3. Transaction Cost Economics

OLIVER E. WILLIAMSON

Transaction cost economics is an effort to better understand complex economic organization by selectively joining law, economics, and organization theory. As against neoclassical economics, which is predominantly concerned with price and output, relies extensively on marginal analysis, and describes the firm as a production function (which is a technological construction), transaction cost economics (TCE) is concerned with the allocation of economic activity across alternative modes of organization (markets, firms, bureaus, etc.), employs discrete structural analysis, and describes the firm as a governance structure (which is an organizational construction). Real differences notwithstanding, orthodoxy and TCE are in many ways complements—one being more wellsuited to aggregation in the context of simple market exchange, the other being more well-suited to the microanalytics of complex contracting and nonmarket organization.

I begin by contrasting the lens of contract (out of which TCE works) with the lens of choice (orthodoxy). Vertical integration, which is the paradigm problem for TCE, is then examined. The operationalization of TCE is discussed in Section 3. Variations on a theme are sketched in Section 4. Public policy is discussed in Section 5. Concluding remarks follow.

1. THE LENSES OF CHOICE AND CONTRACT1

Big Ideas

Hal Varian has recently distinguished between important ideas and Big Ideas and describes Ronald Coase’s classic paper, “The Nature of the Firm” (1937) as a Big Idea (2002, p. C2). Although there is widespread agreement on this, the nature of the big idea took a long time to register. Thus as of 1972, thirty-five years after the publication of “The Nature of the Firm,” Coase described his 1937 article as “much cited and little used” (1972, p. 63). It was much cited because it was onto something important, perhaps even big. But it was little used because the big idea was only dimly perceived and/or lacked operationalization (Coase, 1992, pp. 716–718).

1 This subsection is based on Williamson (2002b).

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C. Menard´ and M. M. Shirley (eds.), Handbook of New Institutional Economics, 41–65.C 2005 Springer. Printed in the Netherlands.

42 Oliver E. Williamson

The essence of the Coasian contribution has been variously described (Williamson, 1994, p. 202; North, 2000, p. 37; Werin, 2000, p. 45). For the purposes of TCE, I contend that the overarching big idea was to move from choice to contract: bring the lens of contract systematically to bear on economic phenomena of all kinds. For many transactions, of which the make- or-buy decision is one (Coase, 1937), the contractual structure is easily recognized. Other transactions, such as the externality problem (Coase, 1960), needed to be reformulated to bring out their latent contractual features. The object, in these and other cases described herein, is to uncover previously neglected but, often, consequential features, the discovery of which often leads to different and, sometimes, deeper understandings than the orthodox lens of choice affords. If, as James Buchanan declares, “mutuality of advantage from voluntary exchange is . . . the most fundamental of all understandings in economics” (2001, p. 29), then at least some of us should be thinking of economics as the “science of exchanges” (Buchanan, 2001, p. 28).2

The Sciences of Choice and Contract

Economics throughout the 20th century has been developed predominantly as a science of choice. As Lionel Robbins famously put it in his book, The Nature and Significance of Economic Science, “Economics is the science which studies human behavior as a relationship between ends and scarce means which have alternative uses” (1932, p. 16). Choice has been developed in two parallel constructions: the theory of consumer behavior, in which consumers maximize utility, and the theory of the firm as a production function, in which firms maximize profit. Economists who work out of such setups emphasize how quantities are influenced by changes in relative prices and available resources, a project which became the “dominant paradigm” for economics throughout the twentieth century (Reder, 1999, p. 48).

But the science of choice is not the only lens for studying complex economic phenomena, nor is it always the most instructive lens. The other main but less fully developed approach is the science of contract. Indeed, Buchanan (1975, p. 225) avers that economics as a discipline went “wrong” in its preoccupation with the science of choice and the optimization apparatus associated therewith. What was needed was the parallel development of a science of contract. Awaiting this, some phenomena would go unnoticed, others would be poorly understood, and public policy error would result.

2 Students of the history of thought will remind us that catallactics—meaning “the science of exchanges”—has much earlier origins. Indeed, a book by E. B. de Condillac on this subject was published in 1776, which is when The Wealth of Nations first appeared (see Murray Rothbard (1987, pp. 377–378) for an historical sketch). Recurrent interest in the science of contract notwithstanding, it has operated in the shadows of the science of choice. Why the disparity? Here as elsewhere, good ideas need to be operationalized. Contractual analysis has gotten under way in a sustained way only during the past 40 years.

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As perceived by Buchanan, the principal needs for a science of contract were to the field of public finance and took the form of public ordering: “Politics is a structure of complex exchange among individuals, a structure within which persons seek to secure collectively their own privately defined objectives that cannot be efficiently secured through simple market exchanges” (1987, p. 296; emphasis added). Thinking contractually in the public ordering domain leads into a focus on the rules of the game. Issues of a constitutional economics kind are posed (Buchanan and Tullock, 1962; Brennan and Buchanan, 1985).

Whatever the rules of the game, the lens of contract is also usefully brought to bear on the play of the game. This latter is what I refer to as private ordering, which entails self-help efforts by the immediate parties to a transaction to align incentives and craft governance structures that are better attuned to their exchange needs. John R. Commons’ prescient statement on the nature of the economic problem provides the unifying theme: “the ultimate unit of activity . . . must contain in itself the three principles of conflict, mutuality, and order. This unit is the transaction” (1932, p. 4).3 Not only does transaction cost economics take the transaction to be the basic unit of analysis, but governance is the means by which to infuse order, thereby to mitigate conflict and realize mutual gain.

Although market competition serves these governance purposes in the context of the “simple market exchanges” to which Buchanan made reference (which is wholly in the spirit of orthodox price theory), transaction cost economics is predominantly concerned with complex market exchange where there are small numbers of parties on each side of the transaction. Rather than examine such issues with the price-theoretic apparatus of oligopoly or oligopsony, transaction cost economics focuses instead on uncovering and explicating the strategic hazards that are posed by small numbers exchange in the context of incomplete contracting and the cost-effective deployment of governance to mitigate these hazards. Strategic issues that had been ignored by neoclassical economists from1870 to 1970 now make their appearance (Makowski and Ostroy, 2001, pp. 482–483, 490–491).

Figure 1 sets out the main distinctions. The initial divide is between the science of choice (orthodoxy) and the science of contract. The latter then divides into public (constitutional economics) and private ordering parts, where the second is split into two related branches. One branch deals with ex ante incentive alignment (mechanism design, agency theory, the formal property rights literature) while the second features the ex post governance of contractual

3 Not everyone associated with the lens of contract would agree. Coase, for example, contends that “American institutionalism,” of which Commons was a prominent part, “is a dreary subject . . . All it had was a stance of hostility to the standard economic theory. It certainly led to nothing” (1984, pp. 229–230). My view is that Commons was ahead of his time. He had a lens of contract conception of economics as early as the 1920s.

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Figure 1. The sciences of choice and contract

relations (contract implementation). Albeit related, these two are in tension. Thus whereas transaction cost economics locates the main analytical action in the ex post stage of contract (where maladaptation problems appear), the formal incentive alignment literature annihilates ex post governance.4 One device for accomplishing this is to assume common knowledge of payoffs and costless bargaining.

The use of strong assumptions (of which common knowledge of payoffs and costless bargaining are two) to strip away inessentials and get at the essence is, to be sure, vital to the scientific enterprise. Simplifications, however, that lose contact with core issues are deeply problematic: “A model can be right in . . . [a] mechanical sense . . . [yet be] unenlightening because . . . [it is] imperfectly suited to the subject matter. It can obscure the key interactions, instead of spotlighting them” (Solow, 2001, p. 112). In the degree to which the core issues that are posed by contractual incompleteness are those of maladaptation,

4 Contract theorists who concentrate the analytical action on the ex ante incentive alignment stage of contracting might complain that TCE makes strong assumptions also, the effect of which is to annihilate the ex ante incentive alignment stage. For example, TCE assumes that contracting parties in intermediate product markets are risk neutral, whence efficient risk bearing plays no role in incentive alignment. Contract theorists who rely on risk aversion for their main results might protest against risk neutrality.

Be that as it may, TCE also assumes that contracting parties look ahead, recognize consequential contractual hazards that arise during contract implementation, and factor these into the ex ante contractual design—by pricing out unrelieved contractual hazards and by introducing credible commitments (in cost effective degree)—so ex ante and ex post stages of contract are definitely joined. What TCE disallows are assumptions which vaporize maladaptation and strategizing during contract implementation—of which common knowledge of payoffs and costless bargaining are two.

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formalizations that preserve rather than annihilate ex post governance are needed (Bajari and Tadelis, 2001).

2. THE PARADIGM PROBLEM: VERTICAL INTEGRATION

Contract is an encompassing concept. Rather than treat the issue in its full generality, it will be instructive to begin with a specific puzzle of economic organization, ideally one for which other contractual issues will turn out to be variations on a theme.

