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

SSRN Read Now

Citation:

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

We consider the identification and estimation of demand systems in models of imperfect competition. Under standard assumptions about demand and supply, the bias that arises from price endogeneity can be resolved without the use of instruments. We provide a constructive identification result where the causal price parameter can be expressed as a function of the covariance of unobserved shocks. The function is estimated efficiently by the output of ordinary least squares regression. Thus, with a covariance restriction on unobservable shocks, structural parameters can be point identified. Further, it can be possible to place bounds on the structural parameters without imposing a covariance restriction. We illustrate the methodology with applications to ready-to-eat cereal, cement, and airlines.

Economic theory suggests that demand is more elastic in the long run relative to the short run, but evidence on the empirical relevance of this phenomenon is scarce. We study the dynamics of residential electricity demand by exploiting price variation arising from a natural experiment: the introduction of an Illinois policy that enabled communities to select electricity suppliers on behalf of their residents. Using a flexible difference-in-differences matching approach, we estimate a one-year price elasticity of -0.16 and three-year elasticity of -0.27. We also present evidence that consumers increased usage ahead of these announced price changes. Finally, we project that the price elasticity converges to a value between -0.30 and -0.35 after ten years. Our findings highlight the importance of accounting for consumption dynamics when evaluating energy policy.

Faculty & Research

Transaction Costs and the Duration of Contracts

Abstract

Citation:

About the Author

More from the Author