Armies & transactions costs

Alex points out that in Libya, as in Egypt, the government has been hiring expensive mercenaries to attack protestors. This raises an interesting issue in transactions cost economics, as inspired by Coase (pdf) and Williamson.
The obvious question is: why should a government resort to markets to buy protection when it has huge organizations - the police and army - which are supposed to do this job?
The answer, I think, lies in the fact that, occasionally, the alleged benefits of organization - that they reduce the costs associated with market transactions - actually break down. I’m thinking of three things here:
1. Incomplete contracts. It’s often impossible or expensive to write a contract specifying what a supplier should do in all contingencies. Where this is a big problem, internal organization is one solution. It allows the buyer to simply order the supplier around.
However, if a government looks like collapsing, this mechanism doesn’t work. The supplier of protection - soldiers - will not accept orders to kill protestors for fear that they will be prosecuted for human rights abuses if the revolution succeeds. In such cases, the implicit contract within organization is incomplete and unenforceable. 
By contrast, because mercenaries can disappear more easily - there’s no paper trail proving their employment - they are more able to get away with murder.
2. The hold-up problem. A buyer might want a supplying firm to invest in particular plant or area. The supplier, though, might be loath to do so, for fear that it will be left with unprofitable assets if it loses the contract with that buyer. In such cases, the supplier holds up the buyer’s production. The solution is for the buyer and supplier to merge, so organization replaces a market transaction.
However, this does not automatically solve the problem. Suppliers might still be reluctant to obey orders, if - given point 1 - they cannot be assured of a reward.
3. Asset specificity. It’s widely thought that if a buyer needs a highly specialized asset, it should own it directly, as this gives one greater control over it. By contrast, general purpose assets can be bought easily in the market.
The thing is, the very specificity of the Egyptian army made it difficult for Mubarak to control. Many Egyptian soldiers took a specific view of their job, figuring “I didn’t join up to fire on my compatriots”. Mubarak therefore needed a more general asset - thugs and arseholes - which he bought in the market.
As for why such arseholes are so expensive, I suspect there’s an element of Smith’s compensating advantages - governments have to compensate for the risk of being caught by protestors - but also of efficiency wages; governments have to buy a modicum of loyalty.
There are, I think, a couple of general principles here. First, transactions costs are such that they can cause markets to supplant organizations even in very unexpected places, such as the army. Organization does not necessarily solve the problems of incomplete contracts, hold-ups and asset specificity. A smarter writer than I would write a piece along the lines of "Mubarak's lessons for the AOL-HuffPo merger."
Secondly, even where markets are superior to internal organization, they can fail badly. Just ask Mubarak.

Comments

[chris strange]

The protestors where even less hierarchical than Mubarak's hired help. To continue the financial analogy it was effectively composed of individual entrepreneurs rather than the firms (as the Krays might have called them) hired by Mubarak.

[vermogensbeheerder]

Our economy is drowning because of some reasons which are not actually important. Just like of this blog. Why do we need to pay for another group of people for our protection, which are supposed done y our police and army. It costs too much to do such thing. Instead ,of having that idea, what if let just focus to the assets of our government and let us just preserve and use them wisely.

[Roger]

So OK why do we assume that mercenaries recruited from literally dirt-poor countries are more expensive than Libyan regulars?

Certainly flying in elite former-Spetsnaz commandos from Russia might cost a lot - but Zimbabweians, Sudanese and Chadians?

They may well just be paying a few hundred of these guys $10 a day plus a license to loot and rape.

And Gaddafi owns an entire oil-rich country - there is almost literally no limit to how much money he has to spend on his personal survival.