A little more on transaction costs

I encourage you to both read M&R chapter 2 where transaction costs are discussed and to review the presentation materials for both the class this past Tuesday and the class today.

Here is another little anecdote to illustrate the issue.  My wife had our house built to her specification and worked with a contractor she liked to get that done.  In turn, the contractor hired out various subcontractors to do particular work on the house.  We only paid the contractor for the work when the house was completed.  We did not know the details about the arrangements between the contractor and the subcontractor.

A few years ago we had flooding in our basement.  The sump pump stopped working and we had a lot of standing water.  All the carpet was damaged and had to be replaced.  We had insurance cover some of it, but we still had a lot of out of pocket cost.  Worse still was the not knowing why it happened.  We brought in a couple of different companies to fix it and figure out what was going on.

Ultimately one company had a sophisticated camera to make a movie about the pipeline from the house to the development's water line.  It turned out the pipeline had burst - a tree root had broken through the pipe.

After further inspection, the subcontractor who had put in the pipe used high quality pipe to the boundary of our property but then used cheap pipe from the boundary to the development's water line.  The tree burst the cheap pipe.

Use of cheap pipe in this instance is just like selling snake oil.  It is something impossible to monitor once the pipe is laid underground.  At the time of install it might be determined whether the building materials are high quality.  But we didn't find out about the problem till more than 10 years after we had lived in the house.  I am sure the contractor we used had long since retired by then.

So, for the subcontractor who saved a few bucks on cheaper pipe, we went through all this grief with a flooded basement.    We would have gladly paid the subcontractor up front whatever he saved on the cheaper pipe, but of course we weren't given that option at the time.  And had we paid him, he still might have used the cheaper pipe.

In this case, he needed to be watched like a hawk while he was doing the work.  Unfortunately, that didn't happen.