British politics is changing: there’s Nigel Farage’s new Brexit party; there’s The Independent Group. But will these nascent parties succeed?

In this long read blog piece, to attempt an answer, I use a key theory from organisational microeconomics which helps explain both the existence and success of political parties.

Short answer?  In the long term the new parties are probably doomed.

The theory

Transaction Cost Economics (TCE) is a post-war strand of organisational and microeconomic thinking that initially came about to answer the following question: why do firms exist?   The dominant Neoclassical theory has nothing to say on the matter; it just presupposes that there are firms that compete and aim to maximise profits. But why don’t individual sole traders just contract with each other to produce goods and services?  Why do they come together in firms?

The answer, according to TCE, is that it would just be too costly, especially as tasks become complex. Imagine the thousands of people that are needed to build a new office block, say.  Then imagine each of them having to have a separate legal agreement with all the others.  Every stage of the construction would be a slow, messy, expensive nightmare of paperwork.

Thus, firms come about to internalise all these contracts within one legal identity: in doing so, they reduce the transactions cost – the overhead – of economic organisation.  In place of economic atoms, instead you see economic molecules.

TCE predicts that firms (the molecules) will grow until it becomes uneconomic for them to do so any further – when the rising marginal cost of coordinating activities within the firm begins to outstrip that of contracting outside it. Think about it this way: even the very biggest construction company doesn’t plant forests, grow trees, cut the trees down and then pulp them just to make their own photocopier paper. Firms don’t do everything; instead, they specialise.

As well as explaining what activities firms get up to and how big they grow (issues of vertical and horizontal integration on the asset side of the balance sheet), TCE has explanatory power on the liability side, too: that is to say, the way firms are controlled.

In partnerships, ownership and control are interlinked.  But, as entities grow in size, they tend to adopt a corporate structure wherein the shareholders and managers of the business are separate groups; the managers act as ‘agents’ for the shareholders.  Why?  Transactions costs again.  It’s typically just too complex and time consuming for a multitude of shareholders to acquire the expertise needed, or to dedicate and coordinate the effort required, to run a large company.  They subcontract the tasks.

TCE in politics

Which brings us to the subject of politics.  The notion of ‘subcontracting’ is very familiar to us in representative democracies, even though we don’t normally call it that.  But how else should you describe the process of voting for MPs?

In theory, we could all be consulted in endless referenda on every aspect of running the country.  We could stay in at night boning up on how to vote on the Domestic Gas and Electricity (Tariff Cap) Act or the Prisons (Interference with Wireless Telegraphy) Act.

We could, but we clearly are not going to.  Even if it were feasible it would surely be a colossal misallocation of time and resources.   So, instead, we hire experts to do it for us: MPs and the civil servants who support them.  To get the ‘managers’ we prefer, we use voting to select those who, in aggregate, most closely agree with us about how they should do their jobs.

Unsurprisingly, there are strong parallels between the controversies faced in corporate governance and those in representative democracy.

Consider the long-acknowledged drawbacks of the corporate structure.  First, there’s the problem of ‘agency’ whereby the managers of a firm have a conflict of interest with the shareholders.  The managers, as agents, are always meant to act to benefit the shareholders but are faced with the constant temptation to enrich themselves and their buddies instead – it’s the ‘ bad agent problem’. The current rising level of protest against ‘political elites’ in the Western world is because this ‘bad agent problem’ is held by some to be manifest in the world of politics.

Another problem with corporations is that a majority of shareholders can gang up on the minority and screw them: this is called ‘minority shareholder oppression’ in the jargon.  In the sphere of politics, I think we can all agree that ‘minority oppression’ is a problem – or certainly perceived to be a problem – in democracies the world over.

The TCE parallels also extend to the way party politics in organised.  But to understand the way political parties evolve we have to switch our viewpoint.  Instead of thinking, as we have been, of politicians as being managers of a corporation (the nation state) in their role as agents of the shareholders (voting citizens), we need to think of politicians as sole traders selling their services (managing the country) to a market of buyers of those services (voters).

