by Robin Johnson
Contributed paper to 45th Annual Conference of the Australian Agricultural and Resource Economics Society, Adelaide, January 23-25, 2001.
In Agribusiness Perspectives - Paper 36, the author presented a paper on “Institutions and Public Policy”. Paper 36 discussed how the new institutional economics (NIE) could be applied to government organisations, and in particular, marketing boards. In this paper the author examines the basic assumptions used by Oliver Williamson in determining his conceptual approach to organisation theory and how these might relate to government organisations. These issues include the usefulness of the zero- transaction cost model, the meaning of bounded rationality, the meaning of the ‘institutional environment’, and the implications for economic efficiency criteria. This paper then discusses how such an organisational approach can be applied to government entities. This discussion is based on the work of Horn (1995) and Dixit (1996). Emphasis now falls on the transaction costs of government policy formation and implementation and the pressures that exist to minimise these costs in the policy making process. The paper concludes with a discussion of some recent applications of NIE theory to governmental reform in agricultural services.
Key Words: institutional economics, zero-transaction cost models, alternative organisational solutions, conduct of government business, agricultural services.
Further Reflections on Williamson's New Institutional Economics and Policy
Introduction
What are transaction costs?
Why is Coase so important?
What is bounded rationality?
What are the constitutional implications?
What are implications for the efficiency criteria?
Can the analysis be applied to political and administrative entities?
Have meaningful organisational changes in administrative entities resulted?
Conclusions
Oliver Williamson gave a keynote address to the Australian Agricultural and Resource Economics Society in Sydney in January 2000 (Williamson 2000). In that paper he sets out what he thought had been achieved by the new institutional economics (NIE) and the particular attributes that he thought were “good ideas”. He particularly mentioned the importance of bounded rationality, the feasibility principle in choosing better organisational forms, the idea of the firm as a governance structure, and the operationalisation of the theory into refutable hypotheses.
These “good ideas” spring from the basic concepts which are employed in the theory. These are the role of transaction costs in real life decision making, the abandonment of the firm-as-production-function basis of theory, the power of alternative organisational structures in determining optimal outcomes, and the dependence on bounded rationality and agency theory. These basic steps in the analysis are worth examining in their own right as a way of assessing the claims that Williamson makes. The theory of transaction cost economics (TCE) derives from the work of Ronald Coase (1960).
In this paper, we examine at each of these assumptions in turn and compare them with the approach of Douglass North in his papers on institutions and economic performance. The ideas springing from the NIE have also been adapted to the making and implementation of economic policy (Horn 1995; Dixit 1996). I want to explore this latter development as this is where many of the policy applications of TCE have taken place.
Transaction cost economics (TCE) deals with “an examination of the comparative costs of planning, adapting, and monitoring task completion under alternative governance structures” such as markets, hierarchies, hybrids and public bureaus, says Williamson (1985, p.2). Rational agents will select governance structures that minimise their aggregate production and transaction costs. Transaction costs are derived from weaknesses in the contractual situation. “The identification, explication, and mitigation of contractual hazards....are central to the exercise”, says Williamson (1996, p.3). Ex ante transaction costs are those arising from attempts to prevent transaction failures due to asset specificity and opportunism, including drafting, negotiating and safeguarding a contract. Ex post transaction costs are the costs of altering contracts to correct ex post misalignments, the costs of setting up and maintaining governance structures and the costs of bonding to guarantee contractual commitments (Williamson 1996, p.379). These costs are in turn distinguished from normal production costs (although the distinction is not always tightly drawn (Boston et. al., 1996, pp.19-20)). This distinction is made clearer by North as discussed below.
Williamson uses “the market” to indicate the arena in which autonomous parties engage in exchange; “hierarchy" to indicate transactions taking place under unified ownership and subject to administrative controls; “hybrid" to indicate long term contractual relations that preserve autonomy but provide added transaction-specific safeguards; and a “contract” to indicate an agreement between buyer and seller. Most important, “incomplete contracting” refers to situations where future contingencies are obscure or incompletely understood. Finally, “bureaucracy” is the support staff that is responsible for developing plans, collecting and processing information, operationalizing and implementing executive decisions, auditing performance, and more generally, providing direction to the operating parts of a hierarchical enterprise (Williamson 1996, pp.377-78).
The costs of overcoming contractual hazards loom large in the Williamson analysis.
“...... such considerations largely account for the concentration of production in some sectors of the economy in a few large firms, whereas in other sectors there are numerous competing firms. Where uncertainty, asset specificity [including human assets], opportunism and so forth are high, firms have an incentive (in the interests of minimising their transaction costs) to integrate forward (by taking over the person or firm to which they are selling) and/or integrate backwards (by taking over their suppliers or developing their own supply networks). Where the opposite conditions apply, firms are likely to rely more heavily on external contracting ....” (Boston et. al. 1996, p.24).
