New Economic Sociology and New Institutional Economics
(1)
Department of Economics, Saarland University, Saarbrücken, Germany
Updated and slightly modified version of a paper presented at the 5th Annual Meeting of the International Society for New Institutional Economics at Berkeley, USA, Sept. 13–15, 2001. I benefited from detailed comments by Mark Granovetter, Richard Swedberg, and Oliver E. Williamson. The usual disclaimer applies.
1 Introductory Remarks
This article deals with similarities and differences between the New Economic Sociology (NES) in below explained sense and the New Institutional Economics (NIE) as described in the previous chapters. As we shall see, both deal with social actions. What are then the differences between the two fields—the fundamental differences that is—or are there none?
According to Smelser and Swedberg (1994b: 4) there are considerable differences at least between classical sociology and classical economics:
in sociology actors are influenced by other actors,
in economics actors are uninfluenced by other actors, the conditionds of perfect competition prevail.1
But at a closer look, the contrast between the two fields is less sharp. Economists since Cournot (1838) know and recognize the fact that “actors are influenced by other actors.” But with the evolution of neoclassical economics,2 economists become obsessed with the goal of efficiency (Pareto efficiency that is), and wanted to establish in the real world conditions “as if” we would have perfect competition. It is this ideal-typical view of neoclassical economics that has been challenged, among others, by NIE in the sense of Oliver Williamson.
A deeper difference between classical sociology and (neo-)classical economics exists with regard to their respective models of man:
sociologists allow for various types of human action, including rational action;
(neoclassical) economists assume only perfect rationality. (Smelser and Swedberg 1994b: 4)
More precisely, perfect individual rationality is the fundamental assumption of neoclassical microeconomics. It was challenged by Simon (1957), whose concept of bounded rationality was applied by Williamson as an important element of his NIE (Williamson 1975). North, in his later work, seems to go even further. He states that
a modification of these [rational choice] assumptions is essential to further progress in the social sciences. The motivation of the actors is more complicated (and their preferences less stable) than assumed in received theory. (North 1990: 17)
With the development of NIE, economists deeply infiltrated sociologists’ territory and sociologists, understandably, rose in arms. They lined up to a counter attack under the banner of New Economic Sociology (NES). It was started in the 1980s at Harvard by former students of Harrison White, among them Eccles (1981), Granovetter (1985), Michael Schwartz. Independently of the Harvard group, several other sociologists joined battle, among them Abolafia (1984), Shapiro (1984), Zelizer (1983). Their objective was to attack economists “by elaborating the sociological viewpoint as forcefully as possible.” (Granovetter and Swedberg 1992: 7) In this article, we are using the term “NES” in above limited sense.
The number of studies in economic sociology exploded during the following years as illustrated by the review article of Baron and Hannan (1994), the Handbook of Economic Sociology edited by Smelser and Swedberg (1994a, 2005).3 Sociologists rediscovered their old object of research, “institutions”, and developed their own brand of new institutionalism (Powell and DiMaggio 1991: 1 ff.; Brinton and Nee 1998: 1 ff.; Nee 2005). Not amazingly, the overlap between the syllabi of graduate courses in economic sociology and issues of microeconomics became remarkable (cf. James Montgomery4). Are the two fields growing together?
They should, writes Granovetter (2001: 1). Economists and sociologists should build a unified theory on what they have accomplished—an old dream of Max Weber’s, a continuation of the views of Gustav Schmoller, whom Schumpeter (1926: 355) described as the “father” of American institutionalism. However, the growing together of sociology and economics was thoroughly destroyed by the German battle of methods (Methodenstreit) opened by Menger (1883/1963). Menger’s opinion of the “true methodology” of economics, i.e., neoclassical microeconomics became the dominant methodological position among mainstream economists. Is this still the case? We don’t think so. There has been a change in economics since, among others, Coase (1937, 1960) and the development of modern institutional economics.
We shall continue as follows: We shall start with a brief report on the basic ideas first of New Economic Sociology (as understood in this article) and then New Institutional Economics. As for the latter, we shall concentrate on NIE in the sense of Oliver Williamson who introduced the term (Williamson 1975: 1). Next, we shall report on representatives of NES fighting Oliver Williamson’s ideas. Their battering ram “social network theory” will be briefly described and an attempt made to combine network analysis with new institutional economics as understood by Williamson. The paper will be concluded with some thoughts on the convergence of NES and NIE.
