The Efficient Scope of Private Transactions-Cost-Reducing Institutions: The Successes and Failures of Commodity Exchanges

Abstract

Commodity exchanges historically have served as private organizations that govern contractual relations between market participants. Their functions have included commodity measurement, contract enforcement, the policing of theft and fraud, and the mitigation of information asymmetries. In contrast to these successes, the Chicago Board of Trade failed signally in its attempt to introduce a grain grading system after the Civil War. This effort failed because (a) the proposed reform imposed significant costs on interests whose cooperation was essential to its success and (b) the transactions costs of reaching an agreement to compensate these interests for their losses under the efficient property rights were prohibitive. A comparison of the successes and failures of commodity exchanges reveals that exchanges succeed when the benefits of exchange governance are symmetric and fail when the costs and benefits are extremely asymmetric.

Private ordering, collective action, and the self-enforcing range of contracts

“…3 In a sense, this is close to the operating mode of Maghrebi traders analyzed by Greif et al (1994). 2 In his analysis of the private enforcement mechanisms and rules designed by the Chicago Board of Trade, Pirrong (1995) shows that the implementation of new rules that would increase the volume of transactions required legal intervention of the state to impose them, since some participants were loosing part of their bargaining power and their profits because of better delineated property rights and more transparency of transactions. 3 Referring to the example of cooperatives, Hendrikse (2004) provides interesting elements in that perspective.…”

“…Indeed, a non negligible body of literature on enforcement has shown that collective organizations, e.g., trade associations, frequently rely on agreements among members to bring contract disputes under arbitration regulated by ''laws'' and procedures established by the trade association itself (Milgrom et al 1990;Bernstein 1992;Pirrong 1995). This is so either because formal rules of the game are absent or cannot rely on credible public institutions to be enforced, or because public courts cannot efficiently play their role, due to substantial procedural delays, overload, and so on… Private dispute resolution mechanisms would provide complementary solutions for reducing contractual costs and increasing credible commitments by overcoming failures of public institutions.…”

“…Formal private institutions generate administrative costs, but these costs can be compensated through collective gains made possible by the reduction of conflicts and distrust among parties, thus providing ex ante incentives to comply with contractual agreements. This costbenefit equilibrium requires that all parties take advantage of formal trading rules complementing private agreements, with institutions that allow a ''win-win'' solution (Pirrong 1995). 2 In a pioneering study focusing on the legal foundations of such formal institutions in the French agriculture, Danet (1982) introduced a distinction between two forms of collective organizations that could support such equilibrium.…”

“…This is very much of a nature similar to that of public goods. The larger the number of individuals benefiting from private information about the individual value of a specific good, the lower the probability of finding agreements that maintain the capacity of private institutions to retaliate against deviants (Pirrong 1995).…”

“…One important consequence is that in situations of multilateral reputation-based mechanisms, law enforcement by a supportive state may improve the efficiency of private institutions by backing private contracts with public order, thus reinforcing their legal authority and legitimacy, as well as their ability to provide efficient private enforcement devices to their members (Pirrong 1995). Indeed, as suggested by Greif (1993), formal private enforcement institutions rely primarily on the balance between administrative costs and expected benefits from improved efficiency in the organization of transactions.…”