The obvious transaction with which to begin is that of vertical integration, or, in more mundane terms, the make-or-buy decision. Not only is the make- or-buy decision the transaction on which Coase focused in 1937, but it has a prior and continuing history of importance within economics. Examining the intermediate product market transactions (within and between firms) also has an advantage in that it relieves many of the asymmetry conditions—of information, budget, legal talent, risk aversion, and the like—that complicate the analysis of transactions in final product markets.5

Coase’s classic article opens with a basic puzzle: Why does a firm emerge at all in a specialized exchange economy? If the answer resides in entrepreneurship, why is coordination “the work of the price mechanism in one case and the entrepreneur in the other” (Coase, 1937, p. 389)? Coase appealed to transaction cost economizing as the hitherto missing factor for explaining why markets were used in some cases and hierarchy in other cases and averred that “The main reason why it is profitable to establish a firm would seem to be that there is a cost of using the price mechanism, the most obvious . . . [being] that of discovering what the relevant prices are” (1937, p. 391). That sounds plausible, but is it truly comparative? How is it that internal procurement by the firm avoids the cost of price discovery?

The “obvious” answer is that sole-source internal supply avoids the need to consult the market about prices because internal accounting prices of a formulaic kind (say, of a cost-plus kind) can be used to transfer a good or service from one internal stage to another. If, however, that is the source of the advantage of internal organization over market procurement, the obvious lesson is to apply this same practice to outside procurement. The firm simply advises its purchasing office to turn a blind eye to the market by placing orders, period by period, with a qualified sole-source external supplier who agrees to sell on cost-plus terms. In

5 Final product market transactions and transactions between suppliers and distributors need to be distinguished. The former refer to transactions between firms (as suppliers) and final consumers (buyers). Serious asymmetry conditions for which consumer protections are sometimes warranted arise for final product market transactions. By contrast, the transactions between the manufacturer and the distributor are between firms. Thus the manufacturer can sell outright to distributors (which is a market transaction). Or the manufacturer can integrate forward into distribution (so both stages are under unified ownership/hierarchy). Or the manufacturer can create franchisees (which are a hybrid mode of contracting).

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that event, firm and market are put on a parity in price discovery respects—which is to say that the price discovery burden that Coase ascribes to the market does not survive comparative institutional scrutiny.

Even, however, if price discovery did survive comparative institutional scrutiny, that seems to be a thin basis upon which to rest the case for using firms rather than markets if, as I contend, firm and market differ in kind rather than in degree. What economic purposes are served by the discrete structural changes that distinguish market and hierarchy? Does the move from choice (where prices are focal) to contract implicate other, possibly more basic, considerations? What rudiments inform the logic of contract and comparative economic organization?

3. THE RUDIMENTS

This last invites the student of economic organization to step back and address contract “on its own terms.” What are the attributes of human actors that bear on the efficacy of contract? What unit of analysis should be employed? Of the many purposes of contract, which are salient? How are alternative modes of governance described? What refutable implications accrue upon reformulating the problem of economic organization in comparative contractual terms? Are the data corroborative? What are the public policy ramifications?

(a) Human Actors

If “Nothing is more fundamental in setting our research agenda and informing our research methods than our view of the nature of the human beings whose behavior we are studying” (Simon, 1985, p. 303), then economists and other social scientists are well-advised to describe the key cognitive, self-interest, and other attributes of human actors on which their analyses rest. Simon’s view of cognition is that the usual hyperrationality assumption be supplanted by bounded rationality—behavior that is “intendedly rational but only limitedly so” (1957a, p. xxiv). He further recommends that self-interest be described as “frailty of motive” (1985, p. 305). TCE concurs that bounded rationality is the appropriate cognitive assumption and takes the chief lesson of bounded rationality for the study of contract to be that all complex contracts are unavoidably incomplete. But TCE also takes a further step, which takes exception with the common view that bounded rationality implies that human actors are myopic. As against myopia, human actors are assumed to have the capacity to look ahead, uncover possible contractual hazards, and work out the contractual ramifications (Shultz, 1995).

TCE also pushes beyond frailty of motive to make provision for opportunism. This latter does not deny that most people will do what they say and some will do more most of the time. Opportunism, however, has reference to exceptions— outliers where there is a lot at stake and parties are often observed to defect from the spirit of cooperation to insist on the letter of the incomplete contract. Strategic considerations are introduced upon making provision for opportunism.

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(b) Unit of Analysis

The natural unit of analysis for lens of contract purposes is the transaction. Naming a unit of analysis is always much easier, however, than identifying the critical dimensions for describing the unit of analysis—as witness the fact that the key attributes for so many would-be units of analysis are never identified.6 Awaiting dimensionalization, transaction cost economics remained a largely tautological construction.

To be sure, transactions can be variously described—depending on the purpose. Transaction cost economics holds that three dimensions that have pervasive ramifications for governance are asset specificity (which takes a variety of forms—physical, human, site, dedicated, brand name—and is a measure of nonredeployability), the disturbances to which transactions are subject (and to which potential maladaptations accrue), and the frequency with which transactions recur (which bears both on the efficacy of reputation effects in the market and the incentive to incur the cost of specialized internal governance). The absence of asset specificity describes the ideal transaction in law and economics for which competition works well: “sharp in by clear agreement; sharp out by clear performance” (Macneil, 1973, p. 734). As asset specificity builds up, however, bilateral dependency develops and, in combination with uncertainty (which pushes incomplete contracts out of alignment), the aforementioned contractual complications set in.

(c) Main Purpose

Interestingly, both the economist Friedrich Hayek (1945) and the organization theorist Chester Barnard (1938) were in agreement that adaptation is the central problem of economic organization. Hayek (pp. 526–527) focused on the adaptations of economic actors who adjust spontaneously to changes in the market, mainly as signaled by changes in relative prices: Upon looking “at the price system as . . . a mechanism for communicating information,” the marvel of the market resides in “how little the individual participants need to know to be able to take the right action.” By contrast, Barnard featured coordinated adaptation among economic actors working through administration (hierarchy). The latter is accomplished not spontaneously but in a “conscious, deliberate, purposeful” way (p. 9) and comes into play when the simple market exchanges on which Hayek focused break down.

In effect, the adaptations to which Hayek refers are autonomous adaptations in which individual parties respond to market opportunities as signaled by changes in relative prices whereas the adaptations of concern to Barnard are cooperative adaptations accomplished through administration within the firm.

6 Examples of would-be units of analysis for which operational content is missing include the role (see Simon’s critique (1957a, p. xxx), the decision-premise (which is Simon’s candidate, but which has found little application outside of cognitive psychology (Newell and Simon, 1972)), and the routine (Nelson and Winter, 1982). The next two paragraphs and Section 4 are based on Williamson (2002a).

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Because a high performance economic system will display adaptive capacities of both kinds, an understanding and appreciation for both markets and hierarchies (rather than the comparative economic systems dichotomy between markets or hierarchies) is needed. The firm for these purposes is described not as a production function (which is a technological construction) but as a governance structure (which is an organizational construction). And the market is described similarly. The lens of contract, as against the lens of choice, is made the cutting edge.

One of the advantages of focusing on adaptation as the main case is that it brings added meaning to the idea of mutual gain. It is elementary that gains from trade will always be realized by moving onto the contract curve. But how is this to be accomplished in a world where complex contracts are incomplete and are implemented over time in the face of disturbances for which contingent provisions either have not been made or, if made, are often in error? Crafting governance structures that are attuned to the hazards and help the parties to restore efficiency (return to the shifting contract curve) where otherwise a costly impasse would develop is needed in these circumstances. More attention to designing processes that have good adaptive properties (and less to concentrating all of the action in the ex ante incentive alignment stage) is thus one of the central lessons of TCE.

(d) Governance Structures

Examining economic organization through the lens of contract both places the spotlight on ex post adaptation and, in the process, gives prominence to the role of governance. Specifically, TCE holds that each generic mode of governance is defined by a syndrome of internally consistent attributes to which different adaptive strengths and weaknesses accrue.

The three attributes of principal importance for describing governance structures are (1) incentive intensity, (2) administrative controls, and (3) contract law regime. Spot markets and hierarchy differ with respect to these attributes as follows: the high-powered incentives of markets are supplanted by low-powered incentives when transactions are organized within firms; market exchange is a hands-off control mechanism whereas hierarchy involves considerable handson administrative involvement; and whereas disputes in markets are treated in a legalistic way and rely on court ordering, courts refuse to hear (most) internal disputes, whereupon the firm becomes its own court of ultimate appeal. Firms have access to fiat that markets do not because of these dispute resolution differences.7

Governance, moreover, is an encompassing concept. Going beyond polar forms, all modes of organization within which (or with the support of which)

7 One of the reasons why markets lack fiat is that attempts to award decision rights to autonomous agents by contract (e.g., A will decide disputed matters of type X; B will decided disputed matters of type Y; etc.) are commonly unenforceable. That is because one of the parties to a market contract can invoke (invent) a “technicality,” the effect of which is to bring the dispute before the courts.

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Figure 3. Simple contracting schema

governance give rise to differential transaction costs among modes, conditional on the attributes of the transactions to be organized.

An unremarked governance complication also needs to be introduced. This is that organization, like the law, has a life of its own (Selznick, 1950, p. 10). Issues of internal organization that have been featured by organization theorists (Barnard, 1938; Simon, 1947; March and Simon, 1958) and by sociologists (Michels, 1912; Merton, 1936; Selznick, 1949; Scott, 1992) thus arise. Note in this connection that while it is relatively easy to show that internal organization is subject to incentive limits and bureaucratic distortions, it is much more difficult to show that comparative cost consequences accrue upon taking a transaction out of the market and organizing it internally (Williamson, 1985, Chap. 6). That is because the goods and services traded in a market are produced within firms. The question of make-or-buy is thus whether the costs (including bureaucratic costs) are greater in two autonomous firms than in one combined entity.

