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

Institutional economics has explored the relationship between markets and firms, institutions of governance and economic performance, and why societies choose inefficient institutions, among other crucial questions in political economy. Building on the seminal insights of Ronald Coase (1937), this article develops a theory as to how and why economic interactions generate institutions of governance in the first place. The theory demonstrates that the same transaction cost dynamics that lie behind the emergence of firms also generate institutionalised processes of governance such as regulation and dispute settlement that facilitate the continuity of market interaction. Conflict and competition in market interaction combined with the transaction cost problem lead to mutually beneficial co-ordination mechanisms and the emergence of order essential to the continuity of market exchange. Thus the broader patterns of institutionalised co-ordination we characterise as governance are endogenous to the self-interested and rational utility-maximising behaviour of economic agents.