Losing Under Contract: Transaction-Cost Externalities and Spot Market Disintegration

Standard economic intuition of revealed preference implies that when two parties freely enter into a contract then neither should be worse off. In this study, we develop a simple model showing that introducing the opportunity to contract can lower welfare for some, and perhaps all, contracting parties. We consider a situation where processors can obtain inputs from suppliers (farmers) using either a spot market or contractual arrangements, and where spot market transaction costs depends on the volume of trade in the spot market. We show that contracting parties may lose when more contracting results in higher transaction costs for spot market participants. At the margin, firms and input suppliers gain from signing contracts. However, contracting raises spot-market transaction costs for those who do not sign contracts, which provides a greater incentive for others to sign contracts, ultimately inducing more contracting than optimal. The model demonstrates why structural or organizational change may be rapid and why the private minimization of transaction costs may not lead to optimal institutional arrangements.