TCE uncovers and explicates the incentive and bureaucratic cost consequences that attend the move from market to hierarchy by postulating two processes: replication and selective intervention. Were it that the firm could replicate the market in all circumstances where market procurement works well and intervene selectively (if expected net gains can be projected) where markets break down, then the firm could never do worse than the market (through replication) and would sometimes do better (through selective intervention). As it turns out, it is impossible to realize this ambition. Incentives are unavoidably

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compromised8 and added bureaucratic cots are unavoidably incurred upon taking a transaction out of the market and organizing it internally. The upshot is that the move from market to hierarchy is attended by tradeoffs. Discriminating alignment is thus needed.

(e) Predictions and Empirical Testing

The main engine from which the predictions of TCE are derived is that of discriminating alignment, according to which transactions, which differ in their attributes, are aligned with governance structures, which differ in their cost and (adaptive) competence, so as to effect a transaction cost economizing result. The upshot is that there is a place for each generic mode of governance, yet each should be kept in its place. The TCE answer to the Coasian puzzle of which transactions go where and why resides precisely in discriminating alignment, the efficacy of which relies in part on weak-form natural selection (Simon, 1983, p. 69) to penalize errors of inefficient alignment.

It will be convenient here to focus on three modes: spot markets (M), hybrid modes of contracting (X), into which credible commitments have been introduced, and hierarchies (H). The basic argument is that (1) markets are well-suited to making autonomous adaptations, firms enjoy the advantage for comparative adaptation purposes, and hybrids are located in between, (2) the needs for adaptation vary among transactions (especially with reference to asset specificity), and (3) bureaucratic cost burdens increase as transactions move from market, to hybrid, to hierarchy.

In a heuristic way, the transaction cost consequences of organizing transactions in markets (M) and hierarchies (H) as a function of asset specificity (k) are shown in Figure 2. As shown, the bureaucratic burdens of hierarchy place it at an initial disadvantage (k = 0), but the cost differences between M(k) and H(k) narrow as asset specificity builds up and eventually reverse as the need for cooperative adaptation becomes especially great (k 0). As indicated, moreover, the hybrid mode of organization X(k), is viewed as a market-preserving credible contracting mode that possesses adaptive attributes located between classical markets and hierarchies. Incentive intensity and administrative control thus take on intermediate values and Karl Llewellyn’s (1931) concept of contract

8 The issues here are rather involved. The interested reader is referred to Williamson (1985, Chap. 6) for a discussion. Briefly the argument is that (1) replication is essential if parity between firm and market is to be assumed, (2) such replication implies that incentives are unchanged in each of the separable stages upon taking a transaction out of the market and organizing it internally, yet (3) unchanged incentive intensity cannot be accomplished if the acquiring stage exercises control over the accounting system (to include transfer prices, overhead rates, depreciation, and the like) and cannot credibly commit to behaving nonstrategically, to include intervening always but only for good cause (selective intervention).

But there is more. Not only is incentive intensity unavoidably weakened when transactions move from market to hierarchy, but cooperative adaptation across successive stages is promoted by intentionally weakening incentive intensity within the firm.

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as framework applies. As shown in Figure 2, M(0) < X(0) < H(0) (by reason of bureaucratic cost differences) while M > X > H (which reflects the differential ability of these three modes to implement coordinated adaptation, the needs for which increase as asset specificity builds up).9 The least cost mode

Whereas many theories of vertical integration do not invite empirical testing, the transaction cost theory of vertical integration invites and has been the subject of considerable empirical analysis. Both the theory of the firm (Holmstrom and Tirole, 1989, p. 126) and the field of industrial organization (Peltzman, 1991) have been criticized for lack of empirical testing; yet empirical research in transaction cost economics has grown exponentially during the past 20 years. (For surveys, see Shelanski and Klein (1995), Lyons (1996), Crocker and Masten (1996), Rindfleisch and Heide (1997), Masten and Saussier (2000) and Boerner and Macher (2001).) Added to this are numerous applications to public policy, especially antitrust and regulation, but also to economics more generally (Dixit, 1996) and to the contiguous social sciences (especially political science). The upshot is that the theory of the firm as governance structure has become a “much used” construction.10

4. VARIATIONS ON A THEME

Vertical integration turns out to be a paradigm. Thus although many of the empirical tests and public policy applications have reference to the make-or-buy decision and vertical market restrictions, this same conceptual framework has application to contracting more generally. Specifically, the contractual relation between the firm and its “stakeholders”—customers, suppliers, and workers along with financial investors—turn out to be variations on the theme set out in the simple contractual schema.

9 M , X , and H refer to the marginal costs of market, hybrid, and hierarchical governance with respect to changes in asset specificity (k).

10 Reprints of leading articles on vertical integration (by Benjamin Klein on Fisher Body-GM (1988), Paul Joskow on long-term coal contracting (1988), Kirk Monteverde and David Teece on automobile integration (1982), Scott Masten on aerospace production (1984), Erin Anderson and David Schmittlein on sales force organization (1984), George John and Barton Weitz on forward integration into distribution (1988), and Scott Masten, James Meehan, and Edward Snyder on the cost of organization (1991)) can be found in Williamson and Masten, Vol. II (1995).

This same volume includes empirical contracting articles (by Thomas Palay on rail freight contracting (1984), Victor Goldberg and John Erickson on long term petroleum coke contracts (1987), Paul Joskow on contract duration (1987), Harold Mulherin on natural gas contracting (1986), Scott Masten and Keith Crocker on take-or-pay provisions (1985), Keith Leffler and Randal Rucker on timber (1991), and Keith Crocker and Scott Masten on the long term contracting process (1991).

Empirical studies of regulation and positive political economy include Oliver Williamson (1976), Victor Goldberg (1976), George Priest (1993), Brian Levy and Pablo Spiller (1994), Barry Weingast and William Marshall (1988), and Rafael Gely and Pablo Spiller (1990). Antitrust applications include Oliver Williamson (1979), Roy Kenney and Benjamin Klein (1983), and Scott Masten and Edward Snyder (1993).

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The Simple Contractual Schema

Assume that a firm can make or buy a component and assume further that the component can be supplied by either a general purpose technology or a special purpose technology. Again, let k be a measure of asset specificity. The transactions in Figure 3 that use the general purpose technology are ones for which k = 0. In this case, no specific assets are involved and the parties are essentially faceless. Those transactions that use the special purpose technology are ones for which k > 0. As earlier discussed, bilaterally dependent parties have incentives to promote continuity and safeguard their specific investments. Let s denote the magnitude of any such safeguards, which include penalties, information disclosure and verification procedures, specialized dispute resolution (such as arbitration) and, in the limit, integration of the two stages under unified ownership. An s = 0 condition is one for which no safeguards are provided; a decision to provide safeguards is reflected by an s > 0 result.

Node A in Figure 3 corresponds to the ideal transaction in law and economics: there being an absence of dependency, governance is accomplished through competitive market prices and, in the event of disputes, by court awarded damages. Node B poses unrelieved contractual hazards, in that specialized investments are exposed (k > 0) for which no safeguards (s = 0) have been provided. Such hazards will be recognized by farsighted players, who will price out the implied risks of contractual breakdown.

Added contractual supports (s > 0) are provided at nodes C and D. At node C, these contractual supports take the form of interfirm contractual safeguards. Should, however, costly contractual breakdowns continue in the face of best bilateral efforts to craft safeguards at node C, the transaction may be taken out of the market and organized under unified ownership (vertical integration) instead. Because added bureaucratic costs accrue upon taking a transaction out of the market and organizing it internally, internal organization is usefully thought of as the organization form of last resort: try markets, try hybrids, and have recourse to the firm only when all else fails. Node D, the unified firm, thus comes in only as higher degrees of asset specificity and added uncertainty pose greater needs for cooperative adaptation.

Note that the price that a supplier will bid to supply under node C conditions will be less than the price that will be bid at node B. That is because the added security features serve to reduce the risk at node C, as compared with node B, so the contractual hazard premium will be reduced. One implication is that suppliers do not need to petition buyers to provide safeguards. Because buyers will receive product on better terms (lower price) when added security is provided, buyers have the incentive to offer cost-effective credible commitments. Also note that whereas such commitments are sometimes thought of as a user-friendly way to contract, the analytical action resides in the hard-headed use of credibility to support those transactions where asset specificity and contractual hazards are at issue. Such supports are without purpose for transactions where generic technologies are employed.

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The foregoing schema can be applied to virtually all transactions for which the firm is in a position to own as well as to contract with an adjacent stage— backward into raw materials, laterally into components, forward into distribution. But for some activities, ownership is either impossible or very rare.11 For example, firms cannot own their workers or their final customers (although worker cooperatives and consumer cooperatives can be thought of in ownership terms). Also, firms rarely own their suppliers of finance. Node D drops out of the schema in cases where ownership is either prohibited by law or is otherwise rare. I begin with forward integration into distribution, after which relationships with other stakeholders of the firm, including labor, finance, and public utility regulation are successively considered.12

Applications

(a) Forward Integration into Distribution

I will set aside the case where mass marketers integrate backward into manufacturing and focus on forward integration into distribution by manufacturers of products or owners of brands. Specifically, consider the contractual relation between a manufacturer and large numbers of wholesalers and, especially, of retailers for the good or service in question.

