Knowledge that Transforms

Recently (1983), I assessed the relative merits of X-efficiency and of neoclassical economic theory generalized to include the constraints imposed by transaction costs and the structure of rights. On both theoretical and empirical grounds, I concluded that such a generalization encompassed whatever limited explanatory power X-efficiency had to offer. Harvey Leibenstein's comment (1983) sharpens his presentation of X-efficiency and, in my view, highlights the limitations of that construct.' Because the main points he raises were already addressed in my original article, further discussion would be repetitive. Leibenstein, however, seems to misinterpret several key aspects of my analysis. Accordingly, it is useful to restate these points to avoid misunderstanding by other readers and to facilitate assessment of the positions at issue. Neoclassical economic theory, defined as the utility-maximization theory of the consumer and the wealth-maximization theory of the firm, assumed-inter alia-that all rights to the use of resources were fully allocated, privately held, and exchanged at zero information and transaction costs. By the late 1950's, empirical studies began to reveal some serious limitations of this framework and stimulated a variety of proposed reforms. Different lines of research eventually led to the generalization of neoclassical theory to include the explicit consideration of transaction costs and the structure of rights. This approach has turned out to be extremely fruitful. Not only has it reconciled the theory with broad classes of previously unexplained phenomena, but it has opened the way for important new applications. In particular, it has allowed extension of the utility-maximization hypothesis to all choices (i.e., by household, business, and government decision makers) subject to constraints. This advance has ended the dichotomy between the theory of consumer choice and the theory of the firm, and has established a more powerful framework for investigating the organization of economic activity. Thus, for example, analysis of the shirking-information problem of team production is offering new insights into why firms exist. Indeed, it is providing a new perspective on vertical integration, occasioning a major reappraisal of antitrust policies; on the circumstances affecting the choice of business organization, including single proprietorships, partnerships and other profit-sharing arrangements, corporations, nonprofits, and government-owned firms; and on the economic consequences of alternative ownership arrangements. Both theory and evidence indicate that the choice of organizational form and the rules adopted within it depend crucially not only on transaction costs, but also on the formal legal system as well as on the work ethic, customs, conventions, and other components of a society's system of rights. Transaction costs and the system of rights simply belong to the group of variables that determine the opportunity set faced by a utility-maximizing decision maker. It follows that property rights, like transaction costs, is not a theory (it is a variable that enters economic theory); it is not a motivational force (other than in the sense that it affects the opportunity set); it does not imply that individuals act to fully maximize wealth given the limits of their rights (its most distinguishing feature is the insistence upon the universal applicability of *Law and Economics Center, University of Miami, P.O. Box 248000, Coral Gables, FL 33124. I am indebted to Roger E. Meiners and Robert J. Staaf for helpful comments. 'Leibenstein's statement that I should have considered other alternative approaches, including Williamson's, is mystifying. First, I was not writing a review of the literature. Second, Williamson's work is a major keystone of the analysis I presented. My paper contained several statements to that effect plus repeated references to his writings.

Consider the problem of a buyer purchasing a (costlessly) storable good at a fixed price under threat of interruption of trade. Suppose there are two distinct and exhaustive regimes: either one can buy as much as desired at the going price, or one can purchase nothing at all and must rely accumulated stocks for consumption. The market moves randomly over time between these two states, which will be referred to here as on and off, respectively. Given the stochastic process governing the evolution of market regimes, the price faced when the market is on, and the intertemporal preferences of the buyer, one may inquire as to the optimal acquisition rate for storage and consumption when the market is on, and the optimal usage of accumulated stocks when the market is off. Solutions for these problems could then be used to ascertain the degree to which buyer (and seller) welfare is affected by the probabilistic curtailment of trading opportunities, and the willingness to pay of the buyer for greater security of supply. As well, the possibility of inferring from purchase and storage behavior the buyer's perception of the likelihood and duration of trade interruptions may be explored. This paper presents a general solution to this problem for stationary environments. That is, assuming intertemporal preferences to be representable by the expected present value of a uniformly discounted, time-independent flow utility function, and taking the stochastic process governing change in regimes to be stationary Markov, optimal behavior and associated expected discounted utility are derived. The method employed adapts to this context the dynamic programming arguments of my 1981 paper, and is similar in structure to that employed in the analysis of resource depletion with technological uncertainty in Partha Dasgupta and Geoffrey Heal (1974) and Dasgupta and Joseph Stiglitz (1981). There are many industrial markets in which these considerations are important. Recent events in the world oil market have stimulated much interest in the study of strategic mineral reserves (see, for example, Thomas Teisberg, 1981). In markets where demand fluctuates randomly and prices are inflexible (for example, the industrial market for natural gas), the possibility of stochastic rationing has important implications for firm behavior (see Dennis Carleton, 1978). The prospect of strike upstream, or lag in the delivery of goods order has significant implications for inventory holdings in some industries. The framework of this paper may even be adapted to the study of labor supply and savings behavior over the life cycle for a worker facing intermittent and uncertain unemployment.

The corporate tax has provided a steadily declining fraction of federal revenues during the postwar era, accounting for 23.0 percent during fiscal year 1966, and 14.2, 13.9, and 10.2 percent in 1971, 1976, and 1981, respectively. However, for several reasons, aggregate tax collections are of limited use in measuring the distortionary impact of the corporate tax. First, one must allow for cyclical and, potentially, long-run changes in the of profit to measure changes in average tax rates. More fundamental problems lie in attempts to relate such an average tax to the desired measure, the marginal tax rate. Assets of different age cohorts historically have faced different tax schedules because of a succession of nonretroactive tax law changes. Average tax rates on current represent an amalgam of such tax rules. Furthermore, even with a constant tax schedule, the taxable income which serves as the base of the corporate tax diverges systematically from economic income, because of the investment tax credit and the acceleration of depreciation allowances relative to actual economic depreciation. An asset typically receives deductions and credits that are more than sufficient to shelter all associated with it in the years immediately after purchase, but faces a tax base exceeding economic in more distant years, after all depreciation allowances have been used up. This implies that taxes will vary as a fraction of depending on the age structure of assets. Fast growing firms will face low and potentially negative average tax rates on current income, though facing the same tax schedule as stagnant firms with positive current tax payments. (This ignores the further complications that arise from the asymmetric treatment accorded gains and losses, which I discuss below.) Finally, there may be serious distortions in the allocation of capital within the corporate sector that aggregate tax rates, average or marginal, cannot measure. These difficulties have led to the general use and acceptance of the tax rate to measure the distortionary effects of the tax system. This is based on a comparison of beforeand after-tax internal rates of return on investment projects; letting rg and rn be these two measures, we define the effective tax to be