Transaction costs thus include costs of obtaining information about sellers or buyers, costs of maintaining contractual obligations to buy and sell, costs of new governance structures, and costs involved in managing buyers and sellers (agents). These costs do not appear in the frictionless firm-as-production-function model identified by Coase (see below). Williamson substitutes the firm-as-governance-structure for the frictionless model and poses that internal structure has economic purpose and effect. He then says, more generally, we need to identify and explicate the properties of alternative modes of governance - markets, hybrids, firms, bureaus etc - which differ in discrete structural ways.
A clear explanation of the Coasian framework comes from Douglass North: “It was Ronald Coase who made the crucial connection between institutions, transaction costs, and neoclassical theory (Coase 1960). The neoclassical result of efficient markets only obtains when it is costless to transact. Only under the conditions of costless bargaining will the actors reach the solution that maximise aggregate income, regardless of the institutional arrangements.......Efficient markets are created in the real world when competition is strong enough via arbitrage and efficient information feedback to approximate the Coase zero-transaction-cost conditions and the parties can realise the gains from trade inherent in the neoclassical argument” (North 1994, p.360).
In a study of the national economy of the US, Wallis and North (1986) identified transaction costs associated with banking, insurance, finance, wholesale and retail trade and found them to constitute more than 45% of national income ....and... this percentage had increased from approximately 25% a century earlier. In the light of their work, a very useful working definition of transaction costs emerges: “Because transaction costs are a part of the costs of production, we need to restate the traditional production relationship as follows. The total costs of production consist of the resource inputs of land, labour and capital involved both in transforming the physical attributes of a good (size, weight, color, location, chemical composition, and so forth) and in transacting - defining, protecting, and enforcing the property rights to goods (the right to use, the right to derive income from the use of, the right to exclude, and the right to exchange)”(North 1990a, p.28). By and large, Williamson's analysis does not hinge on the separation of costs as he is clearly discussing costs of managing contractual relations at the margin.
It is North who clarifies the key role of information in the exchange process: “Commodities, services, and the performance of agents have numerous attributes and their levels vary from one specimen or agent to another. The measurement of these levels is too costly to be comprehensive or fully accurate. The information costs in ascertaining the level of individual attributes of each unit exchanged underlie the costliness of this aspect of transacting. Even if all exchanging individuals had the same objective function (for example, jointly maximising the wealth of a firm that employed them), there would still be transaction costs involved in aquiring the necessary information about the levels of attributes of each exchange unit, the location of buyers (sellers), and so forth. But in fact there are asymmetries of information among the players (my italics) and these and the underlying behavioural function of individuals in combination produce radical implications for economic theory and the study of institutions” (North 1990a, pp.29-30).
North refers to sellers of oranges knowing more than a buyer, the used car dealer knows much more about the valued attributes of a car, and the doctor knows much more about the quality of services and skill than the patient. Not only does one party know more about some valued attribute than the other party, he or she may stand to gain by concealing that information. According to a strictly wealth-maximizing behavioural assumption, a party to exchange will cheat, steal, or lie when the payoff to such activity exceeds the value of the alternative opportunities available to the party. From such informational imbalances spring the problems of adverse selection and moral hazard (op. cit., p.30).
North then sets out the conditions where the neoclassical model is inappropriate. “Consider first the standard neoclassical Walrasian model. In this general equilibrium model, commodities are identical, the market is concentrated at a single point in space, and the exchange is instantaneous. Moreover, individuals are fully informed about the exchange commodity and the terms of trade are known to both parties. As a result, no effort is required to effect exchange other than to dispense with the appropriate amount of cash. Prices, then, become a sufficient allocative device to achieve highest value uses.......To the Walrasian model, which includes the maximising behaviour of individuals, the gains that result from specialisation, and the division of labour that produces exchange, I now add costs of information....these include costs of measuring the valued attributes of goods and services and the varying characteristics of the performance of agents. The net gains from exchange are the gross gains, which are the standard gains in neoclassical theory and in the international trade model, minus the costs of measuring and policing the agreement and minus the losses which result because monitoring is not perfect. On a common sense level, it is easy to see that we devote substantial resources and efforts to the measurement, enforcement and policing of agreements. Warranties, guarantees, trademarks, the resources devoted to sorting and grading, time and motion studies, the bonding of agents, arbitration, mediation, and of course the entire system of judicial process all reflect the ubiquity of measurement and enforcement” (North 1990a, pp.30-31)(my italics). Williamson tends to dismiss the neoclassical model entirely and substitute his governance structure based on comparative transaction costs. Occasionally he refers to zero transaction costs which he calls “the ideal transaction in law and economics” (Williamson 1996, p.106).