Many such transactions are of a generic kind. Although branded goods and services are more specific, some require only shelf space, since advertising, promotion and any warranties are done by the manufacturer. Since the obvious way to trade with intermediaries for such transactions is through the market, in a node A fashion, what is to be inferred when such transactions are made subject to vertical market restrictions—such as customer and territorial restrictions, service restrictions, tied sales, and the like?

Price discrimination, to which allocative efficiency benefits were often ascribed, was the usual price theoretic (science of choice) explanation for such restrictions. Such efficiency claims, however, are problematic once the transaction costs of discovering customer valuations and deterring arbitrage are taken into account (Williamson, 1975, pp. 11–13). Not only are the benefits problematic, but price discrimination is a needlessly narrow interpretation.

11Closely complementary technologies are commonly relegated to the “core technology” (Thompson, 1967, pp. 19–23) and are effectively exempt from comparative institutional analysis, it being “obvious” that these are done within the firm.

12Natural monopoly and government bureaus can be interpreted in terms of the schema in Figure 3 as follows: First, given natural monopoly, the three “evils” to which Milton Friedman (1962, p. 128) referred—unregulated monopoly, regulation, and nationalization—correspond, roughly, to nodes B, C, and D, respectively. Also, for a good or service for which the government is the buyer, nodes A, B, and C are all market nodes (spot market, unrelieved hazard, and long-term (often cost-plus) contracting, respectively), while node D is the government bureau deciding to do the task itself. The government bureau has especially low-powered incentives, is highly bureaucratized (by design), and has its own dispute settlement machinery (Williamson, 1999).

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Viewed through the lens of contract, vertical market restrictions often have the purpose and effect of infusing order into a transaction where the interests of the system and the interests of the parts are otherwise in conflict. For example, the Schwinn bicycle company imposed nonresale restrictions upon franchisees. The concern was that the integrity of the brand, which was a system asset, would be compromised by franchisees who perceived local opportunities to realize individual gain by selling to discounters, who would then sell a “bike in a box,” without service or support (Williamson, 1985, pp. 183–189). More generally, the argument is this: in circumstances where market power is small, where simple market exchange (at node A) would compromise the integrity of differentiated products, and where forward integration into distribution (at node D) would be especially costly, the use of vertical market restrictions to effect credible commitments (at node C) has much to recommend it.

(b) Relationship with Labor

Because the firm is unable to own its labor, node D is irrelevant and the comparison comes down to nodes A, B, and C. Node A corresponds to the case where labor is easily redeployed to other uses or users without loss of productive value (k = 0). Thus although such labor may be highly skilled (as with many professionals), the lack of firm-specificity means that, transition costs aside, neither worker nor firm has an interest in crafting penalties for unwanted quits/terminations or otherwise creating costly internal labor markets (ports of entry; promotion ladders), costly information disclosure and verification procedures, and costly firm-specific dispute settlement machinery. The mutual benefits simply do not warrant the costs.

Conditions change when k > 0, since workers who acquire firm-specific skills will lose value if prematurely terminated (and firms will incur added training costs if such employees quit). Here, as elsewhere, unrelieved hazards (as at node B) invite governance responses to which mutual gains accrue. Because continuity has value to both firm and worker, governance features that deter termination (severance pay) and quits (nonvested benefits) and which address and settle disputes in an orderly way (grievance systems) to which the parties ascribe confidence have a lot to recommend them. These can, but need not, take the form of “unions.” Whatever the name, the object is to craft a collective organizational structure (at node C) in which the parties have mutual confidence and that enhances efficiency (Baron and Kreps, 1999, pp. 130–138; Williamson, 1975, pp. 27–80, 1985, pp. 250–262).13

13 The emphasis on collective organization as a governance response is to be distinguished from the earlier work of Gary Becker, where human asset specificity is responsible for upward sloping age-earnings profiles (1962). Becker’s treatment is more in the science of choice tradition whereas mine views asset specificity through the lens of contract. These two are not mutually exclusive. They do, however, invite different public policy interpretations and redirect the empirical research agenda.

56 Oliver E. Williamson

(c) Relationship with Sources of Finance

Viewed through the lens of contract, the board of directors is interpreted as a security feature that arises in support of the contract for equity finance (Williamson, 1988). More generally, debt and equity are not merely alternative modes of finance, which is the law and economics construction (Easterbrook and Fischel, 1986; Posner, 1986), but are also alternative modes of governance.

Suppose that a firm is seeking cost-effective finance for the following series of projects: general-purpose, mobile equipment; a general-purpose office building located in a population center; a general-purpose plant located in a manufacturing center; distribution facilities located somewhat more remotely; special-purpose equipment; market and product development expenses; and the like. Suppose further that debt is a governance structure that works almost entirely out of a set of rules: (1) stipulated interest payments will be made at regular intervals; (2) the business will continuously meet certain liquidity tests;

(3) principal will be repaid at the loan-expiration date; and (4) in the event of default, the debtholders will exercise preemptive claims against the assets in question. In short, debt is unforgiving if things go poorly.

Such rules-based governance is well-suited to investments of a generic kind (k = 0), since the lender can redeploy these to alternative uses and users with little loss of productive value. Debt thus corresponds to market governance at node A. But what about investment projects of more specific (less redeployable) kinds?

Because the value of holding a preemptive claim declines as the degree of asset specificity deepens, rule-based finance of the above described kind will be made on more adverse terms. In effect, using debt to finance such projects would locate the parties at node B, where a hazard premium must be charged. The firm in these circumstances has two choices: sacrifice some of the specialized investment features in favor of greater redeployability (move back to node A), or embed the specialized investment in a governance structure to which better terms of finance will be ascribed. What would the latter entail?

Suppose that a financial instrument called equity is invented and assume that equity has the following governance properties: (1) it bears a residual-claimant status to the firm in both earnings and asset-liquidation respects; (2) it contracts for the duration of the life of the firm; and (3) a board of directors is created and awarded to equity that (a) is elected by the pro-rata votes of those who hold tradeable shares, (b) has the power to replace the management, (c) decides on management compensation, (d) has access to internal performance measures on a timely basis, (e) can authorize audits in depth for special follow-up purposes,

(f) is apprised of important investment and operating proposals before they are implemented, and (g) in other respects bears a decision-review and monitoring relation to the firm’s management (Fama and Jensen, 1983).14 So construed, the board of directors is awarded to the holders of equity so as to reduce the cost

14 It will not go unnoticed that this is a rather normative way to describe the board of directors. In practice, many boards are rubber stamps to the management (in exchange for handsome fees). Takeover by tender offer is important for precisely because it is a means by which to replace a protective/complacent/compliant board.

Transaction Cost Economics 57

of capital by providing safeguards for projects that have limited redeployability (by moving shareholders from node B to node C).

(d) Regulation and Natural Monopoly

The market-oriented approach to natural monopoly is to auction off the franchise to the highest bidder (Demsetz, 1968; Posner, 1972). But while this is an imaginative proposal, it is not an all-purpose construction. Viewed through the lens of contract, whether this works well or poorly depends on the nature of the transaction and the particulars of governance. The action, once again, resides in the details (Williamson, 1976)—although others counsel that to “expound the details of particular regulations and proposals . . . would serve only to obscure the basic issues” (Posner, 1972, p. 98).

Going beyond the initial bidding competition (“competition for the market”), the governance approach insists upon examining the contract implementation stage. Transactions to which the Fundamental Transformation applies—namely, those requiring significant investments in specific assets and that are subject to considerable market and technological uncertainty—are ones for which the efficacy of simple franchise bidding is problematic. If what had been a large numbers franchise bidding competition at the outset becomes, in effect, a small numbers supply relation during contract implementation and at the contract renewal interval, then the purported efficiency of franchise bidding is problematic.

This is not to say that franchise bidding never works. Neither is it to suggest that decisions to regulate ought not to be revisited—as witness the successful deregulation of trucking (which never should have been regulated to begin with) and more recent efforts to deregulate “network industries” (Peltzman and Whinston, 2000). I would nevertheless urge that examining deregulation through the lens of contracting is instructive for both—as it is for assessing efforts to deregulate electricity in California, where too much deference was given to the (assumed) efficacy of smoothly functioning markets and insufficient attention to potential investment and contractual hazards and appropriate governance responses thereto. As Joskow (2000, p. 51) observes: “Many policy makers and fellow travellers have been surprised by how difficult it has been to create wholesale electricity markets . . . . Had policy makers viewed the restructuring challenge using a TCE framework, these potential problems are more likely to have been identified and mechanisms adopted ex ante to fix them.”

Here as elsewhere, the lesson is to think contractually: look ahead, recognize potential hazards, and fold these back into the design calculus. Paraphrasing Robert Michels (1962, p. 370) on oligarchy, nothing but a serene and frank examination of the contractual hazards of deregulation will enable us to mitigate these hazards.

