The Elgar Companion to Transaction Cost Economics

THE ELGAR COMPANION TO TRANSACTION COST ECONOMICS

The Elgar Companion to Transaction Cost Economics

Edited by

Peter G. Klein Associate Professor, Division of Applied Social Sciences and Associate Director, Contracting and Organizations Research Institute, University of Missouri, Columbia, USA and

Michael E. Sykuta Associate Professor, Division of Applied Social Sciences and Director, Contracting and Organizations Research Institute, University of Missouri, Columbia, USA

Edward Elgar Cheltenham, UK • Northampton, MA, USA

© Peter G. Klein and Michael E. Sykuta 2010 All rights reserved. No part of this publication may be reproduced, stored in a retrieval system or transmitted in any form or by any means, electronic, mechanical or photocopying, recording, or otherwise without the prior permission of the publisher. Published by Edward Elgar Publishing Limited The Lypiatts 15 Lansdown Road Cheltenham Glos GL50 2JA UK Edward Elgar Publishing, Inc. William Pratt House 9 Dewey Court Northampton Massachusetts 01060 USA

A catalogue record for this book is available from the British Library Library of Congress Control Number: 2009941001

ISBN 978 1 84542 766 5

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Printed and bound by MPG Books Group, UK

Contents List of contributors PART I 1 2 3

5 6 7 8 9 10

12 13

3 8

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PRECURSORS AND INFLUENCES

Ronald H. Coase Michael E. Sykuta Cyert, March, and the Carnegie school Mie Augier Chester Barnard Joseph T. Mahoney Commons, Hurst, Macaulay, and the Wisconsin legal tradition D. Gordon Smith F.A. Hayek Peter G. Klein Herbert Simon Saras Sarasvathy Property rights economics Nicolai J. Foss

PART III 11

INTRODUCTION

Editors’ introduction Peter G. Klein and Michael E. Sykuta Transaction cost economics: an overview Oliver E. Williamson Transaction cost economics and the new institutional economics Peter G. Klein

PART II 4

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39 49 58 66 74 85 92

FUNDAMENTAL CONCEPTS

The costs of exchange Alexandra Benham and Lee Benham Asset specificity and holdups Benjamin Klein The transaction as the unit of analysis Nicholas Argyres v

107 120 127

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Bounded rationality and organizational economics Nicolai J. Foss Economizing and strategizing Jackson A. Nickerson and James C. Yen Empirical methods in transaction cost economics Michael E. Sykuta

15 16

PART IV 17 18 19 20 21 22 23 24

25 26 27 28

152

165 176 185 194 205 215 230 244

ALTERNATIVES AND CRITIQUES

Critiques of transaction cost economics: an overview Nicolai J. Foss and Peter G. Klein Subjectivism, understanding, and transaction costs Fu-Lai Tony Yu Austrian economics and the theory of the firm Nicolai J. Foss and Peter G. Klein Limits of transaction cost analysis Geoffrey M. Hodgson

Index

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APPLICATIONS

Vertical integration Peter G. Klein Hybrid organizations Claude Ménard Franchising Steven C. Michael The structure of franchise contracts Emmanuel Raynaud Strategy and transaction costs Laura Poppo Labour economics and human resource management Bruce A. Rayton The Chicago school, transaction cost economics, and antitrust Joshua D. Wright Financial-market contracting Dean V. Williamson

PART V

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263 273 281 297

307

Contributors Nicholas Argyres is Vernon W. and Marion K. Piper Professor of Strategy at the Olin Business School, Washington University, St Louis, USA. Mie Augier is a Research Associate Professor at the Navy Postgraduate School, Monterey, California. Alexandra Benham is a Founder and the Secretary of the Ronald Coase Institute, St Louis, USA. Lee Benham is Professor of Economics at Washington University, St Louis, and a Board Member of the Ronald Coase Institute, St Louis, USA. Nicolai J. Foss is Professor and Director of the Centre for Strategic Management and Globalization at the Copenhagen Business School, Denmark and a Professor at the Norwegian School of Economics and Business Administration, Norway. Geoffrey M. Hodgson is Research Professor in Business Studies at the University of Hertfordshire, UK. Benjamin Klein is Professor Emeritus of Economics at the University of California, Los Angeles, USA. Peter G. Klein is Associate Professor in the Division of Applied Social Sciences, University of Missouri, and Associate Director of the Contracting and Organizations Research Institute, USA. Joseph T. Mahoney is Investors in Business Education Professor of Strategy and Director of Graduate Studies, Department of Business Administration, University of Illinois at Urbana-Champaign, USA. Claude Ménard is Professor of Economics and Senior Researcher at the Centre d’Economie de la Sorbonne (CES) at the University Paris (Panthéon-Sorbonne), France. Steven C. Michael is Professor of Entrepreneurship and Strategy at the Department of Business Administration, University of Illinois at UrbanaChampaign, USA. Jackson A. Nickerson is Frahm Family Professor of Organization and

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Strategy at the Olin Business School, Washington University, St Louis, USA. Laura Poppo is Professor and Fred Ball Faculty Fellow in Business at the University of Kansas, USA. Emmanuel Raynaud is Research Fellow at the French National Institute for Agronomical Research (INRA) and member of the Centre d’Economie de la Sorbonne (CES), University of Paris I, France. Bruce A. Rayton is Lecturer in Business Economics at the University of Bath Management School, UK. Saras Sarasvathy is Isadore Horween Research Associate Professor of Business Administration at the University of Virginia’s Darden School of Business, USA. D. Gordon Smith is Associate Dean for Faculty and Curriculum and Glen L. Farr Professor of Law at the J. Reuben Clark Law School, Brigham Young University, USA. Michael E. Sykuta is Associate Professor in the Division of Applied Social Sciences, University of Missouri, and Director of the Contracting and Organizations Research Institute, USA. Dean V. Williamson is Research Economist at the US Department of Justice, Antitrust Division, Washington, DC, USA. Oliver E. Williamson is Professor of the Graduate School and Edgar F. Kaiser Professor Emeritus of Business, Economics, and Law at the University of California, Berkeley, USA and 2009 Nobel Laureate in Economics. Joshua D. Wright is Associate Professor of Law at George Mason University School of Law and Department of Economics, USA. James C. Yen is Doctoral Candidate in Organization and Strategy at the Olin Business School, Washington University, St Louis, USA. Fu-Lai Tony Yu is Professor in the Department of Economics and Finance, Hong Kong Shue Yan University, Hong Kong.

PART I INTRODUCTION

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Editors’ introduction Peter G. Klein and Michael E. Sykuta

Since its emergence in the 1970s, the transaction cost approach to firms, contracts, and economic organization has become one of the most important, influential, and exciting fields in law, economics, and organization theory. On applied topics such as vertical integration, the structure of networks and alliances, franchise contracting, the multinational firm, parts of antitrust analysis, marketing channels, and more, transaction cost economics (TCE) has become a dominant, if not the mainstream, perspective. The transaction cost approach has its roots in the classic papers by Coase in 1937 and 1960, which articulated the concepts of transaction costs and property rights, and took form with the theories of the firm offered by Williamson (1971, 1979), Alchian and Demsetz (1972), and Klein et al. (1978), which introduced monitoring costs, relationship-specific investments (or ‘asset specificity’), and particular notions of governance and organizational mechanisms into the literature. TCE is expressed most strongly in Williamson’s books Markets and Hierarchies (1975), The Economic Institutions of Capitalism (1985), and The Mechanisms of Governance (1996), though important contributions come from other diverse sources. As described in the pages that follow, TCE has other important antecedents, core concepts, applications, extensions, and critiques. This volume aims to introduce the novice, and to inform the specialist, about TCE’s fundamental elements, about recent controversies and new developments, and about the place of TCE in the larger legal, economic, and managerial literatures on organizations and institutions. It does not attempt to provide a comprehensive overview of the field, a task performed well in recent survey papers and volumes such as Williamson (2000), Ménard and Shirley (2005), Brousseau and Glachant (2008) and in many contemporary textbooks on industrial organization, managerial economics, and business strategy. We were both exposed to TCE in our graduate training and have been closely associated with the field ever since. Klein studied under Williamson at Berkeley in the late 1980s and early 1990s, eventually receiving his PhD under Williamson’s supervision and focusing on the performance effects of organizational form. Sykuta was trained directly by Douglass North, and indirectly by Ronald Coase (via Lee Benham and others) at Washington 3

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University, St Louis, where he wrote his PhD dissertation on the effects of market and government institutions on contracting practices and industry organization. We have both been active members of the International Society for New Institutional Economics (ISNIE), the academic organization founded by Coase, North, Williamson, and others in 1998, and we jointly direct the Contracting and Organizations Research Institute (CORI) at the University of Missouri. CORI is an interdepartmental, interdisciplinary research institute focused on empirical research on contracts and business organization, inspired (and supported) by Coase and his belief that research on contracts is hampered by a lack of data. CORI maintains a digital archive of over 600 000 contracts available to the research and practitioner communities, designed to facilitate research to better understand how contracts are structured, how they are used and enforced, and what purposes they serve. TCE, and the new institutional economics more generally, are particularly important at the University of Missouri. We take turns teaching a required PhD course, ‘Economics of Institutions and Organizations’, in the Division of Applied Social Sciences, we organize seminar and working paper series on contracting and organizations, and we supervise many graduate students working in this area. We also maintain strong ties with institutions and organizations around the world focusing on transaction costs and related issues such as the Centre d’Analyse Théorique des Organisations et des Marchés (ATOM) in Paris, the Centre for Strategic Management and Globalization (SMG) in Copenhagen, PENSA in São Paulo, and others. As we were preparing the manuscript for publication, in the Fall of 2009, we learned that Williamson had been awarded the 2009 Nobel Prize in economics (shared with Elinor Ostrom). The Nobel citation recognized Williamson for ‘develop[ing] a theory where business firms serve as structures for conflict resolution’. Williamson’s and Ostrom’s contributions ‘have advanced economic governance research from the fringe to the forefront of scientific attention’ (The Royal Swedish Academy of Sciences, 2009). Indeed, the transaction cost approach, which focuses on the benefits and costs of alternative institutions of governance, has become part of the mainstream of economics and management research. Coase, the most influential figure in the economic theory of the firm, received the Nobel Prize in 1991, and North was recognized (along with Robert Fogel) in 1993, giving the New Institutional Economics, of which TCE is a part, three Nobel Prizes. We are delighted that the study of transactions, and economic governance more generally, is now acknowledged as a core element of social science research and policy. At the same time, the reaction among economists to Williamson’s Nobel

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Prize highlighted a continuing tension about the role and place of TCE, narrowly defined, within the more general field of organizational economics. The day of the Nobel announcement, Steven Levitt (2009) wrote, in his ‘Freakonomics’ blog: When I was a graduate student at MIT back in the early 1990s, there was a Nobel Prize betting pool every year. Three years in a row, Oliver Williamson was my choice. At the time, his research was viewed as a hip, iconoclastic contribution to economics – something that was talked about by economists, but that students were not actually trying to emulate (and probably would have been actively discouraged from had they tried to do so). What’s interesting is that in the ensuing 15 years, it seems to me that economists have talked less and less about Williamson’s research, at least in the circles in which I run. I suspect most assistant professors of economics have barely heard of him. Yet I suspect the older generation of economists will applaud this choice.

Levitt’s comments allude to the fact that the field of organizational economics, including the theory of the firm, has become increasingly formal, mainstream, and ‘neoclassical’, in a way that Williamson’s work has never been. In particular, much (though by no means all) of the recent theoretical work in the theory of the firm has followed the ‘incomplete contracting’ approach associated with Oliver Hart (Grossman and Hart, 1986; Hart and Moore, 1990; Hart, 1995; Tirole, 1999; Baker et al., 2002). The seminar papers by Coase (1937), Williamson (1971, 1979), Alchian and Demsetz (1972), and Klein et al. (1978) are seen by many economists as inspirational, suggestive, perhaps speculative pieces that provided the basic ideas of the modern theory of the firm but in an informal, ‘loose’, conjectural style that runs against the grain of modern, mainstream theoretical analysis. Just as graduate students in economics no longer read Smith, Ricardo, Marx, Keynes, and Hayek – whatever they need to know about markets is in Debreu (1959), presumably – few of them read Coase or Williamson to learn about organizations. Those wishing to learn more about firms are probably encouraged to study some of the latest incomplete-contracting models. While we respect and admire the formal contracting literature, we agree with Williamson (2000) that these models do not, by any means, capture all the essential and useful features of TCE. We think TCE stands on its own, and is not merely a preliminary step toward some other theory, though we agree with Coase and Williamson that there is much more work to do. As Williamson (2000, p. 595) notes, ‘we are still very ignorant about institutions’. Interestingly, TCE is still highly influential in the strategic management field, as evidenced by the collaborative volume, Economic Institutions of Strategy, produced by a group of Williamson’s former students (Nickerson and Silverman, 2009). Several of the chapters in this

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volume explore the applications of TCE to various topics in strategy and management. The chapters in this work are organized into five sections: an introductory set, a section on precursors and influences, one on fundamental concepts, another on applications, and a final section on alternatives and critiques. The authors, established scholars in economics, management, law, and related disciplines, come from a variety of backgrounds and take different perspectives on TCE. All share the view, however, that the transaction cost perspective offers important, and typically unique, insight into key organizational, managerial, and social issues of our day. When Coase visited the University of Missouri in 2002, he spoke of the need to ‘revolutionize economics’ through the careful, systematic study of contractual relationships and contract documents. TCE may or may not be revolutionary, but it stands with other important fields, movements, or approaches within economics and related disciplines as both a challenge to orthodoxy and an extension, elaboration, and advance upon the strongest elements of that tradition. Williamson (1996, p. 13) describes the development of TCE as ‘modest, slow, molecular, definitive’. We hope the chapters in this volume will not only inform, but also challenge the reader to continue this development. References Alchian, A.A. and H. Demsetz (1972), ‘Production, information costs, and economic organization’, American Economic Review, 62 (5), 777–95. Baker, G., R. Gibbons, and K. Murphy (2002), ‘Relational contracts and the theory of the firm’, Quarterly Journal of Economics, 117 (1), 39–83. Brousseau, E. and J.-M. Glachant (eds) (2008), New Institutional Economics: A Guidebook, Cambridge: Cambridge University Press. Coase, R.H. (1937), ‘The nature of the firm’, Economica, N.S., 4 (16), 386–405. Coase, R.H. (1960), ‘The problem of social cost’, Journal of Law and Economics, 3 (October), 1–44. Debreu, G. (1959), Theory of Value: An Axiomatic Analysis of Economic Equilibrium, New Haven: Yale University Press. Grossman, S. and O. Hart (1986), ‘The costs and benefits of ownership: a theory of lateral and vertical integration’, Journal of Political Economy, 94 (4), 691–719. Hart, O. (1995), Firms, Contracts and Financial Structure, Oxford: Clarendon Press. Hart, O. and J. Moore, (1990), ‘Property rights and the nature of the firm’, Journal of Political Economy, 98 (6), 1119–58. Klein, B., R.A. Crawford, and A.A. Alchian (1978), ‘Vertical integration, appropriable rents, and the competitive contracting process’, Journal of Law and Economics, 21 (2), 297–326. Levitt, Steven D. (2009), ‘What This Year’s Nobel Prize in Economics Says About the Nobel Prize in Economics’, Freakonomics Blog, 12 October, available at: http://freakonomics. blogs.nytimes.com/2009/10/12/what-this-years-nobel-prize-in-economics-says-about-thenobel-prize-in-economics (accessed 16 November 2009). Ménard, C. and M. Shirley (eds) (2005), Handbook of New Institutional Economics, New York: Springer. Nickerson, J.A. and B.S. Silverman (eds) (2009), Economic Institutions of Strategy, Bingley, UK: Emerald.

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The Royal Swedish Academy of Sciences (2009), ‘The Prize in Economic Sciences 2009’, 12 October, available at: http://nobelprize.org/nobel_prizes/economics/laureates/2009/press. pdf (accessed 16 November 2009). Tirole, J. (1999), ‘Implicit contracts: where do we stand?’, Econometrica, 67 (4), 741–81. Williamson, O.E. (1971), ‘The vertical integration of production: market failure considerations’, American Economic Review, 61 (2), 112–23. Williamson, O.E. (1975), Markets and Hierarchies: Analysis and Antitrust Implications, New York: Free Press. Williamson, O.E. (1979), ‘Transaction cost economics: the governance of contractual relations’, Journal of Law and Economics, 22 (3), 233–61. Williamson, O.E. (1985), The Economic Institutions of Capitalism, New York: Free Press. Williamson, O.E. (1996), The Mechanisms of Governance, New York: Oxford University Press. Williamson, O.E. (2000), ‘The new institutional economics: taking stock, looking ahead’, Journal of Economic Literature, 38 (3), 595–613.

2

Transaction cost economics: an overview Oliver E. Williamson

This overview of transaction cost economics (TCE) differs from prior overviews to which I have contributed in two respects: it is especially oriented at students who are new to but curious about the TCE literature; and it is organized around the ‘Carnegie Triple’ – be disciplined; be interdisciplinary; have an active mind. It is partly autobiographical on the latter account.1 The discussion begins with the Carnegie Triple and sets out five key quotations that anchor the TCE project. The next three sections discuss how TCE implements each element in the triple. Operationalization is then examined. The conclusions follow. Introduction The Carnegie Triple It was my privilege to have been a graduate student at the Graduate School of Industrial Administration (GSIA) at the Carnegie Institute of Technology (now the Tepper School of Business at Carnegie-Mellon University) from 1960 through 1963. Those were halcyon years for GSIA.2 The small but accomplished faculty included Herbert Simon, Franco Modigliani, Merton Miller, Richard Cyert, James March, John Muth, Allan Meltzer, and William Cooper, the first three being subsequently awarded Nobel Laureates in Economics. The graduate program was in three parts: economics, organization theory, and operations research. All of the graduate students took core courses in all three and subsequently specialized in one. My major was in economics, but I drew continuously on my training in organization theory (and selectively on operations research). The research atmosphere at Carnegie was exhilarating. Old issues were revisited and new issues were opened up. Upon reflection, I describe the training and research at Carnegie in terms of three imperatives: be disciplined; be interdisciplinary; have an active mind. It has been my experience that all applied microeconomists subscribe to the first of these and many to the third. The imperative ‘be interdisciplinary’ is more controversial. Many students (mine included) boggle at organization theory. This is partly because organization theory is an inherently difficult 8

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subject. Also, few faculties have the likes of Simon, Cyert, and March to learn from. However, my advice to students is to go native by removing their economics cap and putting on an organization theory cap when they open the organization theory text and enter the organization theory classroom. What at first appear to be ‘inanities’ take on an altogether different meaning and significance when they are interpreted not as peculiarities but as intertemporal regularities of complex organizations. Many of these regularities are consequential and need to be factored into the study of economic organization. Five quotations James Buchanan distinguishes between the science of choice (the resource allocation paradigm, which was dominant within economics throughout the twentieth century) and the science of contract. He furthermore urges that the science of contract should be given greater prominence: ‘mutuality of advantage from voluntary exchange . . . is the most fundamental of all understandings in economics’ (Buchanan, 2001, p. 29; emphasis added). As I have discussed elsewhere (Williamson, 2002a), the lens of contract divides into two related branches: public ordering and private ordering. The latter further divides into ex ante incentive alignment (agency theory, mechanism design, property rights) and ex post governance branches. Although these two are related, TCE focuses predominantly on the governance of ongoing contractual relations. This brings me to the second quotation, which is from John R. Commons, who likewise took exception with the all-purpose adequacy of the resource allocation paradigm (prices and output; supply and demand) and reformulated the problem of economic organization as follows: ‘the ultimate unit of activity . . . must contain in itself the three principles of conflict, mutuality and order. This unit is a transaction’ (Commons, 1932, p. 4). This prescient two sentence statement prefigures the study of governance in two respects:3 not only does the lens of contract/governance take the transaction to be the basic unit of analysis, but governance is viewed as the means by which to infuse order, thereby to mitigate conflict and realize mutual gains. This is a recurrent theme. The third quotation goes to the importance of economizing, broadly in the spirit of Frank Knight’s observation that (1941, p. 252; emphasis added): Men in general, and within limits, wish to behave economically, to make their activities and their organization ‘efficient’ rather than wasteful. This fact does deserve the utmost emphasis; and an adequate definition of the science of economics . . . might well make it explicit that the main relevance of the

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The Elgar companion to transaction cost economics discussion is found in its relation to social policy, assumed to be directed toward the end indicated, of increasing economic efficiency, of reducing waste.

Of the various forms that economizing can take, TCE is predominantly concerned with economizing on transaction costs – drawing inspiration from Ronald Coase (1937; 1960) in this respect. The fourth quotation is from Herbert Simon: ‘Nothing is more fundamental in setting our research agenda and informing our research methods than our view of the nature of the human beings whose behavior we are studying’ (1985, p. 303) – especially in cognitive and self-interestedness respects. Although Simon and I had our differences (see, for example, Simon, 1997; and Williamson, 2002c), I always pay heed to statements of his such as this. The fifth quotation is Jon Elster’s dictum that ‘explanations in the social sciences should be organized around (partial) mechanisms rather than (general) theories’ (1994, p. 75; emphasis in original). I not only agree that much of the relevant action is in the microanalytics, but, by reason of the overwhelming complexity of the social sciences (Simon, 1957a, p. 89; Wilson, 1999, p. 183), I share Elster’s skepticism with general theories. Out of respect for such complexity, ‘any direction you proceed in has a very high a priori probability of being wrong’ on which account ‘it is good if other people are exploring in other directions’ (Simon, 1992, p. 21). Accordingly, TCE also subscribes to pluralism. Be disciplined General Although TCE has been an interdisciplinary project from the outset (in that law, economics, and organization theory are selectively combined), first and foremost TCE is informed by economics. Standard textbook economics, where the neoclassical resource allocation paradigm and game theoretic reasoning are the main constructions, is the obvious place to begin. TCE takes exception with the former for its failure to make provision for positive transaction costs, if and as these are believed to be consequential (Coase, 1937; 1960) – as, for example, in examining the make-or-buy decision in the context of vertical integration. But this does not dispute the merits of the neoclassical approach and apparatus as a place to start – and, for many purposes, a place to finish. TCE shares a good deal of common ground with game theory (Kreps, 1999, p. 127), in that the parties to a contract are assumed to have an understanding of the strategic situation within which they are located and position themselves accordingly.4 TCE nevertheless differs in that it expressly makes provision

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for contractual incompleteness as the limits on rationality become binding by reason of transactional complexity. Also, TCE views governance as a means by which to relieve the oppressive logic of ‘bad games’, of which the prisoners’ dilemma is an exemplar.5 More generally, private ordering plays a prominent role in TCE in that, if and as contractual hazards are posed, the immediate parties to an exchange have an incentive to craft contract-specific safeguards – thereby to realize mutual gains. If, moreover, they are unable to mitigate a hazard, they can nevertheless price it out. As discussed in the Appendix, goods and services will be exchanged on better terms with parties who exercise feasible foresight and introduce credible commitments. Private ordering is nevertheless implemented in the shadow of public ordering, as with recourse to the courts for purposes of ultimate appeal. Changes in the rules of the game should nevertheless be done mindful of the benefits that accrue to private ordering. With respect to antitrust enforcement, the public policy lesson is this: non-standard and unfamiliar private-ordering contracting practices and organizational structures can and often do serve valued economizing purposes – whereas, for a long time, these were presumed to have monopoly purpose and effect.6 If instead the economizing purpose to which Knight referred is the ‘main case’, then this ought to be featured. The priority given to economic reasoning does not, however, imply exclusivity: economics can not do it all. As discussed below, organization theory and the law also play important roles. Pragmatic methodology Describing himself as a native informant rather than as a certified methodologist, Robert Solow’s ‘terse description of what one economist thinks he is doing’ (2001, p. 111) takes the form of three precepts: keep it simple; get it right; make it plausible. Keeping it simple is accomplished by stripping away inessentials, thereby to focus on first order effects – the main case, as it were – after which qualifications, refinements, and extensions can be introduced. Getting it right entails working out the logic. Making it plausible means to preserve contact with the phenomena and eschew fanciful constructions. Solow observes with reference to the simplicity precept that ‘the very complexity of real life . . . [is what] makes simple models so necessary’ (2001, p. 111). Keeping it simple requires the student of complexity to prioritize: ‘Most phenomena are driven by a very few central forces. What a good theory does is to simplify, it pulls out the central forces and gets rid of the rest’ (Friedman, 1997, p. 196). Central features and key regularities are uncovered by the application of a focused lens.

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Getting it right ‘includes translating economic concepts into accurate mathematics (or diagrams, or words) and making sure that further logical operations are correctly performed and verified’ (Solow, 2001, p. 112). Especially in the public policy arena (but also more generally), one of these further logical operations is to ascertain whether putative ‘inefficiencies’ survive comparative institutional scrutiny. Because any display of inefficiency simultaneously represents an opportunity for mutual gain, the parties to such transactions have an incentive to relieve inefficiencies (in costeffective degree). What are the obstacles? What is the best feasible result? Because the practice of comparing an actual outcome with a hypothetical (zero transaction cost) ideal has been the frequent source of public policy confusion and error,7 TCE introduces the remediableness criterion, to wit: an extant practice for which no superior feasible alternative can be described and implemented with expected net gain is presumed to be efficient.8 This rebuttable presumption has the merit of forcing the analyst to confront difficult choices rather than become distracted by and enamored with unworkable ideals. Plausible simple models of complex phenomena ought ‘to make sense for “reasonable” or “plausible” values of the important parameters’ (Solow, 2001, p. 112). Also, because ‘not everything that is logically consistent is credulous’ (Kreps, 1999, p. 125), fanciful constructions that lose contact with the phenomena are suspect – especially if alternative and more veridical models yield refutable implications that are congruent with the data. This then brings me to a fourth precept: derive refutable implications to which the relevant (often microanalytic) data are brought to bear. Nicholas Georgescu-Roegen had a felicitous way of putting it: ‘The purpose of science in general is not prediction, but knowledge for its own sake’, yet prediction is ‘the touchstone of scientific knowledge’ (1971, p. 37). To be sure, new theories rarely appear full blown but evolve through a progression during which the theory and evidence are interactive (Newell, 1990, p. 14): Theories cumulate. They are refined and reformulated, corrected and expanded. Thus, we are not living in the world of Popper – [theories are not] shot down with a falsification bullet. Theories are more like graduate students – once admitted you try hard to avoid flunking them out. Theories are things to be nurtured and changed and built up.

Sooner or later, however, the time comes for a reckoning. All would-be theories need to stand up and be counted. Most social scientists know in their bones that theories that are congruent with the data are more influential.9 Milton Friedman’s reflections on

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a lifetime of work are pertinent: ‘I believe in every area where I feel that I have had some influence it has occurred less because of the pure analysis than it has because of the empirical evidence that I have been able to organize’.10 Be interdisciplinary Although there are many phenomena for which the application of selfcontained neoclassical reasoning is altogether sufficient (Reder, 1999), students of complex organization should be alert to the possibility that some – indeed, many – phenomena deviate from the neoclassical ideal in consequential ways. Mechanical application of neoclassical reasoning can and sometimes does lead to contrived, convoluted, and mistaken interpretations. The qualified version of the injunction to ‘be interdisciplinary’ is this: be prepared to cross disciplinary boundaries if and as this is needed to preserve contact with the phenomena. Being interdisciplinary is conditional, therefore, on a perceived need and is introduced strictly in a pragmatic way. Such conditionality notwithstanding, training in one or more of the contiguous social sciences is instructive for all students of economic organization. The pragmatic reason for such training is this: economists who lack an appreciation that some of what is going on out there has non-economic origins will be neglectful of or will misinterpret forces that are responsible for consequential regularities that ought to be taken into account. As hitherto indicated, TCE joins economics with organization theory and selected aspects of the law (especially contract law). Organization theory Organization theory is a vast subject and comes in many flavors (Scott, 1987). My uses of organization theory rely mainly on the ‘rational systems’ approach that is associated with Chester Barnard, Herbert Simon, and Carnegie in its heyday (March and Simon, 1958).11 As matters stand presently, the three chief contributions of organization theory to TCE are the description of human actors, the importance of coordinated adaptation, and recurrent intertemporal regularities. Human actors Attributes of human actors that bear crucially on the lens of contract/governance are cognition, self-interest, and foresight (where the last can be considered an extension upon cognition). Human actors are described as boundedly rational, by which I mean ‘intendedly rational, but only limitedly so’ (Simon, 1957b, p. xxiv). So described, boundedly rational human actors lack hyperrationality but are neither non-rational nor irrational. Rather, such human actors are

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attempting rationally to cope. For TCE purposes, the key ramification of bounded rationality for the study of contract is that all complex contracts are unavoidably incomplete. The analytically convenient fiction of complete contracting is thus disallowed. Self-interest is described in a two-part way. Routine events are described as benign – in that most people will do what they say most of the time and some will do more. Outliers, however, pose tensions. The spirit of cooperation that facilitates ongoing adaptations to routine disturbances prospectively gives way to a more calculative orientation as the stakes increase. The hazard of opportunism – defection from the spirit of cooperation in favor of the letter of the contract – thus arises. Such defection poses a hazard for interfirm contracts if one or both parties make specialized (nonredeployable) investments in support of the contract. The resulting condition of bilateral dependency need not, however, imply that interfirm contracting is no longer viable. To the contrary, the capacity for ‘feasible foresight’ permits the parties to look ahead, uncover possible hazards, work out the mechanisms, and thereafter craft credible commitments. Boundedly rational human agents who possess feasible foresight will thus attempt to mitigate contractual hazards in a cost-effective degree, as a result of which the efficacy of contracting is extended over a wider range. Fewer transactions are taken out of markets and organized internally on this account. Coordinated adaptation Adaptation is taken to be the main problem of economic organization, of which two kinds are distinguished: autonomous adaptations in the market that are elicited by changes in relative prices, as described by the economist F.A. Hayek (1945), and coordinated adaptations of a ‘conscious, deliberate, purposeful kind’ accomplished with the support of hierarchy, as described by the organization theorist Chester Barnard (1938). Conditional on the attributes of transactions, adaptations of both kinds are important – which is to say that TCE examines markets and hierarchies in a combined way (rather than persist with the old ideological divide between markets or hierarchies). Explicating the differential efficacy of alternative modes of governance – whereby markets enjoy the advantage in autonomous adaptation respects, the advantage shifts to hierarchy as transactions pose a greater need for consciously coordinated adaptations, and hybrid modes are a compromise mode that displays adaptive capacities of both kinds (albeit in an intermediate degree) – is central to a predictive theory of governance. Intertemporal regularities As Philip Selznick has observed, organization, like the law, has a ‘life of its own’ (1966, p. 10). If and as intertemporal

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regularities have a significant impact on the organization of economic activities, such regularities need to be uncovered, interpreted, and the economic ramifications worked out. Among the significant regularities that bear on the economics of governance are the entrenchment advantages that accrue to leadership. Both in politics (Michels, 1962) and more generally, ‘there is a tendency for decisions to be qualified by the special goals and problems of those to whom [leadership is delegated]’ (Selznick, 1966, p. 258). The special goals to which Selznick refers often take the form of goal distortions (managerial discretion) and career concerns (influence costs) while many of the problems take the form of bureaucratic costs. In the degree to which these are consequential, intertemporal effects of all three kinds are properly factored into the comparative governance calculus. Most economic theories of firm and market organization nevertheless ignore these and/or regard them as outside the ambit. Thus although Oskar Lange described bureaucratization rather than resource allocation as the ‘real danger of socialism’, he chose to set bureaucratization aside because it ‘belongs to the field of sociology rather than . . . economic theory’ (1938, p. 109). This reluctance to cross interdisciplinary boundaries, if and as the phenomena warrant, is still widespread. The Fundamental Transformation is perhaps the most distinctive intertemporal regularity within the TCE setup. It refers to the transformation of a large numbers bidding competition at the outset into a small numbers supply relation during contract implementation and at contract renewal intervals for transactions that are supported by significant investments in transaction specific assets. Such bilateral dependencies present the parties with contractual hazards for which, as discussed above, governance supports are introduced to effect hazard mitigation in cost-effective degree. Going public with a high-tech start-up firm or leveraged buyout is also attended by significant intertemporal transformations. Start-ups are highrisk undertakings that combine venture capitalists with entrepreneurial, technical, and legal talent in a race to be first. Real-time responsiveness is of the essence. Leveraged buyouts respond to financial and organizational misalignments by mobilizing finance, replacing the incumbent management, and reshaping the firm and its financing by substituting debt for equity (as appropriate) and selling or spinning off unrelated parts. The big rewards for each are concentrated in the ‘going public’ transaction, after which the highpowered incentives and real-time responsiveness of the entrepreneurial actors give way to a business-as-usual enterprise in which routines set in. Also, the array of phenomena that cluster under the rubric of ‘path dependency’ all involve intertemporal transformations of one type or another. Whereas many of these transformations are commonly interpreted

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as unfair or anticompetitive from an orthodox perspective, TCE interprets all path-dependent practices with reference to the aforementioned remediableness criterion. Awaiting a demonstration that superior feasible and implementable alternatives can be devised, social scientists need to come to terms with, rather than denounce, unwanted path-dependent outcomes. Finally, although some students of economic organization aver that TCE is remiss in ‘dynamic’ respects, I would observe that TCE has been an exercise in adaptive, intertemporal economic organization from the outset (Williamson, 1971; 1975; 1985; 1991).12 To be sure, featuring adaptive differences among alternative modes of governance and making provision for intertemporal transformations are primitive forms of dynamics. Critics who would push beyond are invited to do so – mindful of the fact that it is easier to say, rather than do, dynamics.13 Contract law Whereas the details of firm and market organization are scanted under the lens of choice setups, the lens of contract/governance describes each generic mode of governance (market, hybrid, hierarchy) as a distinct syndrome of attributes, each of which differs in incentive intensity, administrative control, and contract law respects. These differences give rise to different adaptive strengths and weaknesses. Of these attribute differences, I call attention here principally to the way in which contract law regimes vary across modes. By contrast with economic orthodoxy, which implicitly assumes that there is a single, all-purpose law of contract that is costlessly enforced by well-informed courts, the lens of contract treats court ordering as a special case and holds that the operative law of contract varies among alternative modes of governance. Thus, whereas the contract law of markets is legalistic (corresponds to the ideal transaction in both law and economics, whereby disputes are settled by court-ordered money damages, after which each party goes its own way), hybrid transactions and, especially, hierarchical transactions are ones for which continuity is valued. The common view of contract as legal rules thus gives way to the more elastic concept of ‘contract as framework’, where the framework ‘never accurately indicates real working relations, but . . . affords a rough indication around which such relations vary, an occasional guide in cases of doubt, and a norm of ultimate appeal when the relations cease in fact to work’ (Llewellyn, 1931, p. 736). Whereas contract as framework applies to hybrid transactions, the coordinated adaptations of the conscious, deliberate, purposeful kind to which Barnard referred are realized through administration. This entails taking transactions out of markets and organizing them internally – to which yet

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another law of contract, the contract law of internal organization, applies. Except when fraud, illegality or conflict of interest is shown, the courts have the good sense to refuse to hear interdivisional disputes that arise within firms – with respect, for example, to transfer pricing, overhead, accounting, the costs to be ascribed to intrafirm delays, failures of quality, and the like. In effect, the contract law of internal organization is that of forbearance, according to which the firm becomes its own court of ultimate appeal (Williamson, 1991). Firms for this reason are able to exercise fiat that markets cannot. Whereas such fiat differences between firm and market were long recognized by organization theorists, Armen Alchian and Harold Demsetz (1972), among others, held that firm and market are indistinguishable in fiat respects. Not only does TCE hold otherwise, but the contract law differences that TCE associates with alternative modes of governance are among the reasons why governance structures differ in discrete structural ways. Have an active mind In the degree to which interdisciplinary training opens windows and promotes curiosity, which it often does, the Carnegie program encouraged the student of economic organization to have an active mind. Roy D’Andrade (1986) captures the spirit in his contrast between authoritative and inquiring research orientations. Whereas the former is characterized by an advanced state of development, is self-confident, and declares that ‘this is the law here’, the latter is more tentative, pluralist, and exploratory and poses the question, ‘What is going on here?’ The first is commonly of a top-down kind; the latter favors bottom-up constructions. Theoretical physics is widely regarded as the exemplar of the imperial tradition, but parts of economics also have these aspirations – as witness Solow’s observation that ‘there is a lot to be said in favor of staring at the piece of reality you are studying and asking, just what is going on here? Economists who are enamored of the physics style seem to bypass that stage’ (Solow, 1997, p. 57; emphasis added). To be sure, few economists have no curiosity whatsoever about the phenomena. The readiness, however, to impose preconceptions – rather than to get close to the phenomena by asking and attempting to answer the question, ‘What is going on here?’ – is nevertheless widespread, as John McMillan notes in contrasting his research strategy and that of others (2002, p. 225; emphasis added): To answer any question about the economy, you need some good theory to organize your thoughts and some facts to ensure that they are on target. You have to look and see how things actually work or do not work. That might seem

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The Elgar companion to transaction cost economics so trite as not to be worth saying, but assertions about economic matters that are based more on preconceptions than on the specifics of the situation are still regrettably common.

Those who have an abiding interest in economic organization are thus advised to combine detailed knowledge of the phenomena, to which the ‘look and see’ contributions of organization theorists are frequently pertinent, with a focused lens. Indeed some economists, myself included, subscribe to pluralism – in that a deeper understanding of complex phenomena will sometimes benefit from the application of several focused lenses (some of which may be rival but others complementary). Note, moreover, that the imperial and inquiring research traditions can coexist, sometimes sequentially. To illustrate, whereas the vast transformation in corporate finance that was accomplished when Franco Modigliani and Merton Miller (1958) pushed the logic of zero transaction cost contracting to completion, many of the follow-on qualifications to the Modigliani–Miller theorem assumed, implicitly if not explicitly, that transaction costs are positive. For students at Carnegie when Modigliani, Miller, Muth, Simon, March, and others were all on the faculty, this was a constructive tension. Operationalization Ronald Coase’s 1937 paper on ‘The Nature of the Firm’ expressly confronted an embarrassing lapse: whereas the distribution of activity between firm and market had been taken as given by economists, the boundary of the firm should be derived from the application of economizing reasoning to the make-or-buy decision. Coase traced this lapse to the prevailing assumption within economics that transaction costs were zero. Even more embarrassing was his subsequent demonstration that externalities (more generally, market failures) would vanish when the logic of zero transaction costs is pushed to completion (Coase, 1960), since the parties would everywhere realize mutual gains by costlessly bargaining to an efficient outcome. Although transaction cost reasoning began to take hold during the 1960s, such costs were often invoked in a one-sided way – as with the argument that, given the presumed efficacy of costless bargaining, the role of the government reduced to defining and enforcing property rights (Coase, 1959). Also, transaction costs were frequently invoked in a tautological way, thereby to ‘explain’ any puzzling phenomenon whatsoever after the fact. Ready recourse to such reasoning earned transaction costs a ‘well-deserved bad name’ (Fischer, 1977, p. 322, n. 5). Both the longstanding neglect of transaction costs and ad hoc uses of

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transaction cost reasoning were unsatisfactory. What to do? The unmet need was to operationalize the concept of transaction cost, broadly with reference to the four precepts of pragmatic methodology. Addressing the issues in a comparative institutional way with applications to specific phenomena facilitated operationalization efforts. Comparative analysis, moreover, relieves the need to take absolute measures of transaction cost, since the object is to ascertain the factors that are responsible for differential transaction costs as between alternative modes of governance.14 Such efforts were begun in the 1970s and continue to this day. As elaborated elsewhere, key operationalizing moves include the following: 1.

2.

3.

4.

5.

6.

Rather than proceed in a fully general way, TCE focuses on specific phenomena, of which vertical integration (the make-or-buy decision) is the paradigm problem. This choice had two advantages: it expressly addresses the puzzle to which Coase (1937) referred; and transactions in intermediate product markets are less beset by contractual complications (such as asymmetries of information, resources, expertise, and risk aversion) than are other transactions. The transaction is made the basic unit of analysis and is thereafter dimensionalized (with emphasis on asset specificity, contractual disturbances (uncertainty), and frequency). Alternative modes of governance are described as internally consistent syndromes of attributes to which distinctive strengths and weaknesses – in autonomous and coordinated adaptation respects – accrue. Economizing on transaction cost is taken to be the cutting edge, where this is implemented through the discriminating alignment hypothesis, to wit: transactions, which differ in their attributes, are aligned with governance structures, which differ in their cost and competence, so as to effect a transaction cost economizing outcome. The basic regularities are captured in the simple contractual schema (see the Appendix), through which many other contractual phenomena can be interpreted as variations on a theme. Indeed, any issue that arises as or can be reconceptualized as a contracting problem can be interpreted to advantage in transaction cost economizing terms. Empirical tests of the predictions of the theory have ensued. By contrast with theories of economic organization that yield few refutable implications and/or are very nearly nontestable, TCE invites and has benefited from empirical testing. Indeed, ‘despite what almost 30 years ago may have appeared to be insurmountable obstacles to acquiring the relevant data [which are often microanalytic and require primary data], today transaction cost economics stands on a remarkably broad empirical foundation’ (Geyskens et al. 2006, p. 531). There is no

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7.

question that TCE is more influential because of the empirical work that it has engendered. Public policy has been transformed by working up the efficiency/ inefficiency ramifications of TCE for complex contract and economic organization.15

Conclusions As compared with most contributions to the rapidly growing literature on contract and economic organization, TCE is more interdisciplinary, insistently emphasizes refutable implications, invites empirical testing, and is more concerned with public policy ramifications. Although still undergoing development in fully formal modeling respects (Bajari and Tadelis, 2001; Tadelis, 2002; Levin and Tadelis, 2005; Tadelis and Williamson, 2007), the combination of semi-formal models (Riordan and Williamson, 1985), diagrams (such as the simple contractual schema), and a widely shared verbal understanding of the logic of discriminating alignment have provided the impetus for the numerous TCE applications described elsewhere (Williamson, 1990, pp. 192–4; 2005b; Macher and Richman, 2006). Indeed, the move from words to diagrams to mathematical models is what the natural progression contemplates. Headway in the future will be realized as it has in the past – not by the creation of a general theory but by proceeding in a modest, slow, molecular, definitive way, placing block upon block until the value added cannot be denied. It is both noteworthy and encouraging that so many young scholars have found productive ways to connect. TCE, moreover, has benefited from rival and complementary perspectives – especially those that subscribe to the four precepts of pragmatic methodology. Such pluralism brings energy to the elusive ambition of realizing the ‘science of organization’ to which Chester Barnard (1938) made reference over 70 years ago. As the Handbook of Organizational Economics (Gibbons and Roberts, 2010) reveals, the economics of organization, of which TCE is a part, is a vibrant research agenda. Notes 1.

Overviews that I have done previously have gone more thoroughly into the mechanisms of governance and applications of the lens of contract/governance (Williamson, 1989, 1998, 2002b, 2005a). See also the recent overviews of Claude Ménard (2004) as well as the forthcoming paper by Steven Tadelis (2010). The target audience for this chapter is students who have completed their second year of a PhD program in economics, business, or the contiguous social sciences and are considering whether to take courses in the economics of organization and/or the economics of institutions preparatory to doing their dissertations. The common features that I associate with success of these students are these: they have a good grasp of textbook microeconomic theory and of the core courses in their respective fields; they have interdisciplinary interests; they have an abiding curiosity in understanding the purposes

An overview

2. 3.

4.

5.

6.

7.

8. 9.

10. 11.

12. 13.

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served by complex economic (and noneconomic) organizations; and, because the action resides in the details, they are prepared to engage the microanalytics in theoretical, empirical, and public policy respects. Jacques Dreze, who was a visitor at Carnegie, speaks for me and many others in recalling his time at Carnegie as follows: ‘Never since have I experienced such intellectual excitement’ (1995, p. 123). This and other insights of older style institutional economics would nevertheless remain dormant for many years, primarily for lack of a positive research agenda (Stigler, 1983, p.170) – which I take to mean lack of operationalization. Older style institutional economics did not, however, lack for good ideas, views to the contrary notwithstanding (Coase, 1984, pp. 229–30). The New Institutional Economics, of which TCE is a part, draws selectively on the insights of Commons and others and seeks to breathe operational content into them. ‘Speaking as a tool-fashioner interested in developing tools that better deal with the world-as-it-is, I believe game theory (the tool) has more to learn from transaction cost economics than it will have to give, at least initially’ (Kreps, 1999, p. 122; emphasis added). But Kreps plainly contemplates give-and-take. Rather than assume that players are accepting of the coercive payoffs that are associated with the prisoners’ dilemma – according to which each criminal is induced to confess, whereas both would be better off if they could commit not to confess – TCE assumes that the criminals (or their handlers, such as the mafia) can, upon looking ahead, take ex ante actions to alter the payoffs by introducing private ordering penalties to deter defections. This latter is a governance move, variants of which can be introduced into many other bad games. Jack Muth, in his low-key way, suggested to me (when I was working on my dissertation on managerial discretion at Carnegie) that since shareholders were not ignorant of deviations from single-minded profit maximization, they would adjust the terms of trade for equity capital accordingly. As Ronald Coase observed of economic thinking in the 1970s, ‘If an economist finds something – a business practice of one sort or another – that he does not understand, he looks for a monopoly explanation. And as in this field we are very ignorant, the number of ununderstandable practices tends to be very large, and the reliance on a monopoly explanation frequent’ (1972, p. 67). Such knee-jerk public policy nevertheless persisted. Here, as elsewhere, it takes a theory to beat a theory. See Coase (1964) and Harold Demsetz (1967). As Dr Stephen Strauss, who directs the National Center for Complementary and Alternative Medicine, puts it, ‘Things that are wrong are ultimately put aside, and things that are right gain traction. There are the conflicting tides of belief and fact, and each has its own chronology. Things don’t change quickly, but over time a cumulative body of evidence becomes compelling’ (as quoted by Jerome Groopman, 2006, p. A12). There is no question that TCE has been more influential because of the large and growing body of empirical research that it has generated (Shelanski and Klein, 1995; Macher and Richman, 2006). Personal communication, 6 February 2006, from Milton Friedman to the author. As I have discussed elsewhere, parts of the ‘resource dependency’ literature are pertinent but fail to push the logic to completion. Of special relevance to TCE is the potentially important concept of embeddedness (Granovetter, 1985). Regrettably, 20 years later and counting, this concept still suffers for lack of operationalization. Be that as it may, economics needs to be informed by those contributions of organization theory that withstand the test of time. TCE implements the proposition that adaptation (of autonomous and coordinated kinds) is the central purpose of economic organization – which is an intertemporal construction to which refutable implications accrue. For an early and primitive effort to work up the dynamics of managerial discretion, see Williamson (1970, Chapter 5).

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14.

‘In general, much cruder and simpler arguments will suffice to demonstrate an inequality between two quantities than are required to show the conditions under which these quantities are equated at the margin’ (Simon, 1978, p. 6). Corporate governance provides a recent example of the interaction of theory and evidence. Thus whereas the initial application of the lens of contract to equity finance led into an interpretation of the board of directors as monitor, thereby to safeguard the interests of shareholders, an examination of boards in practice suggests a dual-purpose interpretation whereby the board serves two credible contracting purposes: monitoring and delegation (Williamson, 2007).

15.

Bibliography Alchian, Armen, and H. Demsetz (1972), ‘Production, information costs, and economic organization’, American Economic Review, 62 (5), 777–95. Bajari, Patrick and Steven Tadelis (2001), ‘Incentives versus transaction costs: a theory of procurement contracts’, RAND Journal of Economics, 32 (3) (Autumn), 287–307. Barnard, Chester (1938), The Functions of the Executive, Cambridge: Harvard University Press (15th edn, 1962). Buchanan, James (2001), ‘Game theory, mathematics, and economics’, Journal of Economic Methodology, 8 (1), 27–32. Coase, Ronald H. (1937), ‘The nature of the firm’, Economica, N.S., 4 (16), 386–405, reprinted in Oliver E. Williamson and Sidney Winter (eds) (1991), The Nature of the Firm: Origins, Evolution, Development, New York: Oxford University Press, pp. 18–33. Coase, Ronald H. (1959), ‘The federal communications commission’, Journal of Law and Economics, 2 (October), 1–40. Coase, Ronald H. (1960), ‘The problem of social cost’, Journal of Law and Economics, 3 (October), 1–44. Coase, Ronald H. (1964), ‘The regulated industries: discussion’, American Economic Review, 54 (3), 194–97. Coase, Ronald H. (1972), ‘Industrial organization: a proposal for research’, in V.R. Fuchs (ed.), Policy Issues and Research Opportunities in Industrial Organization, New York: National Bureau of Economic Research, pp. 59–73. Coase, Ronald H. (1984), ‘The new institutional economics’, Journal of Institutional and Theoretical Economics, 140 (March), 229–31. Commons, John R. (1932), ‘The problem of correlating law, economics, and ethics’, Wisconsin Law Review, 8 (1), 3–26. D’Andrade, Roy (1986), ‘Three scientific world views and the covering law model’, in Donald W. Fiske and Richard A. Schweder (eds), Metatheory in Social Science: Pluralisms and Subjectivities, Chicago: University of Chicago Press, pp. 19–41. Demsetz, Harold (1967), ‘Toward a theory of property rights’, American Economic Review, 57 (2), 347–59. Dreze, Jacques (1995), ‘40 years of public economics – a personal perspective’, Journal of Economic Perspectives, 9 (2) (Spring), 111–30. Elster, John (1994), ‘Arguing and bargaining in two constituent assemblies’, unpublished manuscript, remarks given at the University of California, Berkeley. Fischer, Stanley (1977), ‘Long-term contracting, sticky prices, and monetary policy: comment’, Journal of Monetary Economics, 3 (3), 317–24. Friedman, Milton (1997), in Brian Snowdon and Howard Vane, ‘Modern macroeconomics and its evolution from a monetarist perspective’, Journal of Economic Studies, 24 (4), 192–222. Georgescu-Roegen, Nicholas (1971), The Entropy Law and Economic Process, Cambridge, MA: Harvard University Press. Geyskens, Inge, Jan-Benedict E.M. Steenkamp, and Nirmalya Kumar (2006), ‘Make, buy, or ally: a meta-analysis of transaction cost theory’, Academy of Management Journal, 49 (3), 519–43.

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Gibbons, Robert and John Roberts (eds) (2010), Handbook of Organizational Economics, Princeton, NJ: Princeton University Press. Granovetter, Mark (1985), ‘Economic action and social structure: the problem of embeddedness’, American Journal of Sociology, 91 (3), 481–501. Groopman, Jerome (2006), ‘No “alternative”’, Wall Street Journal, 7 August, p. A12. Hayek, Friedrich (1945), ‘The use of knowledge in society’, American Economic Review, 35 (4), 519–30. Knight, Frank H. (1941), ‘Review of Melville J. Herskovits’ “Economic Anthropology”’, Journal of Political Economy, 49 (2), 247–58. Kreps, David (1999), ‘Markets and hierarchies and (mathematical) economic theory’, in Glenn Carroll and David Teece (eds), Firms, Markets, and Hierarchies, New York: Oxford University Press, pp. 121–55. Lange, Oskar (1938), ‘On the economic theory of socialism’, in Benjamin Lippincott (ed.), On the Economic Theory of Socialism, Minneapolis: University of Minnesota Press, pp. 55–143. Levin, Jonathan and Steven Tadelis (2005), ‘Contracting for government services: theory and evidence from US cities’, unpublished manuscript, University of California, Berkeley. Llewellyn, Karl N. (1931), ‘What price contract? An essay in perspective’, Yale Law Journal, 40 (5), 704–51. Macher, Jeffrey and Barak Richman (2006), ‘Transaction cost economics: an assessment of empirical research in the social sciences’, unpublished manuscript, Georgetown University. March, James G. and Herbert A. Simon (1958), Organizations, New York: John Wiley. McMillan, John (2002), Reinventing the Bazaar: A Natural History of Markets, New York: W.W. Norton. Ménard, Claude (2004), ‘The economics of hybrid organizations’, Journal of Institutional and Theoretical Economics, 160 (3), 345–76. Michels, Robert (1962), Political Parties, Glencoe, IL: Free Press. Modigliani, Franco and Merton H. Miller (1958), ‘The cost of capital, corporation finance, and the theory of investment’, American Economic Review, 48 (3), 261–97. Newell, Alan (1990), United Theories of Cognition, Cambridge, MA: Harvard University Press. Reder, Melvin (1999), Economics: The Culture of a Controversial Science, Chicago: University of Chicago Press. Riordan, Michael and Oliver Williamson (1985), ‘Asset specificity and economic organization’, International Journal of Industrial Organization, 3 (4), 365–78. Scott, W. Richard (1987), Organizations, 2nd edn, Englewood Cliffs, NJ: Prentice-Hall. Selznick, Philip (1966), TVA and the Grass Roots, New York: Harper Torchbooks. Shelanski, Howard A. and Klein, Peter G. (1995), ‘Empirical research in transaction cost economics: a review and assessment’, Journal of Law, Economics, and Organization, 11 (2), 335–61. Simon, Herbert (1957a), Models of Man, New York: John Wiley. Simon, Herbert (1957b), Administrative Behavior, 2nd edn, New York: Macmillan. Simon, Herbert (1978) ‘Rationality as process and as product of thought’, American Economic Review, 68 (2), 1–16. Simon, Herbert (1985), ‘Human nature in politics: the dialogue of psychology with political science’, American Political Science Review, 79 (2), 293–304. Simon, Herbert (1992), Economics, Bounded Rationality, and the Cognitive Revolution, Aldershot, UK and Brookfield, VT, USA: Edward Elgar Publishing. Simon, Herbert (1997), An Empirically Based Microeconomics, Cambridge, UK: Cambridge University Press. Solow, Robert (1997), ‘How did economics get that way and what way did it get?’ Daedulus, 126 (1), 39–58. Solow, Robert (2001), ‘A native informant speaks’, Journal of Economic Methodology, 8 (1), 111–12.

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Stigler, George (1983), in Edmund Kitch (ed.), ‘The fire of truth: a remembrance of law and economics at Chicago, 1932–1970’, Journal of Law and Economics, 26 (1), 163–234. Tadelis, Steven (2002), ‘Complexity, flexibility, and the make-or-buy decision’, American Economic Review Papers and Proceedings, 92 (2) (May), 433–7. Tadelis, Steven (2010), ‘Transaction cost economics’, unpublished manuscript, University of California, Berkeley. Williamson, Oliver E. (1970), Corporate Control and Business Behavior, Englewood-Cliffs, NJ: Prentice-Hall. Williamson, Oliver E. (1971), ‘The vertical integration of production: market failure considerations’, American Economic Review, 61 (2), 112–23. Williamson, Oliver E. (1975), Markets and Hierarchies: Analysis and Antitrust Implications, New York: Free Press. Williamson, Oliver E. (1985), The Economic Institutions of Capitalism, New York: Free Press. Williamson, Oliver E. (1989), ‘Transaction cost economics’, in Richard Schmalensee and Robert Willig (eds), Handbook of Industrial Organization, Amsterdam: North Holland, pp. 135–82. Williamson, Oliver E (1990), ‘Chester Barnard and the incipient science of organization’, in Oliver E. Williamson (ed.), Organization Theory: From Chester Barnard to the Present and Beyond, New York: Oxford University Press, pp. 172–206. Williamson, Oliver E. (1991), ‘Comparative economic organization: the analysis of discrete structural alternatives’, Administrative Science Quarterly, 36 (2), 269–96. Williamson, Oliver E. (1998), ‘Transaction cost economics: how it works, where it is headed’, De Economist, 146 (1), 23–58. Williamson, Oliver E. (2002a), ‘The lens of contract: private ordering’, American Economic Review, 92 (2), 438–43. Williamson, Oliver E. (2002b), ‘The theory of the firm as governance structure: from choice to contract’, Journal of Economic Perspectives, 16 (3), 171–95. Williamson, Oliver E. (2002c), ‘Empirical microeconomics: another perspective,’ in Mie Augier and James March (eds), The Economics of Choice, Change, and Organization, Cheltenham, UK and Northampton, MA, USA: Edward Elgar Publishing, pp. 419–41. Williamson, Oliver E. (2005a), ‘The economics of governance’, American Economic Review, 95 (2), 1–18. Williamson, Oliver E. (2005b), ‘Transaction cost economics and business administration’, Scandinavian Journal of Management, 21 (1), 19–40. Williamson, Oliver E. (2007), ‘Corporate boards of directors: a dual-purpose (efficiency) perspective’, unpublished manuscript, University of California, Berkeley. Wilson, Edward O. (1999), Consilience, New York: Alfred Knopf.

Appendix The simple contractual schema The paradigm transaction for TCE is vertical integration (or, in more mundane terms, the make-or-buy decision). Not only is vertical integration the obvious candidate transaction (Coase, 1937), but, because it is less beset with asymmetries of information, budget, legal talent, risk aversion, and the like than are many other transactions, it is simpler. Not only are transaction cost features more transparent for the make-or-buy decision, but the simple contractual schema described below applies (with variation) to the study of transactions more generally. Thus assume that a firm can make or buy a component and assume

An overview

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A (unassisted market) k=0 B (unrelieved hazard) s =0 C (hybrid contracting)

k>0

market support s >0 administrative support

D (internal organization/firm)

Figure 2.1

Simple contractual schema

further that the component can be supplied by either a general purpose technology or a special purpose technology. Letting k be a measure of asset specificity, the transactions in Figure 2.1 that use the general purpose technology are ones for which k = 0. In this case, no specific assets are involved and the parties are essentially faceless. Transactions that use the special purpose technology are those for which k > 0. Such transactions give rise to bilateral dependencies, in that the parties have incentives to promote continuity, thereby to safeguard specific investments. Let s denote the magnitude of any such safeguards, which include penalties, information disclosure and verification procedures, specialized dispute resolution (such as arbitration) and, in the limit, integration of the two stages under unified ownership. An s = 0 condition is one for which no safeguards are provided; a decision to provide safeguards is reflected by an s > 0 result. Node A in Figure 2.1 corresponds to the ideal transaction in law and economics: there being an absence of dependency, governance is accomplished through competition and, in the event of disputes, by court awarded damages. Node B poses unrelieved contractual hazards, in that specialized investments are exposed (k > 0) for which no safeguards (s = 0) have been provided. Such hazards will be recognized by farsighted players, who will price out the implied risks. Added contractual supports (s > 0) are provided at Nodes C and D. At Node C, these contractual supports take the form of interfirm contractual safeguards. Should, however, costly breakdowns continue in the face of

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best bilateral efforts to craft safeguards at Node C, the transaction may be taken out of the market and organized under unified ownership (vertical integration) instead. Because added bureaucratic costs accrue upon taking a transaction out of the market and organizing it internally, internal organization is usefully thought of as the organization form of last resort: try markets, try hybrids, and have recourse to the firm only when all else fails. Node D, the unified firm, thus comes in only as higher degrees of asset specificity and added uncertainty pose greater needs for cooperative adaptation. Note that the price that a supplier will bid to supply under Node C conditions will be less than the price that will be bid at Node B. That is because the added security features at Node C serve to reduce the contractual hazard, as compared with Node B, so the contractual hazard premium will be lowered. One implication is that suppliers do not need to petition buyers to provide safeguards. Because buyers will receive goods and services on better terms (lower price) when added security is provided, buyers have the incentive to offer credible commitments.

3

Transaction cost economics and the new institutional economics Peter G. Klein

The concept of transaction costs is central to the modern economic analysis of organizations and institutions, and transaction cost economics (TCE) is often regarded as a subset of what has been called the new institutional economics. The term ‘new institutional economics’ (NIE), introduced into the literature by Williamson (1975), emerged in the 1970s and 1980s as a convenient label encompassing TCE, parts of the ‘new’ economic history (particularly the contributions of Douglass North), positive political economy, and related developments in applied social science. Klein (2000, p. 456) describes the NIE as: an interdisciplinary enterprise combining economics, law, organization theory, political science, sociology and anthropology to understand the institutions of social, political and commercial life. It borrows liberally from various socialscience disciplines, but its primary language is economics. Its goal is to explain what institutions are, how they arise, what purposes they serve, how they change and how – if at all – they should be reformed.1

Institutions and the economics of institutions North (1991, p. 97) defines institutions as: humanly devised constraints that structure political, economic and social interaction. They consist of both informal constraints (sanctions, taboos, customs, traditions, and codes of conduct), and formal rules (constitutions, laws, property rights). . . . Together with the standard constraints of economics they define the choice set and therefore determine transaction and production costs and hence the profitability and feasibility of engaging in economic activity.

