A Stylized Case Study:Deriving Economic Governance

Case Studies

Mar 15, 2010 — Neil Boyle

Updated on April 15, 2010 (in red font) for greater clarity on the topic of operationalizing transaction costs.

In the 1960s, economists started actively pursuing research in institutional economics to great success and we see that success in: Transaction Cost Economics (TCE), Agency Theory (AT), and Property Rights Economics (PRE), among others, which are major new fields of institutional economic study and application in a number of prestigious American and European Universities. Two of these: TCE and AT focus on the firm as central to their analytical frameworks, but the firm as focal point for analysis is as far as similarity goes between these two frameworks. In only the TCE framework does the firm evolve out of market adaptation to trading hazards.

The following case describes why it is important to understand markets and how markets are affected by transaction hazards, and how hazards are transformed into transaction costs, and how these costs are mitigated by superior institutions of governance; one of which is the firm. The stylized case below is about the evolution of trading from a simple market transaction to a hierarchy transaction. The case illustrates how markets are governed, transaction costs are mitigated, and how this all led to the development of the field of economic governance. As the reader will see, the common denominator between markets and the firm is vertical integration, which Williamson saw as the paradigm for TCE.

Economic governance is not a new language but it is a new discipline that requires deliberate study to gain familiarization with the subject. To illustrate its application and outline its disciplinary apparatus, a stylized case study was developed for this purpose. The case occurs in a pre-industrial era. It is about: a one-man family farm that barters its surplus produce to ready buyers; a farm that grows over time and space; a farmer who copes with the transaction and contractual governance risks that arise with the incidence of growth and distance; the competition that arises in the process of increased entry by similar farm producers; and the vertical integration that is resorted to as market organization turns out to be insufficient to deal with the hazardous incentives, complex coordination, and enforcement issues that arise between the principal and the agent due to trading hazards.

Most readers are able to follow the text. The study is not based on an actual case. Written as close to reality as possible, it is stylized to illustrate the complex nature of economic governance.  Special attention is given to the characteristics of market organization and governance, and how market governance yields to the firm (a hierarchy governance structure in TCE parlance) as transactions require specialized coordination and safeguards that are supported by the firms hierarchy that enables adaptation to their environment.

Case study: evolution of the firm and vertical integration as TCE paradigm

Once there was a simple market comprised of one seller and a handful of buyers. The seller, a family farm, bartered surplus agricultural produce in exchange for goods the farmer valued but did not produce, or could easily obtain through other means. Proxy prices were negotiated by trading-off quantity and quality of goods until the traders reached agreement. Trading was simple enough that verbal agreements sufficed. Buyers personally inspected the goods they intended to barter and upon agreement took immediate possession. Promises played no role in the transaction as future obligations did not form a part of the exchange process; everything was transacted in the present. Goods were not expected to have long shelf lives so there was no need for long term storage or the need to account for returned goods. This example of early market organization was based on simple bartering, real time and personal measurement of the goods, negotiations of the various permutations of quality and quantity trading-off one for the other, and personal relations and trust, or if not trust, then the credible threat of exclusion from future commerce.

As time went on, agricultural production increased by learning-on-the-job (e.g., crop rotation) and with it the farmer’s surplus increased giving rise to other buyers. Seeing the success of the farmer, other farmers began to produce the same product and as they sold their produce more sellers entered the market. As more producers entered the market the making of the product became increasingly standardized to the point where the costs of production became increasingly determinative among competitors. Competition came into being and with it the relatively large number transactions of thicker markets and the transparency this brought to trade. Pricing had not yet entered the market. Nonetheless, large number competitive exchanges served as a strong incentive that stifled if not prevented the occurrence of opportunism.

Competition also induced strong incentives for farmers to improve upon quality as well as efficiency. But while the farmer’s production grew modestly in size and quality, the market remained simple in scale and scope. The farmer did not expand the size of his land area nor did he acquire new technology as both increments were costly to acquire or unlikely to exist at the time. Barter and carry an early version of cash and carry avoided the need for exchange currency, or delayed payment arrangements and greatly facilitated spontaneous exchange. Trust and credible threat, which in combination were potent mechanisms in the service of market organization, came with the commercial culture of the times.