5. PUBLIC POLICY

The initial public policy applications of TCE were in the field of industrial organization, especially to antitrust and regulation. These were followed by

58 Oliver E. Williamson

public policy applications to labor, health, agriculture, public finance, economic development and reform, and the list goes on. If, indeed, any problem that arises as or can be reformulated as a contracting problem can be examined to advantage through the lens of contracting, then the list of applications is unending.

(a) Antitrust

A long-standing puzzle for antitrust was what to make of vertical integration. If the “natural” way to procure a good or service was in the market, why take a transaction out of the market and organize it internally? For that matter, what explained efforts by firms to go beyond simple market exchange and impose customer, territorial, and other vertical market restrictions on distributors? Issues of both kinds arose during the year that I spent as Special Economic Assistant to the head of the Antitrust Division of the U.S. Department of Justice (1966–67). Stringent vertical merger guidelines were issued by the Department in 1968. And the Justice Department mistakenly ascribed anticompetitive purposes to prohibitions against franchisee resale of bicycles in arguing the Schwinn case in 1967.15 More generally, the prevailing view on vertical market restrictions was that these were to be interpreted “not hospitably in the common law tradition, but inhospitably in the tradition of antitrust.”16 If the natural boundary of the firm was defined by technology (the firm being viewed as a production function), then what useful purpose was served by interfering with nature?

All well and good in the context of simple market exchange. It overreaches, however, to prohibit node C governance by forcing all market transactions for which k > 0 onto node B because the “market is a marvel.” Organization in all of its forms is a marvel—once we understand which transactions go where and why. Monopoly purpose enters into the calculus only when the requisite preconditions for monopoly are satisfied, which is a special case.

(b) Regulation/Deregulation

As discussed above, the obvious regulatory problem to which to bring TCE to bear was the imaginative proposal to use franchise bidding as the solution to natural monopoly. In a TCE world where all feasible forms of organization are flawed, it is not surprising that franchise bidding can be expected to work well in some circumstances but not in all.

Other applications of comparative contractual reasoning to regulation (broadly construed) include the much condemned sugar program (Williamson, 1996, pp. 197–210) and consumer health and safety and labor health and safety (Williamson and Bercovitz, 1996, pp. 343–347) issues. More generally, the lens of contract can be applied to the full range of regulatory issues (at local, state,

15For a discussion see Williamson (1985, pp. 183–189).

16The quotation is attributed to Turner by Stanley Robinson, 1968, N.Y. State Bar Association, Antitrust Symposium, p. 29.

Transaction Cost Economics 59

and federal levels) and such uses have been growing. As matters stand presently, however, TCE is still underused in relation to its potential.

(c) Other Public Policy

Avinash Dixit opens his monograph on The Making of Economic Policy: A Transaction-Cost Politics Perspective (1996) with a contrast with old-style public finance, where the government was described as an omniscient, omnipotent, and benevolent dictator (1996, p. 8), with the lens of contract approach, according to which all feasible forms of organization are flawed. This latter is an immediate ramification of describing human actors as boundedly rational, which disallows omniscience, and given to subgoal pursuit (opportunism), which disallows benevolence. Upon recognizing implementation obstacles, moreover, omnipotence also drops out.

Two crucial TCE moves endorsed by Dixit are the view of the firm as governance structure and to insist upon remediableness. He observes with reference to the first that the standard normative approach to policy analysis views the process as taking place within (1996, p. 9):

. . . a social welfare maximizing black box, exactly as the neoclassical theory of production and supply viewed the firm as a profit-maximizing black box. While some useful insights follow from this, it leaves some very important gaps in our understanding and gives us some very misleading ideas about the possibilities of beneficial policy intervention. Economists studying business and industrial organization have long recognized the inadequacy of the neoclassical view of the firm and have developed richer paradigms and models based on the concepts of various kinds of transaction costs. Policy analysis also stands to benefit from such an approach, opening the black box and examining the actual workings of the mechanism inside. That is the starting point, and a recurrent theme, of this monograph.

The remediableness criterion for evaluating public policy proposals is to be contrasted with that of the Pareto criterion. Whereas the latter typically scants issues of feasibility and implementation, the remediableness criterion makes express provision to both. Thus the remediableness criterion holds that an extant practice or mode of organization for which no feasible superior mode can be described and implemented with expected net gains is presumed to be efficient. Reference to feasibility disallows hypothetical ideals (costlessness in any of its forms, including costless bargaining, is thus disallowed). Reference to implementation entails looking ahead to uncover obstacles to implementation, after which the mechanisms are worked out. And presumptions of efficiency are rebuttable—possibly by showing that the initial conditions (often of a political kind) are not acceptable (Williamson, 1996, pp. 208–212).

Whereas lens of choice reasoning holds that a simple display of deadweight losses is dispositive of inefficiency, the lens of contract (remediableness) holds otherwise. Now the analyst is pushed to establish that the proposed reform is feasible (recall that hypothetical ideals are disallowed) and further to demonstrate

60 Oliver E. Williamson

that “legitimate” resistance can be overcome in a cost-effective way. Those are not impossible obstacles, but they are very demanding. Among other things, ready recourse to costless compensation of losers (of a Hicks-Kaldor kind) is disallowed.

6. CONCLUSIONS

Robert Solow’s prescription for doing good economics is set out in three injunctions: keep it simple; get it right; make it plausible (2001, p. 111). Keeping it simple entails stripping away the inessentials and going for the main case (the jugular). Getting it right “includes translating economic concepts into accurate mathematics (or diagrams, or words) and making sure that further logical operations are correctly performed and verified” (Solow, 2001, p. 112). Making it plausible entails describing human actors in (reasonably) veridical ways and maintaining meaningful contact with the phenomena of interest (contractual or otherwise).

To this, moreover, I would add a fourth injunction: derive refutable implications to which the relevant (often microanalytic) data are brought to bear. Nicholas Georgescu-Roegen has a felicitous way of putting it: “The purpose of science in general is not prediction, but knowledge for its own sake,” yet prediction is “the touchstone of scientific knowledge” (1971, p. 37).

Why the fourth injunction? This is necessitated by the need to choose among alternative theories that purport to deal with the same phenomenon—say vertical integration—and (more or less) satisfy the first three injunctions. Thus assume that all of the models are tractable, that the logic of each hangs together, and that agreement cannot be reached as to what constitutes veridicality and meaningful contact with the phenomena. Does each candidate theory then have equal claims for our attention? Or should we be more demanding? This is where refutable implications and empirical testing come in: ask each would-be theory to stand up and be counted.

Why more economists are not insistent upon deriving refutable implications and submitting these to empirical tests is a puzzle. One possibility is that the world of theory is set apart and has a life of its own. A second possibility is that some economists do not agree that refutable implications and testing are important. Another is that some theories are truly fanciful and their protagonists would be discomfited by disclosure. A fourth is that the refutable implications of favored theories are contradicted by the data. And perhaps there are still other reasons. Be that as it may, a multiplicity of theories, some of which are vacuous and others of which are fanciful, is an embarrassment to the pragmatically oriented members of the tribe. Among this subset, insistence upon the fourth injunction—derive refutable implications and submit these to the data— is growing.

TCE responds to the injunction of keeping it simple by taking economizing on transaction costs to be the main case. The logic of economic organization is

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4. Electoral Institutions and

Political Competition

Coordination, Persuasion and Mobilization

GARY W. COX

In the Schumpeterian conception, democracy consists of regular and non-violent competition for control of government between alternative teams of elites (Schumpeter 1942). The question that much scholarship in electoral studies addresses, and on which this essay will focus, is: how does changing the rules of the electoral game change the strategies of parties and candidates, hence the outcome of elections?

Figure 1 illustrates both the sequence of events in a stylized democracy and some of the topics to be covered. In the beginning, there is a set of potential electoral competitors. These agents decide (at stage 1 of the diagram) whether to enter a particular electoral competition—that is, to formally nominate candidates for one or more elective offices. Since winning office requires amassing a sufficient number of votes, the nature of the entry game between potential competitors has a strong coordination game flavor to it.1 For example, if fifteen right-of-center parties all enter the race as separate competitors, while the left unites behind a single option, the right is likely to do poorly (under most extant electoral systems). The right can do better if some potential competitors withdraw in favor of others, but each potential competitor may prefer that it remain and the others withdraw.

After a given set of competitors have entered the race, each decides to allocate effort to one or more of three vote-producing activities: (2.1) persuasion: providing voters with reasons, such as better policy positions or larger bribes, to prefer it to the other competitors; (2.2) vote coordination: convincing supporters of other parties that the expected utility of their vote, in terms of affecting the allocation of seats across competitors, will be higher if they support it than if they support their most-preferred competitor; (2.3) mobilization: boosting the probability that its known supporters will actually participate in the election.

1 The essence of a coordination game is that the players would like to coordinate their actions on some one of n possibilities but disagree which of these possibilities is the best. For example, two allies, A and B, may wish to coordinate an attack on a third nation but disagree whether the attack should be launched from A’s territory or B’s.

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C. Menard´ and M. M. Shirley (eds.), Handbook of New Institutional Economics, 69–89.C 2005 Springer. Printed in the Netherlands.

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↓(2.1) persuasion; (2.2) coordination of votes; (2.3) mobilization.