It would be perfectly possible for each aspiring politician in each election to present the electorate with a unique platform of his or her own choosing.  The voters would sift through the competing offerings and – in each constituency – choose the one they liked best.  There would be no need for political parties. (This, by the way, is pretty much the way things worked in Ancient Greece.)

Afterwards, in Parliament, the hundreds of folk lucky enough to have been elected would have to decide between themselves how to run things. Compromises would need to be thrashed out – for instance, although a collection of politicians could have a variety of different views on how much tax should be raised, ultimately only one set of rates can be imposed.

And this is where the problems would start.  There would be enormous overheads involved in this series of negotiations. It would be like a construction project using thousands of sole traders: messy, slow, and inefficient.

Thus, groups of like-minded MPs would likely begin to try to coordinate their platforms in advance of any Parliamentary vote. They would form factions, which, in time, would consolidate into parties.  This would happen for the exact same reason sole traders organise into firms: to reduce transactions costs.  In this case, it’s the costs of coming to agreement in Parliament.

(More history: this is precisely the way the Whig and Tory parties originated in the English political system in the late 17thand early 18thcenturies: both sides’ policies coagulated around a series of answers to the interlinked questions of monarchical power, succession and religion.)

The success of parties

The advantages of parties are not just felt within Parliament, though.  Having a coordinated policy position with a solid ‘branding’ is helpful when approaching the electorate: it’s a way of reducing the transactions costs for your ‘customers’ when they are trying to decide how to vote. As one academic paper puts it: “Political parties provide a low cost signal of a candidate’s policies and personal characteristics and, in this way, reduce voters’ information costs.”

In other words, in the same way as we know what we’ll get if we buy a Coke or a BMW, we have a decent idea of what we’ll be getting if we vote Labour or Conservative. Decades of branding have made it easy for us despite the way the parties’ platforms have shifted to appeal to evolving voter preferences as circumstances and attitudes have altered over time.

What’s more, in a further parallel with how TCE works within commercial firms (recall the construction company with no forests), the limits of how big or broad-based a political party can be are determined by transactions costs, too.

All political parties are coalitions to some extent.  Their policy platforms are compromises between differing views.  How ‘big a tent’ or ‘broad a church’ a party can be is determined by conflicting cost/benefit pressures.  Political breadth is a good thing in one way – it provides a bigger ‘funnel’ to capture more voters in a way that extremely narrowly focused parties might not be able to.  And it’s not just voters – it works for members and donations, too.  This in turn feeds through to better branding and better brand recognition.

But breadth imposes an overhead in terms of the transactions costs (both of time and emotional energy) for those party members and MPs having to reach unified, compromise policy positions.  When these costs outweigh the benefits, parties split.

What this means is that the extent to which policy compromises are worked out within big, broad political parties – as opposed to between different, ‘splinter’ parties in coalition in Parliament – is thus crucially dependent on the electoral benefit that breadth brings.  How much benefit is largely determined by the precise mechanisms by which elections are won.

The benefit of breadth in the UK can be pretty dramatic.  Check out this table, which shows the percentage of seats that each party won in the UK’s 2015 general election, compared to its percentage of the national vote.  The final column – the ’Success Ratio’ – is the ratio of the percentage of seats won to the percentage of votes.  The higher this is, the more seats were won for each vote for that party.


The two main, ‘broad’ parties (Labour and Conservative) did rather well. Their success ratios are above 100%.  That is to say, they received more proportional power (in terms of percentage of seats won) than their vote share would suggest they deserved.

On the other hand, UKIP, despite fielding 624 candidates and receiving 12.6% of the total vote only won one seat – 0.2% of the seats available nationally.  The picture is similar for the Liberal Democrats and the Green Party: millions of votes, a couple of handfuls of seats. Significantly, two of these parties (UKIP and the Greens) have a narrow, specialised, almost ‘single issue’ platform.