Traders were autonomous, they knew the identities of the persons they traded with and, could see and touch (i.e., measure and determine the specifications of) the goods they were bartering so they tended to enter into a trade when they were prepared to complete the transaction.i Hence, agreements or contracts as they might have been called (albeit verbal) were complete, unwritten and executed spontaneously, as the objectives of both parties were aligned. Standards for assessing the quality of goods while personalized and informal were a part of village culture.ii Simple exchange agreements were straightforward and generally free of hazard. This is a stylized version of what is commonly referred to as a classic market governance-structure in law and economics.iii The attributes of market organization are shown in the adjacent Table 1 along with the attributes of the two other generic governance structures: hybrid and hierarchy.table1

Nonetheless, clusters of early man were not static and neither were markets. Markets adapted to the demands of growing populations. Populations grew and with their growth, markets and farmer incomes increased. As incomes grew, more and improved agricultural husbandry options became available to farmers and a broader range and increased yields of agricultural produce could be grown. Demand for these products expanded as consumption tracked increased incomes. Distance came into play as neighboring settlements became aware of possibilities in the adjoining settlements. As distance arose, the governance structure of market organization came under stress because it was unable to enforce the completion of the transaction without the high cost of monitoring and enforcement (Demsetz, ______), to wit, the personal presence of the principal farmer and the integrity that he represented in the transaction. Instead, the principal turned to a third-party, a contracted agent, and the hazards of limited cognitive capacity and opportunities for private gain came into play. High monitoring and enforcement costs created incentives for the agent to do less than promised. And as we can infer logically, these agency hazards as we shall call them created incentives for the farmer to spend on monitoring, the agent to spend on bonding, and the family farm to incur the residual loss of misaligned incentives between the farmer and his agent.

Increased scale (e.g., increased numbers of buyers and sellers) required producers to keep written records) and scope (e.g., distance led to expansion in the kinds of tradable goods as preferences changed) in production and marketing practices led to increased governance hazards for the farmer. As mentioned above, monitoring and agency hazards came into play.

As record keeping and product variety increased so did the cost of oversight and enforcement due to two constant human risk factors impacting on two variable environmental risk factors.  The constant human risk factors are: (1) incapacity of parties (limited cognitive capacity that shall be referred to hereafter as bounded rationality) to perform as planned, and (2) the opportunism (guileful self-interest) of parties to yield to the moral hazards of fraud and embezzlement. The impact of the two human risk factors on the environmental factors of uncertainty and small number exchange caused the transaction costs of monitoring and agency costs to increase. As these costs increased, the principal realized that his financial costs exceeded his benefits from bartered trade. (As economists traced these monitoring and agency costs to their systemic human factor origin and joined those human factors with the market parameters of the envionment, the concept of market/organizational failure and transaction costs came into sharper focus.)  iv

But, as transaction costs increased in scale and scope, the classic market governance structure could not adequately govern the distance-induced hazards of the exchange. Something had to be done to mitigate the hazardous incentives or what is technically referred to as the human risk factors that caused the monitoring and agency transaction costs. The principal learned from experience that he had little recourse other than to expand his sole-ownership operation into a two-person owned firm by giving up a portion of his residual control rights and integrating the agent as an owner into his family farm, soon to become a formal business. The principal sold the agent a share of equity ownership that gave the agent a stake in the business. The agent owner now possessed something of value he could lose if the transaction went awry. He had the right to claim a pro-rata ownership share of residual earnings of the business. This enhanced the agent’s benefit-cost ratio and thus his incentive structure, which sufficiently distracted him from side deals and his interest in opportunism, waned.

The term “distance hazard” might have adequately described the problem, but overtime economists learned that hazards of this kind occurred with enough frequency so they called it the principal-agent problem. “An agency relationship is a contract under which one or more persons (the principals) engage another person (the agent) to perform some service on their behalf that involves delegating some decision making authority to the agent.” (Jensen, ____). Agency problems occur when the objectives of an agent are incompatible with the objectives of the principal. Agency hazards “create incentives for the principal to spend on monitoring, the agent on bonding, and the firm to incur residual losses of misaligned incentives in the absence of credible commitments.” Monitoring hazards create incentives for the agent to do less than promised when monitoring costs are high. (R.N. Langlois, _______) Economists further learned that because incentive misalignment of this kind occurred with regularity, they could be mitigated by integrating the agent into the principal’s business, thereby changing the agent’s incentive structure to that of an equity owner. This is a stylized version of vertical integration; vi i.e., the removal of a market organized transaction (e.g., the principal-agent contractual relationship) where incentives are strong but hazard control is weak and placing it into a governance structure of the firm where hierarchy supports strong incentives for coordinated control of the human risk factors. vii