In common with public choice economics, the NIE has adopted the working assumption that there are limits to man's knowledge of the economic environment around him. Economic man has to make decisions with the knowledge he has available to him. The concept of bounded rationality which owes its origins to the work of Simon (1947, 1st edn), rests on the observation that individuals neither have the capacity to gather all the information and knowledge necessary for optimal decision-making nor the cognitive ability to process such information as is available. Hence, rather than making optimal choices, boundedly rational individuals engage in what Simon refers to as “ satisficing” behaviour. That is to say, the inherent limitations on decision-making encourage people to behave according to well-established routines, patterns and rules, to seek predictability and certainty in organised or structured environments, and to be highly selective in the range of information upon which they draw in making choices. As the complexity and uncertainty of a situation increases, the greater the limits imposed on individuals by their bounded rationality and the more likely it is that the transactions into which they enter will fail....... As Williamson (1985, p.6) observes, one way of minimising such failures is to avoid, if possible, governance structures that entail high transaction costs and large cognitive demands" (Boston et. al., 1996, pp.22-23).
More recently, Williamson states that “transaction cost economics expressly adopts the proposition that human cognition is subject to bounded rationality-where this is defined as behaviour ‘intentedly rational, but only limitedly so’ (Simon 1957, 2nd edn, p.xxiv)-but differs from Simon in its interpretation of ‘the degree of depravity’ to which Madison refers [Federalist Papers]. Whereas Simon regards the depravity in question as ‘frailties of motive and reason’, transaction cost economics describes it instead as ‘opportunism-to include self-interest seeking with guile‘ ” (Williamson 1995, p,176).
In line with agency theory, opportunism increases the need for monitoring and surveillance of the performance of agents and induces new [transaction]costs in the form of incentives for agents to conform. Whereas North derives his version of opportunism from imbalances in the information supply (taking advantage of ‘monopoly’ information), Williamson derives the concept out of the bounded rationality literature (“frailties of motive and reason”).
Williamson seeks to make governance issues dominant over the equilibria of classical economics. He recognises that commerce is conducted in a framework of laws and conventions which change only slowly (Williamson 1995). The set of fundamental political, social, and legal ground rules that establish the basis for production, exchange and distribution create the institutional environment (Davis and North 1971). This is to be contrasted with arrangements between economic units that govern the way these units co-operate and/or compete. Such institutional arrangements provide a structure within which members can co-operate and also provide a mechanism that can effect a changes in laws or property rights. This is what Williamson calls the institutions of governance (op. cit., p.174).
More recently, Williamson (2000) distinguishes between four levels of social analysis:
i. informal institutions, customs, traditions, norms and religion;
ii. formal rules of the game;
iii. governance or playing the game; and
iv. neo-classical economics and agency theory.
At the top is the social embeddedness level. This where the norms, customs, mores, and traditions are established in a rather long term framework. This level is taken as a given by most institutional economists. The second level is referred to as the institutional environment. At this level, formal rules (constitutions, laws, property rights) are established. The design instruments include the executive, legislative, judicial, and bureaucratic functions of government as well as the distribution of powers across different levels of government (federalism). The definition and enforcement of property rights and of contract laws are important features (first order economising). These institutions are also difficult to change. The third level is where the institutions of governance are located. These include structure of firms, vertical and horizontal integration, regulatory intervention, bureaus and SOEs, and so on. All these have different patterns of transaction costs which provide a guide to what Williamson calls second order economising. The structural analysis of governance is to be distinguished from the fourth level which is the level at which neo-classical analysis works. In line with production theory, the objective is now to get the marginal conditions right (third order economising).
It can be seen that this schema brings Williamson into line with the distinctions made by North about the place of zero transaction cost models in institutional economics. At the same time it is pertinent to observe that Williamson does not always remind the reader about his basic assumptions in what he presents.
Both Williamson and North suggest that the current institutional environment is the end-result of commercial and political self-seeking in the past. When the need arises the political process will make the necessary changes. Broadly speaking, these changes can be broken down into short-term and long-term adjustments (one is operational and the other is at the fundamental level of the constitution itself)(Johnson, D.B., 1991). The operational level consists of decisions made within a given set of already existing and broadly accepted constitutional rules. The constitutional level is where the basic institutions of society are established including the rules for the application of property rights. These constitutional rules are thought to be established in an atmosphere of conceptual impartiality because the future effects on individuals cannot be foreseen (Dixit 1996, p.13). Once established, they change only very slowly, but sometimes cataclysmic (the French Revolution for example). In between such times, individuals/corporations/governments operate in a relatively unchanging institutional environment and can make operational changes in policies, revenue collection and so on (incrementalism).
The constitutional environment is represented in Williamson (2000) in the first two levels of social analysis: i. informal institutions, customs, traditions, norms and religion; and ii. formal rules of the game, while the operational environment is represented by governance issues (institutional arrangements).
In discussing these issues, Buchanan (1975, p.226) observes that individual policy acts have to complement and fill gaps in the constitution, and to this extent the distinction between the constitutional contract and individual policy acts is often blurred since the policy act may provide a wide measure of interpretation of parts of the constitution. In almost no circumstances will advisors start with a clean sheet to correct some example of market failure. Given the ongoing nature of government policy making, economists should consider the economic problems of government not as agents seeking to maximise economic welfare but as arbitrators, seeking to work out compromises between conflicting claims. Dixit (op. cit., p.71), emphasises that constitutions themselves are incomplete contracts, and the distinction between them and policy acts is one of degree, and not kind.
