Economic Governance Made Intelligible

Jan 10, 2014 — Neil Boyle

Economic governance was made intelligible when Williamson postulated (1975) that markets and firms are distinct governance structures of transactions where governance costs vary with the asset specificity of the exchange asset. The asset specificity of transaction-specific assets carries critical information concerning the incentives of the asset owners. It gives rise to bilateral dependency, a hidden risk that complicates contractual alignments between buyers and sellers, wherein an exposed but farsighted trader will seek collaboration from his counterparty to protect exposed transaction-specific assets from all forms of expropriation. Specialized assets have low value outside of the transaction and since their next best use is near zero, investment in specialized assets is not made except to invest in prospective reductions in production costs or increases in revenues.

In summary, what matters is not only the cost of production, but also the cost of governance. The sum of production and governance costs more accurately referred to in [A]TCE as total “transformation costs” reflect the true cost of doing business. The absence of governance costs have skewed resource allocation policies in the past, the most recent being those that led to the 2007-2008 financial crisis.

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