Introduction
New Institutional Economics is a field of economics which expands the neoclassical concept. Its main representatives are Ronald Coase and Oliver Williamson. In 1937 Ronald Coase describes the firm as a result of relationships which arise when the role of the market is undertaken by the manager-entrepreneur. In the absence of firms, free market exchanges move economic resources to where their use is most valued. Market exchange is atomistic and free, not administered by any authority or central figure. This gives rise to a multitude of market-based contracts which take resources and efforts to design. The costs of designing and enforcing market-intermediated contracts are called transaction costs.
Coase (1937) calls them “marketing costs,” or costs of market transacting.
– Coase
These costs can be significant, as they include the costs of finding a market partner, searching for relevant information on the prevailing market price, the quality levels of products, the terms of delivery, etc. Once a partner is found, one needs to design a suitable deal covering the legal fees of formulating a proper contract. The commercial contract is inevitably incomplete which necessitates adaptation in the negotiation process. There is consistently need of legal advice especially when legal disputes arise ex post, that is, after concluding the deal. Contract enforcement and compliance with commercial contracts give rise to substantive legal and other costs which can be economized by forming a firm. Within the firm the manager does all resource allocation substituting thus the market mechanism. He directs resources in an administrative way which often ignores optimization. The managerial function within the firm and the market mode are two alternative means of resource allocation. In the absence of transaction costs all resource allocation would be performed through the market interface.
About
Oliver Williamson operationalizes this theory by defining transaction costs more strictly. He distinguishes between ex ante transaction costs and ex post transaction costs, i.e., before and after signing the deal. For Williamson the moment of signing is essential. Before that there is a tender where one side can choose from among many potential partners. For instance, a buyer might be searching for the best seller of a given product or component. What is initially a large group of potential partners turns into one, once the contract is signed. The buyer selects the best seller, or what looks like a best seller, in a group of many sellers. Once the contract is signed, the buyer is “trapped” into a relationship with a single seller with no alternatives which substantially modifies the behavior of parties. What initially looks like the perfect deal may turn out to be problematic if the commercial partner fails to perform his or her duties along the contract. The deal goes out of alignment with the initial stipulations or conditions which Williamson calls the “holdup” problem. Once this problem appears any of the parties to a mutual transaction can claim the “quasi-rents” of the other party. The dishonest party may take advantage of the other one violating thus the terms of the contract.
Economic Agents
With persistent opportunism on the part of one commercial partner the other party is vulnerable to the risks of market exchange. Since information is imperfect and economic agents are boundedly rational, that is, they aim at rationality in the presence of objective constraints, firms merge with dishonest or opportunistic partners. This leads to vertical integration and firm expansion. What were previously small firms now turn into big monopolies or oligopolies where there is smoothness of supplies and deliveries. Quality standards are also met so that to satisfy the needs of the customer.
Vertical mergers and the acquisition of an opportunistic partner arise only with consistent opportunism. There can hardly be mergers with one-time deals on the spot market. Vertical mergers also arise with specific assets. Examples of asset specificity are site specificity, dedicated assets, physical assets, human assets, and brand name capital. Two related firms may be located close to each other so that the ensure the timeliness and smoothness of supplies. A firm may be asked to use specialized equipment in order to produce parts, components or products designed to match the specific needs of a particular partner. The equipment used then turns into specialized one. What initially is general-purpose equipment or inventory becomes specialized once it is tailored to the needs of a specific commercial partner. Such equipment cannot be used in alternative uses which is why it may lose productive value in case of contractual or behavioral opportunism. [5] Such productive assets are not salvageable and cannot be recovered in case of non-compliance or violation of the contract. With continuous market contracting even general-purpose assets turn into specific.
Williamson argues
Human assets can be specific, too. The employer and the employee are involved in a long-term relationship. Workers develop firm-specific skills which are hardly transferrable to other firms or uses. The dependence is dual – not only workers develop skills applicable to the particular firm, but the individual firm also becomes dependent on the knowledge, skills and experience of the individual worker. Williamson argues that workers whose knowledge is firm-specific should be rewarded adequately for their uniqueness. Brand-name capital is an investment in advertising and promotion for a specific project. Funds are committed to the advertising campaign of a commercial partner which cannot be recuperated once the commercial relationship is prematurely terminated.
New Institutional Economics also describes the large corporation in transaction cost terms. The modern corporation did not exist until the 1960s. Before that there were only small firms organized along the unitary organizational form which was essentially linear and highly hierarchical. This form organized the firm along the structural areas of business – marketing, management, accounting, information systems, finance, etc. Firm expansion was impossible since the transaction costs of internal organization put severe limits on firm growth. The top management was unable to perform more and more of the functions of the market thus internalizing market operations.
Tactical managers
The problems of bounded rationality and information incompleteness prevented managers from achieving their maximum marginal product and efficiency. The large corporation acquired its optimal shape with the multidivisional form, one which optimally relocates transaction costs within the firm. A team of top managers, called strategic managers, would set the mission, vision, and long-term strategy of the firm, while day-to-day operations would be left to the tactical managers. Tactical managers are, in a sense, operational managers performing the tedious tasks of the respective unit, branch or division. This diversified firm structure organizes the different subsidiaries along a product, region, or activity. The corporation can now grow to a global level. Indeed, some of the largest corporations in the global economy operate on a world-wide scale and have seen dramatic growth in the second half of the last century with the spread of the multidivisional form.
New Institutional Economics can plainly be divided into two major fields, 1) property rights and agency theory and 2) transaction costs. The property rights literature emphasizes that property rights matter for maximizing the cumulative output of an economic system. The goal is to optimally allocate property rights. The government is charged with the task to define and enforce property rights. Agency theory reveals the conflict between the principal and the agent using mathematical models presenting adequate stimuli for the agent so that he can achieve the goals of the shareholders as the principal. Transaction cost economics is the area of new institutional economics which most realistically describes today’s marketplace accounting for all risks of market transacting. Williamson associates those risks with the transactional and behavioral failures of the market. Market failures can take on different shapes and types – opportunism, misrepresented quality, externalities, asymmetric information, moral hazard, adverse selection, etc.
Accounting
Accounting for different market failures, new institutional economics, in general, and transaction cost theory, in particular, are the only fields of economics which can explain the failures and mishaps of economic transition. More specifically, the failures of market transacting stemming from exceptional opportunism and dishonest human behavior lead to the failure of market reforms in some East European countries. New institutional economics properly describes these market failures prescribing reform-oriented measures related to contracts, contract theory and transaction cost economies.
