Markets, Institutions, and Transaction Costs: the Endogeneity of Governance

Geoffrey R.D. Underhill (University of Amsterdam)

Abstract: Much of the literature contrasts the dynamics of free markets with the ‘political’ dynamics of governance. This dichotomy leaves us blind to the empirical observation central to institutional economics: that complex market systems and institutions of governance cannot be found apart. Even as an analytical distinction, binary market-hierarchy distinctions obscure the ways in which interaction among real-world economic agents is constitutive of the wider processes of formal and informal governance that shape the terms of competition in the first place. Institutional economics has explored the relationship between markets and firms, governance institutions and economic performance, and why societies choose inefficient institutions, among other crucial questions in political economy. Yet we have no theory of the precise relationship between market exchange and patterns of governance, nor of how the change in one is related to change in the other. Building on the seminal insights of Coase, this paper theorises how and why economic interactions generate institutions of governance in the first place. Extending the crucial insights of institutional economics, this paper demonstrates in theoretical terms how the interactive utility-maximising behaviour of economic agents generates both formal and informal institutions and processes of governance from regulation to dispute settlement. Conflict and competition in market interaction combined with transaction cost dynamics lead to mutually beneficial co-ordination mechanisms and the emergence of order essential to the continuity of market exchange. Thus the broader patterns of institutionalised co-ordination we characterise as governance are endogenous to the self-interested and rational utility-maximising behaviour of economic agents in a market setting.

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