Figure 1. The office-seeking sequence in a hypothetical democracy

Each of these vote-producing activities is cost-effective under somewhat different conditions.

After the election has been held, an allocation of votes across the available competitors is determined. This allocation of votes is translated into an allocation of seats by a series of deterministic mathematical operations mandated by the relevant electoral rules (in particular, the electoral “formulas”) of a system. Finally, after the allocation of offices has been determined, those competitors who hold seats in the national legislature can bargain among themselves over the distribution of portfolios (defined here to include both cabinet ministerial posts and, in those systems where such positions confer substantial authority over the legislative agenda, legislative committee chairs).

In this essay, I focus on the first three stages of Figure 1, leaving government formation to others. In order to simplify the exposition, I do not deal much with the detailed electoral rules. Rather, I categorize electoral systems by three broad architectonic features: the number of votes per voter; the number of seats per district; and the proportionality of the votes-to-seats translation. These features play the role of independent variables, with candidates’ and parties’ strategies of coordination, persuasion and mobilization in the role of dependent (or sometimes intermediate) variables.2

Although not the focus of this essay, it may be worth suggesting how parties’ strategies in turn affect policy choices. A short answer is that parties’ strategies help define the sort of actor they will be in government. In particular, the larger are the electoral aggregates that form (the greater is the equilibrium level of coordination), the broader are the interests those aggregates will represent; and the more that parties choose to persuade via promises to provide differing packages of public goods, rather than differing packages of private goods, the greater the pressure will be on them to deliver such goods when in office.3

2 Throughout, I focus (albeit not exclusively) on formally derived institutional comparative statics results. For other reviews similar in spirit, see Myerson (1995, 1999).

3 More elaborate answers along these lines can be found in Shugart (2001), Cox and McCubbins (2001), and Tsebelis (2002).

Electoral Institutions and Political Competition 71

1. ELECTORAL RULES

There is an immense range of different electoral rules that can be combined into an even larger number of possible electoral systems. Here, I shall focus on the three main components of any electoral system: votes, seats and the rules translating votes into seats. Each of these components can be characterized in detail, by describing all the features of the particular electoral system at hand. Each can also be characterized in a more summary fashion—the approach taken here.

Translating Votes into Seats

One can characterize a given electoral system in terms of where and how votes are converted into seats. As far as where is concerned, votes can be translated into seats within electoral districts, within upper tiers and within electoral segments. Let’s consider each of these in turn.

An electoral district is a geographical area within which votes are counted and seats awarded. For example, the U.S. House of Representatives has 435 districts, each returning a single member. Votes are counted at the district level and seats are awarded at the district level. There is no process by which votes from an election in California’s 4th district can affect the outcome of the election in New York’s 3rd or California’s 5th.

Other electoral systems have provisions by which votes and sometimes seats are translated from their district of origin to a secondary district (a larger geographic area encompassing two or more districts), with an additional round of votes-to-seats conversions occurring at that level. For example, one could modify the U.S. system by stipulating that all votes not cast for a winning candidate in their district of origin transfer to the national level, where they can translate into seats according to stipulated rules.

Many electoral systems have upper tiers of secondary districts placed over their primary districts. In Belgium as of 1960, for example, votes were cast within 30 arrondissements (primary districts) which were in turn grouped into 9 provinces (secondary districts). A party’s votes in a given arrondissement might suffice to “buy” one or more seats at that level, where the “price” in votes per seat was the so-called Hare quota (equal roughly to the total number of votes cast divided by M). Any unused votes cast for a party in a given arrondissement transferred to the provincial level, where they combined with the party’s unused votes from the other arrondissements in the province, and might then suffice to “buy” some seats at the provincial level. The purpose of layering an upper tier of provinces over a lower tier of arrondissements was to increase the proportionality of the overall system (on which more below).

In addition to layering secondary districts over primary districts, another technique to affect overall proportionality that has become increasingly popular is to have two parallel segments of districts. An electoral segment consists of a set of electoral districts that together cover the entire nation, along with any associated upper tiers. The typical two-segment electoral designs combine one

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segment of single-member districts with one segment of multi-member districts operating under proportional representation (see Shugart and Wattenberg 2001). In Japan, for example, the 1993 electoral reform created one segment of 300 single-member districts (which together covered the entire nation); and one segment of 11 multi-member districts (which also collectively covered the nation) (see Reed and Thies 2001).

A full description of where votes are converted into seats thus involves a stipulation first of the number of segments (one or two) and then a characterization of each segment. In addition, one would wish to specify the procedures by which seats are apportioned to districts and tiers, as well as the procedures (if any) by which district boundaries can be redrawn. Here, however, the structure of districts, tiers and segments will be reduced to a single number (the effective magnitude; see the next section) and the procedures by which reapportionment and redistricting occur will be left in the background.

In addition to knowing where votes are converted into seats, one would also wish to know how. Particular mathematical formulas are used at each stage of seat allocation in an electoral system. In Belgium, for example, the electoral code stipulates a “price” for each seat (the Hare quota) and each party in a given arrondissement wins as many seats as its votes can buy at the stipulated price. A somewhat different formula (a different way of deciding the price per seat) is then used at the provincial level to award seats at that stage.

Individual electoral formulas can be arrayed along a continuum indicating their proportionality. At one extreme are the winner-take-all formulas: the candidate or list with the most votes wins all the seats available to be won in the particular district. Such formulas provide strong incentives to form “large” coalitions, in order to be able to compete seriously for the seats at stake. Opposed to these winner-take-all systems are those in which a list receives seats in strict proportion to its votes. Here, the larger parties receive no bonus seats (seats in excess of what they would get on a strictly proportional allocation).4

Because an electoral system may have more than one electoral formula operating at different levels (as in Belgium or Japan), it is not always easy to characterize the overall proportionality of a system. Putting this technical difficulty aside (as does most of the literature), I shall denote the overall proportionality of the votes-to-seats translation in a system by P, with higher values of P denoting more proportional systems.

4 Of course, there are many different ways to define the gap between vote and seat shares, leading to different algorithmic embodiments of the proportional ideal (Cox and Shugart 1991). Conceptually, I prefer to characterize systems in terms of responsiveness or big-party bias, defined as the degree to which parties with larger vote shares tend also to receive higher-than-proportional seat shares (Cox and Shugart 1991). Most of the literature, however, has focused on proportionality and an array of workable summary measures of it exist (Gallagher 1991; Monroe N.d.). In contrast, measuring bigparty bias (especially in multi-party contexts) has proved more difficult (for the state of the art, see Monroe N.d.).

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between systems that give few votes (and thus enable voters only to distinguish between the best and the rest) and systems that give many votes (and thus enable voters only to distinguish between the worst and the rest).

Empirically, most national assemblies are elected using one-vote (V = 1) best-rewarding methods. A certain number do use methods intermediate between the best-rewarding and worst-punishing extremes, however. For example, Spain’s Senate is elected using a limited vote (Lijphart, Lopez Pintor and Sone 1986), as was part of Great Britain’s House of Commons in the nineteenth century. There are even fewer who use a pure worst-punishing method—the only one of which I am aware is Mauritius (Cox 1997:146–7).

Another distinction worth noting at this point is that between systems in which votes are cast directly for individual candidates; and those in which votes are cast for sets or lists of candidates, with each list endorsed by one or more parties. When votes are cast for lists (or aggregate to the list level), it is possible to use various proportional representation formulas in translating votes into seats. When votes aggregate only to the level of the individual candidate, in contrast, it is not possible to use proportional representation formulas (except in a mathematically trivial sense). Thus, the distinction drawn below between more and less proportional formulas is in part a function of the voting options given to voters.

Summary

In summary, electoral systems can be characterized by how many votes voters cast (by extension, the effective number of votes per voter, V), how many seats are awarded in the typical district (by extension, the effective magnitude, M), and how proportionally votes are converted into seats (P). In the sections that follow, I review what we know about how electoral competitors’ strategies of coordination, persuasion and mobilization change, in response to changes in V, M and P.

2. ELECTORAL COORDINATION

Modern representative democracy presents at its core a series of coordination problems that arise as natural consequences of electoral competition for governmental offices. A group with enough votes to elect some number of candidates in a given (legislative or executive) race will in fact elect that number only if it can make its votes count by concentrating them appropriately. One way to avoid spreading votes too thinly is to limit the number of candidates vying for the group’s support. But which potential candidates, representing what shades of opinion, will withdraw in favor of which others? If attempts to limit the number of candidates fail, another chance to make votes count arises on polling day, when voters can concentrate their votes on a subset of the available candidates.

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But which candidates will bear the brunt of strategic voting and which will be its beneficiaries?

Electoral coordination—whether the coordination of entry, resources or votes—can occur via a variety of processes. These processes can be classified in terms of the main actors involved (voters or elites) and the level at which their interaction is pitched (within individual electoral districts or across districts), yielding four categories. I shall briefly discuss each of these.

Coordination of Votes within Districts

Traditionally, strategic voting (voting so as to secure the best possible outcome rather than to support the most-preferred competitor) has been thought to concentrate votes. Consider, for example, a three-candidate contest for a single seat in which candidates A and B are tied in the polls at 40%, with C trailing at 20%. Those who most prefer the trailing candidate, C, may decide to vote for whichever of the leading candidates they prefer. Such strategic voting would have the consequence of concentrating the actual vote, relative to what would result if every voter simply voted for their most-preferred candidate. Indeed, in the extreme, all C’s supporters might vote strategically and what had been a three-way race would reduce to a two-way race.

