuarial equivalent of the risk.

Polinsky, 12, 18. Transaction costs include costs of information relating to identifying the parties to negotiate with, assessing the risks involved and (if there are a multitude o f people on one side o f the disputes) discussing possible solutions available.

E.g. Laker {Skytrairi) case. See R Baldwin, A British Independent Regulating Body and the "Skytrain” Decision, [1987] Pub L 57. Strategic behaviour may feature in a dispute involving the parties in stranger relationships as in noise/vibration/pollution or surface damage.

^ Sec 5.2 below & sec 2.2.1 above. Sec 6.4 below.

Posner, Tort Law _ Cases and Economic Analysis. 1-8. In the long-run equilibrium, average cost equals marginal cost.

2.3.4 Externality: Unlike voluntary, mutually beneficial transactions occurring in the market, involuntary and external (outside-the-market) exchanges bring about harmful economic effect to society (spillover or third-party effect). For example, the airport operator's activity causes to the residents living around the airport harmful effect (noise- pollution harm) or externality defined as a cost that voluntary actions o f one party impose on third parties without their c o n s e n t . T o quote Pigou, an externality occurs where "one person A, in the course o f rendering some service, for which payment is made, to a second person B, incidentally also renders service or disservice to other persons (not producers of like services), o f such a sort that payment cannot be extracted from the benefited parties or compensation enforced on behalf of the injured parties".E xternality is a social cost and occurs both in market transactions (where consumers have imperfect information on the quality o f service and thus make incorrect decisions on their choice) and in nonmarket transactions (where the producer of goods or service is exempted by error from liability, or where the legal system lacks a device for channelling all small claims for damage).