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)
- 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).
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). 
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.
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, 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.
- 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.
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.
- 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
- Economist’s View (2009). “Transaction Cost Economics”, http://economistsview.typepad.com/economistsview/2009/10/transaction-cost-economics.html
- Society for Institutional & Organizational Economics. “Classification, History, Relations to Other Fields”, https://www.sioe.org/classification-history-relations-other-fields
- The Ronald Coase Institute. “Glossary for New Institutional Economics”, https://www.coase.org/nieglossary.htm
 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)
 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)