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Concepts are introduced and applied for analyzing and selecting arbitrage portfolios in the face of uncertainty about initial positions and risk preferences. A stochastic arbitrage opportunity is defined as a zero-cost investment portfolio that enhances every feasible host portfolio for all admissible utility functions. The alternative to the existence of such investment opportunities is the existence of a solution to a dual system of asset pricing restrictions based on a class of stochastic discount factors. Feasible approaches to numerical optimization and statistical inference are discussed. Empirical results suggest that equity factor investing is appealing for all risk-averse stock investors with a wide range of initial position and sufficiently low transactions costs by mixing multiple factor portfolios with high after-cost appraisal ratios, low mutual correlation, and negative exposures to the relevant host portfolios. These findings weaken the case for risk-based explanations for the profitability of factor investing. This paper was accepted by Kay Giesecke, finance. Supplemental Material: The data files are available at https://doi.org/10.1287/mnsc.2023.4892. [ABSTRACT FROM AUTHOR]

We use a novel data set to examine the impact of exposing institutional orders to electronic liquidity providers (ELPs). We present empirical evidence that marketable pieces of large parent orders are routed to ELPs seemingly to avoid paying liquidity fees on exchanges. This routing decision results in lower net effective spreads for these child orders but leads to higher execution shortfall for the parent order. We provide evidence suggestive of a causal relation by utilizing the parent orders of investors that disallow the broker to route their child orders to ELPs. Our analysis suggests that ELPs detect the presence of the parent order very quickly given the transparent bilateral relation with the broker. This paper was accepted by Lukas Schmid, finance. Supplemental Material: The data files and online appendix are available at https://doi.org/10.1287/mnsc.2023.4871. [ABSTRACT FROM AUTHOR]

The convention when calculating corporate bond trading costs is to estimate bid–ask spreads that customers pay, implicitly assuming that dealers always provide liquidity to customers. We show that, contrary to this assumption, customers increasingly provide liquidity following the adoption of post-2008 banking regulations, and thus, conventional bid–ask spread measures underestimate the cost of dealers' liquidity provision. Among large trades wherein dealers use inventory capacity, customers pay 40%–60% wider spreads than before the crisis. Customers' balance-sheet capacity and their trading relationships with dealers are important determinants of customer liquidity provision. This paper was accepted by Bruno Biais, finance. Supplemental Material: The internet appendix and data are available at https://doi.org/10.1287/mnsc.2022.4646. [ABSTRACT FROM AUTHOR]

Blockchain-based smart contracts can potentially replace certain traditional contracts through decentralized enforcement and reduced transaction costs. However, scalability is a key bottleneck hindering their broader application and adoption, often leading to concentrated or exclusive networks. To avoid falling short of the original promise of the technology, firms actively explore "layer-2" methods for scaling. We provide some initial evidence on the economic implications of a layer-2 scaling solution, which moves information aggregation from on-chain to off-chain peer-to-peer networks. A parallel-system experiment allows clean identification because we observe the same unit in the treatment and control systems at the same time. We find that this scaling solution reduces operating costs by 76%, and importantly, leads to decentralization with lower market concentration and more participation, which in turn improves data accuracy. The findings provide insights on how blockchain and smart contracting technologies evolve toward achieving decentralized and scalable trust. This paper was accepted by David Simchi-Levi, information systems. Funding: W. Cong received funding from Ripple's university blockchain research initiative (UBRI). Supplemental Material: The data files and online appendix are available at https://doi.org/10.1287/mnsc.2023.00281. [ABSTRACT FROM AUTHOR]

We investigate the role of physical distance in corporate lending by exploiting infrastructure improvements as shocks to travel time. Lower travel time increases the likelihood of initiating a new banking relationship, consistent with an economic surplus from lower transaction costs. In existing lending relationships, banks capture part of this surplus by increasing interest rates, in particular, if banks have higher bargaining power. Reductions in travel time to competing banks have the opposite effects. Banks benefit from improved infrastructure through an increase in clients, and lenders that rely more on technology do not exhibit sensitivity to changes in distance. This paper was accepted by Victoria Ivashina, finance. Funding: Financial support from Finans|Bergen is gratefully acknowledged. Supplemental Material: The data files and online appendix are available at https://doi.org/10.1287/mnsc.2022.4346. [ABSTRACT FROM AUTHOR]

We provide direct evidence of how dealers' funding liquidity affects their liquidity provision in securities markets. Worse funding liquidity (higher repo haircuts and rates) leads to larger bid-ask spreads and transaction costs in corporate bonds. We also find that dealers' relationships with money funds are important determinants of their repo haircuts and rates. Using dealers' exposure to the 2016 Securities and Exchange Commission (SEC) money fund reform as an instrument, we show that funding liquidity indeed has a causal effect on market liquidity. Finally, dealers with lower funding liquidity tend to have smaller market shares and execute more trades on an agency basis. This paper was accepted by Haoxiang Zhu, finance. [ABSTRACT FROM AUTHOR]

