The Economics of Governance

The economics of governance is an effort to implement the “study of good order and workable arrangements,” where good order includes both spontaneous order in the market, which is a venerated tradition in economics (Adam Smith, 1776; Friedrich Hayek, 1945; Kenneth A. Arrow and Gerard Debreu, 1954), and intentional order, of a “conscious, deliberate, purposeful” kind (Chester Irving Barnard, 1938 p. 9). Also, I interpret workable arrangements to mean feasible modes of organization, all of which are flawed in comparison with a hypothetical ideal (Avinash Dixit, 1996 pp. 4–9). The object is to work out the efficiency logic for managing transactions by alternative modes of governance—principally spot markets, various long-term contracts (hybrids), and hierarchies. Interest among social scientists, economists included, in the study and practice of good order and workable arrangements has been steadily growing. In contrast with the orthodox lens of choice (prices and output, supply and demand), the economics of governance is a lens of contract construction, broadly in the spirit of James Buchanan’s (2001 p. 29) observation that “mutuality of advantage from voluntary exchange ... is the most fundamental of all understandings in economics.” The economics of governance, as herein described, is principally an exercise in bilateral private ordering, by which I mean that the immediate parties to an exchange are actively involved in the provision of good order and workable arrangements. To be sure, the need for private ordering varies with the rules of the game as provided by the state. Distinctions between lawlessness where the state provides limited or unreliable protection for property and contract (Dixit, 2004) and lawfulness, where the state undertakes to protect property and enforce contracts in a principled way, are pertinent. The first of these applies mainly to primitive and transition economies. The second is commonly associated with Western democracies. Recourse to private ordering under conditions of lawlessness is altogether understandable: given the absence of state support, the * Walter A. Haas School of Business, University of California, Berkeley, CA 94720-1900. The paper has benefited from workshop presentations at the University of California–Berkeley, the University of Valencia, INSEAD (Fountainebleau), and the 2004 annual conference of the International Society for New Institutional Economics. An abbreviated version was also given as the Horst Claus Recktenwald Lecture at Nuremburg on 4 November 2004. Comments and suggestions from Fred Balderston, Ernesto Dalbo, Avinash Dixit, Robert Gibbons, Witold Henisz, Ian Larkin, Steven Tadelis, and Dean Williamson are especially acknowledged. 1 Lon Fuller’s (1954 p. 477) definition of “eunomics” as “the science, theory, or study of good order and workable arrangements” is very much in the spirit of what I refer to as governance. 2 One of the immediate ramifications of insistently comparing feasible alternatives, all of which are flawed, is that the purported inefficiencies that are ascribed to failures to achieve “first best” optimality are not dispositive, but invite the query “As compared with what?” I return to this issue in Section IV. 3 Excluding “corporate governance,” the numbers of articles that used the word “governance” during the period 1998–2000 as compared with the period 1977–1979 in selected economics, business/management, sociology/organization, and political science journals were 60 vs. 1, 76 vs. 4, 79 vs. 18, and 60 vs. 25, where the journals surveyed were: the American Economic Review, Journal of Political Economy, Quarterly Journal of Economics, Rand Journal of Economics, and Journal of Economic Perspectives in economics; Strategic Management Journal, Management Science, Academy of Management Journal, and Academy of Management Review in business/management; Administrative Science Quarterly, Organization Science, American Journal of Sociology, American Sociological Review, and Annual Review of Sociology in sociology/organization; and American Political Science Review, Political Science Quarterly, Journal of Politics, and Political Research Quarterly in political science. Combining these four categories, articles using the word governance increased from 48 to 275 over this 20-year interval. Dixit (2004 pp. 149–50) reports that the number of web pages that turn up under the search for “governance” is huge.