The Role of Measurement in Reducing Transaction Costs and Creating Efficient Markets for Externalities

Coase (1960, 1990) suggests that well-defined property rights drive transaction costs down, and so could, in principle, overcome the market frictions introduced by externalities. Because transaction costs are usually not negligible, they make the initial allocation of property rights a crucial factor in market efficiency. It is generally accepted that property rights should then be assigned to those able to realize the greatest value from them, that the nature of the firm is contingent on its capacities to reduce transaction costs relative to their costs outside of the firm, and that a legitimate role for government is in facilitating efficient corrections of misallocated resources via laws and agencies that reduce transaction costs.

Most of the complex discussions involving these issues, broadly referred to as consequences of the Coase Theorem, take place in the context of extensive assumptions about the nature of capital and capitalism (McChesney, 2006; Cooter, 2000; also many others). Most problematic among these assumptions are those involving a short-term focus on financial bottom lines. No mention is made of sustainable long-term profitability’s dependence on trusting relationships with healthy, motivated workforces and communities living in clean and pleasant environments. The fact that everyone owns, has shares in, and wants to maximize the value of the local stock of social and natural capital goes unrecognized, as is the fact that everyone has the right to increase the value of, and/or contract out, shares of their human capital.

But examples of externality problems rarely put due emphasis on the maximization of social welfare. Even in McChesney’s (2006) third example, in which the cost of a government solution is added, rights are not defined to maximize the social welfare, even though the social value of the pollution abatement is included as a hypothetical factor in all the examples. Where the steel mill and the laundry both have owners and/or stockholders who are financially rewarded or penalized in the short term by the freedom to pollute or by the restriction on pollution, the value associated with the maximization of social welfare is vaguely defined. Its costs and benefits are realized in an aggregate way that shows up only indirectly in anyone’s accounting spreadsheets, as health care costs increase or decrease, as employee recruitment and retention becomes more difficult or easier, as community trust and loyalty spills over into appreciation or lawsuits.

To define rights in a way that would lead to the greatest potential for the maximization of social welfare from the start, we need only think of what it means for markets to function efficiently and apply those considerations to the ownership of human, social, and natural capital. Transaction costs are most fundamentally affected by information on the identification, volume, and quality of what is traded (Barzel, 1982, Benham & Benham, 2000). Common product definitions, universal uniform metrics, and reliable quality indicators make or break markets by the way they clarify or obscure property rights.

For example, it is one thing to own a vineyard in the Margaux terrain producing 20,000 cases (12 bottles of 0.75 liters each) of premier cru 1990 vintage wine, and quite another to own a hospital in New Orleans producing gains of 37.2 units expressed in ordinal health status survey scores of unknown reliability and cross-instrument convertability. Superior value is unmistakable in the widely recognized identity of the Margaux estate, the immediately understood measure of volume, and the well-known quality attached to the premier cru designation and the 1990 year. There is a literal transparency in the measure of quantity, in that each bottle of wine could be shown to contain the same 0.75 liters, no matter where in the world it is measured, no matter who measures it, and no matter which particular instrument of volume measurement is employed. The French and international oenology communities go to great lengths, via their standards associations and in collaborations facilitated by the international Treaty of the Meter, to ensure the global recognition of the value of Margaux wines.

The identity, amount, and quality of the hospital’s health status gain score is quite obscure, however. What exactly is being referred to as a change in health status? Is it a reduction in symptoms associated with a specific disease or condition? Or is it a change in physical or emotional functionality? What is the unit being counted? How much change in health status does a unit stand for? How does this amount of change compare with the changes produced by other health care providers? Is it more or less, and what immediate and long term value is obtained per dollar spent?

Fortunately, over 20 years of research shows that health status surveys, and many other kinds of tests, surveys, and assessments, often can be calibrated to measure in constant linear units (Bezruczko, 2005; Bond & Fox, 2007; Fisher & Wright, 1994), and appear to have the potential to support universally uniform reference standard metrics (Fisher, 1997a, 1997b, 1998, 2000; Fisher, Eubanks, & Marier, 1997; Fisher, Harvey, & Kilgore, 1995; Fisher, Harvey, Taylor, Kilgore, & Kelly, 1995). The opportunities before us in health care, in education, in human and environmental resource management, and in other areas are directly analogous to the historical births of many markets, such as the transformation of the London coal trade effected in the 1830s (Velkar, 2008) the origins of the electrical industry in the 1870s (Hunt, 1994; Schaffer, 1992), or the establishment of standard time in 1883 and the subsequent distribution and sale of uniform time units by astronomic observatories (Bartky, 2000), and the use of the clock in the regulation of the work day.

