The Importance of the Alignment of Formal and Informal Institutions in the Dynamics of Aggregation and Behavior. Illustrated by the Example of the Post-Communist Transformation in East and Central Europe.

  1. Introduction

Markets and hierarchies dichotomy (Williamson, 1975) is not useful in capturing the dynamics of aggregation and behaviour. The dichotomy represents two ideal types, which manifest themselves extremely rarely in the real world, however the communist regime in East and Central Europe (ECE) was one of the remarkable occasions when we could witness a nearly pure hierarchy. Additionally, the post-communist transformation is the rare example of a regime change, when countries tried to go from one end of the dichotomy, pure hierarchy, to the other, markets.

The aggregation happens in the following way. Individuals think, decide and act based on the bounded rationality principle (Simon, 1955), they form organizations (Coase, 1937), which act on the behalf of the individuals. The tool to make these arrangements happen, and the whole aggregation process viable, are contracts. Organizations are set of contracts. Beyond these straightforward mechanisms are other forces working to make aggregation from the individual to a national economy happen. These factors are informal rules, what can be debunked into norms, conventions and culture, and formal rules, which are the constitution, laws and their enforcement mechanism like the judiciary system. If formal and informal rules are not aligned in a society, problems arise regarding the explanatory power of the dichotomy. In my example regarding the transformation, introducing market arrangements in the economies of ECE haven’t yielded the results predicted by the markets and hierarchies framework. (Pejovich, 2003, Swatek, 2008, North,1993)

  1. Review of relevant literature

John Commons in his seminal piece (Commons, 1932) argues that what holds together the U.S. system are the well-articulated and reality tested (due to the precedent based law system) laws, which make expectations and consequences straightforward in each type of transactions. He declares that without working rules no one will bargain across time and take risks and markets would not work. Furthermore, Commons writes, that there are additional means of control (moral, economic), which regulate the flow of affairs in case the disputes are not resolved by the judiciary system. Finally, he argues that the laws are based on the ethical assumption of willingness, which as it holds together the economic system of transactions, which we call the market. This willingness in his terms is that in each transaction, which is taking place there is a “willing buyer and a willing seller”. We see that as many things, my argument can also be derived from Commons. The precedent based law system is nothing else than the historical and continuous matching of informal and formal rules in a society to make aggregation seamlessly happen. If there’s a discontinuity in the process of law making, discrepancy will occur between the informal and formal rules.

If we continue to examine the progress of Commons’ legacy and further development of institutional economics we arrive to a view expressed 60 years later by the Nobel laureate Douglass North. North in his Nobel prize lecture (North, 1993) argues the following way: “And economies that adopt the formal rules of another economy will have very different performance characteristics than the first economy because of different informal norms and enforcement. The implication is that transferring the formal political and economic rules of successful western market economies to Third World and Eastern European economies is not a sufficient condition for good economic performance.”

Svetozar Pejovich, an ECE émigré himself, argues that introducing property rights does not create a market equilibrium instantly, “different cultures require different expenditures of time, efforts and resources to bridge the gap between the enactment of private property rights and their eventual acceptance by the prevailing informal rules.” (Pejovich, 2003)

One might ask, how the misalignment of formal and informal rules comes to directly affect aggregation? What’s the transmission mechanism? As I argued before, this is contracting, what makes informal-formal discrepancy travel between the individual, through organizations to the aggregate level. One of the main critiques concerning transaction cost economics (Foss and Klein, 2010) is that contracts can be affected by actor’s (be it an individual or organization) historical choices, yielding suboptimal outcomes. This phenomenon is called governance inseparability (Argyres and Liebeskind, 1999). More precisely, the authors define it as the following: “Governance inseparability – a condition in which a firm’s past governance choices significantly influence the range and types of governance mechanisms that it can adopt in the future.” (Argyres and Liebeskind, 1999).

  1. Framework

In an economy, even in one in transition, ceasing all contractual agreements or organizations making those agreements, and creating a system from scratch, is not an option. Instead of this, obviously unrealistic solution, the transition countries privatized most of their assets. Initially the only change occurred was in the ownership of the firms, which most of time was just a switch between the public and private arms of the same national elite. Also, the worker base of the privatized firms, in most cases, resembled the situation before the regime change. This statement is underpinned by the research made by Brown, Earl and Vakhitov. They examined survey data of the Ukrainian Longitudinal Monitoring Survey, carried out in 2003 in Ukrainian households. The survey measured the workers situation in three points in time 1991, 1997 and 2002. Their findings say that privatization halves the dismissal and professional quit rates, therefore implying that there’s a higher probability that the privatized firms retained their workforce, than those not privatized (Brown, Earl, Vakhitov, 2006). [1]

The situation outlined in the preceding paragraph indicates a hotbed of governance inseparability. Governance inseparability which stems from the discrepancy between informal and formal rules. It’s easy to concede that the only thing changed in 1989, respectively in 1991, were the formal rules of the game.

