Monthly Archives: August 2011

192 – Transaction costs

If I buy something, I have to pay the asking price, but I may also incur a range of extra costs. These might include things like time, stress and travel costs involved in making the purchase. Economists call these extra costs ‘transaction costs’. There are also transaction costs involved in establishing, running or participating in a government program. I’ve become very interested in how transaction costs affect environmental programs.

I’m visiting China in October, so this week I applied for a visa. When I pick it up next week, it will cost me $30. However, that’s not the only cost I will have borne to get it. They have a new rule that you can’t apply by mail; you have to make a personal visit to the consulate. So far I have had to:

  • complete the application form, which was not straightforward, requiring me to make two queries to the people who are organising the visit;
  • look up the location of the Chinese consulate in Perth;
  • drive about 10 km to where I thought (mistakenly) it was, involving costs of fuel, vehicle wear and tear, and time;
  • pay for parking;
  • spend time walking around the area looking for it, unsuccessfully;
  • look at the street directory again and realise I was about a kilometre from the right place;
  • drive to the right place;
  • pay for parking again;
  • walk to the consulate;
  • wait in a slow-moving queue for about half an hour; and
  • drive home (more petrol, depreciation and time).

When I go to pick it up, I’ll need to invest more time, fuel and vehicle wear and tear. By the time I get the visa, the $30 cash cost will be pretty minor compared to the rest of the costs.

Economists call these other costs ‘transaction costs’. They are costs, using the term broadly, involved in undertaking a transaction, other than the direct financial cost of the transaction itself. They may include costs associated with thinking, analysing, negotiating, monitoring, enforcing, administering, learning, and so on.

In simple text-book economics, transaction costs aren’t accounted for, but in recent decades, economists have paid more attention to them. There have even been a couple of Nobel prizes awarded to people whose work included an emphasis on transaction costs.

I’m interested in transaction costs in environmental policy. I’ve been amazed at how big they can be. For example, under the National Action Plan for Salinity and Water Quality (Pannell and Roberts, 2010), the approximate allocation of Australian government funds to projects was as follows:

Category Budget ($ million)
On-ground works 220
Capacity building 260
R&D 44
Administration, planning, monitoring and evaluation 120

The last category is clearly solely transaction costs involved in getting the program delivered. They are large, but this number greatly understates the total transaction costs of the program. For one thing, the Australian Government took a large slice off the top for its own administration costs (to get the program established and run it), and that’s not included in the above figures. Also, the numbers in the first three categories include significant transaction costs involved in running those individual projects. As a rough guess, I estimate that the share of the Australian Government’s money in the program that was spent on transaction costs could have been about 40 per cent. That’s a lot of money not being spent on managing salinity.

Elsewhere in government, there were four reviews of the program during its life: two by the Australian National Audit Office, one by a committee of the House of Representatives and one by a Senate committee. Each of these involved substantial costs. And there were transaction costs prior to the program being established, as governments around Australia negotiated, discussed, and argued about the shape, the size and the rules of the program.

On top of that were the transaction costs borne by farmers and other organisations who were engaged with the program. They had to incur transaction costs in the course of negotiating with their partners and collaborators about involvement in projects, completing project application forms, completing reports to satisfy accountability requirements, meetings of various sorts, phone calls, and so on. Some of them would have incurred transaction costs from lobbying the government during the period when the program was being developed, or attempting to change aspects of the program once it was up and running.

These are even more invisible than the transaction costs incurred by government, and they are probably even more likely to be overlooked when a program is being designed or implemented.

For example, the first full round of competitive funding for the Caring for our Country program in Australia received about 1300 project applications, of which less than 10% were actually funded. These applications can be quite time consuming and difficult to prepare, but more than 1200 applicants must have felt like they had borne those transaction costs for no benefit. If this had been considered, I think the process would have been designed differently.

Focusing on the transaction costs in environmental programs could be beneficial for various purposes, including:

  • identifying cases where they seem excessive, guiding efforts to reduce transaction costs;
  • designing programs in a way that limits transaction costs to participants;
  • guiding better choices about policy mechanisms;
  • understanding why some policies achieve less than intended; and
  • understanding why people are unwilling to participate in programs in some cases.

Well-conducted studies of transaction costs in environmental programs should ultimately contribute to greater achievement of environmental outcomes from those programs, by encouraging greater participation and leaving more money to be spent on the problem.

David Pannell, The University of Western Australia

Further reading

Pannell, D.J. and Roberts, A.M. (2010). The National Action Plan for Salinity and Water Quality: A retrospective assessment, Australian Journal of Agricultural and Resource Economics, 54, 437-456. Journal web site here

191 – Crowding out

Crowding out is an economic theory that has been highly influential in Australia. It’s about situations where government tries to do things that would be better left to the private sector. Even if the governments do a good job, they may just displace equally good actions by private individuals. Here are some examples from the areas of health, agriculture and the environment.

On a recent visit to Canada I went for a walk in Johnson Canyon, near Banff. It was the day after Canada Day, and everyone was on holiday, with the result that the crowds were extraordinary. Here I was in a place of amazing beauty, which should have been promoting feelings of peace and restfulness, but I was crowded and jostled on all sides. If I’d known what it would be like, I’d have stayed away.

When governments intervene in the economy, they are so big they can be like a crowd on their own. They can have the same sort of effect on people as the crowds in Johnson Canyon had on me – making them decide not to do something positive they otherwise would have done.

For example, in Australia the Government provides free public health insurance. While this, no doubt, results in various benefits, it also crowds out investment in private health insurance, to at least some extent. Some people who would have invested in private health insurance make the judgment that it is not worth doing so when they can simply rely on the Government’s scheme.

Another example is public provision of agricultural extension. State governments in Australia used to provide a high level of extension support to farmers, primarily advice that helped the farmers enhance their production and profitability. In the last two decades, most states have greatly reduced their investment in this sort of support. Subsequently, there has been a substantial growth in the provision of private agricultural business consulting and technical consulting services to farmers, suggesting that these were being crowded out in the old days.

A third example (of a slightly different sort) is payments for provision of environmental services. Some have argued, for example, that paying farmers to do good things for the environment crowds out positive environmental behaviour that they would otherwise have done voluntarily. There is relatively little evidence for this, but Helena Clayton’s recently complete PhD at UWA shows that it is a realistic possibility in at least some cases.

Economists worry about crowding out because it can mean that we end up paying more overall for the same services. Even if governments were equally efficient and effective at delivering services as the private sector are, there are significant costs involved in running the tax system to collect revenue to spend on providing those services. Estimates of these costs of the tax system vary, but it may be that to spend $1 on providing a service, the government has to collect something like $1.20.

Add to that cost the realistic risk that governments might not be so efficient as the private sector at service provision, and there are pretty good reasons to avoid crowding out if possible. (In cases like health insurance, the social benefits might be judged to outweigh the loss of efficiency.)

In Australia, we have had National Competition Policy in place since 1995. A key aim of this policy is to force governments out of parts of the economy where they are perceived to be crowding out the private sector. Interestingly, the onus is put on governments to prove that they are not crowding out.

David Pannell, The University of Western Australia