BlockBytes |Byte 2|Trust & Transaction Cost

In Byte 1 an attempt was made to provide the economic context around the movement of CryptoCurrency and it associated technology. In this Byte the goal will be to understand how Trust aims to reduce transaction cost, after all the biggest contribution of Blockchain technology is Trust Minimization.

A transaction occurs when a good or service is transferred across a technology separable interface.

Transaction Cost can be broken into five basic costs

  1. Search & Information Cost : The cost one incurs to identify necessary goods at lowest price ,matching up to quality standards
  2. Bargaining Cost : The cost incurred by both party in transaction to bring negotiations into a common acceptable price and draw up an acceptable contract.
  3. Transferring Cost: The cost of transferring of material/goods
  4. Monitoring Cost : The cost of monitoring if the stipulated terms of agreement are being followed.
  5. Policing & Enforcement Cost : This cost is incurred to make sure that both party involved in a transaction live up-to their side of the bargain.

For example : If you are buying a second hand car, the time you spent in searching for your desired car with right attributes is your search cost. The time and effort you put into negotiating with multiple dealers or if you are doing a third party paid analysis to evaluate the car gets added up to Bargaining cost. And finally the contract drawn up also adds up to Bargaining cost. Policing and enforcement cost comes at the later end when any claims regarding the performance or any other expectations regarding the car needs to be upheld.

The dimension on which the above transaction costs vary are

  • Asset specificity : These relate to any specific asset either party in a transaction acquire to see the transaction through and cant be used for any other transaction.
  • Frequency of Transactions : The frequency of transaction can work on set up cost and by building trust over each transaction by reducing uncertainty.
  • Uncertainty : Each transaction has uncertainty associated to go through. Higher the uncertainty higher cost set aside to mitigate such risks.

To minimize cost on each dimensions organization come up with contracts/ controls.

Each Control/Contract goes through the following process

Ex-Ante
Search
Negotiation
Commitment
Ex-Post
Performance
Adjudication

However each control/contract assumes is based two human limitations¹

  • Bounded rationality : A normal human being has limited capability to calculate the economic implications of decisions taken
  • Innate urge for personal opportunism : The ever present urge in human entity to work towards personal goals.

Hence the controls/contracts if implemented by human are always susceptible to failure. This leads to a huge amount of time and resource in planning in detailing contract which is in effect is never complete against the human nature to work on personal agenda. Also to reduce the time required for each transaction to go through often such controls/contracts are processed only Ex-Post. This often brings in the argument of Pro-active autonomous contract executions.

How can Trust bring down such cost ?

Trust is the probability of breach of contract agreed upon by both parties over a period of time. While a measurable performance metric over time, built around human exchanges in transaction can be a leading indicator for reduced uncertainty in contract adherence by human entities, moving more and more autonomous contract search and executions will lead to more efficient transactions.

This brings to the two most important feature of a Crypto-Currency technology

  1. Blockchain : The capability to store data immutable over time. The better definition is capability to prevent data from being altered with a noticeable signal of such change. The sooner the data is pushed to block-chain the higher integrity factor it gets
  2. Smart Contracts : Capability to move contract adherence more ex-ante than ex-post. Capability to move contract execution on granular level rather than sampling perse’.

But how will the above two help in building trust and reducing Transaction cost?

Lets dig the thought process a bit further. Why do different institution like a firm/ a market occur in first place. They exist to bring down these transaction costs for individual. They reduce the cost of transactions through aggregation and achieving economies of scale. However each transaction adds cost based on the dimensions mentioned before.

Now imagine single immutable database which stores execution of contract at each transaction only when they meet contract criteria. ( We will talk about privacy concerns in another post ). You as business head will always be sure that your output always is meeting desired standard without having to prepare for eventuality. This reductions in variability then passes upstream to reduce contract costs.

For example : You are fresh food store owner and you sell fresh organic vegetables. You have to make sure that the produce which you get are organic and are actually fresh. Your demand is constant but you cant trust all vendors. Hence you built over the period of time relationship with an XYZ vendor who now charges you premium for this relationship making your product expensive. Now image multiple vendors could produce a legitimate signal of past quality adherence across transaction not involving you and hence reduce the uncertainty. Your trust threshold has been minimized. There are more players in the market and produce procurement now gets reduced.

The next logical steps how should such a Trust reducing Contract look like.

Next Byte: Contract Design and Smart Contracts

Sources

  1. https://www2.bc.edu/candace-jones/mb851/Feb19/Williamson_AJS_1981.pdf
  2. http://nakamotoinstitute.org/formalizing-securing-relationships/