This definition places institutional analysis squarely within the ‘rational’ or optimizing framework of conventional economics. Just as economic actors think, act, and choose while constrained by resource availability, technical and practical knowledge, the behaviour of other actors, and so on, they are also constrained by informal and formal institutions. Some of these, such as characteristics of the legal and political system, language, culture, and social conventions, are taken by actors as exogenous (though they may ultimately be explainable in terms of purposeful human 27

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behaviour – what Hayek (1967, 1973–79) calls the ‘result of human action but human design’). Other constraints, such as contractual arrangements, are designed by particular actors to achieve specific purposes (namely, exploiting gains from trade). What is ‘new’ about the NIE? Until the 1980s, ‘institutional economics’ usually referred to the writings of Thorstein Veblen, John R. Commons, Wesley C. Mitchell, Clarence Ayres, and their followers. This is a diverse group, but their work reflects several common themes, mostly criticisms of orthodox economics: (1) a focus on collective rather than individual action; (2) a preference for an ‘evolutionary’ rather than mechanistic approach to the economy; and (3) an emphasis on empirical observation over deductive reasoning.2 Whatever their contributions, the older institutionalists are little known to most contemporary economists. Coase’s (1984, p. 230) dismissal is typical: ‘Without a theory they had nothing to pass on except a mass of descriptive material waiting for a theory, or a fire’. The NIE, by contrast, eschews the holism of the older school, sharing the methodologically individualist outlook of Max Weber, the Austrians, and most neoclassical economists (Udehn, 2002). Of course, NIE appreciates social phenomena like corporate culture, organizational memory, and so on. Still, the NIE takes these as explananda, not explanans, couching its explanations in terms of the goals, plans, and actions of individuals. Examples include Menger’s (1892) analysis of the origin of money or more recent game-theoretic or rational-choice explanations for the emergence of norms, conventions, and customary law (Ullman-Margalit, 1977; Schotter, 1981; Sugden, 1986; Benson, 1990; Ellickson, 1991). New institutional economists typically work with a broader, or looser, notion of ‘rationality’ than their neoclassical counterparts, however. While Williamson’s (2000, p. 600) claim that there is ‘close to unanimity within the NIE on the idea of limited cognitive competence – often referred to as bounded rationality’ may be an exaggeration, there is certainly more sensitivity to cognitive and behavioural issues in the NIE than in most of applied economics (see Chapter 14 by Foss in this volume on bounded rationality for details). There is also an attention to evolution and process. Institutions, writes North (1991, p. 97), ‘evolve incrementally, connecting the past with the present and the future; history in consequence is largely a story of institutional evolution in which the historical performance of economies can only be understood as a part of a sequential story.’ Another distinction of the NIE is its insistence that policy analysis be guided by what has become known as ‘comparative institutional analysis’. Orthodox welfare analysis typically compares real-world outcomes with the hypothetical benchmark of perfectly competitive general equilibrium. It is unsurprising, then, that actual market outcomes will come up short.

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The relevant question, Coase (1964, p. 195) explains, is whether a feasible alternative can be devised: Contemplation of an optimal system may provide techniques of analysis that would otherwise have been missed and, in certain special cases, it may go far to providing a solution. But in general its influence has been pernicious. It has directed economists’ attention away from the main question, which is how alternative arrangements will actually work in practice. It has led economists to derive conclusions for economic policy from a study of an abstract of a market situation. It is no accident that in the literature . . . we find a category ‘market failure’ but no category ‘government failure’. Until we realise that we are choosing between social arrangements which are all more or less failures, we are not likely to make much headway.3

As Demsetz (1969, p. 1) puts it, ‘[t]he view that now pervades much public policy economics implicitly presents the relevant choice as between an ideal norm and an existing “imperfect” institutional arrangement. This nirvana approach differs considerably from a comparative institution approach in which the relevant choice is between alternative real institutional arrangements’. Levels of analysis The NIE can be divided into two branches following Davis and North’s (1971) distinction between the ‘institutional environment’ and ‘institutional arrangements’. The former refers to the background constraints, or ‘rules of the game’, that guide individuals’ behaviour. These can be both formal, explicit rules (constitutions, laws, property rights) and informal, often implicit rules (social conventions, norms). While these background rules are the product of – and can be explained in terms of – the goals, beliefs, and choices of individual actors, the social result (the rule itself) is typically not known or ‘designed’ by anyone.4 Institutional arrangements, by contrast, are specific guidelines – what Williamson (1985, 1996) calls ‘governance structures’ – designed by trading partners to mediate particular economic relationships. Business firms, long-term contracts, public bureaucracies, nonprofit organizations, and other contractual agreements are examples of institutional arrangements. Williamson (2000) distinguishes further between four levels of analysis: embeddedness (informal institutions, customs, traditions, norms, religion); the institutional environment (formal rules of the game such as property law); governance (the play of the game, as manifest in contracts and organizations); and resource allocation and employment (prices and quantities, incentive alignment). Decisions about resource allocation, focusing on equating benefits and costs at the margin, are made momentby-moment, while changes in governance, aiming to align governance

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structures with transactional characteristics, occur more slowly. Changes to, and the evolution of, the institutional environment and embedded norms take place even more gradually, and are (particularly in the case of embedded norms) typically the ‘spontaneous’ result of unintended consequences. What is the relationship among levels? How does the institutional environment affect institutional arrangements? This is an under-researched area in the NIE and in TCE. Evidence on firm boundaries suggests that firms internalize transactions as a response to weaknesses in the institutional environment. In countries with stable legal institutions, relatively efficient courts, and reasonable default rules for contract terms, for example, contracts tend to be less complete. If contracting parties can trust the courts to fill in the gaps, why bother to write out every contingency? Likewise, if a country has an efficient external capital market, firms can be small and specialized, relying on the capital markets to allocate resources among business units, but if the external capital market performs poorly, diversified business groups may arise to exploit their internal capital markets (Khanna and Palepu, 1999, 2000).5 Aggarwal et al. (2008) find, however, that firms tend to establish better mechanisms for corporate governance in countries that already have strong rules for investor protection, suggesting a complementary, rather than substitute, relationship between aspects of the institutional environment and firms’ preferred institutional arrangements. Moreover, while the NIE typically takes the institutional environment as exogenous, firms can, in some cases, choose the institutional environment they prefer, through foreign expansion or relocation, by ‘forum shopping’ (conducting legal affairs in the most favourable jurisdiction, as in US firms incorporating in Delaware, the state perceived to have the best corporate-chartering and dispute-resolution rules).6 The role of transaction costs and property rights Transaction costs and property rights play a role in all levels of analysis. Transaction costs include both the costs resulting from the transfer of property rights (what Allen (2000) calls the ‘neoclassical’ concept of transaction costs) and the costs of establishing and maintaining property rights.7 Coase’s (1937) famous analysis of the firm takes transaction costs – defined there as the costs of search, communication, and bargaining – as the main determinant of firm existence, boundaries, and organizational structure. In his 1960 paper on social cost, Coase suggests that parties’ ability to rearrange property rights in ways that maximize economic value depends on transaction costs, particularly the costs of drafting, monitoring, and enforcing contractual agreements. As Coase (1988, p. 34) later wrote: ‘Transaction costs were used in the one case to show that if they are

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not included in the analysis, the firm had no purpose, while in the other I showed, as I thought, that if transaction costs were not included into the analysis, for the range of problems considered, the law had no purpose’. Likewise, the economic analysis of legal rules and property rights figures prominently in studies of the institutional environment and institutional arrangements. Beginning with the early literature on the efficiency of the common law (Rubin, 1977; Priest, 1977), economic analysis has been used to study not only the character and effects of law but the mechanisms by which legal rules change. In this sense, law and economics may therefore be considered a part of NIE, although it is customary to speak of law and economics and NIE as separate movements. NIE has been particularly interested in contract law (Llewellyn, 1931; Macneil, 1974, 1978, 2001) and property law (Alchian, 1961; Demsetz, 1967; Barzel, 1989, 1997). However, unlike the ‘legal centralism’ tradition, which holds that disputes are primarily settled by the courts as official agents of the state, NIE often focuses on ‘private ordering’ (Galantner, 1981), private solutions achieved through arbitration, negotiation, and custom and enforced through reputation and social sanction.8 Property rights are also central to the incomplete-contracting (or ‘property-rights’) approach to the firm associated with Grossman and Hart (1986), Hart and Moore (1990), and Hart (1995). In this approach, the boundaries of the firm are determined by comparing the economic value created by alternative arrangements of property rights, where these rights are defined in terms of residual rights of control over alienable assets. While distinct from Williamson’s version of TCE (Williamson, 2000, pp. 605–6; Whinston, 2003), this ‘new’ property-rights approach shares with TCE an emphasis on ownership, asset specificity, and contractual incompleteness. (See Chapter 10 in this volume by Foss on propertyrights economics for more detail.) Questions about the new institutional economics Not surprisingly, scholars working within the broad NIE tradition disagree on the field’s exact boundaries and defining characteristics. Some see the NIE as a different kind of economics, providing an alternative perspective on a variety of applied fields such as industrial organization, regulation, economic development, trade policy, and so on. Others view it as simply another applied field, the economic analysis of institutions and organizations. Similarly, is TCE a general theory of economic organization – as Williamson puts it, ‘[a]ny problem that can be posed directly or indirectly as a contracting problem is usefully investigated in transaction cost economizing terms’ (Williamson, 1985, p. 41) – or is TCE simply the asset-specificity approach to vertical integration? Are NIE and TCE part

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of ‘neoclassical economics’ broadly defined (today’s ‘old institutional’ economists strongly believe so), or does their attention to bounded rationality, complexity, evolution, and the like earn a heterodox label?9 Different scholars working inside (and outside) the NIE give different answers. Newcomers sometimes see the NIE as a pot-pourri of diverse, only weakly connected, topics: the legal environment and property rights; norms, culture, and social conventions; economic history, growth, and development; political economy; Coase and the nature of the firm; moral hazard and agency; TCE; the property-rights approach; resource-based theories; and innovation and organizational change. One way to unify the literature on these topics is to stress common methods and core assumptions (adherence to methodological individualism, reliance on comparative institutional analysis, an attention to interdisciplinary concerns). Another is to focus on common core concepts such as property rights and transaction costs. Yet another is to emphasize North’s (1991) definition of institutions as man-made rules, or constraints, that guide individuals’ behaviour, viewing the institutional environment and institutional arrangements (or Williamson’s (2000) four levels of analysis) as variations on a theme. One problem with the latter approach is that it is often difficult to draw sharp distinctions between the categories or levels. Much of what is usually considered part of the institutional environment, for instance (for example, political decision making), is clearly the result of human design (for example, in legislatures), while many functions or routines that take place within institutional arrangements have an unplanned, ‘spontaneous’ aspect (Langlois, 1995). Clearly, further work is needed to sort out these distinctions. For this reason and more, the NIE, and its TCE subsidiary, remain exciting areas for future research and application. Notes 1. For recent surveys of the field see two edited volumes, Handbook of New Institutional Economics (Ménard and Shirley, 2005) and New Institutional Economics: A Guidebook (Brousseau and Glachant, 2008). 2. For a sampling of the secondary literature see Seckler (1975); Rutherford (1983); Langlois (1989); and Hodgson (1998). On the German roots of American institutionalism, see Richter (1996). See also the Journal of Economic Issues, the Cambridge Journal of Economics, and the Journal of Institutional Economics. 3. Coase’s own investigation of British lighthouses (Coase, 1974), finding that most were – contrary to the standard public-goods explanation – actually privately owned, is an oft-cited example of the kind of comparative institutional analysis Coase has in mind. More recently, Coase has complained that economists have not done the careful, systematic, historical research needed to understand key cases of vertical integration, such as General Motors’ (GM’s) acquisition of Fisher Body in 1926: If it is believed that their theory tells us how people would behave in different circumstances, it will appear unnecessary to many to make a detailed study of how they did in fact act. This leads to a very casual attitude toward checking the facts. If it is

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believed that certain contractual arrangements will lead to opportunistic behavior, it is not surprising that economists misinterpret the evidence and find what they expect to find (Coase, 2006, p. 275).

4.

5.

6.

7. 8. 9.

Ironically, however, Coase’s history of the lighthouse has been challenged on the grounds that his concepts of ‘government’ and ‘private’ are too coarse (Van Zandt, 1993), and that the nominally private lighthouse firms were actually state-chartered, quasi-public entities (Bertrand, 2006). The huge literature on ‘law and finance’ is a well-known example of recent economic research on the institutional environment. La Porta et al. (1998) argued for a strong correlation between a nation’s financial-market development and the origin of its legal system (primarily, common law or civil law). This paper, and a series of follow-up studies by the same authors, established a new strand of literature on economic development using large, cross-country panel datasets containing various measures of legal, political, social, and cultural institutions. Critics argue that financial-market development and overall economic performance are driven not by legal origin but by politics, culture, and geography, among other factors, and that La Porta et al. oversimplify the causal relationships between institutions and growth. See Beck and Levine (2005) and La Porta et al. (2008) for recent overviews. Within a particular country, firms may diversify or refocus in response to the relative effectiveness of external capital markets. For instance, the divestiture wave of the 1980s among US corporations, a partial ‘undoing’ of the conglomerate mergers of the 1960s, can be explained as a consequence of the rise of takeovers by tender offer rather than by proxy contest, the emergence of new financial techniques and instruments like leveraged buyouts and high-yield bonds, and the appearance of takeover and breakup specialists like Kohlberg Kravis Roberts which themselves performed many functions of the conglomerate’s corporate staff (Bhide, 1990; Williamson, 1992). Eisenberg and Miller (2009) show that US firms most often choose New York as the venue for commercial contracting, arguing that New York lawmakers have deliberately designed a contract-law regime that is favourable to commercial transactions, in the same way that Delaware lawmakers created a superior environment for corporate chartering. See Chapter 10 in this volume by Foss on ‘property rights economics’ for more on the economic analysis of property rights and its relationship to transaction cost approaches. See Chapter 7 in this volume by Smith on the legal origins of transaction cost economics and Chapter 10 in this volume by Foss on the property-rights approach. Avner Greif’s game-theoretic work on the emergence of long-distance trade is an example of ‘neoclassical’ work in the new institutional tradition (for example, Greif, 2006). See also Aoki’s (2008) game-theoretic interpretation of Douglass North.

References Aggarwal, R., I. Erel, R. Stulz, and R. Williamson (2008), ‘Differences in governance practices between US and foreign firms: measurement, causes, and consequences’, NBER Working Paper No. 13288. Alchian, A.A. (1961), Some Economics of Property, Santa Monica: Rand Corporation. Allen, D.W. (2000), ‘Transaction Costs’, in B. Bouckeart and G. De Geest (eds), Encyclopedia of Law and Economics, Cheltenham, UK and Northampton, MA, USA: Edward Elgar Publishing, pp. 893–926. Aoki, M. (2008), ‘Understanding Douglas North in game-theoretic language’, Working Paper, Department of Economics, Stanford University. Barzel, Y. (1989), Economic Analysis of Property Rights, Cambridge: Cambridge University Press. Barzel, Y. (1997), Economic Analysis of Property Rights, 2nd edn, Cambridge: Cambridge University Press.

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Beck, T.H.L. and R. Levine (2005), ‘Legal institutions and financial development’, in C. Ménard and M. Shirley (eds), Handbook of New Institutional Economics, New York: Springer, pp. 251–78. Benson, B.L. (1990), The Enterprise of Law: Justice Without the State, San Francisco: Pacific Research Institute for Public Policy. Bertrand, E. (2006), ‘The Coasean analysis of lighthouse financing: myths and realities’, Cambridge Journal of Economics, 30 (3), 389–402. Bhide, A. (1990), ‘Reversing corporate diversification’, Journal of Applied Corporate Finance, 3 (2), 70–81. Brousseau, E. and J.-M. Glachant (eds) (2008), New Institutional Economics: A Guidebook, Cambridge: Cambridge University Press. Coase, R.H. (1937), ‘The Nature of the Firm’, Economica, New Series, 4 (16), 386–405. Coase, R.H. (1960), ‘The problem of social cost’, Journal of Law and Economics, 3 (October) 1–44. Coase, R.H. (1964), ‘The regulated industries: discussion’, American Economic Review, 54 (3) 194–7. Coase, R.H. (1974), ‘The lighthouse in economics’, in R.H. Coase, The Firm, the Market, and the Law, Chicago: University of Chicago Press, pp. 187–213. Coase, R.H. (1984), ‘The new institutional economics’, Journal of Institutional and Theoretical Economics, 140, 229–232. Coase, R.H. (1988), ‘The nature of the firm: influence’, Journal of Law, Economics, and Organization, 4 (1), 33–47. Coase, R.H. (2006), ‘The conduct of economics: the example of Fisher Body and General Motors’, Journal of Economics and Management Strategy, 15 (2), 255–78. Davis, L.E. and D.C. North (1971), Institutional Change and American Economic Growth, Cambridge: Cambridge University Press. Demsetz, H. (1967), ‘Toward a theory of property rights’, American Economic Review, 57 (2), 347–59. Demsetz, H. (1969), ‘Information and efficiency: another viewpoint’, Journal of Law and Economics, 12 (1), 1–22. Eisenberg, T. and G.P. Miller (2009), ‘The market for contracts’, Cardozo Law Review, 30, 2073–98. Ellickson, R.C. (1991), Order Without Law: How Neighbors Settle Disputes, Cambridge, MA: Harvard University Press. Galanter, M. (1981), ‘Justice in many rooms: courts, private ordering, and indigenous law’, Journal of Legal Pluralism, 19, 1–47. Greif, A. (2006), Institutions and the Path to the Modern Economy, Cambridge: Cambridge University Press. Grossman, S. and O. Hart (1986), ‘The costs and benefits of ownership: a theory of lateral and vertical integration’, Journal of Political Economy, 94 (4), 691–719. Hart, O. (1995), Firms, Contracts and Financial Structure, Oxford: Clarendon Press. Hart, O. and J. Moore (1990), ‘Property Rights and the Nature of the Firm’, Journal of Political Economy, 98 (6), 1119–58. Hayek, F.A. (1967), New Studies in Philosophy, Politics, and Economics, London: Routledge. Hayek, F.A. (1973–79), Law, Legislation, and Liberty, Chicago: University of Chicago Press. Hodgson, G.M. (1998), ‘The approach of institutional economics’, Journal of Economic Literature, 36 (1), 166–92. Khanna, T. and K. Palepu (1999), ‘Policy shocks, market intermediaries, and corporate strategy: the evolution of business groups in Chile and India’, Journal of Economics and Management Strategy, 8 (2), 271–310. Khanna, T. and K. Palepu (2000), ‘Is group affiliation profitable in emerging markets? An analysis of diversified Indian business groups’, Journal of Finance, 55 (2), 867–91. Klein, P.G. (2000), ‘New institutional economics’, in B. Bouckeart and G. De Geest (eds),

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Encyclopedia of Law and Economics, Cheltenham, UK and Northampton, MA, USA: Edward Elgar Publishing, pp. 456–89. La Porta, R., F. Lopez-de-Silanes, and A. Shleifer (2008), ‘The economic consequences of legal origins’, Journal of Economic Literature, 46 (2), 285–332. La Porta, R., F. Lopez-de-Silanes, A. Shleifer, and R.W. Vishny (1998), ‘Law and finance’, Journal of Political Economy, 106 (6), 1113–55. Langlois, R. N. (1989), ‘What was wrong with the “old” institutional economics? (and what is still wrong with the “new”?)’, Review of Political Economy, 1 (3), 272–300. Langlois, R.N. (1995), ‘Do firms plan?’, Constitutional Political Economy, 6 (3), 247–61. Llewellyn, K.N. (1931), ‘What price contract? An essay in perspective’, Yale Law Review, 40 (5), 704–51. Macneil, I.R. (1974), ‘The many futures of contracts’, Southern California Law Review, 47, 691–816. Macneil, I.R. (1978), ‘Contracts: adjustments of long-term economic relations under classical, neoclassical, and relational contract law’, Northwestern University Law Review, 72, 854–906. Macneil, I.R. (2001), ‘The relational theory of contract’, in David Campbell (ed.), Selected Works of Ian Macneil, London: Sweet and Maxwell. Ménard, C. and M. Shirley (eds) (2005), Handbook of New Institutional Economics, New York: Springer. Menger, C. (1892), ‘On the origin of money’, Economic Journal, 2 (6), 239–55. North, D.C. (1991), ‘Institutions’, Journal of Economic Perspectives, 5 (1), 97–112. Priest, G.L. (1977), ‘The common law process and the selection of efficient rules’, Journal of Legal Studies, 6 (1), 65–82. Richter, R. (1996), ‘Bridging old and new institutional economics: Gustav Schmoller, the leader of the Younger German Historical School, seen with neoinstitutionalists’ eyes’, Journal of Institutional and Theoretical Economics, 152, 567–92. Rubin, P.H. (1977), ‘Why is the common law efficient?’, Journal of Legal Studies, 6 (1), 51–63. Rutherford, M.H. (1983), ‘J.R. Commons’s institutional economics’, Journal of Economic Issues, 17 (3), 721–44. Schotter, A. (1981), The Economic Theory of Social Institutions, Cambridge: Cambridge University Press Seckler, D.W. (1975), Thorstein Veblen and the Institutionalists: A Study in the Social Philosophy of Economics, Boulder, CO: Colorado Associated University Press. Sugden, R. (1986), The Economics of Rights, Cooperation, and Welfare, Oxford: Basil Blackwell. Udehn, L. (2002), ‘The changing face of methodological individualism’, Annual Review of Sociology, 28, 479–507. Ullman-Margalit, E. (1977), The Emergence of Norms, Oxford: Clarendon Press. Van Zandt, D.E. (1993), ‘The lessons of the lighthouse: “government” or “private” provision of goods’, Journal of Legal Studies, 22 (1), 47–72. Whinston, M.D. (2003), ‘On the transaction cost determinants of vertical integration’, Journal of Law, Economics, and Organization, 19 (1), 1–23. Williamson, O.E. (1975), Markets and Hierarchies: Analysis and Antitrust Implications, New York: Free Press. Williamson, O.E. (1985), The Economic Institutions of Capitalism, New York: Free Press. Williamson, O.E. (1992), ‘Markets, hierarchies, and the modern corporation: an unfolding perspective’, Journal of Economic Behavior and Organization, 17 (3), 335–52. Williamson, O.E. (1996), The Mechanisms of Governance, New York: Oxford University Press. Williamson, O.E. (2000), ‘The new institutional economics: taking stock, looking ahead’, Journal of Economic Literature, 38 (3), 595–613.

PART II PRECURSORS AND INFLUENCES

4

Ronald H. Coase Michael E. Sykuta

As a student at the London School of Economics (LSE), Ronald Coase posed a seemingly naïve question that would, in time, fundamentally change the face of economics and earn him the Nobel Prize: ‘Why do firms exist?’ The import of this simple question derived not only from the response Coase proposed, that is, that firms exist to economize on the costs of using the market, but also from the analytic perspective underlying both the question and the process by which Coase arrived at his conclusion. Coase’s insight and approach to understanding the economic system provided the theoretical foundation for transaction cost economics (TCE) and much of organizational economics more generally.1 Much has been written of Coase’s days as a student at the LSE and lecturer at the Dundee School of Economics and Commerce, most notably Coase’s (1991) autobiographical lectures on the origin, meaning and influence of his 1937 paper, ‘The Nature of the Firm’. One of the most striking realizations for many students is that the basic ideas contained in the 1937 paper had been developed in 1932 when Coase traveled to the United States as a mere 21-year-old, having received a scholarship to study ‘vertical and lateral integration in industry’ (Coase, 1991, p. 38). That the ideas of such a young person with very little formal economics training could have such significant implications for an entire discipline should be an encouragement to students and young professionals. It should also serve as a reminder to the profession as a whole to be careful of overlooking the most basic of its assumptions. The basic question Coase’s basic question arose from the apparent conflict between the lessons of neoclassical microeconomics and the observed reality. Coase attributes his appreciation for and understanding of the efficacy of the market system to his studies under Arnold Plant and his interactions with colleagues, notably Robert Fowler. In particular, Plant reinforced in Coase’s mind the idea that markets (and businesses) are, in the main, competitive and relatively efficient in directing the allocation of resources. However, Coase also observed that an enormous amount of economic activity (that is, resource allocation) occurred not at the direction of the price mechanism, per se, but under the direction of managers within firms. Despite the obviously 39

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important role that firms play in the economy, Coase pointed out that the concept of the firm was poorly defined in the economics literature of the time. He argues (Coase, 1937, p. 386), ‘[s]ince there is apparently a trend in economic theory towards starting analysis with the individual firm and not with the industry, it is all the more necessary . . . that a clear definition of the word “firm” be given’. At the same time, Coase observed the reaction of economists in the west to the introduction of national economic planning in Russia. Many economists (including the likes of Lionel Robbins, Ludwig von Mises, and F.A. Hayek) maintained that running the economy as one big factory was impossible. Yet Coase observed large factories and firms in England and the US, prompting the question of how one could ‘reconcile the impossibility of running Russia as one big factory with the existence of factories in the western world’ (Coase, 1991, p. 39). Thus, Coase’s basic question existed in two complementary and necessary parts to begin developing a definition, and theory, of the firm. First, if the market is such an effective mechanism for governing the allocation of resources, why do we observe the existence of firms that, in effect, subsume resource allocation decisions within the scope of managerial fiat? Second, given there is an economic rationale for the existence of firms, that is, for managerial rather than market-based resource allocations, why would such an organizational form not be effective in allocating resources on a much larger, for instance national, scale? Put another way, what is the source of the natural limits of managerial control that dictate the boundary of the firm? In the process of addressing these two issues, Coase proposed to identify a definition of the ‘firm’ that was both realistic in reflecting the real-world nature of firms and tractable using the principle tools of economic analysis. The ‘simple’ answer Coase argued the defining characteristic of the ‘firm’ is the supercession of the price mechanism in allocating resources. The traditional view of the ‘firm’ as production function, Coase argued, failed as a defining trait since the steps of production could as easily be completed by successive stages governed by the price mechanism. Given this defining trait, Coase quickly concludes the ‘main reason why it is profitable to establish a firm would seem to be that there is a cost of using the price mechanism. The most obvious cost of “organizing” production through the price mechanism is that of discovering what the relevant prices are’ (Coase, 1937, p. 390). Having answered the first part of his query concerning the existence of firms, Coase then turned to the second part: the limits to the size and scope of the firm. If the higher cost of the price mechanism relative to the cost of

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managerial control provides the rationale for establishing a firm, then the converse must define the boundary of adding one additional transaction to the scope of managerial control. Coase argued that as the size of the firm (number of allocations) grows and as the manager’s ability to effectively manage a larger or more diverse set of resource allocations diminishes, the costs of managerial control would increase. Thus, the firm will expand until the point where the marginal cost of arranging one more transaction by managerial control equals the cost of allocating that transaction using the price mechanism. Some scholars have criticized this simple answer as being too simple, even tautological. For instance, Alchian and Demsetz (1972, p. 738), while among the first to intentionally expand upon Coase’s insight, take issue with its usefulness for analysis: We do not disagree with the proposition that, ceteris paribus, the higher is the cost of transacting across markets the greater will be the comparative advantage of organizing resources within the firm; it is a difficult proposition to disagree with or to refute. We could with equal ease subscribe to a theory of the firm based on the cost of managing, for surely it is true that, ceteris paribus, the lower is the cost of managing the greater will be the comparative advantage of organizing resources within the firm. To move the theory forward, it is necessary to know what is meant by a firm and to explain the circumstances under which the cost of ‘managing’ resources is low relative to the cost of allocating resources through market transaction.

In a slightly more positive assessment, Oliver Williamson (1975, p. 3) wrote that ‘[t]ransaction costs are appropriately made the centerpiece of the analysis but these are not operationalized in a fashion which permits one to assess the efficacy of completing transactions as between firms and markets in a systematic way’. The theory roughly sketched by Coase thus became the springboard from which Williamson launched his work to develop a more operational framework of TCE for analyzing the comparative efficacy of firms and markets. Beyond the simple answer Although the simple answer outlined above is perhaps the most common characterization of Coase’s theory of the firm, it belies the fact that Coase laid out a much richer and more useful set of hypotheses concerning ‘the circumstances under which the cost of “managing” resources is low relative to the cost of allocating resources through market transaction’. In particular, Coase identifies several themes which are developed more fully within the context of TCE, but which of themselves would lead to testable hypotheses for differentiating which transactions might be most efficiently organized through the price mechanism versus managerial control.

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Transaction frequency Beyond the cost of price discovery itself, Coase describes the cost of ‘negotiating and concluding’ each contract as reason for consolidating the number of individual transactions among the various factor suppliers into a smaller set of contracts with one entrepreneur (Coase, 1937, pp. 390–391). While Coase first considers this consolidation in the context of coordinating across multiple factors of production (what Jensen and Meckling (1976) refer to as the firm as a ‘nexus of contracts’), the same logic applies to multiple transactions between a given set of parties to the transaction. As Coase writes, ‘It may be desired to make a long-term contract . . . due to the fact that if one contract is made for a longer period instead of several shorter ones, then certain costs of making each contract will be avoided’ (Coase, 1937, p. 391). Bounded rationality While Coase makes no explicit assumption about the rationality of decision makers, he does recognize the limited ability of decision makers to make effective decisions. In explaining the limits to the firm size, he writes ‘it may be that, as the transactions which are organized increase, the entrepreneur fails to place the factors of production in the uses where their value is highest’ (Coase, 1937, pp. 394–5). More specifically, ‘it would appear that the costs of organizing and the losses through mistakes will increase with an increase in the spatial distribution of the transactions organized, in the dissimilarity of the transactions, and in the probability of changes in the relative prices’ (ibid., p. 397). While not using the term ‘bounded rationality’, it seems clear that Coase had in mind something akin to the limited capabilities of rational decision making that feature so prominently in TCE. Uncertainty and contractual incompleteness In addition to the limited cognitive ability implied above, Coase also implicates individuals’ lack of perfect foresight and uncertainty about future states of the world in affecting the costs and completeness of contracting and the decision to internalize transactions within the firm. ‘Now owing to the difficulty in forecasting, the longer the period of the contract is . . . the less possible and, indeed, the less desirable it is . . . to specify what the other contracting party is expected to do. . . . Therefore, the service which is being provided is expressed in general terms, the exact details being left until a later date’ (ibid., pp. 391–2). This early hypothesis was echoed more than 50 years later in studies by Crocker and Masten (1991), Crocker and Reynolds (1993), Saussier (2000) and others. For example, Saussier (2000, p. 193) argues ‘the greater the uncertainty level of the transaction, the

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more difficult, expensive, and risky it will be to establish a contract that aims for completeness (particularly because of the potential costs of being “trapped” in a bad contract)’. The institutional environment Besides foreshadowing several of the transaction characteristics underlying TCE, Coase also recognized the importance of the institutional environment in affecting the relative costs of contracting and the decision to internalize transactions in the firm. ‘Another factor that should be noted is that exchange transactions on a market and the same transactions organized within a firm are often treated differently by governments or other bodies with regulatory powers’ (Coase, 1937, p. 393). While Coase uses tax policy as his example, the general point has much broader implication. Williamson (1991) extended the point by focusing instead on how the courts view and enforce interfirm versus intrafirm transaction agreements and disputes, arguing that neoclassical contract law governs the former while a forbearance regime governs the latter. These differences have consequences for the costs of enforcing ex post disputes. Beyond the ‘nature of the firm’ Thus far, I have focused on the contributions of Coase’s seminal 1937 paper in establishing the economic foundation for TCE. However, Coase continued to offer profound insights throughout his career that changed the nature not only of economics, but of several related social sciences. Many of these contributions revolve around a common, or at least similar, theme; namely, employing the principles of economic analysis to examine the relative efficacy of using the price mechanism rather than alternate organizational forms, whether firms or government, to solve resource allocation problems. In his 1946 paper on marginal costs, Coase proposed the use of multipart pricing as an alternate to subsidized or rate-of-return regulated pricing for firms – specifically utilities – characterized by decreasing average costs. He argued that a multi-part pricing structure that allocated costs across consumers of such firms would be preferable to the use of taxpayer funds to subsidize optimal levels of production or to the use of average cost pricing, which would result in an undersupply of production. Similarly, his 1959 paper ‘The Federal Communications Commission’ takes issue with arguments that the radio frequency spectrum is unique among communication media in requiring regulated allocations of spectrum property rights rather than allowing those rights to be allocated using the price mechanism – a practice adopted 35 years later. In his 1960 paper ‘The Problem of Social Cost’, Coase expounded

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upon the arguments introduced in the FCC paper (Coase, 1959), as well as the concept of transaction costs, to once again take to task the prevailing presumption that government regulation was the necessary means for addressing problems of externalities. Perhaps best known for what Stigler (1966, p. 113) termed the ‘Coase Theorem’, Stigler’s paper not only launched the field of law and economics, but made significant contributions to the theory of the firm by making more concrete the concept of transaction costs introduced in ‘The Nature of the Firm’ (Coase, 1937). Barzel and Kochin (1992, p. 29) argue ‘[f]or quite some time economists have been aware of the effects of the costs of transacting . . . Only after the publication of “The Problem of Social Cost” in 1960, however, did economists start to realize how to make the analysis of transaction costs operational’. Coase and transaction cost economics As noted above, Williamson (1975, p. 3) viewed TCE as providing a framework by which to operationalize the concept of transaction costs in a manner that would allow systematic analyses of the choice of organizational form. Despite the close relation between Coase’s original contributions and Williamson’s construction of TCE, fundamental differences exist between Coase’s understanding of the problems of transacting and the assumptions underlying TCE. In particular, Coase has always been suspect of the reliance of TCE on the concept of asset specificity and the behavioral assumption of opportunistic holdup. In his autobiographical lectures, Coase (1991, pp. 43–5) recounts some of his correspondence with Robert Fowler from 1932. The letters reveal that even then Coase had considered the issue of ‘bilateral monopoly’, or what Williamson termed asset specificity, and the resulting risk of appropriation as a motivation for integration. However, Coase (2006, p. 259) writes: I ultimately came to reject the existence of this risk as an important reason for vertical integration as a result of discussions I had with businessmen. They were unimpressed by my argument. They pointed out that if equipment was required solely for one particular customer, the cost would normally be reimbursed by that customer. They told me of other contractual devices that could be used to handle the problem.

Combined with his observation of relations between A.O. Smith and General Motors, among others, involving significant investments in specific assets that were maintained by contractual arrangements, Coase continues to reject the idea of asset specificity and opportunism as a general theory of firm integration.

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The Fisher Body debate In their paper ‘Vertical Integration, Appropriable Rents, and the Competitive Contracting Practice’, Klein et al. (1978) briefly refer to General Motors’ acquisition of Fisher Body in 1926 as an example of vertical integration as a solution for contractual holdup problems. The Fisher example was but one of several offered to illustrate the authors’ argument. Klein (1984) provided a more thorough and detailed discussion of the Fisher Body case, again reinforcing the idea that the acquisition of Fisher Body was motivated by contractual holdup problems under the terms of Fisher’s contract as the sole provider of closed-body chassis for General Motors. Coase (1991) took issue with this story as having any meaningful import for a general theory of the firm. Having rejected the argument almost 60 years earlier, Coase discounted the relevance of the opportunism argument as an errant deviation from his original ideas. Klein responded in kind, writing ‘Coase’s rejection of the opportunism analysis is based upon too simplified a view of the market contracting process and too narrow a view of the transaction costs associated with that process’ (Klein, 1991, p. 213). This exchange focused increased attention on the case of Fisher Body. In April 2000, the Journal of Law and Economics published three independently initiated critiques of Klein’s portrayal of the Fisher Body acquisition, including one by Coase (2000). The issue also contained a rebuttal by Klein (2000), in which he provided yet another detailed discussion of the contractual relationship between Fisher Body and General Motors and attempted to deflect the arguments of his critics. But the saga had not yet reached its climax. Following this barrage of articles, Klein was asked to produce a copy of the contract at the focal point of the case. As it turns out, Klein had not been in possession of the actual contract, nor had he actually seen the document prior to having it recovered from the archives of General Motors in the early 2000s. The details described in his earlier publications, going all the way back to the 1978 piece with Crawford and Alchian, were derived from second-hand descriptions in court transcripts. However, the actual terms of the contract reflected the very types of protections that Coase had learned of and reported on during his visit to the US in 1932. This revelation prompted Coase to write a critique titled ‘The Conduct of Economics’ (Coase, 2006), taking this entire debate as a launching point to urge economists to exercise more care in their empirical research.2 The validity of TCE does not hinge on the accuracy of the Fisher Body–GM story, of course. One less example does not take away from the abundance of empirical work which is largely consistent with TCE’s testable implications. However, there is also evidence that asset specificity

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is not sufficient to explain vertical integration and that contractual mechanisms may be capable of preventing opportunistic behavior. The challenge remains to more fully explain under what conditions the malincentives associated with asset specificity may be insurmountable by contractual means; or to put it in the language of Coase, under what conditions asset specificity may cause the cost of using the price mechanism to be sufficiently high to warrant an alternate organizational form. Concluding thoughts In the prologue to The Mechanisms of Governance, Williamson (1996) argues that TCE differs from economic orthodoxy in at least six significant ways: (1) behavioral assumptions; (2) the unit of analysis; (3) consideration of the firm as a governance structure; (4) the idea that property rights and contracts are problematic; (5) reliance on discrete structural alternatives; and (6) what Williamson calls the ‘remediableness criterion’, an insistence that comparative analysis be limited to feasible alternatives. On every point, Coase’s work foreshadows, if not directly addressing, these defining characteristics: 1.

2.

3. 4.

5. 6.

the concept of decision makers as limited in their rational capability to make maximizing decisions, or bounded rationality, which features prominently in Coase’s explanation for the limits on the size of the firm; a focus on the marginal transaction as the defining point of the boundary of the firm, where the characteristics of the transaction and the relative costs of organizing the transaction determine the mode of governance; recognition that the firm and market are alternative modes of transactional governance; identifying the costs of contracting as creating potential problems for market exchange, thereby highlighting the importance and consequence of property right allocations for the efficiency of production; considering discrete structural differences of firm, market and government as means for allocation of property rights and resources; and insisting that economists should focus on the real world, the world in which transaction costs exist and must be taken into account if we are to understand the workings of the economic system.

On the fiftieth anniversary of the publication of ‘The Nature of the Firm’ (Coase, 1991, p. 73) Coase, concluded his autobiographical reflection with a summary that reflects not only the state of the literature today, but his passion to see it move forward:

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It has been said that young men have visions and old men have dreams. My dream is to construct a theory which will enable us to analyze the determinants of the institutional structure of production. In ‘The Nature of the Firm’ the job was only half done – it explained why there were firms but not how the functions which are performed by firms are divided up among them. My dream is to help complete what I started fifty-five years ago and to take part in the development of such a comprehensive theory. . . . I intend to set sail once again to find a route to China, and if this time all I do is to discover America, I won’t be disappointed.

Notes 1. Foss and Klein (2009, p. 23) assert that, in essentially following the line of inquiry outlined in Coase’s 1937 paper, ‘most organizational economics is fundamentally Coasian’. 2. The debate over Fisher Body may not yet be over. Goldberg (2008) argues that the contract could not have been legally enforceable, and that General Motors’ lawyers must have known that, suggesting that contractual holdup would not have been tenable. Again, Klein (2008) provides a rebuttal defending the enforceability of the contract, but further argues that whether the contract was enforceable is irrelevant given the way in which the alleged dispute played out.

References Alchian, A. and H. Demsetz (1972), ‘Production, information costs, and economic organization’, American Economic Review, 62 (5), 777–95. Barzel, Y. and L. Kochin (1992), ‘Ronald Coase on the nature of social cost as a key to the problem of the firm’, The Scandinavian Journal of Economics, 94 (1), 19–31. Coase, R.H. (1937), ‘The nature of the firm’, Economica, N.S., 4 (16), 386–405. Coase, R.H. (1946), ‘The marginal cost controversy’, Economica, 13 (50), 169–82. Coase, R.H. (1959), ‘The Federal Communications Commission’, Journal of Law and Economics, 2 (1), 1–40. Coase, R.H. (1960), ‘The problem of social cost’, Journal of Law and Economics, 3 (1), 1–44. Coase, R.H. (1991), ‘The nature of the firm: origin, meaning and influence’, in O. Williamson and S. Winter (eds), The Nature of the Firm: Origins, Evolution and Development, Oxford: Oxford University Press, pp. 34–74. Coase, R.H. (2000), ‘The acquisition of Fisher Body by General Motors’, Journal of Law and Economics, 43 (1), 15–31. Coase, R.H. (2006), ‘The conduct of economics: the example of Fisher Body and General Motors’, Journal of Economics and Management Strategy, 15 (2), 255–78. Crocker, K. and S. Masten (1991), ‘Pretia ex Machina? Prices and process in long-term contracts’, Journal of Law and Economics, 34 (1), 69–84. Crocker, K. and K. Reynolds (1993), ‘The efficiency of incomplete contracts: an empirical analysis of Air Force engine procurement’, RAND Journal of Economics, 24 (1), 126–46. Foss, N. and P. Klein (2009), ‘Organizational governance’, in R. Wittek, T. Snijders and V. Nee (eds), Handbook of Rational Choice Social Research, New York: Russell Sage Foundation, forthcoming. Goldberg, V. (2008), ‘Lawyers asleep at the wheel? The GM–Fisher Body contract’, Industrial and Corporate Change, 17 (5), 1071–84. Jensen, M. and W. Meckling (1976), ‘Theory of the firm: managerial behavior, agency cost and ownership structure’, Journal of Financial Economics, 3 (4), 305–60. Klein, B. (1984), ‘Contract costs and administered prices: an economic theory of rigid wages’, American Economic Review, 74 (2), 332–8. Klein, B. (2000), ‘Fisher-General Motors and the Nature of the Firm,’ Journal of Law and Economics, 43 (1), 105–41.

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Klein, B. (1991), ‘Vertical integration as organizational ownership: the Fisher Body–General Motors relationship revisited’, in O. Williamson and S. Winter (eds), The Nature of the Firm: Origins, Evolution and Development, Oxford: Oxford University Press, pp. 213–26. Klein, B. (2008), ‘The enforceability of the GM–Fisher Body contract: comment on Goldberg’, Industrial and Corporate Change, 17 (5), 1085–96. Klein, B., R. Crawford and A. Alchian (1978), ‘Vertical integration, appropriable rents, and the competitive contracting process’, Journal of Law and Economics, 21 (2), 297–326. Saussier, S. (2000), ‘Transaction costs and contractual incompleteness: the case of Électricité de France’, Journal of Economic Behavior and Organization, 42 (2), 189–206. Stigler, G. (1966), The Theory of Price, 3rd edn, New York: Macmillan. Williamson, O. (1975), Markets and Hierarchies: Analysis and Antitrust Implications, New York: Free Press. Williamson, O. (1991), ‘Comparative economic organization: the analysis of discrete structural alternatives’, Administrative Science Quarterly, 36 (2), 269–96. Williamson, O. (1996), The Mechanisms of Governance, New York: Oxford University Press.

5

Cyert, March, and the Carnegie school Mie Augier

The ‘Carnegie school’ is one of the important intellectual roots of transaction cost economics (TCE), at least (and in particular) as developed and practiced by Oliver Williamson, and Williamson has written about his Carnegie connections on several occasions (1996b, 2002). As Williamson notes in the prologue to The Mechanisms of Governance (1996a), it was a direct result of his background as a student at Carnegie that he became interested in the idea of combining economics with organization theory, so central to today’s transaction cost theory (Williamson, 1996a, p. 18). The interdisciplinary spirit was ‘in the air’ at Carnegie at that time. ‘Those were exciting days’, Williamson recalls, ‘Orchestrating cutting-edge interdisciplinary research and teaching are never easy. . . . [b]ut in the late 1950s and early 1960s, Carnegie was the place to be’ (1996a, p. 21). The ‘Carnegie school’ is often identified with the pioneering work in behavioral economics done by Herbert Simon, James G. March, and Richard Cyert in the 1950s and 1960s (Earl, 1988). The Carnegie behavioralists are known for their interest in understanding how individuals and organizations act and make decisions in the real world, and their challenges to the neoclassical theory of optimization and maximization in decision making and organizations. Concepts such as bounded rationality and satisficing were developed to describe individuals and organizations acting in the face of ‘the uncertainties and ambiguities of life’ (March and Simon, 1958, p. 2). Many of these concepts were first discussed in the book Organizations (March and Simon, 1958), and none of them have lost currency. Williamson (1996a, p. 351) developed bounded rationality into transaction cost theory and was early on attracted to the basic idea: Bounded rationality seemed to me, then and since, as a useful way to go. James March’s course in organization theory revealed that one did not need to think about organizations in classical (machine model) or fanciful (hyperrationality or nonrationality) terms but could address these matters in a behaviorally informed and scientific way. I learned about the behavioral theory of the firm from Richard Cyert – the famous Cyert and March (1963) being in the late stages of completion.

The background for the Carnegie school was the Ford Foundation’s mission to establish a broad and interdisciplinary behavioral social 49

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science in the late 1940s and early 1950s, and much of their efforts were directed at supporting the early set up of the Graduate School of Industrial Administration (GSIA) at Carnegie Mellon University (originally Carnegie Institute of Technology), where Simon, March, and Cyert worked. The Carnegie Institute of Technology had been founded in 1912 by Andrew Carnegie and had established itself as one of the better engineering schools in the country. The early President Robert Doherty, who had come from Yale, wanted Carnegie Tech to be a leader in research and, hence, to break with the traditional mechanical engineering view of business education and include broader, social, and interdisciplinary aspects. As a result of his ambitions, the first dean of what came to be known as the GSIA, George Leland Bach, was hired. Bach wanted to staff his department with economists who combined intellectual skills and experience in applying theory to real world situations and he wanted to put Carnegie at the forefront of US business schools. Simon, March, and Cyert all came to Carnegie to help develop this view. The behavioral group at Carnegie was embedded in a larger group of scholars, which included innovative economists such as Franco Modigliani, John Muth, Charles Holt, and Merton Miller. The spirit at Carnegie was that everybody interacted with everybody else, discussed each other’s research and discussed science, so collaborative teams worked together as well as across each other’s projects. Consisting of different people with different interests, these teams always worked together in a friendly way, despite different disciplines and despite varying degrees of admiration for the idea of rationality. It was an environment in which people were united by their deep and intense interest for doing science. The Carnegie school tried to develop the rudiments of process-oriented understandings of how economic organization and decision making take place. They did so in an interdisciplinary way, linking economics to organization theory, cognitive science, sociology and psychology, and centering around concepts such as uncertainty, ambiguity, norms, routines, learning, and satisficing. They used ideas from social science more broadly to advance understanding of economics and, in the process, contributed to the strands that came to be called behavioral economics (Day and Sunder, 1996). The ideas initiated by the Carnegie school helped to establish a foundation for modern ideas on bounded rationality, adaptive and evolutionary economics, and transaction cost theory, among other areas. According to Williamson, Carnegie was an ‘enormously exciting’ environment, in which organization theory served as linking theory to real problems (without loss of discipline) and in which behavioral economics existed ‘cheek by jowl’ with rational expectation theory (1996a, p. 353). Williamson’s dissertation (1967) grew out of the Ford Foundation project

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on ‘A Behavioral Theory of the Firm’ (see below) and was on the economics of managerial discretion. Key ideas and theories The behavioral research of Simon, Cyert, and March aimed at making understandable how individuals make decisions and behave in the real world. They found that neoclassical economics gave too little attention to the institutional and cognitive constraints on economic and organizational behavior and on individual decisions, and too little room for human mistakes, foolishness, the complications of limited attention, and other results of bounded rationality. As a result, they proposed to include the whole range of limitations on human knowledge and human computation that prevent organizations and individuals in the real world from behaving in ways that approximate the predictions of neoclassical theory. For example, decision makers are sometimes confronted by the need to optimize several, sometimes incommensurable, goals (Cyert and March, 1963 [1992]). Furthermore, instead of assuming a fixed set of alternatives among which a decision maker chooses, the Carnegie school postulated a process for generating search and alternatives and analyzing decision processes through the idea of aspiration levels (March and Simon, 1958), a process that is regulated in part by variations in organizational slack (Cyert and March, 1963 [1992]). Finally, individuals and organizations often rely on routines or rules of thumb learned from experience or from others, rather than seek to calculate the consequences of alternatives. One of the first major results of the Carnegie school’s work was a propositional inventory of organization theory, involving Herbert Simon, James March, and Harold Guetzkow, which led to the book Organizations (March and Simon, 1958). The book was intended to provide the inventory of knowledge of the (then almost nonexisting) field of organization theory, and also a more proactive role in defining the field. Results and insights from studies of organizations in political science, sociology, economics, and social psychology were summarized and codified. The book expanded and elaborated ideas on behavioral decision making, search and aspiration levels and elaborated the idea of the significance of organizations as social institutions in society. March and Simon wrote (1958, p. 151): The basic features of organization structure and function derive from the characteristics of rational human choice. Because of the limits of human intellective capacities in comparison with the complexities of the problems that individuals and organizations face, rational behavior calls for simplified models that capture the main features of a problem without capturing all its complexities.

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March and Simon also wanted to unite empirical data-gathering research with rigorous theorizing in order to create a rigorous empirical theory that could organize and so give meaning to empirical facts with legitimate theory. Science, they believed, was the product of the organization of empirical facts into conceptual schemes, and the progress of science was based on the development of more sophisticated and elegant theoretical systems, but not necessarily the discovery of new facts. The Ford Foundation also supported a larger project on behavioral theories of organizations which was carried out by Richard Cyert and James March (along with their students, including Julian Feldman, Edward Feigenbaum, William Starbuck – and Oliver Williamson). This project originated in the works of Cyert and March to develop improved models of oligopoly pricing by using organization theory. The research on the behavioral theory of the firm aimed at investigating how the characteristics of business firms as organizations affect important business decisions. Integrating theories of organizations with existing (mostly economic) theories of the firm, they developed an empirical theory rather than a normative one and focused on classical problems in economics (such as pricing, resource allocation, and capital investment) to deal with the processes for making decisions in organizations. At the center of ‘A Behavioral Theory of the Firm’ is the idea of the firm as an adaptive political coalition (Cyert and March, 1963 [1992]), a coalition between different individuals and groups of individuals in the firm, each having different goals and hence the possibility of conflict of interest. Cyert and March (1963 [1992], p. 28) said: Since the existence of unresolved conflict is a conspicuous feature of organizations, it is exceedingly difficult to construct a useful positive theory of organizational decision-making if we insist on internal goal consistency. As a result, recent theories of organizational objectives describe goals as the result of a continuous bargaining-learning process. Such a process will not necessarily produce consistent goals.

The firm is therefore seen as an adaptive system that through learning and experimentation adapts to its environment. The experience of the firm is embodied in a number of standard operating procedures (for instance, solutions that have served the firm well in the past will be included in the organizational repertoire and will be easily reactivated in the face of similar problems in the future). As time passes and experience changes, so standard operating procedures change through processes of search and learning. In other words, the firm is not an unchangeable entity – it is a system of rules, driven to change by current aspirations and targets reflecting experienced or anticipated dissatisfaction.

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Influence on transaction cost economics (TCE) In several respects, Williamson’s work and contributions to TCE are shaped by his Carnegie connection (Williamson, 1996b, 2002), including the emphasis on the behavioral assumptions, on process, on adaptation, and on discrete structural analysis.1 Behavioral assumptions From the outset, TCE has consciously been aware of the significance of the behavioral assumptions (contrary to much of neoclassical economics) (Williamson, 1996a, p. 55). This awareness reflects beyond any doubt that Williamson had been influenced by the behavioral economics group during his years at Carnegie, where discussion and questioning of the behavioral assumptions were an important part of the research. In particular, Williamson has adopted and elaborated the idea that people are ‘intendedly rational, but only limitedly so’ (Williamson, 1985, p. 21), reflecting the influence of Herbert Simon’s idea of bounded rationality. Another assumption of Williamson’s program is the idea of opportunism; the conviction that people are ‘self-interest seeking with guile’ (ibid., p. 87). This assumption can be seen as reflecting Williamson’s early (1963a, 1967) managerial theory of discretionary behavior where he tried to incorporate managerial objectives (maximization of private utility) into the neoclassical framework of the firm. Among the implications that follow from these behavioral assumptions are the existence of incomplete contracting and the importance of contractual trust (Williamson, 1996a, pp. 56–7). Process analysis The emphasis on process is yet another Carnegie idea, reflecting in particular ideas connected to Organizations (March and Simon, 1958) and A Behavioral Theory of the Firm (Cyert and March, 1963 [1992]).2 Perhaps in particular consistent with Cyert and March’s view of the firm as a political coalition, Williamson has been cautious about excesses of managerial control (1996a, p. 226). Seeing the firm as a coalition among different individuals and groups of individuals in the firm, each having different goals, conflict of interest is a central idea. As Cyert and March note (1963 [1992], p. 28): Since the existence of unresolved conflict is a conspicuous feature of organizations, it is exceedingly difficult to construct a useful positive theory of organizational decision-making if we insist on internal goal consistency. As a result, recent theories of organizational objectives describe goals as the result of a continuous bargaining-learning process. Such a process will not necessarily produce consistent goals.

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The firm is seen as an adaptive system, which through learning, search, and experimentation adapts to its environment. The experience of the firm is embodied in a number of ‘standard operating procedures’ (routines), procedures for solutions to problems which the firm in the past has managed to solve. As time passes by and experiences change, so do the firm’s routines change through processes of organizational search and learning. As a result, the firm is seen not as a static entity, but as a system of rules, driven by its level of aspiration persistently being different from actual outcomes. Such a process view of organizations – including what Williamson refers to (1996a, p. 226) as intertemporal transformations – has important side effects such as producing the possibility of further bureaucratization of the organization (Williamson, 1996a, p. 228). Organizational adaptation The theme of organizational adaptation also follows quite naturally from the behavioral theory of the firm (although Williamson combines this with Hayek’s emphasis on spontaneous coordination of economic activities). Following March and Simon’s (1958, p. 190) idea that ‘the basic features of organization structure and function derive from the characteristics of human problem solving and rational human choices’, the organization is an adaptive entity which has evolved through a series of responses to people’s decision making problems. But for Williamson the key idea is to combine spontaneous order in markets with intentional order in firms to yield a predictive theory of economic organization. Adaptations of both types are vital to a high performance system. Discrete structural analysis Williamson also sides with Simon (1978) when it comes to choosing the central mode of explanation.3 In keeping with the Carnegie perspective, Williamson sees the need to ‘always study first order (discrete structural) effects before examining second order (marginalist) refinements’ (1996a, p. 232). Applying discrete, structural analysis is difficult to implement, for it relies on the idea that moves between organizational forms are attended by certain discontinuities (Williamson, 2000, p. 14). Williamson sees the main differences between the organization of markets and firms as being a matter of incentive intensity, administrative control, contract law and adaptation (ibid., p. 15). Williamson beyond Carnegie and Conclusion While Williamson went beyond Carnegie in his contributions to and development of TCE (see for instance Williamson, 2002, 2004), he integrated the behavioral ideas with more ‘rational’ theories. For example, whereas

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Williamson attempted to use the idea of organizational slack in his thesis, his 1970 book opened with the confession that ‘[s]ome will regard as paradoxical the fact that support for the neoclassical hypothesis should result from a study that has managerialist origins’ (1970, p. xiii). Williamson sees the M-form innovation as an intentional response by management to overcome control loss in a large organization and to strengthen the profitorientation of management. He insists on bounded rationality throughout the book, but also sees the M-form as more consistent than the U-form with the neoclassical idea of maximization (1970, p. 134) and thus opts for the M-form on efficiency grounds. After the publication of Corporate Control and Business Behavior (1970), Williamson turned towards studying contracting practices. His 1971 paper ‘The Vertical Integration of Production’ signaled a truly fundamental turn in the road. Rather than examine the firm as a production function, Williamson treated it as a governance structure – to be compared with markets for managing transactions. Rather than dealing with final goods and services, intermediate product markets came under examination. This reformulation of the vertical integration problem in transaction cost economizing terms became a paradigm problem, in that many other issues could be interpreted as variations on the very same contractual theme. The problems of writing interfirm contracts stem in part from the combination of bounded rationality and uncertainty. While the 1971 paper does mention bounded rationality (if only once), it became an important paper in featuring the hitherto neglected issue of unique assets although Williamson does not (yet) mention asset specificity. In such situations, bilateral dependency develops, indicating the need for long-term contracts or vertical integration. Vertical integration is a response to contractual incompleteness and opportunism – which is very behavioral (in the Carnegie tradition). Williamson later argues that ‘transactions are assigned to and organized within governance structures in a discriminating (transaction-cost economizing) way’ (1981, p. 1564). The focus on the transaction gradually became clear, and Williamson made in the early 1970s a distinction between transactional factors (such as small-numbers, uncertainty, and information impactness) and human factors (bounded rationality, opportunism, and organizational atmosphere) underlying vertical integration (1971, 1973, 1974).4 These factors would explain the organization of economic activities and the degree of vertical integration. Williamson also took steps towards making the transaction cost treatment of economic organization more general and to combine his institutional/transaction cost economics with aspects of contract law and organization theory to identify and explicate the key differences that distinguish forms of economic organization (1983, 1991). Beginning with

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his work on credible commitments (1983), Williamson emphasized the importance of credibility and the mechanisms which drive it, as these relate to the efficiency of economic organization. In 1991, Williamson demonstrated that the different forms of economic organization are distinguished by different coordinating and control mechanisms and by different abilities to adapt to disturbances. Williamson’s work on applying contract law to economic organization suggests (again) a middleway between neoclassicism and a more behavioral approach, suggesting ‘relational contracting’ which is typically unenforceable in courts and dependent on arbitration and enforcement by private parties. Written as an ‘ambitious effort to operationalize transaction cost economics’ (Williamson, 1996a, p. 89), the 1991 paper also appeals to the interdisciplinary thinking that Williamson learned at Carnegie, and urges further developments along these lines (Williamson, 1996a, p. 119). This indicates that further integration of TCE and Carnegie ideas might lead to fruitful work in the future. Notes 1. Additionally, Williamson (1996a, p. 229) mentions also the issue of politics and of embeddedness and networks, and in (2002) he also mentions near-decomposability and weak-form selection as being part of the Carnegie contributions upon which his work rests; and the importance of reality testing. 2. Cyert and March, in the epilogue to the second edition of A Behavioral Theory of the Firm, acknowledge Williamson’s program as being ‘broadly consistent’ with their own work (Cyert and March, 1963 [1992], pp. 219–20), referring to Williamson’s use of opportunism and bounded rationality. But whereas Williamson later featured the idea of bounded rationality more prominently, he talks in his early work about ‘rational managerial behavior’, defending the idea of maximization (of utility functions that include other things than profits). Williamson notes that profit maximization works only in cases with strong competition and warns against ‘uncritical’ application of the assumption of profit maximization in cases where competition is weak (Williamson, 1963, p. 238). But the real crux of his thesis is the idea that maximization can be defended on other grounds as well, namely through the assumption of self-interest (Williamson, 1963, p. 239). Thus, managers in Williamson’s theory are not maximizing profits, but managerial selfinterest. Williamson calls his model of managerial behavior ‘behavioral’ and summarizes its properties as including that his model uses the same basic assumption of rationality as mainstream economics – people are self-interest seeking – and that under certain conditions his model converges to the profit maximization hypothesis (Williamson, 1963, p. 252). 3. Simon (1978, p. 6) was introducing the term ‘discrete structural analysis’ into organizational economics in the following way: ‘As economics expands beyond its central core of price theory, and its central concern with quantities of commodities and money, we observe in it . . . [a] shift from a highly quantitative analysis, in which equilibration at the margin plays a central role, to a much more qualitative institutional analysis, in which discrete structural alternatives are compared’. 4. Although references to Simon in the 1973 paper are missing, Williamson defines bounded rationality as referring to ‘the rate and storage limits on the capacities of individuals to receive, store, retrieve, and process information without error’ (Williamson, 1973, p. 317).

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References Cyert, R. and J.G. March (1963), A Behavioral Theory of the Firm, 2nd edn (1992), Oxford: Blackwell. Day, R. and S. Sunder (1996), ‘Ideas and Work of Richard M. Cyert’, Journal of Economic Behavior and Organization, 31 (2), 139–48. Earl, P. (ed.) (1988), Behavioral Economics, Aldershot, UK and Brookfield, VT, USA: Edward Elgar Publishing. March, J.G. and H.A. Simon (1958), Organizations, 2nd edn (1993), Oxford: Blackwell. Simon, H.A. (1978), ‘Rationality as process and product of thought’, American Economic Review, 68 (2), 1–16. Williamson, O.E. (1963), ‘A model of rational managerial behavior’, in R. Cyert and J.G. March, A Behavioral Theory of the Firm, Oxford: Blackwell, pp. 237–52. Williamson, O.E. (1967), The Economics of Discretionary Behavior: Managerial Objectives in a Theory of the Firm, Englewood Cliffs, NJ: Prentice-Hall. Williamson, O.E. (1970), Corporate Control and Business Behavior, Englewood Cliffs, NJ: Prentice Hall. Williamson, O.W. (1971), ‘The vertical integration of production: market failure considerations’, American Economic Review, 61 (2), 112–23. Williamson, O.E. (1973), ‘Markets and hierarchies: some elementary considerations’, American Economic Review, 63 (2), 316–25. Williamson, O.E. (1974), ‘The economics of antitrust: transaction cost considerations’, University of Pennsylvania Law Review, 122 (6), 1439–66. Williamson, O.E. (1981), ‘The modern corporation: origins, evolution, attributes’, Journal of Economic Literature, 19 (4), 1537–68. Williamson, O.E. (1983), ‘Credible commitments: using hostages to support exchange’, American Economic Review, 73 (4), 519–40. Williamson, O.E. (1985), The Economic Institutions of Capitalism, New York: Free Press. Williamson, O.E. (1991), ‘Comparative economic organization: the analysis of discrete structural alternatives’, Administrative Science Quarterly, 36 (2), 269–96. Williamson, O.E. (1996a), The Mechanisms of Governance, Oxford: Oxford University Press. Williamson, O.E. (1996b), ‘Transaction cost economics and the Carnegie Connection’, Journal of Economic Behavior and Organization, 31, 149–55. Williamson, O.E. (2000), ‘Why Law, Economics and Organization?’, University of California, Berkeley, Business and Public Policy Working Paper 81. Williamson, O.E. (2002), ‘Empirical microeconomics: another perspective’, in Mie Augier and James March (eds), The Economics of Choice, Change and Organization, Cheltenham, UK and Northampton, MA, USA: Edward Elgar Publishing. Williamson, O.E. (2004), ‘Herbert Simon and organization theory’, in Mie Augier and James March (eds), Models of a Man: Essays in Memory of Herbert A. Simon, Cambridge, MA: MIT Press, pp. 279–95.

