Coordination costs are the most underestimated category of economic costs. They explain more about organisational design, market structure, and institutional form than most economic theory acknowledges.
The Coasian Insight
Ronald Coase's foundational insight — that the boundaries of the firm are determined by the relative costs of coordination within the firm versus coordination through the market — introduced coordination costs as an explicit variable in economic analysis. The firm exists because, for certain transactions, the hierarchical coordination within the firm is less expensive than the market-based coordination that would be required to achieve the same result without an employer-employee relationship. The firm grows until the cost of internal coordination equals the cost of market coordination for the marginal transaction. The insight is elegant and powerful, but it understates the diversity and importance of coordination costs in economic life.
Coordination costs are not limited to the transaction costs that Coase identified — the costs of finding a counterparty, negotiating terms, and enforcing contracts. They include the costs of aligning information — ensuring that the actors who need to coordinate have access to the same relevant information. They include the costs of building the trust that makes coordination reliable — the relationship investment, the reputation maintenance, and the institutional design that allows strangers to transact with confidence. And they include the costs of maintaining coordination over time — the renegotiation, the adaptation to changing circumstances, and the management of the defection risks that sustained coordination always faces.
Coordination Costs as Development Constraint
Coordination costs are disproportionately high in low-income and weakly institutionalised environments — which is a significant part of why those environments are low-income. The absence of reliable contract enforcement raises the cost of market coordination by requiring counterparties to manage the risk of non-performance without recourse to legal remedies. The absence of reliable information infrastructure raises the cost of finding counterparties and verifying the quality of what they offer. And the absence of the trust infrastructure that established relationships and institutional reputation provide raises the cost of all transactions that require confidence in the other party's reliability.
Coordination costs are the hidden tax on every economic transaction. In well-institutionalised environments they are low enough to be ignored. In weakly institutionalised environments they are high enough to prevent the transactions that development requires. Reducing them is institutional development's most consequential contribution to economic performance.
Discussion