Does strategic voting have similar vote-concentrating consequences in other electoral contexts? As it turns out, the extent to which strategic voting concentrates votes depends on the electoral system in place, in two main ways (cf. Cox 1997). First, only in best-rewarding systems does strategic voting concentrate votes; in worst-punishing systems, it typically does just the opposite. Second, within the class of best-rewarding systems, smaller effective magnitudes lead to a greater concentration of votes, according to the “M + 1 rule.” Let’s consider this second proposition in greater detail.

The “ M + 1 rule”: Theory

Best-rewarding systems can be thought of as each having a maximum “carrying capacity” of parties, call it C. When the number of parties falls short of C it is theoretically possible that every party in the system can be in serious competition to win a seat—either expected to win one or more seats or to finish as the runner-up for the last-allocated seat. Strategic voting should be minimal in such situations. When the number of parties exceeds C, in contrast, it is increasingly unlikely that all parties can be seriously in contention for a seat. Instrumentally rational voters will avoid voting for parties that are unlikely to contend for a seat, however. Thus, if voters’ initial priors concerning the distribution of preferences in the electorate are sufficiently precise, so that the identity of the trailing competitors is clear enough, one expects the vote share of trailing parties to fall short of what their vote share would be were all voters to vote

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sincerely.7 That is, weak parties find some of their supporters voting for the best of the candidates still in contention for the last-allocated seat, rather than for them.

For systems using M-seat districts in which each voter has a single vote, cast either for a candidate or a party list, we know that the “carrying capacity” C = M + 1 (Cox 1997). That is, in an M-seat district one expects no more than M + 1 viable competitors.8

The “M + 1 rule”: Evidence

Empirical evidence supporting the M + 1 rule comes in a variety of forms. Here, I shall briefly discuss evidence from mass surveys documenting the existence of strategic voting; and evidence from cross-national aggregate analyses documenting the relationship between district magnitude (M) and the number of viable parties.

Rather than examine survey evidence from a variety of countries, I focus on the case of Great Britain, for which the largest literature on strategic voting exists. Much of this literature deals with the elections of the 1980s, when the Alliance surged to near-parity in votes with the Labour Party. Estimates of the percentage of voters who voted for their secondor third-preference rather than first-preference candidate range from 5.1% to 17% (see e.g. Johnston and Pattie 1991; Heath et al. 1991:54; Lanoue and Bowler 1992; Niemi, Whitten and Franklin 1992; Crewe 1987:55). Estimates of the percentage of voters that would ”consider” voting tactically vary from an average Gallup figure in 1986– 87 of 15% to an average BBC Newsnight figure of 41% (Catt 1989). Even taking the low estimates both of voters that did cast, and voters that would consider casting, a tactical vote, the impact in terms of seats is potentially significant. Butler and Kavanagh (1988:266), for example, reckon that the Conservatives would have won 16 more seats than they did in 1987, had there been no strategic

7 The models of Palfrey (1989), Myerson and Weber (1993), and Cox (1997) all assume that voters’ know the expected constituency-wide breakdown of preferences with certainty. Myatt (n.d.), in contrast, assumes that voters have diffuse priors over this expected breakdown of preferences. These two differing formal assumptions correspond to two polar substantive assumptions. To take the case of three-party competition in a single-member district, one might assume that voters know, from previous elections, that the Conservatives generally get between 40–42% of the vote, with Labour at 38–42% and the Liberals at 16–22%. Pushing this substantive idea—that the voters know a lot about the expected breakdown of the vote between the three parties—to its logical extreme, one arrives at the models of Palfrey, Myerson and Weber, and Cox. On the other hand, what if the race is between three new parties in a new democracy; or a realignment of forces has made past results a poor guide to the future? Pushing this idea—that voters know little about the expected breakdown of preferences in a constituency—to its logical extreme, one arrives at the model of Myatt.

8 The results stated in this paragraph follow from the Palfrey/Myerson-Weber/Cox model. In Myatt’s model (which is fully developed for the M = 1 case), there is a tendency to concentrate votes on two competitors, but it stops short of the extreme identified in the earlier models. Thus, the version of the “M + 1 rule” that Myatt’s model would support would probably read something like: “When there are more than M + 1 competitors, votes will concentrate on M + 1 of them (but only to a limited extent).”

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voting. Kim and Fording (2001), however, estimate much lower impacts until the 1997 election.

These estimates of the proportion of the British population who vote strategically all use narrow definitions whereby a respondent votes strategically only if they report voting for a candidate who was not their most preferred but who was “in the running” to win the seat. If one looks only at voters who have an opportunity to vote strategically—supporters of trailing candidates—one of course finds very much higher rates of strategic voting (cf. Blais and Nadeau 1996).

This excursion into the literature on strategic voting suffices to demonstrate that part of the causal mechanism underlying the M + 1 rule appears to operate more or less as envisioned by the theory. Another sort of study that bears more directly on the M + 1 rule relates characteristics of electoral systems to the size of the party system. Many works investigate this relationship crossnationally, including Rae (1971), Taagepera and Shugart (1989), and Lijphart (1994) (for further citations, consult these works). All report a relationship between the number of parties in a country and the average or median district magnitude that is broadly consistent with the M + 1 rule.

For a limited number of systems, there are more direct tests of the M + 1 rule. These can be roughly divided into systems where the M + 1 rule is predictively accurate—such as the U.S., Japan (Reed 1991; Cox 1997; Niemi and Hsieh 2002), Taiwan (Hsieh and Niemi 1999), and India (Chhibber and Kollman 1998)—and systems where it is not—such as Canada (Gaines 1999, Blais 2002) and Papua New Guinea (Cox 1997). For both cases of apparent success and apparent failure, the interesting question is whether the theoretical preconditions of the M + 1 rule (e.g., relatively precise public knowledge of the candidates’ likely order of finish, prior to polling day) are met or not. Thus far, none of the exceptions to the rule occur where the theoretical preconditions are met; and none of the successes occur where the preconditions clearly fail. Nonetheless, it remains unclear how much the rule’s variable success is driven by variations in strategic voting as opposed to variations in strategic coordination at the elite level.

Summary

To reframe the two results just noted, variations in the voting method (V) affect whether strategic voting leads to a deconcentration of votes (in worst-punishing systems) or to a concentration of votes (in best-rewarding systems). Variations in the effective magnitude (M) affect the carrying capacity of best-rewarding systems, with higher values allowing more competitors in equilibrium.9

9 The third feature, P (proportionality), also plays a role—though it is harder to disentangle from that of V and M. For either V > 1 or M > 1, the possibility of significant variation in P arises, and the general rule is this: the more proportional the system, the less coordination is demanded, and the more parties there can be in equilibrium.

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3. COORDINATION OF ELITES WITHIN DISTRICTS

There are several species of coordination problem that elites face within electoral districts, of which I consider two. One deals with the provision of campaign finance by contributors. Another concerns optimal nomination.

Strategic Contributions

Suppose that contributors of campaign finance are primarily interested in legislative services that an elected representative can provide once in office (e.g., lobbying party leaders on behalf of the contributor; introducing bills for the contributor). Suppose also that potential entrants seek financing for a campaign by essentially selling access to their future labor (cf. Denzau and Munger 1986). If elected to office, candidates pay off their financial backers. Otherwise, their contributors get nothing. Given these assumptions, there will be a tendency for contributors to coordinate their contributions, because only winning candidates pay off and those with more contributions are more likely to win. At an informal level, what can be conjectured is that no more than M +1 competitors in an M-seat district will attract significant financial backing from contributors seeking legislative services (although contributions from ideologically motivated sources are a different story).

Such a conjecture seems to fit the facts in the U.S. congressional case (cf. Jacobson 1980). Often, there is only one well-financed candidate: the incumbent. Occasionally, there are two well-financed candidates, in which case the actual outcome tends to be much closer. Finding three or more well-financed candidates in the general election is extremely rare.

Optimal Nomination

Parties face three recurring problems when nominating candidates for office: overnomination, undernomination, and factional cheating on nomination deals. In this section, I briefly consider each of these problems.

Overnomination means nominating too many candidates, who then split the party’s vote too thinly and end up winning fewer seats than would have been possible had the party nominated fewer candidates.10 Undernomination means nominating fewer candidates than the party has votes to elect. Optimal nomination means fielding a number of nominees that maximizes the party’s expected seat share in the district.

10 In single-member districts, overnomination simply means nominating more than one candidate. It is an easy mistake to spot and all parties operating in single-member districts go to considerable (and generally successful) lengths to avoid dual candidacies. In M-seat districts, it is harder to say what constitutes overnomination. Nominating more than M candidates will usually be overnominating—but not necessarily if votes transfer or pool. In systems where votes do not transfer or pool, the party will have beliefs about its likely vote share. If it has votes enough to win M-2 seats, then it should nominate M-2 candidates and no more.

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In some systems, figuring out the optimal number of nominees is easy. For example, in the U.S. each major party either runs zero or one candidate in each district. The zeroes typically arise in districts that are so “safe” for the other party that the party decides to save itself the cost of running a candidate there. In most districts, both parties decide to run a candidate, although their commitment of resources is highly sensitive to the closeness of the race.