We propose target date funds modified to exploit stock return predictability driven by the variance risk premium. The portfolio rule of these tactical target date funds (TTDFs) is extremely simplified relative to the optimal one, making it easy to implement and to communicate to investors. We show that saving for retirement in TTDFs generates economically large welfare gains, even after we introduce turnover restrictions and transaction costs, and after taking into account parameter uncertainty. This predictability also appears to be uncorrelated with individual household risk, suggesting that households are in a prime position to exploit it. This paper was accepted by Tomasz Piskorski, finance. [ABSTRACT FROM AUTHOR]

We propose an optimal currency hedging strategy for global equity investors using currency value, carry, and momentum to proxy for expected currency returns. A benchmark risk constraint ensures the overlay closely mimics a fully hedged portfolio. We compare this with naïve and alternative hedges in a demanding out-of-sample test, with transaction and rebalancing costs and margin requirements. Other hedging methods generally reduce risk but at a cost. Some tend to short currencies with high returns and all incur substantial costs with frictions, mostly margin requirements and equity rebalancing costs. The proposed strategy uses predictable returns to reduce this cost. It produces a statistically significant 17% gain in Sharpe ratio and an annualized Jensen-α of 0.93% versus a fully hedged benchmark. Notably, most of the implementation costs of the strategy would be incurred by the benchmark anyway. This reduces its marginal cost and highlights a specific synergy of integrating hedging with speculation. This paper was accepted by Gustavo Manso, finance. [ABSTRACT FROM AUTHOR]

For the first time, new regulatory data allow precise measurement of price discrimination against nonfinancial clients in the foreign exchange derivatives market. Consistent with the theoretical literature, transaction costs vary systematically with measures of client sophistication. The median client pays 10.9 pips more than blue-chip companies because of its lower level of sophistication, which compares with a sample average effective spread of 6.9 pips. However, price discrimination is fully eliminated when clients trade electronically on multidealer platforms. We also document that less sophisticated clients incur additional costs when trading with their relationship bank and in fast-moving markets, but only for bilaterally negotiated contracts. This paper was accepted by Haoxiang Zhu, finance. [ABSTRACT FROM AUTHOR]

In over-the-counter markets for assets, such as bonds and securitizations, large volumes can be split into smaller pieces and gradually sold to several final investors with the intermediation of multiple dealers. This paper proposes a model to study this process, called asset dissemination. A dealer buys several units of an asset from a customer and then sells some units to the dealer's customers and to a second dealer, who sells to the second dealer's customers and to a third dealer, and so on. The extent of dissemination is measured by the number of dealers involved and the total customer demand served. We show that asymmetric information on customer demand hinders both dimensions of dissemination. We also study how the quantity to disseminate and the dealers' funding costs impact dissemination and the prices and quantities in interdealer transactions. This paper was accepted by Gustavo Manso, finance. [ABSTRACT FROM AUTHOR]

We examine the problem of an investor who trades in a market with unobservable regime shifts. The investor learns from past prices and is subject to transaction costs. Our model generates significantly larger liquidity premia compared with a benchmark model with observable market shifts. The larger premia are driven primarily by suboptimal risk exposure, as turnover is lower under incomplete information. In contrast, the benchmark model produces (mechanically) high turnover and heavy trading costs. We provide empirical support for the amplification effect of incomplete information on the relation between trading costs and future stock returns. We also show empirically that such amplification is not driven by turnover. Overall, our results can help explain the large disconnect between theory and evidence regarding the magnitude of liquidity premia, which has been a longstanding puzzle in the literature. This paper was accepted by Kay Giesecke, finance. [ABSTRACT FROM AUTHOR]

Will individuals, especially high-risk individuals, avoid a disease test because of information avoidance? We conduct a field experiment to investigate this issue. We vary the price of a diabetes test (price experiment) and offer both a diabetes test and a cancer test (disease experiment) after eliciting participants' subjective beliefs about their disease risk. We find evidence that, first, some people avoid the test even when there is neither a monetary nor a transaction cost, and second, both low- and high-risk individuals select out of the test as the price increases. We explain our findings using three classes of models of anticipatory utility. This paper was accepted by Yan Chen, decision analysis. [ABSTRACT FROM AUTHOR]

We study the interdependencies between transaction costs, portfolio characteristics, and mutual fund performance. Using a novel data set of actual mutual fund trades, we find that, controlling for investment style, larger funds realize lower percentage transaction costs than smaller funds. Larger mutual funds trade less frequently and hold bigger stocks to actively avoid incurring higher trading costs. Gross returns of larger funds are lower than those of smaller funds due, in part, to the characteristics of their holdings, which suggests that decreasing returns to scale could arise due to limited investment opportunities because of trading cost constraints. Taken together, our results highlight the trade-offs faced by mutual funds between trading costs, portfolio characteristics, and fund performance as they grow in size. This paper was accepted by Karl Diether, finance. [ABSTRACT FROM AUTHOR]

A core challenge in studying the real return on artist' work is the extreme difficulty accessing private records from when an artwork was first sold and thus relying on public auction data. In addition, artists do not typically receive proceeds after the initial sale. This paper, for the first time, uses archivally sourced primary market records to model returns on art and introduces a novel fractional equity structure for artists. We first model what would happen if the American artists Jasper Johns and Robert Rauschenberg had retained 10% equity in their work when it was first sold. Second, we model a portfolio return using data from the Betty Parsons Gallery and the Green Gallery. To add a portfolio analysis to the performance of "star" artists, we model the galleries as a fund invested in all of artworks sold, using auction sales as the realization event. We find that the individual Johns and Rauschenberg works would have vastly outperformed equities markets. The gallery portfolio still substantially outperforms the S&P, even including 20% transaction costs. Beyond the art market, our larger conceptual framework for retained fractional equity has broad implications for compensation of early-stage creative work in any field and for potential applications of blockchain technology. This paper was accepted by Karl Diether, finance. [ABSTRACT FROM AUTHOR]