6

Chester Barnard1 Joseph T. Mahoney

Oliver Williamson did his doctoral training at Carnegie and it is clear that the behavioral theory of the firm – originating from the Carnegie School (Cyert and March, 1963; March and Simon, 1958; Simon, 1947) – is an important building block to transaction cost theory (Williamson, 1975). The most important antecedent of the Carnegie School was Chester Barnard’s (1938) The Functions of the Executive. Indeed, Barnard wrote the foreword to Simon’s (1947) Administrative Behavior, and Barnard (1938) foreshadowed the concepts of authority and bounded rationality (Simon, 1947). According to Williamson, Barnard (1938) developed the following: ‘(1) Organization form – that is, formal organization matters; (2) informal organization has both instrumental and humanizing purposes; (3) bounds on rationality are acknowledged; (4) adaptive, sequential decision-making is vital to organizational effectiveness; and (5) tacit knowledge is important’ (Williamson, 1985, p. 6). Andrews maintains that ‘The Functions of the Executive [is] the most thought-provoking book on organization and management ever written by a practicing executive’ (Andrews, 1968, p. xxi), and attributes its endurance to Barnard’s (1) capacity for abstract thought; (2) ability to apply reason to professional experiences; (3) probable expertness in practice; and (4) simultaneous exercise of reason and competence. Barnard’s aspiration was contributing to a ‘science of organization’ (Barnard, 1938, p. 290). Barnard’s (1938) The Functions of the Executive emphasizes skills, judgment, stewardship and professionalism, and connects ethical and practical teachings. Barnard’s (1938) impact on organization theory is well documented (Scott, 1987; Williamson, 1995), and even those taking vigorous exception concede its vast influence: ‘This . . . remarkable book contains within it the seeds of three distinct trends of organizational theory that were to dominate the field for the next three decades. One was the institutional theory as represented by Philip Selznick [1957]; another was the decision-making school as represented by Herbert Simon [1947]; the third was the human relations school’ (Perrow, 1986, p. 63). Barnard (1938) reflects readings in anthropology, economics, law, philosophy, political science, psychology, and sociology. It presents a systems view of organizations containing a psychological theory of motivation and 58

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behavior, a sociological theory of cooperation and complex interdependencies, and an ideology based on meritocracy. Barnard (ibid.) provides organizational theory based on structural concepts of: the individual and bounded rationality; cooperation; formal organization; and informal organization. Dynamic concepts include: free will; communication; a consent theory of authority; the decision process; dynamic equilibrium and the inducement–contributions balance; and leadership and executive responsibility. We consider each of these concepts in turn. Structural concepts The individual and bounded rationality Persons have power of choice, capacity of determination, and possession of free will. But, individuals are limited in terms of biological faculties and capacities (Barnard, 1938, p. 23). Organizations as cooperative systems are seen as overcoming physical and cognitive limitations (bounded rationality) of individuals. Cooperation Barnard submits that cooperation means: genuine restraint of self; service for no reward; courage to fight for principles; and genuine subjection of personal to social interests. When a cooperative system’s purpose is attained, cooperation is effective (ibid., p. 43). Cooperative effort is greatly limited if confidence is lacking in the sincerity and integrity of management. Barnard (1948, p. 11) maintains that: When a condition of honesty and sincerity is recognized to exist, errors of judgment, defects of ability, are sympathetically endured. They are expected. Employees don’t ascribe infallibility to leaders or management. What does disturb them is insincerity and the appearance of insincerity when the facts are not in their possession.

Formal organization Formal organization is viewed as ‘that kind of cooperation . . . that is conscious, deliberate, purposeful’ (Barnard, 1938, p. 4) and as ‘a system of consciously coordinated activities . . . of two or more persons’ (ibid., p. 73) in which the ‘creative side of organization is coordination’ (ibid., p. 256). Scott submits that Barnard (1938) contains ideas consistent with a ‘rational system conception of organizations; what sets them apart is his insistence on the nonmaterial, informal, interpersonal, and, indeed, moral basis of cooperation’ (Scott, 1987, p. 63). Barnard reminds us of the difficult task of achieving and maintaining

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cooperative systems: ‘successful cooperation in or by formal organization is the abnormal, not the normal condition. What are observed from day to day are the successful survivors among innumerable failures’ (Barnard, 1938, p. 5). Within formal organization, Barnard (1938) believed in genuine planning – a process of developing and applying knowledge and intelligence to business problems. Informal organization Barnard maintains ‘“learning the organization ropes” in most organizations as chiefly learning who’s who, what’s what, why’s why, of its informal society’ (Barnard, 1938, p. 121), and sees informal organization as complementary to formal organization. Informal organization improves communication, enhances cohesiveness within formal organization, and protects the integrity of individuals. Informal organization ‘is to be regarded as a means of maintaining the personality of the individual against certain effects of formal organizations which tend to disintegrate the personality’ (ibid., p. 122). The responsibility of management is to balance improving organizational effectiveness and maintaining the individual, which is central in managing personnel where hypocrisy is identified as fatal (Barnard, 1948, p. 9). Dynamic concepts Free will Free will is central to Barnard’s (1938) behavioral theory derived from moral and legal doctrines emphasizing personal responsibility for actions. Endorsement of the free will doctrine underpins management’s moral obligations: ‘the idea of free will is inculcated in doctrines of personal responsibility, of moral responsibility, and of legal responsibility. This seems necessary to preserve a sense of personal integrity’ (ibid., p. 13). Communication Barnard emphasizes that common organizational purpose can only be achieved if it is commonly known, and thus must be communicated effectively in language, oral and written (Barnard, 1938, p. 89). Tacit understandings are often essential (ibid., pp. 301–22). Consent theory of authority Barnard (1938) maintains that management’s authority requires ability to persuade rather than command, and legitimate authority is based on functional skills and not hierarchical position. Organization personnel accept a communication as authoritative when they: understand it; believe it is not

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inconsistent with organizational purpose; believe it compatible with their personal interest as a whole; are able mentally and physically to comply with it; and have a zone of indifference within which it is acceptable (ibid., pp. 165–7). Barnard notes that: ‘Either as a superior officer or as a subordinate, however, I know nothing that I actually regard as more “real” than “authority”’ (ibid., p. 170). Decision-making and the decision process Although organization theory on decision-making from Simon (1947) to the present is expansive, Barnard provides this unique perspective: The making of decisions, as everyone knows from personal experience is a burdensome task. Offsetting the exhilaration that may result from correct and successful decision and the relief that follows the terminating of a struggle to determine issues is the depression that comes from failure or error of decision and the frustration which ensues from uncertainty (1938, p. 189).

Barnard (1938) warns of a tendency for personnel to avoid responsibility (due in part to fear of criticism) and that an executive must distribute responsibility, or otherwise run the risk of being overwhelmed with the burdens of decision: ‘The fine art of executive decision consists in not deciding questions that are not pertinent, in not deciding prematurely, in not making decisions that cannot be made effective, and in not making decisions that others should make’ (ibid., p. 194). Barnard returns to this theme in a 1961 interview: ‘You put a man in charge of an organization and your worst difficulty is that he thinks he has to tell everybody what to do; and that’s almost fatal if it’s carried far enough’ (Wolf, 1973, p. 30). Dynamic equilibrium and the inducement–contributions balance The efficiency and effectiveness of an organization depends upon what the organization secures and the personnel produce (the contributions) and how the organization distributes its resources (the inducements), and these contributions and inducements are dynamic (Barnard, 1938, pp. 57–9). Inducements include material inducements, personal non-material opportunities, desirable physical conditions, ideal benefactions, associational attractiveness, opportunities for enlarged participation, and the condition of communion (ibid., p. 142). Barnard emphasized non-economic motives: Prestige, competitive reputation, social philosophy, social standing, philanthropic interests, combativeness, love of intrigue, dislike of friction, technical interest, Napoleonic dreams, love of accomplishing useful things, desire for regard of employees, love of publicity, fear of publicity – a long catalogue of non-economic motives actually condition the management of business, and

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Leadership, executive responsibility and moral codes For Barnard much is given to leaders and much is expected, and leadership is the key factor in cooperation. While cooperation is the creative process, leadership is the ‘indispensable fulminator of its forces’ (Barnard, 1938, p. 259). The fundamental function of a leader is to create meaning for followers facilitating their commitment and identification: ‘The inculcation of belief in the real existence of a common purpose is an essential executive function’ (ibid., p. 87). Leadership is: connected with knowing whom to believe, with accepting the right suggestions, with selecting appropriate occasions and times . . . an understanding that leads to distinguishing effectively between the important and the unimportant in the particular concrete situation, between what can and what cannot be done, between what will probably succeed and what will probably not, between what will weaken cooperation and what will increase it (Barnard, 1948, pp. 86–7).

Leadership must go beyond deciding the right thing to do, and to the job of getting it done. Barnard states that: An executive is a teacher; most people don’t think of him that way, but that’s what he is. He can’t do very much unless he can teach people. . . . You can’t just pick out people and stick them in a job and say go ahead and do it. You’ve got to give them a philosophy to work against, you’ve got to state the goals, you’ve got to indicate the limitations and the methods (Wolf, 1973, pp. 7–8).

Leadership involves guiding others. Leaders must effectively convey meanings and intentions and receive them with sympathetic understanding (Barnard, 1948, pp. 97–9). Barnard describes the nature of leadership: It is in the nature of a leader’s work that he should be a realist and should recognize the need for action, even when the outcome cannot be foreseen, but also that he should be idealist and in the broadest sense pursue goals some of which can only be attained in a succeeding generation of leaders. Many leaders when they reach the apex of their powers have not long to go, and they press onward by paths the ends of which they will not themselves reach. In business, in education, in government, in religion, again and again, I see men who, I am sure, are dominated by this motive, though unexpressed, and by some queer twist of our present attitudes often disavowed. Yet, ‘Old men [and old women] plant trees’ . . . to shape the present for the future by the surplus of thought and purpose which we now can muster seems the very expression of the idealism which underlies such social coherence as we presently achieve, and without this idealism we see no worthy meaning in our lives, our institutions, or our culture (ibid., pp. 109–10; emphasis added).

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In the expression, ‘old men [and old women] plant trees’ Barnard (1948) indicates that the moral factor is real and that faith in others is supported by observation. Within the cooperative system, the moral factor finds its expression and suggests the necessity of leadership and ‘the power of individuals to inspire cooperative personal decision by creating faith: faith in common understanding, faith in the probability of success, faith in the ultimate satisfaction of personal motives, faith in the integrity of objective authority, faith in the superiority of common purpose as a personal aim of those who partake in it’ (Barnard, 1938, p. 259; emphasis added). The part of leadership that determines the quality of action is responsibility. Responsibility is the ‘quality which gives dependability and determination to human conduct, and foresight and ideality to purpose’ (Barnard, 1938, p. 260) and is the most important function of the executive. Responsibility means honor and faithfulness in the manner that managers carry out their duties and is defined as an ‘emotional condition that gives an individual a sense of acute dissatisfaction because of failure to do what he feels he is morally bound to do or because of doing what he thinks he is morally bound not to do, in particular concrete situations’ (Barnard, 1948, p. 95). Carrying out this function builds the character of executives who must decide and act under the burden of responsibility. Barnard in 1961 evaluates his 1938 classic: In my opinion, the great weakness of my book is that it doesn’t deal adequately with the question of responsibility and its delegation. The emphasis is too much on authority, which is the subordinate subject. . . . The emphasis is put on authority which, to me now, is a secondary, derivative setup (Wolf, 1973, p. 15).

Barnard maintains that: nearly everything depends upon the moral commitment. I’m perfectly confident that, with occasional lapses, if I make a date with you, whom I have never met, you’ll keep it and you’ll feel confident that I’ll keep it; and there’s absolutely nothing binding that makes us do it. And yet the world runs on that – you just couldn’t run a college, you couldn’t run a business, you couldn’t run a church, couldn’t do anything except on the basis of the moral commitments that are involved in what we call responsibility. You can’t operate a large organization unless you can delegate responsibility, not authority but responsibility (Wolf, 1973, p. 35).

Ethical practice determines management’s moral authority and the capability of managers to pass their power to the next generation: ‘responsibility is the property of an individual by which whatever morality exists in him becomes effective in conduct’ (Barnard, 1938, p. 267).

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The survival of organizations as going concerns depends on moral commitment: ‘Organizations endure . . . in proportion to the breadth of morality by which they are governed. This is only to say that foresight, long purposes, high ideals are the basis for the persistence of cooperation’ (Barnard, 1938, p. 282). Barnard recommended combining the two cultures of management – its science and art, calling for ‘a social anthropology, a sociology, a social psychology, an institutional economics, a treatise on management’ (ibid., p. 293). However, we should not deceive ourselves that a science of organization will be enough: ‘Inspiration is necessary to inculcate the sense of unity, and to create common ideals. Emotional rather than intellectual acceptance is required’ (ibid., p. 293). Conclusions Williamson (1996, pp. 41–2) articulates the uses of Barnard (1938) to transaction cost economics including that the formal organization is important; the central problem of organization is adaptation; and the study of induced cooperation deserves a prominent place on the research agenda. In addition, I emphasize here that management requires both art and science and Barnard (1938) achieves this balance. Barnard (ibid.) is enriching when read for the practical purpose of understanding the science of management, but it is an aesthetic reading that explains the intensity of responses to this classic. Barnard (ibid.) offers an intense, structured and coherent work that depends on students using their capacities to apprehend the aesthetic experience of management based on the author’s intimate habitual interested experience. Barnard dedicates his book to his father: ‘At a crisis in my youth, he taught me the wisdom of choice: to try and fail is at least to learn; to fail to try is to suffer the inestimable loss of what might have been’. Toward the purpose of conveying the aesthetic experience of management, Barnard (ibid.) did not fail. Barnard’s finale is an exemplar of the poetic and provocative nature of his work: This study, without the intent of the writer or the expectation of the reader, had at its heart this deep paradox and conflict of feelings in the lives of men. Free and unfree, controlling and controlled, choosing and being chosen, inducing and unable to resist inducement, the source of authority and unable to deny it, independent and dependent, nourishing their personalities, and yet depersonalized; forming purposes and being forced to change them, searching for limitations in order to make decisions, seeking the particular but concerned with the whole, finding leaders and denying their leadership, hoping to dominate the earth and being dominated by the unseen – this is the story of man in society told in these pages. Such a story calls finally for a declaration of faith. I believe in the power of the cooperation of men of free will to make men free to cooperate; that only as they choose to work together can they achieve the fullness of

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personal development; that only as each accepts a responsibility for choice can they enter into the communion of men from which arise the higher purposes of individual and of cooperative behavior alike. I believe that the expansion of cooperation and the development of the individual are mutually dependent realities, and that a due proportion or balance between them is a necessary condition of human welfare. Because it is subjective with respect both to society as a whole and to the individual, what this proportion is I believe science cannot say. It is a question for philosophy and religion (ibid., p. 296).

Note 1. This chapter draws from Mahoney (2002).

Bibliography Andrews, K.R. (1968), ‘Introduction to the thirtieth anniversary edition of The Functions of the Executive’, Cambridge, MA: Harvard University Press. Barnard, C.I. (1938), The Functions of the Executive, Cambridge, MA: Harvard University Press. Barnard, C.I. (1948), Organization and Management: Selected Papers, Cambridge, MA: Harvard University Press. Cyert, R.M. and J.G. March (1963), A Behavioral Theory of the Firm, Englewood Cliffs, NJ: Prentice-Hall. Mahoney, Joseph T. (2002), ‘The relevance of Chester I. Barnard’s teachings to contemporary management education: communicating the aesthetics of management’, International Journal of Organization Theory and Behavior, 5 (1–2), 159–72. March, J.G. and H. Simon (1958), Organizations, New York: John Wiley and Sons. Perrow, C. (1986), Complex Organizations: A Critical Essay, New York: Random House. Scott, W.R. (1987), Organizations: Rational, Natural, and Open Systems, Englewood Cliffs, NJ: Prentice-Hall. Selznick, P. (1957), Leadership in Administration: A Sociological Interpretation, Berkeley, CA: University of California Press. Simon, H.A. (1947), Administrative Behavior: A Study of Decision-Making Processes in Administrative Organization, New York: Free Press. Williamson, O.E. (1975), Markets and Hierarchies: Analysis and Antitrust Implications, New York: Free Press. Williamson, O.E. (1985), The Economic Institutions of Capitalism: Firms, Markets, and Relational Contracting, New York: Free Press. Williamson, O.E. (1995), ‘Chester Barnard and the incipient science of organization’, in O.E. Williamson (ed.), Organization Theory: From Chester Barnard to the Present and Beyond, New York: Oxford University Press, pp. 172–206. Williamson, O.E. (1996) The Mechanisms of Governance, New York: Oxford University Press. Wolf, W.B. (1973), Conversations with Chester I. Barnard, Ithaca, NY: School of Industrial and Labor Relations: Cornell University, ILR Paperback Number Twelve.

7

Commons, Hurst, Macaulay, and the Wisconsin legal tradition D. Gordon Smith

In art ‘negative space’ is the space between, around, and behind the positive forms in a visual composition (Rockman, 2000, p. 22). While our brains are conditioned to recognize, name and categorize objects, negative space helps to define those objects, and artists consider both positive shapes and negative space in arranging a composition (Edwards, 1989, pp. 98–100). Perhaps the most famous illustration of negative space is Rubin’s vase, an optical illusion in which a white vase is formed by opposing black silhouettes. When first presented with the composition, most people see the opposing faces, but when the shading is reversed – so that the vase is black and the faces are white – the vase is easily perceived. Over a period of a half century, scholars at the University of Wisconsin focused our attention on the negative space surrounding contract law (Gilmore, 1974, p. 3, n. 1). What they found there was a fascinating world of contracting behaviour – or, in more modern parlance, private ordering – that Ian Macneil (1974, 2000) subsequently explored in developing his relational theory of contracts. Oliver Williamson was aware of the work of the Wisconsin scholars (Williamson, 1985, p. 3) and Macneil (Williamson, 1996, p. 355), and in this chapter I trace the legal precursors of transaction cost economics (TCE) by focusing on three prominent faculty of the University of Wisconsin: John Commons, Willard Hurst, and Stewart Macaulay. This focus necessarily omits some of the connective tissue in the intellectual history, from Oliver Rundell and Jacob Beuscher in the first half of the twentieth century to Lawrence Friedman, Marc Galanter, and William Whitford in the second half. Nevertheless, by focusing on the development of private ordering from Commons to Hurst to Macaulay, I hope to show in broad brushstrokes the evolution of private ordering from negative space to positive shape. John R. Commons: the law as positive shape By the 1920s, John R. Commons had already solidified his reputation as a labour economist. After a disappointing start to his academic career, Commons joined Richard Ely at the University of Wisconsin in 1902, when Ely enlisted Commons in a project to collect records relating to the 66

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history of labour in the United States. Commons suggested that the collection be printed for the benefit of scholars, and A Documentary History of American Industrial Society was later published in a ten-volume set (Commons and Ely, 1910). Commons then turned his attention to the four-volume History of Labor in the United States, which contained a series of articles by various scholars examining the labour movement from the colonial period to 1920. In assembling these massive works, Ely and Commons collaborated with professors in the University of Wisconsin Law School, who were stationed in the same building as the economists on the University of Wisconsin’s campus (Carrington and King, 1997). This collaboration extended beyond the collection of records to the drafting of legislation and lobbying of legislatures. To this day, these activities remain the best exemplar of ‘The Wisconsin Idea’ – the notion that the resources of the University should promote the practical welfare of the state and its citizens. After World War I, Commons shifted his attention to institutional economics, which focused on the ‘collective control of individual transactions’ (Commons, 1934, pp. 5–6). Building on earlier work by Thorstein Veblen (1899), this so-called ‘old’ institutional economics was designed to respond to the shortcomings of neoclassical economics, which assumed frictionless markets and complete contracts. By contrast Veblen and Commons described a world with imperfect markets and incomplete contracts, sometimes referred to as a ‘socialized’ view of economic behaviour (Kaufman, 2006, pp. 11–12). While neoclassical economics had no room for law, institutional economics treated law as central to the development and maintenance of markets. In a critical move for purposes of our story, Commons treated the ‘transaction’ as the fundamental unit of measurement in economic theory (Kaufman, 2006, p. 24). While Legal Realists were transforming the way in which lawyers viewed the adjudication process (Leiter, 2005), Commons was directing our attention to the behaviour of contracting parties and inquiring about the role of law in influencing their behaviour. Unfortunately, most legal scholars paid more attention to the Realists than to Commons.1 Willard Hurst: using negative space to define the law Commons retired from the University of Wisconsin in 1934, and Willard Hurst did not join the faculty of the University of Wisconsin Law School until 1937, but Hurst was certainly acquainted with Commons and his work.2 Perhaps more importantly, Hurst arrived at a law school that was significantly shaped by Commons and his colleagues on the law faculty.3 Those who have explored the scholarly intellectual history of Hurst have

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debated the extent of Commons’ influence on Hurst, but it seems fair to assume that the core of the so-called ‘Hurstian Revolution’ in legal history – namely, placing the historical study of law in a broader social, economic, and political context – was influenced to a large extent by Commons’ legacy, both direct and indirect.4 Although Hurst himself was at a loss to describe the source of his inspiration, he typically pointed to his undergraduate studies in economics and history at Williams College as a potential wellspring (Hurst, 1981, p. 18). A particularly formative experience for Hurst at this time was his study of Charles and Mary Beard’s Rise of American Civilization. According to Daniel Ernst (2000, pp. 5–6), Hurst was inspired by ‘[t]he Beards’ project of creating a usable past for a modernizing society’. Given this foundation, it’s no surprise that Hurst found much of his first year at the Harvard Law School of the early 1930s intellectually arid. He later remembered his classes being ‘as abstractly doctrinal as it is possible to get,’ and said that his law professor Samuel Williston treated contracts ‘like an exercise in Euclid’s geometry’ (Hartog, 1994, p. 372). During his Harvard years, Hurst found respite in reading the works of Karl Llewellyn and other Legal Realists. Despite his admiration, Hurst recognized that the Legal Realists were interested primarily in the work of judges, while Hurst – during the rise of the New Deal – was increasingly drawn to the study of the administrative state. Hurst’s interest in legislation and regulation brought him within the orbit of Felix Frankfurter, who specialized in teaching administrative law at Harvard. Hurst worked extensively with Frankfurter on issues of administrative law as a student, law review editor, and research assistant (Ernst, 2000, p. 12). Then, after graduation, Hurst served as Frankfurter’s research fellow, a job that paved the way for Hurst’s clerkship with Justice Louis Brandeis on the United States Supreme Court. While each of these experiences imbued Hurst with important new insights on the role of law in society, his mentors remained lawyers who were primarily interested in the role of courts in the development of law. Hurst was eager for a more expansive view of law, and he was attracted to Lloyd Garrison, then Dean at the University of Wisconsin Law School. Garrison had assumed the position of Dean in 1932, when John R. Commons and other professors in the Economics Department still had offices alongside law professors in the Law Building (Labor Law Studies, 1982, p. 7).5 Hurst (1981, p. 17) later recalled that Garrison ‘had very ambitious ideas about extending the intellectual range of legal education, particularly in the direction of involving it more with the social sciences and with knowledge about social structure and process’.6 Hurst had discovered a kindred spirit, and the two collaborated on materials for a

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course entitled ‘Law in Society’, which included substantial materials on legislation and administrative agencies. In his well-known book, Law and the Conditions of Freedom (1956), Hurst stated that he ‘seek[s] to understand the law not so much as it may appear to philosophers, but more as it had meaning for workaday people and was shaped by them to their wants and vision’ (Hurst, 1956, p. 5). This pursuit led Hurst far beyond the examination of traditional legal sources. Although Hurst used social context to illuminate law, the focus remained on law. Others have suggested that Hurst conceived of law as a dependent variable, and this method of legal analysis came to define the Wisconsin tradition of socio-legal scholarship (Garth and Sterling, 1998, pp. 439–40). Stewart Macaulay: the law as negative space It would be difficult to overstate Hurst’s influence on Stewart Macaulay. Writing a tribute to Hurst in 1997, Macaulay (1997, p. 1163) called Wisconsin ‘Willard’s Law School’, but Hurst’s influence on Macaulay was not merely institutional. Hurst was a hands-on mentor. He advised Macaulay and other junior members of the faculty to ‘plan a career and think in terms of five to ten year projects if not more’, and said they ‘should not waste time responding eclectically to the latest appellate decision or big event in the New York Times’ (Macaulay, 1997, p. 1170). Hurst told them that ‘law could not be studied as a system apart from the society that created it’, and he encouraged them to ‘take risks, think broadly and make connections with worlds of ideas outside of the law schools’ (Macaulay, 1997, p. 1170). Hurst also ‘taught [them] not to be afraid of studying legal events in Wisconsin as case studies of law in context’ (Macaulay, 1997, p. 1172). In crafting his iconic study of non-contractual relations in business, Macaulay (1963a) followed Hurst’s advice to the letter and changed forever the way legal scholars approached the study of contracts.7 When Stewart Macaulay began teaching Contracts at the University of Wisconsin Law School in 1957, he was 26 years old (Macaulay, 1995, p. 248). He had never practised law, and he did the sensible thing by adopting the casebook used by his more experienced colleagues: Lon Fuller, Basic Contract Law (1947). Macaulay’s father-in-law – Jack Ramsey, the retired General Manager of S.C. Johnson and Son – was not impressed with the casebook. According to Macaulay, Ramsey ‘thought that much of it rested on a picture of the business world that was so distorted that it was silly’ (Macaulay, 1995, p. 249). To assist Macaulay in gaining real-world perspectives on contracts, Ramsey arranged for a series of meetings with corporate executives

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that became the basis of Macaulay’s seminal article, ‘Non-Contractual Relations in Business: A Preliminary Study’ (Macaulay, 1963a). As indicated by the title, Macaulay focused on non-contractual relations – how parties regulated their behaviour without the assistance of written contracts.8 During the course of his interviews, Macaulay found that ‘many, if not most, exchanges reflect no planning, or only a minimal amount of it, especially concerning legal sanctions and the effect of defective performances’ (Macaulay, 1963a, p. 60). If problems arose, the parties often negotiated to a solution without relying explicitly on the written contracts or threats of legal sanctions.9 Ian Macneil (1985, p. 509) later referred to Macaulay’s famous article as a ‘demolition effort’ that cleared the way for relational contract theory.10 When Macaulay and Macneil first met at a summer workshop for young contracts teachers held at New York University in 1962, Macaulay already had written ‘Non-Contractual Relations in Business’ (1963a), and Macneil was writing doctrinal pieces about contract law (Macneil, 1962, 1963, 1964).11 Macneil’s renowned work on ‘relational contracts’ did not begin to emerge for several years, with the earliest pieces emanating from his work in Africa (Macneil, 1968) and his ‘first systematic formulation’ (Macneil, 1987, p. 273, n. 4) of relational contract theory appearing in 1974 (Macneil, 1974).12 Conclusion Not surprisingly, legal scholars did not know what to make of Macaulay and Macneil. Enthralled by courts, many law professors searched in vain for the legal doctrinal implications of this work (Smith and King, 2009, p. 10). The study of private ordering would not have occurred to most of them, as that would hardly seem like the study of law.13 Thus, the systematic examination of private ordering was left to economists, mostly inspired by Ronald Coase, as interpreted and expanded by Benjamin Klein and Oliver Williamson.14 Recently, however, legal scholars have begun to return to transactions in scholarship and teaching,15 and one hopes that the future collaboration of disciplines will shine new light on transactions. Notes 1.

Williamson (1985, p. 3) noted: The proposition that economic organization has the purpose of promoting the continuity of relationships by devising specialized governance structures rather than permitting relationships to fracture under the hammer of unassisted market contracting, was . . . an insight that could have been gleaned from Commons. But the message made little headway against the prevailing view that the courts were the principal forum for conflict resolution.

Commons, Hurst, Macaulay, and the Wisconsin legal tradition 2.

3.

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Asked about the influence of Commons on his own thinking, Stewart Macaulay commented, ‘I certainly read Commons when I was beginning, at Willard’s suggestion. But I was reading Frank Knight at the same time. Probably, I got my dose of Commons and progressive law making from reading and talking with Willard’ (personal communication, 5 May 2009). Note Carrington and King (1997, p. 324): One effect of the Wisconsin Idea was to bring the university’s new, young law teachers into contact not only with public affairs, but also with academic colleagues in other disciplines who possessed useful expertise. . .. Between 1904 and 1910 law faculty . . . collaborated with economics faculty such as John Commons and Richard Ely in a large-scale endeavor to document the history of labor in America.

4.

Harris (2003, p. 326) notes that ‘[r]ecent research suggests that institutional economics, by way of John Commons . . . and his disciples, was not as important to Hurst as some scholars previously believed’. Prior to Hurst, the writing of legal history was dominated by lawyers. Harris (2003, pp. 323–4) describes the resulting focus on legal doctrine: These lawyer-legal historians were primarily interested in studying change in legal doctrine. They considered the judges of the supreme courts and the courts of appeals to be the agents of doctrinal change. Therefore lawyers’ legal history focused on them; on their sources of influence, in the form of earlier decisions and elite legal literature; and on their products, appeal courts’ case law, and the evolving formal legal doctrine.

5.

6.

Hurst was inclined to study ‘law in society’ long before he arrived at Wisconsin (Hartog, 1994, p. 372). See Ernst (2000) for a description of his intellectual development prior to arriving at Wisconsin, including Hurst’s work as a research assistant to Felix Frankfurter at Harvard Law School. Among the economics professors in that space was Elizabeth Brandeis Raushenbush, daughter of Justice Brandeis, who taught economics at Wisconsin for 42 years. Raushenbush made the connection between Hurst and Garrison after meeting Hurst while visiting her father in Washington DC (Hurst, 1981, p. 17). What Hurst found when he arrived at Wisconsin was a Law School that reflected Garrison’s ambitious ideas: [I]t was apparent right from the very outset that this was a law school unlike most law schools, that did not exist in isolation from all the rest of the university. It was just taken for granted that we would have working contact with the economics department, with sociologists, only later with historians, because legal history was still regarded as not really history. But economics and sociology, it was taken for granted that people there were interested in the law school, and the law school was interested in them.

7.

8. 9.

Macaulay’s article (1963a) was published in the American Sociological Review, not in a student-edited law review, and Macaulay attributes the placement to Hurst. ‘That article was published in the American Sociological Review, largely because Robert Merton, the great sociologist, told the editor to print it. Merton knew about my work because he was Willard’s friend from their days together on the Social Science Research Council’ (Macaulay, 1997, p. 1170). Despite Macaulay’s focus on non-contractual relations, he does not argue that contracts are irrelevant. Indeed, he observed that ‘many business exchanges reflect a high degree of planning’ (Macaulay, 1963a, p. 60). Macaulay (1963a, p. 61) observed: Disputes are frequently settled without reference to the contract or potential for actual legal sanctions. There is a hesitancy to speak of legal rights or to threaten to

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10. 11.

12.

13. 14. 15.

Macaulay (1963a) ranks fifteenth on Shapiro’s (1996) list of all-time most highly cited law review articles. Macaulay presented the paper at a meeting of the American Sociological Association held in Washington DC immediately following the New York University workshop (personal communication from Stewart Macaulay, 3 October 2006). In this formative stage, Macneil developed a ‘general dissatisfaction with the classical law’ of contracts (Campbell, 2001, volume 3, p. 6). Macneil continued to develop relational contract theory after 1974, partly in response to critiques of the 1974 article, and he later wrote, ‘None of these changes alters the fundamental nature of the theory, and I would worry more if there had been no changes’ (Macneil, 1987, p. 273, n. 4). Notable exceptions include Ellickson (1991), Bernstein (1992), and Crocker and Masten (1991). For a survey of empirical studies of contracts, see Smith and King (2009, pp. 19–24). The seminal piece of scholarship in this transactional awakening among legal scholars is Gilson’s (1984) ‘Value Creation by Business Lawyers: Legal Skills and Asset Pricing’. As suggested by the title, Gilson’s work was inspired by economic theory. Smith and King (2009, pp. 2–3) ‘highlight the dominant role of economic theories in framing empirical work on contracts’ and express the desire ‘to enrich the empirical study of contracts through application of four organizational theories’. In the summer of 2009, the Association of American Law Schools sponsored a Workshop on Transactional Law as part of the Association’s mid-year meeting in Long Beach, California. Perhaps a sign of the embryonic state of transactional studies among law professors, one of the goals of the conference was to ‘define “transactional scholarship” in a way that accurately captures the potential breadth and depth of transactional law, and how transactional scholarship differs from traditional legal scholarship’.

References Beard, C.A. and M.R. Beard (1927), The Rise of American Civilization, New York: Macmillan. Bernstein, L. (1992), ‘Opting out of the legal system: extralegal contractual relations in the diamond industry’, Journal of Legal Studies, 21 (1), 115–57. Campbell, D. (ed.) (2001), Selected Works of Ian Macneil, London: Sweet & Maxwell. Carrington, P.D. and E. King (1997), ‘Law and the Wisconsin idea’, Journal of Legal Education, 47 (3), 297–340. Commons, J.R. (1918), History of Labor in the United States, New York: Macmillan. Commons J.R. (1934), Institutional Economics: Its Place in Political Economy, New York: Macmillan. Commons, J.R. and R.T. Ely (1910), A Documenting History of American Industrial Society, Cleveland: The Arthur K. Clark Co. Crocker, K.J. and S.E. Masten (1991), ‘Pretia ex machina? Prices and process in long-term contracts’, Journal of Law and Economics, 34 (1), 69–99. Edwards, B. (1989), Drawing on the Right Side of the Brain: A Course in Enhancing Creativity and Artistic Confidence, Los Angeles: Tarcher. Ellickson, R.C. (1991), Order Without Law: How Neighbors Settle Disputes, Cambridge, MA: Harvard University Press. Ernst, D.R. (2000), ‘Willard Hurst and the administrative state: from Williams to Wisconsin’, Law and History Review, 18 (1), 1–36. Fuller, L. (1947), Basic Contract Law, St. Paul, Minn.: West Publishing Co.

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Garth, B. and J. Sterling (1998), ‘From legal realism to law and society: reshaping law for the last stages of the social activist state’, Law and Society Review, 32 (2), 409–72. Gilmore, G. (1974), The Death of Contract, Columbus: Ohio State University Press. Gilson, R.J. (1984), ‘Value creation by business lawyers: legal skills and asset pricing’, Yale Law Journal, 94, 239–313. Harris, R. (2003), ‘The encounters of economic history and legal history’, Law and History Review, 21 (2), 297–346. Hartog, H. (1994), ‘Snakes in Ireland: a conversation with Willard Hurst’, Law and History Review, 12 (2), 370–390. Hurst, J.W. (1956), Law and the Conditions of Freedom in the Nineteenth Century United States, Madison: University of Wisconsin Press. Hurst, J.W. (1981), ‘J. Willard Hurst: an interview conducted by Laura L. Smail’, Madison: University Archives Oral History Project, University of Wisconsin-Madison. Kaufman, B.E. (2006), ‘The institutional economics of John R. Commons: complement and substitute for neoclassical economic theory’, Socio-Economic Review, 5 (1), 3–45. ‘Labor Law Studies – A Wisconsin Tradition’ (1982), The Gargoyle, 14, 7–9. Leiter, B. (2005), ‘American Legal Realism’, in M.P. Golding and W.A. Edmundson (eds), The Blackwell Guide to the Philosophy of Law and Legal Theory, London: Blackwell. Macaulay, S. (1963a), ‘Non-contractual relations in business: a preliminary study’, American Sociological Review, 28 (1), 55–67. Macaulay, S. (1963b), ‘Willard’s law school?’, Wisconsin Law Review, 1997(6), 1163–79. Macaulay, S. (1995), ‘Crime and custom in business society’, Journal of Law and Society, 22 (2), 248–58. Macneil, I.R. (1962), ‘Power of contract and agreed remedies’, Cornell Law Quarterly, 47 (4), 495–528. Macneil, I.R. (1963), ‘Exercise in contract damages: city of Memphis v. Ford Motor Company’, Boston College Industrial and Commercial Law Review, 4 (2), 331–342. Macneil, I R. (1964), ‘Time of acceptance: too many problems for a single rule’, University of Pennsylvania Law Review, 112 (7), 947–79. Macneil, I.R. (1968), Contracts: Instruments of Social Co-operation – East Africa, South Hackensack, N.J.: F.B. Rothman. Macneil, I.R. (1974), ‘The many futures of contracts’, Southern California Law Review, 47 (3), 691–816. Macneil, I.R. (1985), ‘Relational contract: what we do and do not know’, Wisconsin Law Review, 3, 483–525. Macneil, I.R. (1987), ‘Relational contract theory as sociology: a reply to Professors Lindenberg and de Vos’, Journal of Institutional and Theoretical Economics, 143 (2), 272–90. Macneil, I.R. (2000), ‘Relational contract theory: challenges and queries’, Northwestern University Law Review, 94 (3), 877–907. Rockman, D.A. (2000), The Art of Teaching Art: A Guide for Teaching and Learning the Foundations of Drawing-Based Art, New York: Oxford University Press. Shapiro, F.R. (1996), ‘The most-cited law review articles revisited’, Chicago-Kent Law Review, 71 (1), 85–100. Smith, D.G. and B.G. King (2009), ‘Contracts as organizations’, Arizona Law Review, 51 (1), 1–45. Veblen, T. (1899), The Theory of the Leisure Class: An Economic Study of Institutions, New York: Macmillan. Williamson, O.E. (1985), The Economic Institutions of Capitalism, New York: Free Press.

8

F.A. Hayek Peter G. Klein

Oliver Williamson dedicates his 1985 book, The Economic Institutions of Capitalism, to four ‘teachers’: Kenneth Arrow, Alfred D. Chandler, Jr, Ronald Coase, and Herbert Simon. Another influential teacher, or predecessor, is F.A. Hayek, the 1974 Nobel laureate and best-known representative of the modern ‘Austrian’ school. Hayek began his career as a specialist in monetary and business-cycle theory but also made important contributions to the economics of knowledge and competition, legal and constitutional theory, evolutionary economics, and the theory of economic change. Hayek’s emphasis on the ubiquity of dispersed, tacit knowledge, the importance of adaptation, and the function of abstract rules have significantly influenced Williamson’s understanding of markets and hierarchies. More generally, Hayekian ideas about knowledge, competition, discovery, and complexity figure prominently in the transaction cost approach to economic organization. Hayek’s life and work Hayek’s life spanned the twentieth century, and he made his home in some of the great intellectual communities of the period.1 Born Friedrich August von Hayek in 1899 to a distinguished family of Viennese intellectuals, Hayek attended the University of Vienna, earning doctorates in 1921 and 1923. Hayek came to the University of Vienna just after World War I, when it was one of the three best places in the world to study economics (the others being Stockholm and Cambridge, England). Though Hayek was enrolled as a law student, his primary interests were economics and psychology. He studied with Friedrich von Wieser and was also influenced by Ludwig von Mises, particularly Mises’s 1922 book Socialism. Hayek began attending Mises’s Privatseminar along with Gottfried Haberler, Fritz Machlup, Oskar Morgenstern, Paul Rosenstein-Rodan, Richard von Strigl, and other promising young Viennese economists and social theorists. Mises was known at this time primarily as a monetary theorist, and Hayek began working on the theories of money, capital, interest, and the business cycle. Following Mises, Hayek explained the origin of the business cycle in terms of bank credit expansion and its transmission in terms of capital malinvestments (Hayek, 1931, 1933a). His work in this 74

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area eventually earned him an invitation to lecture at the London School of Economics and Political Science and then to occupy its Tooke Chair in Economics and Statistics, which he accepted in 1931. There Hayek found himself among a vibrant and exciting group: Lionel Robbins, J.R. Hicks, Arnold Plant, Dennis Robertson, T.E. Gregory, Abba Lerner, Kenneth Boulding, and George Shackle, to name only the most prominent. Gradually, the ‘Austrian’ theory of the business cycle became known and accepted and, until Keynes’s General Theory appeared in 1936, was becoming the preferred explanation for the Great Depression. Hayek and Keynes had sparred in the early 1930s in the pages of the Economic Journal, over Keynes’s A Treatise on Money (1930). As one of Keynes’s leading professional adversaries, Hayek was well situated to provide a full refutation of the General Theory, but he never did. One reason, as Hayek later explained, was that Keynes was constantly changing his theoretical framework, and Hayek saw no point in working out a detailed critique of the General Theory, if Keynes might change his mind again (Hayek, 1963 [1995], p. 60; 1966 [1995], pp. 240–241). Hayek thought a better course would be to produce a fuller elaboration of BöhmBawerk’s capital theory (1884–1909 [1959]), and he began to devote his energies to this project. Unfortunately, The Pure Theory of Capital was not completed until 1941, and by then the Keynesian macro model had become firmly established. In 1950 Hayek joined the Committee on Social Thought at the University of Chicago. There he again found himself among a dazzling group: the economics department, led by Frank Knight, Milton Friedman, and later George Stigler, was one of the best anywhere, and Aaron Director at the law school soon set up the first law and economics program. While Hayek had taught graduate-level theory courses for many years at the London School of Economics (LSE), he became disenchanted with the positivism and formalism of postwar neoclassical economics, and began working primarily in adjacent fields such as psychology, philosophy, politics, and the history of ideas. Hayek’s receipt of the 1974 Nobel Prize (shared with Gunnar Myrdal, whose work was very different from Hayek’s) helped spur a revival of the Austrian tradition, which had remained largely dormant since the 1930s (Vaughn, 1994; Salerno, 2002). Hayek continued to write, producing The Fatal Conceit in 1988, at the age of 89. Hayek died in 1992 in Freiburg, Germany, where he had lived since leaving Chicago in 1961. Hayek’s contributions to economics Hayek’s legacy in economics is complex. Among mainstream economists, he is mainly known for his popular The Road to Serfdom (1944) and

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for his work on knowledge in the 1930s and 1940s (Hayek, 1937, 1945). Specialists in business-cycle theory recognize his early work on industrial fluctuations, and modern information theorists often acknowledge Hayek’s work on prices as signals, although his conclusions are typically disputed (Grossman and Stiglitz, 1976; Grossman, 1980, 1989). Hayek’s work is also known in political philosophy (Hayek, 1960), legal theory (Hayek, 1973–79), and psychology (Hayek, 1952). Within the Austrian school of economics, Hayek’s influence, while undeniably immense, has very recently become the subject of some controversy. His emphasis on spontaneous order and his work on complex systems have been widely influential among many Austrians. Others have preferred to stress Hayek’s work in technical economics, particularly on capital and the business cycle, citing a tension between some of Hayek’s and Mises’s views on the social order. In ‘Economics and Knowledge’ (1937) and ‘The Use of Knowledge in Society’ (1945) Hayek argued that the central economic problem facing society is not, as is commonly expressed in textbooks, the allocation of given resources among competing ends: It is rather a problem of how to secure the best use of resources known to any of the members of society, for ends whose relative importance only those individuals know. Or, to put it briefly, it is a problem of the utilization of knowledge not given to anyone in its totality (Hayek, 1945, pp. 519–20).

Much of the knowledge necessary for running the economic system, Hayek contended, is in the form not of ‘scientific’ or technical knowledge – the conscious awareness of the rules governing natural and social phenomena – but of tacit knowledge, the idiosyncratic, dispersed bits of understanding of ‘particular circumstances of time and place’ (Hayek, 1945, p. 521). This tacit knowledge is often not consciously known even to those who possess it and can never be communicated to a central authority. The market tends to use this tacit knowledge through a type of ‘discovery procedure’ (Hayek, 1968), by which this information is unknowingly transmitted throughout the economy as an unintended consequence of individuals’ pursuing their own ends. Indeed, Hayek’s (1948) distinction between the neoclassical notion of ‘competition’, identified as a set of equilibrium conditions (number of market participants, characteristics of the product, and so on), and the older notion of competition as a rivalrous process has been widely influential in Austrian economics (Kirzner, 1973; Machovec, 1995). Most commentators view Hayek’s work on knowledge, discovery, and competition as an outgrowth of his participation in the socialist calculation debate of the 1920s and 1930s. The socialists erred, in Hayek’s view, in failing to see that the economy as a whole is necessarily a spontaneous

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order and can never be deliberately made over in the way that the operators of a planned order can exercise control over their organization. This is because planned orders can handle only problems of strictly limited complexity. Spontaneous orders, by contrast, tend to evolve through a process of natural selection, and therefore do not need to be designed or even understood by a single mind. Hayek’s influence on Coase Ronald Coase was a student at the LSE in the late 1920s and early 1930s. Coase reports that Hayek’s concept of the time-structure of capital, or ‘structure of production’, was ‘the subject which dominated the discussion of economics at LSE’ (Coase, 1988, p. 7). Coase’s own interest lay in a related but distinct concept, the ‘organizational structure of production’ (Coase, 1988, p. 7). His main influences were his teacher Arnold Plant and a fellow student, Ronald Fowler (Coase, 1988). Coase was familiar, however, with Mises’s and Hayek’s arguments in the socialist calculation debate, and cites Hayek’s ‘Trend of Economic Thinking’ (1933b) when describing, in his own work ‘The Nature of the Firm’ (1937), the idea of ‘the economic system as being coordinated by the price mechanism’, making society ‘not an organisation but an organism’ (Coase, 1937, p. 387). ‘Indeed’, he adds, again citing Hayek, ‘it is often considered to be an objection to economic planning that it merely tries to do what is already done by the price mechanism’ (Coase, 1937, p. 387). Here Coase is alluding to Hayek’s claim that market competition generates a particular kind of order – an order that is the product ‘of human action, but not . . . human design’ (a phrase Hayek borrowed from Adam Smith’s mentor Adam Ferguson) (Ferguson, 1767, p. 187). This ‘spontaneous order’ is a system that comes about through the independent actions of many individuals, and produces overall benefits unintended and mostly unforeseen by those whose actions bring it about. To distinguish between this kind of order and that of a deliberate, planned system, Hayek (1933b) initially used the terms ‘organism’ for a spontaneous order and ‘organization’ for a planned one, switching later to the Greek terms cosmos and taxis, respectively (Hayek, 1973–79, pp. 35–54). Examples of a cosmos include the market system as a whole, money, the common law, and even language. A taxis, by contrast, is a designed or constructed organization, like a firm or bureau; these are the ‘islands of conscious power in [the] ocean of unconscious cooperation like lumps of butter coagulating in a pail of buttermilk’ (D.H. Robertson, quoted in Coase, 1937, p. 388). Coase’s argument, of course, is that reliance on the spontaneous order of the market imposes particular costs: searching for trading partners, discovering the relevant prices, negotiating and enforcing contracts, and so

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on. Within the firm, the entrepreneur may be able to reduce these ‘transaction costs’ by coordinating these activities himself. Coase recognizes that there are limits to the firm – he refers in his 1937 paper to ‘diminishing returns to management’ (Coase, 1937, p. 395) – but does not spell out these limits in detail. The modern theory of the firm tends to conceptualize the optimal boundary by comparing the transaction costs of using the market with what might be called internal transaction costs: problems of information flow, incentives, monitoring, and performance evaluation. The boundary of the firm, then, is determined by the tradeoff, at the margin, between the relative transaction costs of external and internal exchange. Hayek’s ‘Economics and Knowledge’ appeared in 1937, the same year as Coase’s ‘The Nature of the Firm’, and there are obvious connections between Coase’s and Hayek’s understandings of the market. Kirzner (1992, p. 162), for example, describes Coase’s argument in Hayekian terms: In a free market, any advantages that may be derived from ‘central planning’ . . . are purchased at the price of an enhanced knowledge problem. We may expect firms to spontaneously expand to the point where additional advantages of ‘central’ planning are just offset by the incremental knowledge difficulties that stem from dispersed information.2

Hayek and Williamson Williamson has been influenced more directly by Hayek’s approach to knowledge, adaptation, and coordination. In the early pages of Williamson’s Markets and Hierarchies (1975, pp. 4–5), he describes four key Hayekian observations: 1. The problem of a rational economic order is trivial in the absence of bounded rationality limits on human decision makers. It is accordingly essential at the outset to appreciate that bounds on rationality do exist and must be expressly taken into account if organizational issues are to be addressed in operational terms ([Hayek] 1945, pp. 519, 527). 2. Much of the knowledge required to make efficient economic decisions cannot be expressed as statistical aggregates but is highly idiosyncratic in nature: ‘practically every individual has some advantage over all others in that he possesses unique information of which beneficial use might be made, but of which use can be made only if the decisions depending on it are left to him or are made with his active cooperation. We need to remember . . . how valuable an asset in all walks of life is knowledge of people, of local conditions, and of special circumstances’ ([Hayek] 1945, pp. 521–522). 3. The economic problem is relatively uninteresting except where economic events are changing and sequential adaptations to changing market circumstances are called for ([Hayek] 1945, pp. 523–524). 4. The ‘marvel’ of the economic system is that prices serve as sufficient statistics, thereby economizing on bounded rationality ([Hayek] 1945, pp. 525–528).

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Williamson (1975, p. 5) then notes that he uses these observations: in a somewhat different way than does Hayek – mainly because I am interested in a more microeconomic level of detail than he. Given bounded rationality, uncertainty, and idiosyncratic knowledge, I argue that prices often do not qualify as sufficient statistics and that a substitution of internal organization (hierarchy) for market-mediated exchange often occurs on this account.

As I read Williamson, he is not referring here to the welfare properties of prices, the issue that concerns Grossman and Stiglitz (1976), Grossman (1980, 1989), and Bolton and Farrell (1990), who argue that contrary to Hayek, real-world market prices are not ‘sufficient statistics’ for changes in tastes and technology, and that in general only perfectly competitive prices convey useful information. Rather, Williamson is simply following Coase in arguing that direct coordination of factors by an entrepreneur, inside a firm, can be an effective way of organizing production in the face of dispersed, tacit knowledge in markets, knowledge that is not always parameterized effectively in prices.3 Besides bounded rationality, tacit knowledge, and the informational role of prices, at least two other Hayekian concepts appear in Williamson’s work. One is Hayek’s (1967) emphasis on the role of general, abstract rules, rather than particular mandates, and Hayek’s claim that social scientists should study patterns, rather than specific outcomes. Williamson sees his own general model of contractual relationships or ‘simple contracting schema’, in which contractual hazards pose problems that require safeguards such as incentive alignment, specialized governance mechanisms (like vertical integration), or reputation through repeated dealings (Williamson, 1985, pp. 32–5), as an example of a Hayekian general rule: ‘Although the particulars differ, vertical integration, nonstandard contracting for intermediate goods, the employment relation, corporate governance, and regulation are all, according to the argument developed [here], variations on a theme’ (Williamson, 1985, p. 348). Transaction cost economics, in Williamson’s view, is a highly general theory of economic organization. The other important Hayekian concept in Williamson’s work is the idea of spontaneous order, in the context of adaptation to unanticipated change. In ‘Economic Institutions: Spontaneous and Intentional Governance’ (Williamson, 1991), Williamson argues that economists, following Adam Smith and Hayek, have tended to focus on ‘spontaneous governance’, the ability of decentralized market systems to evolve in response to changes in resource availability, technical knowledge, demand characteristics, and the like. The study of coordinated or intra-firm adaptation, Williamson argued, has received less attention, though it was a chief concern of earlier

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scholars of administrative behaviour such as Chester Barnard (1938) and Herbert Simon (1947). Barnard too argued for the importance of adaptation, but in a bureaucratic context. Williamson (1991, pp. 163–4) attempts to reconcile Hayek and Barnard in this way: I submit that adaptability is the central problem of economic organization and that both Hayek and Barnard are correct. That both are correct is because they are referring to adaptations of different kinds, both of which are needed in a high-performance system. The adaptations to which Hayek referred could be implemented autonomously: each party examined prices in relation to his own opportunities and responded autonomously. Accordingly, such adaptations will be referred to as adaptations A, where A denotes autonomous. By contrast, the adaptations with which Barnard was concerned involved ‘that kind of cooperation among men that is conscious, deliberate, purposeful’ (Barnard, 1938, p. 4) and were realized through formal organization – especially hierarchy. Adaptations of a consciously coordinated kind will be referred to as adaptations C, where C denotes cooperative. Recourse to fiat provides better assurance that adaptations of the latter kind will be performed in a coordinated way. Contrary opinions notwithstanding, markets and hierarchies are not indistinguishable in fiat respects. Hierarchy is superior to the market in bilateral adaptability respects – precisely because of its differential access to fiat.

The ability to effect bilateral adaptation is, in Williamson’s framework, an advantage of internal organization. And yet, firms cannot mimic spontaneous adaptation through internal markets, due to the ‘impossibility of selective intervention’, the inability of a firm’s central management to commit credibly not to intervene in the affairs of subunits and subordinates, which attenuates the incentives of the latter. Williamson illustrates with an extensive, and nuanced, discussion of the socialist calculation debate (Williamson, 1991, pp. 176–83). Williamson does not, ultimately, accept the arguments of Mises and Hayek that socialism fails because of the lack of monetary calculation (Mises) or the inability of socialist planners to obtain the necessary specific knowledge (Hayek), placing emphasis instead on the incentive effects of state control of resource allocation: specifically, state apparatchiks cannot make credible commitments not to appropriate the gains created by other agents in the system. But Williamson’s discussion of the problem, in both a static and a dynamic context, displays considerable familiarity with the Austrian arguments. Curiously, Williamson does not make the link, in his writings, between the core transaction cost economics concept of asset specificity and Hayek’s theory of capital, despite close similarities and complementarities. Asset specificity refers to ‘durable investments that are undertaken in support of particular transactions, the opportunity cost of which investments are much lower in best alternative uses or by alternative users should the original transaction be prematurely terminated’ (Williamson, 1985, p.

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55). Like Klein et al. (1978), Williamson emphasizes the ‘holdup’ problem that can follow such investments, and the role of contractual safeguards in securing the returns to those assets. Hayek’s (1931, 1933a, 1941) theory of capital focuses on a different type of specificity, namely the extent to which resources are specialized to particular places in the time structure of production. Carl Menger (1871), founder of the Austrian school, famously characterized goods in terms of orders: goods of the lowest order are those consumed directly; tools and machines used to produce those consumption goods are of a higher order; and the capital goods used to produce the tools and machines are of an even higher order. Building on his theory that the value of all goods is determined by their ability to satisfy consumer wants (that is, their marginal utility), Menger showed that the value of the higher-order goods is given or ‘imputed’ by the value of the lower-order goods they produce. Moreover, because certain capital goods are themselves produced by other, higher-order capital goods, it follows that capital goods are not identical – at least by the time they are employed in the production process. The claim is not that there is no substitution among capital goods, but that the degree of substitution is limited. As Lachmann (1956) put it, capital goods are characterized by ‘multiple specificity’. Some substitution is possible, but only at a cost. Mises and Hayek used this concept of specificity to develop their theory of the business cycle. Williamson’s asset specificity focuses on specialization not to a particular production process but to a particular set of trading partners. Williamson’s aim is to explain the business relationship between these partners (arm’s-length transaction, formal contract, vertical integration, and so on). The Austrians, in other words, focus on assets that are specific to particular uses, while Williamson focuses on assets that are specific to particular users. But there are obvious parallels, and opportunities for gains from trade. Austrian business-cycle theory can be enhanced by considering how vertical integration and long-term supply relations can mitigate, or exacerbate, the effects of credit expansion on the economy’s structure of production. Likewise, transaction cost economics can benefit from considering not only the time-structure of production, but also Kirzner’s (1966) refinement that defines capital assets in terms of subjective, individual production plans – plans that are formulated and continually revised by profit-seeking entrepreneurs. A few recent works apply asset specificity to macroeconomics (Caballero and Hammour, 1996, 1998; Caballero, 2007; Agarwal et al., 2009) and other aggregate phenomena such as economy-wide restructuring (Caballero, 2007) and international trade (Nunn, 2007; Antràs and Rossi-Hansberg, 2009), and this may signal the start of a promising

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new direction in contemporary macroeconomics, particularly now that ‘Austrian’ concerns about industry-specific effects of boom and bust are gaining attention (for example, Oppers, 2002). Notes 1. For biographical treatments see Hayek (1994), Klein (1999), Ebenstein (2001), and Caldwell (2003). 2. Murray Rothbard, one of the most influential twentieth-century Austrian economists, states that his own treatment of the limits of the firm serves to extend the notable analysis of Professor Coase on the market determinants of the size of the firm, or the relative extent of corporate planning within the firm as against the use of exchange and the price mechanism. Coase pointed out that there are diminishing benefits and increasing costs to each of these two alternatives, resulting, as he put it, in an ‘“optimum” amount of planning’ in the free market system. Our thesis adds that the costs of internal corporate planning become prohibitive as soon as markets for capital goods begin to disappear, so that the free-market optimum will always stop well short not only of One Big Firm throughout the world market but also of any disappearance of specific markets and hence of economic calculation in that product or resource (Rothbard, 1976, p. 76). See also Klein (1996). 3. Coase and Williamson do not mean, as is sometimes assumed, that firms are not part of the market. They are talking about a completely different issue, namely the distinction between types of contracts or business relationships within the larger market context. The issue is simply whether the employment relationship is different from, say, a spot-market trade or a procurement arrangement with an independent supplier. Alchian and Demsetz (1972) famously argued that there is no essential difference between the two – both are voluntary contractual relationships, there is no coercion involved, no power, and so on. Coase, Williamson, Herbert Simon, Grossman and Hart (1986), Foss et al. (2007), and most of the modern literature on the firm argues that there are important, qualitative differences, based on differences in court enforcement of internal and external agreements, the allocation of residual control rights, and the judgment that accompanies asset ownership.

References Agarwal, R., J.B. Barney, N. Foss, and P.G. Klein (2009), ‘Heterogeneous resources and the financial crisis: implications of strategic management theory’, Strategic Organization, 7 (4), 467–84. Alchian, Armen A. and Harold Demsetz (1972), ‘Production, information costs, and economic organization’, American Economic Review, 62 (5), 772–95. Antràs, P. and E. Rossi-Hansberg (2009), ‘Organizations and trade’, Annual Review of Economics, 1 (1), 43–64. Barnard, C.I. (1938), The Functions of the Executive, Cambridge, MA: Harvard University Press. Böhm-Bawerk, E. von (1884–1909), Capital and Interest, South Holland, IL: Libertarian Press, 1959. (Published in three volumes in 1884, 1889, and 1909; the 1959 edition is the first single-volume version in English.) Bolton, P. and J. Farrell (1990), ‘Decentralization, duplication, and delay’, Journal of Political Economy, 98 (4), 803–26. Caballero, R. (2007), Specificity and the Macroeconomics of Restructuring, Cambridge, MA: MIT Press. Caballero, R. and M. Hammour (1996), ‘The “fundamental transformation” in macroeconomics’, American Economic Review, 86 (2), 181–6.

