What Embeddedness Is
‘Economics,’ said Robert Lucas once, ‘cannot tell us much about the human character. It can, however, tell us about the choices we make given a particular set of preferences.’ This article tells the story of how a group of sociologists and anthropologists found the Lucas position untenable. Isn’t the point of social science to tell us about the human character, they asked? In trying to develop methods to pursue the question of where our preferences come from, these scholars created a new field of research: economic sociology1.
The empirical focus of economic sociology, the propensity of its exponents to go out into the field, to offices and factories and shops to actually observe economic behavior, gave rise to a number of startling results that neo-classicists seem to have left unexamined. This article is an exposition of one of the seminal results of this stream of research, embeddedness1.
The neo-classicists assume rational behavior and perfect markets, and so social relationships have only minute effects on economic outcomes. Economists treat them as frictions that give rise to inefficiencies2. The new economic sociology has postulated that economic choice does not occur within a vacuum – social relationships are central to the conduct of exchange. Such social relationships have a profound effect on economic action. Economic behavior is thus embedded in a matrix of social relationships. The embeddedness approach predicts that concrete social relationships or ‘networks’ will matter and thus be found wherever the price system (and its associated institutions) is less efficient in coordinating economic activity in comparison3.
Different Forms of Embeddedness
Embedded ties have three definitive components: 1) trust; 2) fine-grained information transfer; 3) joint problem solving arrangements. The following examples of different forms of embeddedness serve to illustrate the operation of these components.
a) Between women’s better-dress firms in New York City
Embeddedness is prominent in interfirm networks among women’s better-dress firms in New York City. Such firms conduct transactions using two kinds of ties: arm’s length ties and embedded ties. Most inter-firm relationships are arm’s length ties – social relationships that are ‘strictly business,’ managed as the neo-classical model would dictate, but every firm has special relationships critical to its smooth functioning that are embedded3.
Many CEOs interviewed noted that embedded ties between their firms and others were characterized by trust. They noted that ‘trust is the distinguishing characteristic of a personal relationship’ and that ‘trust means he [the partner] is not going to find a way to take advantage of me’3.
b) Between individuals in a Moroccan bazaar: Fine Grained Information Transfer
The rational behavior assumption by itself does not prevent economic agents from using force or fraud to gain their ends1. Information about the likelihood of a given agent engaging in malfeasance is costless in perfect competition, but imperfectly competitive markets display information asymmetries often1. Price and quantity data in such markets does not reveal to economic actors all that they want to know. Such asymmetries enable agents to pursue ‘self-interest seeking with guile’2. This is the classical problem: why economic action does not disintegrate due to mistrust and malfeasance2.
One form of economic embeddedness in social structure arises because of ordered preference for such information: information from a trusted informant that he has dealt with that individual and found him reliable is preferred over information from, say, an acquaintance. Even better is information from one’s own experience of past dealings with the individual2.
This is for four reasons: 1) it is cheap; 2) it is richer and known to be accurate; 3) continuing relationships discourage malfeasance because both agents have an interest in future transactions and 4) continuing relationships generate social expectations of trust2.
Evidence for this theory can be seen in the functioning of a Moroccan bazaar. This bazaar is characterized by information asymmetries even though it is a case of near-perfect competition. The seller knows more about the commodity he is selling than the buyer does. The buyer does not move through each seller in the market to search for information because it is costly to do so (in terms of time and effort). Instead, he or she often chooses to develop a social relationship with one seller and continue this relationship over time2.
c) From Real Analysis at the University of Chicago to: Joint Problem Solving Arrangements
Real analysis is the first upper-level mathematics sequence in which undergraduate math majors enroll at the University of Chicago. The course syllabi are clear on the way to approach this course: in groups. A student must form social relationships (‘study groups’) with those in his or her section to work on homework together and produce optimum output in the form of homework points and human capital gained.
The math department seems to recognize that better output is produced if people work together on problem sets using embedded ties. Cut-throat market competition where students only use arms length ties to generate output (in the form of homework points and human capital gained) might not yield optimum results4.
Effects of Embedded Ties
The most important effect of embedded ties is trust. One way to view the formation of social relationships is trusts generation. Economic agents seem to realize that trust can provide huge efficiency gains. Trust substitutes for neo-classical risk calculation when such calculation is complicated, and information to conduct this is hard to come by. Firms in embedded relationships do not try and cull this information, nor do they construct costly monitoring mechanisms, to keep track of every action of the partner. The heuristic nature of trust allows firms to make complex decisions quickly and accurately. It also enables firms to adapt flexibly to variegated stimuli in a way that would be impossible were risk to be calculated in the neo-classical way3.
A relationship based on trust can have negative effects too. It is a well-known fact that ‘we hurt most the ones we love.’ The trust engendered by personal relations naturally presents enhanced opportunity for malfeasance. Confidence rackets work by gaining trust and then abusing it3. Force and fraud are most efficiently pursued in teams. A certain level of trust must exist between members of such teams2.
New institutional economics posits that continuing relationships can generate seemingly altruistic behavior on the part of individuals who are otherwise shrewd and self-seeking, but high levels of trust generate considerable temptation. The example of a diamond exchange is illustrative. Diamonds change hands frequently in the exchange, and in most cases malfeasance does not occur (due also in part to an internal system of mutual monitoring) but the diamond business has seen a series of well publicized ‘insider thefts’2.
The presence of embedded ties, because they are based on trust, yields greater network returns for firms. Pareto-improvements in solving coordination problems become more likely and firms can adapt to fast-changing environments quickly and in a flexible way. The greater a firm’s embeddedness in a network, the greater will be its investment activity and risk-taking. It also increases the likelihood of integrative agreements between firms being reached, allowing them to economize on searching for information. These are just a selection of the benefits that embedded ties carry with them3.
However, there is an equilibrium level of embeddedness for every network. A firm that relies only on embedded ties in its operation will be susceptible to institutional change that rationalizes the basis of embedded ties or preclude their formation. Overembeddedness also makes every firm in the network more susceptible to the loss of the ‘core’ organizations in the network. Another negative effect of overembeddedness occurs if the social aspects of exchange outweigh economic imperatives. It follows that only firms that make use of both social networks and the price system will be operating at optimum level3.
To an observer like me, by no means a professional economist, it seems that neo-classical economics makes an implicit claim to having a monopoly on the study of economic behavior. This claim is as counterproductive as it is incorrect. Once we acknowledge that economic relations and social relations each would not be possible without the other, boundless potential for rich new streams of research emerges. It is for both economists and sociologists to recognize this potential and exploit it in the coming years. Whether we can bridge the chasm that separates economists from other social scientists, only time will tell.
- Granovetter, Mark and Richard Swedberg. The Sociology of Economic Life, 2nd ed. Westview Press, 2001.
- Brian Uzzi. “Social Structure and Competition in Interfirm Networks.” SEL, pp. 207- 240.
- Granovetter, Mark. “Economic Action and Social Structure: the Problem of Embeddedness, SEL, pp. 51-76.
- Ronald Dore, “Goodwill and the Spirit of Capitalism”. SEL.
- Image credit (Creative Commons): Tom Kelly. “Istanbul Grand Bazaar.” Flickr. Last modified 2010.