To summarize my argument in an efficient manner I introduce a framework (Figure 1), which shows which variables are controlled by the markets and hierarchies dichotomy and which are the other factors affecting the dynamics of aggregation.

framework.jpg
Figure 1: Framework to emphasize the additional factors in aggregation

The grey area is the mechanism of markets and hierarchies dichotomy. Aggregation happens there, from the individual through contracts (organizations) to a national level. In theory, if market principle based, voluntary contracting is suddenly allowed and property rights are established in a system characterized by total hierarchy, the shift simply happens, from hierarchy to market. However, the reality is different. The sudden shift becomes a painful and slow transition. The main causes to this are the enduring norms, conventions and culture in a society, the informal rules. Those can’t be changed overnight as the formal rules can. As we see in the framework, there is a high degree of interdependency and reflexivity in the system, which makes the dynamics of aggregation less straightforward. Informal rules are embedded in individuals[2], who either make the formal rules (through representative democracy and as politicians) or try to act according to those formal rules (through contracts).  These formal rules regulate the contracts, which transmit individual behaviour to an aggregate level.

  1. Case study

My point is reinforced by a case study of the Brewery of Nikisch in Montenegro (Pejovich, 2003:355). A foreign investor acquired 70% stake in the firm in the beginning of the 1990s, while the other 30% remained in the ownership of employees and local businessmen. The new owners promised that the real wage will never be lower than at the time of the purchase and also agreed to invest an additional amount of money in the company. All these contractual promises were fulfilled. The problem was that the socialist working discipline endured, but the formal institutional arrangements underpinning it does not. Workers were used to long coffee breaks, subsidized housing and using the company’s assets for private purposes. With the new foreign investor, all this was gone. The formal rules were set in order to further higher productivity, efficiency and make the transition happen. Even though the fulfilled contractual promises and the clear formal rules the employees started to be unsatisfied and the first strike occurred in 2002. The workers aimed to achieve a 35% salary increase, which would make their average salary the double of the country wide average at that time, they also demanded the owners to buy cars for the union office and, among many further claims, they wanted the company to build them subsidized apartments. Clearly, the norms, conventions and culture of the employees was not aligned with the formal rules established on a nation and firm wide level. This is a prime example of governance inseparability. The transaction of employee relations was handled in a given way in the past and difficulties arised when the governance practices started to deteriorate from the historically present manner.  At the end of the year, 2002, the foreign investor decided to move the brewery out of Montenegro. The employee’s response was the following: “They said that new owners didn’t build the factory and, therefore, they have no right to close it down” (Pejovich, 2003: 356). This statement reflects the deep running discrepancy between the informal and formal settings of the polity, the discrepancy, which made a sound, market based business decision bad and terminated many market like, voluntary, formally satisfying contractual agreements. Therefore, resulting in a problematic dynamic of aggregation, which is far less straightforward than going from hierarchy to markets in a sudden shift by introducing property rights and liberalizing markets.

This example is not an isolated one, Pejovich in his paper describes two more and also Swatek (Swatek, 2008) presents a macroeconomic viewpoint on the matter. The general experience of transition countries in ECE is no different from the case of the Brewery of Nikisch. A statement that transition economies are market economies is an ecological fallacy. We have seen that despite market like macro attributes (nationwide property rights, liberalized prices and foreign direct investment) the individual citizens can’t be regarded as market oriented. Instead, they are aligned to the enduring culture of collectivism, egalitarianism and very low level of personal responsibility (Swatek, 2008: 61, Pejovich, 2003:351). The citizens with culture alignments to hierarchy aggregate up to a market economy, but to a peculiarly functioning one. The root of this fallacy is the substantial difference between the described culture and the formal rules in effect.

  1. Conclusion

My argument is that the markets and hierarchies dichotomy fails to account for this kind of transition. It lacks the dynamics of moving from one end to the other, because of complexities in the dynamics of aggregation from the individual level. It is not sufficient to describe a system, which is two-faced, formally closer to the markets, but informally rather still a hierarchy. Behind this lays the framework I outlined. History can’t be neglected, the discrepancy between the informal and formal rules stem from it. This difference affects contractual arrangements, through the mechanism of governance inseparability, which makes the dynamics of aggregation much more difficult to capture with the simple dichotomy of markets and hierarchies.