Risk mitigation by insertion of superior institutions and mechanisms

Vertical integration suggests that the act of mitigating a transaction cost is to insert a superior institution or mechanism into the economic organization of the transaction in order to economize on the human risk factors of bounded rationality and opportunism that challenge the integrity and the cost of exchange. In the stylized case, two superior mechanisms were inserted by the principal: (i) the residual claimant mechanism of the firm whereby the contracted agent was transformed from employee into a residual claimant thus becoming a principal who is imbued with a powerful incentive to minimize costs and maximize the revenues of the firm. Insertion of this superior mechanism helped to align the objectives of the parties and reduce monitoring costs; and (ii) the hierarchy mechanism of the firm whereby the new residual claimant is able to utilize the sequential administrative decision-making apparatus of the firm’s bureaucracy to monitor and control oversight and enforcement to protect his newly gained asset. Insertion of these two superior institutional mechanisms economized on the human risk factors of bounded rationality and opportunism and realigned the incentive structures of both parties by changing their benefit-cost ratios. The result was a reduction of the production costs of the firm.

It should be noted that the insertion of a superior mechanism into the economic organization of the concerned transaction or project is not straightforward and entails farsighted thinking and planning. Insertion goes way beyond the negotiating of terms and the writing of an appropriate clause into a contract. It entails a different approach to project planning and thinking ahead not just of exante incentives to achieve the outcomes that are desired but also of expost incentives to account for the expected but unknown hazards.  The designer is prompted to think of the contract clause as actually changing the assignments of property rights within the economic organization of the project.  This requires the designer to be thoroughly informed about the internal organizations of the partnership including the government executing agency.

Derivation of new institutional analysis and economic governance

Not only was vertical integration illustrated in the stylized case, but the principal ingredients of a simple analytical framework can be derived as well from the case to illustrate how a science-based analytical framework for economic governance originates and functions. Consider that the stylized case description has some traction in real life and that one can identify the following stylized regularities below in tabular form:viii

 Empirical rules that govern economic exchange

Stylized Regularities of the Case

The focus of analytical interest is the transaction. Economic exchange (i.e., the transaction) is the unit of analysis in matters of economic governance.
Hazards increase directly with complexity of transactions.
Markets and firms are distinct governance structures of transactions where governance costs vary with “complexity” of the transaction. Complexity has to do with the disturbance of transaction alignments (more on this will be covered later).
Market organization gives way to the firm as transactions become more complex and production-consumption demands and preferences increase.
Simple market transactions are not free of hazards. They are less prone to hazards than complex transactions because simple market organization offers fewer opportunities for opportunism.
An essential administrative control ingredient of a firm is hierarchy contained in its vertical sequential decision-making authority. Firms control by means of administrative bureaucracy.
An essential incentive ingredient of a firm is residual claimancy contained in equity ownership.
Alignment of the incentives of the actors occurs when superior institutions are inserted for the purpose of economizing on transaction costs. Increased revenues and/or reduced costs accrue when principal-agent transaction costs are mitigated by vertical integration of the transaction into the firm thus aligning the incentives of the parties.
Governance differs systematically with transaction attributes whose main transaction syndrome is asset specificity and uncertainty, and main governance structure syndrome is incentive intensity, administrative control and contract law regime.
Governance of economic exchange is determined by identifying governance structures which differ in discrete structural ways (e.g., in costs and competencies) as means by which to manage transactions, and joining these two in a discriminating transaction cost economizing way.
Vertical integration is an institution comprised of residual claimancy and hierarchy as institutional mechanisms.

Further, consider that the case is a regularity in economic and political organization so that the regularities above explain similar governance phenomena over space and time. As such and until proven otherwise, these regularities can be considered as “the rules” that govern these kinds of phenomena. Explanations that are derived from these rules become second generation refutable hypotheses. As this analytical framework is applied in practice, new refutable hypotheses are generated to explain the institutional behavior of the transaction under examination, and to the extent that these hypotheses are validated by evidence, new knowledge is added to the initial knowledge stocks of economic governance.

This process of generating refutable hypotheses in analysis and explanation, in the testing and reformulation of these hypotheses, and in the accrual of new knowledge relative to previous knowledge stocks forms the basis of new institutional analysis. Depending on the degree of validation with evidence, refutable hypotheses may be referred to as precepts, that is, until they are proven otherwise.ix (See Williamson, 1975, 1985, 1996) Validation of refutable hypotheses  is rarely a once and for all proposition as it might be in mathematical terms. Validation is a matter of evidence and deep knowledge rather than of large population statistical data, just as decision making is for informed senior managers, and court verdicts are in law.  If it works, consider it tentatively validated; the opportunity costs may be prohibitive otherwise.

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