A Political Economy of Russia from the 10th Century to 2008
The Locke Institute series
Chapter 1: Markets versus Hierarchies
In 1937, Coase explained the difference between the coordinating efforts of an entrepreneur and the coordinating function of the price mechanism in the market and why vertical integration is sometimes necessary. There are two ways of allocating resources – one is through markets, the other is through hierarchies. The cost of market operation is more than zero, therefore, delegating the allocation of resources to an authority saves some of that cost, especially when a longer-term contract is desirable. This is when a firm emerges. At the relevant margins, markets will end and bureaucratic hierarchies will appear when transaction costs are too high. The firm must carry out its function at less than market cost, otherwise the employees would revert back to the open market.1 But this does not tell the full story. Williamson (1985) asserts that bounded rationality, asset specificity and opportunism play a decisive role in sustaining hierarchies. Bounded rationality means that the agents are perfectly rational – will not do anything to violate their preferences – only part of the time. This reflects the limit of their cognitive competence. Opportunism is a calculated effort to misrepresent information to the other party for a personal gain. Asset specificity means that an asset has a lower value outside of a particular transaction. When bounded rationality, opportunism and asset specificity are simultaneously present, the form of contracting that emerges is governance. Where court enforcement is problematic, the system must rely on the institutions of private ordering.2 This is where the role of transaction costs...
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