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Caballero, R. and M. Hammour (1998), ‘The macroeconomics of specificity’, Journal of Political Economy, 106 (4), 724–67. Caldwell, B.J. (2003), Hayek’s Challenge: An Intellectual Biography of F.A. Hayek, Chicago: University of Chicago Press. Coase, R.H. (1937), ‘The Nature of the Firm,’ Economica, N.S., 4 (16), 386–405. Coase, R.H. (1988), ‘The Nature of the Firm: Origin’, Journal of Law, Economics and Organization, 4 (1), 3–17. Ebenstein, A. (2001), Friedrich Hayek: A Biography, London: Palgrave Macmillan. Ferguson, A. (1767), An Essay on the History of Civil Society, 2nd edn, London: Millar and Cadell. Foss, K., N.J. Foss, and P.G. Klein (2007), ‘Original and derived judgment: an entrepreneurial theory of economic organization’, Organizational Studies, 28 (12), 1893–912. Grossman, S.J. (1980), ‘On the impossibility of informationally efficient markets’, American Economic Review, 70 (3), 393–408. Grossman, S.J. (1989), The Informational Role of Prices, Cambridge, MA and London: MIT Press. Grossman, Sanford and Oliver Hart (1986), ‘The costs and benefits of ownership: a theory of vertical integration’, Journal of Political Economy, 94 (4), 691–719. Grossman, S.J. and J.E. Stiglitz (1976), ‘Information and competitive price systems’, American Economic Review, 66 (2), 246–53. Hayek, F.A. (1931), Prices and Production, London: Routledge and Sons. Hayek, F.A. (1933a), Monetary Theory and the Trade Cycle, London: Jonathan Cape. Hayek, F.A. (1933b), ‘The trend of economic thinking’, Economica, 13 (40), 121–37. Hayek, F.A. (1937), ‘Economics and knowledge,’ Economica, 4 (13), 33–54. Hayek, F.A. (1941), The Pure Theory of Capital, London: George Routledge and Sons. Hayek, F.A. (1944), The Road to Serfdom, London: Routledge and Kegan Paul. Hayek, F.A. (1945), ‘The use of knowledge in society’, American Economic Review, 35 (4), 519–30. Hayek, F.A. (1948), ‘The meaning of competition’, in F.A. Hayek, Individualism and Economic Order, Chicago: University of Chicago Press, pp. 92–106. Hayek, F.A. (1952), The Sensory Order, Chicago: University of Chicago Press. Hayek, F.A. (1960), The Constitution of Liberty, Chicago: University of Chicago Press. Hayek, F.A. (1963), ‘The economics of the 1930s as seen from London’, in F.A. Hayek (1995), Contra Keynes and Cambridge: Essays, Correspondence, B.J. Caldewell (ed.) (1995), Collected Works of F.A. Hayek, vol. 9, Chicago: University of Chicago Press, pp. 49–73. Hayek, F.A. (1966), ‘Personal recollections of Keynes and the “Keynesian revolution”’, in F.A. Hayek (1995), Contra Keynes and Cambridge: Essays, Correspondence, B.J. Caldewell (ed.) (1995), Collected Works of F.A. Hayek, vol. 9, Chicago: University of Chicago Press, pp. 240–246. Hayek, F.A. (1967), New Studies in Philosophy, Politics, and Economics, London: Routledge. Hayek, F.A. (1968), ‘Competition as a discovery procedure’, trans. M. Snow (2002), Quarterly Journal of Austrian Economics, 5 (3), 9–23. Hayek, F.A. (1973–79), Law, Legislation, and Liberty, Chicago: University of Chicago Press. Hayek, F.A. (1988), The Fatal Conceit: The Errors of Socialism, W.W. Bartley III (ed.), Collected Works of F.A. Hayek, vol. 9, Chicago: University of Chicago Press. Hayek, F.A. (1994), Hayek on Hayek: An Autobiographical Dialogue, Stephen Kresge and Leif Wenar (eds), Chicago: University of Chicago Press. Hayek, F.A. (1995), Contra Keynes and Cambridge: Essays, Correspondence, in B.J. Caldwell (ed.), Collected Works of F.A. Hayek, vol. 9, Chicago: University of Chicago Press. Keynes, J.M. (1930), A Treatise on Money, London: Macmillan. Keynes, J.M. (1936), The General Theory of Employment, Interest, and Money, London: Macmillan. Kirzner, I.M. (1966), An Essay on Capital, New York: Augustus M. Kelley.

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Kirzner, I.M. (1973), Competition and Entrepreneurship, Chicago: University of Chicago Press. Kirzner, I.M. (1992), The Meaning of Market Process, London: Routledge. Klein, B., R.A. Crawford, and A.A. Alchian (1978), ‘Vertical integration, appropriable rents, and the competitive contracting process’, Journal of Law and Economics, 21 (2), 297–326. Klein, P.G. (1996), ‘Economic calculation and the limits of organization’,Review of Austrian Economics, 9 (2), 51–77. Klein, P.G. (1999), ‘F.A. Hayek (1899–1992)’, in R.G. Holcombe (ed.), Fifteen Great Austrian Economists, Auburn, AL: Mises Institute. Lachmann, Ludwig M. (1956), Capital and Its Structure, Kansas City: Sheed Andrews and McMeel. Machovec, F.M. (1995), Perfect Competition and the Transformation of Economics, London: Routledge. Menger, C. (1871), Principles of Economics, Auburn, AL: Ludwig von Mises Institute, 2007. Mises, L. von (1922), Socialism: An Economic and Sociological Analysis, trans. J. Kahane, London, Jonathan Cape, 1936. Nunn, N. (2007), ‘Relationship-specificity, incomplete contracts, and the pattern of trade’, Quarterly Journal of Economics, 122 (2), 569–600. Oppers, S.E. (2002), ‘The Austrian theory of business cycles: old lessons for modern economic policy?’, IMF Working Paper No. 02/2. Rothbard, M.N. (1976), ‘Ludwig von Mises and economic calculation under socialism’, in L.S. Moss (ed.), The Economics of Ludwig von Mises: Toward a Critical Reappraisal, Kansas City: Sheed and Ward, pp. 67–77. Salerno, J.T. (2002), ‘The rebirth of Austrian economics – in light of Austrian economics’, Quarterly Journal of Austrian Economics, 5 (4), 111–28. Simon, H.A. (1947), Administrative Behavior: A Study of Decision-Making Processes in Administrative Organization, New York: Free Press. Vaughn, K.I. (1994), Austrian Economics in America: The Migration of a Tradition, Cambridge: Cambridge University Press. Williamson, Oliver E. (1975), Markets and Hierarchies: Analysis and Anti-Trust Implications, New York: Free Press. Williamson, O.E. (1985), The Economic Institutions of Capitalism, New York: Free Press. Williamson, O.E. (1991), ‘Economic institutions: spontaneous and intentional governance’, Journal of Law, Economics, and Organization, 7 (special issue), 159–87.

9

Herbert Simon Saras Sarasvathy

In a series of published and unpublished exchanges toward the end of the twentieth century, Herbert Simon and Oliver Williamson argued about the relationship between transaction cost economics (TCE) and behavioural economics. The exchange derived from personal biography as well as intellectual history and attested to differences not only of ideas but of world views. Augier and March (2001) provide one explanation for the disagreement in terms of a family quarrel about the degree to which one ought to assume unbounded rationality, opportunism, and conflict in the creation and sustenance of human organizations. Another aspect to the quarrel consists in the fact that Simon was not merely or even primarily an economist or social scientist. He was a Renaissance man, a polymath – deeply interested in how the human mind works and how that coheres with how the universe works. Opportunism, like unbounded rationality and conflict, did not make sense to him as fundamentals of human behaviour either empirically or historically and certainly not in terms of what we know about biological evolution. These concepts also did not make sense to him normatively, as guides for future action, for creatures consciously engaged in ‘designing’ their own environments, nor for scientists studying such creatures – scientists of ‘the artificial’ (Simon, 1996). Concepts such as bounded rationality, docility, and intelligent altruism were more interesting and fundamental to him, even if they were ‘messier’ because (i) they were empirically-based, and (ii) they were necessary to hold together a larger, more general tapestry of what we know about human evolution and history within which organizations and markets play smaller roles. Simon explicitly stated that he was not in favour of sacrificing an empirical understanding of how actual humans behaved even if this meant sacrificing simplicity and elegance in the theories that ensued. His argument about Occam’s razor is telling in this regard (Simon, 1979, p. 495): The application of the principle of satisficing to theories is sometimes defended as an application of Occam’s Razor. But Occam’s Razor has a double edge. Succinctness of statement is not the only measure of a theory’s simplicity. Occam understood his rule as recommending theories that make no more assumptions than necessary to account for the phenomena (essentia non sunt multiplicanda praeter necessitatem).

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Throughout a career spanning over six decades, Simon inveighed against economists’ penchant for ignoring facts on the ground and clinging to an edifice of economic ‘laws’ built on increasingly shaky behavioural foundations. In a full-scale argument on this topic in 1997, in a published version of the Raffaele Mattioli Lectures, Simon (1997b, p. 21) emphasized the importance of getting the empirics right: The [neoclassical] model itself is manipulated with great mathematical formality, and if it is tested with quantitative data, high standards of sophistication are imposed on the statistical methods employed. What is omitted is any serious testing of the validity of the assumptions of the model itself, even the kind of historical, experiential and anecdotal testing that we find in Smith and Marshall. This might be all right if the quantitative, econometric tests were generally sharp and decisive. Almost always, they are not. The literature of modern economics is full of examples of the sensitivity of models to small changes of assumptions – many, if not most of them beyond the limits of accuracy of statistical tests.

For the most part, Simon has won the argument with regard to bounded rationality, but his challenges continue with regard to other assumptions. One such assumption of particular importance to TCE is opportunism. Opportunism in TCE Just as Simon’s early decades were focused on convincing economists and others that ‘the major reason why we humans do not behave in a globally rational way was because we cannot’, in the latter decades, he began to focus on the fact that ‘we are highly dependent on those around us’ (Simon, 1997b, p. 40). Both empirical findings and evolutionary arguments led Simon to conclude that pure self-interest, or its stronger cousin, opportunism, was an inappropriate assumption in models of transactions, not to say inaccurate and even normatively dangerous for our understanding and design of organizations. We can trace back TCE’s behavioural assumptions about opportunism and the ensuing lack of trust in concepts such as altruism, loyalty, and organizational identification, to a partial reading of Adam Smith. For example, economists often cite and build upon The Wealth of Nations (Smith, 1776 [1981]), in which Smith developed his ideas about the spontaneous benefits of selfishness, an idea he got from Mandeville (1714). The oft-quoted but mostly misunderstood passage from Smith’s book (1776 [1981]) concerning the butcher and baker (Baumol, 2002) forms the basis for economists’ generalization of the fundamental behavioural assumption about human self-interest. But Smith’s (arguably) most important work, The Theory of Moral Sentiments (Smith, 1759 [2000]), needs to be consulted if we are to have a complete picture of Smith’s position on the

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matter (Werhane, 1991; Sen, 1985). By ignoring The Theory of Moral Sentiments, economists have set the stage for a continuing debate between their own normative theorizing and the observed empirical experience of human transactions, both within and outside organizations. The notion of opportunism, defined as ‘self-interest seeking with guile’ is rather recent and can be found in Williamson (1975). It is important to note here that Williamson is not saying that opportunism is always at work; he is only saying that contracts should be made on the assumption that it could be at work. In other words, contracts should be made with an eye to the opportunistic potential they offer (Williamson, 1985). The work of Douglass North (1978) in economic history illustrates well both the potential for and limits to economic analysis built on assumptions of opportunism. In using opportunism-driven transaction costs as prime movers in economic history, North had to provide an explanation for the observed evidence of successful collective action such as the voting paradox, the absence of free riding in various human organizations, the pervasiveness of charity, and so on. In seeking to explain these manifest phenomena, North introduces the notion of ‘ideology’ as the missing factor in economic analyses. However, North does not have an underlying explanation why people should buy into ‘ideology.’ Similarly, scholars who argue in a more strictly neoclassical vein, such as Stigler and Becker (1977), Becker (1976), and Gauthier (1984), all have the problem of being unable to explain why rational actors would acquire beliefs and behaviours that are not in their narrow self-interest. While North’s conclusions also cohere with those of Arrow (1974) and Sen (1985), others have posited other exogenous factors such as the Protestant ethic (Weber, 1905 [2001]). Docility and intelligent altruism Simon has a different explanation, a behavioural construct that brings together experimental evidence and formal evolutionary models to provide an alternative assumption for transactional and organizational economics. That construct is docility. Simon defined it as: ‘The tendency to depend on suggestions, recommendation, persuasion, and information obtained through social channels as a major basis of choice’ (1993, p. 156). Docility follows directly from the limitations of human cognition. Through a series of articles, essays and lectures, Simon developed a notion of ‘intelligent’ altruism based on this notion of docility to argue that bounded rationality not only limits our ability to undertake the computational demands of highly opportunistic behaviour, but also selects such behaviour out (in an evolutionary sense) and selects in those who are willing and able to depend on others and help sustain others in a group – that is, intelligent altruists (Simon, 1997a, 1997b).

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More recently, Knudsen (2003) has argued for the role of docility in the emergence of altruism in biological populations. The case for the evolutionary dominance of intelligent altruists is also well-argued from perspectives other than those resting on docility. Hill (1990) for example, shows that under the normal assumptions of neoclassical economics, the invisible hand of the market will tend to weed out persistently opportunistic behaviour. Interestingly enough, without resorting to evolutionary arguments, Adam Smith himself had made the case for the fundamental behavioural assumption of persuasion in all economic exchanges: Different genius is not the foundation of this disposition to barter which is the cause of the division of labour. The real foundation of it is that principle to persuade which so much prevails in human nature . . . We ought then to mainly cultivate the power to persuasion, and indeed we do so without intending it. Since the whole life is spent in the exercise of it, a ready method of bargaining with each other must undoubtedly be attained. (Smith, 1776 [1981], pp. 493–494)

Game-theoretic and behavioural-economic evidence of all kinds has been accumulating over the last two or more decades pressing us to rethink the assumption of pure opportunism. In fact, what we know about self-interest based on empirical evidence, both in the lab (see Rabin, 1998, for a comprehensive review) and in the field, suggests that neither opportunism nor altruism or trust can possibly form clear bases for predictions about human behaviour. Both are not only confounded by heterogeneity in behavioural traits and choices, but are situated and change over time. Dawes and Thaler (1988, p. 195) capture this in an eloquent passage: In the rural areas around Ithaca it is common for farmers to put some fresh produce on the table by the road. There is a cash box on the table, and customers are expected to put money in the box in return for the vegetables they take. The box has just a small slit, so money can only be put in, not taken out. Also, the box is attached to the table, so no one can (easily?) make off with the money. We think that the farmers have just about the right model of human nature. They feel that enough people will volunteer to pay for the fresh corn to make it worthwhile to put it out there. The farmers also know that if it were easy enough to take the money, someone would do so.

Besides the negative evidence against any default propensity for opportunism, there is also direct positive evidence for the construct of docility – the fact that human beings are prone both to give and take advice. In a summary of findings on the subject, Schotter (2003, p. 196) concludes: (i) (ii)

Laboratory subjects tend to follow the advice of naïve advisors (i.e. advisors who are hardly more expert in the task at hand than they are). This advice changes their behavior in the sense that subjects who play

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games or make decisions with naïve advice play differently than those who play identical games without such advice. (iii) The decision made in games played with naïve advice are closer to the predictions of economic theory than those made without it. (iv) If given a choice between getting advice or the information upon which that advice was based, subjects tend to opt for the advice, indicating a kind of underconfidence in their decision-making abilities that is counter to the usual egocentric bias or overconfidence observed by psychologists. (v) The reason why advice increases efficiency or rationality is that the process of giving or receiving advice forces decision-makers to think about the problem they are facing in a way different from the way they would if no advice were offered.

For Simon the important point was that most of what we do we have learned from those around us because ‘[b]ehaving in this fashion contributes heavily to our fitness because . . . the information on which this advice is based is far better than the information we could gather independently. As a result, people exhibit a very large measure of docility’ (Simon, 1993, p. 157, italics in original). By fitness, Simon meant our biological fitness, that is, the effectiveness with which we produced progeny. Simon theorized that social information contributes so heavily to our fitness – it is such an adaptive trait – that docile human beings drove out non-docile human beings in actual evolutionary competition. He believed that ‘[t]he farther the complexities of the real world extend beyond our capabilities for knowledge and calculation, the more valuable is docility, to enable us to benefit from the collective knowledge and skill of our society’ (Simon, 1997b, p. 41). From a gene’s-eye perspective, docility would be strongly selected for because it enhances the reproductive fitness of each human being. In other words, docility is the individual’s way of leveraging the advantages of social living (including the rudimentary division of labour, which is thought to extend a million years into human history (Ridley, 1997)). As a result of being fitness-enhancing at the level of the gene, the population of human beings that now walks the planet exhibits a large degree of docility. It is interesting to speculate what a TCE that took docility as its fundamental behavioural assumption would look like. Perhaps we would need to go beyond bargaining to negotiation – and not merely distributive negotiation (aimed at dividing the pie) but integrative negotiation to grow the pie under negotiation (Pruitt, 1981; Pruitt and Lewis, 1975; Pruitt and Rubin, 1986). In other words, TCE could be incorporated into growth models and into the economics of innovation in new ways – not only competition but also cooperation could serve as a discovery procedure (Hayek, 1945, 1968). In fact, the results summarized by Schotter (2003) suggest an explicit role for docility in coming up with creative solutions to problems.

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Similarly docility-based TCE might provide ways to move beyond static models of social networks to dynamic ones. In a world view in which opportunism is not such a big hurdle and the ability and willingness to persuade and be persuaded is a dominant characteristic, humans will be able to build new relationships more easily and grow their networks faster. This could bring to the fore interesting challenges to current static models such as Burt’s (1992) structural holes. Simon the man It is perhaps appropriate to conclude with a biographical sketch of the scholar’s personal stance on the subject of behavioural assumptions at the heart of our choices in building a better society. In terms of personal political preference, Simon was a New Deal Democrat. In a characteristically profound yet simple way, he explained his choice as follows (Simon, 1991, p. 133): The reason is depressingly simple, and has little to do with the wisdom or unwisdom of specific policies of either political party. Among the fundamental problems in every society, two stand out. People have to be motivated to contribute to the society, to produce. At the same time, they have to be protected if they are unable to take care of themselves adequately. You can think of it as the balance between incentives and distributive justice. Too much concern with the latter may weaken the former, and vice versa. Using this simple-minded dichotomy, you can classify people (roughly) into two groups by their answers to the following question: Is it more important that (a) all chiselers be detected and removed from the welfare lists, or (b) no sparrow should fall from Heaven unseen and uncared for? If the answer is (a), the respondent is a Republican; if (b), a Democrat. Either answer is rationally defensible. I just happen to prefer the second one.

In a world where ‘liberal’ has become a bad word that current American politics is striving to re-define, it is perhaps time for economists too to rethink the fundamental assumption about human behaviour that is used to explain and inform the design of our social and political institutions. It is cause for comfort to know that while Simon, the scientist, urged this from an empirical standpoint, Simon, the person, also believed it would be a good guiding principle for building a better society. References Arrow, K.J. (1974), ‘Limited knowledge and economic theory’, American Economic Review, 54 (1), 1–10. Baumol, W.J. (2002), The Free-Market Innovation Machine: Analyzing the Growth Miracle of Capitalism, Princeton: Princeton University Press. Becker, G.S. (1976), The Economic Approach to Human Behavior, Chicago: University of Chicago Press.

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Burt, R. (1992), Structural Holes: The Social Structure of Competition, Cambridge, MA: Harvard University Press. Dawes, R.M. and R.H. Thaler (1988), ‘Anomalies: cooperation’, The Journal of Economic Perspectives, 2 (3), 187–97. Gauthier, D. (1984), ‘Deterrence, maximization, and rationality’, Ethics, 94 (3), 474–95. Hayek, F.A. (1945), ‘The use of knowledge in society’, American Economic Review, 35 (4), 519–30. Hayek, F.A. (1968), ‘Competition as a discovery procedure’, in F.A. Hayek, New Studies in Philosophy, Politics and Economics, Chicago: University of Chicago Press, pp. 179–90. Hill, C.W.L. (1990), ‘Cooperation, opportunism, and the invisible hand: implications for transaction cost theory’, Academy of Management Review, 15 (3), 500–514. Knudsen, T. (2003), ‘Simon’s selection theory: why docility evolves to breed successful altruism’, Journal of Economic Psychology, 24 (2), 229–44. Mandeville, B. (1714), The Grumbling Hive (re-issued, with notes, as, F.B. Kaye (ed.) (1988), The Fable of the Bees, Indianapolis: Liberty Fund). North, D.C. (1978), ‘Structure and performance: the task of economic history’, Journal of Economic Literature, 16 (3), 963–78. Pruitt, D.G. (1981), Negotiation Behavior, New York: Academic Press. Pruitt, D.G. and S.A. Lewis (1975), ‘Development of integrative solutions in bilateral negotiation’, Journal of Personality and Social Psychology, 31 (4), 621–33. Pruitt, D.G. and J.Z. Rubin (1986), Social Conflict: Escalation, Stalemate, and Settlement, New York: Random House. Rabin, M. (1998), ‘Psychology and economics’, Journal of Economic Literature, 36 (1), 11–46. Ridley, M. (1997), The Origins of Virtue, New York: Viking Press. Schotter, A. (2003), ‘Decision making with naïve advice’, American Economic Review, 93 (2), 196–201. Sen, A. (1985), ‘Well-being, agency and freedom: the Dewey Lectures 1984’, The Journal of Philosophy, 82 (4), 169–221. Simon, H.A. (1991), Models of My Life, New York, NY: Basic Books. Simon, H.A. (1993), ‘Altruism and economics’, American Economic Review, 83 (2), 156–61. Simon, H.A. (1996), Sciences of the Artificial, Cambridge: MIT Press. Simon, H.A. (1997a), ‘A mechanism for social selection and successful altruism’, Models of Bounded Rationality, 3, 205–16. Simon, H.A. (1997b), An Empirically Based Microeconomics, Cambridge, UK: Cambridge University Press. Smith, A. (1759 [2000]), The Theory of Moral Sentiments, Great Books in Philosophy, Amherst: Prometheus Books. Smith, A. (1776 [1981]), An Inquiry into the Nature and Causes of the Wealth of Nations, in R.H. Campbell and A.S. Skinner (eds), Glasgow Edition of the Works and Correspondence of Adam Smith, vol. II, Indianapolis: Liberty Fund. Stigler, G.J. and G.S. Becker (1977), ‘De gustibus non est disputandum’, American Economic Review, 67 (2), 76–90. Weber, M. (1905 [2001]), The Protestant Ethic and the Spirit of Capitalism, Classics Series, New York: Routledge. Werhane, P. (1991), Ethics and Economics: The Legacy of Adam Smith for Modern Capitalism, New York: Oxford University Press. Williamson, O.E. (1975), Markets and Hierarchies: Analysis and Antitrust Implications, New York: Free Press. Williamson, O.E. (1985), The Economic Institutions of Capitalism, New York: Free Press.

10 Property rights economics Nicolai J. Foss

The 1960s were extraordinarily fertile in applied as well as formal microeconomics. Thus the decade witnessed fundamental breakthroughs in the economics of uncertainty and information and in human capital theory, the first stabs at what would later be called ‘agency theory’ and ‘mechanism design’, and other advances in mathematical economics. One of the important breakthrough theories of the 1960s was property rights economics (PRE). ‘First-generation’ property-rights economists such as Armen Alchian, Ronald Coase, Harold Demsetz, and (Coase student) Steven Cheung developed a refined but mainly verbal approach to an economic explanation that they saw, and advertised, as fundamentally neoclassical but with a much wider explanatory reach. Their work served as direct inspiration for the slightly later work of the ‘secondgeneration’ PRE theorists such as Louis De Alessi, Yoram Barzel, Eirik Furubotn, Douglass North, Steven Pejovich, and John Umbeck. Modern (third-generation) representatives of the PRE are Douglas Allen, Lee Alston, Thrainn Eggertson, Gary Libecap, Dean Lueck, Ellinor Ostrom, and others. A different approach, emerging in the mid 1980s (Grossman and Hart, 1986), growing out of formal contract theory as well as key ideas in transaction cost economics (TCE), and associated with the work of Oliver Hart and his colleagues and students, is often also referred to as the ‘property-rights approach’. This approach will be briefly discussed towards the end of the chapter. PRE has been directly and strongly influential in law and economics (Coase, 1960), economic history (Alchian and Demsetz, 1973; North, 1990), the theory of the firm (Alchian and Demsetz, 1972), contract economics (for example, Cheung, 1970; Allen and Lueck, 1995), early comparative systems research (see Furubotn and Pejovich, 1972), and resource and agricultural economics (for example, Cheung, 1969; Libecap, 1989; Allen and Lueck, 1998). It has had a large, but less direct, influence on industrial organization, agency theory, and corporate governance (including the ‘Yugoslav firm’ debate as well as the debate on ‘co-determination’, see Furubotn and Pejovich, 1972). The basic analytical category proffered by the PRE is, of course, that of property rights, and the main explanatory aims have consistently been to investigate how the delineation, exchange, and enforcement of property 92

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and ownership rights influence resource allocation, and how this frames an economic approach to institutions and organizations. Thus, in a number of ways, the PRE is akin in its aims to TCE. Both acknowledge a fundamental debt to the thinking of Coase (1937, 1960) (Barzel and Kochin, 1992; Williamson, 1996), both place the notion of transaction costs centre stage in the explanatory structure of the theory, and there is some overlap in terms of explanandum phenomena. However, there are also important differences, most obviously that the PRE is more directly situated within neoclassical economics than TCE. Property rights Property-rights theorists often portray the PRE as fundamentally an extension of neoclassical economics, in the sense that: (1) the utilitymaximization hypothesis is applied to virtually all choices (Alchian, 1958, 1965; Barzel, 1997); (2) it considers all of the constraints implied by the prevailing structure of property rights and transaction costs (for example, Demsetz, 1964; Alessi, 1990); and (3) it explicitly considers the contractual, organizational, and institutional implications of (1) and (2) (Eggertson, 1990). In sum, introducing the notion of property rights very significantly extends the reach of economic thinking because it expands and refines the understanding of individuals’ opportunity sets. While true, this is also something of a retrospective rationalization. The PRE actually begins by introducing a new unit of analysis in a specific context, namely the analysis of externalities in Coase (1960), and the three characteristics above unfolded only gradually over the following decade. For example, the full implications of the zero-transaction-costs assumption – for example, that if transaction costs are zero monopolies do not influence resource allocation (Demsetz, 1964) and that all institutional alternatives are efficient (Cheung, 1969) – were not present in PRE thinking from the beginning, and are indeed still under debate (for example, Furubotn, 1991; Barzel, 1997). Thus, the unit of analysis in PRE is the property right. As indicated already, the first paper to put forward the property right explicitly as a meaningful unit of analysis is Coase (1960), although the property-rights ideas in that famous paper are anticipated in Coase’s 1959 paper on the allocation of radio frequencies (Coase, 1959) and a paper by Alchian (1958). Coase (1960) examines the economic implications of allocating legally delineated rights (liability rights) to a subset of the total uses of an asset, namely those that have external effects on the value of other agents’ abilities to exercise their use rights over assets. As part of his critique of the Pigouvian tradition in welfare economics, Coase (1960, p. 155) notes that a reason for its failure to come fully to grips with externality issues lies in

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its ‘faulty concept of a factor of production’, which, according to Coase, should be seen not as a physical entity but as a right to perform certain actions. These rights are property rights. A fundamental insight emerging from Coase’s work is that transactions involve the exchange of property rights (rather than goods and services per se). As Coase explained, property rights to an asset can be partitioned in various ways. Much subsequent work within PRE refined this insight, applying it to issues like public ownership and the public corporation. Yoram Barzel’s (1997) work in particular has been taken up with examining the consequences of the multi-attribute nature of most assets. It had long been recognized, of course, that some rights may be held in common, with open access, while other rights are held in private (Knight, 1924). However, unfolding the concept of property rights and its application to the public–private spectrum revealed that the range of property rights is very extensive indeed (Alessi, 1990). This led to a highly sophisticated analysis of how the property rights associated with an asset impact individual incentives, because property rights are fundamentally about who should bear the consequences of choices involving the relevant asset. Like the rest of economics, PRE assumes that behaviours vary predictably as a consequence of such incentives. Characteristics of property rights The analysis of the nature of property rights has clearly evolved within the PRE. Coase (1960) was mainly interested in the allocation of use rights to assets. Demsetz (1964) and Alchian (1965) went beyond this, defining property rights as individuals’ rights to the use, income, and transferability of assets, a definition corresponding to the partition in Roman law between usus, fructus, and abusus, respectively.1 The relation to property law was also debated. It became increasingly clear that property rights can be analysed conceptually apart from legal considerations (some scholars therefore talk about ‘economic rights’, for example, Barzel, 1997). In fact, it was recognized that property rights may exist in the absence of the state, that is, under wholly anarchic conditions (Bush and Mayer, 1974; Umbeck, 1981). Physical force or strong social norms may guarantee de facto control over the uses of and income from a resource. It also became clear that property rights have an inherently forward-looking dimension and that, therefore, uncertainty is an important aspect of property rights. Finally, it became clear that from an economic perspective property rights can be understood in value terms and that agents seek to maximize the value of the control they hold over assets. In line with such ideas, Alchian and Allen (1969, p. 158) offered a highly compact definition of property rights as ‘the expectations a person has

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that his decision about the uses of certain resources will be effective’ (see also Cheung, 1970). Barzel (1994, p. 394; emphasis in original) explains property rights as: an individual’s net valuation, in expected terms, of the ability to directly consume the services of the asset, or to consume it indirectly through exchange. A key word is ability: The definition is concerned not with what people are legally entitled to do but with what they believe they can do.

Essentially, property rights in such definitions refer to an individual’s expected opportunity set, and they imply that even Robinson Crusoe would hold property rights. They also suggest that the definition of a property right is independent of legal considerations; to the extent that he holds effective control over an asset, a thief holds property rights to that asset (Barzel, 1997). However, although property rights may thus exist potentially in the absence of law, in reality they have legal counterparts and the value of property rights is influenced by legal sanction and enforcement (Barzel, 1997). Not surprisingly, many property-rights scholars have strongly stressed the fundamentally social nature of property rights. Thus, Demsetz (1967, p. 347) argues that: [i]n the world of Robinson Crusoe property rights play no role. Property rights are an instrument of society and derive their significance from the fact that they help a man form those expectations which he can reasonably hold in his dealings with others. These expectations find expression in the laws, customs, and mores of a society. An owner of property rights possesses the consent of fellowmen to allow him to act in particular ways. An owner expects the community to prevent others from interfering with his actions, provided that these actions are not prohibited in the specifications of his rights.

Levels of analysis Such definitions direct attention to ‘macro’ determinants of property rights such as norms, customs, and law. Of course, norms defining property rights can exist on lower levels, such as within or between firms. Thus, corporate culture (Jones, 1983) and relational contracting (Williamson, 1996) serve to delineate and enforce property rights. Moreover, property rights are, of course, allocated in formal contracts. This suggests distinguishing various analytical levels at which property rights can be enforced. (Of course, property rights also exist on various levels; for example, both natural and corporate persons can hold property rights). Indeed such a distinction has been made in the PRE literature, notably in the work of Douglass North (1990), whose distinction between organizations and institutions captures the difference between the more micro propertyrights arrangements in the form of contracts and organizations and the

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macro property regimes embodied in laws, customs, and the coercive machinery of the state. Property rights and transaction costs Transaction costs were introduced by Coase in his 1937 paper on the firm (Coase, 1937), well before the 1960 paper on social cost (Coase, 1960). Arguably, one reason so little progress was made on the analysis in the first paper is that transaction costs are difficult to define without a clear conception of property rights (Barzel and Kochin, 1992). However, Coase (1960) does not systematically derive transaction costs from property rights. Instead, he defines the former as search costs, communication costs, bargaining costs, contract drafting costs, and contract monitoring costs (Coase, 1960, p. 15). Thus, transaction costs in Coase (1960) are a more refined version of the ‘costs of using the price mechanism’ introduced by Coase (1937) (Cheung, 1969). Indeed, the link between property rights and transaction costs that interests Coase (1960) is the fact that when transaction costs are positive, property rights are ill-defined, which reduces attainable output. Of course, this link between inputs, ‘organization’, and allocative consequences provided a vital overall framing that was crucially important for future thinking on the theory of the firm (Barzel and Kochin, 1992). Alchian’s (1958) almost simultaneous examination of the absence of private property rights in government links transaction costs and property rights in a different way. Alchian develops a general argument that government assets are insufficiently protected and that this leads to a failure of marginal pricing and use of government services. Thus, insecure property rights induce costly racing to capture wealth, an argument later refined in several contributions to the PRE (for example, Anderson and Hill, 1990; Lueck, 1995). Thus, transaction costs as waste result from ill-defined or ill-protected property rights. Actually, both causal processes (that is, transaction costs leading to illdefined property rights, and ill-defined and ill-protected property rights leading to transaction costs) take place, and the overall PRE perspective on contracts, organizations, and institutions is that these exist to minimize the allocative distortions implied by both processes (Eggertson, 1990; Lueck, 1995). Thus, in terms of the property-rights view of Hart (1995) transaction costs of drafting contracts make contracts incomplete (that is, property rights are ill-defined). This gives rise to a loss in terms of inefficient investments, which may also be seen as transaction costs, because it is an allocative distortion induced by direct transaction costs. In Williamson’s (1996) thinking, ill-defined contractual rights give rise to processes of costly ex post haggling.

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Still, transaction costs are probably most conveniently defined in terms of property rights, and most of the PRE has done exactly this. Thus, transaction costs can be defined as the resources spent on delineating, protecting, and capturing control over resources in use and in exchange (Eggertson, 1990; Barzel, 1997). A particular case of transaction costs is the measurement costs of inspecting attributes of goods and services elegantly analysed by Barzel (1982). A famous benchmark case obtains when transaction costs are zero: in what has become known as the ‘Coase theorem’ (Stigler, 1966), Coase (1960) shows that if transaction costs are zero – so that any property right can be costlessly delineated and protected – any allocation of property rights results in the same pattern of economic activities under which maximum value is created from the use of resources.2 The mechanisms underlying this remarkable result are that: (1) property rights to all possible uses of resources are delineated; (2) all property rights are priced; and (3) all property rights can be traded – all at zero cost. Maximizing agents will have incentives to trade property rights so that resources end up in those uses where their contribution to value creation is maximized. The Coase theorem is no doubt one of the most extensively debated pieces of economic thinking (for example, Cooter, 1982; Usher, 1998). While it is surely warranted to devote resources to clarifying key benchmark constructs, the Coase theorem is, as Coase emphatically insists (Coase, 1988), just that: a benchmark designed to serve as a starting point for analysis involving transaction costs. The PRE and TCE Of course, transaction costs are also central to Williamsonian TCE and PRE and TCE share many important features. The PRE emerged first; Furubotn and Pejovich’s (1972) and Alchian and Demsetz’s (1973) stock takings of accomplishments since Coase (1960) were published when TCE was in its infancy (Williamson, 1971). However, the influence of the PRE on Williamson’s thinking seems fairly limited. He does not use propertyrights terminology, is critical of specific PRE papers (for example, see the critique of Alchian and Demsetz, 1972, in Williamson, 1985), characterizes the PRE as a distinct approach (for example, characterizing Barzel’s work as the ‘measurement approach’ in Williamson, 1985), and sees property rights lying on a higher analytical level than his own concern with levels of analysis that involve the firm (Williamson, 2000). Moreover, certain distinct features set Williamson’s thinking apart from that of most propertyrights economists. In particular, Williamson’s insistence on bounded rationality does not resonate with all scholars associated with PRE (for example, Barzel and Kochin, 1992). On the other hand, key PRE scholar Armen Alchian is one of the originators of the emphasis on the problems

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caused by asset specificity in the context of incomplete contracting (Klein et al., 1978). The treatment of this problem and its remedies is a key concern in TCE, and is not inconsistent with the PRE. Property rights economics: old and new Much work in PRE has focused on differences between property-rights systems as alternative ownership arrangements (collective versus private ownership). However, the economic meaning of asset ownership does not seem to be pinned down precisely in PRE. Coase (1960) thinks of private ownership as possession of ‘the right to carry out a circumscribed list of actions’; that is, private ownership of an asset is the possession of a vector of use rights for that asset. However, ownership per se is what primarily interests Coase; his major concern is the allocation of use rights. Conceptually, this allocation can be separated from the ownership, because one can imagine that all possible uses (including future ones) of assets are known and can be contracted for (indeed, this is one possible interpretation of the Coase theorem). Under this interpretation, the concept of ownership and the issue of who owns an asset are unimportant if transaction costs are zero. Even when Coase relaxes the zerotransaction-cost assumption, his interest lies more in understanding the allocative consequences of different legal arrangements of use rights than ownership issues. Thus, a major problem left unaddressed by Coase is how far one needs to ‘relax’ the assumptions underlying the Coase theorem to produce a role for ownership. Coase’s understanding also left unresolved the role played by other types of economic rights besides use rights, such as income and alienability rights, in the function of ownership. What economic considerations determine the allocation of these rights? The PRE only partially succeeded in giving answers to the puzzles left by Coase. In fact, Demsetz (1988, p. 19) argues that the meaning of ownership is inherently ‘vague’ because there is no bound to the number of attributes, uses, and so on of an asset that can be owned, although he thinks that ‘certain rights of action loom more important than others. Exclusivity and alienability are among them’.3 Perhaps because of the perceived vagueness of the notion of ownership, PRE scholars have been more concerned with the efficiency consequences of property-rights allocation across agents when transaction costs are positive than the issue of ‘who owns an asset’. At the same time, ownership has a concrete meaning in the law: both legislation and jurisprudence distinguish the law relating to contract from the law relating to asset ownership. The law relating to ownership is more than simply part of a low-cost enforcement institution; it provides default rules or a ‘standard contract’ that reduces information and communication

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costs and has allocative consequences for this reason. Moreover, legal ownership is a low-cost way of allocating hitherto undiscovered uses of assets. For example, giving people legal ownership implies that they hold the legal right to future, as yet undiscovered, attributes of assets, in the sense that courts will not interfere with the use of these assets by the parties identified as the owners. In fact, the overall thrust in economics thinking about property rights has changed from the focus of the PRE (that is, the allocation of rights to an asset across multiple agents) to the issue of who owns an asset and why this matters, the key concern of what may be called the ‘new’ PRE (Grossman and Hart, 1986; Hart, 1995). Historically and theoretically, the new PRE has been developed in the context of the theory of the firm, more precisely the analysis of the vertical boundaries of the firm (Grossman and Hart, 1986), the key explanandum of TCE. Indeed, while contributors to the new PRE routinely make reference to Williamson, references to the old PRE are conspicuous by their absence from the new PRE. The new PRE approach begins with the idea that ownership of nonhuman assets is what defines the firm; if two different assets are owned by one person, there is one firm, while if the same two assets are owned by different persons, there are two firms. The assets that are relevant here are non-human assets, because human assets are non-alienable. The importance of non-human assets derives from their (potential) function as bargaining levers in situations not covered by contract. This may be crucially important when parties invest in specific assets – notably, investments in the parties’ own human capital – and these assets are complementary to specific non-human assets. Crucially, the parties’ investments in human assets are assumed to be non-contractible. All bargaining after the parties have made their investments in human assets is assumed to be efficient (in marked contrast to, for example, Williamson, 1996). Therefore, the model revolves around the effect of ownership of non-human assets on the incentives to invest in human assets. Specifically, bargaining determines the allocation of returns from investments, so that each party gets his or her opportunity cost plus a share (assumed equal) of the (verifiable) profit stream. Since in this setup individual returns differ from social returns, and agents are sufficiently farsighted to foresee this, investments will be inefficient. It is possible to influence the investment of one of the parties positively by reallocating ownership rights to non-human assets. A reallocation of ownership of physical assets alters the parties’ opportunity costs of noncooperation (the status quo) after specific investments have been made, and thus the expected pay-offs from the investments. However, this comes only at the cost of reducing one of the parties’ investment incentives

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(excepting the situation in which the parties’ marginal costs of investment are equal). This trade-off determines allocation of ownership and hence the efficient boundaries of the firm. Thus, the central issue of who owns an asset or a bundle of assets. Underlying this focus is the idea that it is possible to identify unambiguously the owner of an asset. A central idea in the new PRE is the distinction between specific rights of control and residual rights of control. The former can be delineated and directly allocated through contract, while the latter are obtained through the legal ownership of assets and imply the ‘right to decide usages of the asset in uncontracted-for contingencies’ (Hart, 1996, p. 371). However, residual control rights encompass not only the rights to use assets, but also to ‘decide when or even whether to sell the asset’ (Hart, 1995, p. 65). In the new PRE ownership is defined as the legally enforced possession of an asset. The economic importance of ownership stems from the owner’s ability to exercise residual rights of control over the assets. This economic conception is thus explicitly derived from the juristic conception. In other words, the function of ownership is to allocate residual rights of control. Thus, the meaning of ownership and its relation to property rights and the legal system are addressed straightforwardly. At first glance the new PRE notion of residual rights of control appears to be a conceptual sword cutting through the Gordian knot of the meaning of ownership in the old PRE literature. However, it does so by means of some drastic simplifications (Foss and Foss, 2001). Recall that a key point in the old PRE is an explicit distinction between the formal, legal title to an asset and the economic rights to that asset (for example, Coase, 1960; Alchian, 1965; Barzel, 1997). In the presence of transaction costs (particularly measurement and enforcement costs), this distinction is important for any asset, whether human capital or non-human capital. While these two asset categories are treated symmetrically in the old PRE, the new PRE treats them differently. In the new PRE ownership to, and contracts over, physical assets are assumed to be fully and costlessly enforced by the legal system, but contracts involving investments in human capital are assumed to be completely unenforceable because of an asserted non-verifiability. Foss and Foss (2001) argue that this asymmetry underlies the difficulty in the new PRE in conceptualizing the difference between quasi-vertical and vertical integration and in explaining the employment contract. Conclusion Relatively few economists today define themselves as working in the old PRE tradition. Over the last two decades or so (that is, since the publication of Grossman and Hart, 1986), property rights have received attention mainly because of the new PRE. It might thus appear that the old PRE

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is essentially defunct, that its largely verbal mode of discourse has been supplanted by the heavily formal approach of the new PRE. This view is naïve, however. First, the new PRE is a considerably narrower approach in terms of the phenomena it investigates. Second, the reason that relatively little old PRE research appears in today’s economics journals may be the old PRE’s success: property-rights reasoning has penetrated applied price theory, the theory of economic organization, agricultural economics, and many other fields, changing these fields in the process. Still, creative work lying directly in the old PRE tradition continues to be carried out by scholars such as Doug Allen, Yoram Barzel, Thrainn Eggertson, Dean Lueck, and others. Notes 1. Legal scholars may distinguish between ‘property’ (that is, having usus, fructus, and abusus rights) and ‘possession’ (that is, having only usus and abusus rights). However, PRE theorists think of all these rights as ‘property rights’. See Foss and Foss (2001). 2. And there are no ‘wealth effects’, that is, individuals do not change their consumption patterns and firms do not change their investment patterns when they obtain more wealth. 3. Typically, ownership has been defined in this literature depending on the analytical purpose. For example, Demsetz (1988) and Alchian (1965) both put much emphasis on the rights to exclude and alienate as the relevant criteria of private ownership in their work on systems of property rights, and see owners as those agents who can exercise these rights. However, they slightly change these latter criteria when they analyse the organization of the firm and corporate governance, where owners become defined as those possessing control rights (Demsetz, 1967) or residual income rights (Alchian and Demsetz, 1972).

References Alchian, A.A. (1958), ‘Private property and the relative cost of tenure’, in P.D. Bradley (ed.), The Public Stake in Union Power, Charlottesville, VA: University of Virginia Press, pp. 350–371. Alchian, A.A. (1965), ‘Some economics of property rights’, Il Politico, 30 (4), 816–29. Alchian, A.A. and W.R. Allen (1969), Exchange and Production: Theory in Use, Belmont: Wadsworth. Alchian, A.A. and H. Demsetz (1972), ‘Production, information costs, and economic organization’, American Economic Review, 62 (5), 772–95. Alchian, A.A. and H. Demsetz (1973), ‘The property rights paradigm’, Journal of Economic History, 33 (1), 16–27. Alessi, L. (1990), ‘Development of the property rights approach’, Journal of Institutional and Theoretical Economics, 146, 6–11. Allen, D.W. and D Lueck (1995), ‘Risk preferences and the economics of contracts’, American Economic Review, 85 (2) (Papers and Proceedings), 447–451 Allen, D. and D. Lueck (1998), ‘The nature of the farm’, Journal of Law and Economics, 41 (2), 343–86. Anderson, T.L. and P.J. Hill (1990), ‘The race for property rights’, Journal of Law and Economics, 33 (1), 177–97. Barzel, Y. (1982), ‘Measurement costs and the organization of markets’, Journal of Law and Economics, 25 (1), 27–48. Barzel, Y. (1994), ‘The capture of wealth by monopolists and the protection of property rights’, International Review of Law and Economics, 14 (4), 393–409.

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Barzel, Y. (1997), Economic Analysis of Property Rights, 2nd edn, Cambridge: Cambridge University Press. Barzel, Y. and L. Kochin (1992), ‘Ronald Coase on the nature of social cost as a key to the problem of the firm’, Scandinavian Journal of Economics, 94 (1), 19–31. Bush, W. and L. Mayer (1974), ‘Some implications of anarchy for the distribution of property’, Journal of Economic Theory, 8 (4), 401–12. Cheung, S.N.S. (1969), ‘Transaction costs, risk aversion, and the choice of contractual arrangements’, Journal of Law and Economics, 12 (1), 23–42. Cheung, S.N.S. (1970), ‘The structure of a contract and the theory of a non-exclusive resource’, Journal of Law and Economics, 13 (1), 49–70. Coase, R.H. (1937), ‘The nature of the firm’, Economica, N.S., 4 (16), 386–405. Coase, R.H. (1959), ‘The federal communications commission’, Journal of Law and Economics, 2, 1–40. Coase, R.H. (1960), ‘The problem of social cost’, Journal of Law and Economics, 3, 1–44. Coase, R.H. (1988), ‘Notes on the problem of social cost’, in R.H. Coase (1988), The Firm, the Market and the Law, Chicago: University of Chicago Press, pp. 157–85. Cooter, R. (1982), ‘The cost of Coase,’ Journal of Legal Studies, 11 (1), 1–33. Demsetz, H. (1964), ‘The exchange and enforcement of property rights’, Journal of Law and Economics, 7, 11–26. Demsetz, H. (1967), ‘Toward a Theory of Property Rights’, reprinted in H. Demsetz (1988), Ownership, Control, and the Firm, Oxford: Basil Blackwell, pp. 104–16. Demsetz, H. (1988), ‘A framework for the study of ownership’, in H. Demsetz, Ownership, Control, and the Firm, Oxford: Basil Blackwell, pp. 12–27. Eggertson, T. (1990), Economic Behavior and Institutions, Cambridge: Cambridge University Press. Foss, K. and N.J. Foss (2001), ‘Assets, attributes, and ownership’, International Journal of the Economics of Business, 8 (1), 19–37. Furubotn, E.G. (1991), ‘General equilibrium models, transaction costs, and the concept of efficient allocation in a capitalist economy’, Journal of Institutional and Theoretical Economics, 147 (4), 662–86. Furubotn, E. and S. Pejovich (1972), ‘Property rights and economic theory: a survey of recent literature’, Journal of Economic Literature, 10 (4), 1137–62. Grossman, S. and O. Hart (1986), ‘The costs and benefits of ownership: a theory of lateral and vertical integration’, Journal of Political Economy, 94 (4), 691–719. Hart, O. (1995), Firms, Contracts and Financial Structure, Oxford: Clarendon Press. Hart, O. (1996), ‘An economist’s view of authority’, Rationality and Society, 8 (4), 371–86. Jones, G.R. (1983), ‘Transaction costs, property rights, and organizational culture: an exchange perspective’, Administrative Science Quarterly, 28 (3), 454–67. Klein, B., R.A. Crawford, and A.A. Alchian (1978), ‘Vertical integration, appropriable rents, and the competitive contracting process’, Journal of Law and Economics, 21 (2), 297–326. Knight, F.H. (1924), ‘Some fallacies in the interpretation of social cost’, Quarterly Journal of Economics, 38 (4), 582–606. Libecap, G.P. (1989), Contracting for Property Rights, Cambridge: Cambridge University Press. Lueck, D. (1995), ‘The rule of first possession and the design of the law’, Journal of Law and Economics, 38 (2), 393–436. North, D.C. (1990), Institutions, Institutional Change, and Economic Performance, Cambridge: Cambridge University Press. Stigler, G.J. (1966), The Theory of Price, New York: Macmillan. Umbeck, J. (1981), ‘Might makes rights: a theory of the formation and initial distribution of property rights’, Economic Inquiry, 19 (1), 38–59. Usher, D. (1998), ‘The Coase theorem is tautological, incoherent or wrong’, Economics Letters, 61 (1), 3–11.

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Williamson, Oliver E. (1971), ‘The vertical integration of production: market failure considerations’, American Economic Review, 61 (2), 112–23. Williamson, O.E. (1985), The Economic Institutions of Capitalism, New York: The Free Press. Williamson, O.E. (1996), The Mechanisms of Governance, Oxford: Oxford University Press. Williamson, O.E. (2000), ‘The new institutional economics: taking stock, looking ahead’, Journal of Economic Literature, 38 (3), 595–613.

PART III FUNDAMENTAL CONCEPTS

11 The costs of exchange1 Alexandra Benham and Lee Benham

What determines what goods and services are traded on markets and therefore priced? What determines the flow of real goods and services and therefore the standard of living? (Ronald Coase, 1999)

The law of one price is a fundamental assumption in economics. It states that in a competitive market all individuals face the same price. Our thesis here is that if the appropriate price is measured, different individuals often face different prices for the same good, even in a competitive market. These price variations affect what is produced and what exchanges take place in and out of the market, which organizations and specialties survive, and which rules of the game persist. What is the appropriate price? Consider an individual making choices based on prices and budget constraints. The relevant price the individual faces is the full set of opportunity costs associated with those choices, including the prices of the goods themselves plus the transaction costs of obtaining the goods. Even if the money price of a particular good varies little across individuals, the opportunity cost of engaging in the transaction to obtain the good often varies substantially. This opportunity cost will be affected by the individual’s personal knowledge, personal network, transaction skills, time costs, location, organization, institutional setting, and so on. Only in very exceptional cases will all active participants in a transaction face identical opportunity costs. And even more rarely will all potential participants face identical opportunity costs. Definitions of costs Transaction costs Transaction costs are frequently invoked to explain economic phenomena.2 Yet direct empirical estimates of transaction costs are rare.3 The benefits of having better estimates are clear. Why does better information not currently exist? One problem is that there is no standard terminology. Many different definitions of transaction costs appear in the literature. They often serve as heuristic devices that are not used actually to measure transaction costs. These definitions offer powerful conceptual insights, but they have 107

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not been translated into widely accepted operational standards. Kenneth Arrow has defined transaction costs as ‘the costs of running the economic system’ (Arrow, 1969, p. 48, as noted in Furubotn and Richter, 1997, p. 40). Yoram Barzel defines transaction costs as ‘the costs associated with the transfer, capture, and protection of rights’ (Barzel, 1997, p. 4). Thrainn Eggertsson observes, ‘In general terms, transaction costs are the costs that arise when individuals exchange ownership rights to economic assets and enforce their exclusive rights. A clear-cut definition of transaction costs does not exist, but neither are the costs of production in the neoclassical model well defined’ (Eggertsson, 1990, p. 14).4 Eirik Furubotn and Rudolf Richter examine transaction costs in the following terms: [T]ransaction costs include the costs of resources utilized for the creation, maintenance, use, change, and so on of institutions and organizations. . . . When considered in relation to existing property and contract rights, transaction costs consist of the costs of defining and measuring resources or claims, plus the costs of utilizing and enforcing the rights specified. Applied to the transfer of existing property rights and the establishment or transfer of contract rights between individuals (or legal entities), transaction costs include the costs of information, negotiation, and enforcement (Furubotn and Richter, 1997, p. 40). Typical examples of transaction costs are the costs of using the market [market transaction costs] and the costs of exercising the right to give orders within the firm [managerial transaction costs]. . . . [There is also] the array of costs associated with the running and adjusting of the institutional framework of a polity [political transaction costs]. . . . For each of these three types of transaction costs, it is possible to recognize two variants: (1) ‘fixed’ transaction costs, that is, the specific investments made in setting up institutional arrangements; and (2) ‘variable’ transaction costs, that is, costs that depend on the number or volume of transactions (Furubotn and Richter, 1997 p. 43).

A second problem is that estimating transaction costs separately is highly problematic because production and transaction costs are jointly determined. Both theory and evidence suggest that changes in transaction costs have a first-order impact on the production frontier. Lower transaction costs mean greater specialization, more trade, changes in production costs, and increased output. Changes in production costs also alter transaction costs. Thus the impediments to isolating transaction costs are formidable. The costs of exchange To overcome some of these difficulties, we propose to examine a related measure that we call the costs of exchange. We measure the costs of exchange in terms of the opportunity cost faced by an individual to

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obtain a specified good using a given form of exchange within a given institutional setting. More specifically, we define the costs of exchange Cijkm as the opportunity cost in total resources – money, time, and goods – for an individual with characteristics i to obtain a good j using a given form of exchange k in institutional setting m.5 The costs of exchange therefore include both the cost of the good itself and the transaction costs incurred by the individual in obtaining the good. While we cannot decompose the costs directly into these components, in comparative contexts this approach focuses attention on the total cost consequences of differing transaction costs. Where transaction costs are very high, many transactions do not take place at all. Even when a specific transaction does occur, it may not take place in an open market context with money prices. Hence only a small subset of all potential transactions actually occur, and of these only a subset appear as market transactions. Knowledge of the opportunity costs of alternatives is obviously important in ascertaining why a particular individual undertakes a particular transaction. To understand the choices made, we may need to estimate the costs of those potential transactions that did not actually occur. Why costs of exchange vary The costs of exchange can be expected to vary across individuals, groups, and countries, both for some well understood reasons and for some less explored. In the economics literature, it is well accepted that transaction costs vary with tariffs, taxes, price controls, monopoly, price discrimination, information asymmetries, asset specificity, strategic behavior, and opportunism. However, actual estimates of the direct effects are rare. Furthermore, there are indirect effects. Tariffs, taxes, and price controls require regulations, monitoring, and a bureaucratic process that can alter transaction costs beyond the sectors that are directly regulated. Other elements likely to contribute significantly to variation include personal networks, formal and informal rules, and norms. Across countries and over time Many of the factors discussed above vary significantly across countries. Taxes and tariffs are obvious sources of price variation. The institutions of a country – the formal and informal rules of the game, including constitutional constraints, regulations, and norms, plus their enforcement characteristics, the mix of personal versus impersonal exchange – all vary enormously and are likely fundamentally to affect the costs of exchange.6 Elements such as corruption, social capital, and constitutional constraints have received attention (for example, see Knack and Keefer, 1997; Keefer,

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2001), but systematic analysis of their relationship to actual cost consequences is generally limited (see Benham and Benham, 1997). The types of organizations in a country – private, public, and cooperative – influence the costs of exchange. For example, state-owned enterprises typically have different incentive structures than their private counterparts, and this can be expected to have an impact not only on the price of goods but also on waiting times, forms of exchange, and the overall costs of exchange (The World Bank, 1995). Political connections are likely to assume greater importance in this case. Some economic models assume that countries with substantial natural endowments will have a comparative advantage in those products, and will have higher output. However, countries with abundant and readily accessible natural resources are often poor. The explanation here is straightforward: resource-rich countries are subject to greater rent-seeking, which in turn leads to higher costs of exchange. In addition, government decisionmakers there have less incentive to support transaction-cost-reducing institutions like the rule of law, because they can obtain funds directly by appropriating natural resources.7 Across individuals and groups There are some conventional and relatively well-explored reasons for different individuals (and groups) to face different costs of exchange. Long-standing reasons are variations in transportation costs and in the opportunity cost of time. Many other factors will also affect individuals’ costs of exchange. These include specialization in the exchange (and frequency of conducting this kind of exchange), skill in negotiating, local knowledge,8 personal networks, including elements of trust and social capital, political connections, and ethnic membership. For individuals possessing different characteristics, price controls or other state regulations will likely differentially alter their costs of exchange. Empirical illustrations of cost variations If different individuals face different costs of exchange, estimating these costs empirically requires a standardized methodology to gather information at the micro–micro level. We require information which specifies particular transactions in terms of the characteristics of the individual, the good to be obtained, the form of exchange, and the setting. Our approach is to select and specify some transactions in detail so that researchers can measure the time and money costs incurred when the transaction takes place. Individuals with designated characteristics (and by group or country) can then be interviewed concerning the full time and money costs

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they have actually incurred in engaging in the transaction. These will serve as our proxies for the costs of exchange.9 The fact that the money price paid for a good can vary across noncompetitive groups is recognized. The same is also true if the commodity is non-tradable. However, as the examples below show, transaction costs can be large and highly variable compared to variability in money price. Let us consider the following examples. Variations in costs of exchange across countries First, consider the simple transaction of obtaining a land-line business telephone. The costs here affect the size of the telephone communications network, the extent of use, the overall size of the market, and the extent of specialization, particularly so prior to the introduction of cell phones. In the early 1990s, we investigated the cost of obtaining a business telephone in several countries. The actual price to obtain a telephone installed within two weeks ranged from US$130 in Malaysia to US$6000 in Argentina. In Egypt in l996, the official published price for a telephone was US$295 and the official published ‘urgent response’ price was US$885. To proxy for the opportunity cost, we compared the purchase prices for similar Cairo apartments with and without a telephone already installed. This difference, which reflects the expected spot market price for a telephone for someone not well-connected in this market, was approximately US$1180 to US$1770. The costs of transferring ownership provide another example. Efficient transfer of ownership of assets is fundamental to a modern market economy. The costs associated with transferring ownership of an apartment can be examined in this context. In Cairo, an individual who bought an apartment in the 1990s and registered the transfer of ownership paid an additional 12 percent of the apartment price to third parties: 6 percent for taxes and 6 percent for a lawyer to register the transfer as required by law. The services of a real estate agent, which were optional, cost about 1.5 percent of the sale price. In St Louis, Missouri, USA, the cost of legally transferring ownership was approximately 1.5 percent of the sale price. If the services of a real estate agent were used there, they cost 6 percent of the sale price. The differences across these rates are striking. Within the statecontrolled sector, fees were eight times as high in Cairo as in St Louis, but within the competitive sector, they were only one-fourth as high (Benham, 1997). Transactions across national borders are important indicators of the extent of the market. To look at variation across countries, we examined the costs of exchange associated with importing a crankshaft for a large earthmoving tractor. In Peru in 1989, formally obtaining such a crankshaft

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cost four times as much in money price and over 280 times as much in waiting time (41 weeks versus one day) as in the USA. In Argentina, the money price was twice that in the USA, and the waiting time was up to 30 days. In contrast, in Malaysia the money price and waiting time were essentially the same as in the USA. In Hungary, before currency and import regulations were liberalized around 1989, it took 30–48 weeks to replace a crankshaft for a western-made tractor; after liberalization, this wait dropped to two weeks. A related measure during this period was the average waiting time to clear items already in port. In Singapore this was 15 minutes, while in Tanzania it was 7–14 days, with waits of up to 91 days reported (The Services Corporation, 1998). The 14 days’ wait in Tanzania was more than 1300 times the average waiting time in Singapore. Obtaining legal permission to open a new business is another arena of interest. A study of these costs using a simulation approach is included in Hernando de Soto’s book, The Other Path (1989). In Lima, Peru, in 1983 it took 289 days of full-time work by a team of researchers to go through all the legal steps to obtain all the permits necessary to open a small textile firm, without paying (many) bribes or using political connections (de Soto, 1989).10 It is not clear that anyone in Peru other than de Soto’s team ever went through this entire process to obtain a permit, but this estimate of opportunity cost was entirely consistent with the choices individuals were making at that time. Those without political connections typically remained in the informal sector, not legally registered. When de Soto repeated the simulation in Tampa, Florida, USA, it took only two hours to obtain a permit to open a small business. Thus in Peru the time cost was over 1000 times as high as in Florida. In this kind of highly bureaucratized environment, the costs of not being physically located in the capital city can be daunting. For example, in Tanzania a business partnership based in Mwanza outside the capital spent five to ten times as long to register as a business partnership based in Dar-es-Salaam (The Services Corporation, 1998). A study by Djankov et al. (2000) examined the regulation of business entry in 75 countries by tabulating the number of steps officially required to open a new business. They found wide variations, for example two days, two procedures, and US$280 fees in Canada versus 154 days, 12 procedures, and US$11 612 fees in Austria. The World Bank has expanded this approach to obtain some measures of costs across 183 countries (The World Bank, 2010).11 Variations in costs of exchange across individuals When we ask individuals within a given setting what it costs to do something, we often find substantial heterogeneity in responses. A survey of

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Table 11.1 Bulgaria 2000: How did you register your firm, how many days did that take, and how much did it cost? How many days did it take?

How much did it cost? (levs)

Registered without an intermediary Median Mean Minimum Maximum

(N = 81)

(N = 59)

15 22 1 90

100 211 6 5000

Registered through an intermediary Median Mean Minimum Maximum

(N = 34)

(N = 25)

14 20 1 90

140 157 1 500

Source:

Adapted from Gancheva (2000).

Bulgarian business owners illustrates large variability in time and money costs to register a new firm. Results are shown in Table 11.1. As in any survey, some respondents may have under- or overestimated their actual experience here, but it is most unlikely that this range of reported experience is due wholly to measurement error. Classifying all variation in reports as measurement error assumes that all face the same price. It is also important to note that only established businesses were queried, so this example captures only the variability across individuals who successfully registered their firms. No information is provided here on the perceived costs faced by those who were deterred from actually registering. Obviously, these latter costs are highly relevant for many issues, and not including them biases the overall expected costs of exchange. However, estimating these non-incurred costs is very difficult. Variations in money prices The variations in the costs of exchange discussed above are large compared with variations commonly reported in money prices. In economic theory and textbooks, monopolies are considered to be a principal source of price distortion. Yet in developed countries, monopolies rarely sustain long-run money prices more than 20 percent above the competitive level.

