Transaction Costs and the Duration of Contracts

Alexander  MacKay

Working Paper | HBS Working Paper Series | 2017

Transaction Costs and the Duration of Contracts

Abstract

The duration of a vertical relationship depends on two types of costs: (i) the transaction costs of re-selecting a supplier and (ii) the cost of being matched to an inefficient supplier when the relationship lasts too long. For commodified goods and services, this tradeoff can be the primary determinant of the duration of supply contracts. I develop a model of optimal contract duration that captures this tradeoff, and I provide conditions that identify underlying costs. Latent transaction costs are identified even when the exact supplier selection mechanism is unknown. I estimate the model using federal supply contracts and find that transaction costs are a significant portion of total buyer costs. I use the structural model to estimate the value of the right to determine duration to the buyer, compared to a standard duration. Finally, a counterfactual analysis illustrates why quantifying transaction costs is important for the accurate analysis of welfare.

Keywords: vertical relationships; transaction costs; contract duration; auctions; identification; Supply Chain; Cost; Contracts; Auctions; Mathematical Methods;

Language: English

Format: Print

75 pages

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Citation:

MacKay, Alexander. "Transaction Costs and the Duration of Contracts." Harvard Business School Working Paper, No. 18-058, December 2017.

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Transaction Costs and the Duration of Contracts

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