  1. Sources
  • Williamson, O.E. (1991). “Comparative Economic Organization: The Analysis of Discrete Structural Alternatives.” Administrative Science Quarterly 36(2), pp. 269-296
  • Commons, John R. (1932). “The Problem of Correlating Law, Economics, and Ethics.” Wisconsin Law Review 8/1, 3–26
  • Coase, Ronald (1937), “The Nature of the Firm.” Economica, New Series, vol. 4/16, 386-405
  • Geoffrey Underhill (2016). “Markets Institutions, and Governance: the Endogeneity of
    ” paper for SASE annual conference, Berkeley California
  • North, Wallis and Weingast (2009). “Violence and Social Order: A Conceptual Framework for Interpreting Recorded Human History”, Cambridge University Press, chapters 1.-3.
  • Adam Smith (1759). Excerpts from The Theory of Moral Sentiments in R. Heilbroner (1987) The Essential Adam Smith (Norton & Co.), pp. 65-77
  • R.D. Underhill (2017). Seminar slides for “Specialization Course: Political Economy”
  • James Buchanan & Gordon Tullock (1962). The Calculus of Consent (University of Michigan Press), Intro. chs. 1-6
  • Herbert Simon (1955). “A Behavioural Model of Rational Choice” in The Quarterly Journal of Economics, vol. 69/1 (February), pp. 99-118
  • Douglass North (1991). “Institutions.” in Journal of Economic Perspectives” vol. 5/1 (Winter), 97-112
  • Reading blogs written by me throughout the Specialization Course: Political Economy
  • Williamson, O.E. (2007). “Transaction Cost Economics: An Introduction”, Discussion paper, University of California, Berkeley
  • Williamson, O.E. (1975). “Markets and Hierarchies: A Study in the Economics of Internal Organization”, The Free Press, Collier Macmillan Publishers, London, chapters 1.-3.
  • Foss, N. J. and Klein, P.G. (2010). “Critiques of Transaction Cost Economics: An Overview”, The Elgar Companion to Transaction Cost Economics, 2010, Edward Elgar Publishing, chapter 25.
  • Swatek, M. (2008). “Transformation of Central and Eastern European Countries from the Perspective of New Institutional Economics”, Ekonomika, pp. 54-62
  • North, D. (1993). “Economic Performance through Time”, Nobel Prize Lecture
  • Argyres, N. S. and Liebeskind, J. P. (1999). “Contractual Commitments, Bargaining Power, and Governance Inseparability: Incorporating History into Transaction Cost Theory”, The Academy of Management Review, 24. No. 1, pp. 49-63
  • Hayek, F.A. (1948). “Economics and Knowledge”, Individualism and Economic Order, The University of Chicago Press, pp. 33-56
  • Boland, L.A. (1979). “Knowledge and the Role of Institutions in Economic Theory”, Journal of Economic Issues, XIII. No. 4., pp. 954-972
  • Pejovich, S. (2003). “Understanding the Transaction Costs of Transition: It’s the Culture, Stupid”, The Review of Austrian Economics, 16:4, 347-361
  • Brown J.D., Earle J.S, Vakhitov V. (2006). “Wages, Layoffs, and Privatization: Evidence from Ukraine”, Journal of Comparative Economics 34(2), June 2006, pp. 272-294

 Websites

Notes

[1] Brown, Earl and Vakhitov’s argument is the following: „The results of the separations analysis suggest that privatization reduces worker separations of all types, halving the dismissal and professional quit rates. Wage levels are also reduced by about 5 percent, however. Workers in worker-controlled firms have suffered large wage losses, while those in outsider-controlled firms may have enjoyed wage gains. A possible explanation for this pattern could be that worker-controlled firms have not seen substantial efficiency gains, necessitating labor cost cuts. Workers have chosen to accept lower wages in exchange for continued employment. In contrast, workers in outsider-controlled firms need not make such an unpleasant trade, as the firms may have expanded their scales, making cuts in labor costs unnecessary.” (Brown, Earl, Vakhitov, 2006:23)

[2] I regard this a Smithian proposition, based on how we interpreted the notion of sympathy in class. “The notion what is to be ourselves is socially constructed itself. Our moral fibre and our judgments are built up empirically through constant interaction with each other in society.” (Underhill, SMPE 1st class, 2017/09, and Adam Smith, “The Theory of Moral Sentiments, 1759)

Advertisements

Reading Blog 7: Trade and Migration: Cost, Benefits and the Rules of the Global Game

This week’s pieces touched on the fundamental issue of moving of goods, capital and humans. How to ensure, or to ensure at all, the movement of these factors? This question can be clearly linked to development.

The basic, underlying idea of the article written by Estevez-Abe, Iversen and Soskice is that we should regard humans as rational agents who evaluate the returns of their investments in themselves (education and skills), before making them. This closely corresponds with Pritchett’s view of the human being. He argues, the fact that “we prevent people from moving their human capital for higher returns but allow them to invest their physical and monetary capital elsewhere creates perverse incentives”. (Pritchett, 2006) If we add the “new trade theory” to the equation by Paul Krugman, which states that: “Increasing returns provide an incentive to concentrate production of any one product in a single location, given this incentive to concentrate, transport costs are minimized by choosing a location close to the largest market, and this location then exports to other markets.” (Krugman, 2008), we easily conclude why development is not a piece of cake. To plainly state, people tend maximize their skills to enhance their returns, if those returns can’t be reaped at home (production is concentrated elsewhere), then they wish to move to attain higher returns, but movement is restricted. To solve the problem, we should let people move freely, which is politically contestable in most receiving countries, or establish production at emerging countries where individual returns can be reaped.

Realizing the importance of the problem, Pritchett outlines a solution package, which is in his opinion is both politically acceptable and development-friendly. But admits that the details, which are about to be developed are where the devil resides.

On the other hand, Hoekman and Kostecki’s piece aims to describe the existing solution we have for the other part of the story (trade and industry policy). They state that openness, and most importantly the depth of that, is what leads to economic growth (in my argument to the individual’s rent realization at home). However, they also state that it’s a complicated issue, with almost more constraining factors than dynamics working in favour of that. But they emphasize one important point, which leads back to many of our past readings, the rules of the game of global trade. They argue that rules should be laid in order to provide legal security and property rights in the system. Therefore WTO, which can be seen as a mechanism for exchanging trade commitments and also as a code of conduct, is a necessary, and constantly evolving, institution for development. Furthermore, the five basic principles of WTO serve as an insurance for participants than no member will take advantage of the other in the system, and no strong country will exploit others, which is essential to make development happen.

While the global rules of the game regarding trade are set, the same should be done for migration, the other way of individual return maximization. However, other rules of the game are in play, which are the rules of the home labour markets of countries. Based on Estevez-Abe, Iversen and Soskice it’s possible to argue that these are endogenous to the former two in a globalized economy. Since the welfare production regime in a country is conditional on the median voter, which are those who are most favoured by the system in place. As we know trade liberalization always has winners and losers, just as migration, as well. For instance, if unskilled labour is let to flow freely in a country of general skill orientation wage inequalities will emerge and the skilled middle-class is becoming the favoured, therefore the median voter, determining further political outcomes.