This powerful approach has enabled Williamson and others to carry out meaningful analysis of the structure of firms and organisations outside the normal conventions of production theory (Buchanan (1975), North (1990a,1990b), Williamson (1995), Horn (1995), Dixit (1996), and Williams (1997)). The emphasis on transaction costs moves the analysis of the firm (and other entities) away from the marginal equilibria to a less specific optima based on organisational alternatives. Total costs and gains can still be assessed and a net benefit criteria derived. As North states “...the private objectives of those with the bargaining strength to alter institutions, produce institutional solutions that turn out to be or evolve into socially efficient ones” (1990a, p.16).
Williamson (op. cit., p.8) rejects hypothetical ideals which work off omniscience, benevolence, zero transaction costs, and full credibility. He prefers feasible organisational alternatives, none of which are perfect. If a proposed feasible alternative cannot be costlessly implemented, then the costs of implementation are appropriately included in the net benefit calculus. His proposed efficiency test consists of a `remediableness' criterion which holds that an extant mode of organisation for which no superior feasible alternative can be described and implemented (with expected net gains) is presumed to be efficient.
It was Coase (1960) who argued that when it is costless to transact, the efficient competitive solution of neoclassical economics obtains. It does so because the competitive structure of efficient markets leads the parties to arrive costlessly at the solution which maximises aggregate income regardless of the institutional arrangements (North, 1999a, p.15). “...because competition is strong enough via arbitrage and efficient information feedback to approximate the Coase zero transactions cost conditions, the parties can realise the gains from trade inherent in the neoclassical argument”. But “individuals act on incomplete information and with subjectively derived models that are frequently erroneous. Institutions are not necessarily or even usually created to be socially efficient; rather they, or at least the formal rules, are created to serve the interests of those with the bargaining power to devise new rules. In a zero-transaction-cost world, bargaining strength does not affect the efficiency of outcomes, but in a world of positive transaction costs it does and given the lumpy indivisibilities which characterise institutions, it shapes the direction of long-run economic change” (italics in original).
As usual, it is North who underpins the practical view of events that Williamson eschews!
There are profound reasons why welfare economic is of limited use in actual policy making. Blackboard models of producer and consumer surplus assume away the presence of transaction costs." The Pigouvian approach in welfare economics tends to assume omniscience (having infinite or very extensive knowledge) on the part of the observing economist (Buchanan 1987, p.5). However, there may be little or no relationship between the costs and benefits estimated by the outside observer and the evaluations that individuals place on alternatives in actual choice situations, And, if the data upon which choices are based cannot be obtained, the marginal efficiency conditions stressed in black-board models are of little prescriptive use for public policy. In public policy analysis in the Pigouvian world, transactions costs are not an important consideration because information problems tend to be assumed away. However, Coase (1988) shows that transaction costs are highly important in studying the world that actually exists. Consider the example of a spillover in the form of soil erosion which pollutes streams. Market failure carries with it the connotation that the government should intervene to eliminate it. However, a divergence between private costs and social cost provides no decisive justification for government action. Indeed, as Coase emphasises, the costs of intervention in the United States frequently have been found to outweigh the benefits.
“The reason that individuals and private organisations do not eliminate soil erosion and other spillovers is that the perceived gain would no more than offset by what would be lost in doing so. And, if with government intervention the losses exceed the gains, the spillover should remain. Moreover, as Coase emphasises, the transaction costs of making the arrangements necessary to bring about the results are properly included in the calculation of costs and benefits. But if such costs are included, it cannot be proven that "market failure" exists in the sense that government action is warranted...... In other words, given the institutional constraints, `that which exists is the best that can be done' is a logical implication of the axioms of rational behaviour ..” (from Pasour 1993, pp.3-4).
Williamson's approach has implications for both private organisations and public organisations. The approach is based on the recognition of different outcomes from different forms of organisation with different governance structures. It recognises the presence of a number of transaction costs that prevent the pure model of competition from operating in firms. Authors like North (1990b), Horn (1995), and Dixit (1996), have applied the theories to government organisational structures and decision-making. There is a new recognition of the role of transaction costs in policy making institutions. In turn, these constructs enable the policy forming and delivery process to be identified separately from the political process.
The study of alternative institutional arrangements in policy making again derives from the work of Coase. “Whereas the conventional approach in welfare economics is to consider an ideal economic system and then prescribe what is necessary to achieve this ideal state without much attention given as to how this might be done, a recognition of the importance of transactions costs suggests a quite different emphasis for economic analysis. Economic policy involves a choice between alternative social institutions, which are created by law or are dependent on it. Without knowledge of what could be achieved under alternative institutional arrangements, it is impossible to choose wisely among them (Coase 1988, p.30). This suggests that the emphasis of economic analysis in public policy work should be changed; in the Coase approach, economists would devote more attention to the effects of alternative institutional arrangements. This approach is consistent with classical economics where the primary objective of political economy was to contrast alternative political and frameworks in order that choice among these institutional arrangements might be better informed (Buchanan 1989, 1991)..... The economist following the Pigouvian approach in the analysis of market failure problems is likely to prescribe government action where none is warranted because the method has an implicit bias toward interventionist solutions ...” (Pasour 1993, p.4).