We examine the portfolio holdings of funds of hedge funds (FoFs) to identify the channels through which FoFs add value for their clients. FoFs offer access to a diversified portfolio of funds that would be costly for constrained investors to manage on their own. Although we find only limited evidence that FoFs exhibit skill when selecting hedge funds, we find strong evidence that FoFs make skillful termination decisions. After FoFs divest from a hedge fund, those hedge funds subsequently underperform and fail more often. Our evidence indicates that FoFs learn and skillfully process information about their portfolio funds after they become investors, enabling them to forecast poor future performance. Our study suggests that FoFs serve an important role as intermediaries in a market characterized by significant frictions and transactions costs. [ABSTRACT FROM AUTHOR]

The "law of one price" states that if prices for the same or highly similar goods vary across geographic locations by more than the cost of transport, then traders will shift supply and demand to exploit the price differences. However, several frictions prevent traders from doing this, including lack of information about prices and difficulty trading across locations. Electronic commerce has the potential to reduce these frictions by increasing price visibility and lowering transaction costs. We analyze this by studying how the diffusion of an electronic channel affected geographic trading patterns and price dispersion in the wholesale used vehicle market from 2003 to 2008. We find that buyers used the channel to shift their demand geographically to exploit price differences, which reduced geographic price dispersion. We find that the electronic channel also influenced how sellers distributed supply, but we find little evidence that this led to reduced geographic price dispersion. [ABSTRACT FROM AUTHOR]

We are interested in whether preventing resale of tickets benefits the capacity providers for sporting and entertainment events. Common wisdom suggests that ticket resale is harmful to event organizers’ revenues, and event organizers have tried to prevent resale of tickets. For instance, Ticketmaster recently proposed paperless (nontransferrable) ticketing, which would severely limit the opportunity to resell tickets. We consider a model that allows resale from both consumers and speculators with different transaction costs for each party. Surprisingly, we find that this wisdom is incorrect when event organizers use fixed pricing policies; in fact, event organizers benefit from reductions in consumers’ (and speculators’) transaction costs of resale. Even when multiperiod pricing policies are used, we find that an event organizer may still benefit from ticket resale if his capacity is small. Although paperless ticketing is suggested as a way to reduce ticket resale and prevent speculators from buying tickets, our results suggest that it may reduce the capacity providers’ revenues in many situations. Instead, we propose ticket options as a novel ticket pricing mechanism. We show that ticket options (where consumers would initially buy an option to buy a ticket and then exercise at a later date) naturally reduce ticket resale significantly and result in significant increases in event organizers’ revenues. Furthermore, since a consumer only risks the option price (and not the whole ticket price) if she cannot attend the event, options may face less consumer resistance than paperless tickets. [ABSTRACT FROM AUTHOR]

This paper examines the effects on equity home bias of two mechanisms adopted by Euronext when it was formed by the merger of four European countries’ stock exchanges in 2002. The two structural mechanisms are the integration of trading platforms across the four predecessor exchanges and the creation of named segments of the integrated exchange on which firms could voluntarily list by precommitting to enhanced disclosure and transparency. Employing a difference-in-differences research design using other European Union companies as a control group, we document that the integration of the Euronext market was associated with a reduction in home bias for firms listed on the named segments of the Euronext exchange, but not for the nonsegment Euronext firms. Our results suggest that the reduction in transaction costs from the integration of the trading platforms did not make the nonsegment Euronext firms more attractive to the specific investors for whom the transaction costs were reduced. On the other hand, the decrease in information costs due to the precommitments to enhanced transparency made the segment firms more attractive to all categories of foreign investors, consistent with the information costs hypothesis. [ABSTRACT FROM AUTHOR]

This paper shows that the effect of different distribution channel structures on product quality depends on the type of consumer heterogeneity and its distribution in a market. When consumer heterogeneity is uniformly distributed either vertically on willingness to pay or horizontally on transaction costs, a manufacture may provide the same or lower product quality in a decentralized channel than in a centralized channel. In contrast,when consumer heterogeneity follows a more general distribution on willingness to pay, under certain conditions, the manufacturer may provide higher product quality in a decentralized channel than in a centralized channel. Decentralization also may lead to a higher product quality if consumer heterogeneity is uniformly distributed both vertically and horizontally, but not if consumer heterogeneity is uniformly distributed vertically on each of two product-quality attributes. Additionally, competition at the retail level may amplify these findings. [ABSTRACT FROM AUTHOR]

The recent financial crisis highlights the importance of market crashes and the subsequent market illiquidity for optimal portfolio selection. We propose a tractable and flexible portfolio choice model where market crashes can trigger switching into another regime with a different investment opportunity set. We characterize the optimal trading strategy in terms of coupled integro-differential equations and develop a quite general iterative numerical solution procedure. We conduct an extensive analysis of the optimal trading strategy. In contrast to standard portfolio choice models, changes in the investment opportunity set in one regime can affect the optimal trading strategy in another regime even in the absence of transaction costs. In addition, an increase in the expected jump size can increase stock investment even when the expected return remains the same and the volatility increases. Moreover, we show that misestimating the correlation between market crashes and market illiquidity can be costly to investors. [ABSTRACT FROM AUTHOR]

