Transaction costs in the context of Oliver E. Williamson

Bilateralism is the conduct of political, economic, or cultural relations between two sovereign states . It is in contrast to unilateralism or multilateralism, which is activity by a single state or jointly by multiple states, respectively. When states recognize one another as sovereign states and agree to diplomatic relations, they create a bilateral relationship. States with bilateral ties will exchange diplomatic agents such as ambassadors to facilitate dialogues and cooperations.

Economic agreements, such as free trade agreements (FTAs) or foreign direct investment (FDI), signed by two states, are a common example of bilateralism. Since most economic agreements are signed according to the specific characteristics of the contracting countries to give preferential treatment to each other, not a generalized principle but a situational differentiation is needed. Thus through bilateralism, states can obtain more tailored agreements and obligations that only apply to particular contracting states. However, the states will face a trade-off because it is more wasteful in transaction costs than the multilateral strategy. In a bilateral strategy, a new contract has to be negotiated for each participant. So it tends to be preferred when transaction costs are low and the member surplus, which corresponds to "producer surplus" in economic terms, is high. Moreover, this will be effective if an influential state wants control over small states from a liberalism perspective, because building a series of bilateral arrangements with small states can increase a state's influence.

Rational choice institutionalism (RCI) is a theoretical approach to the study of institutions arguing that actors use institutions to maximize their utility, and that institutions affect rational individual behavior. Rational choice institutionalism arose initially from the study of congressional behaviour in the U.S. in the late 1970s. Influential early RCI scholarship was done by political economists at California Institute of Technology, University of Rochester, and Washington University. It employs analytical tools borrowed from neo-classical economics to explain how institutions are created, the behaviour of political actors within it, and the outcome of strategic interaction.

RCI explains the creation of institutions as an attempt to reduce transaction costs of collective activity which would be significantly higher without such institutions. Institutions persist after their creation because they reduce uncertainty and allow gains from exchange. Rational choice institutionalism assumes that political actors within the institutional setting have a fixed set of preferences. To maximize those preferences actors behave highly instrumental through systematic foresight and strategic cost-benefit calculation. Institutions lay down the 'rules of the game', define the range of available strategies and the sequence of alternatives. The actors' behaviour will be highly influenced by the expectation how other players will bargain. The institutional environment provides information and enforcement mechanism that reduce uncertainty for each actor about the corresponding behaviour of others. This 'calculus approach' explains how the institutional setting influences individual behaviour and stresses how strategic interaction determines policy outcomes.