As we see there’s a high degree of interdependence between the global regime of trade, migration and the welfare production regime in a given country, but it’s important to see that the interplay of these will either make or break development in emerging markets.

Sources:

  • Paul Krugman – Prize Lecture, 2008
  • Estevez-Abe, Iversen, Soskice – Social Protection and the Formation of Skills: a Reinterpretation of the Welfar State, 2001
  • Hoekman and Kostecki – The Global Trading System, 2001
  • Lance Pritchett – Accomodating Forces and Ideas to Achieve Development-Friendly Labor Mobility, 2006

Reading Blog 6: Labour Market, Human Capital and Economic Competitiveness

To this point we aimed to gain, mostly theoretical, knowledge and formulate a view about what the market exactly is, and how it works. As I understand, now, armoured with this new body of knowledge, we take on the parts of the system. The first one is the labour market. My thoughts about the labour market, before I read the pieces, were quite straightforward. Market solves it all, rigidities and distortions are bad for efficiency, growth and employment. Needless to say, my view has been challenged.

Baldwin and Wyplosz presented the basics, the labour market economics 101. But one of their points is exceptionally important: “Labour markets are very special, people’s time, talent and effort is what exchanged, which are not standard goods.” (Baldwin, Wyplosz, 2009). This view is substantially and explicitly reflected in the humanist pieces of Kwon Dae-Bong and Amartya Sen. While Sen is more theoretical and philosophical about the question, differentiating between the human capital and human capability, and tracing back his analysis to Adam Smith’s work.  On the other hand, Kwon Dae-Bong’s is more operational and practical, but builds on the same, not so, underlying argument that humans are not mere factors of production, but strive to live lives they have reason to value. Both authors emphasize the importance of broader organizations and institutions (education, healthcare), in addition to economic growth to develop human capability, and therefore to live a fuller, freer life. An interesting picture emerges here from the arguments. If we consider what Sen writes: “Human beings are not merely means of production but also the end of the exercise.” (Sen, 1997), we realize that the system is interdependent. This interdependence is present not just between the narrow notion of human capital and economic growth, but in the broader sense between human capability and institutions/organizations and consequently between the social order. By getting back to the cited statement from Baldwin and Wyplosz, we understand, that this interdependent complexity is what makes the labour markets very special.

While the previous paragraph, in this reading blog, concerns an attribute of the labour market, and the questions, what is the labour markets main purpose and why is it complex. This paragraph, and the last two pieces by Kuttner and Freeman aim to tackle the issue that how should it be governed. Trying to answer the how question results in the authors discussing more specific labour market institutions, rather than the broad societal ones (education, healthcare).

Kuttner argues, in a more ideologically laden, but scientific way, that full employment is a desirable, but in today’s world not necessarily attainable, goal for a society. He argues that welfare capitalists got the whole picture wrong when they assumed that it’s possible to put together a system without full employment, which will be just and equal. So, his conclusion is that a welfare state with full employment solves the centuries old dilemma of equality or efficiency, which inarguably has to be solved. Through this view he establishes a strong relation to Keynes, Sen and the second paragraph of this writing.

Freemans more evidence based approach yields a less radical answer to the how question. Based on a methodological study of the literature on the matter, he argues that labour market institutions do have distributional effect. The country with more labour market institutions has higher income equality. On the other hand, he argues that the presence of labour market institutions can’t be directly linked to the aggregate performance of the economy.

In conclusion, my view has changed. Now I see the labour market as a more complex and interdependent system, where the market approach should not be trivial and where the labour market and broader societal institutions are key to a great performance. By great performance I mean economic growth and well-being of citizens.

Sources:

  • Baldwin and Wyplosz – The Economics of the European Integration, 2009
  • Dae Bong Kwon – Human Capital and its Measurement, 2009
  • Amartya Sen – Editorial: Human Capital and Human Capability, 1997
  • Robert Kuttner – The Economic Illusion: False Choices between Prosperity and Social Justice, 1984
  • R. Freeman – Labor Market Institutions around the World, 2007

 

Reading Blog 5: Development, Economic Openness and Democracy

I just need to press again what I wrote in the previous reading blog that everything starts to culminate in a coherent understanding of how markets function. However, the first two readings for this class present the phenomenon more from a macroeconomic and historical point of view, while the solid theoretical microeconomic/collective action foundations are underlying each piece.

Charles Tilly argues, with brilliance and sometimes considerable wit, based on the European history, that war making, state making and capital accumulation are mutually reinforcing processes. Additionally, he argues that the size of the government is the function of the effort devoted to extraction, state making, protection and war making. In general, his argument favours Underhill’s proposition that governance is endogenous to the markets, but Tilly’s theory adds another layer, the role of violence and wars in this process.