As much as 12% of the daily volume on the New York Stock Exchange, and similar volumes on other major world exchanges, involves sales by institutional investors to brokers through blind portfolio auctions. Such transactions typically take the form of a first-price sealed-bid auction in which the seller engages a few potential brokers and provides limited information about the portfolio being sold. Uncertainty about the portfolio contents reduces bids, effectively increasing the transaction cost paid by the seller. We consider the use of a trusted intermediary or equivalent cryptographic protocol to reduce transaction costs. In particular, we propose a mechanism through which each party provides relevant private information to an intermediary who ultimately reveals only the portfolio contents and price paid, and only to the seller and winning broker. Through analysis of a game-theoretic model, we demonstrate substantial potential benefits to sellers. For example, under reasonable assumptions a seller can reduce expected transaction costs by more than 10%. [ABSTRACT FROM AUTHOR]

We study the impact of financial innovations on real investment decisions within the framework of an incomplete market economy comprised of firms, investors, and an intermediary. The firms face unique investment opportunities that arise in their business operations and can be undertaken at given reservation prices. The cash flows thus generated are not spanned by the securities traded in the financial market and cannot be valued uniquely. The intermediary purchases claims against these cash flows, pools them together, and sells tranches of primary or secondary securities to the investors. We derive necessary and sufficient conditions under which projects are undertaken due to the intermediary's actions, and firms are amenable to the pool proposed by the intermediary, compared to the no-investment option or the option of forming alternative pools. We also determine the structure of the new securities created by the intermediary and identify how it exploits the arbitrage opportunities available in the market. Our results have implications for valuation of real investments,synergies among them, and their financing mechanisms. We illustrate these implications using an example of inventory decisions under random demand. [ABSTRACT FROM AUTHOR]

We address the empirical implementation of the static asset allocation problem by developing a forward-looking approach that uses information from market option prices. To this end, we extract constant maturity S&P 500 implied distributions and transform them to the corresponding risk-adjusted ones. Then we form optimal portfolios consisting of a risky and a risk-free asset and evaluate their out-of-sample performance. We find that the use of risk-adjusted implied distributions times the market and makes the investor better off than if she uses historical returns' distributions to calculate her optimal strategy. The results hold under a number of evaluation metrics and utility functions and carry through even when transaction costs are taken into account. Not surprisingly, the reported market timing ability deteriorated during the recent subprime crisis. An extension of the approach to a dynamic asset allocation setting is also presented. [ABSTRACT FROM AUTHOR]

Many markets that have traditionally relied on collocation of buyers, sellers, and products have introduced electronic channels. Although these electronic channels may provide benefits to buyers and sellers by lowering the transaction costs of participating in the market, there are trade-offs related to quality uncertainty and increased risk that may limit the adoption of the electronic channels. As a result, buyers and sellers use physical channels for some transactions and electronic channels for others. These usage patterns may evolve over time, particularly when the electronic channels are new. We examine buyer and seller use of electronic and physical channels in a market for products of uncertain quality (used vehicles) over a 2.5-year period. Results indicate that transactions involving low quality uncertainty and relatively rare products occurred in the electronic channels, whereas transactions involving high quality uncertainty and relatively plentiful products occurred in the physical channels. These patterns became clearer over time as buyers and sellers gained experience with the electronic channels. The electronic channels led to discounts for products of high quality uncertainty, but not for those of low quality uncertainty. [ABSTRACT FROM AUTHOR]

Research on industry life cycles suggests that competitive pressures are more severe during the shakeout stage, which could be associated with the emergence of a dominant design, than at other stages. Transaction-cost theory, on the other hand, assumes generally competitive markets and does not address the industry life cycle. It therefore implies that transaction-cost economizing is a superior firm strategy regardless of the stage of the life cycle. This paper seeks to reconcile these two streams of research by investigating whether aligning transactions with governance modes in accordance with transaction-cost prescriptions has a differential effect on firm survival in preshakeout versus shakeout stages of the industry life cycle. Analyzing data from the early U.S. auto industry (1917-1933), we find that while transaction misalignment did not have a significant impact on firm survival during the preshakeout stage or during the period as a whole, it did have a significantly larger negative impact on survival during the shakeout stage than during the preshakeout stage. We also find that the negative effects of misalignment on survival were significantly weaker for larger firms during the shakeout stage. This suggests that applications of transaction-cost theory which assume uniformly severe selection pressures across the industry life cycle and uniform effects of misalignment across firms of different sizes could be misleading. It also suggests that theories of the industry life cycle could usefully take transaction costs into account along with production costs in their analyses of competition over the life cycle. [ABSTRACT FROM AUTHOR]