In systems with larger-magnitude districts, figuring out the optimal number of nominees is not as easy. For example, in a three-seat district in the Japanese election of 1980, some Liberal Democrats might have thought the party had enough votes to sweep the three seats, while others believed that only two seats could be won. If there were currently two Liberal Democratic incumbents in the district, they would naturally not wish to have a third colleague nominated, as this might reduce their probability of winning a seat from essentially 1 to roughly 2/3 (if they are correct that the party will win only two seats and if additionally each of the party’s nominees has an equal chance of winning a seat).

Studies of nomination in the Japanese system over the period of Liberal Democratic dominance (1955–1993) find a steady improvement in the party’s ability to arbitrate internal disagreements over nominations of the sort described above. In particular, early in the period the party fairly often overnominated, with the consequence that two or more of its candidates “fell down together,” as the Japanese put it, in a version of the game of Chicken. Experiences of this sort led fairly quickly to improved deal-making among the factions and fewer overnominations (Reed 1991; Cox and Rosenbluth 1994; Niemi and Hsieh 2002).

Similar coordination problems arise under other systems with multi-member districts, such as the limited vote in Spain (Lijphart, Pintor and Sone 1986), the single non-transferable vote in Taiwan (Cox and Niou 1994), and the cumulative vote system in Illinois (Goldburg 1994). When district magnitudes exceed five, there is an increasing probability that elections will be based on lists, which essentially solve the coordination problem mechanically by forcing candidates to share their votes with one another (or, alternatively, forcing voters to vote for indivisible groups rather than individuals).

4. COORDINATING ACROSS DISTRICTS

A distinctly different problem of coordination arises at the cross-district level. If there are multiple districts, each with its own population of parties, will those parties cooperate across district lines or not?

One advantage of cross-district coordination—or linkage—can be suggested by considering two districts in which two leftist parties each run a candidate against a single rightist candidate. Let us suppose that the leftists can win both districts, if they combine their votes, but neither, if they split. One solution to their problem is to negotiate cooperation in each district separately. Another,

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interests, rather than fulfill campaign pledges?13 The credibility of competitors’ promises is an important analytical issue for some purposes. However, this problem does not appear to affect the main comparative statics result derived above—that increases in V, M or P induce greater niche-seeking by competitors. Thus, I ignore it here.

Rent-Seeking Competitors with Credible Promises

In the office-seeking models discussed above, winning an office confers a fixed amount of utility on the victor. Conceptually, this utility might consist of the salary of the office, its prestige and any other “ego rents” attached thereto.

Another class of models assumes that office-holders can extract a variable amount from their office. In particular, several models envision one or more “predatory parties” whose maximand is their expected rent: the probability of their winning control of government, times the fiscal residuum they can extract once in control. Each party promises a certain tax rate; a certain expenditure on public goods; and a certain bundle of transfers to the groups in the electorate. If elected, the party collects taxes, provides the level of public goods and transfers promised, and keeps any residual for itself.

Several comparative static results drawn from this model hinge on electoral rules. I consider just one here: Persson and Tabellini (2000) show that changing from a single nationwide district operating under proportional representation (high M and high P) to a set of single-member districts operating under plurality rule (low M and low P) induces the following changes: parties promise more transfers to swing districts, financing the increased expenditure by reducing both the provision of public goods and their own rents. The logic of this result is as follows. If control of government comes down to who wins in a particular handful of districts, as it can in a district-based electoral system, competition will focus on those districts. But this means that both parties will offer more transfers to the voters in the swing districts, than they would offer to the same voters were there were no districts ( just a nationwide PR election).14 Studies

13There are several approaches to dealing with this credibility problem. Ferejohn (1986) and Alesina (1988), for example, consider repeated games of various sorts, attempting to identify when credibility will emerge endogenously. Bernhardt and Ingberman (1985) simply assume it is costly to state positions distant from those taken in the past. Osborne and Slivinski (1996) and Besley and Coate (1997) go even further, stipulating that the only credible promise that a candidate can make is to implement his or her ideal point. The Besley-Coate and Osborne-Slivinski models can be construed as replacing one sort of credibility problem with another. There is no longer the problem of voters believing anything the candidates say, because the candidates only state their ideals, which they then have an incentive to implement if elected. However, the models depend heavily on common knowledge of ideal points of all citizens. If a particular citizen’s ideal point is not common knowledge, then that citizen faces the issue of how credibly to communicate what his or her ideal really is.

14That these increased transfers are financed by reducing both public goods and private rents simply reflects that neither the level of public goods nor the fiscal residuum were pegged at corner solutions prior to the lower of M and P.

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by Lizzeri and Persico (2001) and Milesi-Ferretti, Perotti and Rostagno (2000) also conclude that, because targetable goods are electorally more valuable in district-based systems, the equilibrium level of transfers (pork barrel projects and other geographically targetable benefits) will be higher. As evidence in favor of the idea that district-based electoral systems promote transfers at the expense of general public goods, Persson and Tabellini (2000) show that expenditures on welfare are higher in more proportional systems, controlling for the age structure of the population, per-capita income, trade openness and federalism, inter alia.

6. MOBILIZATION

There are no formal game-theoretic models that consider how electoral mobilization varies with electoral rules. However, the literature has offered decisiontheoretic analyses (see Cox 1999b for a review). In terms of the current independent variables, the main results appear to be as follows. Higher levels of mobilization are more likely as V decreases; M increases; or P becomes more proportional. The logic of the first result is simply that, if voters cast lots of votes, then the mobilizing competitor may not internalize the full benefits of mobilizing any particular voter or segment of voters. The argument in favor of the second and third results is that more proportional translations of votes into seats reward mobilizational effort more surely and smoothly. In contrast, mobilizing in a single-member district may simply reduce the margin by which one loses, or increase the margin by which one wins—and neither of these outcomes is worth the effort to an office-seeking competitor. Empirical evidence in favor of these arguments can be found in Blais and Carty (1990), Blais and Dobrzynska (1998), Jackman (1987), Jackman and Miller (1995), and Powell (1980, 1982, 1986).

7. CONCLUSION

The vast majority of models of electoral competition have not been concerned with institutional comparative statics. Only a few take the electoral rules themselves as the primary independent variables. And, thus far, there is almost no work that alters non-institutional features of the model, then considers whether those alterations condition the effect of changing the rules. In this sense, the formal literature analyzing electoral systems is relatively thin.

In this essay, I have characterized the independent variable—the electoral system—in terms of three features: the effective number of votes per voter, the effective number of seats per district, and the proportionality of the votes-to- seats mapping(s). The dependent variables—the strategies adopted by electoral competitors within a given electoral system—have been parsed into strategies of coordination, persuasion and mobilization.

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Coordination

Taking voters’ preferences and turnout probabilities as fixed, political competitors face problems in coordinating endorsements, entry, campaign finance and votes to maximize their respective seat shares. The severity of the coordination problem(s) that competitors face depends on the electoral rules governing their competition. The most prevalent voting methods give citizens just one vote to cast (either for a candidate or a list) and fall into the “best-rewarding” category. For such voting methods, strategic coordination leads to a concentration of votes upon a subset of viable candidates. The size of this subset is determined by the number of seats available to be won, with the most general rule of thumb encapsulated in the “M + 1 rule”: the number of viable competitors cannot exceed M + 1 in equilibrium (when voters are primarily interested in who wins the current election and have sufficiently precise information concerning the likely order of finish of the competitors).

Persuasion

Rather than taking preferences as fixed, political competitors can also engage in a variety of persuasive activities. They can promise to deliver either broadly targeted goods (in the extreme, Samuelsonian public goods) or narrowly targeted goods (in the extreme, private goods) or something in-between. The results on persuasion I have reviewed here all make essentially the same point: that electoral systems differ in the extent to which they encourage competitors to fashion narrow appeals.

At the within-district level, fewer votes per voter, more seats per district, and greater proportionality lead competitors to cater to narrower clienteles within the electorate. If competitors are constrained to promise only public goods, they “cater to narrower clienteles” by spreading out over the ideological spectrum, rather than bunching at the median (Cox 1987; 1990). If they are constrained to promise only private goods, they “cater to narrower clienteles” by targeting their bribes, rather than diffusing them (Myerson 1993).

At the across-district level, elections based on small-magnitude districts lead competitors to prefer geographically targetable goods, rather than national public goods. The reason is, roughly, that geographically targetable goods can be promised specifically to districts where the competition is close, whereas public goods cannot.

Mobilization

Holding voters’ preferences and their estimates of candidates’ viability constant, competitors can seek to affect their decisions to vote or abstain. The general findings in the literature are that fewer votes per voter, more seats per district, and greater proportionality increase the mean level of turnout and decrease the variance in turnout. This relationship suggests an alternative causal mechanism to

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explain the observation (Persson and Tabellini 2000) that more proportional electoral systems foster greater expenditures on welfare: more proportional systems (higher M and P) lead to higher turnout rates among the poorest citizens (those who are the first to “drop out” under more majoritarian systems with their lower turnouts); more consistent turnout among the poorest citizens leads to more consistent policies serving their social insurance desires (cf. Lijphart 1997).

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