Capital is made fungible when its monetary expressions can be summed across properties owned, when it can be divided into shares for sale to investors, and when its value can be transparently and efficiently represented via some form of currency or instrument recognized and accepted at any point across a network of linked agencies, such as trading centers, banks, courts, laboratories, etc. (Ashworth, 2004; Barzel, 1982; De Soto, 2000; Latour, 1987, p. 223; Fisher, 2002). The unification of measurements and standardization of quantitative expressions facilitate common product definitions, lower transaction costs, and market transparency by enabling more precise determinations of property rights—who owns what, how much of it, and of what quality.

Probabilistic models for calibrating and equating ability tests, attitude surveys, and performance assessments (Rasch, 1960; Wright, 1977, 1999; Andrich, 1988) offer a scientific basis for rigorous, practical, and convenient methods of unifying the measurement of human, social, and natural capital (Fisher, 2002, 2005, 2007, 2009, 2010). One way in which governments could, then, perform their optimal role would be to introduce laws and institutions focused on reducing living capital transaction costs, as would occur via the expansion of the Treaty of the Meter to include uniform standards for the measurement of the various forms of human, social, and natural capital.

The origins of the metric system (SI) were explicitly framed in terms of a mutual conformity between universal rights for all people and universal standards of measurement (Alder, 2002, p. 3). The question we face today is, what might a metric system for human, social, and natural capital imply for the co-production of new scientific, economic and social orders? In particular, how might business practices be made more just, sustainable, and profitable through the better management of intangible assets? How and when will we as individuals be able to represent our hireability, promotability, retainability, and productivity in terms recognized and accepted as far and wide as the terms for expressing time, distance, weight, and temperature are? Can universal human rights to equal opportunities be realized in the absence of fair and comparable metrics for representing abilities, health, performance, and credibility? Will we get ahead of this issue and proactively develop the systems we need, or will we need to be driven to action by yet another new crisis?  We hold the keys to our liberation.

References

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Andrich, D. (1988). Rasch models for measurement. (Vols. series no. 07-068). Sage University Paper Series on Quantitative Applications in the Social Sciences). Beverly Hills, California: Sage Publications.

Ashworth, W. J. (2004, 19 November). Metrology and the state: Science, revenue, and commerce. Science, 306(5700), 1314-7.

Bartky, I. R. (2000). Selling the true time: Nineteenth-century timekeeping in America. Stanford: Stanford University Press.

Barzel, Y. (1982). Measurement costs and the organization of markets. Journal of Law and Economics, 25, 27-48.

Benham, A., & Benham, L. (2000). Measuring the costs of exchange. In C. Ménard (Ed.), Institutions, contracts and organizations: Perspectives from new institutional economics (pp. 367-375). Cheltenham, UK: Edward Elgar.

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Coase, R. (1990). The firm, the market, and the law. Chicago, Illinois: University of Chicago Press.

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3 Responses to “The Role of Measurement in Reducing Transaction Costs and Creating Efficient Markets for Externalities”

  1. Matt Barney Says:

    William

    As usual, brilliant and thought provoking post. No doubt the friction-reducing aspects of objective measurement have important implications for all types of capital.

    The one area where I’d love to hear more of your thoughts is on the area we’ve discussed/debated before around the philosophy and the practice. On the ethical side, I’m increasingly concerned about relying on institutions (Gov’t) that use force to achieve their goals. On the practical side, I’m quite concerned that governments don’t do a good job of playing the roles you propose for them. The recent Wall-Street bailouts of friends/colleagues of politically powerful people seems like a major friction and multi-billion dollar externality. Social Security’s coming insolvency sure looks a lot worse to me than Bernie Maddoff’s Ponzi scheme in terms of the sheer toll on all Americans. http://www.nytimes.com/2010/03/25/business/economy/25social.html I’m worried about the violence these groups are responsible for, such as Democide http://www.hawaii.edu/powerkills/

    The US isn’t unique in this regard. The Treaty of the Meter wasn’t really adopted in the US. My British friends here in India tell me they often don’t use metric systems, at least for some areas (e.g. Real Estate) – so I’m not convinced that governments are very effective at this.

    I’d love to think about how Rasch can help us avoid these problems.

    • livingcapitalmetrics Says:

      Thanks for your observations, Matt. I’m familiar with the democide work, and I agree that governments don’t have great histories of leadership and innovation. But I don’t think that’s really their function. The collective social mind has to arrive at a consensus, whether de facto or de jure, before government can act, which means at best that it is always lagging, and at worst, it lags and also sinks to the lowest common denominator of different factors that aren’t really equivalent.

      What you say leads me to want to expand on your themes a bit…

  2. 2010 in review « Livingcapitalmetrics’s Blog Says:

    […] The Role of Measurement in Reducing Transaction Costs and Creating Efficient Markets for Externaliti… March 2010 2 comments 4 […]

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