The theoretical literature on managing R&D pipelines is largely based on real option theory making decisions about undertaking, continuing, or terminating projects. The theory typically assumes that each project or causally related set of projects is independent. However, casual observation suggests that firms expend much effort on managing and balancing their R&D pipelines, where managing appears to be related to the choice of R&D selection thresholds, project risk, and whether to buy or sell projects to fill the pipeline. Not only do these policies appear to differ across firms, they also appear to vary over time for the same firm. Changes in management policies suggest that the choice of R&D selection thresholds is a time-varying strategic decision and there may be some type of vertical interdependency among R&D projects in different stages. In this paper we develop a model using dynamic-programming techniques that explain why firms vary in their R&D project-management policies. The novelty and value of our model derives from the central insight that some firms invest in downstream cospecialized activities that would incur substantial adjustment costs if R&D efforts are unsuccessful whereas other firms have no such investment. If transaction costs in technology markets are positive, which implies that accessing the market for projects is costly, these investments lead to state-contingent project-selection rules that create a dynamic and vertical interdependency among R&D activities and product mix. We describe how choices of R&D selection thresholds, preferences over project risk, and use of technology markets for the buying and selling of projects differ by the state of the firm's pipeline, the magnitude of transaction costs in the adjustment market, and the magnitude of technology costs. These results yield interesting managerial and public policy implications. [ABSTRACT FROM AUTHOR]

Using an unusually comprehensive database on 858 transactions for information technology products and accompanying services, we study how close partners who are exposed to opportunistic hazards structure and control a significant transaction. We analyze data on the terms of contracting to determine whether transaction and supplier characteristics that generate opportunistic hazards are related to the formal management control structure. We also examine whether misalignment between transaction and supplier characteristics and the control structure is associated with ex post performance problems. Characteristics associated with hazards are found to be positively related to contract extensiveness. Factor analysis of the use of 24 contract terms reveals four groups of contract terms that are commonly used in combination. We interpret these factors as "dimensions of management control" and label them: assignment of rights, product and price, after-sales service, and legal recourse. Characteristics associated with hazards are positively related to the use of all four dimensions of management control, with different hazards associated with different controls. We then examine the relation between transaction characteristics and ex post transaction problems, demonstrating that even in the presence of mutually agreeable contracts, hazards remain. We conclude that costs of contracting are associated with increased use of contract terms on assignment of rights, after-sales service, and legal recourse. Finally, we present evidence that management control structures that are better aligned with transaction hazards mitigate subsequent performance problems, though at a nontrivial cost of contracting. [ABSTRACT FROM AUTHOR]

We consider the problem of maximizing an expected utility function of n assets, such as the mean-variance or power-utility function. Associated with a change in an asset's holdings from its current or target value is a transaction cost. This cost must be accounted for in practical problems. A straightforward way of doing so results in a 3n-dimensional optimization problem with 3n additional constraints. This higher dimensional problem is computationally expensive to solve. We present a method for solving the 3n-dimensional problem by solving a sequence of n-dimensional optimization problems, which accounts for the transaction costs implicitly rather than explicitly. The method is based on deriving the optimality conditions for the higher-dimensional problem solely in terms of lower-dimensional quantities. The new method is compared to the barrier method implemented in Cplex in a series of numerical experiments. With small but positive transaction costs, the barrier method and the new method solve problems in roughly the same amount of execution time. As the size of the transaction cost increases, the new method outperforms the barrier method by a larger and larger factor. [ABSTRACT FROM AUTHOR]

Theorists have long believed that Dutch auctions are strategically equivalent to standard sealed bidding. However, in recent controlled experiments with actual Dutch and sealed-bid Internet auctions of collectibles, the Dutch auctions produced significantly more revenue. We believe that this happened, in part, because the Internet Dutch auctions are a slow process in which bidders incur incremental transaction costs if they delay bidding. This paper presents models of slow Dutch auctions that include these costs and explain this belief. We first present a decision-theoretic model of a slow Dutch auction. While simple, the decision-theoretic model is fairly general and provides the basic intuition underlying our revenue results. We then develop a game-theoretic model of a slow Dutch auction. We derive two symmetric, payoff-equivalent equilibria of the game in the absence of a cost of return and then consider the more general case of costly return. When the cost of return is in an appropriate range, the seller's expected revenue is an increasing function of that cost. [ABSTRACT FROM AUTHOR]

This paper analyzes optimal pricing for information goods under incomplete information, when both unlimited-usage (fixed-fee) pricing and usage-based pricing are feasible and administering usage-based pricing may involve transaction costs. It is shown that offering fixed-fee pricing in addition to a nonlinear usage-based pricing scheme is always profit improving in the presence of nonzero transaction costs, and there may be markets in which a pure fixed-fee is optimal. This implies that the optimal pricing strategy for information goods is almost never fully revealing. Moreover, it is proved that the optimal usage-based pricing schedule is independent of the value of the fixed fee, a result that simplifies the simultaneous design of pricing schedules considerably and provides a simple procedure for determining the optimal combination of fixed-fee and non-linear usage-based pricing. The introduction of fixed-fee pricing is shown to increase both consumer surplus and total surplus. The differential effects of setup costs, fixed transaction costs, and variable transaction costs on pricing policy are described. These results suggest a number of managerial guidelines for designing pricing schedules. For instance, in nascent information markets, firms may profit from low fixed-fee penetration pricing, but as these markets mature, the optimal pricing mix should expand to include a wider range of usage-based pricing options. Minimum fees, quantity discounts, and adoption levels across the different pricing schemes are characterized, strategic pricing responses to changes in market characteristics are described, and the implications of the paper's results for bundling and vertical differentiation of information goods are discussed. [ABSTRACT FROM AUTHOR]