2 Basic Ideas of New Economic Sociology
According to Smelser and Swedberg (1994b: 18) NES covers many of the substantive areas of old economic sociology. But there are also a number of new directions. Their theoretical approaches are fundamentally eclectic and pluralistic. No single perspective is dominant. The influence of Weber (1922, 1968) and Parsons (1937) is evident, also that of Polanyi (1944). Some representatives of NES are attracted by the critique of capitalism like Mintz and Schwartz (1985). More interesting, however, is the concept of “embeddedness” as used by Granovetter in the sense that “economic action takes place within the networks of social relations that make up the social structure.” DiMaggio (1990) adds that the economic action is embedded not only in social structure but also in culture. Points of interest are
What are the most prominent concepts of new economic sociology? That is no easy question to answer for an economist. We shall try our best, following Max Weber’s (1968) line of thought.
2.1 Some Preparatory Remarks
As mentioned above, sociological concepts are targeted on social action, “which … may be oriented to past, present or future behavior of others.” (Weber 1968: 22) Interestingly, the reference point is, for Weber, the same as for neoclassical economists—the ideal type of a “purely rational course of action … which has the merit of clear understandability and lack of ambiguity.5 By comparison with this, it is possible to understand the ways in which actual action is influenced by irrational factors …” (ibid.).
In other words, Weber used as reference point the zero transaction cost world with perfect individual rationality; a benchmark strongly opposed by representatives of NIE (cf. Furubotn and Richter 2005: 510 f.). Demsetz (1968) coined the term “nirvana approach” for such comparisons.
Sociologists, as economists, deal with empirical uniformities or laws related to social actions. “Sociological investigation is concerned with these typical modes of action.” (Weber 1968: 29) The existence of such “typical modes of action”(hypotheses, laws) enables us to predict or explain social phenomena, that is, to logically derive them from other known social phenomena.
An economist is tempted to translate the analytic methods of economic sociology into the analytic methods of economics. Economists tend to reduce their concepts to rational choice theory. Concepts without such a “micro-foundation”, like the Keynesian absolute income hypothesis, are what economists call “ad hoc.” Thus, old Keynesian macroeconomics is “ad hoc,” while Neokeynesians try to clear Keynesianism of their bad name by developing “micro foundations” of old Keynesian hypotheses. Economists assume perfect individual rationality to which they try to reduce all social phenomena including power or trust.6 Sociologists, instead, have a broader view; they dislike this “reductionism” and tend to regard phenomena like power or trust as fundamental parts of their theoretical constructions. Thus, what looks ad hoc to an economist may be a basic axiom for a sociologist.
Nevertheless, Max Weber (1968: 9) distinguishes between “sociological mass phenomena, the average of, or an approximation to, the actual meaning” and “the meaning appropriate to a scientifically formulated pure type (an ideal type) of a common phenomenon.”7 The first corresponds, in the language of economists, to an ad hoc reasoning the second, in the terminology of sociologists, to a “reductionist” view. Still, average regularities in human behavior need not be reduced to the axioms of individual rationality. They could also be reduced to other underlying principles like neuro-biological, sociobiological, social-psychological, etc. laws. Economists, born reductionists, are becoming increasingly aware of such alternatives to pure rational choice (see, e.g., Robson 2001). Nevertheless, in the following we’ll disregard any “reductionism” ourselves concentrate, in the language of economists, on sociological concepts of the “ad hoc” type.
2.2 Some Fundamental Sociological Concepts of NES
We choose the following three NES concepts8 by understanding them to be (in above sense) ad hoc assumptions:
1.
Economic Action as Social Action:
“Economic action is seen only as a special if important, category of social action.” (Granovetter 1992: 76) Economic relations between two parties can be of different character: implicit or explicit; hierarchical or among equals, mutually binding contractual relations with freely chosen partners (according to the principle of freedom of contract) or power relationships (dominance and compliance), reciprocal or one-sided, based on trust or burdened by suspicion, etc.
2.
Embeddedness of Social Action
Social actions are constrained by ongoing social relations and cannot be explained by reference to individual motives alone (Granovetter 1992: 53). They are “embedded” in ongoing networks of personal relationships, economic and non-economic, rather than being carried out by atomized actors. The embeddedness concept can be described by social network analysis.
3.