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To get a sense of the magnitude of international price variations for a standardized good that is locally produced and consumed, consider the variation across countries in the money cost of a McDonald’s Big Mac, as reported by The Economist in 2009.12 The highest price observed was US$5.60 in Switzerland, and the lowest was US$1.52 in Malaysia. The ratio of the highest to lowest price observed is 3.68. As another illustration, across 44 countries, the price of electricity per kilowatt-hour for industry in 1999 varied from 1.8 US cents in Kazakhstan to 16.3 US cents in Grenada, a ratio of 9.06.13 For more clearly tradable goods, price variation should – according to the standard analysis – be smaller. Haskel and Wolf examined more than 100 manufactured household items sold by IKEA, a Swedish furniture retailer, across 25 countries for the years 1995–1998 (Haskel and Wolf, 2001). They found the median differences across countries in catalog prices were 20–30 percent for most goods. The price difference between the cheapest and the most expensive stores in the sample exceeded 50 percent for most goods, with ranges up to 900 percent. The variation in these money prices – although smaller than the variations discussed above for costs of exchange – are nevertheless surprisingly large. Price data are typically collected and reported in ways that do not capture or investigate fully the variation in the money prices which individuals face. The emphasis is generally on estimating and comparing mean prices, and when substantial variation appears this is often seen as grounds for rejecting outliers or the whole sample.14 Haskel and Wolf and a few other researchers are exceptions in systematically examining money price variations across outlets and countries in great microeconomic detail. This is an important step. However, it still misses much of the variation in opportunity costs facing different individual buyers. Conclusions The costs of exchange that individuals incur to obtain a specific good or service – that is, the money price plus the transaction costs – vary substantially across individuals and across countries. We have observed costs in some countries that are ten times, 100 times, even 1000 times as great as in other countries.15 These variations are far greater than those reported in the published data on money prices. The published price data that economists typically use often poorly represent the opportunity costs facing individuals who are deciding what exchanges to undertake. The expense of obtaining data to measure the costs of exchange is a major deterrent to the undertaking. Given the difficulty of collecting credible market price data (for example, determining if the posted price is what people actually pay), how realistic is it to advocate the use of an even more

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costly metric? In some cases, low-cost proxies may emerge for measuring these costs,16 but in general the data are expensive to collect in both time and money (see Timoshenkov and Nashchekina, 2006). In cases where all parties to transactions want to suppress information, the costs of measuring opportunity costs are likely to be especially high. In a study of corrupt regulatory practices faced by business owners in Ukraine, expensive interviews that guaranteed anonymity yielded substantially different estimates of the costs of corruption than studies using more conventional interviewing and sampling techniques. The economics profession has by and large avoided the effort of gathering such primary data, particularly at this level of micro detail.17 The standard unadorned price-theoretic model, elegant and powerful as it is, explains only a modest share of phenomena that economists address. Economists augment this standard model by invoking a variety of auxiliary concepts such as asymmetric information, imperfect competition, social capital, and institutions.18 These concepts can be characterized in terms of transaction costs, but the lack of clear definitions and empirical measures often hinders efforts to assess their impact. Indeed, standard analysis frequently assumes that certain transaction costs are infinite (for example, that it is prohibitively costly to exchange information), while the other transaction costs are zero. Rarely are attempts made to measure the actual transaction costs. We suggest that the power of the basic pricetheoretic model will be enhanced by considering as the relevant price the opportunity costs that individuals actually face. Notes 1. 2.

3.

4.

Substantial portions of this chapter are adapted from Benham and Benham (2000). Searching EconLit for the year 2007 (American Economic Association, 2007), we found 3467 publications with ‘transaction cost(s)’ mentioned in the text. For comparison, 4231 articles mentioned ‘imperfect’ in the text, as in imperfect market or imperfect information. For an alternative methodology to estimate the size of the transaction cost sector, see Wallis and North (1986). Eigen-Zucchi (2001) has been developing an indicator of transaction costs using a variety of cross-country indices including stability of money supply, corruption, and communication variables. Eggertsson continues (1990, p. 15): When information is costly, various activities related to the exchange of property rights between individuals give rise to transaction costs. These activities include: 1. the search for information about the distribution of price and quality of commodities and labour inputs, and the search for potential buyers and sellers and for relevant information about their behavior and circumstances; 2. the bargaining that is needed to find the true position of buyers and sellers when prices are endogenous; 3. the making of contracts; 4. the monitoring of contractual partners to see whether they abide by the forms of contract;

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5. 6. 7.

8.

9.

10.

11.

12. 13. 14.

15.

16. 17.

The form of exchange refers to the type of market (formal vs informal) in which the exchange takes place, or to dimensions such as pecuniary versus barter exchange. See for example the discussion of personal and impersonal exchange in North et al. (2009). Sachs and Warner (2001) summarize and extend research showing that countries with great natural resource wealth tend to grow more slowly than resource-poor countries. They find that there is little direct evidence that omitted geographical or climate variables explain this, or that there is a bias resulting from other unobserved growth deterrents. They find that resource-abundant countries tend to be high-price economies and to miss out on export-led growth. An individual possessing what Hayek (1945) termed ‘local knowledge’ can typically accomplish things faster, better, and cheaper than individuals without that local knowledge. This means lower transaction costs in that domain for that individual. Local knowledge differs across individuals and is much less transparent than market price. Note that this framework focuses on the opportunity cost faced by an individual seeking to enact a specified form of exchange (for example, via formal contract or informal arrangement, money or barter compensation) in a specified institutional setting. It does not include the costs of building market institutions, the costs of setting the political framework in place, or the cost to the individual of creating personal networks, establishing a reputation, or developing transaction-related skills. This option was open to everyone, but the costs were prohibitive to most individuals in the society. These costs vary depending on the social and political position of the persons involved in the transaction. If we simulated the process of conducting the necessary exchanges to start producing in the informal sector, different groups would likely have a comparative advantage in that setting. ‘Doing Business’, The World Bank (2010). The methodology used here is to estimate costs by making inquiries of the experts in the subject area, for example lawyers or accountants. The actual costs that individuals encounter when involved in the transaction are not collected. This has the merit of much lower costs of obtaining the information as compared to the survey of individuals involved in the transaction. For a discussion of some of the measurement and application issues with this method, see Arruñada (2007). Big Mac Index from The Economist, 4 February 2009. The mean is 7.05 cents and the standard deviation is 3.44 cents, measured in US dollars per kilowatt-hour; see International Energy Agency (2001). For example, a recent international price comparison study of branded and generic consumer items across four countries was commissioned by the Department of Trade and Industry in the UK. Given the goal of producing estimates of average prices with a margin of error within certain prescribed boundaries, the report comments: ‘As a guideline, we have considered a coefficient of variation greater than 20% to indicate inherently high variability in the price data collected’. Under some circumstances high variability led to items being rejected for reporting purposes; see UK Department of Trade and Industry (2000). Visas to enter the host country are an important intermediate good for attendance at international conferences. In the process of helping several participants to obtain visas for a conference in France in 1998, we observed that the time price was easily 100 times as high in some cases as in others. Djankov et al. (2000) use the officially stated number of steps, fees, and times required to obtain permission to open a new business. Among the few exceptions is the work by Stone et al. (1996).

The costs of exchange 18.

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Transaction cost economics is among the most successful approaches within the field of industrial organization. ‘The primary objective of transaction cost economics (TCE) is to understand how variations in certain basic characteristics of transactions lead to the diverse organizational arrangements that govern trade in a market economy’ (Joskow, 2001). Good examples of work in this area are Joskow (1985) and Williamson (1985). For reviews of the literature see Shelanski and Klein (1995), and Boerner and Macher (2001), who provide a discussion of the methodology within the field. Numerous studies classify firms by, say, their degree of asset specificity and from that predict and examine governance structures, degree of vertical integration, and contractual forms.

References Alston, Lee J., Thrainn Eggertsson, and Douglass C. North (eds) (1996), Empirical Studies in Institutional Change, Cambridge: Cambridge University Press. American Economic Association (2007), EconLit (electronic bibliography), available at: http://www.aeaweb.org/econlit/index.php (accessed 20 March 2010). Arrow, K.J. (1969), ‘The organization of economic activity: issues pertinent to the choice of market versus non-market allocation’, in The Analysis and Evaluation of Public Expenditures: The PBB-System, Joint Economic Committee, 91st Congress, 1st session, vol. 1, Washington DC: Government Printing Office. Arruñada, Benito (2007), ‘Pitfalls to avoid when measuring institutions: is “Doing Business” damaging business?’, Journal of Comparative Economics, 35 (4), 729–47. Barzel, Yoram (1997), Economic Analysis of Property Rights, 2nd edn, Cambridge: Cambridge University Press. Benham, Alexandra and Lee Benham (1997), ‘Property rights in transition economies: a commentary on what economists know’, in Joan M. Nelson, Charles Tilly, and Lee Walker (eds) (1997), Transforming Post-Communist Political Economies, Washington, DC: National Academy Press, pp. 35–60. Benham, Alexandra and Lee Benham (2000), ‘Measuring the costs of exchange’, in Claude Ménard (ed.) (2000), Institutions, Contracts and Organizations: Perspectives from New Institutional Economics, Cheltenham, UK and Northampton, MA, USA: Edward Elgar Publishing, pp. 367–75. Benham, Lee (1997), On Improving Egypt’s Economic Performance: The Costs of Exchange, Cairo: Egyptian Center for Economic Studies, Working Paper No. 13. Boerner, Christopher S. and Jeffrey T. Macher (2001), ‘Transaction cost economics: an assessment of empirical research in the social sciences’, unpublished manuscript. Coase, Ronald H. (1999), ‘The task of the society: opening address to the annual conference, September 17, 1999’, Newsletter of the International Society for New Institutional Economics, 2 (2), 1. de Soto, Hernando (1989), The Other Path: The Invisible Revolution in the Third World, New York: Harper and Row. Djankov, Simeon, Rafael La Porta, Florencio Lopez-de-Silanes, and Andrei Shleifer (2000), The Regulation of Entry, Cambridge, MA: National Bureau of Economic Research. Eggertsson, Thrainn (1990), Economic Behavior and Institutions, Cambridge: Cambridge University Press. Eigen-Zucchi, Christian (2001), ‘Towards the development of an indicator of transactions costs’, unpublished manuscript. Engerman, Stanley L. and Robert E. Gallman (eds) (1986), Long-term Factors in American Economic Growth, Studies in Income and Wealth, No. 51, Chicago and London: University of Chicago Press. Furubotn, Eirik G. and Rudolf Richter (1997), Institutions and Economic Theory: The Contribution of the New Institutional Economics, Ann Arbor: The University of Michigan Press.

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Gancheva, Yordanka (2000), Rules, Regulations and Transaction Costs in Transition Bulgaria, Sofia: Institute for Market Economics. Haskel, Jonathan and Roger Wolf (2001), ‘The law of one price – a case study’, CESifo Working Paper No. 428, March 2001, Munich, Germany: Center for Economic Studies and Ifo Institute for Economic Research. Hayek, Friedrich (1945), ‘The use of knowledge in society’, American Economic Review, 35 (4), 519–30. International Energy Agency (2001), ‘Energy prices and taxes – quarterly statistics’ (Third Quarter 2000, Part II, Section D, Table 19, and Part III, Section B, Table 18), Paris: International Energy Agency, available at: http://eia.doe.gov/emeu/international/elecprii. html. Joskow, Paul L. (1985), ‘Vertical integration and long-term contracts: the case of coal-burning electric generating plants’, Journal of Law, Economics, and Organization, 1 (1), 33–80. Joskow, Paul L. (2001), ‘Transaction cost economics and competition policy: keynote address to the annual conference, September 23, 2000’, Newsletter of the International Society for New Institutional Economics, 3 (1), 1. Keefer, Philip (2001), ‘When do special interests run rampant? Disentangling the role of elections, incomplete information and checks and balances in banking crises’, unpublished manuscript. Knack, Stephen and Philip Keefer (1997), ‘Does social capital have an economic payoff? A cross-country investigation’, Quarterly Journal of Economics, 112 (4), 1251–88. Ménard, Claude (ed.) (2000), Institutions, Contracts and Organizations: Perspectives from New Institutional Economics, Cheltenham, UK and Northampton, MA, USA: Edward Elgar Publishing. Nelson, Joan M., Charles Tilly, and Lee Walker (eds) (1997), Transforming Post-Communist Political Economies, Washington, DC: National Academy Press. North, Douglass C., John Joseph Wallis, and Barry R. Weingast (2009), Violence and Social Orders: A Conceptual Framework for Interpreting Recorded Human History, Cambridge: Cambridge University Press. Sachs, Jeffrey D. and Andrew M. Warner (2001), ‘The curse of natural resources’, European Economic Review, 45 (4–6), 827–38. Shelanski, Howard and Peter Klein (1995), ‘Empirical research in transaction cost economics: a review and assessment’, The Journal of Law, Economics and Organization, 11 (2), 335–61. Stone, Andrew, Brian Levy, and Ricardo Parades (1996), ‘Public institutions and private transactions: a comparative analysis of the legal and regulatory environment for business transactions in Brazil and Chile’, in Lee J. Alston, Thrainn Eggertssson, and Douglass C. North (eds) (1996), Empirical Studies in Institutional Change, Cambridge: Cambridge University Press, pp. 95–128. The Economist (2009), ‘Big Mac Index’, 4 February, available at: http://www.economist. com/markets/indicators/displaystory.cfm?story_id E1_TPDVVGVD (accessed 19 March 2010). The Services Corporation (1998), USAID Executive Summary, The Investor Roadmap to Tanzania, unpublished report. Timoshenkov, Igor V. and Olga N. Nashchekina (2006), ‘How good are we at estimating barriers to business? A close look at the Ukrainian business environment’, unpublished working paper. UK Department of Trade and Industry (2000), ‘A report into international price comparisons prepared for the Department of Trade and Industry’, conducted by ACNielsen, available at: http://webarchive.nationalarchives.gov.uk/tna/+/http://www.berr.gov.uk/ files/file33054.pdf. Wallis, John J. and Douglass C. North (1986), ‘Measuring the transaction sector in the American economy, 1870–1970’, in Stanley L. Engerman and Robert E. Gallman (eds) (1986), Long-term Factors in American Economic Growth, Studies in Income and Wealth, No. 51, Chicago and London: University of Chicago Press, pp. 95–161.

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Williamson, Oliver E. (1985), The Economic Institutions of Capitalism, New York: Free Press. World Bank (1995), Bureaucrats in Business: The Economics and Politics of Government Ownership, Oxford: Oxford University Press. World Bank (2010), ‘Doing business: measuring business regulations’, available at: http:// www.doingbusiness.org/ (accessed 19 March 2010).

12 Asset specificity and holdups Benjamin Klein

Specific assets are assets that have a significantly higher value within a particular transacting relationship than outside the relationship. To illustrate, consider the classic Fisher Body–General Motors case.1 In 1919 Fisher Body undertook a very large expansion in its capacity to supply bodies to General Motors. Automobile bodies, like many other productive inputs, are not sold in a spot market. Therefore, if General Motors decided to stop purchasing from Fisher after Fisher Body made its capacity investments, the Fisher capacity used to produce bodies for General Motors could not immediately and costlessly be transferred to the production and sale of bodies to other automobile companies. Consequently, once Fisher Body made the investment, the plants Fisher built to supply General Motors had a higher value within the General Motors relationship than outside the General Motors relationship. The difference in value within and outside the General Motors relationship is equal to the General Motorsspecific element of the assets.2 The economic relevance of specific assets is that they create the potential for holdups. Once a transactor makes a relationship-specific investment, its transacting partner has the ability to take advantage of the specificity to appropriate some of the rents the transactor expects to earn on the investment. For example, after Fisher Body made its somewhat General Motors-specific capacity investments General Motors could threaten to stop purchasing bodies from Fisher and impose a capital cost on Fisher Body equal to the value of the General Motors-specific element of Fisher’s capacity investments. Therefore, General Motors could, in principle, negotiate to obtain part (often assumed in theoretical models to be half) of the value of Fisher’s General Motors-specific assets, by demanding either a lump-sum payment or a reduction in future body prices. Consequently, because transactors expect that they may lose a share of the return on their specific investments when a holdup occurs, one of the economic costs associated with holdups involves the reduced incentive of transactors to make efficient relationship-specific investments. These costs, however, are reduced because transactors, aware of the risks associated with specific investments, design contractual arrangements that avoid the likelihood of holdups. Asset specificity and the associated holdup potential, therefore, is an important economic determinant of contractual arrangements. 120

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Contractual solutions to potential holdups When transactors plan to make significant relationship-specific investments they often adopt explicit contract terms that, in combination with transactor reputational capital, reduce the ability and economic incentive for transactors to engage in a holdup. This use of a contractual arrangement to control the holdup potential associated with specific investments is illustrated by the Fisher Body–General Motors case, where a long-term contract was used to control the anticipated potential holdup problems. In particular, before Fisher made its General Motors-specific capacity investments, General Motors contracted to purchase all its closed auto bodies from Fisher Body over the next ten years. By making this long-term exclusive dealing commitment General Motors gave up the ability to hold up Fisher Body since General Motors could no longer threaten to switch its purchases to another body manufacturer. The contract therefore protected Fisher Body’s large General Motors-specific investments.3 Of course, General Motors would not make such an exclusive purchase commitment without also receiving contractual price protection. In the absence of price protection Fisher Body could take advantage of the longterm General Motors exclusive commitment to raise body prices without worrying about General Motors switching its purchases to another supplier. The exclusive contract therefore included provisions whereby the price of bodies was set on a cost-plus basis that permitted Fisher Body to earn a normal rate of return on its capital investments in plant and equipment required to supply bodies to General Motors.4 Contractual solutions to holdup problems may include other ways to control long-term prices, with or without the presence of exclusive dealing, such as most-favored customer clauses or indexing to independently published price indices where appropriate. But these and other contractual devices designed to prevent holdup problems are inherently incomplete, in the sense that contracts do not accurately cover every possible future contingency or fully define all aspects of transactor performance in a court-enforceable way. Consequently, there may be significant contract negotiation costs associated with the presence of relationship-specific investments, as transactors attempt to negotiate advantageous contract terms that both reduce the probability they will be held up and increase the probability they will be able to take advantage of imperfect contract terms to engage in a holdup. In addition, transactors recognize that when they make specific investments and enter imperfect contracts they may bear rent-dissipating economic costs during a transitional contract renegotiation process when ex post conditions that are not covered by the contractual arrangement develop and a holdup occurs.

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Ex post contractual problems Because real world contracts are inherently imperfect, there is a possibility in all contractual arrangements that a transactor will be able to take advantage of the agreed-upon contract to appropriate some of the return on its transacting partner’s relationship-specific investments. When this occurs the imperfect long-term contract terms used to solve potential holdup problems in the face of specific investments may actually induce holdups. This is vividly illustrated by the changes that occurred over time in the Fisher Body–General Motors contractual relationship. In particular, the Fisher Body–General Motors contract did not cover the unexpected contingency that arose in 1922 when General Motors asked Fisher Body to build smaller body-producing plants co-located with General Motors assembly plants. Fisher resisted General Motors’ demand for co-located body plants and used this development to negotiate a highly favorable adjustment in the contractual arrangement, whereby General Motors made half of Fisher Body’s required additional capital investments. This resulted, under the unchanged cost-plus body pricing formula originally designed to provide Fisher Body with a competitive return on its capital investments, in a large wealth transfer from General Motors to Fisher Body. General Motors had little choice because it was operating under a long-term exclusive dealing contract, and therefore could not switch its purchases of bodies to an alternative supplier. Consequently, the exclusive dealing contract designed to protect Fisher Body’s original General Motors-specific capacity investments against a holdup threat by General Motors created conditions whereby Fisher Body held up General Motors. The Fisher Body–General Motors case demonstrates, however, that there are economic reasons to expect that a holdup, if it occurs, may not involve very significant rent-dissipating costs. Although Fisher Body clearly conveyed to General Motors in 1922 its reluctance to make efficient co-located plant investments, all the new Fisher Body plants built during 1922–24 were co-located with General Motors assembly facilities (Coase, 2000). However, this does not mean that Fisher Body did not engage in a holdup during this period. One must distinguish between how a transactor may threaten to hold up its transacting partner (Fisher refusing to make co-located plant investments) and how a holdup is actually accomplished (Fisher negotiating a highly favorable contract adjustment in return for agreeing to make the co-located plant investments). If contract rights are clearly specified and transaction costs are low, as they generally will be with only two transactors who have similar information, we would expect a negotiated solution to be reached and contract terms adjusted to the new, post-holdup equilibrium in a way that

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minimizes rent-dissipating transitional economic inefficiencies. Therefore, it is not surprising that the holdup was accomplished in the Fisher Body– General Motors case without an inefficient increase in transportation and other costs from mislocated plants. Instead, the holdup was accomplished by Fisher Body renegotiating the contract so that General Motors made a significant part of the required new plant investments. This decreased Fisher Body’s capital relative to its sales and, under the pricing terms of the contract, increased Fisher’s profitability and General Motors’ cost of bodies while avoiding any inefficiencies. In this way the total pie continued to be maximized while Fisher Body’s share of the pie increased.5 However, in contrast to the rapid contractual adjustment made by Fisher Body and General Motors in 1922, a contractual impasse between Fisher Body and General Motors persisted during 1925–26 over the terms of a new adjusted Fisher Body–General Motors relationship and a required new Buick body plant investment in Flint. This resulted in transitional inefficiencies, as Fisher Body continued to supply Buick bodies from Detroit rather than from the more efficient proposed Flint location. These difficulties arose because General Motors also was negotiating to acquire the remaining 40 percent interest of Fisher Body it did not already own. General Motors firmly believed that these acquisition terms should not reflect the increased profit Fisher Body had been earning since 1922 on the renegotiated General Motors body supply contract. In 1926 General Motors, in fact, successfully concluded these negotiations on terms that did not provide Fisher Body any continuing financial return for its past holdup (Klein, 2007, pp. 20–22). Increased General Motors control associated with vertical integration also largely eliminated the possibility of any future Fisher Body holdup. The economic benefit of increased control achieved by General Motors with vertical integration entailed the economic cost of a reduced Fisher profit incentive. It is this reduction in economic incentives associated with vertical integration that presumably explains why General Motors and Fisher Body did not adopt a full vertical integration type of contractual arrangement in 1919 when they initially entered their relationship. They expected the particular long-term, fixed-price formula, exclusive dealing contractual arrangement they designed could handle holdup problems while also preserving increased Fisher Body economic incentives. However, the analysis of the Fisher Body–General Motors case illustrates that because long-term contracts may create, as well as solve, potential holdup problems, vertical integration sometimes is the contractual arrangement that prevents potential holdup problems most cheaply. Integration avoids the difficulties that were created with the imperfect long-term, fixed-price formula body supply contract. In fact, integration eliminated the need for

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any automobile body supply contract. Rather than attempt to specify performance contractually, General Motors, as the employer/owner of Fisher Body, could now more flexibly organize production since it possessed the legal power to unilaterally make important investment and management decisions. And these control benefits associated with vertical integration at this point in time outweighed the costs of reduced Fisher incentives.6 Why does a holdup occur? Some economists are skeptical regarding the economic importance of asset specificity and associated holdups as a determinate of vertical integration. For example, Coase claims that ‘the incentive for opportunistic behavior is usually checked by the need to take account of the effect on future business’ and that there are ‘contractual devices that could be used to handle the problem’ (Coase, 2006, pp. 259–60). Transactors do employ their reputational capital and contract terms to design contractual arrangements whereby holdups are avoided. In fact, the exclusive dealing contractual arrangement initially adopted by Fisher Body and General Motors can be explained in terms of these two economic forces. However, the fact that holdup problems are usually successfully handled with a combination of contract terms and transactor reputations does not mean that holdups never occur. Because contract terms are inherently imperfect and transactor reputational capital is limited, transactors know when they design their contractual arrangements that there is some probability that they will be placed in a position where unanticipated events push the contractual relationship outside what I have called ‘the self-enforcing range’ and that a holdup will occur (Klein, 1996).7 This probabilistic view of holdups should be contrasted with the view that a holdup involves deceptive or fraudulent behavior. Coase, for example, claims that ‘[o]pportunism is analogous to fraud’ (Coase, 2006, p. 260). Williamson has also misleadingly defined a holdup in terms of deception: By opportunism I mean self-interest seeking with guile. This includes but is scarcely limited to more blatant forms, such as lying, stealing and cheating. Opportunism more often involves subtle forms of deceit. . . . More generally, opportunism refers to the incomplete or distorted disclosure of information, especially to calculated efforts to mislead, distort, obfuscate, or otherwise confuse (Williamson, 1985, p. 47).

The major problem here is a semantic one because of the misleading connotation of ‘holdup’. All that is necessary for a holdup to occur is that the contract governing a relationship with specific investments does not cover some unanticipated change in market conditions, and that reputational

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capital is insufficient to prevent one transactor from taking advantage of these circumstances to shift rents in its favor by appropriating some portion of the relationship-specific assets. The existence of a holdup does not mean that a transactor has deceived its transacting partner. In fact, the possibility of holdup behavior understood in this way pervades and fundamentally influences all market exchange and the contractual arrangements chosen by transactors. Notes 1. This highly cited case was first described in Klein et al. (1978). There has been an ongoing debate regarding the facts and interpretation of events surrounding the case, with the most recent and complete statement of the facts provided in Klein (2007). 2. Fisher Body’s capacity investments to serve General Motors are referred to in the literature as ‘dedicated assets’. See Williamson (1983, p. 526) and Joskow (1987, pp. 168, 170–172). Williamson describes five other different types of asset specificity: site specificity, physical asset specificity, human asset specificity, temporal specificity, and brand name capital (Williamson, 1991). We now know that the important General Motorsspecific Fisher Body investments did not consist of Fisher Body investments in General Motors tools and dies. Although tools and dies necessary for the production of General Motors bodies were highly General Motors-specific, General Motors merely purchased and owned these physical assets. See Klein (2007). 3. Segal and Whinston (2000) mistakenly claim that exclusive dealing did not protect Fisher Body’s General Motors-specific investments. In the Segal and Whinston model the only effect of exclusive dealing is to prevent a buyer from free-riding by using a seller’s specific investments when transacting with other sellers. Since Fisher Body’s General Motorsspecific capacity investments could not be used by General Motors with another body supplier, General Motors free-riding could not occur and exclusive dealing is asserted to serve no economic purpose. Segal and Whinston recognize that once a seller makes specific investments a holdup problem exists because the buyer can threaten to stop buying from the seller and thereby substantially reduce the value of the seller’s specific investments. But Segal and Whinston maintain that exclusive dealing does not protect against such holdups because the penalty that can be imposed by the seller on the buyer with exclusive dealing can be imposed independent of buyer behavior. However, this unrealistically assumes that Fisher Body could legally enforce the exclusive deal and also decide not to supply General Motors whether or not General Motors attempted a holdup by threatening to purchase elsewhere. Once one more realistically assumes that Fisher Body can impose a penalty on General Motors only if General Motors attempts a holdup, exclusive dealing can be used to protect Fisher Body’s General Motors-specific investments from the threat of a General Motors holdup. See Klein (2007, pp. 7–9). 4. General Motors also acquired a 60 percent ownership of Fisher Body at the same time it entered into this contractual arrangement. However, the shares of Fisher Body common stock owned by General Motors were placed in a five year Voting Trust over which Fisher had veto power and therefore did not prevent Fisher Body from holding up General Motors in 1922, as described in the following section. Furthermore, after expiration of the Trust General Motors could not use its 60 percent ownership share to unilaterally abrogate the Fisher Body contract and reverse the holdup because it could not legally vote its Fisher Body shares without respecting the minority Fisher Body economic interests. The negotiated agreement that resulted in the vertical integration of General Motors and Fisher Body in 1926, however, involved terms that clearly eliminated any continuing Fisher Body holdup return. See discussion below and Klein (2007). 5. This result is related to the costless holdup renegotiation assumption made in the property rights theory of the firm originally proposed by Grossman and Hart (1986).

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6. The likelihood that vertical integration will be used by transactors to solve potential holdup problems in any particular case will depend not only on the extent to which specific investments are present, but also on a number of other factors, including the difficulty of contractually specifying performance, the uncertainty associated with future performance, and the level of reputational capital possessed by transactors. However, holding these other factors constant, integration is more likely the greater the relationship-specific investments made by transactors. Empirical confirmation of this proposition has been described as ‘one of the great success stories in industrial organization over the last 25 years’ (Whinston, 2001, pp. 184–5). 7. The goal of contractual specification in this context often is not to create optimal incentives on some imperfect court-enforceable proxy for performance, but to economize on the reputational capital necessary to make a contractual relationship self-enforcing in the widest range of post-contract circumstances.

Bibliography Coase, Ronald H. (2000), ‘The acquisition of Fisher Body by General Motors’, Journal of Law and Economics, 43 (1), 15–32. Coase, Ronald H. (2006), ‘The conduct of economics: the example of Fisher Body and General Motors’, Journal of Economics and Management Strategy, 15 (2), 255–78. Grossman, Sanford J. and Oliver D. Hart (1986), ‘The costs and benefits of ownership: a theory of vertical and lateral integration’, Journal of Political Economy, 94 (4), 691–719. Joskow, Paul L. (1987), ‘Contract duration and relationship-specific investments: empirical evidence from coal markets’, American Economic Review, 77 (1), 168–85. Klein, Benjamin (1996), ‘Why holdups occur: the self-enforcing range of contractual relationships’, Economic Inquiry, 34 (3), 444–63. Klein, Benjamin (2007), ‘The economic lessons of Fisher Body–General Motors’, International Journal of the Economics of Business, 14 (1), 1–36. Klein, Benjamin, Robert G. Crawford, and Armen A. Alchian (1978), ‘Vertical integration, appropriable rents and the competitive contracting process’, Journal of Law and Economics, 21 (2), 297–326. Segal, Ilya R. and Michael D. Whinston (2000), ‘Exclusive contracts and protection of investments’, RAND Journal of Economics, 31 (4), 603–33. Whinston, Michael D. (2001), ‘Assessing the property rights and transaction-cost theories of firm scope’, American Economic Review, 91 (2), 184–8. Williamson, Oliver E. (1983), ‘Credible commitments: using hostages to support exchange’, American Economic Review, 73 (4), 519–40. Williamson, Oliver E. (1985), The Economic Institutions of Capitalism, New York: The Free Press. Williamson, Oliver E. (1991), ‘Comparative economic organization: the analysis of discrete structured alternatives’, Administrative Science Quarterly, 36 (2), 269–96.

13 The transaction as the unit of analysis Nicholas Argyres

Transaction cost economics (TCE) is so named because it analyzes the costs of different kinds of ‘transactions’. Indeed, one of the important departures TCE makes from neoclassical economics is to take the ‘transaction’ as its unit of analysis (Williamson, 1985). In this chapter, I discuss how the transaction is a different unit of analysis than that of neoclassical economics, and then discuss some of the advantages and limitations of analyzing economic activity at the level of the transaction. Neoclassical economics is primarily the study of economic choices by individual consumers or firms. It is concerned, for example, with how the price system guides consumer and firm choices about how much to produce and consume of various goods, with the implications of these choices for the allocation of resources in particular markets, and with overall social welfare. In models of general equilibrium, consumers and firms are assumed to enjoy many alternate trading opportunities for inputs and outputs, and to act autonomously in choosing which of these opportunities to pursue. Trade is generally treated as involving discrete, well-defined goods (‘spot market’ trades), or promises of future delivery of such goods (‘futures market’ trades). This focus on the individual decision-making unit arguably led neoclassical economics to neglect an important feature of economic activity; namely, trading relationships between two economic actors, such as firms, in which the terms of trade are not fully defined, and where the value of continuing the relationship is high because both sides’ outside trading options are much less profitable for them. These kinds of trading relationships are pervasive in the economy, and even in the polity. They range from long-term exchanges between firms to exchanges between employees and their firm to exchanges of promises between legislators and or even different branches of government (for example, Weingast and Marshall, 1988; Dixit, 1996). Whereas neoclassical economics offers little insight into how these kinds of exchanges are arranged and efficiently governed, TCE offers quite a bit of insight into these questions. (The most important of these insights is that governance arrangements will reflect parties’ attempts to safeguard their transaction-specific investments, with vertical integration being the last resort.) Indeed, this is what gives TCE its power: it is able to shed light on the governance of a very wide range of exchange 127

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relationships that neoclassical economics does not directly address. These insights were made possible in large part because TCE takes the ‘transaction’, rather than the individual firm or consumer, as its unit of analysis. TCE and game theory This focus on the transaction lends TCE a bilateral, rather than individuallevel, orientation: TCE is interested in explaining joint decision-making between two transacting parties who, because they have some goals in common, also have an interest in maintaining a cooperative relationship. TCE also assumes, however, that the transacting partners have incentives that can at some point conflict. In this way, TCE is similar to the game-theoretic approaches that have become dominant in the industrial organization literature. Game-theoretic approaches in economics usually take the two-player game or duopoly as the unit of analysis. The players’ (for example, firms’) incentives in these games may coincide or conflict (or some of both). The focus in these approaches is on determining each player’s optimal choices when they depend sensitively on the other player’s choices, and therefore to predict the outcome(s) of the game. This is a situation that of course does not arise in neoclassical economics because of its assumption that markets are ‘thick’ with buyers and sellers. In this kind of market, each actor’s optimal decision is independent of the decisions of other individual actors. Because the unit of analysis for game-theoretic approaches is similar to that in TCE, it is not surprising that game-theoretic approaches have succeeded in shedding light on how transactions are efficiently governed (Baker et al., 2002; Gibbons, 2005). Still, David Kreps, a prominent game theorist, has argued that there are fundamental limits on game theory’s ability to formalize TCE’s main insights and to build on its foundation (Kreps, 1996). This is because even if the unit of analysis is similar, the behavioral assumptions are quite different. TCE assumes, following Simon (1957), that the rationality of economic actors is bounded, whereas for most game-theoretic models to be useful in making predictions, they must assume quite a high degree of rationality. The recent explosion of experimental research in behavioral economics is certainly more consistent with the assumption of bounded rationality than with the high degrees of rationality needed for many game-theoretic models, though economic irrationality is a common finding (for example, Camerer, 2003). Bounded rationality and foresight TCE emphasizes that when seeking to understand why a transaction is governed in a particular way, it is important to consider the transaction in

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its entirety. That is, it is important to recognize that while actors’ rationality may be bounded, they are alert enough to take into account all the elements of the ‘deal’, and are able to foresee at least the more obvious threats to their interests in the transaction. Failure to account for the entire transaction may cause the analyst to mistakenly view an efficiently governed transaction as inefficiently governed. Williamson’s (1985) example of the remote company town provides an illustration. Historians and others long argued that such towns, in which a single employer owns all of the housing as well as the only retail store, exploit the workers in the town. They are therefore inefficient and should be heavily regulated or banned. Williamson (1985) points out, however, that housing and retail stores in remote locations are transaction-specific investments that workers would be unwilling to make in the absence of a strong safeguard, which is difficult to devise. Therefore, ownership of these assets by the company may in fact be efficient. Moreover, before moving to a company town, a ‘hard-headed’ worker will foresee that the company will have the ability to charge monopoly prices for housing and other goods, and will avoid being exploited by demanding a wage premium to compensate, without which he or she will not move. That is, the worker will recognize that the entire transaction involves not just payment of a wage in exchange for work, but also payments for housing and other goods. Now, Williamson (1985) acknowledges that there may be other factors at work that make the company town an inefficient arrangement. But here we can take Williamson’s point as purely a methodological one: alert, far-sighted economic actors will take the entire transaction into account when evaluating whether to participate in, and how to govern, that transaction. Governance inseparability This issue of contracting in its entirety and the assumption of farsightedness brings us to some of the limitations of taking the transaction as the unit of analysis. First, note that some economic actors may not be so hard-headed, at least not all of the time. Once again, recent work in behavioral economics has shown that experimental subjects often allow their economic decisions to be influenced by impulsiveness, incorrect statistical inferences, altruistic feelings towards strangers, and other behaviors not accounted for in traditional economic analysis. The implication for TCE is that some actors may not consider contracting in its entirety for these or other reasons, and this may lead to systematically inefficient governance arrangements that TCE alone cannot explain. Williamson (1985, 1996) acknowledges considerations such as these, but suggests that they are likely to be more relevant for transactions involving consumers or

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individuals rather than firms with experience in business decision-making, and with a more focused orientation toward efficiency. Moreover, TCE assumes that firms that make systematic mistakes due to say, impulsiveness, will not long survive market competition, whereas there may be more scope for less than economically rational behavior among consumers. However, the Internet bubble of the 1990s, as well as the recent events in which millions of home mortgages were overvalued by highly sophisticated firms, suggests some caution in automatically assuming that firms are always hard-headed and always engage in contracting in its entirety. A second limitation to using the transaction as the unit of analysis is more subtle. It emerges not from economically irrational behavior, but from uncertainty in the environment that makes it difficult for actors to foresee even major threats to the stability of their transactions. In these cases, the actors in question may be quite hard-headed and may strive to be far-sighted, but because some future events are essentially unforseeable, they are unable to adequately safeguard transactions for those events. When the environment is uncertain in this way, governance arrangements may be observed that are (at least for some time) inefficient in ways that TCE alone cannot explain. For example, if a major unforseeable event occurs that reduces the bargaining power of one party to an agreement struck in the past, the more powerful party may be able to hold its contractual partner to the original terms of that agreement, even if those terms are no longer efficient. Argyres and Liebeskind (1999) described such situations as involving one kind of ‘governance inseparability’, because in such cases the governance arrangements in the current agreement cannot be separated from those struck in prior agreements. One example of this kind of phenomenon involved General Motors (GM). During the mid 1990s, GM attempted to change the way it governed transactions involving certain automobile components; in particular, it attempted to move toward more outsourcing of production. This led to a major strike by the United Automobile Workers (UAW) union that cost GM approximately US$600 million. The union sought to protect union jobs, wages and work rules, and invoked a prior commitment GM had made to the union to limit outsourcing. The strike was successful in derailing GM’s outsourcing plans. Governance inseparability was manifested in this example in that GM failed to anticipate the later bargaining strength of the union, as shown by the union’s ability to carry out a damaging strike. Had it anticipated this future strength, GM might have safeguarded its interests more by, for example, avoiding such a sweeping commitment to limit outsourcing as part of its earlier agreement with the union. Analysts agreed, however, that the increased bargaining power for the union was a surprise to many in the industry, coming

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after a long period in which union power in the US had been declining precipitously. Likely this change in bargaining power could not have been anticipated. As a result of its inability to separate prior governance arrangements from current arrangements, GM remained more vertically integrated than efficiency considerations demanded. A second form of governance inseparability links not so much sequential transactions, but concurrent transactions within an organization (Argyres and Liebeskind, 1999). In these kinds of cases, transaction cost considerations suggest that transactions carried out within the firm which have very different characteristics will be governed differently. However, bringing a transaction inside a firm has an important consequence; the governance of that transaction becomes immediately dependent, to one degree or other, on the way other transactions within the firm are governed. That is, it becomes subject to firm-wide policies that do not distinguish between transactions. The existence of such policies is almost the definition of ‘bureaucracy’. Under these conditions, it again becomes difficult to explain observed governance arrangements using transaction cost analysis applied at the level of the individual transaction. Argyres and Liebeskind (2002) provide examples from the US biotechnology industry. One feature of this industry is that despite years of attempts, large pharmaceutical firms have not been able to match the research capabilities of small biotechnology firms, either by developing such capabilities de novo, or by systematically acquiring the smaller firms. A major reason is large firms have not been able to match the incentive arrangements that small firms offer to their scientists. Such arrangements typically include stock options, freedom to publish and attend conferences, influence on choice of research projects, and so on. Instead, large firms have maintained their same firm-wide policies that involve restrictions on publishing, lowered-power incentives, and the like. In part this may be because of influence activity by scientists in more traditional research areas who act (or threaten to act) out of envy or concern for relative income and status. Whatever the precise underlying motivation, it becomes difficult for the large firm to treat its transactions with the two groups of scientists (traditional and biotechnological) differently, using separate governance arrangements. Conclusions To conclude, much of TCE’s success as a predictive theory is due to its choice of the transaction as its unit of analysis. It appears that in many, many cases, this choice helps explain arrangements that would be otherwise difficult to explain using the tools of neoclassical economics. On the other hand, there appear to be cases where the transaction is not the

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appropriate unit, such as when behavioral considerations loom large, or when the governance of linked transactions cannot be separated. An important goal for future research, then, is to more clearly identify when and where these kinds of circumstances are more or less likely to arise. References Argyres, N. and J. Liebeskind (1999), ‘Contractual commitments, bargaining power and governance inseparability: Incorporating history into transaction cost theory’, Academy of Management Review, 24 (1), 49–63. Argyres, N. and J. Liebeskind (2002), ‘Governance inseparability and the evolution of the US biotechnology industry’, Journal of Economic Behavior and Organization, 47 (2), 197–219. Baker, G., R. Gibbons, and K. Murphy (2002), ‘Relational contracts and the theory of the firm’, Quarterly Journal of Economics, 117 (1), 39–83. Camerer, Colin (2003), Behavioral Game Theory: Experiments in Social Interaction, Princeton, NJ: Princeton University Press. Dixit, A. (1996), Transaction Cost Politics, Cambridge, MA: MIT Press. Gibbons, R. (2005), ‘Four formal(izable) theories of the firm’, Journal of Economic Behavior and Organization, 58 (2), 202–47. Kreps, D. (1996), ‘Markets, hierarchies and (mathematical) economic theory’, Industrial and Corporate Change, 5 (2), 561–95. Simon, Herbert (1957), Models of Man, New York: John Wiley and Sons. Weingast, B. and W. Marshall (1988), ‘The industrial organization of Congress; or why legislatures, like firms, are not organized as markets’, Journal of Political Economy, 96 (1), 132–64. Williamson, Oliver E. (1985), The Economic Institutions of Capitalism, New York: The Free Press. Williamson, Oliver E. (1996), The Mechanisms of Governance, New York: Oxford University Press.

14 Bounded rationality and organizational economics Nicolai J. Foss

In very overall terms the existing research efforts on bounded rationality may be understood as a very diverse set of attempts to elaborate and examine the insights that: (1) the human capacity to process information is limited (Simon, 1955); (2) humans try to economize on cognitive effort by relying on short-cuts (‘heuristics’; Simon and Newell, 1972); and (3) because of (1) and (2), as well as other factors, such as the influence of emotions on cognition, human cognition and judgment is subject to a wide range of biases and errors (Tversky and Kahneman, 1986; Rabin, 1998). Economists’ thinking about the role of rationality (bounded as well as full) has surprisingly often been done with reference to the business firm. Thus, the issue has been highlighted in debates ranging from the descriptive validity of profit maximization in the 1940s over Herbert Simon’s criticism of oligopoly theory (Simon, 1979) to modern debates on incomplete contracting and therefore issues that are central to new institutional economics, such as efficient firm boundaries (for example, Williamson, 1985; Hart, 1990; Tirole, 1999). The reason why economists have associated firm organization and bounded rationality (BR) arguably lies in the inherent complexity and uncertainty of decisions relating to competitive strategy, investment decisions, the design of human resource management systems, and so on. By comparison most consumption choices seem relatively simple and more given to a treatment in terms of the standard maximizing model. Recently, BR has, under the banner of behavioural economics, neuronomics, and so on, been generalized much beyond the theory of the firm context, and appears prominently in finance, law and economics, and much else. However, the theory of the firm or, more broadly, organizational economics remains an area where discussion of BR takes place, and it is of course also a stronghold of new institutional economics (Williamson, 1985, 1996; Furubotn and Richter, 1997; Brousseau and Glachant, 2003). For these reasons, most of this chapter makes reference to organizational economics. Instead of providing a comprehensive overview of work on BR and its use in organizational economics, I shall argue that although many organizational economists have agreed on the importance of BR, upon 133

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closer inspection it turns out that BR itself is seldom explicitly modelled, organizational economists do not seem to hold precise views of what BR is and how it may be incorporated into models (if they do, they are likely to stress different modelling approaches), and the main purpose of BR is to provide intuition for contractual incompleteness. BR and organizational economics Organizational economists would likely agree that BR is important to the study of economic organization (for example, Williamson, 1975, 1985, 1996; Milgrom and Roberts, 1992; Kreps, 1996; Furubotn and Richter, 1997). Indeed, some argue that it is indispensable, in the sense that BR is a strictly necessary assumption in the theory of economic organization (Williamson, 1996; MacLeod, 2000). Oliver Williamson is not only the flag bearer of the modern literature, but also the most outspoken proponent of the necessity to include BR in the economics of organization. ‘But for bounded rationality’, he argues, ‘all issues of organization collapse in favor of comprehensive contracting of either Arrow-Debreu or mechanism design kinds’ (Williamson, 1996, p. 36). What Williamson calls ‘comprehensive contracting’ does not allow for ‘governance structures’ in the sense of mechanisms that handle the coordination and incentive problems produced by unanticipated change (Williamson, 1996, Chapter 4), simply because the latter is ruled out under assumptions of ‘comprehensive’ or complete contracting. More generally, Williamson (1998) argues that taking more account of the relevant psychological literature will improve the understanding of organization ‘as an instrument for utilizing varying cognitive and behavioral propensities to best advantage’ (Williamson, 1998, p. 12). Many organizational economists would seem to concur. Following the strong general increase in interest in building insights of cognitive science into economics models, not only calls for drawing more strongly on the relevant psychology research (for example, Lazear, 1991) but also actual modelling efforts that incorporate some notion of BR are now relatively common. To exemplify, Mookerji (1998) shows how ambiguity aversion may be a source of contractual incompleteness; Anderlini and Felli (1999) invoke costs associated with complexity to do the same, while Gifford’s (1999) take on contractual incompleteness is to explain it as an outcome of the trade-off between devoting scarce attention to managing existing contracts and writing new ones. Hart (2006), who earlier was sceptical of the use of BR in organizational economics (Hart, 1990), now argues that an important source of the ex post haggling costs emphasized by Williamson (1985) may lie in contractual parties holding different reference points. Thus, a cursory glance at contemporary organizational economics may

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easily convey the impression that Simon’s lessons have been absorbed, and that organizational economists have realized the need to place BR truly centre stage in their theorizing. However, this would clearly be an exaggeration. The fact remains that very large parts of organizational economics have no use whatsoever for BR. In particular, the complete contracting paradigm of agency theory (Holmström, 1979) rules out BR. More generally, most contemporary organizational economics research is entirely mainstream in character, and this also holds for most work on incomplete contracts. Formal, mainstream economics typically assumes that agents hold the same, correct model of the world and that model does not change. Organizational economics is in general no exception to this. More precisely, these assumptions are built into formal contract theory through the assumption that pay-offs, strategies, and the like are common knowledge, assumptions that are clearly at odds with BR. Indeed, the game-theoretic models used in most theoretical research on the theory of the firm ignore BR altogether. Fundamental notions and modelling principles of mainstream economics, such as subjective expected utility, common priors, rational expectations/dynamic programming, backward induction, and so on, are not too easily aligned with fundamental findings of cognitive psychology with a strong bearing on BR (such as gain–loss asymmetries, role-biased expectations, and so on) (Camerer, 1998). The result of the attempt to combine these notions with an attempt to make room for BR is ‘hybrid models’ where BR is introduced in a highly selective manner as the spanner in the works of an otherwise entirely mainstream machinery, so that agents are assumed to be boundedly rational with respect to one variable and fully rational with respect to all other variables (Furubotn and Richter, 1997; Foss, 2001). ‘Thin’ and ‘thick’ notions of BR Many writers have observed that to the extent that BR enters contemporary economics, it is in rather ‘thin’ forms (Schlicht, 1990; Akerlof, 1991; Lindenberg, 1990; Furubotn and Richter, 1997; Macleod, 2000; Furubotn, 2001). This is also the case of organizational economics. The treatment of BR in the literature at large is a far cry indeed from the rich, concrete and ‘thick’ treatments of BR in the behavioural economics literature. For example, Milgrom and Roberts (1992, p. 128) define BR as a matter of ‘[l]imited foresight, imprecise language, the costs of calculating solutions and the costs of writing down a plan’. They then go on to develop at length the implications of this in terms of imperfect contracts and subsequent problems of imperfect commitment between contractual parties. However, Milgrom and Roberts do not develop or truly explain their definition of BR. In fact, it is quite arguable (see Foss, 2001, 2003) that the versions of

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BR that are applied in organizational economics are thin versions, in the sense that BR per se is not explicitly modelled, but simply asserted as a sort of ‘background variable’ that functions to provide an intuitive foundation for contractual incompleteness. In spite of his insistence on the necessity of assuming boundedly rational behaviour, Williamson is in actuality rather vague on BR. He notes that ‘[e]conomizing on bounded rationality takes two forms. One concerns decision processes and the other involves governance structures. The use of heuristic problem-solving . . . is a decision process response’ (Williamson, 1985, p. 46). The latter ‘form’ is not central, however, in transaction cost economics, which, Williamson argues, ‘is principally concerned . . . with the economizing consequences of assigning transactions to governance structures in a discriminating way’ (ibid.). Thus, Williamson is interested in making use of BR for the purpose of explaining the existence and boundaries of firms and therefore the choice between alternative governance structures rather than for the purpose of explaining ‘administrative behaviour’, as in Simon (1947). However, it is open to some debate whether it makes much sense to separate BR as an important ingredient in the understanding of governance structures from BR as the starting point for the understanding of decision processes, as different governance structures likely exhibit different decision process properties (March and Simon, 1958). Clearly, from an organizational theory point of view, the lack of concern with decision processes means that the important possibility that bounds on rationality may be endogenous to organization is not inquired into (the exception being team theory: Marschak and Radner, 1972; Radner, 1996). However, even the use of thin notions of BR is problematic from the point of view of a number of scholars, particularly those with a formalist bent (which means most modern research economists): as a minimum, contractual incompleteness must be endogenously derived in a well specified model (as in, for example, Gifford, 1999) rather than being postulated through a loose appeal to BR. Such a position indicts most of the largely verbal TCE approach. More fundamentally, theorists have argued that BR, in contrast to Williamson (1985), is in fact not necessary to organizational economics. Thus, what BR primarily does in the theory – namely, rationalize contractual incompleteness and therefore the inefficient investment levels that are centre stage in much contract theory (Grossman and Hart, 1986; Hart, 1995) – can be done more elegantly by asymmetric information assumptions, particularly the assumption that investments in a relation are unverifiable by a third party (for example, a judge) (for this argument, see Hart, 1990). This raises the issue of the future of work on BR in organizational economics.

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Whither BR? The role of BR in future organizational economics may be unchanged, diminished or increased. If ‘unchanged’ this means that organizational economics will continue to invoke BR as a catchy label for what makes contracts incomplete in the context of otherwise entirely mainstream models. For reasons given above, this is hardly a satisfactory scenario, because this use of BR is flagrantly ad hoc. However, notions of BR abound, and it is notoriously hard to formalize BR. This may lead to the persistence of the ad hoc strategy of making use of BR. On the other hand, the ad hoc use of BR and the difficulty of formalizing it in a general manner may lead theorists to abandon the concept. A further reason why theorists may abandon the concept is they feel it does not add anything. This is the case that has been forcefully argued by Maskin and Tirole (1999). They essentially argue that BR, specifically the inability to perfectly anticipate or describe all relevant contingencies, does not constrain the set of feasible contracts relative to the complete contracting benchmark. Of course, this implies that considerations of BR are essentially irrelevant to the understanding of inefficient investment patterns. Maskin and Tirole zoom in on the assumption in incomplete contracts theory that although valuations are not verifiable, they may still be observable by the parties, implying that trade may be conditioned on message games between the parties. These games are designed ex ante in such a way that they can effectively describe ex post all the trades that were not described ex ante. Maskin and Tirole provide sufficient conditions under which the indescribability of contingencies does not restrict the pay-offs that can be achieved. Space does not allow us to go into the subtle details of their argument, nor into the responses (for example, Hart and Moore, 1999). Suffice it to be mentioned that the Maskin and Tirole point is developed in the context of a specific modelling approach and that it does not indict the use of BR in organizational economics in general. The current general enthusiasm in economics for psychology may in fact lead to a stronger incorporation of BR in organizational economics models. A research strategy for this may proceed along these lines: (a) consider the massive body of largely psychology-based research science on biases to human cognition and judgement (summarized for economists by Conlisk, 1996; Camerer, 1998; Rabin, 1998); (b) identify the regularities in how human decision-making systematically differs from the Savage model; (c) treat these deviations as sources of transaction costs; and (d) examine the implications for comparative contracting and the choice of governance structures (Williamson, 1998, p. 18). Such a program may be seen as primarily an invitation to explore mechanisms, that is, causal connections that may or may not be triggered in specific situations, rather

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than search for general regularities. To be more concrete, it is a call for exploring how a specific manifestation of BR – such as, say, reference level biases (Hart, 2006) – translates into transaction costs confronted by agents in a specific setting, and how this influences the contract or governance structure chosen by these agents to regulate their trade. Thus, we can imagine manifestations of BR such as context-dependent risk-preferences and weakness-of-will problems complicating agency models, the endowment effect complicating models that make use of assumptions of transferable utility, the self-serving bias throwing light on ex post haggling costs, and so on. While this would seem to be a feasible research strategy, it is open to debate whether it is also a desirable one. The fear is that the field may end up with a mass of extremely partial models of strongly limited applicability. The optimist may counter that insights of rather general applicability may follow, because of the generality of many of the manifestations of BR. For example, Babcock and Loewenstein (1998) argue that self-serving biases are likely to be a very frequent determinant of a specific type of transaction cost, namely bargaining impasse. Moreover, new insights may be produced and old puzzles may be resolved. For example, in many work situations, precise signals on output are available, yet monitoring still takes place. Office workers may thus be supervised although it is trivial to count the number of forms they have processed at the end of the day. It seems unrealistic to argue that some random and unobservable factor should intervene in the work process, shifting too much risk on to the agent (Postrel and Rumelt, 1992). A more realistic explanation is lack of self-discipline in the performance of a boring job (Rabin, 1998). References Akerlof, G.A. (1991), ‘Procrastination and obedience’, American Economic Review, 81 (2), 1–19. Anderlini, L. and L. Felli (1999), ‘Incomplete contracts and complexity costs’, Theory and Decision, 46 (1), 23–50. Babcock, L. and G. Loewenstein (1997), ‘Explaining bargaining impasse: the role of selfserving biases’, Journal of Economic Perspectives, 11 (1), 109–27. Brousseau, E. and J.-M. Glachant (2003), The Economics of Contracts, Cambridge: Cambridge University Press. Camerer, C. (1998), ‘Behavioral economics and nonrational organizational decision making’, in J.J. Halpern and R.N. Stern (eds), Debating Rationality, Ithaca: Cornell University Press, pp. 53–77. Conlisk, J. (1996), ‘Why bounded rationality?’, Journal of Economic Literature, 34 (2), 669–700. Foss, N.J. (2001), ‘Bounded rationality in the economics of organization: present use and future possibilities’, Journal of Management and Governance, 5 (3–4), 401–25. Foss, N.J. (2003), ‘The rhetorical dimensions of bounded rationality: Herbert A. Simon and organizational economics’, in S. Rizzello (ed.), Cognitive Paradigms in Economics, London: Routledge, pp. 158–76.

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Furubotn, E. (2001), ‘The new institutional economics and the theory of the firm’, Journal of Economic Behavior and Organization, 45 (2), 133–53. Furubotn, E. and R. Richter (1997), Institutions and Economic Theory, Ann Arbor: Michigan University Press. Gifford, S. (1999), ‘Limited attention and the optimal incompleteness of contracts’, Journal of Law, Economics, and Organization, 15 (2), 468–86. Grossman, S. and O. Hart (1986), ‘The costs and benefits of ownership: a theory of lateral and vertical integration’, Journal of Political Economy, 94, 691–719. Hart, O. (1990), ‘Is “bounded rationality” an important element of a theory of institutions?’, Journal of Institutional and Theoretical Economics, 146, 696–702. Hart, O. (1995), Firms, Contracts, and Financial Structure, Oxford: Clarendon Press. Hart, O. (2006), ‘Reference points and the theory of the firm’, National Bureau of Economic Research, Working Paper No. 13481. Hart, O. and J. Moore (1999), ‘Foundations of incomplete contracts’, Review of Economic Studies, 66, 115–38. Holmström, B. (1979), ‘Moral hazard and observability’, Bell Journal of Economics, 10 (1), 74–91. Kreps, D.M. (1996), ‘Markets and hierarchies and (mathematical) economic theory’, Industrial and Corporate Change, 5 (2), 561–95. Lazear, E.P. (1991), ‘Labor economics and the psychology of organizations’, Journal of Economic Perspectives, 5 (2), 89–110. Lindenberg, S. (1990), ‘Homo socio-oeconomicus: the emergence of a general model of man in the social sciences’, Journal of Institutional and Theoretical Economics, 146, 727–48. MacLeod, W.B. (2000), ‘Complexity and contract’, Revue d’Économie Industrielle, 92, 149–78. March, J.G. and H.A. Simon (1958), Organizations, 2nd edn, London: Wiley-Blackwell. Marschak, J. and R. Radner (1972), The Theory of Teams, New Haven: Yale University Press. Maskin, E. and J. Tirole (1999), ‘Unforeseen contingencies and incomplete contracts’, Review of Economic Studies, 66 (1), 83–114. Milgrom, P. and J. Roberts (1992), Economics, Organization, and Management, New York: Prentice-Hall. Mookerji, S. (1998), ‘Ambiguity aversion and incompleteness of contractual form’, American Economic Review, 88, 1207–31. Postrel, S. and R.P. Rumelt (1992), ‘Incentives, routines, and self-command’, Industrial and Corporate Change, 1 (3), 397–425. Rabin, M. (1998), ‘Psychology and economics’, Journal of Economic Literature, 36 (1), 11–46. Radner, R. (1996), ‘Bounded rationality, indeterminacy, and the theory of the firm’, Economic Journal, 106 (438), 1360–73. Schlicht, E. (1990), ‘Rationality, bounded or not, and institutional analysis’, Journal of Institutional and Theoretical Analysis, 146, 703–19. Simon, H.A. (1947), Administrative Behavior, 4th edn, New York: The Free Press. Simon, H.A. (1955), ‘A behavioral model of rational choice’, Quarterly Journal of Economics, 69 (1), 99–118. Simon, H.A. (1979), ‘Rational decision making in business organizations’, American Economic Review, 69 (4), 493–513. Simon, H.A. and A. Newell (1972), Human Problem Solving, Englewood Cliffs: Prentice-Hall. Tirole, J. (1999), ‘Implicit contracts: where do we stand?’, Econometrica, 67 (4), 741–81. Tversky, A. and D. Kahneman (1986), ‘Rational choice and the framing of decisions’, Journal of Business, 59 (4), S251–78. Williamson, O.E. (1975), Markets and Hierarchies, New York: Free Press. Williamson, O.E. (1985), The Economic Institutions of Capitalism, New York: Free Press. Williamson, O.E. (1996), The Mechanisms of Governance, Oxford: Oxford University Press. Williamson, O.E. (1998), ‘Human Actors and Economic Organization’, paper for the 1998 Paris ISNIE conference.