Opportunism is a central construct in exchange theory. Economists contend that despite the firm's best efforts to erect governance structures that reduce opportunism and preserve outcomes, there is always some opportunism that remains once the transaction is in place. Despite this, there are few studies that systematically investigate the safeguarding efficacy of relationship attributes in the presence of such ex post opportunism. In this research, we develop a theoretical framework and provide a longitudinal test of the ability of various relationship safeguards to preserve performance outcomes and future expectations given varying levels of ex post opportunism in the relationship. Our survey results from over 300 buyers and suppliers indicates that given lower levels of opportunism, bilateral idiosyncratic investments and interpersonal trust enhance performance outcomes and future expectations, while goal congruence has no discernable effect. However, at higher levels of opportunism, goal congruence becomes a more powerful safeguard, while interpersonal trust becomes less effective. Bilateral idiosyncratic investments continue to preserve performance outcomes and future expectations even at higher levels of opportunism. Implications for the long-term management of interorganizational alliances are discussed. [ABSTRACT FROM AUTHOR]

We consider the order-fulfillment process of a supplier producing a customized capital good, such as production equipment, commercial aircraft, medical devices, or defense systems. As is common in these industries, prior to receiving a firm purchase order from the customer, the supplier receives a series of shared forecasts, which are called "soft orders." Facing a stochastic internal manufacturing lead time, the supplier must decide at what time to begin the fulfillment of the order. This decision requires a trade-off between starting too early, leading to potential holding or cancellation costs, and starting too late, leading to potential delay costs. We collect detailed data of shared forecasts, actual purchase orders, production lead times, and delivery dates for a supplier-buyer dyad in the semiconductor equipment supply chain. Under the assumption that the supplier acts rationally, optimally balancing the cancellation, holding, and delay costs, we are able to estimate the corresponding imputed cost parameters based on the observed data. Our estimation results reveal that the supplier perceives the cost of cancellation to be about two times higher and the holding costs to be about three times higher than the delay cost. In other words, the supplier is very conservative when commencing the order fulfillment, which undermines the effectiveness of the overall forecast-sharing mechanism. [ABSTRACT FROM AUTHOR]

We construct a dynamic game to model a monopoly of finitely durable goods. The solution concept is Markov-perfect equilibria with general equilibria embedded in every time period. Our model is flexible enough to simultaneously explain or accommodate many commonly observed phenomena or stylized facts, such as concurrent leasing and selling, active secondary markets for used goods, heterogeneous consumers, endogenous consumption patterns, depreciation, an infinite time horizon, and nontrivial transaction costs. Within our model, consumers have incentives to segment themselves into various consumption classes according to their willingness to pay, and nontrivial transaction costs to sell used goods put strong constraints on consumers' consumption sequences in time. As a direct consequence of the finite durability, the market power of the monopolist remains intact. Leasing manifests itself as a facilitator of price discrimination by debundling the durable good into new and used portions that are naturally bundled together under outright sales. The concurrent leasing and selling reflects the degree of the comparative advantage the monopolist has over consumers in disposing used goods. This comparative advantage, which is partially exploited by the monopolist and partially shared by the consumers, provides a sufficient mechanism to gain Pareto improvement on the market. [ABSTRACT FROM AUTHOR]

This paper focuses on the connection between product complexity and vertical integration using original empirical evidence from the auto industry. A rich literature has address the choice between internal production and external sourcing components in the auto industry. More recent literature has developed the concept of product architecture as another choice variable that may be one of the important contributors to product complexity. In this paper, we connect these two important decisions and study them jointly. We use the property rights approach to argue that complexity in product design and vertical integration of production are complements: that in-house production is more attractive when product complexity is high, as firms seek to capture the benefits of their investment in the skills needed to coordinate development of complex designs. We test this hypothesis with a simultaneous equations model applied to data from the luxury-performance segment of the auto industry. We find a significant and positive relationship between product complexity and vertical integration. This has implications for optimal incentive structures within firms, as well as for interpreting firm performance. [ABSTRACT FROM AUTHOR]

This study considers how a firm's resource base affects the choice of industries into which the firm diversifies. It offers two main extensions of prior research. First, it operationalizes technological resources at a more detailed level than in prior studies, thereby enabling a more stringent analysis of the direction of diversification. This analysis shows that the predictive power of the "resource-based view of the firm" is greatly improved when resources are measured at a finer level. Second, the study integrates principles from transaction cost economics into resource-based predictions concerning diversification. In particular, it tests the common assumption that rent-generating resources are too asset specific to allow contracting. The findings point to circumstances where resources can be and are exploited through contracting rather than through diversification. [ABSTRACT FROM AUTHOR]

This paper analyses the accumulated hedging errors generated by discretely rebalanced option hedges. We show that simple generalizations of the prior research can underestimate the variance of the accumulated hedging errors and that even with daily rebalancing, these accumulated hedging errors can introduce substantial risk in arbitrage strategies suggested by the Black-Scholes option pricing model. We also show that the correlation between the accumulated hedging errors for different options can be quite high, so that the risk of arbitrage due to hedging errors can be substantially reduced by optimally combining options into portfolios. The results also suggest that tests of market pricing of traded options which are based on employing a portfolio approach are likely to be much better specified than the standard tests that focus on individual options. [ABSTRACT FROM AUTHOR]