The Social Construction of Economic Institutions
Real world institutions are rarely the result of games of pure coordination in which agents interests coincide perfectly, they are seldom the work of “invisible hand” as in David Hume’s or Carl Menger’s famous examples. They are mostly mixtures of conflict and coordination, of opposing and coinciding interests (Lewis 1969: 14). Sociologists, therefore, understand institutions to be “social constructions,”9 i.e., the product of visible hands. Thus, e.g., there is no “invisible hand” behind the creation of a market but a sharp struggle of interests (Granovetter and Swedberg 1992: 17). Further, institutions need not be the result of [purely] rational choice. The way to develop institutions may be by trial and error, which may be understood as a form of boundedly rational action. Another form may be habituated actions that precede any institutionalization (Berger and Luckman 1966: 53).
Path dependency of institutions matters, not necessarily efficiency. The most efficient solution does not always win out as illustrated by the famous, though questionable, QUERTY example (David 1986, but Liebowity and Margolis 1990; Williamson 1996: 242). Scott (1994: 78) points out “Economists, political scientists, and sociologists productively debate the uses and limits of rational choice, and some economists have begun to wonder whether rule-driven behavior may not have its [boundedly] rational aspects.” Hamilton and Biggart (1988, 1992: 182) emphasize the cultural view of organizations: “… industrial enterprise is a complex modern adaptation of preexisting patterns of domination to economic situations in which profit, efficiency, and control usually form the very conditions of existence.”
3 Basic Ideas of New Institutional Economics
The term “New Institutional Economics” was introduced by Williamson (1975: 1) in his book on Markets and Hierarchies. It became soon catchword for the economic analysis of institutions, in general.10 After some additions, Williamson called later his version of NIE “transaction cost economics”, or shortly TCE (cf. Williamson 1979, 1985). There are many more representatives of this analysis, but it is mainly Williamson’s style of reasoning, which challenged sociologists most vehemently. We shall, therefore, concentrate on the comparison of Williamson’s NIE with NES, starting with a brief review of the basic ideas of Oliver Williamson’s older and newer versions of the New Institutional Economics.
What became transaction cost economics was developed stepwise in a series of articles published roughly between 1971 and 1985.11 These articles were published and rounded off in Williamson’s two books Markets and Hierarchies of 1975 and The Economic Institutions of Capitalism of 1985. Williamson’s claims are bold: “Contrary to earlier conceptions—where the economic institutions of capitalism are explained by reference to class interest, technology, and/or monopoly power—the transaction-cost approach maintains that these institutions have the main purpose and effect of economizing on transaction costs.” (Williamson 1985: 1). To sociologists, born skeptics of efficiency considerations, this view was like a red rag to a bull.
The main thrust of his two books may be sketched as follows.
3.1 The Markets and Hierarchies Approach to Economic Organization: Williamson (1975)
Williamson’s markets and hierarchies approach concerns social actions, underlining the affinity of his theory to sociology. The unit of analysis is the transaction understood as a bilateral or dyadic relation. Its execution causes transaction costs part of which are transactions specific investments. Transaction costs are related to incomplete information (uncertainty) and the limits of human cognitive abilities—in sum: with bounded rationality. Specific investments and incomplete information invite opportunism. Court ordering is only partly ineffective and has to be complemented or even substituted by private ordering through internal organization (hierarchy).
Chapter 8 of Williamson (1975) deals with the transition of the organizational form of large enterprises from the unitary form (U-form) to a multidivisional structure (M-form). The chapter relates to Williamson (1967, 1970) and Williamson and Bhargava (1972), which are largely based on the “control loss phenomenon” (1967: 129). Transaction costs are not mentioned. Central argument is the advantage of the M-form relative to the U-form, but Williamson lists als, textbook style, five “characteristics and advantages of the M-form innovation” (1975: 137). Among these are the division between operating and strategic decisions, the first “assigned to (essentially self-contained) operating divisions”, the latter “principally” to the general office. The M-form would be “corrupted” when the general management involves in the operating affairs (1975: 148). This contention became later an easy target of sociologists’ critique.12
3.2 The Transaction Cost Approach to Economic Organization: Williamson (1985)
The term “transaction cost economics” as a name for a new type of economics was first mentioned in Williamson (1979). The concepts used are the same as in Williamson (1975) plus two more, the concepts of fundamental transformation and relational contracts. These two additional concepts together with the main ideas of Williamson’s TCE may be reviewed as follows:
Non-standard contracts need not result from monopolistic practices. The reason is that transaction specific investments can play an essential role after the conclusion of a contract. Williamson illustrates this by use of his concept of the fundamental transformation 13: After contract conclusion, the parties find themselves locked into a bilateral monopoly situation, whereas before they were free to choose with whom to trade. Transaction-specific investments of whatever kind (if only in the form of time invested in search, inspection, and bargaining) are the reason for this transformation. In addition, the parties don’t know what the future will bring. Under uncertainty, it is impossible to write a complete contract that details all possible future contingencies. Contracts, in particular longer term contracts, remain unavoidably incomplete or “relational”, i.e., the relationship between the parties matters. The problem is that the lock-in of the parties, in combination with transaction costs and incomplete foresight, may invite opportunistic behavior (“hold up”) on the other side. Due to transaction costs the parties have difficulties or are unable to verify their case to a third party (e.g., court). Thus, court ordering may have to be supplemented or even substituted by private ordering to protect the parties against opportunism of their trade partners. There exist various ways to organize the governance structure of the contractual relationship, not only markets and hierarchies.14 Their efficacy depends on particular circumstances, among other things, the size of specific investments and the frequency of transactions between the parties.