15 Economizing and strategizing Jackson A. Nickerson and James C. Yen

Research in business strategy explores how organizations create and capture economic value. Two of the leading economic approaches that inform this field are the economizing and strategizing perspectives. In this chapter we define and explore the strengths and weaknesses of both perspectives. In particular, we explore the relationship between economizing and strategizing perspectives and how they interact to inform each other. Our exploration focuses on sunk costs as a central premise in both perspectives as they apply to business strategy. Finally, we assess the extent to which these perspectives provide necessary and sufficient perspectives for business strategy. What is business strategy? Successful firms are believed to have unique business strategies that create value for customers by producing products and services at sufficiently low outlays such that resulting profits exceed the cost of capital. A necessary condition to maintain these profits appears to be that actual and potential competitors find it difficult to imitate the strategy. Yet, business strategy is a term that has many definitions in business and academic arenas (Ghemawat et al., 2001, Chapter 1). For instance, scholars have defined strategy as ‘a long-term plan’ (Chandler, 1962, p. 13), ‘actions of player’ (Camerer, 1991, p. 139), and ‘fit’ among internal activities (Porter, 1996, p. 70). Although managers and scholars have different definitions for strategy, all can agree that ‘strategic decisions are concerned with the long-term health of the enterprise’ (Chandler, 1962, p. 11). A course on business strategy in the Masters in Business Administration programs was first urged by the Ford Foundation and Carnegie Corporation Reports on business education in the late 1950s (for an interesting discussion see Arben, 1997). Harvard Business School was the first business school to add a ‘Business Policy’ Course which ‘integrated what the student had learned in the functional courses, serving as a capstone to the core curriculum’ (Rumelt et al., 1994, p. 10). Business strategy then grew from a capstone course of the 1960s into a field unto itself today. Because of this history, the intellectual roots of strategic management draw sustenance from many disciplines. Research disciplines such as economics, organizational sociology, 140

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political science, and psychology contributed to the development and evolution of the strategy field (Rumelt et al., 1994). Yet, many view that economics has been foundational to business strategy (Rumelt et al., 1991). That said, economic contributions to the field of strategy are not monolithic (Hesterly and Zenger, 1993) with various economics subdisciplines separately and distinctly contributing to the field. Two of these subdisciplines, namely strategizing and economizing, are elaborated below and their theoretical relationship is explored in the context of the field of business strategy. What is the strategizing approach to business strategy? There are many perspectives on the notion of strategy but they all agree that strategy should contribute to the performance improvement of the firms. For example, Porter (1980, 1985) emphasizes the importance of strategic positions in the product markets and the competitive advantages derived from the fit among the activity systems of the firms. Moreover, the resource-based view (RBV) emphasizes the possession of valuable resources and the capability-based view (CBV) focuses on the integration, recombination and development of the resources to create value. This chapter, however, focuses on the ‘strategizing’ perspective that explores the effects of strategic interactions on the creating and capturing of value. Teece et al. (1997, p. 509) define the strategizing approach as those organizational actors ‘engaging in business conduct that keeps competitors off balance, raises rival’s costs, and excludes new entrants’. More formally, strategizing is associated with the methodology of game theory. Mas-Colell et al. (1995) define strategy from a game-theoretic perspective as a ‘complete contingent plan, or decision rule, that specifies how the player will act in every possible circumstance in which she might be called upon to move’ (Mas-Colell et al., 1995, p. 228, original emphasis). Game theory offers a mathematical approach to the analysis of strategic interaction between individuals who can contemplate what their counterparts think and can act on the basis of this contemplation (von Neumann and Morgenstern, 1944). When applied to business, the game-theoretic methodology largely is used to explore signaling, preemption and coordination among firms in concentrated industries (see Saloner, 1991; Shapiro, 1989; Tirole, 1988). The application of game-theoretic approaches has been a growth area in economics since the 1980s with the development of highly specific models with each model applicable to a precise set of assumptions and conditions. Employing the set of firms as the unit of analysis, common assumptions associated with game-theoretic models of industrial organization typically involve a small number of firms with expectations about their and others’ strategy set, self-interest and perfectly

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rational decision making (for a discussion on the assumption of the degree of rationality see Saloner, 1991). Tirole (1988), in his book The Theory of Industrial Organization, offers an early and comprehensive compilation of the topics in game-theoretic industrial organization. Shapiro (1989) boldly summarizes the progress and contributions of game-theoretic work in industrial organization and claims that this collection of specific models of business rivalry in concentrated markets is better described as a general ‘theory of business strategy’ (Shapiro, 1989). The central insight from this general theory of business strategy is the role that ‘commitment’ plays in analyzing the dynamics of strategic interactions (Shapiro, 1989). Strategic commitment Strategic commitment is perhaps the most important key to a firm’s long-term performance. Commitment creates sunk costs that can be a credible signal (threat) to the competitors regarding the focal firm’s future actions (for a comprehensive treatment on commitment see Ghemawat, 1991). These irreversible investments signal to others that there is no profit should they proceed with a certain action because ‘it changes other players’ expectations about your future responses’ (Dixit and Nalebuff, 1991, p. 120). Hence, the game-theory approach of business strategy emphasizes the irrecoverability of strategic investments (Shapiro, 1989) as means to shape competitor behavior and capture value. Generally speaking, costlessly reversible actions do not constitute commitments and have no strategic role. Following this logic, the theory suggests that ‘firms may try to convert recoverable costs into sunk costs for some strategic purpose’ (Shapiro, 1989, p. 128). Dixit (1980) provides a classic example of the role of an irrevocable commitment of investment in entry-deterrence in altering the ‘initial conditions of the post-entry game to the advantage of the established firm, for any fixed rule under which that game is to be played’ (Dixit, 1980, p. 106). Therefore, strategizing is a means to create and exploit market power. Empirical evidence on strategizing Despite the empirical studies that Shapiro (1989) has summarized and the fact that game theory is a powerful apparatus to analyze the dynamics of business interactions, it remains a puzzle that strategy scholars do not widely apply this approach (Ghemawat, 1997). Peltzman’s (1991) critic on the game-theoretical IO models may be relevant. He argues that researchers’ emphasis of the theoretical modeling without the obvious applications to business practices cannot sustain the growth of the theory. Ghemawat

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offers another reason which is that ‘game theoretic models have not lent themselves to conventional large-sample tests’ (Ghemawat, 1997, p. 1) and thus researchers suspect the utility of game-theoretic models. Ghemawat responds to this puzzle and presents several detailed and persuasive case studies to illustrate various strategizing behaviors in real business settings. For instance, Ghemawat presents two different studies on capacity decisions. One is capacity expansion in the titanium dioxide industry for the purpose of pre-emption, and the other is capacity reduction in the declining chemical industry (Ghemawat, 1997). What is the economizing approach to business strategy? In contrast to Shapiro (1989), Williamson boldly argues that economizing ‘is the best strategy’ (1991a, p. 77). Economizing refers to designing governance arrangements to align with the transaction attributes in order to economize on transaction costs due to fundamental transformation (Williamson, 1985). The performance advantages of economizing behaviors can be examined in Williamson’s discriminating alignment hypothesis, which predicts that managers who align organizational structures with exchange attributes will achieve performance benefits, which can manifest higher profitability and greater survivability (Williamson, 1993; Silverman et al., 1997). Williamson (2005) summarizes the discriminating alignment hypothesis in three steps. First, identify the exchange attributes of asset specificity, uncertainty, and frequency that make some transactions simple and others complex. Of these three attributes, asset specificity, defined as ‘a specialized investment that cannot be redeployed to alternative users or by alternative users except at a loss of productive value’ (Williamson, 1996, p. 377), is the main locomotive. Second, specify the costs and competencies of alternative modes of governance such as the differences between market, hybrid, and hierarchy. For example, in autonomous adaptations, market mechanisms excel because price signals are the only necessary information needed to complete the transactions. On the contrary, cooperative adaptations are those for which coordinated responses are required and for which hierarchies surpass markets. Moreover, the argument extends to include hybrid forms that are located between markets and hierarchies, such as long-term contracts, joint ventures and so on (Williamson, 1991a). Third, the discriminating alignment hypothesis predicts that transactions are aligned with governance structures so as to realize a transaction cost economizing result (Williamson, 2005). Empirical evidence on economizing Despite three decades of empirical research and hundreds of empirical transaction cost economics (TCE) studies (David and Han, 2004; Macher

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and Richman, 2008; Masten, 1995; Shelanski and Klein, 1995), most empirical studies on TCE are preoccupied with testing whether the discriminating alignment hypothesis is supported, assuming that firms are optimally organized given the transaction attributes. Consequently, the number of empirical studies on economic performance at a transaction level or on firm survival remains surprisingly small. Armour and Teece (1978) provide one of the earliest empirical tests on Williamson’s M-form hypothesis (1975, Chapter 8), a version of the discriminating alignment hypothesis, which predicts the performance advantages enjoyed by large corporations organized as a multidivisional form (M-form) rather than organized as a centralized functional form (U-form). Masten et al. (1991) provided the first estimates of economic performance at a transaction level in shipbuilding components (pipefitting). They found that overall organization costs in ship construction were lower when transactions and organizational forms were aligned according to the discriminating alignment hypothesis. Mayer and Nickerson (2005) provided the first estimates of profitability at a transaction level based on the discriminating alignment hypothesis. By examining the contracts of an information technology company, Mayer and Nickerson estimated that when the project’s governance structure is misaligned with project attributes, the project’s profit margin drops by 20.8 percent and 200 percent for the expropriation concerns and 99.6 percent and 28.6 percent for the measurement costs, depending on whether they predict outsourcing or insourcing. This asymmetric impact on profits shows that for different transaction attributes (expropriation concerns or measurement costs), the relative costs of misaligned governance structures depend on the type of misalignment. Besides investigating profitability at the transaction level, research has explored the extent to which transaction misalignment impacts firm survival. In two papers, Nickerson and Silverman (Silverman et al., 1997; Nickerson and Silverman, 2003) studied discriminating alignment of the employment relation in the trucking industry following deregulation in the US. Silverman et al.’s (1997) empirical analysis is among the first to show increased mortality when firms do not adhere to operating policies consistent with transaction cost minimization principles. Nickerson and Silverman (2003) further found that poorly aligned firms (according to transaction cost reasoning) realize lower profits than their better-aligned counterparts, and that these firms will attempt to adapt so as to better align their transactions. In another study on firm survival, Argyres and Bigelow (2007) analyzed the early US auto industry (1917–33) to explore the effects of discriminating alignment on firm survival during the preshakeout stage and during the post-shakeout phase. They found that

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aligning the engine transaction according to transaction cost economizing principles had a significantly larger impact on increasing survival during the shakeout stage than during the pre-shakeout stage, although alignment did not have a statistically significant impact over the entire period. Argyres and Bigelow’s (2007) study indicates that transaction cost theory needs to account for variation in selection pressures across the industry life cycle. What is the relationship between strategizing and economizing? To explore the relationship between economizing and strategizing, we first identify one common feature embedded in both approaches. This commonality is the notion of sunk costs. Sunk costs are the set of expenditures that, once incurred, cannot be recovered. In the strategizing perspective, sunk costs represent the commitment that sends a signal to shape competitors’ behavior. For instance, in a review of sunk costs, Tirole (1988, p. 315) argues that the decision to buy equipment today may have strategic consequences because competitors, while observing this action, will expect the focal firm to ‘be around tomorrow if it cannot resell the equipment’. Rivals will thus interpret the focal firm’s action of buying equipment as a credible signal to stay in the business and ‘bad news’ for the profitability of the product market, and they may decide to cooperate by reducing production scale or to not enter the market at all. Specific investments, a term associated with TCE, represent sunk costs that emerge through the fundamental transformation. While sunk costs may affect competitor behavior through strategizing, the focus in TCE is on the ability of specialized investments to create value by lowering production cost or enhancing quality. For instance, investments in specific physical assets like machine dies or human asset specificity that arises in learning by doing provide just two illustrations of specific investments that can create value. Sunk costs therefore are critical in both theoretical perspectives but for different reasons. Strategic commitment allows a firm to capture from competitors a greater portion of the profit pie because it sends a credible signal to the opponents to foreclose entry and investment or to signal cooperation and collusion. Investment in asset specificity, on the other hand, generates value because it can create the benefits of specialization in a transaction and enables the firm to capture value if its transactions are better aligned than at least some competitors. Transaction cost economists therefore argue that these specialization benefits can be realized by designing appropriate governance structures to mitigate potential opportunism. Although value is captured through differing mechanisms, sunk costs are a common feature in both theories and provide an opportunity

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to theoretically integrate strategizing and economizing approaches in the business strategy literature, which we now explore. When does economizing inform strategizing? Foss (2003, p. 139), in a methodological essay, argues that TCE is ‘necessary for adequately understanding the nature of strategizing, because transaction costs are essential aspects of processes of creating, capturing and protecting value’. That is, strategic moves involving some costs have implications for governance choice, the cost of which may affect the choice of strategic move. Nickerson and Vanden Bergh (1999) provide a specific application of this perspective. In the context of competition between Coca-Cola and Pepsi-Cola in the fountain channel, their research explores the choice of asset-organization pair (a specific asset organized under hierarchy or a generic asset organized through a market) in Cournot competition. The model theoretically indicates that governance costs through strategic interactions can influence which asset-organization pair is chosen for each firm. Strategizing without consideration of economizing and its attendant governance costs can lead to different equilibria because of differences in cost functions. For instance, governance costs vary not only by governance mode but also by institutional environment (Williamson 1991b). Without accounting for such differences game-theoretic analysis not only can generate different equilibria but does little to inform organizational choices. More generally, the economizing perspective can inform the strategizing perspective by identifying the set of feasible firm strategies and inform not only the choice of sunk costs but also organizational and pricing choices. These strategic alternatives then can be assessed employing game-theoretic tools. For instance, recent approaches by Ghosh and John (1999), Nickerson (1997) and Nickerson et al. (2001) identify alternative strategies in various contexts by linking the economizing perspective with Porter’s (1985, 1996) strategic positioning approach. Nickerson et al. (2001), for instance, employ TCE to econometrically identify alternative strategic positions within the international courier and small package industry, identified by the nature of investment (co-specialized or re-deployable) along an activity chain, the organization (make or buy) of each activity, and the market position supported by these choices. This type of analysis provides a full set of feasible strategies that can then be analyzed in a strategizing context. Boundary conditions of the strategizing perspective Economizing can inform strategizing, but only within those boundary conditions where game theory offers an appropriate methodology. Teece

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et al. (1997, p. 513) argue that strategizing ‘is most relevant when competitors are closely matched and the population of relevant competitors and the identity of their strategic alternatives can be readily ascertained’. The boundary condition of the game-theoretic approach is the number of competitors within an industry. The relevance of game-theoretical predictions decreases as the number of market participants increases because developing expectations of other firms’ alternatives and their effect on the focal firm’s profitability becomes increasingly difficult and complex. The impact of strategic interactions on firm decisions thus decreases as the market approaches a traditional model of perfect competition. When does strategizing inform economizing? Strategizing can inform economizing on several fronts. Williamson argues that contracting parties can foresee, although not with perfect foresight, the potential for opportunistic behavior and then design appropriate governance structures to minimize transaction costs (Williamson, 1991a). This anticipation and ex ante contract design is consistent with the game-theoretic logic of a contingency action plan. Therefore, in order to design transaction cost economizing contracts ex ante, firms should invest in foreseeing the potential opportunistic behaviors of their trading partners and the potential strategic moves of their competitors. This contemplation argues for considerations of strategizing when choosing economizing governance structures. Should strategizing models provide additional foresight then it should be folded into the transaction cost economizing calculus for designing appropriate contracts as well as efficient governance arrangements. A weakness of the economizing perspective is that it offers little insight on which transactions a firm should pursue. Indeed, Williamson’s (1985) conceptualization of TCE assumes that a firm already contains a core set of transactions for which a ‘comparative assessment is unneeded’ and therefore explores the organization of transactions that are added to the core and ‘for which make-or-buy decisions can only be made after assessing the transformation and transaction cost consequences of alternative modes’ (Williamson, 1985, p. 96). Strategizing may inform economizing by helping to identify which transactions to undertake as well as the desirable level of asset specificity. For instance, Nickerson and Vanden Bergh’s (1999) Cournot model informs the level of asset specificity firms should invest in; although, it does little to inform which transaction firms should enter into. Finally, the strategizing approach has been profitably employed to explore behavior within bilateral relationships. Numerous models employ a game-theoretic methodology to explore the vertical scope of a firm’s activities (Grossman and Hart, 1986) and self-enforcing contract regimes

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(Klein, 1996). While these strategizing approaches do inform the economizing approach, we do not consider this class of models further because such analysis is between vertical trading partners as opposed to the horizontal competition discussed in this chapter, and it rarely takes into account potential strategic moves by horizontal competition (for a more comprehensive treatment see Rey and Tirole, 2007). Boundary conditions of the economizing perspective While strategizing does and can inform economizing there nonetheless are important boundary conditions. Most important is Williamson’s (1985) assumption of bounded rationality where individuals are intendedly rational but limitedly so. In contrast, the strategizing perspective often and typically assumes perfect rationality. In relatively simple situations where the bounds of rationality do not pose constraints, both perspectives are compatible. This compatibility breaks down as cognitive limits are reached and represents a boundary condition for a joint economizing– strategizing perspective. Bounded rationality imposes other boundary conditions as well. Economizing usually is treated as if it were, in principle, a strategy equally available to every firm all the time. However, not every firm may align transactions according to the discriminating alignment hypothesis and not all managers may have the capacity to recognize contracting hazards and ways to mitigate them. Argyres and Liebeskind (1999) described how prior contractual commitments that did not foresee new transactions may constrain governance choices. In all of these contexts, bounded rationality is sufficiently severe to limit the applicability both of economizing and strategizing. Are strategizing and economizing necessary and sufficient perspectives for business strategy? The large numbers of academic papers that consider investments in sunk costs to signal to competitors and that explore the use of governance structures to safeguard investments in asset specificity indicate that these perspectives offer necessary insights to the field of business strategy. For instance, Saloner (1991) reviews work on game-theoretic models and illustrates how game-theoretic modeling techniques are relevant to the studies of strategic management and Williamson (1991a) does the same for TCE. These perspectives assist managers and scholars alike in determining ways to capture value either by holding competitors at bay or gaining cooperation or by appropriating returns from investments in specific assets. The economizing and strategizing perspectives undoubtedly provide necessary insights to understanding how firms capture value.

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A more challenging question involves the extent to which these perspectives are sufficient foundations for the field of business strategy. Both approaches have a common weakness in that they only address one of the fundamental strategy questions we mentioned in the outset of this chapter, namely, value appropriation. Neither economizing nor strategizing has much to say about value creation. For example, the strategizing literature emphasizes the strategic moves to generate and exploit market power but relies on the assumed existence of demand and marginal cost curves. The literature on economizing, on the other hand, focuses largely on value appropriation from economizing on transaction costs, assuming that the transactions in which the firm is engaged are already chosen. Therefore, these perspectives alone or in combination offer a necessary but not sufficient foundation for the theory of business strategy because they fail to provide insights into value creation. By assuming that specific assets can create value to the transaction, Williamson (1991a) can focus on the analysis of economizing on the costs of opportunistic behaviors. In addition, Williamson emphasizes that hierarchy is an effective mode of governance to deal with cooperative adaptation. Although these adaptation benefits create value to the transaction and firms, future research is required for the economizing perspective to provide insight into value creation. Conclusion In this chapter we introduced the literature on economizing and strategizing in the context of business strategy. The value of TCE rests on the minimization of transaction costs with respect to potential opportunism and the performance benefits the discriminating alignment hypothesis engenders. On the other hand, the value of game theory rests on applying its method to develop a contingency action plan based on considering the strategic interactions among firms. Moreover, we described how investing in sunk costs is a central decision premise in both theories as they apply to business strategy, albeit enabling different mechanisms. Relying on this central decision premise we introduced research that explores the intersection of strategizing and economizing of business strategy and their boundary conditions. We concluded that while the economizing and strategizing perspectives are necessary foundations to business strategy they neither individually nor combined offer a sufficient theory of business strategy at least because they do not inform value creation. References Arben, P.D. (1997), ‘The integrating course in the business school curriculum, or, whatever happened to business policy?’, Business Horizon, 40 (2), 65–70.

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Argyres, N. and L. Bigelow (2007), ‘Does transaction misalignment matter for firm survival at all stages of the industry life cycle?’, Management Science, 53 (8), 1332–44. Argyres, N. and J. Liebeskind (1999), ‘Contractual commitments, bargaining power and governance inseparability: incorporating history into transaction cost theory’, Academy of Management Review, 24 (1), 49–63. Armour, H.O. and D.J. Teece (1978), ‘Organization structure and economic performance: a test of the multidivisional hypothesis’, Bell Journal of Economics, 9 (1), 106–22. Camerer, C.F. (1991), ‘Does strategy research need game theory?’, Strategic Management Journal, 12 (special issue), 137–52. Chandler, A.D., Jr (1962), Strategy and Structure: Chapters in the History of the American Industrial Enterprise, Cambridge, MA: MIT Press. David, R.J. and S.K. Han (2004), ‘A systematic assessment of the empirical support for transaction cost economics’, Strategic Management Journal, 25 (1), 39–58. Dixit, A.K. (1980), ‘The role of investment in entry deterrence’, Economic Journal, 90 (357), 95–106. Dixit, A.K. and B.J. Nalebuff (1991), Thinking Strategically, New York: W.W. Norton. Foss, N.J. (2003), ‘The strategic management and transaction cost nexus: past debates, central questions, and future research possibilities’, Strategic Organization, 1 (2), 139–69. Ghemawat, P. (1991), Commitment, New York: Free Press. Ghemawat, P. (1997), Games Businesses Play: Cases and Models, Cambridge, MA: MIT Press. Ghemawat, P., D.J. Collis, G.P. Pisano and J.W. Rivkin (2001), Strategy and the Business Landscape: Core Concepts, Upper Saddle River, NJ: Prentice Hall. Ghosh, M. and G. John (1999), ‘Governance value analysis and marketing strategy’, Journal of Marketing, 63 (special issue), 131–45. Grossman, S. and O. Hart (1986), ‘The costs and benefits of ownership: a theory of vertical and lateral integration’, Journal of Political Economy, 94 (4), 691–719. Hesterly, W.S. and T.R. Zenger (1993), ‘The myth of a monolithic economics: fundamental assumptions and the use of economic models in policy and strategy research’, Organization Science, 4 (3), 496–510. Klein, B. (1996), ‘Why holdups occur: the self-enforcing range of contractual relationships’, Economic Inquiry, 34 (3), 444–63. Macher, J.T. and B.D. Richman (2008), ‘Transaction cost economics: an assessment of empirical research in the social sciences’, Business and Politics, 10 (1), 1–63. Mas-Colell, A., M.D. Whinston and J.R. Green (1995), Microeconomic Theory, Oxford: Oxford University Press. Masten, S.E. (1995), ‘Empirical research in transaction-cost economics: challenges, progress, directions’, in John Groenewegen (ed.), Transaction Cost Economics and Beyond, New York: Springer, pp. 43–64. Masten, S.E., J.W. Meehan, and E.A. Snyder (1991), ‘The costs of organization’, Journal of Law, Economics, and Organization, 7 (1), 1–25. Mayer, K. and J. Nickerson (2005), ‘Antecedents and performance implications of contracting for knowledge workers: evidence from information technology services’, Organization Science, 1 (3), 225–42. Nickerson, J. (1997), ‘Toward an economizing theory of strategy’, Olin working paper 97–107. Nickerson J. and B.S. Silverman (2003), ‘Why firms want to organize efficiently and what keeps them from doing so: inappropriate governance, performance, and adaptation in a deregulated industry’, Administration Science Quarterly, 48 (3), 433–65. Nickerson, J. and R. Vanden Bergh (1999), ‘Economizing in a context of strategizing: governance mode choice in Cournot competition’, Journal of Economic Behavior and Organization, 40 (1), 1–15. Nickerson J., B.H. Hamilton, and T. Wada (2001), ‘Market position, resource profile and governance: linking Porter and Williamson in the context of international courier and small package services in Japan’, Strategic Management Journal, 22, 251–73.

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Peltzman, S. (1991), ‘The handbook of industrial organization: a review article’, Journal of Political Economy, 99 (1), 201–17. Porter, M.E. (1980), Competitive Strategy, New York: Free Press. Porter, M.E. (1985), Competitive Advantage, New York: Free Press. Porter, M.E. (1996), ‘What is strategy?’, Harvard Business Review, 74 (6), 61–78. Rey, P. and J. Tirole (2007), ‘A primer on foreclosure’, in M. Armstrong and R. Porter (eds), Handbook of Industrial Organization, Volume 3, Amsterdam: North Holland. Rumelt, R.P., D.E. Schendel, and D.J. Teece (1991), ‘Strategic management and economics’, Strategic Management Journal, 12 (special issue), 5–29. Rumelt, R.P., D.E. Schendel and D.J. Teece (1994), ‘Fundamental issues in strategy’, in R.P. Rumelt, D.E. Schendel and D.J. Teece (eds), Fundamental Issues in Strategy: A Research Agenda, Boston, MA: Harvard Business School Press, pp. 9–47. Saloner, G. (1991), ‘Modeling, game theory, and strategic management’, Strategic Management Journal, 12 (special issue), 119–36. Shapiro, C. (1989), ‘The Theory of Business Strategy’, The RAND Journal of Economics, 20 (1), 125–37. Shelanski, H.A. and P.G. Klein (1995), ‘Empirical research in transaction cost economics: a review and assessment’, Journal of Law, Economics, and Organization, 11 (2), 335–61. Silverman, B.S., J. Nickerson and J. Freeman (1997), ‘Profitability, transactional alignment, and organizational mortality in the US trucking industry’, Strategic Management Journal, 18 (special issue), 31–52. Teece, D.J., G. Pisano and A. Shuen (1997), ‘Dynamic capabilities and strategic management’, Strategic Management Journal, 18 (7), 509–33. Tirole, J. (1988), The Theory of Industrial Organization, Cambridge, MA: MIT Press. von Neumann, J. and O. Morgenstern (1944), Theory of Games and Economic Behavior, Princeton: Princeton University Press. Williamson, O.E. (1975), Markets and Hierarchies: Analysis and Antitrust Implications, New York: Free Press. Williamson, O.E. (1985), The Economic Institutions of Capitalism, New York: Free Press. Williamson, O.E. (1991a), ‘Strategizing, economizing, and economic organization’, Strategic Management Journal, 12 (special issue), 75–94. Williamson, O.E. (1991b), ‘Comparative economic organization: the analysis of discrete structural alternatives’, Administrative Science Quarterly, 36 (2), 269–96. Williamson, O.E. (1993), ‘Contested exchange versus the governance of contractual relations’, The Journal of Economic Perspectives, 7 (1), 103–8. Williamson, O.E. (1996), The Mechanisms of Governance, Oxford: Oxford University Press. Williamson, O.E. (2005), ‘The economics of governance’, American Economic Review, 95 (2), 1–18.

16 Empirical methods in transaction cost economics Michael E. Sykuta

Transaction cost economics (TCE), and the New Institutional Economics (NIE) more generally, places a strong emphasis on empirical research. That research, in a number of applied fields, is described throughout this volume. Empirical observation and analysis has played a central role in the development of TCE, going back to Coase’s original inquiry into the nature of the firm (Coase, 1937). Coase’s seminal work was motivated by observations of incongruities between economic theory and the real world, and a desire for a theory of the firm ‘where the assumptions may be both manageable and realistic’ (Coase, 1937, p. 386). This approach has led TCE researchers to crack open not only the black box of production known as the firm, but also the market itself, examining the structures of individual transactions and their implications for firm and market performance. The result is a burgeoning field of empirical research on the causes and consequences of different modes for governing the allocation and coordination of resources in an economy. Is the empirical evidence persuasive? Macher and Richman’s (2008) review of the application of TCE across the range of social science disciplines finds ‘considerable support for the main propositions derived from transaction cost economic theory’ (p. 138) but concludes there are lingering challenges. Oliver Williamson (2000, pp. 605–7) is more bold, calling TCE an ‘empirical success story’. But this view is by no means universal (see, for example, Chapter 25 by Foss and Klein and Chapter 28 by Hodgson, in this volume). Some of TCE’s core concepts are difficult to define, explanatory variables such as asset specificity and uncertainty are difficult to measure, correlations between asset specificity and firm behaviour and organization are not necessarily causal relationships, moderating influences are often omitted, and so on. Williamson (2000, p. 610) characterizes the NIE (and hence TCE) as ‘a boiling cauldron of ideas’. He continues on to state, ‘Not only are there many institutional research programs in progress, but there are competing ideas within most of them’ (p. 610). This bubbling mix of competing ideas manifests itself as a wide range of questions and perspectives on economic organization. Several reviews of these competing theories as well as of 152

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the empirical literatures they have spawned are available elsewhere. This chapter reviews some of the empirical methods and techniques that are most common in TCE research and reviews the empirical and theoretical challenges facing scholars in this field. (Sykuta, 2008, provides further details.) Basic modeling frameworks The most basic question in NIE research dates back to Ronald Coase’s original (1937) inquiry: why use a firm (managerial control) instead of the market (price mechanism) to coordinate the allocation of resources? Coase addresses this general question in two steps. First, he considers the question of ‘why a firm emerges at all in a specialised exchange economy’ (1937, p. 390). His proposed answer, as is now familiar to many economists, is that there are costs to using the price mechanism that may make internal organization more efficient. However, this raises the second point Coase considers, namely ‘why is not all production carried on by one big firm?’ (ibid., p. 394). Employing the principles of marginal analysis, Coase argues that the costs of managerial coordination increase as firm scale and heterogeneity of transactions increase, to the point that the marginal cost of internalizing another resource allocation decision (transaction) exceeds the cost of using the price mechanism. Hence, the basic empirical question resulting from Coase’s insights may be summarized as ‘what factors affect the relative costs of internal coordination and market transactions that determine whether a firm will internalize resource allocations or use the price mechanism?’, that is, the make-or-buy decision. Empirically, the make-or-buy decision would seem to present a straightforward econometric problem. Given the dichotomous nature of the decision, a simple dummy variable is sufficient to capture the distinction. The econometric problem is to then estimate the probability that the activity will be internalized based on a set of explanatory variables hypothesized to affect the relative costs of managerial and market coordination. The issue is how best to estimate the relationship between the discrete choice of internalization and the set of explanatory variables, suggesting use of probit or logit models (Hubbard and Weiner, 1991; Allen and Lueck, 1992, 1998; Geddes, 1997; Helland and Sykuta, 2004; James and Sykuta, 2006). The make-or-buy decision is caricatured as the choice between two extremes, (spot) market transactions and internalization. However, between spot markets and hierarchy there is a wide range of contractual relations that exemplify characteristics of both spot (autonomous) transactions and managerial coordination to varying degrees. This is the gray range of organizational structure called ‘hybrids’ (Williamson, 1991;

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Ménard, 2004). The addition of hybrids to the analysis simply adds one more choice in organizational structure: market, hybrid, or hierarchy. Of course, hybrids themselves may range from long-term contracts between two otherwise autonomous parties to joint ventures and strategic alliances that involve more mutual investment and governance to franchise agreements with a quasi-managerial contractual control. The first question to address with more than two discrete choices or outcomes is whether the choices are inherently ordinal or simply represent multiple alternatives. For example, consider how the degree of asset specificity affects governance structures. Williamson (1991) suggests that as the degree of asset specificity increases, the optimal organizational structure moves from market to hybrid to hierarchy. If one considers market, hybrid, and hierarchy as degrees of hierarchical control, then a discrete choice variable taking on values of 0, 1, and 2, respectively, makes ordinal sense. Hierarchy (2) is more control than hybrid (1), which is more control than market (0). As with the make-or-buy decision, however, the richness of these differences is difficult to capture in discrete choice models, although in principle increasingly fine categorizations of ‘hybrid’ could be addressed by simply allowing more discrete values for the dependent variable. When discrete choices have ordinal relevance, an ordered probit or ordered logit model may be the most appropriate specification (Hubbard, 2001; James and Sykuta, 2005). For multiple discrete outcomes that do not have an inherently ordinal relation, a multinomial logit model provides an appropriate mechanism (Crocker and Masten, 1991; Ménard and Saussier, 2000). The preceding models are well suited to studies of choices between two or more discrete choices, such as choices among organizational forms, whether to include or exclude a particular characteristic or contract term, or choices reflecting varying degrees of an attribute. A different set of research questions focuses on cardinal measures of organizational and contractual characteristics, such as the number of terms included in contracts, the number of business divisions or production lines in a firm, or the number of members of corporate boards. Questions such as these suggest use of a counting model such as a Poisson regression model (Gompers and Lerner, 1996; Helland and Sykuta, 2004). Other problems include censored data (for which Tobit models can be useful) and survivorship bias (for which maximum likelihood estimation is preferred to ordinary least squares). Dichotomous variables may also be needed for cases in which firms simultaneously employ multiple governance modes (the ‘make-and-buy’ decision) (Monteverde and Teece, 1982; Fan, 2000; Lafontaine and Shaw, 2005). Most of the empirical research on contracting and organization attempts

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to explain some attributes of governance mechanisms based on, or given, the characteristics of the transaction being studied. However, it is clearly the case that in many instances transaction characteristics as well as governance attributes are endogenously determined. For instance, the level of specific investment and the nature of protections against post-contractual hazards related to those investments may be simultaneously determined. Indeed, the incomplete contracts theory of the firm (Grossman and Hart, 1986; Hart and Moore, 1990) implicitly recognizes this, as the ex ante ownership arrangement is chosen based on its expected effect on the level of specific investment. More generally, decision makers choose (self-select) a governance mechanism with the objective of maximizing their payoff. To deal with endogeneity researchers have typically used instrumental variables, seemingly unrelated regression (SUR), switching models, and other techniques (Ackerberg and Botticini, 2002; Hamilton and Nickerson, 2003; Mayer and Nickerson, 2005). Identification is often particularly difficult in these studies, however. A related issue is the endogeneity of terms within a contract and the relationship between various contract terms. Sykuta and Parcell (2003) argue that transactions have three fundamental characteristics: the allocation of value, the allocation of exposure to uncertainty, and the allocation of decision rights. Terms affecting any one of these three allocations are likely to have implications for allocations elsewhere in the contract. Thus, it is important to consider the complete set of contract terms rather than focusing on individual terms in isolation. Both Joskow (1987) and Crocker and Masten (1991) examine the interaction between contract terms using standard simultaneous equation techniques. In discussing this challenge, Masten and Saussier (2002, p. 291) claim [t]he binding constraint is not technique, but data availability. As the number of provisions analyzed increases, the number of explanatory variables and the size of the data set needed for statistical identification multiplies. Often, sufficient numbers of observations to analyze more than two or three provisions at a time will simply not exist.

Another issue relates to the performance effects of organization form and the assumption of equilibrium contracting. As Williamson (1985, p. 22) states, ‘the question is whether organizational relations (contracting practices; governance structures) line up with the attributes of transactions as predicted by transaction cost reasoning or not’. The hypothesis test, then, is based on the assumption that if we do not observe the expected relation between transaction cost factors and (presumably efficient) organizational design, the theory is not substantiated. The possibility of misalignment and dynamic adjustment has not been well addressed. In short,

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little work has been done directly examining the performance (or transaction cost) implications of governance design and the dynamics of governance structures. Although there have been attempts to measure the relation between organizational design and performance (Armour and Teece, 1978; Silverman et al., 1997; Poppo and Zenger, 1998), there is little conclusive evidence. Masten (2002) explains the methodological and empirical challenges for establishing a causal relationship between organizational form and performance. A major impediment concerns the ability to measure performance at the unit of analysis: the resource allocation decision or transaction. An important exception is Mayer and Nickerson (2005) who actually examine transaction-level financial returns as a function of organizational form. Using data on individual information technology service agreements, Mayer and Nickerson find that service agreements structured in ways consistent with transaction cost-based predictions have higher financial returns, suggesting governance structure matters for performance. Although not direct tests of the link between organization and performance, recent studies do offer indirect evidence. Nickerson and Silverman (2003) examine the dynamic implications of organizational misalignment in the US interstate for-hire trucking industry and find that firms with structures inconsistent with TCE predictions ‘realize lower profits than their better-aligned counterparts, and that these firms will attempt to adapt so as to better align their transactions’ (Nickerson and Silverman, 2003, p. 433). Argyres and Bigelow (2007) incorporate transaction cost economizing in a life cycle model for the early US automotive industry and find firms that were not organized in transaction cost economizing ways were more likely to fail during the industry’s shakeout period in the 1920s. The dynamics of contract structure – that is, how contracts evolve and whether contracting parties learn from their experiences – have also received little attention. This is a different question than the effect of repeat dealing or reputation on contract design (Crocker and Reynolds, 1993). Hill (2001) provides a legal production function explanation for the persistence of poorly written contract documents, explaining how judicial institutions and the nature of legal work limit lawyers’ incentives to innovate or improve upon previously sanctioned contract language. Argyres and Mayer (2004) conduct an in-depth study of a series of contracts between two parties to determine when and why contract terms change, and find many changes that cannot be readily explained by changes in the assets at risk. They also find a positive relation between inter-organizational trust and contract length, if not contractual completeness.

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Theoretical and conceptual challenges Empirical research on contracting and organizations has generally been successful, particularly the applications of Williamson’s (1985, 1996) TCE theory. However, challenges still exist. Key terms and concepts in the underlying theories are both poorly defined and difficult to measure. This section briefly highlights these areas of potential concern not as a warning sign against proceeding, but simply as a caution or perhaps as a call for intentional focus to address these challenges. Measurement is a fundamental difficulty in empirical TCE research. While measurement problems are often the result of imperfect data, several key measurement problems result from theoretical concepts that are not well defined. It is difficult to appropriately measure something that is not clearly defined. This section highlights particular terms and concepts that hamper effective research on contracting and organizational structure. Vertical integration From Coase’s original work in 1937, the make-or-buy decision has been a focal point for empirical research. However, the concept of vertical integration is not well defined either in the NIE or in the traditional industrial organization literature. The unanswered question regarding vertical integration is: what is the economic relevance of the concept? Without that understanding, one cannot begin to determine the appropriate measure of vertical integration. Perhaps the most common understanding of vertical integration is ownership of productive assets at consecutive stages of production. While measuring ownership of assets at two stages of production is relatively straightforward, such a measure ignores two important economic implications. First, such a measure does not address whether the volume of production at one stage corresponds with the volume at the other stage, what might be called the degree of vertical integration. A firm that vertically integrates 10 percent of its input requirements is not the same as a firm that integrates 100 percent of its needs. Fan (2000) and Fan and Lang (2000) develop a measure of relatedness using input–output production ratios to calculate the relative share of the vertically integrated resource. Such a measure provides a better perspective of the economic relevance of the integrated activity. Second, defining vertical integration based on asset ownership at consecutive stages of production may miss the economic point. In Coase’s 1937 paper, the economic question is not: ‘why are assets commonly owned?’ It is: ‘why are resources allocated by managerial control rather than by the price mechanism?’ Common ownership of assets is neither a necessary nor sufficient condition for managerial (or non-price) coordination

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or control of resources. It is not uncommon for commonly owned divisions of a company to operate autonomously in the marketplace without direct managerial intervention. Similarly, ownership is not required to exert managerial control over assets. This is amply clear in US agriculture, where production contracts in poultry and hogs, among other products, stipulate many managerial practices and asset allocations – to the point that such independent contracting arrangements are under scrutiny for appearing too much like employment contracts. An alternate definition of vertical integration would be based on control of productive assets at adjoining stages of production. One might envision a measure similar to Fan’s (2000) capturing the percentage of input needs (distribution access) controlled. However, since assets can be controlled by managerial discretion either through ownership or by contract, such a definition of integration would fail to discriminate between the type of governance mechanism used. Moreover, at least in the case of contractual control, contractual incompleteness may give rise to circumstances in which the residual rights of control do not correspond to the contractual control rights, raising the question of which party actually ‘owns’ the asset (the basis of the Grossman–Hart–Moore framework (Grossman and Hart, 1986; Hart and Moore, 1990)). Asset specificity The concept of asset specificity plays a prominent role in Williamson’s (1985, 1996) TCE and the incomplete-contracts approach as well. The argument is that asset specificity creates a quasi-rent in the transaction relationship that may induce one party or the other to engage in opportunistic behaviour and/or costly negotiations in an attempt to appropriate the value of the quasi-rent. These quasi-rents are typically considered the difference in the value of the specific asset in its current use versus its next best use, net of any conversion, retooling, and redeployment costs. Another way of thinking about the quasi-rent is as the difference between the price currently being paid for the asset and the price required to keep the asset employed in its current use (that is, its shutdown or reservation price). The greater the quasi-rent, the greater the incentive for at least one party to attempt to appropriate the value of the quasi-rent. Thus, the key for arguments of asset specificity rests in the size of the quasi-rent. Empirical research examining the role of asset specificity rarely uses direct estimations of the size of the quasi-rent itself due to the difficult nature of measuring opportunity costs. Rather, most research asserts a positive correlation between certain characteristics and the size of the quasi-rent, and attributes any incentives resulting from asset specificity to the characteristics themselves. For instance, Fan (2000) uses geographic

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proximity among petroleum refiners to proxy for specificity. Joskow (1987) uses both the physical proximity of electric plants and coal mines and the type of coal available from the mines as measures of geographic and technical specificities. Masten et al. (1991) use survey results from production managers rating the degree of specificity and complexity of component parts in shipbuilding. Saussier (2000) uses a dummy variable to indicate whether suppliers deliver to facilities requiring specially-designed physical assets. While the link between such measures of specificity and the existence of a quasi-rent are intuitively reasonable, the size of the appropriable rent and hence the incentive for opportunistic behaviour are imperfectly captured, at best. A more appealing proxy for asset specificity may be the amount of investment required in non-redeployable assets, such as Saussier’s (2000) measure of site-specific investment. However, while quasi-rents may be attributable to such sunk investments, a measure of redeployment costs rather than initial deployment costs would be more accurate. Obviously, quasi-rents are difficult to measure empirically and proxies such as those described above may be the best alternative available to researchers. Nonetheless, researchers should bear in mind the goal of measuring the size of the appropriable quasi-rent itself rather than immediately relying on characteristics of assets that may generate such rents. A more fundamental question that researchers must address is ‘specific to what?’ The general premise in NIE theories of the firm is that investments or assets that are relationship-specific give rise to potential quasi-rents and associated behavioural ills. What is less clear is whether, or when, assets that are firm-specific or industry-specific are necessarily relationship-specific. For instance, Pirrong (1993) and Hubbard (2001) use ‘thinness’ of the market to proxy for specificity of assets that, of themselves, are not necessarily specific to a particular transaction or trading partner. Thinness in the market creates a potential temporal hazard like unto that in Masten et al. (1991). However, in the former case, the temporal specificity derives from the sequential nature of a production process rather than market structure characteristics. One may ask to what extent the optimal governance response for such temporal specificities depends on the source of the specificity, or the circumstances under which the implications of the empirical results are more or less generalizable. Conclusion From the original seeds sown by Coase’s inquiry into why we observe firms in a specialized market economy, TCE research has been characterized by an interest in developing theories ‘where the assumptions may be both manageable and realistic’ (Coase, 1937, p. 386). This intention to develop

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models based in realism places a premium on quality empirical research both to test alternative theories and to identify empirical phenomena that might spur further innovations in our theoretical frameworks. The tremendous variation in governance structures and transaction attributes observed in the economy suggests numerous types of inquiries, each with different statistical characteristics. Therefore the econometric toolkit for researchers in the NIE must encompass a wide array of formulations and researchers must be flexible in their abilities to adapt to new techniques as are appropriate to their investigations. Despite the large number of empirical studies to date and the general consistency of empirical results with transaction cost-based theories of economic organization, there is much work to be done. Theoretical concepts must be refined to provide clearer insight into the nature of organizational structure. Competing theories suggest opportunities to take what is best from each to develop a more complete whole. New and better sources of data on contract and organizational structures will provide fuel for empirical research and facilitate more robust statistical analyses of the causes and consequences of alternate governance forms. Though challenges exist, our understanding of how the economic system works will be greatly enhanced as scholars continue their work. References Ackerberg, Daniel A. and Maristella Botticini (2002), ‘Endogenous matching and empirical determinants of contract form’, Journal of Political Economy, 110(3), 564–91. Allen Douglas and Dean Lueck (1992), ‘Contract choice in modern agriculture: cash rent versus cropshare’, Journal of Law and Economics, 35 (2), 397–426. Allen, Douglas and Dean Lueck (1998), ‘The nature of the farm’, Journal of Law and Economics, 41 (2), 343–87. Armour, Henry Ogden and David J. Teece (1978), ‘Organizational structure and economic performance: a test of the multidivisional hypothesis’, Bell Journal of Economics, 9 (1), 106–22. Argyres, Nicholas S. and Lyde Bigelow (2007), ‘Do transaction costs matter for firm survival at all stages of their lifecycle?’, Management Science, 53 (8), 1332–44. Argyres, Nicholas S. and Kyle J. Mayer (2004), ‘Learning to contract: evidence from the personal computer industry’, Organization Science, 15 (4), 394–410. Coase, Ronald H. (1937), ‘The nature of the firm’, Economica, N.S., 4 (16), 385–405. Crocker, Keith J. and Scott E. Masten (1991), ‘Pretia ex machina?: prices and process in long-term contracts’, Journal of Law and Economics, 34 (1), 69–99. Crocker, Keith J. and Kenneth J. Reynolds (1993), ‘The efficiency of incomplete contracts: an empirical analysis of air force engine procurement’, RAND Journal of Economics, 24 (1), 126–46. Fan, Joseph P.H. (2000), ‘Price uncertainty and vertical integration: an examination of petrochemical firms’, Journal of Corporate Finance: Contracting, Governance, and Organization, 6 (4), 345–76. Fan, Joseph P.H. and Larry Lang (2000), ‘The measurement of relatedness: an application to corporate diversification’, Journal of Business, 73 (4), 629–60. Geddes, R. Richard (1997), ‘Ownership, regulation, and managerial monitoring in the electric utility industry’, Journal of Law and Economics, 40 (1), 261–88.

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Gompers, Paul and Josh Lerner (1996), ‘The use of covenants: an empirical analysis of venture partnership agreements’, Journal of Law and Economics, 39 (2), 405–34. Grossman, Sanford J. and Oliver D. Hart (1986), ‘The costs and benefits of ownership: a theory of vertical and lateral integration’, Journal of Political Economy, 94 (4), 691–719. Hamilton, Barton H. and Jackson A. Nickerson (2003), ‘Correcting for endogeneity in strategic management research’, Strategic Organization, 1 (1), 53–80. Hart, Oliver and John Moore (1990), ‘Property rights and the nature of the firm’, Journal of Political Economy, 98 (6), 1119–58. Helland, Eric and Michael Sykuta (2004), ‘Regulation and the evolution of corporate boards: monitoring, advising, or window dressing?’, Journal of Law and Economics, 47 (1), 167–94. Hill, Claire A. (2001), ‘Why contracts are written in “legalese”’, Chicago Kent Law Review, 77 (1), 59–85. Hubbard, R. Glenn and Robert J. Weiner (1991), ‘Efficient contracting and market power: evidence from the US natural gas industry’, Journal of Law and Economics, 34 (1), 25–68. Hubbard, Thomas N. (2001), ‘Contractual form and market thickness in trucking’, RAND Journal of Economics, 32 (2), 369–86. James, Harvey S., Jr and Michael E. Sykuta (2005), ‘Property rights and organizational characteristics of producer-owned firms and organizational trust’, Annals of Public and Cooperative Economics, 76 (4), 545–80. James, Harvey S., Jr and Michael E. Sykuta (2006), ‘Farmer trust in producer- and investorowned firms: evidence from Missouri corn and soybean producers’, Agribusiness: An International Review, 22 (1), 135–53. Joskow, Paul L. (1987), ‘Contract duration and relationship-specific investment: empirical evidence from coal markets’, American Economic Review, 77 (1), 168–85. Lafontaine, Francine and Kathryn L. Shaw (2005), ‘Targeting managerial control: evidence from franchising’, RAND Journal of Economics, 36 (1), 131–50. Macher, Jeffrey T. and Barak D. Richman (2008), ‘Transaction cost economics: an assessment of empirical research in the social sciences’, Business and Policy, 10 (1), 1–63. Masten, Scott (2002), ‘Modern evidence on the firm’, American Economic Review, 92 (2), 428–32. Masten, Scott and Stéphane Saussier (2002), ‘Econometrics of contracts: an assessment of developments in the empirical literature on contracting’, in Eric Brousseau and Jean Michel Glachant (eds), The Economics of Contracts, Cambridge, UK: Cambridge University Press, pp. 273–92. Masten, Scott E., James W. Meehan, and Edward A. Snyder (1991), ‘The costs of organization’, Journal of Law, Economics, and Organization, 7 (1), 1–25. Mayer, Kyle J. and Jackson Nickerson (2005), ‘Antecedents and performance implications of contracting for knowledge workers: evidence from information technology services’, Organization Science, 16 (3), 225–42. Ménard, Claude (2004), ‘The Economics of Hybrid Organizations’, Journal of Institutional and Theoretical Economics, 160 (3), 1–32. Ménard, Claude and Stéphane Saussier (2000), ‘Contractual choice and performance: the case of water supply in France’, Revue d’économie industrielle, 2nd–3rd Trimesters, 92, 385–404. Monteverde, Kirk and David J. Teece (1982), ‘Supplier switching costs and vertical integration in the automobile industry’, Bell Journal of Economics, 13 (1), 206–13. Nickerson, Jackson A. and Brian S. Silverman (2003), ‘Why firms want to organize efficiently and what keeps them from doing so: inappropriate governance, performance, and adaptation in a deregulated industry’, Administrative Science Quarterly, 48 (3), 433–65. Pirrong, Stephen Craig (1993), ‘Contracting practices in bulk shipping markets: a transactions cost explanation’, Journal of Law and Economics, 36 (2), 937–76. Poppo, Laura and Todd Zenger (1998), ‘Testing alternative theories of the firm: transaction cost, knowledge-based, and measurement explanations for make-or-buy decisions in information services’, Strategic Management Journal, 19 (9), 853–77.

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Saussier, Stéphane (2000), ‘Transaction costs and contractual incompleteness: the case of Électricité de France’, Journal of Economic Behavior and Organization, 42 (2), 189–206. Silverman, Brian, Jackson Nickerson, and John Freeman (1997), ‘Profitability, transactional alignment, and organizational mortality in the US trucking industry’, Strategic Management Journal, 18 (S1), 31–52. Sykuta, Michael (2008), ‘New institutional econometrics: the case of research on contracting and organization’, in E. Brousseau and J.-M. Glachant (eds), New Institutional Economics: A Guidebook, Cambridge: Cambridge University Press, pp. 122–41. Sykuta, Michael and Joseph Parcell (2003), ‘Contract structure and design in identity preserved soybean production’, Review of Agricultural Economics, 25 (2), 332–50. Williamson, Oliver (1985), The Economic Institutions of Capitalism, New York: Free Press. Williamson, Oliver (1991), ‘Comparative economic organization: the analysis of discrete structural alternatives’, Administrative Science Quarterly, 36 (2), 269–96. Williamson, O. (1996), The Mechanisms of Governance, New York: Oxford University Press. Williamson, Oliver (2000), ‘The new institutional economics: taking stock, looking ahead’, Journal of Economic Literature, 38 (3), 595–613.

PART IV APPLICATIONS

17 Vertical integration Peter G. Klein

Vertical integration, or the ‘make-or-buy decision’, has been described as the ‘paradigm problem’ of transaction cost economics (TCE) (Williamson, 1996b, p. 65). Indeed, while TCE can be regarded as a highly general approach to economic organization – Williamson (1996b, p. 8) states that ‘any problem that arises as or can be posed as a contracting problem can be examined to advantage in transaction cost economics terms’ – the theory was largely developed in the context of a particular application: organizing the vertical stages of production. When Coase (1937, pp. 393–4) famously asks, ‘[w]hy does the entrepreneur not organise one less transaction or one more?’, he is referring to transactions between the entrepreneur and a factor of production (for example, labour) – a vertical transaction. Why, then, do some firms choose a vertically integrated structure, while others specialize in one stage of production and outsource the remaining stages to other firms? Why are some inputs procured on the spot market, others through ongoing relationships with particular suppliers, yet others through complex supplier networks or alliances? Should a manufacturing firm use its own distributors, or should it contract with independent retailers? Should investment projects be funded on the external capital markets, or should the firm rely on internal finance? Traditionally, economists viewed vertical integration or tight vertical relationships as attempts by dominant firms to earn monopoly rents by gaining control of input markets or distribution channels, to engage in price discrimination, or to eliminate multiple markups along the supply chain. Antitrust authorities, steeped in what Williamson (1985, p. 369) calls the ‘inhospitality tradition’ toward vertical restrictions, generally frowned upon vertical integration and long-term contracting. The transaction cost approach, by contrast, emphasizes that vertical coordination can be an efficient means of protecting relationship-specific investments or mitigating other potential conflicts under incomplete contracting.1 The theory of vertical boundaries Coase was the first to explain that the boundaries of the organization depend not only on the productive technology, but also on the costs of transacting business. In the Coasian framework, the decision to organize 165

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transactions within the firm as opposed to on the open market depends on the relative costs of internal versus external exchange. The market mechanism entails certain costs: discovering the relevant prices, negotiating and enforcing contracts, and so on. Within the firm, the entrepreneur may be able to reduce these ‘transaction costs’ by coordinating these activities himself. However, internal organization brings other kinds of transaction costs, namely problems of information flow, incentives, monitoring, and performance evaluation. The boundary of the firm, then, is determined by the tradeoff, at the margin, between the relative transaction costs of external and internal exchange. In this sense, the firm’s vertical boundaries depend not only on technology, but also on organizational considerations; that is, on the costs and benefits of various contracting alternatives. According to TCE, economic organization, both internal and external, imposes costs because complex contracts are usually incomplete – they provide remedies for only some possible future contingencies.2 This obviously applies to written contracts for all but the simplest forms of trade. It also applies to relational contracts, agreements that describe shared goals and a set of general principles that govern the relationship (Goldberg, 1980; Baker et al., 2002), and to implicit contracts, agreements that while unstated are assumed to be understood by all sides. Moreover, contractual incompleteness exposes the contracting parties to certain risks. Primarily, if circumstances change unexpectedly, the original governing agreement may no longer be effective. The need to adapt to unforeseen contingencies constitutes an additional cost of contracting; failure to adapt imposes what Williamson (1991a) calls ‘maladaptation costs’.3 The most often discussed example of maladaptation is the ‘holdup’ problem associated with relationship-specific investments.4 The holdup problem figures prominently in Williamson’s (1975, 1985, 1996b), Klein et al.’s (1978), and Grossman and Hart’s (1986) interpretations of the transaction cost theory. Investment in such assets exposes agents to a potential hazard: if circumstances change, their trading partners may try to expropriate the rents accruing to the specific assets. Rents can be safeguarded through vertical integration, where a merger eliminates any adversarial interests. Less extreme options include long-term contracts, partial ownership, and agreements for both parties to invest in offsetting relationship-specific investments. Overall, several governance structures may be employed. According to transaction cost theory, parties tend to choose the governance structure that best controls the underinvestment problem, given the particulars of the relationship. In this sense, TCE may be considered the study of alternative institutions of governance. Its working hypothesis, as expressed by Williamson (1991b,

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p. 79), is that economic organization is mainly an effort to ‘align transactions, which differ in their attributes, with governance structures, which differ in their costs and competencies, in a discriminating (mainly, transaction cost economizing) way’. Simply put, the contractual approach tries to explain how trading partners choose, from the set of feasible institutional alternatives, the arrangement that best mitigates the relevant contractual hazards at least cost.5 The theory is fleshed out by specifying which governance structures go with which transactions. Transactions differ in the degree to which relationship-specific assets are involved, the amount of uncertainty about the future and about other parties’ actions, the frequency with which the transaction occurs, and so on. Each matters for the preferred institution of governance, although the first – asset specificity – is particularly important. Williamson (1985, p. 55) defines asset specificity as ‘durable investments that are undertaken in support of particular transactions, the opportunity cost of which investments is much lower in best alternative uses or by alternative users should the original transaction be prematurely terminated’.6 This could describe a variety of relationship-specific investments, including both specialized physical and human capital, along with intangibles such as R&D and firm-specific knowledge or capabilities. Governance structures include markets, hierarchies, and hybrids. The pure anonymous spot market suffices for simple transactions such as basic commodity sales. Market prices provide powerful incentives for exploiting profit opportunities and market participants are quick to adapt to changing circumstances as information is revealed through prices. When relationship-specific assets are at stake, however, and when product or input markets are thin, bilateral coordination of investment decisions may be desirable and combined ownership of these assets may be efficient. Ownership is completely combined in the fully integrated firm. The transaction cost approach maintains that such hierarchies offer greater protection for specific investments and provide relatively efficient mechanisms for responding to change where coordinated adaptation is necessary. Compared with decentralized structures, however, hierarchies provide managers with weaker incentives to maximize profits and normally incur additional bureaucratic costs.7 Alternatively, partial alignment may be achieved within intermediate or hybrid forms such as long-term contracts, partial ownership agreements, franchises, networks, alliances, and firms with highly decentralized assignments of decision rights. Hybrids attempt to achieve some level of central coordination and protection for specific investments while retaining the high-powered incentives of market relations.

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Empirical research on vertical boundaries Most of the empirical work on the make-or-buy decision adopts the transaction cost framework and follows the same basic model. The efficient form of organization for a given economic relationship – and, therefore, the likelihood of observing a particular organizational form or governance structure – is seen as a function of certain properties of the underlying transaction or transactions: asset specificity, uncertainty, frequency, and so on. Organizational form is the dependent variable, while asset specificity, uncertainty, complexity, and frequency are independent variables. Specifically, the probability of observing a more integrated governance structure depends positively on the amount or value of the relationship-specific assets involved and, for significant levels of asset specificity, on the degree of uncertainty about the future of the relationship, on the complexity of the transaction, on the frequency of trade, and possibly on some aspects of the institutional environment. Detailed surveys of this literature are in Klein (2005), Macher and Richman (2008), and elsewhere. Classic papers include Masten’s (1984) study of aerospace component procurement, a series of papers by Joskow (1985, 1987, 1988, 1990) on long-term contracting for coal, Crocker and Masten’s (1991) study on natural gas contracts, research by Erin Anderson and co-authors on marketing channels (Anderson and Schmittlein, 1984; Anderson, 1985; Anderson and Coughlan, 1987) and several other industry case studies. In most of these studies, organizational form is often modelled as a discrete variable – ‘make’, ‘buy’, or ‘hybrid’, for example – though it can sometimes be represented by a continuous variable. Of the independent variables, asset specificity has received the most attention, presumably because of the central role it plays in the transaction cost approach to vertical integration. Williamson (1991a) distinguishes among six types of asset specificity. The first is site specificity, in which parties are in a ‘cheek-by-jowl’ relationship to reduce transportation and inventory costs and assets are highly immobile. The second, physical asset specificity, refers to relationship-specific equipment and machinery. The third is human asset specificity, describing transaction-specific knowledge or human capital, achieved through specialized training or learning-by-doing. The fourth is brand-name capital, reflected in intangible assets reflected in consumer perceptions. The fifth is ‘dedicated assets’, referring to substantial, general-purpose investments that would not have been made outside a particular transaction, the commitment of which is necessary to serve a large customer. The sixth is temporal specificity, describing assets that must be used in a particular sequence. Case studies comprise the bulk of the studies on the make-or-buy decision, primarily because the main variables of interest – asset specificity,

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uncertainty, frequency – are difficult to measure consistently across firms and industries. Of course, the classification of discrete variables like ‘make-or-buy’, for example, may require more discretion by the researcher than economists are comfortable with. Also, of course, the evidence from individual cases may not apply to other cases. Still, the cumulative evidence from different studies and industries is remarkably consistent with the basic transaction cost argument, though naturally there remain outstanding puzzles, challenges, and controversies. Identification, selection, unobserved heterogeneity One problem with the empirical literature on vertical boundaries, common to many areas of empirical social science research, concerns the thorny issues of identification, selection, and unobserved heterogeneity. The main problem is that we typically observe only the business arrangements actually chosen, not the complete set of feasible arrangements. If these arrangements are presumed to be efficient, then we can draw inferences about the appropriate alignment between transactional characteristics and organizational form simply by observing what firms do. Indeed, the early empirical work on the transaction cost approach implicitly assumed that market forces work to cause an ‘efficient sort’ between transactions and governance structures. Williamson (1988, p. 174) acknowledges this assumption, while recognizing that the process of transaction cost economizing is not automatic, maintaining that TCE ‘relies in a general, background way on the efficacy of competition to perform a sort between more and less efficient modes and to shift resources in favor of the former’. Concerning vertical integration, for example, Williamson (1985, pp. 119–20) writes that ‘backward integration that lacks a transaction cost rationale or serves no strategic purposes will presumably be recognized and will be undone’, adding that mistakes will be corrected more quickly ‘if the firm is confronted with an active rivalry’. Within the last two decades, researchers have begun to examine this conjecture more closely, looking to see if appropriately organized firms – that is, firms that match transactional characteristics to governance structures as the theory says they should – really do outperform the feasible alternatives. Several papers use a two-step procedure in which organizational form (in particular, the relationship between transactional characteristics and governance structure) is endogenously chosen in the first stage, then used to explain performance in the second stage. By endogenizing both organizational form and performance this approach also mitigates the selection bias associated with OLS regressions of performance on firm characteristics.8 This evolutionary approach sheds considerable light on the processes

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by which organizations adapt and change, along with the costs of misalignment or maladaptation. However, reliance on evolutionary models introduces additional problems. In many cases, survival may not be the best measure of performance, compared with profitability or market value. Poorly performing firms may survive due to inefficient competitors, regulatory protection, or legal barriers to exit such antitakeover amendments or an overprotective bankruptcy code. In short, efficient alignment between transactions and governance should be expected only if the selection environment is strong. Moreover, when market conditions change rapidly and unexpectedly, ex post survival may not be a good measure of ex ante efficiency; a particular organizational form may be right for the times, but the times change.9 More generally, most of the applied studies on vertical boundaries establish correlations, not causal relations, between asset specificity and internal governance. These studies typically test a reduced form model where the probability of observing a more hierarchical form of governance increases with the degree of relationship-specific investments. Plausibly, if the presence of such investments reduces the costs of internal organization, then asset specificity could lead to integration, independent of the holdup problem or other maladaptation costs. Masten et al. (1991) attempt to distinguish these two effects in the context of human capital. They find that specific human capital investments appear to reduce internal governance costs more than they increase market governance costs. Further studies of this type would be valuable in assessing the implications of the evidence for the reduced form version of the basic theory. However, we do not yet have a general theory of how relationship-specific assets might reduce the costs of internal organization. By contrast, the underinvestment problem associated with specific assets and market governance is fairly well understood. Make, buy, or hybrid? Another issue relates to the place of hybrids in the transaction cost story. As described elsewhere in this volume by Ménard (Chapter 18), Michael (Chapter 19), and Raynaud (Chapter 20), there is a healthy literature on the characteristics of hybrid forms. However, the choice between hybrids and alternative organizational structures is less well understood. Perhaps surprisingly, most of the make-or-buy studies examine the binary choice between market procurement and some, more hierarchical, alternative, either vertical integration or a hybrid arrangement. The choice between one hierarchical agreement and another – between longterm contracting and vertical integration, for example – has received less attention.