This paper studies the problem of contracting between two firms when they try to exploit their complementary resources in a collaborative venture (CV), but their performance in the CV cannot be precisely verified by the other party or by a third-party arbiter. Using a mathematical model that treats performance verifiability as a continuous variable, the paper first establishes that a party whose performance cannot be perfectly verified has an incentive to shirk if it is paid only a flat fee and that this shirking problem is more severe as its performance is less verifiable. Then, the paper shows in a general setting that a contract under which each party shares a fraction of the output is superior to a contract under which one of them is paid only a flat fee when performance verifiability is sufficiently low. In addition, with some specific assumptions about the forms of the revenue and cost functions, the paper also shows that a party's share of the venture's residual output in the equilibrium is an increasing function of its productivity and a decreasing function of its opportunity cost. Finally, the numerical examples constructed in the paper suggest that a contract which combines the self-enforcing mechanism of output sharing with the third-party enforcement mechanism of arbitration generally performs better than a contract that utilizes only one of these mechanisms. [ABSTRACT FROM AUTHOR]

This paper examines empirically two distinctions of internal and external markets: influence activities and strategic coordination. Influence activities that arise from decentralization, imperfect monitoring, and a relative performance system are a potential liability of internal markets; coordination may be worse in internal markets than in external markets. However, strategic coordination is an advantage of internal markets: a hierarchy can more effectively implement strategic policies in internal markets than external markets. The results of this study show that profit center managers engage in influence activities by haggling over price adjustments, causing greater renegotiation costs in internal markets than in comparable external markets. However, implementation of cost reduction, which is a strategic policy, appears to be more effective in internal markets: the results show that supplying profit centers disclose more private cost information than external market suppliers. Thus cooperation and competition appear to operate simultaneously in internal markets. In addition, the results suggest that internal markets appear to undermine one advantage of a vertical integration strategy: the creation of unique assets, an organizational resource that can generate rents. These results, which are based on data gathered from the internal and external markets of one Fortune 100 company, are exploratory and further work is needed to generalize the findings. [ABSTRACT FROM AUTHOR]

This paper seeks to uncover dominant configurations of interorganizational relationships across the United States and Japan in the automotive industry. We integrate relevant theoretical concepts from transaction cost economics, organization theory and political economy to develop a conceptual model of interorganizational relationships based on the fit between information processing needs and information processing capabilities. This model is employed to collect data on 447 buyer-supplier relationships in these two countries. We empirically uncover a set of five naturally occurring patterns of interorganizational relationships. These configurations provide rich explanations of the complexity of interorganizational relationships as well as offer differential insights across United States and Japan. We discuss implications for further research pertaining to the logic and development of configurations. [ABSTRACT FROM AUTHOR]

What determines a service firm's organizational choice between equity-based control and franchising? This question, which has elicited some theoretical answers and a few empirical tests in a domestic setting, has never been addressed in an international context before. This study explains the mode of control chosen in terms of a theoretical framework which borrows from agency theory and transaction cost analysis. The propensity to franchise internationally was found to be directly related to (i) monitoring costs associated with geographical and "cultural" distance between the principal (franchisor) and its foreign agents (franchisees), (ii) the principal's international experience, and (iii) the degree of host countries' contextual uncertainty but inversely related to the service firm level of branch name asset specificity. [ABSTRACT FROM AUTHOR]

Joint ordering policies are examined as a method for reducing the transactions cost for multiple products sold by a seller to a homogeneous group of buyers. The problem of determining efficient joint ordering policies has the same structure as the previously-examined problem of determining the efficient ordering policy for a single product. Efficient joint lot-sizes are independent of prices, and are supported by a range of average-unit prices that permit every possible allocation of the transactions-cost saving between the buyer and the seller. Product bundling supports efficient joint orders across products, just as a quantity discount supports efficient transactions for a single product. [ABSTRACT FROM AUTHOR]

Electronic integration--a form of vertical quasi-integration achieved through the deployment of dedicated computers and communication systems between relevant actors in the adjacent stages of the value-chain--is an important concept to researchers in the information systems field since it focuses on the role of information technology in restructuring vertical relationships. Drawing on theoretical and empirical research on transaction costs, we develop and test a model of the determinants of the degree of electronic integration in the commercial segment of the property and casualty (P&C) industry. Based on a sample of 120 independent agencies operating under dedicated information technology-mediated conditions, we provide empirical support for three hypotheses on the determinants of electronic integration. Implications and research extensions are identified to guide further research in this important area. [ABSTRACT FROM AUTHOR]

We examine the effect of proportional transaction costs on dynamic portfolio strategies for an agent who maximizes his expected utility of terminal wealth. For portfolios composed of a single risky asset and a single riskless asset, Constantinides (1979) shows that the optimal investment policy is described in terms of a no transaction region, where the optimal policy is to refrain from trading if initial portfolio holdings lie within the region, and to transact to the nearest boundary of the region if portfolio holdings lie outside the region. Because the boundaries could not be derived analytically, we developed an efficient and tractable algorithm to obtain the boundaries, which are expressed as the ratio of the dollar holdings in stocks and bonds. We considered two cases: the same transaction costs for the two assets, and costs incurred on only the risky asset. We derived the optimal trading strategies and utility levels for a large set of realistic parameters. In particular, we show that the no transaction region narrows and converges rapidly to the infinite horizon limit as the time horizon increases. [ABSTRACT FROM AUTHOR]

