The new institutional economics has developed into two complementary parts, one that focuses on the institutions of governance, and another that is mainly concerned with institutions at a higher level, the institutional environment. Although the institutions of governance are at the core of transaction cost economics, TCE does take the institutional environment into account. The institutional environment is ‘the set of fundamental political, social and legal ground rules that establishes the basis for production, exchange and distribution. Rules governing elections, property rights, and the right of contract are examples’ (Davis and North, 1971: 6). It is also simply referred to as ‘the rules of the game’ (North, 1990: 5), to be distinguished from the play of the game: the institutions of governance. The rules define the way the game is played. This is one of the most salient differences between the institutional environment and the institutions of governance; the environment defines, and is a constraint on, the forms of governance (Williamson, 1996a: 5)10. The following sections (2.6.1 and 2.6.2) on Williamson’s four-layer scheme and parameter changes expand on this environmental influence on the governance structures.
2.6.1 Four-layer scheme
In his familiar four-layer scheme (see figure 2.2), Williamson shows that there exist four levels of institutions and of economic analyses: the first level of informal institutions, such as customs, norms and traditions, is the domain of economic historians and sociologists; the fourth level of the individual is the one at which neoclassical economics works; and the second and third level of respectively the institutional environment and the governance structures are the focus of the new institutional economics and transaction cost economics. With the solid arrow from level two to three, Williamson illustrates that transaction cost economics focuses on the environmental influence on governance structures. The dashed arrow from governance
10 Although Williamson puts the emphasis on the institutional environment as a constraint on the lower-
level forms of governance, on several occasions (e.g. Williamson, 1999a) he illustrates the enabling role of the environment. For example, having the courts available for purposes of ultimate appeal is said to delimit threat positions, and thereby provides support for private ordering (Williamson, 1996a: 42).
to the institutional environment indicates that Williamson recognizes that this opposite influence exists, but that he ‘mainly neglects these feedbacks’ (Williamson, 2000: 596). In comparison, Douglass North analyses the institutional environment and changes in the rules of the game. The emphasis on governance structures, or what North refers to as organizations, is ‘primarily on their role as agents of institutional change’ (North, 1990: 5). North thus explicitly focuses on these feedbacks that Williamson ignores.
Figure 2.2 Williamson’s four-layer scheme (Williamson, 1998a)
2.6.2 Parameter changes
Within transaction cost economics, level two, the institutional environment, is taken as given. It is treated as a set of parameters; changes in the institutional environment (or, if making international comparisons, differences between institutional environments (Williamson, 1996a: 18)) elicit shifts in the comparative costs of governance, and thereby change the comparative use of governance structures. Williamson identifies ‘property rights, contract law, reputation and uncertainty’ (Williamson, 1991) as parameters, and thereby locates these in the institutional environment. Several examples can be given of the effect of parameter changes on
Embeddedness: informal institutions (1)
Institutional environment: formal rules of the game (2)
Governance: play of the game (3)
the comparative use of governance structures. Firstly, a change in property rights: a weaker appropriability and a consequent increased risk of leakage increases the costs of hybrids and markets. Transaction cost economics predicts an increase in the use of the hierarchy. Secondly, a change in contract law: an improvement of excuse doctrine, increases the use of the hybrid form (Williamson, 1991: 287). At some point in a contractual relation, governed by a hybrid form, one of the contracting parties may realize that continuing the relation has lower gains than a literal enforcement of the contract. Excuse doctrine can be used to relieve the other contracting party from strict enforcement of the contract, when this strict enforcement would unduly harm this contracting party, when the altered contractual relation is the result of unforeseen events, and when the enforcement is driven by opportunism of the departing contracting party. A sensible use of the excuse doctrine means that it is not too lax and not too strict. When it is too lax, contracting parties will pay less attention to constructing a good contract and setting up a well-governed contractual relation. When it is too strict, contracting parties are discouraged to use a hybrid form, and prefer internalizing their transactions, because of the possible harmful consequences of a literal enforcement of the contract. Thirdly, improvements in inter-firm and intra-firm reputation effects will respectively increase the use of hybrids and hierarchies. Finally, uncertainty is also located in the institutional environment. Two forms of greater uncertainty can be distinguished: disturbances can become more numerous or they can become more consequential due to an increase in the variance of the disturbances. When the frequency of disturbances increases, the use of the hybrid mode of governance is likely to decrease. Adaptations through the hybrid form of governance require mutual consent of the contracting parties. Since consent takes time, the market or hierarchical form of governance will be preferred in an environment characterized by numerous disturbances (Williamson, 1991).
2.6.3 First-order economizing
As discussed in section 2.3, the core argument of transaction cost economics is the discriminating alignment hypothesis, according to which transactions are aligned with
governance structures in a transaction cost economizing way. The institutional environment is, in fact, a second factor that determines the comparative efficiency of governance structures11 (Williamson, 1999a: 1090), as the examples on property rights, contract law, reputation and uncertainty illustrate. Linking the institutional environment to the institutions of governance in this way is an additional source of refutable hypotheses and of predictive content for transaction cost economics (Williamson, 1996c: 17-18). A consequence of including the institutional environment into transaction cost economics is thus that an opportunity for an additional form of economizing is introduced. Where second-order economizing refers to getting the governance structures right, through the efficient alignment of transactions with modes of governance, first-order economizing refers to getting the institutional environment (or the formal rules of the game) right. This additional form of economizing is relevant, because the structure of the institutional environment has large consequences for the economic productivity of a country (North, 1990; Levy and Spiller, 1994). Williamson identifies the instruments for designing the institutions at the environmental level. These are said to include ‘the executive, legislative, judicial, and bureaucratic functions of government as well as the distribution of powers across different levels of government (federalism)’ (Williamson, 2000: 598). Williamson does not, however, analyze how to get the formal rules of the game right or how to structure the functions and powers of government. This can partly be explained by TCE’s focus on governance structures, and Williamson’s claim that ‘cumulative change of a gradual kind (of the institutional environment) is difficult to orchestrate’ (Williamson, 1998a: 27). It is much more complicated to change the institutional environment in order to enhance the efficiency of this institution (Williamson, 1996a: 5), as compared with altering governance structures. Changes in the rules of the game are believed to occur in the order of decades or centuries (e.g. Williamson, 1998a).
11 In an empirical study on intellectual property protection and inter-firm alliances, Oxley (1999) finds
that both the institutional environment and transaction attributes are important drivers of governance choice.