But the Pigouvian approach is flawed precisely because it ignores transaction costs. “As a crude but effective caricature, one can say that normative policy analysis began by supposing that the policy was made by an omnipotent (having infinite power), omniscient (infinite knowledge), and benevolent dictator. The work on second best removed the omnipotence. That on information removed the omniscience. However, the assumptions of benevolence and dictatorship have remained unaffected by all these improvements in our understanding of the limits on instruments and information....In reality, a policy proposal is merely the beginning of a process that is political at every stage - not merely the process of legislation, but also the implementation, including the choice or formation of an administrative agency and the subsequent operation of this agency” (Dixit 1996, p.8-9) (italics in original).
The alternative is to adopt the organisational approach promoted by Buchanan, North, and Williamson. In terms of the political process “the standard normative approach to policy analysis views this whole process as a social-welfare-maximising black box, exactly as the neoclassical theory of production and supply viewed the firm as a profit-maximising black box. ...Economists studying business and industrial organisation have long recognised the inadequacy of the neoclassical view of the firm and developed richer paradigms and models based on the concepts of various transaction costs” (Dixit 1996, p.9). Dixit therefore suggests that a richer model of the policy forming process should also be based on an analysis of the relevant transaction costs.
Dixit (1996) asks what organisational forms will overcome the monopoly of information held by bureaucrats, the opportunistic behaviour of civil servants, the problem of divided principals, and government-owned asset specificity? He clearly derives his approach from the writings of Oliver Williamson and Douglass North. Dixit identifies transaction costs involved in overcoming the asymmetric distribution of information between parties (signaling and screening costs, costs of monitoring and incentives, auditing costs, and costs of misrepresentation), costs involved in managing agents (monitoring, incentives, and contractual obligations), costs of agents responding to multiple principals (coordination of policies, playing off one principal against another), and costs related to asset specificity (irreversible investments and lack of durability).
Dixit takes the view that the election process creates a contract between the politicians (individuals or parties) or administrators (regulatory agencies etc), and the citizens (individuals or interest group organisations)(op. cit., p.48). The contract is a promise of a policy (or programme) in return for votes (or contributions). Unlike private contracts, such policy contracts are difficult to enforce.
First, political contracts are rarely between two clearly identifiable contractors; they have multiple parties (voters or lobbyists) on at least one side of the relationship. Second, their terms are generally much more vague (unspoken) than those of economic contracts. They leave much room for interpretation, and many loopholes for escape and opportunities to blame third parties or force majeure for failure to deliver (unforseeable course of events excusing from fulfillment of contracts). Thus a promise to cut taxes rarely specifies by how much, and can be rescinded when the budget situation turns out to be much worse than expected. In the electoral contract, the citizens have granted the elected representatives certain powers to collect taxes and make decisions on their behalf, the only safeguards in this process remains the free vote, and if this goes, abuse of power is likely to follow.
A similar approach has been put forward by Horn (1995). He spells out some of the details of the exchange the two parties enter into. His interpretation is also driven by bounded rationality, opportunism, agency theory and transaction costs. He introduces some of the details of the political process and the accompanying transaction costs including the cost of durability or lasting impacts. This is a wider definition of transaction costs than described by Dixit though very consistent with the views of North (1990b).
Horn's transactions approach examines the relationship among three sets of actors with different roles and motivations (op. cit., p.8-10). “Legislators” are the elected representatives who perform both legislative and executive functions. Legislation can only be enacted by an “enacting coalition” of individual legislators - that is, a group of legislators that is large enough to guarantee the passage of a bill into law. Constitutional differences between countries affect such groupings and the solutions they might seek. “Administrators” are appointed rather than elected. They answer to the legislature. Horn assumes that they do not bring policy preferences to their work! “Constituents” conveys the idea of particular groups in society that have a [vested] interest in the policy making process. Constituents enjoy the benefits - or suffer the costs - of legislation, offer support or opposition to legislators, and, ultimately, elect legislators to office. While these stereotypes tend to simplify the complexity of the political/administrative process in any one country, Horn maintains that they are sufficiently general to explain decisions legislators make about the organisation of public administration on a broad front.
The approach focuses on the difficulties political decision makers have in securing continued electoral support on a longer term basis. Legislators are regarded as self-seeking in their use of legislation to increase their net political support and lasting power. Their opportunities are limited by the transaction costs of achieving agreement on their proposals. These are the time and effort it takes to reach agreement on legislative refinements and any time and effort that affected private interests have to subsequently devote to participating in implementation and administration; political uncertainty that the legislation will last; uncertainty that the legislation will be administered as intended; and, uncertainty about the distribution of private benefits and costs (op. cit., p.13). If such relationships are regarded as the hazards of the “exchange” between the respective actors, then they are generically similar to Williamson's “far-sighted but incomplete contracting” (1996, p.10).