Multinational firms can enter a foreign market by taking over existing local firms (acquisitions) or by setting up new ventures (greenfield investments). Surprisingly, there has been limited empirical work on this topic. This paper examines the determinants of this choice by looking at Japanese entries into the United States. By focusing on firms of one country entering a single market, we are able to separate the impact of a firm's strategy from that of the characteristics of the target industry or country. This paper tests simultaneously a number of competing hypotheses. The results suggest that acquisitions are used by Japanese investors with weak competitive advantages, while investors with strong advantages find that greenfield investments are a more efficient way to transfer these advantages to the U.S. Acquisitions are also chosen to enter industries with either very high or very low growth rates, when entry is at a scale that is large relative to the parent, and when entry is into a different industry. The Japanese investor's previous experience of the U.S. market, its financial situation, and its status as a follower in an oligopolistic industry have no statistically significant impact on the entry mode. Neither do U.S. stock market conditions. [ABSTRACT FROM AUTHOR]

Tills paper explores the impact of adjustments to the inputs on total returns, terminal wealth, and portfolio turnover in an unconstrained monthly mean-variance (MV) asset allocation over time. It is well known that MV allocations are very sensitive to small forecast errors in the means and covariances. This sensitivity is especially pronounced for errors in means. One way to control this sensitivity to forecast errors is to use Stein estimation. We examined three naive applications of Stein estimation for six individual country stock indexes, five country bond indexes and five cash indexes. This study has two major conclusions. First, any of the suggested adjustments to inputs dominate the results of an unadjusted-input MV optimization. Adjusted-input portfolios have higher mean return, less variance and greater terminal wealth than unadjusted-input portfolios. Second, these improvements become even greater with transaction costs. [ABSTRACT FROM AUTHOR]

In an earlier issue of Management Science, Thomas Malone (1987) utilizes the concept of vulnerability costs in order to compare the degree of flexibility exhibited by markets and hierarchies. The purpose of this note is to redefine the concept of vulnerability to include the corresponding opportunity costs that are created when a coordinating structure restricts the ability to adjust to a change in market conditions. The conclusion reached is that those structures experiencing the lowest opportunity costs are the least vulnerable, and can therefore be classified as the most flexible. [ABSTRACT FROM AUTHOR]

Transaction cost is considered as an explanatory variable for the choice between markets and various organizational arrangements for performing some predefined tasks, such as engaging in private R&D. With respect to R&D cooperation between firms, we show that the perception of high transaction cost is related to certain characteristics of the firm and to the type of R&D task. We also show a relationship between the perception of transaction cost and the perceived success of the cooperation. The analysis sheds light on various determinants of transaction costs. [ABSTRACT FROM AUTHOR]

A buyer and seller alternate making offers until an offer is accepted or someone terminates negotiations. The seller's valuation is common knowledge, but the buyer's valuation is known only by the buyer. Impatience to reach an agreement comes from two sources: the traders discount future payoffs and there are transaction costs of bargaining. Equilibrium behavior involves either immediate trade, delayed trade, or immediate termination, depending on the size of the gains from trade and the relative bargaining costs. This contrasts with the pure discounting model where termination never occurs, and the pure transaction cost model where delayed trade never occurs. [ABSTRACT FROM AUTHOR]

This paper offers the first large sample empirical study of the factors which influence the choice of Japanese firms between full or partial ownership of their U.S. manufacturing subsidiaries. It studies for the first time the ownership policies of investors of a single home country in a single host country, thus keeping variations within home and host countries constant. One methodological improvement over previous studies is the use as independent variables of the relevant characteristics of the investing firms. These had been proxied in previous studies by data on U.S. industries entered. The results suggest that the degree of ownership taken by Japanese manufacturing investors in their American subsidiaries is driven by the same general transaction costs variables that determine the choices made by their U.S. counterparts: Japanese parents joint venture when they need to combine with other firms intermediate inputs which are subject to high market transaction costs. An intriguing result, however, is the lack of significance of two variables which, in the U.S. case, strongly push towards full control of foreign subsidiaries. In this study neither the Japanese parent's R&D nor its advertising intensities had any significant impact on their ownership policies. [ABSTRACT FROM AUTHOR]

The problem of minimizing the variance of discounted wealth at the end of a fixed period is solved when the expectation of terminal wealth is constrained to a specified Investment goal. The results are obtained in a continuous trading framework under the assumption that the funds can be exchanged between a riskless bond and a stock whose discounted price is described by a geometric Brownian motion. Transaction costs are Ignored (i.e., the market is "frictionless" ) and unlimited borrowing is permitted at the same rate as the return on the bond. Typically the optimal trading policy under the above assumptions involves a highly leveraged investment in the stock in the early stages followed by an accumulation of the bond in the later stages. Numerical results are provided as an illustration of the theory. [ABSTRACT FROM AUTHOR]