Transaction Costs

A world of smaller businesses means more transactions between businesses. Transactions have a cost. If these transaction costs are high, it is cheaper to merge the businesses doing the transaction to eliminate these costs. It pays to do so up to the point that the costs of bureaucratic inefficiency outweigh the transaction costs.

A major transaction cost is the cost of enforcing contracts between businesses. A subordinate in a branch office can be monitored and fired if he doesn’t serve the corporation. A supplier, contractor or buyer often has to be sued. If the legal system is expensive to use, then it pays to limit transactions to those that are large enough so that legal costs are small compared to the size of the transaction.

Simplifying the legal system is a huge subject, so I cannot give it full justice here. Further, I am not a legal expert. I can, however, give a few rules of thumb to think about in order to reduce legal costs.

  1. Reduce the availability of appeals and other delaying tactics. Such tactics can be used by a rich litigator to defeat a poorer litigator. It is better to have imperfect justice through a speedy trial than to have all trials subject to the injustice of excessive legal costs.
  2. Base laws upon principles and even simple mathematical formulas instead of myriads of special cases. It is time to shrink the law books.
  3. Judicial discretion can be reduced by specifying penalties and damages as simple mathematical functions instead of a maximum penalty for a particular class of infraction. Reducing discretion makes the law more predictable making risks more manageable.
  4. Penalties should be based on the magnitude of the damages vs. the wealth of the entity that did the damages. Otherwise, the high stakes justify excessive litigation. Not to mention that punitive damage awards are often incredibly unjust.
  5. In common transactions, there are common contract terms. In such cases, contracts can be stated in terms of a basic contract with a list of deviations. This eliminates having to read and write reams of boilerplate.

The last point is particularly important. With the huge amount of boilerplate language in so many contracts, many people sign without reading the contract. This practice has become so common that it is hard to hold people to a contract since people can justifiably claimed they were tricked. Consider the license terms of the software you have on your computer. Have you read the terms each time you have installed a program or an update? Are you sure you haven’t signed away your firstborn?

Some may consider the fourth point a step to the Right. The theory is that big corporations need big damages in order to be effectively punished. But if the legal system is working efficiently, this is not true. If a big corporation is repeatedly damaging many others, then it owes damages to many others. Instead of gigantic damages to the successful litigator, we need a system that makes it easier for the many smaller litigators to get justice.

As an example close to my heart, I have been told by multiple experts in patent law that it does not pay to defend a patent in court unless the damages are worth at least a million dollars. This basically means that the patent office no longer serves the small inventor. It has become a tool of large corporations only, except in those few cases that a small inventor can successfully sue a large corporation. (But the small inventor needs a contingency fee lawyer or some other source of capital to do so.)

Further Reading

  1. Simple Rules for a Complex World, by Richard Epstein.
  2. Law's Order, by David D. Friedman. Subtitled: What Economics Has to Do with Law and Why It Matters.