Discussion
Williamson’s new “1985” version of NIE, his TCE, is a theory of bilateral contracts under conditions of uncertainty and asymmetric information where legal enforcement and self-enforcement complement one another. Both, court ordering and private ordering, characterize the governance structure (or “organization”) of non-standard contractual relationships. Attentive actors agree before they come to terms with a governance structure that they regard suitable to protect them against ex post opportunism. Market and hierarchy are two of the imaginable ideal types in the n-dimensional space of possible governance structures. It is important to see that the choice of an efficient (better: “efficacious”) governance structure results not from constrained optimization. It should rather be understood as a form of boundedly rational or “suitable” choice from a set of governance structures in the sense of Selten’s hypothesis of the casuistic structure of boundedly rational strategies (see Furubotn and Richter 2005: 180). An alternative would be Alchian’s (1950: 218) earlier argument “that modes of behavior replace optimum conditions as guiding rules of action.”15 Which governance structure the parties choose depends on the existing situation. To be chosen is the governance structure with the higher probability of survival. The problem for the parties, then, is to agree on both the “right” diagnosis and the relative “best” cure (governance structure). Williamson’s (1985: 79) table of “efficient governance”, where he suggests four types of governance structures or his later distinction between “market, hybrid, hierarchy” (1996: 117), is to be understood as an example of how to think, not an answer to the parties’ actual decision problem.
Note that TCE, as described above, is concerned with the governance structure of strictly dyadic relations. In real life, as Granovetter (1985) pointed out, actors are embedded in complex networks of contractual relationships (rights of disposition), formal and informal ones. Thus, the application of the TCE approach to network analysis might be of interest. Williamson (1993: 56) concedes:
Transaction cost economics mainly works out a dyadic set-up. Albeit adequate and instructive for studying many complex transactions, provision for larger numbers of actors and interaction is sometimes needed
4 The Attack of New Economic Sociologists on Transaction Cost Economics
As mentioned above, sociologists’ critique centers largely on Williamson (1975), viz., on the contrast between markets and hierarchies, or on the assumption of a continuum between the extremes of markets and hierarchies.16 We shall briefly report and discuss the critical comments by seven proponents of NES: Perrow (1981, 1986), Fligstein (1985), Granovetter (1985), Bradach and Eccles (1989), Powell (1990), and Freeland (1996a).
Perrow (1986: 236) criticizes Williamson’s argument “… that efficiency is the main and only systematic factor responsible for the organizational changes [to giant organizations] that have occurred.”17 In Perrow’s view, Williamson ignores the uses of power in shaping behavior both inside and outside the organization and oversimplifies the motivational complexity leading to different social arrangements (Perrow 1986: 247). Rather, the reasons for firms to become big would be quite diverse, saving on transaction costs might be only of modest importance (248).