The two big parties were the beneficiaries – and the three minor parties the victims – of the UK’s first-past-the-post electoral system.  Under this method of electing MPs, voting for a party that has no chance of winning in your constituency is a wasted vote.  Only voting for the front-runners is effective.

The exception to this rule is the list of minor parties that concentrate all their efforts on one geographical niche – one sub-market – of the whole electorate. The SNP, for instance, by concentrating exclusively on Scotland with a message targeted at Scottish voters, won a representation in 2015 way in excess of their vote share.  A similar pattern can be discerned in the Northern Irish parties and, to a lesser extent, Plaid Cymru.

Still, to gain power and form a government, it has been the two big, national parties that have dominated for the best part of century.  In that long period there have only been occasional spells of coalition government.

This is in stark contrast to Germany.  There, an electoral system that combines direct district-by-district representation with a ‘top up’ from a party list ensures (by design) that there is close to proportional representation in the Bundestag.  Smaller parties thus have less of a disadvantage in getting a toehold in power – a toehold that confers credibility and helps branding for the future.  New parties can – and do – emerge: witness the AfD.

All this means that, in Germany, coalition government is the rule, not the exception. In TCE terms a larger chunk of the process of policy negotiation occurs between, not within parties (as compared to the UK).

Can Labour’s rise be repeated?

But, given that first-past-the-post looks like it is here to stay in the UK, what is the prognosis for the new Farage-led Brexit party or the proto party ‘The Independent Group’?

To answer that it is instructive to look at the only occasion in the last century when a new party rose to prominence in the UK – the rise of the Labour party in the years between the end of the First and Second World Wars.

The party was founded in 1900 as the political wing of the trade union movement. By 1910 it had made some headway but it was very much still a minority party.  This began to change in the 1920s and by 1924, then 1929, it had made sufficient electoral progress to form a minority government.  During the Second World War it was powerful enough to warrant a place in the wartime coalition.  In 1945 it won a landslide.   The graph shows the party’s progress at the expense of the Liberals.


Given the way that the first-past-the-post method crushes new parties, how was it possible for Labour to do this?

Simply put, they had a brand new ‘market’ to aim at.  The proportion of the population able to vote increased in bursts as the UK approached universal suffrage.  In 1918, all men over 21 were given the vote; previously only about 60% were able to, restricted by property qualifications.  In addition, the vote was given to 40% of women.  Together, these moves meant that the voting population grew from 7.7 million to 21.4 million.  In 1928, all women got the vote.

Thus, between 1918 and 1928, a huge number of new, less well off voters were enfranchised.  They made up the Labour party’s natural base – a base made more radical by the immense economic and social catastrophe of the First World War.

Returning to the present, do any of these extraordinary conditions apply today?  Plainly, they do not.  I’m sure a ‘no deal’ Brexit will be quite nasty if it happens but, let’s face it, it’s not the First World War.  Nor are there umpteen millions of new voters coming into the voting pool.  No: the new parties will have to fight it out in an electoral ‘marketplace’ in which no truly seismic changes have occured.

This spells doom for The Independent Group if its members were ever to form a proper party.  In my view, in time it will simply be wiped out piecemeal by the more recognisably branded and more credible Labour or Conservative parties in parliamentary elections.  It will be fighting a futile battle against the forces of Transaction Cost Economics in an electoral ‘market’ where generations-old branding is all important..

As for Farage’s Brexit start up, like UKIP in the past, it could easily do well in – now meaningless, not-first-past-the-post – EU elections.  And even in parliamentary contests I suppose it may be able to make some headway if it adopts the strategy of the SNP and concentrates all its efforts on a regional sub-market.  If it goes national, it will most likely suffer the fate of UKIP in 2015.

To conclude: times may change, parties may be born and die, but the iron laws of political microeconomics are with us always.

New parties: beware!