The elected/political appointees who are most likely to remain in power are those who are most successful in overcoming these transaction problems, such as those who are best able to reassure their supporters that the benefits of legislation will not be lost to administrators in implementation, or undone by subsequent legislatures (op. cit., p.14). Successful implementation will depend on administrative agents who do not necessarily share the objectives of the enacting coalition and its constituents; these divergences create transaction costs to do with monitoring the performance of such agents and devising a system of rewards and sanctions that improve performance. There is no reference to asset specificity in this version of the model though government administrations are likely to depend on labour specificity in the administrative staff. Wiiliamson (1999, pp.322, 339) notes that asset specificity is negligible in most public sector departments but human assets in many public bureaucracies involve considerable specificity (e.g. nontransferable training and social conditioning).
Furthermore, the amount of net electoral support legislators receive from promoting a piece of legislation depends on the net flow of costs and benefits that private interests expect it to generate over time. Implementation bears on this calculus because private interests are sufficiently forward looking to anticipate how decisions on implementation will affect the flow of benefits and costs. Political support will cease unless they are well pleased (over time).
Horn's model supplements Dixit's model and brings back the broader concepts of public choice into main focus. The uncertainties identified by Dixit (information asymmetry, monitoring of agents, and opportunism) create costs in the political process that have to be overcome if lasting control of the political side of government is to be achieved. The model posits that the endeavours of the legislators/politicians will continuously be directed to their own survival. This will be achieved by paying greater attention to the wishes of their supporters in a longer term framework. One term of office is never sufficient.
Now in some sense, these endeavours can be regarded as an optimal arrangement of the nation's affairs. The model posits that effective public administration requires that the transaction costs be minimised in determining and pursuing society's goals (Zeckhauser 1995). There will be pressure from constituents to find least cost solutions to the problems of the day. There will be limits on the revenue and challenges from alternative expenditure items including government programmes. Debate and bargaining will tend toward least cost solutions. North has finally come home!
The outstanding advantage of these formulations is that they get closer to the political decision making process and enable us to mimic how decisions are actually reached in the real world and thus to better understand how they come about. In addition better understanding of the political decision making process allows us to better understand the problems of policy implementation and assessment.
The test of a pudding is in the eating. Or, as Williamson (2000) asks, what are the mechanisms through which a proposed theory operates and what are the refutable implications? I have not collected the evidence on private sector responses to the theory; indeed one might say that in this case the theory merely serves to describe something which has already taken place. In the public sector, the reverse is true. The public sector is a decision system driven by political survival and winning votes. Part of the electoral success or not is expressed through measures which please constituents including cost cutting and reduced taxes. In the 1980s and 1990s it is the thrust of cost cutting and the search for efficiencies in the delivery of public policy that has seen institutional reform invoked.
In the field of agricultural economics this has largely been expressed through smaller budgets for departments of agriculture, withdrawal of funds from research and extension, and increased emphasis on user pays. There have many examples spread all over the world, especially in western English speaking countries and also in Eastern Europe. Not all are reported. Box 1 shows some of the literatures in agricultural economics that I have noted in preparing my IAAE paper on the subject (Johnson 2000).
The government reforms in New Zealand in the 1980s have been quoted as examples of the NIE at work. According to Boston et. al. (1996), government advice from the Treasury department was structured around the NIE particularly regarding governance structure and institutional choice. The Treasury view was that most government departments lacked clear, consistent objectives but also that the existing structures tended to generate `provider capture' and interorganisational conflict. Accordingly, the Treasury placed emphasis on minimising transaction costs and agency costs, avoiding dual or multiple accountabilities, minimising the risks of provider capture, and distancing Ministers from decisions of an operational nature. It also extolled the virtues of contestibility (or multi-source supply), transparency (e.g. of organisational objectives, public subsidies and desired governmental outcomes), competitive neutrality (e.g. between public and private suppliers), and the institutional separation of potentially conflicting objectives (such as ownership and purchase interests).
I stress that this was the advice offered to the government of the day. As Williamson himself notes (2000, p.3), this particular set of advice was adopted by the government in a brief period between July 1984 and November 1987. That is, the institutional philosophy offered was acceptable to the political decision makers (or a majority of them) possibly because it suited a particular political agenda as much as it was based on its intrinsic worth. My own feeling is that fiscal pressure is seldom absent from government programmes and that savings in one quarter can be used to finance advances somewhere else. “Fiscal bureaucrats afraid of rising fiscal deficits and public debt sought to control what they saw as rent seeking behaviour and agent abuse of principals in the public sector. They argued these changes would reduce incentives for collective rent seeking behaviour and prevent shirking. Fiscal bureaucrats thus sought to control future behaviour in the public sector by changing the incentive structures workers and agency managers faced” (Schwartz 1996).