Discussion
Williamson and Ouchi (1981: 388) replied to the power argument that “vertical integration knows no limits. In the quest for power, integrate everything.” This would be a refutable implication, contradicted by the facts. “Selective rather than comprehensive vertical integration is predicted by the transaction cost approach.” (loc.cit.: 389) Over time, only integration moves that have better rationality properties would tend to have better survival properties (ibid.). As for the rest, Williamson (1996: 238 ff.) argues, power is a diffuse and vaguely defined concept.18 Of the various forms of power at most resource dependency would be distinctive to organization theory (and TCE). But it assumes myopic contracts, i.e. contracts without sufficient ex ante safeguards against ex post opportunism (Williamson 1996: 239) while TCE “regards dependency very differently because it works out of a farsighted rather than myopic contract perspective.” (Williamson 1995: 35)
Fligstein (1985) compares various theories of what causes the change in the organization of enterprises from the unitary form (U-form) to a multidivisional structure (M-form), among them the transaction cost analysis. According to Williamson (1975), the M-form is a consequence of cumulative “control loss” effects with increasing size due to transaction costs, bounded rationality and opportunism.
Fligstein (1985: 382) tests the various theories on the basis of the lists of the 100 largest firms by asset size and finds that Williamson’s argument is not “an important explanation” of the genesis of the M-form. Organizational change does not imply that the most important organizational problems are being solved. Instead, Fligstein advances the theory that actors are first constructing an organizational problem, then claim to be able to solve it, and finally, in order to do so, have to be in a position to implement their proposed solutions. In other words, they must be key actors whose strategic bases of power are consistent with the proposed organizational form (386). “In the end, the actions of key actors may or may not work to preserve the organization.” (1985: 388 f.)
Fligstein later clarifies that his model of action is not to be mistaken for the model of perfectly rational or boundedly rational actors of economic theory. Rather, “actors are assumed to construct rationales for their behavior on the basis of how they view the world. Their goals and strategies result from those views and are not the product of abstract rationality. The construction of courses of action depends greatly on the position of actors within the structure of the organization, which forms the interests and identities of actors.” (Fligstein 1990: 11)
Discussion
Fligstein’s view comes close to the power argument by Pfeffer (1981) and Perrow (1970, 1981). He argues “actors must have some resource base either within the organization or the environment whereby they have the power to enforce their solution in the organization.” (Fligstein 1985: 388) Insofar as resource dependency is the source of power, Williamson’s (1996, 238 ff.) counterarguments apply. They are quoted above. The comparative character of Williamson’s argument, that the M-form “favors goal pursuit and least-cost behavior more…than does the U-form organizational alternative” (Williamson 1975: 150) is disregarded or takes second place.
Freeland (1996a, b) doubts that the M-form succeeded because it reduced costs by creating a clear distinction between strategic and tactical planning. He supports his view by a paradigmatic case study of General Motors between 1924 and 1958. “For most of its history, GM intentionally violated the axioms of efficient organization to create managerial consent… The textbook M-form may actually undermine order within the firm, thus leading to organizational decline.” (1996: 483)—“Although TCE makes the problem of order central to organizational analysis, the resolution that it offers is fraught with difficulties.” (487).
Discussion
Freeland calls the target of his critic “TCE,” though Williamson developed TCE only in 1979ff.. De facto, Freeland criticizes Williamson’s earlier work of 1967, 1970 and 1972, which is based, as was mentioned above, on the control-loss phenomenon (Williamson 1967: 123). The term “transaction cost” does here not appear, let alone transaction cost economics. Freeland could have mentioned that in his critic. In its substance, Freeland’s criticism tends to be somewhat sophistical. Williamson develops, expressis verbis, his arguments for the M-form relative to the U-form. Of course, voluntary acceptance of an order (i.e., its legitimacy) is vital for its functioning. But that includes a broad range of control techniques of a hierarchy from strict fiat (e.g., military command structures) to utmost participative decentralization (e.g., in extreme cases of codetermination). The most effective type of voluntary acceptance of an order, if there is one, depends probably on ruling circumstances. Williamson did not analyze this issue.
Granovetter (1985, 1995) wrote, according to Hamilton and Feenstra (1995: 56), the most important critique of Williamson’s NIE. His critique also centers on Williamson (1975). Granovetter argues that Williamson’s appeal to authority relations “in order to tame opportunism” constitutes a rediscovery of Hobbesian analysis, an over-emphasizing of hierarchical power. The ‘market’ would resemble Hobbes’s state of nature. “It is [in the end] the atomized and anonymous market of classical political economy, …” (Granovetter 1995: 224). Instead, “the anonymous market of neoclassical models is virtually nonexistent in economic life and … transactions of all kinds are rife with … social connections … This is not necessarily more the case in transactions between firms than within …” (1995: 217). Williamson’s dyadic approach disregards the individual’s embeddedness in a social network and its effect on the creation of trust (Granovetter 1995