Measuring Transaction Costs in China’s Rural Land Rental Market: Ex-Ante Bargaining associated with Ex-Post Contract Violation Uncertainty and Location Specificity

Abstract

I measure the monetary value of transaction costs associated with China’s mature rural land rental market, confirming rumors that have appeared in the literature of transaction costs in that market. Merging and extending transaction-cost theory and contract theory, I demonstrate that the ex-ante bargaining costs associated with contractual formality represent the main transaction costs in the market, functioning as a precautionary strategy that smoothes ex-post adaptation costs. In a three-step theory, I model the process through which transaction costs are generated. First, uncertainty regarding ex-post contract violations caused by non-agricultural income shocks and location specificity in China’s scattered agricultural landscape result in conflicting partner preferences for contractual formality. Second, the com- promise mechanism that facilitates efficient bargaining maximizes joint profits by making it more likely that the agent facing lower compromise costs is the one who compromises. Third, ex-ante bargaining costs are generated in inefficient bargaining when theoretically predicted agents refuse to compromise. Using a subsample of transactional-level data utilized in Yang (2020) that matches rental partners, I sup- port my theory empirically and find that 18% of rental contracts experience ex-ante bargaining costs of 126.5 RMB and 35.4 RMB per year per mu, respectively, for renting-out agents’ and renting-in agents’ refusal to compromise.