The second reading (North, Wallis and Weingast, 2009) goes on with elaborating on the role of violence in the making of social orders, and in a broader sense on the different developmental trajectories of countries. North et al differentiates three social orders, the foraging order, the natural state and the open access order. Their main proposition is that the open access order has several institutional characteristics, which favour growth and welfare. They argue that open access order societies have not just the most developed economic apparatus and highest degree of welfare, but also the most articulate and democratic political institutions, therefore political and economic development is closely interrelated. They argue that in order to attain this degree of development violence has to be curbed, which is done through institutions, which embody the rules of the game. The goal of these institutions is to support complicated and sophisticated contractual organizations, both inside and outside the state, therefore control violence. Development is the function of the number and sophistication of these organizations and institutions. But it’s important to note that this process is not teleological, the internal dynamics of elites, can yield multiple equilibria and create a constant instability. This point is vividly illustrated in the third chapter, that even Britain lingered back and forth between the different developmental stages.  The book’ underlying argument intersects and builds on the insight of Buchanan, that individual act the same, but outcomes are determined by the institutional framework. The proposition that rent-seeking is a natural behaviour, present in all systems, but institutions can tame it and make it beneficial to the society. Implicitly arguing that the inherent logic of markets does not make a country more developed, institutions are needed to make it happen.

Brousseaue and Glachant also underpin what has been said before, that markets need institutions and they are closely interrelated, but from the microeconomic point of view. They argue that markets are manufactured, therefore imperfect, before they are made by humans (who are boundedly rational), therefore they need governance. But on the other hand governance is also imperfect due to the short-sightedness of collective action. Based on this they argue that market as a system is difficult to and is rarely the result of an optimization process.

In the last piece, the great A. O. Hirschman revisits exit and voice. The main argument related to our inquiry is on the end of the third essay. He argues that public goods increase loyalty in a society, and understood complexity is the ultimate factor preventing exit. So, he implicitly argues that a developed institutional framework and a historically developed social order in a society can serve to prevent one from “voting with his feet”. This also corresponds to the conclusions of the other three readings, institutions are key in the success of a society.

Sources:

  • Charles Tilly – War-making and State-making as Organized Crime, 1985
  • North, Wallis and Weingast – Violence and Social Order, 2009
  • Brousseau and Glachant – Introduction: Manufacturing Markets – what it means and why it matters, 2014
  • Hirschmann – Around Exit, Voice and Loyalty, 1981

Reading Blog 4: Diversity and Market Integration

The whole literature of this seminar builds on the observation of Adam Smith that economic agents sometimes stick together to “widen the market and narrow the competition”. This motive is also present at Fligstein (Fligstein, 2001), when he argues that the goal of entrepreneurs is not profit maximization but survival, which implies the pursuing of stability, which results in continuous efforts to attain a monopolistic position on the market. I think the starting point of this argument is arguable since the underlying motivation to pursue stability is profit maximization. If the firm is profitable in a stable manner for a longer period, it constitutes to the overall return to the entrepreneur, therefore a stable environment serves profit maximization. However, this argument does not change the fact that economic agents aim to become monopolists, the sole players on the market.

The previous readings and this seminar’s papers (Tullock, 1967, Krueger 1974 and Peltzman 1989) culminate in Underhill’s beautiful paper as a big picture and interdependent model of how markets work.

In the first reading Gordon Tullock argues that tariffs, thefts and monopoly have additional welfare costs to those observed in the classic analysis of welfare effects (Harberger’s triangle). The paper not just urged me to rethink my bicycle lock buying habits, but additionally refined the picture why such behaviour (monopolies and cartels) outlined by Smith and Fligstein should be overcome more efficiently by means of control. Plainly stated, Tullock made it clear why a “Third Order” (Underhill, 2016) of governance is needed.

Krueger’s argument is similar to Tullocks, she deals with the welfare costs of competitive rent-seeking in the case of import licenses. Both authors arguing in favour of free trade or the correct type of policies (Third order governance). But pure, neo-classical free trade is something, which slowly has become overly simplistic, unrealistic and not sufficient as an answer. It lacks institutions, the essential manner of those is proven in the following paragraphs.

Peltzman’s overview and update of the economic theory of regulation offers valuable insights into why regulations emerge (or disappear). We should consider three of Peltzman’s arguments, one is, which comes from Olson (Olson, 1982), that “Compact, well-organized groups will tend to benefit more from regulation than broad, diffuse groups.” (Peltzman, 1989), the other is that incumbents favour regulation until the point it favours them, and the third is that regulation usually emerges as an answer to a crisis.

Since Coase we know that due to transaction costs being greater than 0, free market yields two co-ordination mechanisms, and therefore the emergence of firms. From Smith and Fligstein we know that once firms are in the system they aim to become monopolists. Additionally, from Buchanan we know that acting this way is not that straightforward, since some goods can be attained only in partnership with other economic agents (Buchanan, 1965). Adding all this together we arrive at Underhill’s theory, which states that “Governance is endogenous to the self-interested and rational utility-maximising behaviour of economic agents.” (Underhill, 2016).

All in all, I must say that this the point when everything starts to make a truly interconnected and coherent sense. The fragments were put together in these readings perfectly to make a theory of markets and society going from micro to macro and back.

Sources:

  • Gordon Tullock – The Welfare Costs of Tariffs, Monopolies and Theft, 1967
  • Anne Krueger – The Political Economy of the Rent-Seeking Society, 1974
  • Sam Peltzman – The Economic Theory of Regulation after Decade of Deregulation, 1989
  • Geoffrey Underhill – Markets Institutions, and Governance: the Endogeneity of Governance, 2016

Why I do what I do?

As a business bachelor and a business oriented person why I am pursuing an Msc. in Political Economy?