In the area of institutional responsibilities there was a preference for divided over inclusive responsibility (i.e. the separation of policy and operations, the separation of funder, purchaser and provider, the separation of operations and regulation, the separation of provision and review/audit, the separation of commercial and non-commercial, and the separation of responsibilities for monitoring the Crown's ownership interests and its purchase interests)(op. cit. p.81). According to Boston et al,
the formal institutional separation of policy and operations (and, where relevant, the separation of funder, purchaser and provider roles) was implemented to the greater extent in defence, environmental administration, health care, housing, justice and scientific research than in areas like labour, police, and social welfare. The strictist application of the functional model is the area of scientific research (See Box 1). There was a formal split between the roles of funder, purchaser and provider; the Ministry of Research, Science and Technology became a single purpose policy ministry, while the Foundation for Research, Science and Technology was created to purchase scientific research via a competitive bidding process from a series of Crown Research Institutes (CRIs), tertiary educational institutions, and private providers and monitors the performance of the providers. The monitoring of the Crown's ownership interest in the CRIs is carried out by the Crown Company Monitoring Advisory Unit (CCMAU), another government advisory agency formed to monitor State Owned Enterprises (SOEs).
Within the Agriculture Ministry, a series of reforms in the 1980s took place which introduced charging for inspection services (particularly meat inspection), the separation of extension services (later sold to private enterprise), the separation of research services (into CRIs), and most recently, the separation of quality assurance services into independent supervisory agencies.(Johnson 1994). In theory, the complete separation and privatisation of policy services was considered but not pursued (Storey 1996).
In Australia, there have been fundamental changes in the organisation of research and extension services (Marsh and Pannell 2000). “Government agencies, including agricultural agencies, are increasingly being asked to reconsider whether their activities are consistent with the objective of economic efficiency. To satisfy this goal, an activity must address an area of market failure, including public goods (i.e. non-rival goods or non-price-excludable goods), externalities (at least those involving public-good characteristics), and other information-related market failures (uncertainty, ignorance, misinformation).”
The market failure test must take into account the costs of intervention including compensation for uncertain outcomes. “If it is possible to identify a case of market failure that is sufficiently strong to outweigh costs of acting and the risk of government failure, then a case exists for government intervention on efficiency grounds” (Marsh and Pannell, op.cit.). This approach is thus consistent with an institutional approach although the authors do not explicitly make the connection.
In common with New Zealand, the reforms have emphasised the separation of funding and execution of government services. “...the Funder-Purchaser-Provider system, and other new institutional arrangements, seem certain to reduce the direct contact between farmers and public sector researchers”. Furthermore “...the system [FPP] is fraught with very substantial transaction costs”. The alternative of encouraging local voluntary groups to come together, such as Landcare, is assessed and found wanting. “The increased Landcare focus means the government is investing in areas where short- or medium-term economic returns are likely to be less than if they had invested directly in technology transfer for productivity-raising innovations”.
In institutional terms, the neoclassical model is very restricted if one takes seriously the definition of transaction costs. A zero-transaction cost entity would be very rare. North has noted the nearest competitive models that could approach this state. The answer is fairly simple; the net gain calculus must take account of all the costs involved in any evaluation involving amalgamation of firms, integration of units, monitoring of agents, and overcoming knowledge deficiencies. Sometimes a better position can be identified. Sometimes this will involve institutional choices modeled on the NIE.
Nevertheless the NIE model has been used to orchestrate government organisational reforms in many countries. There has been a political willingness to embrace the advice given by bureaucratic reformers. It is suggested that this acceptance could well be related to political desires to change direction in budget matters and that organisational change is a convenient excuse to allocate resources in new directions.
In the private sector, the NIE explains a number of organisational conundrums that occur. Among them are vertical and horizontal integration, hierarchical command structures, monitoring of suppliers, and principal-agent failures. These examples are solutions found by private agents in the market place and are not built on theoretical structures invented by economists. The NIE merely serves to explain the mutual solutions found by private actors in everyday commerce. We should remain aware of these distinctions.
The models posited by Horn and Dixit provide a very useful framework for analysing the transaction costs involved in political decision-making and organisational relationships in government administration. The evaluation of past policy decisions, and the formulation of new policy positions can be suitably based on such an institutional framework.
Boston, J., Martin J., Pallot, J. and Walsh, P. (1996), Public Management: the New Zealand Model, Oxford University Press, Auckland.
Buchanan, J.M. (1975), A Contractarian Paradigm for Applying Economic Theory, American Economic Review 65(2), 225-230.
Buchanan, J.M. (1987), The Constitution of Economic Policy, American Economic Review 77(3), 243-250 (quoted by Pasour 1993).
Buchanan, J.M. (1989), Explorations into Constitutional Economics, R.D.Tollison and V.J. Vanberg (eds), College Station, Texas A & M University Press (quoted by Pasour 1993).
Coase, R. H. (1960), The Problem of Social Cost, Journal of Law and Economics 3, 1-44 (quoted by North 1990).
Coase, R. H. (1988), The Firm, The Market and the Law, Chicago, The University of Chicago Press (quoted by Pasour 1993).