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An exception is the continuing controversy surrounding the purchase of Fisher Body by General Motors (GM) in 1926. Klein et al. (1978) and Klein (1988) cite the case as a classic example of vertical integration designed to mitigate holdup in the presence of asset specificity. Fisher refused to locate its plants near GM assembly plants and to change its production technology in the face of an unanticipated increase in the demand for car bodies, leading GM to terminate its existing ten-year supply contract with Fisher and acquire full ownership. Coase (2000), revisiting the original documents, argues instead that the contract performed well, and was gradually replaced with full ownership only to get Fisher’s top managers (the Fisher brothers) more closely involved in GM’s other operation. Coase (2000) reveals that the original ten-year supply contract included provisions that GM would acquire 60 per cent of Fisher’s stock and that three of the five members of Fisher’s finance committee would be appointed by GM. Moreover, in 1921 one of the Fisher brothers became a director of GM, with two other brothers joining him in 1924, one of whom became president of GM’s Cadillac division. A fourth brother was added to the board in 1926 when GM acquired the remainder of Fisher’s stock. As Coase points out, the interests of the two companies were sufficiently aligned during the period covered by the original contract that it is unlikely that Fisher would have used the contract to extract rents from GM. Also, contrary to the conventional understanding of the case, Fisher did in fact build eight new body plants between 1922 and 1925 that were close to GM facilities and had incentives to use the most efficient technology available. In short, GM did not acquire the remaining 40 per cent of Fisher’s stock in response to an inappropriate alignment between transactional attributes and an existing governance structure. Rather, the long-term contract signed in 1919 was adequate for mitigating holdup in the face of asset specificity and uncertainty, and was replaced by vertical integration for secondary reasons.10 Klein (2000, 2007) vigorously disputes Coase’s revisionist account, holding that the newest evidence confirms his earlier claim that GM’s acquisition of Fisher in 1926 was a response to opportunistic behaviour by Fisher.11 Conclusion Despite these and other challenges, the transaction cost theory of the firm has had remarkable success in explaining the vertical structure of the enterprise. Indeed, the empirical literature on the make-or-buy decision is generally considered one of the best-developed parts of the new institutional economics. As noted in the chapters below by Foss and Klein (Chapter 25) and Hodgson (Chapter 28), not all critics agree with Williamson (1996a,

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p. 55) that TCE is ‘an empirical success story’. But even the negative attention TCE sometimes draws is a testament to its influence in the theory and practice of vertical boundaries. Notes 1. 2. 3.

4.

5.

6.

7.

8. 9. 10.

Recent surveys of the theoretical and empirical literatures on the transaction-cost and agency-theoretic approaches to vertical integration include Joskow (2005), Klein (2005), Lafontaine and Slade (2007), and Macher and Richman (2008). This contrasts with the agency-theoretic literature (for example, on franchise contracts), which generally works within a complete-contracting perspective. Williamson (1975, 1985, 1996b) attributes incompleteness to bounded rationality (see Chapter 14 by Foss in this volume for a detailed discussion). Klein (1996) frames the problem instead in terms of drafting costs, while the modern incomplete-contracting literature (Grossman and Hart, 1986; Hart, 1995) simply assumes that certain variables are non-contractible, either because they are unobservable or because they cannot be verified to third parties (for example, courts). More generally, contractual difficulties can arise from several sources: ‘(1) bilateral dependence; (2) weak property rights; (3) measurement difficulties and/or oversearching; (4) intertemporal issues that can take the form of disequilibrium contracting, real time responsiveness, long latency and strategic abuse; and (5) weaknesses in the institutional environment’ (Williamson, 1996b, p. 14). Each of these has the potential to impose maladaptation costs. Foreseeing this possibility, agents seek to reduce the potential costs of maladaptation by matching the appropriate governance structure with the particular characteristics of the transaction. Most of the literature assumes that, for each transaction or class of transactions, there exists a uniquely optimal governance structure. Sometimes, however, we observe bisourcing, the simultaneous use of in-house and outsourced production for the same components by the same firm. Du et al. (2006) use bargaining theory to show how simultaneously making and buying can mitigate the holdup problem associated with exclusive reliance on an external supplier. He and Nickerson (2006) tell a more nuanced story in which ‘the interaction of efficiency, appropriability, and competition concerns’ explains simultaneous bi-sourcing. Klein et al.’s (1978) definition is similar, though they omit the qualifier ‘much’. Essentially they define a relationship-specific asset (‘specialized asset’) as any asset that generates appropriable quasi-rents; that is, any asset whose value to its current renter exceeds its value to another renter. Williamson (1975, 1991b, 1996b), unlike Klein et al. (1978) and Grossman and Hart (1986), places particular emphasis on adaptation as a characteristic of organizational forms, leading Gibbons (2005) to call Williamson’s approach (in at least one variant) the ‘adaptation theory’ of the firm, as distinct from the ‘rent-seeking’ approach. For more on adaptation see Mayer and Argyres (2004), Argyres and Mayer (2007), and Costinot et al. (2009). Papers using a two-stage approach (such as Heckman’s selection model) in this fashion include Masten et al. (1991), Poppo and Zenger (1998), Saussier (2000), Macher (2006), Nickerson et al. (2001), Sampson (2004), and Yvrande-Billon (2004). In this sense experimentation – even the reversal or ‘undoing’ of previous actions – can be consistent with efficient behaviour (Mosakowski, 1997; Boot et al., 1999; Matsusaka, 2001; Foss and Foss, 2002; Klein and Klein, 2002). Coase (2006) reviews the evidence on Fisher and GM and traces the development and evolution of the canonical account. His explanation for the widespread acceptance of the Fisher Body ‘myth’ is complex. First, Coase doubts the overall value of the basic asset specificity-holdup-opportunism story of TCE, and thinks researchers have exaggerated the importance of this case because it supports what would otherwise be a suspect theory. Coase has a broader purpose in mind, however. He uses this episode to

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criticize economists for overreliance on deductive methods, for failing to investigate the ‘facts on the ground’, and for general sloppiness in empirical work: If it is believed that their theory tells us how people would behave in different circumstances, it will appear unnecessary to many to make a detailed study of how they did in fact act. This leads to a very casual attitude toward checking the facts. If it is believed that certain contractual arrangements will lead to opportunistic behavior, it is not surprising that economists misinterpret the evidence and find what they expect to find. (Coase, 2006, p. 275) 11.

See Chapter 12 by Klein in this volume for further details on this case.

References Anderson, E. (1985), ‘The salesperson as outside agent or employee: a transaction cost analysis’, Marketing Science, 4 (3), 234–54. Anderson, E. and A.T. Coughlan (1987), ‘International market entry and expansion via independent or integrated channels of distribution’, Journal of Marketing, 51 (1), 71–82. Anderson, E. and D.C. Schmittlein (1984), ‘Integration of the sales force: an empirical examination’, RAND Journal of Economics, 15 (3), 385–95. Argyres, N.S. and K.J. Mayer (2007), ‘Contract design as a firm capability: an integration of learning and transaction cost perspectives’, Academy of Management Review, 32 (4), 1060–1077. Baker, G., R. Gibbons, and K.J. Murphy (2002), ‘Relational contracts and the theory of the firm’, Quarterly Journal of Economics, 117 (1), 39–84. Boot, A.W.A., T.T. Milbourn, and A.V. Thakor (1999), ‘Megamergers and expanded scope: theories of bank size and activity diversity’, Journal of Banking and Finance, 23 (2–4), 195–214. Coase, R.H. (1937), ‘The nature of the firm’, in R.H. Coase, The Firm, the Market and the Law, Chicago: University of Chicago Press. Coase, R.H. (2000), ‘The acquisition of Fisher Body by General Motors’, Journal of Law and Economics, 43 (1), 15–31. Coase, R.H. (2006), ‘The conduct of economics: the example of Fisher Body and General Motors’, Journal of Economics and Management Strategy, 15 (2), 255–78. Costinot, A., L. Oldenski, and J. E.Rauch (2009), ‘Adaptation and the boundary of multinational firms’, NBER Working Paper No. w14668. Crocker, K.J. and S.E. Masten (1991), ‘Pretia ex machina? Prices and process in long-term contracts’, Journal of Law and Economics, 34 (1), 69–99. Du, J., Y. Lu, and Z. Tao (2006), ‘Why do firms conduct bi-sourcing?’, Economics Letters, 92 (2), 245–9. Foss, K. and N.J. Foss (2002), ‘Organizing economic experiments: property rights and firm organization’, Review of Austrian Economics, 15 (4), 297–312. Gibbons, R. (2005), ‘Four formal(izable) theories of the firm’, Journal of Economic Behavior and Organization, 58 (2), 202–47. Goldberg, V. (1980), ‘Relational exchange: economics and complex contracts’, American Behavioral Scientist, 23 (3), 337–52. Grossman, S.J. and O.D. Hart (1986), ‘The costs and benefits of ownership: a theory of vertical and lateral integration’, Journal of Political Economy, 94 (4), 691–719. Hart, O.D. (1995), Firms, Contracts, and Financial Structure, New York: Oxford University Press. He, D. and J.A. Nickerson (2006), ‘Why do firms make and buy? Efficiency, appropriability and competition in the trucking industry’, Strategic Organization, 4 (1), 43–69. Joskow, P.L. (1985), ‘Vertical integration and long-term contracts: the case of coal-burning electric generating plants’, Journal of Law, Economics and Organization, 1 (1), 33–80. Joskow, P.L. (1987), ‘Contract duration and relationship-specific investments: empirical evidence from coal markets’, American Economic Review, 77 (1), 168–85.

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Joskow, P.L. (1988), ‘Price adjustment in long-term contracts: the case of coal’, Journal of Law and Economics, 31 (1), 47–83. Joskow, P.L. (1990), ‘The performance of long-term contracts: further evidence from the coal markets’, RAND Journal of Economics, 21 (2), 251–74. Joskow, P.L. (2005), ‘Vertical integration’, in C. Ménard and M. Shirley (eds), Handbook of New Institutional Economics, New York: Springer, pp. 319–48. Klein, B. (1988), ‘Vertical integration as organized ownership: the Fisher Body–General Motors relationship revisited’, Journal of Law, Economics and Organization, 4 (1), 199–213. Klein, B. (1996), ‘Why hold-ups occur: the self-enforcing range of contractual relationships’, Economic Inquiry, 34 (3), 444–63. Klein, B. (2000), ‘Fisher-General Motors and the nature of the firm’, Journal of Law and Economics, 43 (1), 105–41. Klein, B. (2007), ‘The economic lessons of Fisher Body-General Motors’, International Journal of the Economics of Business, 14 (1), February, 1–36. Klein, B., R.A. Crawford, and A.A. Alchian (1978), ‘Vertical integration, appropriable rents, and the competitive contracting process’, Journal of Law and Economics, 21 (2), 297–326. Klein, P.G. (2005), ‘The make-or-buy decision: lessons from empirical studies’, in C. Ménard, and M. Shirley (eds), Handbook of New Institutional Economics, New York: Springer, pp. 435–64. Klein, P.G. and S.K. Klein (2002), ‘Do entrepreneurs make predictable mistakes? Evidence from corporate divestitures’, in N.J. Foss and P.G. Klein (eds), Entrepreneurship and the Firm, Cheltenham, UK and Northampton, MA, USA: Edward Elgar Publishing, pp. 173–92. Lafontaine, F. and M. Slade (2007), ‘Vertical integration and firm boundaries: the evidence’, Journal of Economic Literature, 45 (3), 629–85. Macher, J.T. (2006), ‘Technological development and the boundaries of the firm: a knowledge-based examination in semiconductor manufacturing’, Management Science, 52 (6), 826–43. Macher, J.T. and B.D. Richman (2008), ‘Transaction cost economics: an assessment of empirical research in the social sciences’, Business and Politics, 10 (1), Article 1. Masten, S.E. (1984), ‘The organization of production: evidence from the aerospace industry’, Journal of Law and Economics, 27 (2), 403–17. Masten, S.E., J.W. Meehan, and E.A. Snyder (1991), ‘The costs of organization’, Journal of Law, Economics and Organization, 7 (1), 1–25. Matsusaka, J.G. (2001), ‘Corporate diversification, value maximization, and organizational capabilities’, Journal of Business, 74 (3), 409–31. Mayer, K.J. and N.S. Argyres (2004), ‘Learning to contract: evidence from the personal computer industry’, Organization Science, 15 (4), 394–410. Mosakowski, E. (1997), ‘Strategy making under causal ambiguity: conceptual issues and empirical evidence’, Organization Science, 8 (4), 414–42. Nickerson, J.A., B.H. Hamilton, and T. Wada (2001), ‘Market position, resource profile, and governance: linking Porter and Williamson in the context of international courier and small package services in Japan’, Strategic Management Journal, 22 (3), 251–73. Poppo, L. and T. Zenger (1998), ‘Testing alternative theories of the firm: transaction cost, knowledge-based, and measurement explanations for make-or-buy decisions in information services’, Strategic Management Journal, 19 (9), 853–77. Sampson, R.C. (2004) ‘The cost of misaligned governance in R&D alliances’, Journal of Law, Economics and Organization, 20 (2), 484–526. Saussier, S. (2000), ‘Transaction costs and contractual incompleteness: the case of Electricitié de France’, Journal of Economic Behavior and Organization, 42 (2), 189–206. Williamson, O.E. (1975), Markets and Hierarchies: Analysis and Antitrust Implications, New York: Free Press. Williamson, O.E. (1985), The Economic Institutions of Capitalism, New York: Free Press. Williamson, O.E. (1988), ‘The economics and sociology of organization: promoting a

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dialogue’, in George Farkas and Paula England (eds), Industries, Firms, and Jobs: Sociological and Economic Approaches, New York: Plenum Press, pp. 159–85. Williamson, O.E. (1991a), ‘Comparative economic organization: the analysis of discrete structural alternatives’, Administrative Science Quarterly, 36 (2), 269–96. Williamson, O.E. (1991b), ‘Strategizing, economizing, and economic organization’, Strategic Management Journal, 23 (special issue), 75–94. Williamson, O.E. (1996a), ‘Economic organization: the case for candor’, Academy of Management Review, 21 (1), 48–57. Williamson, O.E. (1996b), The Mechanisms of Governance, New York: Oxford University Press. Yvrande-Billon, A. (2004), ‘Contractual choices and performances: evidence from the British Railways’, in George Hendrikse, Josef Windsperger, Gérard Cliquet, and Mika Tuunanen (eds), Economics and Management of Franchising Networks, Heidelberg: Physica/Springer, pp. 174–86.

18 Hybrid organizations Claude Ménard

There are many ways to organize transactions in a modern market economy. Beside the polar cases of spot markets on the one hand, in which trading activities are coordinated through the price mechanism, and integrated firms on the other hand, in which the allocation of resources and the coordination of decisions depend in the last resort on a hierarchical structure, many different types of arrangements have developed, from long-term bilateral contracts to franchise systems and networks of tightly interwoven firms. These non-standard forms likely represent the usual way of doing business, although they deviate from the usual representation of microeconomic textbooks in which there are firms, that is, ‘producers’ processing goods and services through a production function, and ‘markets’, that is, places in which producers and consumers proceed to exchanges. In what follows I concentrate on forms that involve multiple partners pooling some strategic decision rights and even some property rights while keeping distinct ownership over key assets, so that they require specific governance to monitor and discipline their interactions. I identify these arrangements as ‘hybrid organizations’, in line with the terminology proposed by Oliver Williamson (1991).1 In the next section I go farther in identifying and delineating these arrangements. I will then discuss the forces at work that may explain why parties accept to share strategic rights in the next section. The following section exhibits different mechanisms of coordination that may play distinctly or in combination. The next section suggests a typology of hybrid organizations based on the prevalence of each different mechanism. The final section concludes by emphasizing problems raised by the very existence of hybrids, particularly with respect to competition policies. What are hybrids? Although there is an abundant empirical literature describing the many different forms that the organization of transactions can take, from strategic alliances involving several partners to networks of firms tightly coordinated to franchise systems, the terminology fluctuates, making it difficult to capture exactly what is at stake. These variations in the vocabulary reflect the richness of arrangements to be considered as well as the lack of 176

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a unifying theory that could properly identify the nature of these arrangements and the logic underlying their diversity. To fix ideas about what can be assembled under the term ‘hybrid organizations’, let me start with a stylized fact.2 In the late 1970s, French millers were confronted by a sharp decline in the consumption of bread, particularly the famous ‘baguette’, and this decline exacerbated competition among them. A group of millers decided to react by establishing a niche of high quality products. To do so, they created a brand name to signal these products, with a strict list of requirements regarding the quality of flour to be used, the conditions under which it should be transformed and commercialized, and so on. Marketing the product also required contracting with thousands of bakers who would commit to follow strict rules (for example, using only the high quality flour delivered by these millers, never selling products that have been frozen, and so on). The millers established a joint entity, with each miller represented on the board of directors, to define the requirements, to develop new products (for example, mixing different cereals), to market the brand, and to control quality and prevent free-riding. However, disciplining parties remained a major issue. To make control more efficient, the millers implemented a private court, delegating to three of them the power to investigate cases in which one party or the other would have cheated and to penalize the free-riders, up to the point where one could be excluded from the network. So we have an arrangement in which parties were sharing some major decision rights and some property rights (for example, over the brand name, over the investments required by the joint venture), while remaining legally and economically autonomous. Indeed, the millers were also competitors: for example, eight of them were competing to attract well-located bakers for selling their products in metropolitan Paris. Of course this is not a unique example, although it has its own specificity. Strategic alliances in the airline industry, groups of producers committing to deliver high-quality products in the agri-food industry, partners creating joint ventures for R&D projects in high-tech industries, and so on, are confronted with similar problems and find solutions in implementing modes of governance that differ markedly from those implemented in integrated firms while not primarily relying on market prices. We can generalize the underlying logic of these ‘facts’ as follows. Assume three players, A, B, and C. Let SA, SB, and SC be vectors of the respective specific assets they hold, let dA, dB, and dC be the vectors of their respective decision rights, and let πA, πB, and πC be the payoffs associated with their respective property rights. Now, assume these parties pool specific investments ShA, SiB, and SjC and decision rights dhA, diB, and djC, these joint activities generating a joint payoff π9A,B,C, the allocation of

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which is not fully contractible ex ante. Forms of governance must then be implemented to monitor joint decisions and sharing rules, with rights that are pooled and uncertainties in the allocation of payoffs determining the choice of means of coordination and control that shape these forms. There is indeed a large variety of possible combinations of the three dimensions identified above. Empirically, it is the presence or absence of a specific coordinating entity – call it a ‘strategic centre’ – and the extension of its authority when it exists that seems to differentiate arrangements on the wide spectrum of hybrid modes of organization (I come back to what determines these choices below). To illustrate, subcontracting or supplier parks usually depend on a leading firm that operates as a ‘buyer’ imposing specification on goods or services, although the ‘leader’ may also hold some decision rights and even property rights on its partners. Franchise systems or joint ventures markedly differ in that they unambiguously rely on a coordinating centre, whether this centre gets its decision rights through delegation (joint ventures) or imposes its rules on participating partners (franchise). There are also the various forms taken by strategic alliances, supply chain systems networks, and so on, which may restrict coordination to identifiable persons in charge of monitoring the agreement or may create bureaus or autonomous entities to control parties to the arrangement more or less tightly, as illustrated by the millers’ case. Notwithstanding their diversity, these forms qualify as hybrids in that they differ markedly from markets as well as from hierarchies. To simplify, using the notation above in the context of two parties, if we identify SE as a strategic entity that coordinates partners, we can characterize ‘ideal types’ (in a Weberian sense) as follows: MARKET

HYBRID

FIRM

STRATEGIC ENTITY = Ø

STRATEGIC ENTITY = {SA1, SB2, dB1, dB2, ␲'}

STRATEGIC ENTITY = {SA, SB, dA, dB, ␲A, ␲B}

FIRM A

FIRM B

FIRM B

FIRM B

SA dA ␲A

SB dA ␲B

SA1, SB2,

SA1, SB2,

dB1, dB2 ␲A

dB1, dB2 ␲B

Figure 18.1

Hybrids contrasted

Division A

Division B

Ø

Ø

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Why do parties delegate or even abandon part of their rights? Given the above characterization, why do holders of property and decision rights who could transact through markets renounce significant rights in deciding to pool resources? From a certain point of view, this question has similarities with that of why employees transfer their decision rights to employers (Coase, 1937; Cheung, 1983). However, there is an important difference: in hybrid arrangements legally distinct entities also share some specific assets and property rights. Why do they engage in activities that seriously weaken their residual rights (so much so that finding an adequate sharing rule is a key issue, and often a source of instability in hybrids)? Three leading factors seem to be at work. First, parties may accept to share rights in order to face complexity.3 Complexity has two dimensions. It may result from the need to coordinate multiple interwoven transactions; or it may be due to a changing environment. In both cases, cooperation that involves the abandonment or delegation of some rights may prevail in order to overcome the resulting uncertainties or to develop an adequate buffer. For example, the tight networks developed by general contractors and their subcontractors in the construction industry are determined by the specificity of each project and the highly variable demand, both dimensions generating uncertainties that make adaptability among parties a key issue. More generally, unstable or unpredictable demand; technological changes; potential variations in the quality of inputs; risks of opportunistic behaviour; and unsecured institutional environments are all factors that might push partners to choose hybrid forms, mitigating uncertainty through buffer strategies, shared knowledge, common standards, and joint governance. Second, parties may view mutual dependence as a source of value, notwithstanding the fact that they often remain competitors, as strategic alliances in the airline industry illustrates. Several factors can motivate firms to endorse mutual dependence in holding pooled assets. The size of investments required may exceed their individual capacity, and/or economies of scale may be expected, as in many R&D projects. Complementarity may offer strategic responses to resource dependence, securing access to existing resources or facilitating access to new ones. Learning effects might also be anticipated, each firm becoming a portfolio of skills that networking allows to transfer and recombine more efficiently. Also, joint investments may help in building a reputation with an expected snowball effect on revenues. Third, payoff expected from interaction among parties may not be contractible ex ante, with specific contributions difficult to assess, so that partners look for organizational solutions that facilitate ex post negotiations to share rents with the lowest possible transaction costs. Indeed, because

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standard incentive contracts would perform poorly and measurement problems may be at stake, defining rules that allow a satisfactory split of the gains is not trivial. Some hybrid forms seem to have found relatively standardized solutions to the implementation of adequate sharing rules, as in franchise systems. However, many other forms rely on ex post negotiations and on non-contractible rules such as fairness or ‘perceived equity’. Unfortunately and notwithstanding recent developments in experimental economics, we still know little about how such rules work effectively. Governance mechanisms What is clear, though, is that hybrid arrangements need monitoring. This is so because of high risks of opportunistic behaviour and free riding, which is the dark side of the forces pushing towards cooperation. Hence selecting the right partners, building trust through relational ties, and developing a credible threat in case of misbehaviour might impose specific mechanisms of governance. Indeed, there is a continuing tension between the search for stability and the pressure coming from opportunistic temptations. In that respect, different devices can be implemented, with varying degree of authority over partners who can always exit. At the loose end of the authority spectrum, information systems such as integrated logistics, joint buying procedures, shared transportation facilities, and so on offer the possibility to reduce information asymmetries among partners, reducing risks of opportunism and facilitating mutual control. They also provide means for shaping the interface with the environment through the implementation of shared routines, standards facilitating communication, devices allowing conversion, and translation of protocols at low cost. Although information technologies play an important role in that respect, numerous studies also show the significance of informal relationships such as social ties in building and sharing appropriate information that contributes to organizing and consolidating hybrid arrangements.4 The existence of formal contracts represents a step forward in tightening coordination. As emphasized by Macaulay (1963), contracts mainly provide a framework, a blueprint facilitating decisions and orienting joint actions. In doing so, contracts help delineate a stable environment within which partners can plan collaboration, set reciprocal expectations, and reduce misunderstandings and costly missteps. At the same time, contracts suffer the limitations of blueprints, leaving most decisions on tasks and process aside and often opening the way to adjustments through legally unenforceable clauses (for example, arbitration provisions waiving rights to bring disputes before the courts).5 However, most hybrids are not composed solely of independent

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entrepreneurs operating an outside structure governed solely by formal contracts. Other devices complement and interfere. One is the possibility of exogenous regulators initiating, implementing and eventually monitoring coordination among partners. In many cases, public authorities provide the backbone to hybrid arrangements, either directly through bureaus or agencies, as illustrated by Galileo, a global satellite navigation system designed to compete with the GPS system, developed by a network of firms at the initiative of the European Commission; or indirectly, as when public authorities provide subsidies and other incentives conditional on cooperation among the benefactors (for example, the so-called technology parks). However, such exogenous monitoring often mixes public and private interests. A good example is provided by the French certifying organizations, in which representatives of the government, producers, consumers, and distributors define standards and allocate rights associated with the identification of networks delivering high-quality products (the successful ‘red label’ system). Last, but not least, hybrids often coordinate through a formal body that operates as a depository of authority for monitoring their joint actions. The simplest case is that of joint ventures, in which parent companies monitor their ‘child’ through a Board of Administration that they control. More complex forms also develop in which a strategic centre might operate along rules that exceed the power of individual partners to control joint activities, as illustrated by the example of the millers. A governing body with rules of its own can be implemented in charge of defining collective actions and joint strategies, designing enforcement mechanisms and implementing rules. Such entities can take different forms, for example, co-owners assemblies (as in the condominium model), delegates composing an autonomous board, or a specific permanent entity. All of these arrangements involve centralization of key decisions, a non-negligible level of formal rules, and partial control over property rights. A typology of hybrid arrangements These different mechanisms of governance suggest a trade-off among hybrid arrangements, from forms that involve loose coordination, with separation of decision rights and property rights among partners, to forms that impose very tight control, with strictly monitored shared rights. The variety of franchise systems illustrates this spectrum well. On the one hand, the richness of observable arrangements may suggest a continuum of hybrid forms spread between spot markets and the command-and-control hierarchical firm. At the same time, forms such as strategic alliances differ from franchises and joint ventures. To capture this intuition, one possibility is to hypothesize the existence of discrete

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structural forms that could relate to the characteristics identified so far. The underlying model could be synthesised as in Figure 18.2. Explanatory variables

Costs of governance

Forces pushing towards hybrid arrangements

Figure 18.2

Types of hybrids

Four coordinating devices

Discrete structural forms

More explicitly, the degree of transfer of property rights and decision rights should translate into the need for coordinating devices that imply different costs of governance, determining different types of hybrids. Specifically: (1) the more concentrated property rights are over relationshipspecific assets, the easier it is to coordinate, although at higher costs of governance; (2) the more concentrated joint decision rights are, the tighter the coordination involved, but also the more costly the associated governance mechanism; and (3) the more centralized control is over residual gains, the easier it is to coordinate, but this also pushes costs upwards. Using a deeply revised version of a representation provided by Williamson (1991), I would then suggest that hybrid forms tend to crystallize around four typical arrangements, determined by their dominant governance mechanism (which does not preclude the presence of elements of the other mechanisms). Figure 18.3 illustrates these arrangements. Costs of governance Hybrids

Markets

Informational networks

Integration

Relationalbased agreements

Monitoring leadership

Formal authority centre

Benefits of coordination/control

Figure 18.3

Hybrids and governance costs

If we assume that partners to hybrid arrangements target the maximization of the expected value of their joint activities while minimizing the

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associated costs of governance, then they will want to make a trade-off that will keep them on the inferior frontier of the cost curve associated with the different governance mechanisms they can select. Problems raised by hybrid arrangements In all modern market economies, hybrid modes of organization proliferate because the advantages of cooperation and coordination often overcome the gains associated to market competition, while the capacity for partners to maintain their autonomy of decision and their control over the core of their residual rights provides more flexibility and better incentives than can be expected from an integrated structure. However, the very nature of these arrangements blurs the frontiers of the firm as well as challenges the standard representation of markets. Unfortunately theories encompassing the nature and variety of these arrangements remain remarkably poor. Moreover, we still miss adequate data for estimating precisely the weight and dynamics of these forms, even for a form as well defined and extensively studied as franchising. We also need to understand better why in so many sectors hybrids co-exist with integrated firms, apparently without one prevailing over the other even in the long run. Another issue has to do with the role institutional environments, for example, rules governing property rights, may play in that co-existence as well as in the comparative degree of development of hybrid arrangements and of specific forms of hybrids. Last, but not least, hybrids almost always involve vertical as well as horizontal restrictions, which seriously challenge standard competition policies still largely built around the trade-off between markets and hierarchies. In-depth revision of these policies is therefore likely to be needed in the near future. Notes 1. This terminology is convenient in that it embeds hybrid types of organizational arrangements in a well-defined framework, as argued below. It also has its drawbacks in suggesting that these forms could be interpreted as a simple mixture of ingredients coming from the pure forms that are markets and hierarchies, although the biological connotation of the term should clearly indicate that specific processes and forms are at stake in hybrids. 2. This case is extensively described in Raynaud (1997). 3. This was the argument already developed by Simon (1951) to explain the employment contract. 4. Greif (1993) provides a nice example of how a network can depend on informal information channels in a particularly challenging institutional environment. 5. Ryall and Sampson (2006) illustrate this aspect well.

References Cheung, S. (1983), ‘The contractual nature of the firm’, Journal of Law and Economics, 26 (1), 1–22. Coase, R.H. (1937), ‘The nature of the firm’, Economica, 2 (1), 386–405.

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Greif, A. (1993), ‘Contract enforceability and economic institutions in early trade: the Maghribi traders’, American Economic Review, 83 (3), 525–47. Macaulay, S. (1963), ‘Non-contractual relations in business. A preliminary study’, American Sociological Review, 28 (1), 55–67. Ménard, Claude (2004), ‘The economics of hybrid organizations’, Journal of Institutional and Theoretical Economics, 160 (3), 345–76. Raynaud, E. (1997), Propriété et exploitation partagée d’une marque commerciale: aléas contractuels et ordre privé, PhD dissertation, Université de Paris (Panthéon-Sorbonne). Ryall, M.D. and R.C. Sampson (2006), ‘Do prior alliances influence contract structure? Evidence from technology alliance contracts’, in A. Arino and J. Reuer (eds), Strategic Alliances: Governance and Contracts, London: Palgrave Macmillan, pp. 206–16. Simon, H.A. (1951), ‘A formal theory of the employment relationship’, Econometrica, 19 (3), 293–305. Williamson, O.E. (1991), ‘Comparative economic organization: the analysis of discrete structural alternatives’, Administrative Science Quarterly, 36 (2), 269–96.

19 Franchising Steven C. Michael

Franchising, in which independent businesses operate under a shared trademark using a common production process, is used primarily by service businesses. It is an enduring and pervasive organizational form. As an organizational form, franchising has a large and visible presence in consumer industries such as restaurants, lodging, auto repair, real estate, hair styling, and specialty retailing, where it has captured typically 30 to 40 per cent of sales. Business services in which franchising is prominent include temporary employment, commercial cleaning, printing and copying, tax preparation, and accounting services. Recent areas of growth include home health care, business signage, and child development and education. Historically, franchising was introduced in the US in the early twentieth century by manufacturers in order to secure local distribution of their product (Dicke, 1992). Franchise chains formed at that time still dominate automobile and gasoline retailing, and soft drink and beer distribution. This type of franchising is called product franchising. A second type, business format franchising, was initiated in the 1950s by entrepreneurs in service industries, and is the subject of this chapter. When sales from product franchises such as gas stations and soda bottlers are combined with business format franchises such as restaurants and dry cleaners, franchise chains account for over 40 per cent of retail sales in the US (International Franchise Association, 2004). Further, franchising has become a key mode of expansion for US and European firms in foreign markets; there are over one million franchisees worldwide (Michael, 2003). The mechanics of business format franchising are as follows. A franchise is a legal contract between the owner of a production process and a trademark (the franchisor, such as McDonald’s) and a local businessperson (franchisee) to sell products or services under the franchisor’s trademark employing a production process developed by the franchisor. When a franchise contract is signed, the franchisee pays a lump sum, a franchise fee. After signing the contract, the franchisor gives the franchisee services needed to open the unit, including training and blueprints for the production process, and in some cases support for site selection or construction management. The franchisee typically makes all necessary investments in land, building, and equipment to open the particular site. 185

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After opening, the franchisor provides periodic inspection of the franchise (to ensure operating standards are being followed), access to trademarks and marketing services (such as advertising and new product development). In return for these services, the franchisee pays a royalty on sales (typically ranging between 1 and 10 per cent) and a royalty for marketing expenses (from 0 to 6 per cent), commonly called the advertising fee. Generally franchisees do not sell products of the franchisor (although important exceptions exist); the franchisor is compensated for the trademark and its management (Michael, 2000c). The franchise chain is composed of units franchised to local operators and units owned by the franchisor. Both types operate the same production process and sell under the same trademark, but most franchise chains are primarily composed of franchised units. Research contribution Franchising has two characteristics that distinguish it from other interorganizational forms such as equity joint ventures and strategic alliances. First, franchising typically occurs in businesses where there is a notable service component that must be performed near customers. The result is that service-providing outlets must be replicated and dispersed geographically. The second key characteristic is that franchise contracts typically reflect a unique allocation of responsibilities, decision rights, and profits between a centralized principal (the franchisor) and decentralized agents (franchisees). Franchising furnishes a visible contract embodying much of this allocation that facilitates testing important organizational hypotheses. And franchise chains exist in numbers large enough for statistical analysis. Franchising has been a subject of interest for students of the economics of organizations for many years. Initial and still-insightful works are Caves and Murphy (1976) and Rubin (1978). Lafontaine and Slade (1997) reviewed much of the empirical literature from economics and highlighted agency theory as a motivation for franchising; further amplification and analysis can be found in Blair and Lafontaine (2005). A perspective combining economics and organization theory can be found in the review by Combs et al. (2004). Most relevant to this collection, Williamson has discussed franchising inter alia in several of his works (see Williamson, 1985, 1996). Franchising has not been analysed explicitly but it has instead been cited as an example of hybrid governance. Here is a typical reference: The distribution of branded product from retail outlets by market, hierarchy, and hybrid, where franchising is an example of this last, illustrates the argument

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. . . Forward integration out of manufacturing into distribution would be implied by hierarchy. That would sacrifice incentive intensity but would (better) assure that the parts do not operate at cross-purposes with one another. The market solution would be to sell the good or service outright. Incentive intensity is thereby harnessed, but suboptimization (free riding on promotional efforts, dissipation of the brand name, etc.) may also result. Franchising awards greater autonomy than hierarchy but places franchisees under added rules and surveillance as compared with markets. Costs control and local adaptations are stronger under franchising than hierarchy, and suboptimization is reduced under franchising as compared with the market. The added autonomy (as compared with hierarchy) and the added restraints (as compared with the market) under which franchisees operate nevertheless come at a cost. If, for example, quality assurance is realized by constraining the franchisee to use materials supplied by the franchisor, and if exceptions to that practice are not permitted because of the potential for abuse that would result, then local opportunities to make ‘apparently’ cost-effective procurements will be prohibited. Similarly, the added local autonomy enjoyed by franchisees may get in the way of some global adjustments (Williamson, 1996, p. 107).1

Broadly speaking, these insights have been demonstrated to be correct. The purpose of this chapter is to briefly review empirical and theoretical amplifications. It is important to note, however, that the insight that franchising gives a larger share of high-powered incentives (relative to corporate ownership) is redolent of the key arguments of agency theory, and indeed the language of agency has been more commonly employed than that of transaction cost economics (for example, residual claims and ownership rather than ‘high-powered’ incentives). Similarly, the problem of ‘suboptimization’ that Williamson describes has usually been described as ‘free-riding’. Nonetheless, the analysis is the same. Franchising yields higher incentives and effort Strategically, franchising is an organizational form chosen by entrepreneurs in order to compete in certain industries. Services entrepreneurs choose franchising in order to solve the incentive problem. When operating a chain of dispersed service outlets, each outlet typically requires intensive on-site supervision. Franchising makes the local supervisor the owner of the local business, granting to the supervisor-franchisee the profits after all expenses have been paid. Requiring site managers to invest their own capital and giving them profits after costs induces the franchisee-manager to put forth more effort in supervision than would a corporate employee-manager (Rubin, 1978). Franchisees do not shirk (that is, reduce effort) because their income is tied to their effort. Through franchising, higher-powered incentives are offered (compared to corporate ownership), greater operational efficiency is obtained, and the agency problem is mitigated.

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In franchising, however, the potential for shirking is two-sided (a double-sided moral hazard). The franchisor can fail to invest in the trademark or inadequately screen prospective franchisees, for example. Given that both parties can shirk, one stream of research has focused on how franchise contracts divide tasks and residual claims to create incentives that promote efficiency and minimize shirking. Lafontaine (1992) analysed royalties and franchise fees and observed that the division of revenue between franchisee and franchisor reflects the effort required of each. Klein (1995) argued that chains’ brand name reputations create pricing power that allows franchisors to pay franchisees quasi-rents – amounts greater than the franchisee’s opportunity cost in alternative employment. Hence franchisees suffer if they leave the franchise chain. By paying quasirents, coupled with ongoing monitoring and the threat of contract termination, the franchisor motivates the franchisee. Michael and Moore (1995) compared franchisees’ total returns to an estimated return on franchisee labour plus return on invested capital and found that franchisees earn considerably more than either independent entrepreneurs in similar businesses or employee-managers in company-owned outlets. Franchising yields more free-riding As theory predicts, free-riding is indeed a significant problem in the hybrid organizational form of franchising. Because all outlets operate under a shared trademark and customers transfer goodwill associated with one outlet to others with the same trademark, certain investments franchisees make have spillover benefits to other franchisees. For example, the cleanliness of one outlet affects customers’ perception of all outlets under the trademark. Because the benefits are shared, franchisees prefer to free-ride on others rather than to invest their own effort. These individual actions potentially can lead to chain-wide underinvestment. This argument applies to all local investments that strengthen the brand and that cannot be contractually specified by the franchisor. For example, franchisee local advertising spills over by reaching distant customers who purchase in nearby markets and by reaching local customers who purchase further afield. Franchisees who benefit from national advertising by the franchisor and spillover advertising by nearby franchisees might therefore under-invest in advertising. Franchisors attempt to limit free-riding through monitoring (Brickley et al., 1991), with practices such as periodic inspections, mystery shoppers, and advertising audits. Free-riding has been shown to occur in franchising. Using chain-level hotel and restaurant data, Michael (1999) found that chains that rely heavily on franchising advertise less (as a percentage of sales). In addition, Michael (2000a) found that franchised chains offered lower quality

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in both the restaurant and hotel industries. These two studies uniquely compared franchised chains and chains that do not franchise. In addition, Lafontaine (1999) showed that prices are higher at franchised outlets than company-owned outlets in restaurant chains. Thus, while franchising appears to solve shirking, the consequences of using franchising also include higher prices, lower quality, and less advertising. This suggests that gains from the control of shirking may be offset by costs of freeriding. The possibility that ‘local autonomy’ can hamper ‘global adjustment’ has also been demonstrated. Research has shown that franchisors also appear less able than firm-owned chains to coordinate elements of the marketing mix of price, quality, and advertising. Michael (2002) observed that price and quality were positively related and price and advertising were negatively related (presumably the chain is advertising lower prices) among firm-owned chains as recommended by marketing practice. Among franchised chains, however, price and quality were inversely related, and price and advertising had no relation, suggesting an inability to coordinate the marketing mix. Thus a further conclusion from this line of research is that franchise chains are less able to present a consistent product positioning with their marketing mix of price, quality, and advertising to customers. Thus, franchising is truly a hybrid organizational form; high-powered incentives do yield predictable results of superior operating efficiency – an improvement over hierarchy – but inferior investment in chain-wide public goods such as quality and advertising – a disadvantage versus hierarchy. Identical transactions are sometimes treated differently Franchising is a hybrid organizational form in a second sense: it contains units that are hierarchy (company-owned units) and units that are closer to the market (franchises) within the same system. Explaining this observed fraction (proportion of outlets franchised or per cent franchised) has also been a focus of research. In general, variation in transaction conditions affecting the cost of monitoring has driven the outcome. Firms use more franchising when the cost of monitoring outlets through direct observation and inspection increases. Specifically, rural (Norton, 1988), distant (Brickley and Dark, 1987), and foreign (Fladmoe-Lindquist and Jacque, 1995) outlets are more frequently franchised because of the costs of frequent travel by monitoring personnel (Carney and Gedajlovic, 1991) and the difficulty of assessing managers’ efforts in unfamiliar markets (Minkler, 1990). Norton (1988), for example, observed that the Waffle House relied more on franchising in the southwestern US than near its

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headquarters in the southeast. Franchising is also used more often when outlet managers’ local market expertise is an important competitive input (Combs and Ketchen, 2003); the need for such expertise makes centralized monitoring difficult and costly (Minkler, 1990). Finally, larger outlets are less frequently franchised (Combs and Ketchen, 2003); large outlets give the firm greater economies of scale in monitoring (Lafontaine, 1992). These results collectively support the idea that franchising is a solution to agency. Firms substitute strong incentives via franchising when outlets are costly to monitor. A challenge to this explanation is that some firms frequently maintain both franchised and firm-owned outlets in close proximity to one another. This practice is called either dual distribution (Gallini and Lutz, 1992) or the plural form (Bradach, 1997). Having two identical outlets in the same market with different ownership implies that differences in monitoring costs are not exclusively driving franchising decisions. The puzzle can be explained through application of the Williamsonian analysis of neoclassical contract law (Michael, 2000b). The contract law that enables and underpins franchising is characterized as ‘neoclassical’ contract law (Williamson, 1991). Neoclassical contract law is generally more elastic than classical contract law. Rather than specifying explicit and formal terms for all conditions, the neoclassical contract creates an ‘adaptive range’, a framework and a set of boundaries, within which conflicts are resolved through negotiation between the parties. Negotiation within the adaptive range rather than literal adherence to contract terms facilitates adaptation to change and the preservation of the relationship. Such a negotiation is always carried out in the shadow of the law; when the parties cannot agree within the adaptive range, they resort to the courts. Thus the franchisor has incentive to increase bargaining power. In the context of the ongoing negotiation between franchisee and franchisor, ownership of some units suggests to the franchisee that the franchisor has the information and the willingness to operate those units if quality declines, thus strengthening the bargaining power of the franchisor. In support of this hypothesis, research found that franchisors resorted to litigation less when they owned units (Michael, 2000b). An important extension of transaction costs is added here. Given the frequency and similarity of franchising transactions, it is possible that the opportunity for strategic interaction affects the choice of whether to own or franchise. Hence action taken with regard to one franchisee can signal behaviour to other franchisees. Identical transactions are governed differently, and the set of transactions becomes worthy of analysis.

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Within chains, incentives do appear to be aligned The general logic of the economics of organizations suggests that inefficient organizational forms are eliminated through market competition. To succeed, interorganizational forms such as franchising must align incentives of participants. Nonetheless, empirical tests of this proposition have been rare. Investigating the alignment of incentives through contract terms was a useful by-product of a study of franchisee failure. Michael and Combs (2008) examine how terms of the franchise contract affected franchisee failure. They found that franchisor policies designed to limit adverse selection and moral hazard reduce failure by franchisees. The results are consistent with the argument of Williamson (1983) who notes that franchisees should desire many restrictive policies to be imposed by the franchisor because such policies strengthen the brand that all franchisees rely upon. To examine the efficiency premise of organizational economics, Michael and Combs’s (2008) analysis also compared the effect of contractual terms on franchisee survival in their paper and on franchisor survival elsewhere in the literature (Combs and Ketchen, 1999; Shane, 1998, 2001; Shane and Foo, 1999). Such provisions as requiring industry experience, requiring active ownership, length of training, exclusive territories, and brand investments enhance survival of both franchisees and franchisors. In addition, Michael and Combs (2008) found that franchisor performance (here return on assets) positively and significantly affects franchisee survival. Thus, a strong commonality of interest exists between franchisor and franchisee, and the organizational form seems to be efficient. Conclusion Franchising research has largely supported the research program of the incipient science of organization. Moreover, the use of a different theoretical language (though not a different theoretical reasoning) should not obscure the observation that franchising has provided valuable service (albeit indirectly) to transaction cost economics. In particular, franchising has amplified and elaborated what a hybrid form requires, and has introduced the possibility of strategic effects that one (seemingly identical) transaction can have on another. Important tasks remain. It is certainly desirable to learn more of the dynamics of hybrid organizations, and how such organizations successfully innovate (or do not). The management of such hybrid organizations remains a challenge for study by business and management scholars, if not economists (directly). More generally, franchising can and should continue to be a valuable subject for transaction cost economics research.

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Note 1. Williamson also uses the term franchise in another sense: the allocation by government of the right to engage in an (exclusive) business. See, for example, Williamson (1985), Chapter 13. This chapter does not examine this alternative usage.

References Blair, Roger D. and Francine Lafontaine (2005), The Economics of Franchising, New York: Cambridge University Press. Bradach, J.L. (1997), ‘Using the plural form in the management of restaurant chains’, Administrative Science Quarterly, 42 (2), 276–303. Brickley, J.A. and F.H. Dark (1987), ‘The choice of organizational form: the case of franchising’, Journal of Financial Economics, 18 (2), 401–20. Brickley, James A., Fredrick H. Dark and Michael S.Weisbach (1991), ‘The economic effects of franchise termination laws’, Journal of Law and Economics, 34 (1), 101–31. Carney, M. and E. Gedajlovic (1991), ‘Vertical integration in franchise systems: agency theory and resource explanations’, Strategic Management Journal, 12 (8), 607–29. Caves, Richard E. and William F. Murphy (1976), ‘Franchising: firms, markets, and intangible assets’, Southern Economic Journal, 42 (April), 572–86. Combs, J.G. and D.J. Ketchen (1999), ‘Explaining interfirm cooperation and performance: toward a reconciliation of predictions from the resource-based view and organizational economics’, Strategic Management Journal, 20 (2), 867–88. Combs, J.G. and D.J. Ketchen (2003), ‘Why do firms use franchising as an entrepreneurial strategy?: A meta-analysis’, Journal of Management, 29 (3), 443–65. Combs, J.G., S.C. Michael, and G.J. Castrogiovanni (2004), ‘Franchising: a review and avenues to greater theoretical diversity’, Journal of Management, 30 (6), 907–31. Dicke, Thomas S. (1992), Franchising in America: The Development of a Business Method, 1840–1980, Chapel Hill, NC: University of North Carolina Press. Fladmoe-Lindquist, K. and L.L. Jacque (1995), ‘Control modes in international service operations: the propensity to franchise’, Management Science, 41 (7), 1238–49. Gallini, N.T. and N.A. Lutz (1992), ‘Dual distribution and royalty fees in franchising’, Journal of Law, Economics, and Organization, 8 (3), 471–501. International Franchise Association (2004), Economic Impact of Franchised Businesses, Washington, DC: IFA Educational Foundation. Klein, Benjamin (1995), ‘The economics of franchise contracts’, Journal of Corporate Finance, 2 (1), 9–37. Lafontaine, Francine (1992), ‘Agency theory and franchising: some empirical results’, RAND Journal of Economics, 23 (2), 263–83. Lafontaine, Francine (1999), ‘Franchising versus corporate ownership: the effect on price dispersion’, Journal of Business Venturing, 14 (1), 17–34. Lafontaine, Francine and Margaret E. Slade (1997), ‘Retail contracting: theory and practice’, The Journal of Industrial Economics, 45 (1), 1–25. Michael, Steven C. (1999), ‘Do franchised chains advertise enough?’, Journal of Retailing, 75 (4), 461–78. Michael, Steven C. (2000a), ‘The effect of organizational form on quality: the case of franchising’, Journal of Economic Behavior and Organization, 43 (3), 295–318. Michael, Steven C. (2000b), ‘Investments to create bargaining power: the case of franchising’, Strategic Management Journal, 21 (4), 497–514. Michael, S.C. (2000c), ‘The extent, motivation, and effect of tying in franchise contracts’, Managerial and Decision Economics, 21 (5), 191–201. Michael, S.C. (2002), ‘Can a franchise chain coordinate?’, Journal of Business Venturing, 17 (4), 325–41. Michael, Steven C. (2003), ‘Determinants of franchising across nations’, Management International Review, 43 (3), 267–90.

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Michael, Steven C. and James G. Combs (2008), ‘Entrepreneurial failure: the case of franchisees’, Journal of Small Business Management, 46 (1), 73–90. Michael, Steven C. and Hollie J. Moore (1995), ‘Returns to Franchising’, Journal of Corporate Finance: Contracting, Governance, and Organization, 2 (1/2), 133–55. Minkler, A.P. (1990), ‘An empirical analysis of a firm’s decision to franchise’, Economics Letters, 34 (1), 77–82. Norton, S.W. (1988), ‘Franchising, brand name capital, and the entrepreneurial capacity problem’, Strategic Management Journal, 9 (Summer Special Issue), 105–14. Rubin, Paul H. (1978), ‘The theory of the firm and the structure of the franchise contract’, Journal of Law and Economics, 21 (1), 223–33. Shane, Scott (1998), ‘Research notes and communications: making new franchise systems work’, Strategic Management Journal, 19 (7), 697–707. Shane, Scott (2001), ‘Organizational incentives and organizational mortality’, Organization Science, 12 (2), 136–60. Shane, Scott and Maw-Der Foo (1999), ‘New firm survival: institutional explanations for new franchisor mortality’, Management Science, 45 (2), 142–59. Williamson, Oliver E. (1983), ‘Credible commitments: using hostages to support exchange’, American Economic Review, 73 (4), 519–40. Williamson, Oliver E. (1985), The Economic Institutions of Capitalism, New York: The Free Press. Williamson, Oliver E. (1991), ‘Comparative economic organization: the analysis of discrete structural alternatives’, Administrative Science Quarterly, 36 (2), 269–96. Williamson, Oliver E. (1996), The Mechanisms of Governance, New York: Oxford University Press.

20 The structure of franchise contracts Emmanuel Raynaud

The word franchise comes from an old French word meaning ‘privilege’ or ‘freedom’. In the Middle Ages a franchise was a privilege or a right. In those days, the local sovereign or lord would, for instance, grant the right to hold markets or fairs. Eventually, the king could grant a franchise for many commercial activities such as building roads and the brewing of ale. The modern use of the term, as business franchising, is in the same spirit. Franchising may be defined as a contractual agreement in which one firm, the franchisee, buys from another firm, the franchisor, the right to operate under a particular trademark and follow a set of guidelines.1 In 2001, franchised businesses operated in the US 764 483 outlets and accounted for 7.4 per cent of all private-sector jobs.2 This chapter adopts a ‘contractual’ approach to the study of franchising. It explains the role of franchising as an efficient governance structure – that is, as an attempt to mitigate various contractual hazards (Williamson, 1996; Blair and Lafontaine, 2005). It omits the industrial-organization literature that explains governance choices as strategic tools to mitigate actual or potential competition (see Lafontaine and Slade, 2005). Franchising is an interesting ‘contractual laboratory’ for at least two reasons: first, data on organizational design in franchising are available that allow empirical analysis. Insights gleaned from studies on franchised chains allow researchers to understand better how firms organize their activities across business units and markets much more generally. Second, franchising agreements include several contractual provisions, sometimes called vertical restraints (for example, selective or exclusive distribution), that can be used to analyse the rationale behind contractual design. To study the organization of franchised chains, the overall governance question will be broken down into a two-step, sequential decision: first, get the allocation of ownership right (the ‘make-or-buy’ decision), and second, get the contractual design right. An extension of step 1 will focus on an interesting stylized fact, the coexistence of both company-owned and franchised units within the same chain. While this sequence might not correspond to the real decision-making process, it is a useful expository device. Moreover, if a chain decides to rely partly on franchising as an alternative to vertical integration, it must still decide what the (formal) contract should look like (see James, 2000, for a distinction similar in spirit). 194

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Building on the contractual approach, most of the literature reviewed here adopts an economizing logic to explain franchising. The decision to makeor-buy (or make-and-buy) and the choice of contractual provisions turn on the comparative costs of the various alternatives, and the organizational modes selected should be the ones that economize on coordination costs. Choosing the right governance structure One of the most important empirical regularities in franchising is the existence of both franchised and company-owned units in most chains. So it is hardly surprising that much of the literature studies the determinants of vertical integration in chains, that is, the ‘make-or-buy’ problem. Moreover, a recent wave of papers also attempts to understand governance of chains as a way to ‘make-and-buy’. Franchising vs company ownership Initial explanations for franchising focused on mitigating capital and managerial constraints (Caves and Murphy, 1976; Norton, 1988). If franchisors do not have enough capital to open their own stores, franchisees can reduce this constraint by providing their own capital. Despite its popularity among practitioners, this approach has been widely criticized for being inconsistent. Rubin (1978) argues convincingly that if franchising is a way for the franchisor to alleviate a capital constraint, there is a more efficient (that is, cheaper for the franchisor) alternative in terms of risk allocation. At the same time, empirical work does not support the main proposition deduced from the capital-constraint argument. If chains are successful, the capital constraint should be reduced over time. Lafontaine and Shaw (2005) show, however, that the extent of company-owned units is stable over time. Moreover, it is not unusual for a franchisor to provide franchisees with funding, which appears to contradict the capital-constraint explanation. The previous argument may be further extended to another form of capital scarcity, namely managerial human capital scarcity (Shane, 1996). The empirical propositions derived from this approach are partly similar to the previous one. If selection and human-resource scarcities decrease with chain’s maturity, there should be less reliance on franchising. As pointed out earlier, this is not backed up by empirical analysis, suggesting that chains probably use other means to mitigate this problem.3 Building on the modern theory of the firm, an alternative body of research emerged to explain franchising. The larger part of this literature emphasizes moral hazard and free-riding (see Lafontaine and Slade, 2001, 2007, for summaries).4 A few papers also emphasize the holdup problem as a motive for the extent of vertical integration in franchising.