  • It is interesting and intellectually challenging, I think it’s quite an important criterion regarding one’s studies.
  • It teaches you to think. To think independently, critically and in a structured way about anything in the World.
  • Throughout my business administration bachelor studies, internships and the year I spent in the investment banking industry I had to realize that businesses don’t exist in a vacuum. I want to understand what’s outside the firm and the industry, make a step beyond Michael Porter’s beautiful frameworks, the discounted cash flow model and the trading comparable valuations. I believe it’s essential to understand the broader working environment of a firm to be able to navigate and make sense of a business organization in a successful manner.

After finishing my graduate studies, armed with plethora of new knowledge, I plan to return to the world of business, most preferably investments (venture capital & private equity) and NOT plan to pursue any career in politics or international relations. If you think I could add value to your company please do not hesitate to hit me up with a message here in LinkedIn.

A nyugat és mi

Életemben először történt meg velem, hogy valaki be akarta nekem magyarázni, hogy a kommunizmus működik. És most nem „az ötlet szép, de a megvalósítás el lett rontva” típusú szólamokra gondolok, hanem arra, amikor valaki hithűen, csillogó szemmel érvel amellett, hogy a kommunizmus az egyetlen megoldás az emberiség problémáira. Ami pedig a leginkább meglepett, hogy mindezt vitathatatlan társadalomtudományi képzettsége ellenére mondta.

A vita közben, mivel a pengeváltás tempójától köpni nyelni nem tudtam, csak a piaci rendszer melletti érveken gondolkodtam, és igyekeztem megtalálni a réseket a másik logikájában. Eszembe jutott Hayek elegáns érvelése a tudás szétaprózodottságával kapcsolatban, az empíria területén maradva pedig a hasonló rendszerek kudarca (Kuba, Venezuela), vagy épp a Szovjetunió tündöklése és bukása.

Meggyőzni természetesen nem tudtam, ő sem engem. Ennek kapcsán felmerül a kérdés, vajon miért ennyire meglepő számomra egy ilyen vélemény, és hogy miért nem voltunk meggyőzhetőek?

 

A válasz a háttérben keresendő, több szinten. Én közgazdaságtant tanultam és üzleti tanulmányokat folytattam, vitapartnerem politológiát. Én a racionális döntések, hasznossági függvények, profitmaximalizálás és Michael Porter szellemében pallérozódtam, míg ő a demokrácia, igazságosság, nemzetközi lobbi és a választási rendszer bűvkörében. Nézeteink szöges ellentétét magyarázhatná akár ez a tanulmányokbeli különbség is, valamilyen szinten talán magyarázza is, de biztos vagyok benne, hogy nem kizárólagosan. Voltak már vitáim politológusokkal, de sosem ilyen jellegűek. Inkább arról szóltak, hogy az ember hogy dönt, egy politikust mi motivál, az állam allokálja-e a javakat vagy sem, de sosem jutottunk el odáig, hogy bárki is a kommunizmus mellett érvelt volna. Valamennyien közép-kelet európaiak voltak, jelenlegi vitapartnerem viszont francia.

A háttér következő eleme tehát az ember származása. Mi, Közép-Kelet Európában úgy nőttünk fel, hogy számunkra a kommunizmus egy szitokszóval ért fel, hasonlóan ahhoz, amikor egy németnek a nemzeti szocializmus vívmányait bizonygatják. A mi olvasatunkban a kommunizmus maga a mészárlás, rablás, elnyomás és minden, amit az ember nem akar. Mi ezt tanultuk nagyszüleinktől, szüleinktől, a történelemkönyvekből és ezt sugallta a mindennapi politika retorikája is. Egy közép-kelet európai zsigeri undort, elutasítást és némi dohszagú nosztalgiát érez, ha ezzel a fogalommal találja szemben magát.

Szerintünk Franciaország maga a felvilágosodás, Napóleon, de Gaulle, a jólét, sajtok, borok és persze az észak-afrikai bevándorlók. És a franciák szerint? Egy nagy, etatista állam, ahol magas a redisztribúció, mégis nagyok az egyenlőtlenségek. Viszont vegyük észre, hogy ez egy gondoskodó, és nem egy ragadozó állam képe. Amikor egy francia azt mondja, hogy egy adott jövedelem fölött 75%-os személyi jövedelemadót kell kivetni, arra gondol, hogy az államnál jobb kezekben lesz a pénz, mint egy magánembernél, mivel ezzel a Robin Hood-i transzferrel biztosítani lehet az elharapódzó egyenlőtlenség ellenpólusát. Nehéz belekötni, mégis, közép-kelet európaiként teljesen egyértelmű, hol az érv gyenge pontja. Még hogy az állam jobban bánik a pénzzel? Nem lopja el? Nos, a mi régiónkban még nem találkoztam olyan emberrel, akinek nem egy korrupt államkép élne a fejében. Megint csak elmondatjuk, hogy nagyszüleinktől, szüleinktől, a hírekből és a mindennapi diskurzusból ezt tanultuk meg. Az állam lop, az állam nem átlátható, nem hatékony és nem elszámoltatható.

Lépjünk egyet hátra. Csak Franciaország olyan, amilyennek leírtam? Csak ott nagyok az egyenlőtlenségek a magas újraelosztás és évszázados kapitalizmus ellenére? Csak ott él gondoskodó, elszámoltatható és (relatíve) hatékony állam képe az emberekben? Mivel a vitában két német, egy skót és egy holland is részt vett, állíthatom, hogy nem. Egyszerűen Nyugat-Európa így vélekedik önmagáról. Ennek fényében, hogy is várhatnánk, hogy valaki megértse a meglepettségünket, amikor felmerül a kommunizmus, mint alternatíva? Vagy esetleg az állami szerepvállalás növelésével szembeni frusztrációnkat?

