Markets, Institutions, and Transaction Costs: The Endogeneity of Governance

Geoffrey R. D. Underhill
2007 Social Science Research Network  
Much of the literature contrasts the dynamics of free markets with the 'political' dynamics of governance. The distinction portrays the process of 'economic' competition as separate from the deployment of private political resources to affect the terms of competition in line with agent preferences. This yields a distorted view of the ways in which real-world economic agents compete with each other, and the market-governance/state-market dichotomy creates more confusion than it clarifies,
more » ... to account for the empirical observation that complex market systems and institutions of governance cannot be found apart. Even as an analytical distinction, the dichotomy blinds us to the ways in which states are active constituents of the market place, and the ways in which market actors and their constituencies are part of the wider process of governance shaping the terms of competition. This paper will extend the transaction cost approach and the insights of institutional economics to demonstrate in theoretical terms that the emergence of the institutions of governance is endogenous to the utility-maximising behaviour of economic agents. Utility-maximising behaviour and conflict over the terms of competition in the market generate both the formal and informal institutions and processes of governance such as regulation and dispute settlement. The paper then presents a conceptual model for understanding the essential integration of market and governance processes, the 'state-market condominium', in which markets are not just about what firms do in competition with each other, but are conceptualized as an ensemble of regulatory authority operating simultaneously through policy processes and the competitive interaction of firms. Contrasting forms of market correspond to political compromises based on the preferences of interacting agents. The model hypothesises reflexively that conflict over the terms of competition in markets generates changes in actor preferences concerning regulation and governance, and that the outcome of conflict over divergent actor preferences concerning governance and regulation generates changes in market structures. Changes in preferences concerning governance therefore are intimately bound up with preferences concerning market structure. This approach brings the work of economists and political scientists closer together. "We cannot solve problems with the same kind of thinking which created them." (A. Einstein, attributed) This paper contributes to our theoretical understanding of the relationship between governance and institutions on the one hand, and patterns of market exchange on the other, thus bringing the study of each closer together. Given the clear historical interdependencies between the two, the study of each will arguably be the weaker if such attempts are not regularly undertaken. The starting point is two empirical observations: that systems of market exchange and institutions of some sort are not to be found apart from each other, 1 and that the terms of competition in the market are shaped as much by the political as by the economic strategies and resources of firms and of other economic agents. Market systems thus range in nature from the highly competition-oriented to more collusive and/or regulated systems. These observations should provide an in-built exhortation to theorists to develop concepts which better theorise the relationships between governance and the market, and thus the real world we live in. Introduction: the Literature and the Argument The idea that there are important interdependencies between the institutions of governance and the functioning of the market is certainly not new. Classical political economists were well aware of the symbiosis between the two (Smith 1937(1776); Krätke and Underhill 1 As has been firmly established by the transaction cost literature, among others.
doi:10.2139/ssrn.1026332 fatcat:acie7zln6ncnrhyl4dwc5pznzy