Davis, L.E., and North, D.C. (1971), Institutional Change and American Economic Growth, Cambridge: Cambridge University Press.
Dixit, A. K.(1996), The Making of Economic Policy: A Transaction-Cost Politics Perspective, MIT Press, Cambridge, Massachusetts.
Haebig, M., Johnson, R., Rossmiller, E., Sandiford-Rossmiller, F., Urban, K., and Williams, R. (1998), The Changing Environment for Agricultural Policy Implementation, paper presented to Annual Conference of the Agricultural Economics Society, University of Reading.
Horn, M. (1995), The Political Economy of Public Administration, New York, Cambridge University Press.
Hubbard, M. (1995), The ‘new public management’ and the reform of public services to agriculture in adjusting economies: the role of contracting, Food Policy 20, 529-536.
Johnson, D.B. (1991), Public Choice: An Introduction to the New Political Economy, Bristlecone Books, California.
Johnson, R.W.M. (1994), The National Interest, Westminster, and Public Choice, Australian Journal of Agricultural Economics 38, 1-30.
Johnson, R.W.M. (1999), The Role of Political and Economic Institutions in Rural Strategy, Formulation and Implementation, World Bank (http://WBLN0018.worldbank.org/trade/decagridoc.nsf/referencedocuments).
Johnson, R.W.M. (2000), The Role of Institutions in Policy Formation and Delivery, Invited Plenary paper, XXIV Conference of the International Association of Agricultural Economists, Berlin.
Leonard, D.K. (1993), Structural Reform of the Veterinary Profession in Africa and the New Institutional Economics, Development and Change 24, 227-267.
Leonard, D.K., Koma, L.M.P.K., Ly, C., and Woods, P.S.A. (1999), The New Institutional Economics of Privatising Veterinary Services in Africa, Rev. Sci. Tech. Off. Int. Epiz 18(2), 544-561.
Marsh, S.P., and Pannell, D.J. (2000), Agricultural Extension Policy in Australia: the Good, the Bad, and the Misguided, Australian Journal of Agricultural and Resource Economics 44, 573-604.
North, D.C. (1987), Institutions, Transaction Costs and Economic Growth, Economic Inquiry 25, 419-428.
North, D.C. (1990a), Institutions, Institutional Change and Economic Performance, Cambridge University Press.
North, D.C. (1990b), A Transaction Cost Theory of Politics, Journal of Theoretical Politics 2, 355-67.
North, D.C. (1994), Economic Performance Through Time, American Economic Review 84, 359-368.
Pasour, E.C. (1993), Economics and the Public Policy Process: What Can Economists Do?, New Zealand Economic Papers 27, 1-17.
Schwartz, H.M. (1996), Public Choice Theory and Public Choices: Bureaucrats and State, Reorganization in Australia, Denmark, New Zealand, and Sweden in the 1980s, Department of Government and Foreign Affairs, University of Virginia, Charlottesville (http://darwin.clas.virginia.edu/~hms2f/pubchoic.txt).
Simon, H. (1947), Administrative Behaviour, 1st Ed, New York, Macmillan (quoted by Boston et al 1996)
Simon, H. (1957), Administrative Behaviour, 2nd Ed, New York Macmillan (quoted by Williamson 1995).
Storey, G.G. (1996), Investigation on the Implications of Government Reform in New Zealand for Obtaining Economic and Policy Analysis for the Agri-Food Sector, Department of Agricultural Economics, University of Saskatchewan, for Agriculture Canada.
Vernimmen, T., Verbeke, W., and van Huylenbroeck, G. (2000), Transaction cost analysis of outsourcing farm administration by Belgian farmers, European Review of Agricultural Economics 27, 325-345.
Wallis, J.J. and North, D.C. (1986), Measuring the Transaction Sector in the American Economy, in S.L. Engerman and R.E. Gallman, eds, Long-term Factors in American Economic Growth, Chicago, University of Chicago Press.
Williams, R. (1997), The Political Economy of the Common Market in Milk and Dairy Products in the European Union, FAO Economic and Social Development Paper 142, FAO, Rome.
Williamson, O.E. (1985), The Economic Institutions of Capitalism: Firms, Markets, Relational Contracting, New York, Free Press (quoted by Boston et al 1996).
Williamson, O.E. (1995), The Institutions and Governance of Economic Development and Reform, Proceedings of the World Bank Annual Conference on Development Economics 1994, Washington, 171-197.
Williamson, O.E. (1996), The Mechanisms of Governance, New York, Oxford.
Williamson, O.E. (1999), Public and Private Bureaucracies: A Transaction Cost Economics Perspective, Journal of Law, Economics and Organisation 15, 306-342.
Williamson, O.E. (2000), The New Institutional Economics: Taking Stock/Looking Ahead, Invited Paper presented to Annual Conference of the Australian Agricultural and Resource Economics Society, Sydney, January 23-25.
Zeckhauser, R. (1995), Dust Jacket: Horn, M. (1995) The Political Economy of Public Administration, Cambridge University Press.