Mivel ennyire markánsan más kontextuális hatások értek minket, közép-kelet európaiakat a történelem során, ezért csak nagyon kis valószínűséggel történhet meg az, hogy egy, a nyugati kultúrkörben szocializálódott ember teljes mértékben megértsen minket. Viszont fontos észrevennünk, hogy ezen csak egy dolog változtathat: ha nyitottak vagyunk. A nyugati kontextuális ignoranciát csak a mi, háttérhatásokat kiiktató nyitottságunk tudja áthidalni.

Reading Blog 3: Market Exchange and the Emergence of Firms

The article by John R. Commons contains several stellar points, but here I’d like to focus on the underlying logic in the article. At first he defines the universal unit of activity in society, which represents conflict of interest, mutual dependency and security of expectations, which is the transaction. He argues that what holds together the system are the well-articulated and reality tested (due to the precedent based law system) laws, which make expectations and consequences straightforward in each type of transactions. Furthermore Commons writes, that there are additional means of control (moral, economic), which regulate the flow of affairs in case the disputes are not resolved by the state. Finally, he argues that the laws are based on the ethical assumption of willingness, which as it holds together the economic system of transactions, which we call the market. This willingness in his terms is that in each transaction, which is taking place there’s a “willing buyer and a willing seller” (Commons, 1933).


Building on transactions, Coase raises the essential question why are there two forms of coordination in the system (managerial and price)? Coase brings an argument based on transaction costs and uncertainty to theoretically prove the existence of the firm in the economic system. He argues that a firm emerges due to the savings in transactions costs. In his words “
The operation of a market costs something and by forming an organisation and allowing some authority (an ” entrepreneur “) to direct the resources, certain marketing costs are saved.” (Coase, 1937) At the later part in the paper he elaborates on the entrepreneur, arguing that his art is to navigate in uncertainty (to forecast) and then based on the forecasts to rearrange the means of production in the firm.


In this brief, 4 page long essay, Buchanan summarizes his main points regarding the mechanics of collective choice. Argues that the same individual is making the choice in the market and in the political environment, while the observable differences come from the different institutional settings. Therefore implicitly argues that institutional settings alter rational choice. Based on this it’s easy to concede that setting the sufficient rules is vital in any environment, since it is what clearly determines outcome.


Williamson aims to establish a connection between institutional environment and the forms of institutional governance (market, hybrid, hierarchy), by arguing that the environment is the locus of shift parameters (Williamson, 1991). The paper is the continuation of the transaction cost tradition, however reaches a different conclusion. While at Commons the willing participants of a transaction are the one shaping the institutions (through precedents), and at Coase the entrepreneurs interpretation of uncertainty was the determinant, Williamson’s point is exactlythe opposite.


Fligstein’s central argument is that economic growth is dependent on social factors (governments, institutions). The underlying, political-cultural logic of the argument is the field theory. Fields contain collective actors who try to produce a system of domination, which requires a local culture. This culture is then reproduced by the powerful (state, workers or firms) in the system (Fligstein, 2001). Fligstein’s theory maps how a new social space emerges, how it becomes and remains stable. Being stable means path-dependent, since the interests of the ruling group are predictably favoured. He also changes the profit maximizing motive to a survival motive, which implies the need for stability, which is attained through political means. This stability is what underlies economic growth. The theory builds from the micro to the macro level elegantly, and connects several dots, which haven’t been connected yet during our inquiry. 

This week’s readings put more color in the discussion about what market is and how it operates. Introducing new types of coordination, apart from the price mechanism and also putting collective choice on its place in this vast system. In addition to these a new front line has been opened, the relationship of market and the institutions. The question of institutions is not settled, since we were presented with opposing views, but the obsolescence of the state vs. market dichotomy is now obvious, it’s clear that the system is more complex, interdependent and reflexive than that.

Sources:

  • Commons, John R. (1932). “The Problem of Correlating Law, Economics, and Ethics.”
  • Coase, Ronald (1937), “The Nature of the Firm.”
  • Buchanan, James M. (1987). “The Constitution of Economic Policy,”
  • Williamson, O.E. (1991). “Comparative Economic Organization: The Analysis of Discrete Structural Alternatives.”
  • Neil Fligstein (2001). The Architecture of Markets

Reading Blog 2: The Political Economy of Agency, Aggregation, Co-ordination, and Collective Action

The readings present a beautifully designed architecture of thoughts.  Each piece deals with the topic in a different way. James Buchanan’s Calculus of Consent outlines a “methodologically individualistic” decision making model of the individual regarding when to get involved in different types of actions (individual, voluntary/contractual, collective). He argues that a rational person would minimize his interdependence costs in each situation, is transitive in his preferences and is able to rank all the actions. This theory is determined by the rational-logical decisions of each individual, not by the decision of the group. In plain words we could say that Buchanan describes when an individual chooses to act collectively.

On the other hand, Mancur Olson in the first chapter of his book, The Rise and Decline of Nations, describes when collective actions work. He argues that large groups comprised of rational individuals do not act in their interest. This happens due to fact that the larger a group the smaller the per capita benefit from collective action, therefore an individual is not incentivized to take action in favor of the collective good. Partly because the costs to act is lower that the received benefit, partly because of the free rider problem.

