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    Transaction Costs and the Duration of Contracts
    23 Jan 2018Working Paper Summaries

    Transaction Costs and the Duration of Contracts

    by Alexander MacKay
    When buyers transact with sellers, they select not only whom to transact with but also for how long. This paper develops a model of optimal contract duration arising from underlying supply costs and transaction costs. The model allows for the quantification of transaction costs, which are often unobserved, and the impact of these costs on welfare.
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    Author Abstract

    The duration of a vertical relationship depends on two types of costs: (i) the transaction costs of reselecting 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.

    Paper Information

    • Full Working Paper Text
    • Working Paper Publication Date: December 2017
    • HBS Working Paper Number: HBS Working Paper #18-058
    • Faculty Unit(s): Strategy
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    Alexander J. MacKay
    Alexander J. MacKay
    Assistant Professor of Business Administration
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