Buchanan in his other paper, An Economic Theory of Clubs, introduces club goods. While he outlines the analysis of club goods, he also defines the private and public goods in relation to the group size and total costs and benefits per person. At the end of the analysis he concludes that this theory is essentially the theory of optimal exclusion, which could be applied to reality with the continuous adjustment of property rights. Therefore implicitly arguing that the cost/benefit relations derived from individual, group-size enhanced, utility functions should determine the rules. In my understanding this perfectly corresponds to the logic described in the Calculus of Consent, that causation goes from the individual to the rules in collective action, not the other way around.

This is further strengthened by the results of Elinor Ostrom’s scientific work. She argues that there are 4 types of goods (adds common-pool resources). Based on this she elaborates her theory that if users of common-pool resources are let to communicate, set rules and sanction, they’ll yield much better results on the long-run than conventional game theory (common pasture) predicts. We see that this corresponds with logic described, rules set by the participant individuals are the key determinant to success in these situations.

The only paper, which challenges this logic is Phil G. Cerny’s Globalization and the Changing Logic of Collective Action. Cerny argues that the logic of collective actions is cemented in the current notion of territorial state, but this notion is transformed by globalization and the state’s relevance in providing possibilities to collective action will diminish. He argues: “In this new context the logic of collective action is becoming a heterogeneous, multilayered logic, derived not from the on particular core structure, such as the state but from the structural complexity embedded in the global arena.” (Cerny, 1995). However, as seen in the previous theories, collective actions is not derived from the state, but from the participating individual itself. Therefore I tend to be critical with Cerny’s argument since it completely neglects the individual.

To conclude, it’s more the individual’s affect how the whole comes to be, and not the macro, ‘system’ level is the main influencer. What makes the connection between the two, are the rules made by participating individuals.

Sources:

  • James Buchanan & Gordon Tullock (1962). The Calculus of Consent
  • Mancur Olson (1982). Rise and Decline of Nations
  • James Buchanan (1965). “An Economic Theory of Clubs,”
  • Elinor Ostrom (2010). “Beyond Markets and States.”
  • Phil Cerny (1995). “The Changing Logic of Collective Action.”

 

Reading Blog 1: Retro-fitting Neoclassical Economics

Adam Smith wrote his seminal book in times of historically significant economic growth, on the beginning of the industrial revolution. His theory is based on the benevolent notion of sympathy, which develops into an elaborate model of the commercial society. To assume that a kind of mutual sympathy is the key to the harmony of our society is as optimistic as the conclusions of his theory, continuous growth thanks to innovation spurred by the division of labor. (Smith, 1759 and Gopnik, 2010)

Ricardo and Malthus experienced population growth and most importantly obscenely high food prices due to the market distorting measures imposed by the ruling landowner class (Corn Laws). This resulted in their gloomy conclusions based on the subsistence theory of wages. As Ricardo’s abstract system puts: the capitalist save, invest and raise wages (to lure workers to their industries), the workers consume and multiply (in relation to wages) and the landowners increase the rent and reap the benefits of the whole system. As Robert Heilbroner puts it: “..in Ricardo’s exposition the young industrialist class saw the theory that just fitted their needs. Were they responsible for low wages? No, since it was only worker’s own blindness that drove him to multiply his numbers. Were they responsible for the progress of society? Yes…” (Heilbroner, 1953, p. 57). Ricardo’s theory perfectly fits his background and the call of those times. (Heilbroner, 1953)

Friedrich List on the other hand put the whole thing on its head, going against the mighty power of free trade and arguing that that system serves just the already developed nations. No wonder he was seeing the problem from this angle, since he owned vast lands in the developing United States of America. What other things can we derive from the context? USA was the country, which in the turbulent times of the late 18th century gave the world the notion of political union of states. This by the time of List emerged into also a thriving commercial union. Again it’s not a surprise that based on these experiences List argued that political unionization of states should precede free trade between parties, since perpetual peace is not the result of commerce but its condition. (List, 1841)

The point I’m trying to make is that each theory depicted in the readings is conditional on the context it was originally written in. Adam Smith could be best understood and regarded true in the late 18th century Britain, List’s context is the burgeoning USA (and Germany waiting to be unified) in the 1830’s, Quesnay’s is the middle of the 18th century in France and Ricardo’s and Malthus’s is the time of the Corn Laws in Britain.

Of course universal and still holding arguments were raised in all of the works. But as a matter of fact this is the great feat of the neoclassical school, they managed to extract several not context dependent notions, arguments and processes from the preceding theories and build a coherent, yet a bit mathematically dogmatic, system of political economy. We can discover Ricardo’s tool of abstraction, Adam Smith’s self-interest and an updated theory of value in the neoclassical theory. However to correspond to logical purity the Neoclassical model lacks several truly important notions, for example economic inequality (present at Ricardo and Malthus) and economic boom and bust processes (elaborated by Malthus and the Physiocrats).

Sources:

  • Adam Gopnik – New Yorker, 2010, “Market Man”
  • Adam Smith – Wealth of Nations, 1776
  • Adam Smith – The Theory of Moral Sentiments, 1759
  • Guy Routh – Origin of Economic Ideas, 1975
  • Friedrich List – National System of Political Economy, 1841
  • Robert Heilbroner – The Wordly Philosophers, 1953
  • John Caporaso, David Levine – Theories of Political Economy, 1992