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Asset specificity and the holdup problem feature prominently in the empirical transaction cost economics (TCE) literature on governance structure in industrial procurement (see Klein, 2005, and Chapter 12 in this volume by Benjamin Klein). However, asset specificity and holdup play a smaller role in the literature in retail contracting in general and franchising in particular (see Lafontaine and Slade, 2001, 2007). Some authors even doubt the relevance of specific investment as the driver of organizational choice in franchising (Lafontaine and Slade, 2001). On the one hand, the chain’s brand name may be considered a specific asset (Williamson, 1991). The managers of outlets have an incentive to expropriate quasi-rents generated by the value of the brand (Bercovitz, 2004; Minkler and Park, 1994). However, this approach is similar to the previous free-riding story: the more valuable the brand, the larger the extent of vertical integration expected in chains. On the other hand, some empirical evidence suggests that the value of franchisees’ investments is not significantly lower outside of the relationship (even if the value of the investments can be quite significant) (Kaufman and Lafontaine, 1994). Despite this lack of enthusiasm for the holdup problem in franchising, the literature has begun to pay more attention to the consequences of contractual incompleteness as a motive for vertical integration. For instance, Lutz (1995), Maness (1996), and Hennessy (2003) all rely on incomplete contracts models to shed light on the vertical integration decision. Dual distribution as make and buy What if, instead of trying to solve the make-or-buy problem for each individual outlet, franchisors make-and-buy at the chain level at the same time? This phenomenon is called dual distribution or plural form. The point is to assess the governance benefits of simultaneous making and buying. The first explanations for dual distribution suggest a transitory phenomenon, but more recent works explain that dual distribution can be an efficient governance structure. If franchising is more profitable than company ownership, a franchisor may initially operate several units either to demonstrate the quality of its business plan to potential franchisees (Gallini and Lutz, 1992) or to commit credibly to protecting the value of its brand name (Scott, 1995). The extent of company ownership is thus likely to decrease with chain maturity and brand name reputation (franchising redirection). Other authors suggest that the rationale for franchising should instead disappear with chain maturity. As previously seen, franchising yields access to certain scarce resources, either capital (Caves and Murphy, 1976), managerial talent (Norton, 1988), or local information (Minkler and Park, 1994), all of which facilitate expansion. As firms become established, they

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should reduce their reliance upon franchising (ownership redirection). These two extreme franchising evolution patterns (franchising redirection and ownership redirection) are not seen in the data, however. For instance, Lafontaine and Shaw (2005) have shown stability in the franchise mix as chains become mature. This suggests that dual distribution may be an efficient and persistent organizational form. As noted by Williamson (1985, 1991), different economic circumstances require different organizational solutions. The overall governance of the chain – that is, the extent of dual distribution – is simply the aggregation of governance decisions made at the store level. Most studies explain dual distribution in terms of heterogeneous outlet characteristics such as distance to headquarters (Brickley and Dark, 1987), percentage of repeated business (Brickley, 1999), or risk (Norton 1988). This implies that if all units are similar, the chain should be either wholly franchised, or company owned. This raises the question of whether different characteristics are needed for dual distribution to emerge, or whether dual distribution arises for other (maybe complementary) reasons. Recent papers have shown that dual distribution may emerge in situations with identical units. In Gallini and Lutz (1992), all units are identical and dual distribution is an efficient response to ex ante asymmetric information about the value of the chain. Similarly, Bai and Tao (2000) model local managers (franchisees or employees) as responsible for both local sales effort and goodwill provision. Chains have company-owned units because this directs the production of goodwill. The chain offers some unit managers a balanced contract to induce goodwill effort and a more high-powered incentive contract on sales for the remainder. Dual distribution emerges as an optimal means for providing incentive for both tasks. A related explanation is provided by Scott (1995), who emphasizes the importance of franchisor effort for the profitability of individual outlets. However, the franchisor also needs an incentive to make these efforts. One possibility is setting a high royalty rate but this reduces the incentives for franchisees. An alternative is for the franchisor to have a stake in the business and own some units. More recently, the literature suggests that dual distribution should be studied at a more ‘systemic’ or ‘chain’ level. Bradach (1997) emphasizes the complementarities between the two governance structures to maintain quality and homogeneity of the business concept across the units while also promoting innovation. Combining both governance modes creates ‘synergy benefits’. It is important, however, to explore the sources of these gains in more detail. For instance, Bergen et al. (1995) identify two main benefits, the first relating to asymmetric information, the second to credible commitment. Exclusive reliance on market governance can be plagued with information problems. Firms may be limited in their ability

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to evaluate ex ante, and monitor ex post, the performance of franchisees. In-house operations allow firms to mitigate these problems. By owning some outlets, the chain is better able to assess the costs and difficulties of the task and can use this information to design a better performance evaluation and monitoring system. The other benefit relates to ex post governance issues. Terminating a partnership with an opportunistic distributor is an efficient sanction when assets are non-specific. If the chain has invested in specific assets in its transaction with a distributor, premature termination is a less credible sanction because part of the quasi-rents will be lost by the firm. An in-house operation restores part of the incentive effects of a threat of termination. If the firm terminates its relation with the supplier, it can use the internal agent as an alternative. Choosing the right contractual design: aligning incentives in chains Vertical integration is not the only mechanism for mitigating contractual hazards. Franchising basically involves franchisors granting franchisees the right to operate under their trademarks and use their business procedures. But as these intangible assets remain the property of the franchisor, the granting of these rights results in incentive problems. Two main types of incentive mechanisms to mitigate these problems have been highlighted in the literature: the granting of residual claimancy rights through monetary provisions (see Mathewson and Winter, 1985) and the reliance on self-enforcement (Klein and Saft, 1985; Klein, 1995). Other non-monetary dimensions of franchise contracts have also been recently explored. Franchising as incentive contract: monetary provisions Most literature on franchise contracts and incentives focuses on monetary provisions, namely establishing the ‘right’ royalty rates and initial franchise fees. When franchisee effort is not observable, and thus cannot be contracted on directly, the best option for the franchisor is to sell the outlet to the franchisee for a fixed price. This outright sale makes franchisees full residual claimants, giving them incentives to put forth optimal effort (Mathewson and Winter, 1985). However, in practice, the typical franchise contract involves sharing, which prevents the first-best outcome, as the franchisee has an incentive to reduce his or her effort. The literature suggests two amendments to the model to account for sharing arrangements. The first, and most traditional, is to assume the franchisee is risk averse. Sharing in this model then becomes a means of shifting risk from risk-averse franchisees to risk-neutral franchisors. The second amendment to the model relies, instead, on the assumption that the franchisor brings some valuable input to the production process and that his or her behaviour, like that of the franchisee, is difficult to monitor. In this double-sided

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moral-hazard model, sharing arises from the need to provide incentives to both franchisees and franchisor (Rubin, 1978; Bhattacharyya and Lafontaine, 1995). Three main testable implications arise from this principal–agent model. The share parameter will be higher: (a) the lower the importance of franchisee effort; (b) the higher the level of risk involved (assuming the franchisee is more risk averse than the franchisor); and (c) the greater the importance of franchisor effort (assuming this is not observable). Empirical studies have found support for the first and third, but not the second, implication (see Lafontaine and Slade, 2007, for a survey). Self-enforcement in contracting Parties to a contract can also be given effort incentives by making sure they derive benefits from the relationship that are at risk if the relationship ends. The capitalized value of these benefits acts as a hostage (Williamson, 1985). Incentives embedded in franchise contracts stem from the combined effect of three elements: (a) an ongoing stream of rents that the franchisee earns within the relationship, but forgoes if he or she ‘leaves’ the franchised chain; (b) franchisee monitoring by the franchisor; and (c) the franchisor’s ability to terminate the franchise contract. Because the ease or cost of termination is largely determined by the legal system, the franchisor is left with the tasks of choosing the level of ongoing rent to be left with franchisees and selecting the frequency of monitoring so as to minimize the ex post costs of enforcing the desired effort level.5 In this literature, a franchise contract is said to be self-enforced if, in every period, the present value of the ongoing rent the franchisee earns from the partnership exceeds the (expected) franchisee benefit from deviating from the franchisor’s requested behaviour. For the contract to be continuously self-enforcing, the franchisee must earn a minimum amount of rent each period. For that reason, given that the expected rent over the remainder of the contract decreases as the franchise gets closer to expiration, the value of ‘cooperative behaviour’ must include not only this rent, but also rent associated with future additional outlets, and with the probability of contract renewal.6 In this context, specific contract terms play different roles (Klein, 1995). Some terms specify certain franchisee obligations, for example, mandatory input purchases from the franchisor. These contract terms limit the gains from cheating as they make it easier for the franchisor to detect non-performance and to intervene quickly. They also make it less costly for the franchisor to rely on third parties, or court enforcement, as they provide more objective bases for establishing non-performance. Other contract terms ensure the stream of ongoing rent, the potential loss of

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which gives incentives to the franchisee. Clauses such as exclusive territories limit intra-brand competition, and thus contribute to the franchisee’s profitability (Lafontaine and Raynaud, 2002). At the same time, there is a maximum amount of rent to which the franchisor can credibly commit. If the franchisor prefers franchising to company-managed stores, it is presumably because vertical integration is less profitable than franchising. So the franchisor’s promise of rent to the franchisee is credible if the present value of the rent is less than the discounted profit difference between franchising and vertical integration, in every period. If this condition is continuously met, then it is in the best interests of the franchisor to pay the rent. Otherwise, it is more profitable for the franchisor to vertically integrate and appropriate the rent. Empirically, Kaufmann and Lafontaine (1994) show, through a detailed analysis of US McDonald’s restaurants, that rent is indeed left downstream in that chain. Using a similar method, Michael and Moore (1995) confirm the existence of rents in a number of other franchised chains. More on non-monetary contractual provisions So far, most of the papers on franchise contracts focus on monetary terms, namely royalty rates and franchise fees. This is not surprising, given that incentive contracts are the cornerstone of formal contract theory. Data limitations also play a role. Information on non-monetary terms is extremely limited. Nevertheless, despite such scarcity, studies on nonmonetary contractual terms are slowly appearing. Arruñada et al. (2001) study the alignment between the allocation of decision rights and incentive mechanisms in Spanish automobile distribution. The (incomplete) contract is unable to specify ex ante all the relevant decisions to be taken. However, the contract does specify an allocation of decision rights among the parties. They reveal that this allocation is rather unbalanced; franchisors own many more decision rights than franchisees (a point already noted in Hadfield, 1990). This degree of asymmetric allocation is explained by the extent of franchisee moral hazard. The more severe the likelihood for franchisee moral hazard, the more the contract allocates decisions and enforcement rights to the franchisor.7 In a similar vein, several other papers focus on more narrowly defined contractual provisions. Brickley (1999) links the occurrence of contractual restrictions (such as exclusive territories) to the likelihood of free-riding among franchisees. Contractual provisions can mitigate this problem by increasing investment benefits or by committing franchisees to make minimum contractible efforts on specific tasks.8 Consistent with this proposition, Brickley (1999) shows that the occurrence of contractual restrictions increases with the level of horizontal externalities (proxied

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here by repeated customers).9 Similar papers explain contract duration in franchising (see, for instance, Brickley et al., 2006). Finally, Bercovitz (2003) studies the use of multi-unit ownership as a way of supporting self-enforcement. By increasing the potential of ex ante and ex post rents, multi-ownership should mitigate franchisee opportunistic behaviour. Empirical results support the idea that litigation and termination rates are negatively related to multi-unit ownership. More generally, the multi-unit ownership is interesting because it shows that chains have greater margins for organizing than have been initially presumed. Chains not only choose the kind of contract and the extent of vertical integration but also the concentration of ownership among franchisees, the spatial distribution of unit ownership among franchisees, and more. All of these can be studied in terms of their efficiency effects (Kalnins and Lafontaine, 2004). Conclusion This chapter has highlighted numerous issues for which the contractual perspective appears to be fruitful. It shows that chains have different margins for efficiently governing their contractual relations with individual outlets. First, the chain decides on the extent of vertical integration. Second, the chain designs the contractual provisions of franchise agreements. Monetary as well as non-monetary provisions respond to incentives and coordination issues. More generally, these margins are largely explained by expected contractual hazards, either vertical (between franchisees and franchisor) or horizontal (among franchisees). Issues such as the difficulties of monitoring outlets, the relative importance of outlet and chain effort levels, and free-riding, are also important. Empirical findings provide a set of stylized facts and generally support most of the efficiency explanations on franchising. This empirical support is particularly important. Most work in contract theory is based on theoretical models that provide important insights into the determinants of contractual and organizational choice, but for which empirical evidence is missing. Franchising is a case for which lots of data are available. Furthermore, empirical regularities found in franchising are also relevant for other contractual issues. The new institutional economics (NIE) is typically motivated by realworld contracting problems and should play a role in controversies about real contracting practices. One controversial area in franchising is the chain’s ability to terminate the contract prematurely. Some authors, mostly lawyers and practitioners, argue that termination provisions are imposed by the franchisor when negotiating the agreement, because of unbalanced bargaining power. Others, mostly economists, see these provisions as essential parts of the enforcement mechanism needed to mitigate opportunistic

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behaviour by franchisees (see Raynaud, 2008). Empirical results suggest that the cost of termination does affect franchisors’ decisions to franchise or vertically integrate, as well as the terms of their contracts, supporting the idea that franchisors rely on rent and termination provisions in their dealings with their franchisees. It also shows that chains react to mandatory requirements by modifying the pricing of franchise contracts. Another controversial issue is antitrust (Lafontaine and Slade, 2001). A ‘bad’ application of competition law can distort the costs and benefits of alternative governance structures and restrict firms’ abilities to provide appropriate incentives. Thanks to contributions within the NIE field, the antitrust attitude toward the motivations behind vertical restrictions in distribution contracts has considerably evolved over the years. This is true both in the US and Europe (OECD, 1994). We have shifted from a regime of open hostility to a new regime where the benefits of vertical restraints in promoting efficient coordination are more explicitly recognized and accepted. Notes 1. See the FTC document, ‘Disclosure Requirements and Prohibitions Concerning Franchising and Business Opportunity Ventures’ (16 CFR § 436.1 et seq.) (FTC, 1986), and European Union rule (4087/88) for legal definition of franchising (EC, 1999). 2. These statistics count both outlets owned by franchisees and establishments owned by franchisors. See ‘The Economic Impact of Franchised Businesses’ by the International Franchise Association (2008). 3. For instance, Bradach (1997) shows that new franchisees are quite often previous employees of company-owned units. This reduces the asymmetric information problem regarding their talent and motivation, and decreases the time they need to efficiently run the outlet. 4. See Michael, Chapter 19 in this volume, for details. 5. For self-enforcement to work, the franchisor must be able to evaluate, ex post, whether or not the franchisee’s performance is satisfactory, even if the desired effort is too complex to specify in the contract. 6. Indeed, only high performance franchisees can expect renewal and additional outlets within the same chain. These decisions therefore involve rent that gives further incentives to franchisees. 7. According to Arruñada et al., the potential for franchisors to display opportunistic behaviour is limited by his reputation vis-à-vis actual and potential franchisees. 8. If part of the returns of local marketing investments accrues to other units, an individual franchisee will underinvest. By granting him or her an exclusive territory, or by requiring a mandatory (and verifiable) minimum level of expenditure on local promotions, the incentive to invest is restored. 9. Brickley (1999) also tested the impact of externalities on the extent of vertical integration and found a non-significant result. It seems that the favoured margin by which chains adjust to free-riding hazards risks is contractual design.

References Arruñada, B., L. Garicano, and L. Vazquez (2001), ‘Contractual allocation of decision rights and incentives: the case of automobile distribution’, Journal of Law, Economics and Organization, 17 (1), 257–84.

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Bai, C.E. and Z. Tao (2000), ‘Contract mixing in franchising as a mechanism for public good provision’, Journal of Economics and Management Strategy, 9 (1), 85–113. Bercovitz, J. (2003), ‘The option to expand: the use of multi-unit opportunities to support self-enforcing agreements in franchise relationships’, working paper, University of Illinois Urbana-Champaign. Bercovitz, J. (2004), ‘The organizational choice decision in business-format franchising: an empirical test’, in J. Windsperger and G. Hendrikse (eds), Economics and Management of Franchising Networks, New York: Springer, pp. 38–65. Bergen, M., S. Dutta, J. Heide, and G. John (1995), ‘Understanding dual distribution: the case of reps and house accounts’, Journal of Law, Economics and Organization, 11 (1), 189–204. Bhattacharyya, S. and F. Lafontaine (1995), ‘Double-sided moral hazard and the nature of share contracts’, RAND Journal of Economics, 26 (4), 761–81. Blair, R. and F. Lafontaine (2005), The Economics of Franchising, Cambridge: Cambridge University Press. Bradach, J. (1997), ‘Using the plural form in the management of restaurant chains’, Administrative Science Quarterly, 42 (2), 276–303. Brickley, J. (1999), ‘Incentive conflicts and contractual restraints: evidence from franchising’, Journal of Law and Economics, 42 (2), 745–74. Brickley, J.A. and F.H. Dark (1987), ‘The choice of organizational form: the case of franchising’, Journal of Financial Economics, 18 (2), 401–20. Brickley, J.A., S. Misra, and L. Van Horn (2006), ‘Contract duration: evidence from franchising’, Journal of Law and Economics, 49 (1), 173–96. Caves, R. and W.F. Murphy (1976), ‘Franchising: firms, markets and intangible assets’, Southern Economic Journal, 42 (4), 572–86. European Commission (EC) (1999), ‘Commission Regulation No 2790/1999’, available at: http://eur-lex.europa.eu/LexUriServ/LexUriServ.do?uri OJ:L:1999:336:0021:0025:EN: PDF, accessed on 26 April, 2010. Federal Trade Commission (FTC) (1986), ‘Disclosure requirements and prohibitions concerning franchising and business opportunity ventures’, available at: http://www.ftc.gov/ bcp/franchise/16cfr436.shtm, accessed on 26 April, 2010. Gallini, N.T. and N.A. Lutz (1992), ‘Dual distribution and royalty fees in franchising’, Journal of Law, Economics and Organization, 8 (2), 471–501. Hadfield, G. (1990), ‘Problematic relations: franchising and the law of incomplete contracts’, Stanford Law Review, 42 (4), 927–92. Hennessy, D. (2003), ‘Property rights, productivity and the nature of noncontractible actions in franchising’, Journal of Economic Behavior and Organization, 52 (4), 443–68. International Franchise Association (2008), ‘The economic impact of franchised businesses’, available at: http://www.buildingopportunity.com/download/Part1.pdf, accessed on 26 April, 2010. James, H.S. (2000), ‘Separating contract from governance’, Managerial and Decision Economics, 21 (2), 47–61. Kalnins, A. and F. Lafontaine (2004), ‘Multi-unit ownership in franchising: evidence from the fast-food industry in Texas’, RAND Journal of Economics, 35 (4), 745–61. Kaufmann, P.J. and F. Lafontaine (1994), ‘Costs of control: the source of economic rents for McDonald’s franchisees’, Journal of Law and Economics, 37 (2), 417–53. Klein, B. (1995), ‘The economics of franchise contracts’, Journal of Corporate Finance, 2 (1–2), 9–37. Klein, B. and L. Saft (1985), ‘The law and economics of franchise tying contracts’, Journal of Law and Economics, 28 (2), 345–61. Klein, P. (2005), ‘The make or buy decision: lessons from empirical studies’, in C. Ménard and M. Shirley (eds), Handbook of New Institutional Economics, New York: Springer, pp. 435–64. Lafontaine, F. and E. Raynaud (2002), ‘Residual claims and self-enforcement as incentive mechanisms in franchised contracts: substitutes or complements?’, in E. Brousseau and

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J.M. Glachant (eds), The Economics of Contracts: Theories and Applications, Cambridge: Cambridge University Press, pp. 315–36. Lafontaine, F. and K.L. Shaw (2005), ‘Targeting managerial control: evidence from franchising’, RAND Journal of Economics, 36 (1), 131–50. Lafontaine, F. and M. Slade (2001), ‘Incentive contracting and the franchise decision’, in K. Chatterjee and W. Samulelson (eds), Game Theory and Business Applications, Boston: Kluwer Academic Press, pp. 133–88. Lafontaine, F. and M. Slade (2005), ‘Exclusive contracts and vertical restraints: empirical evidence and public policy’, mimeo. Lafontaine, F. and M. Slade (2007), ‘Vertical integration and firm boundaries: the evidence’, Journal of Economic Literature, 45 (3), 629–85 Lutz, N. (1995), ‘Ownership rights and incentives in franchising’, Journal of Corporate Finance, 2 (1–2), 103–31. Maness, R. (1996), ‘Incomplete contracts and the choice between vertical integration and franchising’, Journal of Economic Behavior and Organization, 31 (1), 101–15. Mathewson, F.G. and R.A. Winter (1985), ‘The economics of franchise contracts’, Journal of Law and Economics, 28 (3), 503–26. Michael, S. and H.J. Moore (1995), ‘Returns to franchising’, Journal of Corporate Finance, 2 (1–2), 133–56. Minkler, A. and T.A. Park (1994), ‘Asset specificity and vertical integration’, Review of Industrial Organization, 9 (4), 409–23. Norton, S. (1988), ‘An empirical look at franchising as an organizational form’, Journal of Business, 61 (2), 197–217. OECD (1994), Competition Policy and Vertical Restraints: Franchising Agreements, Paris: Organization for Economic Cooperation and Development. Raynaud, E. (2008), ‘The governance of retail chains’, in E. Brousseau and J.M. Glachant (eds), New Institutional Economics: A Textbook, Cambridge: Cambridge University Press, pp. 235–51. Rubin, P. (1978), ‘The theory of the firm and the structure of the franchise contract’, Journal of Law and Economics, XXX (1), 503–26. Scott, F.A. (1995), ‘Franchising versus vertical integration as a decision variable of the firm’, Review of Industrial Organization, 10 (1), 69–81. Shane, S. (1996), ‘Hybrid organizational arrangements and their implications for firm growth and survival: a study of new franchisors’, Academy of Management Journal, 39 (1), 216–34. Williamson, O.E. (1985), The Economic Institutions of Capitalism: Firms, Market and Relational Contracting, New York: Free Press. Williamson, O.E. (1991), ‘Comparative economic organization: the analysis of discrete structural alternatives’, Administrative Science Quarterly, 36 (2), 269–96. Williamson, O.E. (1996), The Mechanisms of Governance, New York: Oxford University Press.

21 Strategy and transaction costs Laura Poppo

Strategy is a complex domain, and while I do not intend to trivialize alternative definitions and approaches to strategic management, in this chapter strategy is fundamentally about achieving competitive advantage through resources, capabilities, and/or competences: the resource-based view of the firm. According to Williamson (1999), this realization of ‘strategy’ occurs by economizing through optimal governance: choosing the optimal form of governance. For rent-generating assets, firm ownership offers the greatest ability to coordinate, adapt, and protect because potential conflict ‘threatens to undo or upset opportunities to realize mutual gains’ (Williamson, 1999, p. 1090). Bounded rationality, opportunism, and the characteristics of the transaction remain central conditions that constrain this boundary decision. Through a comparative governance choice assessment, managers assess how should they organize an activity given its ‘pre-existing strengths and weaknesses (core competences and disabilities)’ (Williamson, 1999, p. 1103). Firms thus generate advantage by minimizing the misappropriation of rent, adaptation delays, and coordination problems (transaction costs). Some strategists, however, do not necessarily agree that the transaction cost framework ultimately informs strategic analysis. Some dismiss its applicability outright because opportunism can be mitigated through informal mechanisms, such as trust (Madhok, 1995; Adler, 2001). Others offer alternative views of the firm (Conner and Prahalad, 1996; Foss, 1996) or of the dynamic nature of resources (Langlois, 1992; Teece and Pisano, 1994) that necessitate a broader domain or set of logics than that offered by the transaction cost logic alone. For example, resources may generate profit for the firm not simply from avoiding transaction costs, but through realizing performance gains that occur through specialization (Conner and Prahalad, 1996; Poppo and Zenger, 1998). This conversation on whether strategy, namely the resource-based view of the firm and its extension to knowledge and dynamic capabilities, and the transaction cost logic converge, diverge, or coexist is dated, but it is by no means resolved (Williamson, 1999; Carter and Hodgson, 2006). Rather than review the entire spectrum of this conversation, in this chapter I will first present some general comments on whether empirical analysis confirms the viability of using the transaction cost framework to 205

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inform strategy research. Next, I focus more narrowly on a set of strategy research that continues to challenge the applicability of the transaction cost logic for more complex forms of transactions that commonly occur in markets: the viability of hybrids, in particular alliances, to produce competitive advantage. Is the transaction cost framework an empirical success story? Hybrids, as an institutional governance form, are commonly used in business practice and generally share both ‘market’ features, such as highpowered incentives, and hierarchical features, such as rules and directives (for example, formal contracts) (Hennart, 1993; Hodgson, 2002; Ménard, 2004). While hybrids were initially believed to undermine the integrity of the transaction cost framework, Williamson (1991) aptly responded to these criticisms by extending the framework to consider hybrid governance choices. While Williamson (1999) maintains that the transaction cost framework is an empirical success story, others offer a more fine-grained analysis and interpretation of its success. The underlying motive for these more fine-grained reviews is to inquire whether the transaction cost framework is a viable framework and whether it needs to be ‘broadened’ in order to meaningfully inform strategy research. Related, unresolved is whether the empirical examination of hybrids supports the transaction cost prediction (Madhok, 1995; Carter and Hodgson, 2006). Criticizing some of the earlier reviews because they lacked a systematic selection and evaluation criteria, David and Han (2004) diligently analyzed empirical transaction cost papers for their consistency in both measurement and findings (for example, actual vs predicted relationships). Consistent with Williamson’s (1999) success story, the most important relationship proposed by the transaction cost logic receives the greatest level of empirical confirmation: asset specificity is associated with an increased likelihood of vertical integration. Yet, as David and Han (2004) note, systematic measurement of variables, namely uncertainty and its multiple dimensions, is lacking across empirical transaction cost economics (TCE) works. Moreover, studies do not generally test all of the relationships predicted by the framework. For example, few studies include frequency or measure the interaction of uncertainty and asset specificity. Fewer studies have outcome measures (for example, performance or transaction costs), which are an integral aspect of a comparative choice analysis. Thus, in their view, success has yet to be fully established regarding the predictive validity of the framework. More recently, Carter and Hodgson (2006) try to diminish the value of the transaction cost framework as a definitive strategic framework by showing that for some empirical studies, results support a resource-based

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logic as well as a transaction cost logic. In particular, asset specificity, especially human-intensive asset specificity, measures both specific assets and a potentially productive capability or routine. This conceptual overlap implies that a transaction cost prediction and empirical finding of internalization is also consistent with that of a competence or resource logic. While not reviewed by Carter and Hodgson (2006), work shows that these two logics can be meaningfully separated in terms of analytics (Poppo and Zenger, 1998). Nonetheless, Carter and Hodgson’s (2006) review does highlight the need to consider and test transaction cost and resource-based theories simultaneously. That is, TCE is not the only perspective that meaningfully informs strategic outcomes. A focus on alliance research Strategic alliances between firms are a common vehicle for exchanging, sharing, or developing various products, services, and technologies. While there are different forms of hybrid organizations, I deliberately choose alliances because the sizable number of empirical works enables a more cogent focus on whether or how transaction cost analysis informs strategic analysis. In addition, some of this research questions not only the original resource-based logic that competitive advantage stems from the internalization (for example, ownership) of the resources and capabilities, but also the comparative governance prediction that ownership is necessary to minimize transaction costs that arise due to uncertainty and self-interest. Alliances and value creation Early research found that most alliances are short lived and a variety of factors may account for termination, and thus the alliance failure (Harrigan, 1988; Kogut and Singh, 1988). This work, however, fell short of capturing the intended duration of the alliance, a likely determinate of termination. It also did not explore the performance or potential sources of value created through alliance activity: that is, the strategic value of alliances. In the last ten years, this focus, the positive performance of alliances, is a focal point of theoretical development and empirical work. In particular, some strategists extend the resource-based logic to consider that a firm’s exchange partners are important sources of value-creation: that is, alliances may offer important sources of new ideas and information (Dyer and Singh, 1998; Inkpen, 2000). Related, the relationship between two trading entities may constitute ‘a unique and productive resource for value creation’ (Madhok and Tallman, 1998, p. 327; McEvily and Marcus, 2005). This literature generally posits that social mechanisms enable firms to extract value from alliances: cooperative, trusting relationships can both

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effectively govern complex market exchanges and produce synergistic gains. Underlying value creation are relational routines, such as information sharing, collaborative norms, and reciprocity (MacNeil, 1978; Kale et al., 2002), which are supported by trust (McEvily et al., 2003). These relationship-specific investments ease coordination and enhance bilateral cooperation, thereby minimizing transaction costs. Moreover, when both parties undertake specific human, yet relationship-specific activities that promote collaboration, synergistic outcomes are possible (Madhok and Tallman, 1998). For example, partners may ‘invest’ in knowledge-sharing routines by committing specific individuals to frequent interactions, meetings, and problem-solving activities (Kale et al., 2002). If these interactions permit not only the transfer of tacit and explicit knowledge, but also its recombination and extension to current and future projects, then the alliance may create value for both alliance partners. The focus on trust and cooperation as mechanisms to minimize opportunism in market exchanges is not incidental: it directly challenges the transaction cost assumption that market exchanges are atomistic, under socialized relationships (Williamson, 1996). Social theorists offer an alternative conceptualization: market exchanges are embedded in a social context and trust is a natural byproduct of social and business interaction (Granovetter, 1985). This characterization of business practice is also contrary to the transaction cost position that social interaction between transactors is limited to clarifying contractual intent. Williamson (1996) further counters the social theorist’s position by arguing that in economic exchanges trust is inherently calculative; the personal form of trust advanced by social theorists does not characterize market exchanges, and thus cannot effectively govern them. Consistent with this calculative logic, recent empirical work shows that the presence of trust depends critically on ‘a shadow of the future’: prior history supports trust only through its effect on expectations of future exchanges (Poppo et al., 2008a). Still, this controversy over ‘trust’ has generated a large research stream on trust, governance, and economic exchange. For social theorists, when trust exists, parties to both organizations hold a collective trust-orientation toward each organization (Zaheer et al., 1998), and thus display a willingness to rely on and to be vulnerable to the other organization (Rousseau et al., 1998). Consistent with this governance objective, studies show that trust and its related normative conventions decrease transaction costs (Larson, 1992; Artz and Brush, 2000), improve satisfaction with exchange performance (Zaheer et al., 1998; Poppo and Zenger, 2002), and improve knowledge transfer (Szulanski et al., 2004). Recent work further shows that knowledge sharing between a focal firm and its broader supplier network does not appear to ‘leak’ to the suppliers’ exchanges with

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other buyers, demonstrating the network can be a source of capabilitydevelopment (Dyer and Hatch, 2006). Research further argues that prior experience triggers the capture and extension of value. Because managing an alliance poses numerous challenges, including adverse selection, moral hazard, and uncertain and complex transactions, firms that learn and develop skills and capabilities that facilitate coordination realize greater alliance performance (Kale et al., 2002). Prior experience in a related technological area may further increase the focal firm’s absorptive capacity, providing an additional source of value-creation in the focal alliance. Consistent with this, empirical works show that prior alliance experience improves the performance of the focal alliance (Zollo et al., 2002; Sampson, 2005). They further show that firms with a dedicated alliance function are associated with greater abnormal stock gains following an alliance announcement because the firm is more able to effectively manage, share, and disseminate know-how gained from prior experience (Kale et al., 2002; Kale and Singh, 2007). Trust: a complement of or substitute for formal contracts A second focus of this research is examining the relationship between prior alliance experience and formal contracts. Initially, some proposed that one benefit of trust is reduced transaction costs, such as less stringent contracts. These theorists offered this proposal because as alliance partners learn over time what to expect from one another, they form a basis of trust and cooperation. Parties, thus, no longer need to craft such complex contracts (Gulati, 1995; Dyer and Singh, 1998). Dyer and Singh (1998) pointedly argue that relational advantage is best achieved through an effective governance system that employs informal rather than third party or formal enforcement mechanisms. Thus, trust as a governance form may effectively substitute for formal governance. Subsequent empirical work, however, does not fully support this logic: the combined use of trust and its related normative conventions is associated with greater performance than any one governance mechanism alone (Poppo and Zenger, 2002). Works further show that managers learn to craft better contracts over time as they learn better methods for fostering adaptation (Mayer and Argyres, 2004). In fact, contrary to the substitution logic, prior experience (Reuer and Arino, 2007) or trust (Dyer and Chu, 2003) does not lead managers to drop enforcement provisions (such as arbitration clauses, confidentiality provisions, restrictions on proprietary information). Thus, at this time it does not appear that trust necessarily substitutes for formal governance. The behavioral mechanisms of information sharing, cooperation, and collaboration may also explain why trust and contracts appear to operate

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as complements in fostering alliance performance (Poppo and Zenger, 2002). When well-specified contracts exist, parties are more likely to understand the boundaries for acceptable behavior and punishments for non-compliance. Because expectations and consequences are known, the contract provides rules of the game which can then encourage cooperation and ultimately enhance alliance performance. It also provides general guidelines that may ease conflict and uncertainty as parties adapt the exchange given exogenous change. The complementarity of trust and contracts in enhancing alliance performance may also work in reverse. Trust may guide cooperative action for situations in which the contract is incomplete. It may also shield alliance performance from losses that arise when contracts are imperfect mechanisms for fostering adaptation. Trust, for example, hinges critically on perceptions of equity and justice; a bilateral orientation, whose absence not only is likely to undermine cooperation but may derail the alliance agreement (Arino and Torre, 1998; Husted and Folger, 2004). The potential dark side to long-standing ties While most of the literature focuses on the benefits that accrue from embedded, long-standing ties, more recent work suggests that they may actually undermine alliance performance. For example, the lack of hierarchical oversight may cause managers to fail to systematically evaluate and restructure alliances when needed. As parties become complacent with the existing partner, they fail to adequately search for new partners and capabilities, even when newness is desirable (Uzzi, 1997; Gulati and Gargiulo, 1999; Anderson and Jap, 2005). Empirical studies examining this dark side of embedded ties remain nascent, though Goerzen (2007) finds that repeated partnerships are associated with lower firm performance and Poppo et al. (2008b) similarly find that the performance benefits associated with relational governance decline when parties rely on repeated partnerships. Sampson (2005) also finds that the performance benefits from experience decline over time presumably because the knowledge, and thus its value, depreciates over time. Conclusions According to Williamson (1999), the transaction cost framework guides strategy research that focuses on competitive advantage through resources. The transaction cost question ‘What is the best generic mode (market, hybrid, firm or bureau) to organize X?’ is rephrased to ‘How should firm A – which has pre-existing strengths and weaknesses (core competences and disabilities) – organize X?’ (Williamson, 1999, p. 1103). As shown in the above review, the alliance research has focused on the viability of hybrids

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as a governance form and as a potential vehicle for rent-generation. It has also focused on a discriminating alignment hypothesis regarding the use of contracts and trust, and shown that the transaction cost logic does not wholly account for how firms generate advantage through resources. One unresolved issue, however, is to more fully understand the boundaries of the firm, given the strategic search and development of resources and advantage. For example, there are some theorists that speculate that alliances, if properly managed, may substitute for firm ownership. For example, Madhok (1995, p. 117) argues that a ‘trust-centered logic is largely consistent with approaches that emphasize the issue of ownership’ and that ‘a shift in focus from ownership to relational dynamics is encouraged’. Most empirical work on alliances has focused on equity ownership, and demonstrates support for the transaction cost logic that transactions that are associated with more risk are governed through more hierarchical contracts (see, for example, Oxley, 1997; Sampson; 2005; Gulati, 1995; and Reuer and Arino, 2007). These empirical works, however, have yet to fully incorporate relationship dynamics into empirical models as well as to compare the governance choice of a trust-based hybrid to that of vertical integration. Relatedly, Hill (1990, p. 509) argues that the case for vertical integration may be overstated: ‘among a population of actors who are engaged in repeated transactions that require investments in specialized assets, behaviors that stress cooperation, trust, and forgiveness of isolated opportunism by others have an economic value’. This logic implies that over time cooperative rather than opportunistic actors will dominate a population and raises serious questions about the transaction cost logic for vertical integration. Hill foresaw the idea that social networks may constitute another kind of hybrid that competes with or may complement vertical integration. Consistent with this logic, Dyer’s (1996, p. 649) research on the Japanese keiretsu argues that ‘hybrids/alliances as employed by Japanese automakers realize virtually all of the advantages of hierarchy (e.g., asset co-specialization) without the disadvantages (e.g., loss of market discipline; loss of flexibility, higher labor costs)’. This hybrid form has numerous safeguards that include financial hostages, reputation, formal contracts and trust. Thus, a query for future research is whether or more precisely when network governance may supplant or substitute for vertical integration and the more ‘atomistic’ ties that characterize simple forms of market governance. In sum, left unanswered in these research probes is the comparative analysis of governance choices, namely ownership versus hybrids, and their outcomes. While research on alliances has expanded our understanding of their social context and their likely impacts on governance and

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value-creation, future work is still needed to explore their comparative governance. References Adler, P.S. (2001), ‘Market, hierarchy, and trust: the knowledge economy and the future of capitalism’, Organization Science, 12 (2), 215–34. Anderson, E. and S.D. Jap (2005), ‘The dark side of close relationships’, MIT Sloan Management Review, 46 (3), 75–82. Arino, A. and J. Torre (1998), ‘Learning from failure: toward an evolutional model of collaboration ventures’, Organization Science, 9 (3), 306–25. Artz, K. and T. Brush (2000), ‘Asset specificity, uncertainty and relational governance: an examination of coordination costs in collaborative strategic alliances’, Journal of Economic Behavior and Organization, 41 (4), 337–62. Carter, R. and G.M. Hodgson (2006), ‘Impact of empirical tests of transaction cost economics on the debate on the nature of the firm’, Strategic Management Journal, 27 (5), 461–76. Conner, K. and C.K. Prahalad (1996), ‘A resource-based theory of the firm: knowledge versus opportunism’, Organization Science, 7 (5), 477–501. David, R.J. and S. Han (2004), ‘A systematic assessment of the empirical support for transaction cost economics’, Strategic Management Journal, 25 (1), 39–58. Dyer, J.H. (1996), ‘Does governance matter? Keiretsu alliances and asset specificity as sources of Japanese competitive advantage’, Organization Science, 7 (6), 649–66. Dyer, J.H. and W. Chu (2003), ‘The role of trustworthiness in reducing transaction costs and improving performance: empirical evidence from the United States, Japan, and Korea’, Organization Science, 14 (1), 57–68. Dyer, J.H. and N.W. Hatch (2006), ‘Relation-specific capabilities and barriers to knowledge transfers: creating competitive advantage through network relationships’, Strategic Management Journal, 27 (8), 701–19. Dyer, J.H. and H. Singh (1998), ‘Relational view: cooperative strategy and sources of interorganizational competitive advantage’, Academy of Management Review, 23 (4), 660–679. Foss, N.J. (1996), ‘Firms, incomplete contracts, and organizational learning’, Human Systems Management, 15 (1), 17–26. Goerzen, A. (2007), ‘Alliance networks and firm performance: the impact of repeated partnerships’, Strategic Management Journal, 28 (5), 487–509. Granovetter, M. (1985), ‘Economic action and social structure: the problem of embeddedness’, American Journal of Sociology, 91 (3), 481–510. Gulati, R. (1995), ‘Does familiarity breed trust? The implications of repeated ties for contractual choice in alliances’, Academy of Management Review, 38 (1), 85–112. Gulati, R. and M. Gargiulo (1999), ‘Where do interorganizational networks come from?’, The American Journal of Sociology, 104 (5), 1439–93. Harrigan, K.R. (1988), ‘Joint ventures and competitive strategy’, Strategic Management Journal, 9 (2), 141–58. Hennart, J.-F. (1993), ‘Explaining the swollen middle: why most transactions are a mix of “market” and “hierarchy”’, Organization Science, 4 (4), 529–47. Hill, C. (1990), ‘Cooperation, opportunism, and the invisible hand: implications for transaction cost theory’, Academy of Management Review, 15 (3), 500–513. Hodgson, G.M. (2002), ‘Legal nature of the firm and the myth of the firm-market hybrid’, International Journal of the Economics of Business, 9 (1), 37–60. Husted, B. and R. Folger (2004), ‘Fairness and transaction costs: the contribution of organizational justice theory to an integrative model of economic organization’, Organization Science, 15 (6), 719–29. Inkpen, A.C. (2000), ‘Learning through joint ventures: a framework of knowledge acquisition’, Journal of Management Studies, 37 (7), 1019–43. Kale, P. and H. Singh (2007), ‘Building firm capabilities through learning: the role of the

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alliance learning process in alliance capability and firm-level alliance success’, Strategic Management Journal, 28 (8), 981–1000. Kale, P., J.H. Dyer, and H. Singh (2002), ‘Alliance capability, stock market response, and long-term alliance success: the role of the alliance function’, Strategic Management Journal, 23 (10), 747–67. Kogut, B. and H. Singh (1988), ‘Effect of national culture on the choice of entry mode’, Journal of International Business Studies, 19 (2), 411–32. Langlois, R.N. (1992), ‘Transaction-cost economics in real time’, Industrial and Corporate Change, 1 (1), 99–127. Larson, A. (1992), ‘Network dyads in entrepreneurial settings: a study of the governance of exchange relationships’, Administrative Science Quarterly, 37, 76–104. Macneil, I.R. (1978), ‘Contracts: adjustment of long-term economic relations under classical, neoclassical and relational contract law’, Northwestern University Law Review, 72 (6), 854–905. Madhok, A. (1995), ‘Revisiting multinational firms’ tolerance for joint ventures: a trustbased approach’, Journal of International Business Studies, 26 (March), 117–38. Madhok, A. and S.B. Tallman (1998), ‘Resources, transactions, and rents: managing value through interfirm collaborative relationships’, Organization Science, 9 (3), 326–39. Mayer, K.J. and N.S. Argyres (2004), ‘Learning to contract: evidence from the personal computer industry’, Organization Science, 15 (4), 394–410. McEvily, B. and A. Marcus (2005), ‘Embedded ties and the acquisition of competitive capabilities’, Strategic Management Journal, 25 (11), 1033–55. McEvily, B., V. Perrone, and A. Zaheer (2003), ‘Trust as an organizing principle’, Organization Science, 14 (1), 91–103. Ménard, C. (2004), ‘Economics of hybrid organizations’, Journal of Institutional and Theoretical Economics, 160 (3), 345–76. Oxley, J.E. (1997), ‘Appropriability hazards and governance in strategic alliances: a transaction cost approach’, Journal of Law, Economics, and Organization, 13 (2), 387–409. Poppo, L. and T. Zenger (1998), ‘Testing alternative theories of the firm: transaction cost, knowledge-based, and measurement explanations for make-or-buy decisions in information services’, Strategic Management Journal, 19 (9), 853–77. Poppo, L. and T. Zenger (2002), ‘Do formal contracts and relational governance function as substitutes or complements?’, Strategic Management Journal, 23 (8), 707–25. Poppo, L., K. Zhou, and S. Ryu (2008a), ‘Alternative origins to interorganizational trust: an interdependence perspective on the shadow of the past and the shadow of the future’, Organization Science, 19 (1), 39–55. Poppo, L., K. Zhou, and T. Zenger (2008b), ‘Examining the conditional limits of relational governance: specialized assets, performance ambiguity, and long-standing ties’, Journal of Management Studies, 45 (7), 1195–216. Reuer, J.J. and A. Arino (2007), ‘Strategic alliance contracts: dimensions and determinants of contractual complexity’, Strategic Management Journal, 28 (3), 313–30. Rousseau, D.S., S.R. Burt, and C. Camerer (1998), ‘Not so different after all: a crossdiscipline view of trust’, Academy of Management Review, 23 (3), 393–404. Sampson, R.C. (2005), ‘Experience effects and collaborative returns in R&D alliances’, Strategic Management Journal, 26 (11), 1009–31. Szulanski, G., R. Cappetta, and R. Jensen (2004), ‘When and how trustworthiness matters: knowledge transfer and the moderating effect of causal ambiguity’, Organization Science, 15 (5), 600–613. Teece, D. and G. Pisano (1994), ‘Dynamic capabilities of firms: an introduction’, Industrial and Corporate Change, 3 (3), 537–56. Uzzi, B. (1997), ‘Social structure and competition in interfirm networks: the paradox of embeddedness’, Administrative Science Quarterly, 42 (1), 35–67. Williamson, O.E. (1991), ‘Comparative economic organization: the analysis of discrete structural alternatives’, Administrative Science Quarterly, 36 (2), 269–96. Williamson O.E. (1996), The Mechanisms of Governance, Oxford: Oxford University Press.

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Williamson, O.E. (1999), ‘Strategy research: governance and competence perspectives’, Strategic Management Journal, 20 (12), 1087–108. Zaheer, A., B. McEvily, and V. Perrone (1998), ‘Does trust matter? Exploring the effects of interorganizational and interpersonal trust on performance’, Organization Science, 9 (2), 141–59. Zollo, M.J., J.J. Reuer, and H. Singh (2002), ‘Interorganizational routines and performance in strategic alliances’, Organization Science, 13 (6), 701–13.

22 Labour economics and human resource management Bruce A. Rayton

It has become fashionable among modern labour economists to treat labour economics and industrial relations as distinct and separable subjects, allowing economists to concentrate on the operation of labour markets, while the influence of ‘institutional’ factors is delegated (or relegated) to industrial relations experts. Kaufman (2005, p. 409)

Kaufman (2005) suggests that the practice of labour economics and industrial relations are largely separate enterprises, but recent developments in labour economics emphasizing the significance of contracting problems and examining employment relationships as organizational responses to contracting failures suggest that fashions are changing. Transaction cost economics (TCE) is well placed to inform these new developments in the field. In what ways can TCE inform the study of labour economics and by extension the study of personnel economics and human resource management? This chapter offers some answers to this question by first enumerating the characteristics of labour market decisions that have meant that the study of these phenomena has generated a unique field of economic inquiry. Next, the chapter delineates the basic features of the neoclassical approach to labour economics in order to make explicit the areas in which the recognition of transaction costs can improve our understanding of labour market phenomena. What makes labour markets special? Defined in the most general terms, labour economics is the study of the allocation of a scarce resource across unlimited wants, where the resource is time and the unlimited demands on this time include leisure, employment, self-employment, home production, and any other uses of time. This definition of labour economics is certainly comprehensive, but it raises an interesting question: why should we regard the study of labour markets as a separate field within economics? After all, there are not separate subfields in microeconomics for every market. There is no field called ‘wheat economics’, nor are there fields for the analysis of computer software, airframes, or breakfast cereals. What is it about the labour–leisure choice that makes it special? 215

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The most obvious thing to say is that the majority of adults in developed countries participate in labour markets, and a detailed understanding of the systems, processes, and motivations at work in these markets appears crucial to understanding how such economies work. Second, and perhaps more compelling, we note that labour market decisions are the logical inverse of decisions in goods markets. Households supply their time through labour markets to earn the income that allows them to purchase goods and services from other markets. Thus the supply decision in labour markets is based on utility maximization rather than on profit maximization, while the converse is true for labour demands. Labour demands are built as derived demands. In other words, the demand for employees is not based on some intrinsic valuation of the degree to which employing workers enhances employers’ utility, but it is instead based on a calculation of the additional profits made possible through the employment of workers. Similarly, workers are presumed to work (at least in part) in order to earn the income required to purchase utility-enhancing products in goods markets. This perspective is captured in the name for payments to labour in national income accounts: employee compensation. According to Jacobsen and Skillman (2004, p. 9), there have been three eras of labour economics. The emergence of labour economics as a distinct field within economics began with a largely descriptive and case study-based stream of work which was based on institutionally informed neoclassical economics (Kerr, 1988, p. 14). This was followed by human capital theory which relied on modified principles of supply and demand, and focused on labour market outcomes rather than industrial institutions and practices. Mincer (1958), Schultz (1963), and Becker (1964) represent the departure points in this area, and this work was substantially extended and modified by Sherwin Rosen (1972) and Richard Freeman (1971). The contributions of human capital theory continue to be felt today, but these are augmented by a third phase of labour economics that reinstates the importance of contracting difficulties and the organizational responses to these difficulties. It is this recent strand of labour economics which is most informed by transaction cost approaches. Contributions of TCE to labour economics Neoclassical analysis of labour markets forms the foundation of modern labour economics. Consistent with neoclassical models of other markets, this foundation is based on several key assumptions that are detailed in Part I of this book. As in other markets, these assumptions combine to allow the generation of supply and demand curves that interact via some invisible hand to determine a market-clearing equilibrium price (wage) and quantity (hours worked). As in other markets, there are also a range

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of standard transaction cost critiques of these assumptions, and readers interested in these details are encouraged to examine Part III of this book. In the following subsections we highlight some of the specific ways in which a transaction costs approach enhances the study of labour markets. Transaction costs and the labour–leisure choice The most basic choice analysed in labour economics is the choice of whether or not workers offer their time to firms through labour markets (labour force participation). This choice is often modelled as a choice between home production (or self-employment) and labour market participation. Individuals compare the utility they gain from market employment with the utility they gain from non-participation, where the gains from market employment are an increasing function of the wage rate. Thus we see the standard result that generates the labour supply curve: that increases in the wage rate increase the quantity of labour supplied to the market. We can also see that the value of non-market options is equally important in determining the choices individuals make. Local institutional settings may contribute heavily to the relative values of these non-market options, and there is substantial evidence of differences in labour market participation rates and the importance of the informal sector across countries (for example, Johnson et al., 1997). The assumptions of the neoclassical model of labour markets include homogeneous labour inputs and perfect information about the actions undertaken and outcomes generated by these labour inputs. Neither of these assumptions is, unsurprisingly, strictly true in most settings, and the violation of such assumptions has implications for the costs of the process by which workers find and ultimately contract with potential employers for the time they offer through labour markets. In particular, worker heterogeneity, coupled with difficulties associated with observing or credibly communicating these heterogeneous qualities, generates substantial costs for potential employers and employees as they search for a good match (for example, Rogerson et al., 2005). Labour contract form and transaction costs Transaction costs feature in various models of the choice between formal employment relationships and market contracts for specific labour services. In essence the choice can be likened to a particular application of the decision to ‘make’ or ‘buy’ inputs to the production process, where this decision depends on the attendant transaction costs associated with transaction frequency, uncertainty and specificity (Williamson, 1979, p. 245). Transaction frequency reflects the number of hours of work required in the production process. Greater scale enhances the likelihood of

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employment because it allows for more intensive use of human capital. For example, very small firms are unlikely to hire a lawyer on a full-time basis, and instead are likely to purchase legal services from individuals who serve a range of clients. Uncertainty about the tasks required of workers enhances the desirability of formal employment because in the presence of uncertainty the costs of constant recontracting with an external agent may be high relative to the costs of signing a long-term contract with an employee in which the employee agrees to carry out the commands of the employer (Coase, 1937: 391; Simon, 1951). Uncertainty in the demand for a firm’s output may also raise transaction costs, as the volatility of firm output will, on the assumption that workers are relatively risk averse in comparison with firms, raise the expected value of long-term contracts in the eyes of employees, while raising the expected value of short-term relationships in the eyes of firms. This increased divergence of opinion about the desired labour relationship has the potential to increase the costs of negotiations surrounding any individual relationship, while the demand volatility itself will increase the likelihood that any individual relationship will face renegotiation. Transaction costs related to specificity can arise either through the nature of the output produced through work or through the nature of the human capital required to generate output. Like other investments in specific assets, previous investments in job-specific, career-specific and firm-specific human capital represent sunk costs. These generate quasirents that induce costs associated with market transactions (Williamson, 1985). Thus jobs with nontrivial job-specific and task-specific skills give rise to serious costs associated with market-based labour transactions that lead to greater formalization of employment relationships and the creation of internal labour markets on efficiency grounds (Williamson et al., 1975). Dealing with transaction costs arising from human capital is complicated by the inability to use one of the standard solutions to bargaining problems as the outright sale and purchase of human capital (slavery) is prohibited. What results is a decision between the use of ‘contractors’ or ‘employees’, where contractors retain the rights to all surplus generated from their human capital, and where the inability to purchase human capital creates a range of unrelieved hazards in the employment relationship. Employment relationships can be thought of as rental agreements in which the employer exercises control over the job done and the methods used to achieve it, and may also invest in training that builds the value of human capital. Any returns generated by an individual’s human capital within the terms of the rental agreement accrue to the employer, but any

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improvements in the value of human capital and any returns to this capital that are generated outside the rental agreement (either after its termination or out of normal hours) are the property of the employee. Investments in training in general human capital are thus exposed to ex post external appropriation while investments in specific human capital may require credible commitments in order to facilitate employee participation. TCE argues that such difficulties can be minimized by careful choice of institutional arrangement. For example, Simon (1951) illustrates that greater uncertainty about the value of a specific employee action generates costs of contracting, thus creating incentives for the use of formal employment contracts. Hashimoto (1979, 1981) and Hashimoto and Yu (1980) argue that investments in specific human capital create an environment in which employer and employee have an incentive to sever their relationship even though they have a collective interest in the continuation of the employment relationship. Hashimoto describes a sharing arrangement in which the parties attempt to minimize the loss associated with separation by sharing the gains from the specific investment. This sharing comes in the form of pre-specifying wages in an employment contract, and Hashimoto shows that costs associated with measuring and agreeing on worker productivity levels (ex post negotiation) increase the attractiveness of such sharing arrangements. Hashimoto effectively suggests that employer and employee tie their hands with a contract to avoid ex post opportunism, though the result is inefficient to the extent that self-interested contracting parties consider only their share of the return rather than reflecting the full value of the relationship. Carmichael (1983) suggests that a third party is required in order to achieve the best solution in this environment, and that seniority-based promotion systems can fill this role, as ex post opportunism by the firm is mitigated by the fact that firing a worker simply raises another worker one rung up the seniority ladder (Carmichael, 1983, p. 252). The work of both Hashimoto and Carmichael illustrates the role that institutional arrangements can play in influencing the transaction costs associated with employment relationships. In the absence of specific investments, for instance, the selection of these institutional arrangements would be suboptimal as they impose non-trivial governance costs on the relationship, but as the character of the economic relationship changes the institutional arrangements best-suited to managing this relationship change as well. Contractual variety is possible even within the employment relationship. For example, the pay mechanism may be altered to reflect the needs of a particular environment. Several authors show that deferred compensation (for example, pensions) can provide worker motivation (Lazear, 1979; Medoff and Abraham, 1980). Others show that relative performance

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can provide motivation in promotion hierarchies (for example, Lazear and Rosen, 1981), and there is also ample research on the effects of piece-rate pay systems on quality and quantity (for example, Freeman and Kleiner, 2005). Oyer and Schaffer (2005) present an investigation of the value of granting stock options to employees throughout a company hierarchy. Like stock options, linking the pay of employees to company profits (profit sharing) ties pay to firm performance (for example, FitzRoy and Kraft, 1986; Kruse, 1993). Holmström (1982) presents a model of profit sharing in which the efficient outcome can be approximated through the introduction of discontinuities in the mechanisms used to share company profits with employees. Employees in Holmström’s model are presented with only two potential outcomes: one option generates the efficient outcome, and the other option provides employees with a level of utility below the utility value attainable if employees elect to shirk. This suggests that employers should limit their discretion in making pay awards in order to solve the problem of suboptimal employee effort. This is another way of saying that employers should raise the costs of making anything other than the two payment options mentioned earlier. Milgrom (1988) presents a model that similarly argues that firms may have an interest in restricting their ability to undertake particular actions. Milgrom argues that employment contracts usually fail to compensate workers for the effects of events that occur after the formation of these contracts when employees are faced with costs associated with job change. This situation leads to an environment in which employees may spend valuable time and energy attempting to influence the decisions of managers with authority to make discretionary decisions. This means that firms may choose to tie the hands of managers (limit discretion), particularly for decisions that have largely distributional (rather than efficiency) effects, thus eliminating the incentive for employees to waste their time and energy. As in Holmström (1982), Milgrom (1988) describes a world in which firms impose limits on discretion in order to avoid waste. Transaction costs and wage rigidities Kahn (1997, p. 993) documents three important features of nominal wage dynamics in the US: 1. 2.

3.

A significant proportion of workers remaining in the same job over a year receive the same nominal wage/salary in adjacent years. When a given real wage change requires a small nominal wage/salary change it is less likely to occur than when it requires a larger nominal change. There is evidence of downward nominal wage stickiness.

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This evidence of transaction costs in US labour markets is complemented by more recent work by Dickens et al. (2006) that identifies both real and nominal wage rigidities in their investigation of 31 million wage changes from 16 countries. The existence of nominal wage rigidities is important because these rigidities have featured heavily in theories of the macroeconomic effects of labour market phenomena. Early theories often explained the existence of nominal rigidities with reference to phenomena like money illusion, where individuals systematically mistake nominal values for real values when making decisions, but such assumptions do not sit well with economic assumptions of rationality, and other answers have been sought. These sorts of wage dynamics can be better understood with reference to specific transaction costs. Menu costs are an example of a transaction cost that generates nominal wage rigidities. Introduced in Akerlof and Yellen (1985), menu costs are the costs associated with changing prices (for example, selecting new prices and reprinting menus, and so on). In the context of labour markets, it is useful to think of menu costs in terms of activities like performance appraisal and wage negotiations as well as wholesale systemic changes in the reward system. Examples of such changes might include the introduction of profit sharing systems or the implementation of structured job grading and evaluation systems (e.g. Hay-style systems) designed to map roles across the organization and facilitate banding. Contract structure is not the only source of rigidity. For example, Wachter (1986) suggests that union wage rigidities are influenced not only by the nature of the labour contract (especially contract renegotiation lags), but also by the regulations surrounding the union–management relationship. US labour law dictates who firms must negotiate with and stipulates many of the precedents and customs within which negotiations take place. It also dictates the process through which disputes may be resolved, as well as limiting the tactical options available to each side. US labour law is seen through this lens as imposing a particular set of transaction costs on labour markets, and we can see other ways in which broader institutional environments influence transaction costs. Links between institutional arrangements and organizational performance Williamson refers to the role of institutional arrangements in the organization of firm activities, and suggests that such arrangements could be well-adapted to their institutional environment or ‘maladapted’, where maladaptation is thought to damage the performance of the organization. Much energy is spent in the transaction cost literature to understand the circumstances under which particular activities are best performed in the firm and which are best performed through markets or hybrid organizational

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forms. Understandably, this question features heavily in analyses of labour issues. The ‘make-or-buy’ question typically appears in the analysis of the decision to employ workers on a part time vs full time basis (for example, Davis-Blake and Uzzi, 1993); or the decision to employ workers rather than hire consultants or other external specialists (for example, Masten, 1988; Masters and Miles, 2002). Jensen and Meckling (1992) argue that such decisions about organizational structure are influenced by the desirability and extent of specific and general knowledge transfer between agents. Freeman and Kleiner (2005) use a case study environment to examine the financial performance of a shoe company in its move from a piecerate to a simple hourly wage system. They identify meaningful declines in worker productivity as a result of the change, but they also identify substantial improvements in firm performance which they attribute to savings made on monitoring workers under the (much simpler) wage system. This work is consistent with earlier work by Nalbantian and Schotter (1997, p. 314), who find that, ‘monitoring can elicit high effort from workers, but the probability of monitoring must be high and, therefore, costly’. The focus in the existing new institutional economics (NIE) literature is on the relative costs of internal organization vs market procurement under different circumstances. Relatively little research has been devoted to building our understanding of how various institutional arrangements affect the costs of internal governance. This issue, in the context of labour issues, has been considered extensively in research in human resource management (HRM). The next section characterizes the nature of current debate on the link between HRM and firm performance, and discusses the ways in which TCE can inform this debate. Contributions of TCE to human resource management TCE lies very much within the realm of economics, and the relationship between research in economics and in human resource management has been fairly tumultuous. This is typified by a critique of economic models of human behaviour by O’Reilly and Pfeffer (2000, p. 16): [T]here is a presumption that people are unlikely to expend effort unless they are paid to do so or are supervised closely. A second common belief is that people . . . will often misrepresent their true preferences and engage in guile and deceit. A third widespread assumption is that . . . employees and managers want different outcomes at work . . . Although each of these assumptions may be valid in a specific situation, or for a particular individual, none is likely to be right in most settings with normal human beings.

Economists would not disagree that many people are motivated for a range of interesting reasons, nor that they receive some intrinsic value

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from undertaking certain activities, but economists typically abstract from these issues by restricting their analysis to behaviour at the margin. The fact that individuals might choose to volunteer to work for a charity in the absence of financial compensation is not at odds with economic models of behaviour, as these models are designed to be accurate for marginal decisions. Thus if tax laws change the way they treat the donation of services to charitable organizations an economic model of human behaviour can make predictions about the extent to which the amount of volunteered hours will change, under the assumption that there have not been changes to the intrinsic value of the work done by the charity or to the ethics of the volunteer, but instead there has been a change in the relative price of making such a donation of time. TCE, like other branches of economics, is focused on behaviour at the margin. This difference of approach between HRM and economics has presented several interesting opportunities for research informed by economics and, more specifically, TCE. One notable area in which this has occurred is personnel economics, which sits directly between economics and HRM. According to Lazear (2000, p. 611), personnel economics is, ‘the application of microeconomic principles to human resources issues that are of concern to most businesses’. Coalescing in the early 1980s, personnel economics was based on a conscious attempt to use the tools of labour economics in a way that would be of greater interest and relevance to business decision makers and students. Lazear (2000) argues that this move was facilitated by advances in economic theory which included early developments in agency theory (for example, Johnson, 1950; Cheung, 1969; and Ross, 1973), contract theory (Baily, 1977; Azaridis, 1975; and Gordon, 1974), and the role of monitoring in the presence of team production (Alchian and Demsetz, 1972). Personnel economics takes the ideas of labour economics into a more practical realm, and this makes its connections with TCE even more apparent. While the focus of labour economics tends to be on labour supply and demand at the market level, personnel economics tends to focus more on the within-labour-market activity of individuals: in particular on the selection of effort levels by employees. There is a large literature that has developed, in part because the advent of the personal computer has greatly lowered the costs to researchers of making sense of company data. Baker et al. (1994a, 1994b) provide detailed analysis of 20 years of personnel data from one particular firm in order to investigate several hypotheses about the operation of internal labour markets. Prendergast (1999) and Lazear (2000) both provide useful surveys of the literature on employee incentives in firms, with the former focusing more on tests of agency theory and the latter focusing more specifically on research in personnel economics.

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TCE has the prospect of further informing debates in HRM research outside of personnel economics. For example, there has been a great deal of work in HRM over the past decade which has attempted to link HRM to business performance, but the results have been widely questioned. Within this literature, there has been a tendency to focus on identification of statistical associations between stated HR policies and financial performance, with little attention to how these policies are implemented through the organization (HR practices). There has been a particular lack of research trying to uncover the causal chains driving these associations, and this appears to be the result of a narrow focus on HR policies to the exclusion of wider factors which impact on employee attitudes and behaviour. A few studies have used the term ‘people management’ in preference to HRM (Paul and Anantharaman, 2003; Purcell et al., 2003; Michie and West, 2004) to indicate a broader conception of the area of study. This broader focus allows for the development of a deeper causal model linking policy to performance via employees, and it also allows the inclusion of factors such as organizational values, operational strategies, and the role of line managers together with HR policies in their effect on work climate, job experience, and employee attitudes and behaviours. This is important because an influence of HRM on financial performance can only be expected to exist if HRM changes employee behaviours. This may come in the form of easier recruitment, better retention, increased work effort, enhanced team working, expanded beyond-role effort (organizational citizenship behaviour), or any of a wide range of other employee behaviours that may influence the bottom line. This literature resonates with the TCE perspective because the features of the people management environment that are suggested by recent developments in HRM research appear to satisfy the definitions of institutions and institutional arrangements described in this book, and as such could be usefully investigated from a transaction cost perspective. Williamson (1996, p. 378) defines an institutional arrangement as, ‘the contractual relationship or governance structure between economic entities that defines the way in which they cooperate and/or compete’. HR policies on recruitment, retention, training, job design, performance evaluation, and promotion surely fit within this definition, but they are only a part of a much larger set of institutions that influence behaviour and performance in firms. North (1990, p. 3) refers to institutions as; ‘the rules of the game in a society, or more formally, the humanly devised constraints that shape human interaction’. Aoki (2001, p. 2) suggests a complementary definition that defines institutions as a set of ‘relevant characteristics’ of an

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equilibrium, particularly in instances where the institutions are conceptualized as being endogenously generated. These characteristics might be regarded as effort levels, cooperation, organizational commitment, or elements of organizational culture. This is clearly alluded to in Aoki’s (1995) work on A-type vs J-type equilibria, where he explains how different organizational structures might represent optimal structure given the institutional background in which each firm operates. Many of the broader set of HR issues included within ‘people management’ fall within definitions of institutions and institutional arrangements. In discussing these issues, it is helpful to draw upon North’s (1990) distinctions between types of institution: North notes that institutions can be formal or informal; and can also be constructed or emergent. In the context of HRM, HR policies can be thought of as constructed institutions and HR practices can be thought of as emergent institutions. Policies may differ in their levels of formality but there are still important differences between the intentions of these policies and the way they are implemented (Kinnie et al., 2005). Adopting the perspective of ‘people management’ suggests the treatment of HR policies and practices as part of a wider institutional structure. This approach allows a deeper understanding of the effects of human resource management on firms, and allows us to think of HR policies and practices both as a cause of firm performance and a response to the extant institutional environment in which the firm operates. The focus of ‘people management’ is the whole range of policies, practices, and processes which are hypothesized to influence organizational outcomes by stimulating employees’ behaviours, whether positively or negatively. The approach starts from the premise that while the application of HR polices to, on or for employees is the central interest it can never be sufficient to cover the various ways in which employees are managed and which are likely to influence their performance. Included in this wider focus are such attributes as organizational values and culture as articulated by senior management, the work climate of the organization as experienced by employees, the nature and experience of doing the jobs allotted to employees, the influence and role of line managers in enacting HR policies, and operational management strategies concerning technology and task integration. In seeking to evaluate how these ‘clusters’ of activities together with HR policies impact on organizational performance the critical focus is placed on employee attitudes and behaviours since it is asserted that it is the employees’ experience of being managed, of working in the organization and doing the job which is likely to influence their work related attitudes and behaviour. It is these people management behaviours which impact performance in association with a wide range of non-human resources, such as technology.

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The focus on organizational culture, leadership and work related attitudes and behaviour also appears in recent work in economic sociology. Akerlof and Kranton (2005) open their article by describing the US Army approach to recruitment, selection, and training to illustrate both the importance of organizational norms and the mutability of individual preferences. Through this lens, Army training can be seen as a period in which the pre-existing preferences of individuals are replaced with preferences more suited to the Army. Such change is less costly to achieve for individuals who arrive with preferences that are already near those desired, and this has implications for recruitment and selection. Cultural factors matter in many organizations. Some of these factors are national or regional in nature, but others are specific to the organization or workplace. Purcell et al. (2003, 2004) suggest that companies perform better when they have a clear sense of mission underpinned by values and a culture expressing what the firm is and its relationship with customers and employees. Clarity of this ‘big idea’ makes the basis for decision making clearer for those who are distant from the strategic decision makers of the organization. This allows better exercise of discretion on the job, thus facilitating greater delegation of authority in the organization, all else equal. Building a sense of group cohesion may also enhance trusting and trustworthy behaviour (Goette et al., 2006), thus allowing greater capture of the benefits of cooperation in the prisoners’ dilemma environment that characterizes the firm (Miller, 1993). Conclusion Industrial relations and labour economics have been separate subjects for many years, but recent advances in labour economics have closed this gap substantially. Institutional features of labour markets previously of primary interest in industrial relations have become important features of labour economic models. Of particular note are recent developments emphasizing the significance of contracting problems and examining employment relationships as organizational responses to contracting failures, and TCE is well placed to inform these new developments in the field. References Akerlof, George A. and Rachel E. Kranton (2005), ‘Identity and the economics of organizations’, Journal of Economic Perspectives, 19 (1), 9–32. Akerlof, George A. and Janet L. Yellen (1985), ‘A near-rational model of the business cycle, with wage and price inertia’, Quarterly Journal of Economics, 100 (4) (supplement), 823–38. Alchian, Armen A. and Harold Demsetz (1972), ‘Production, information costs and economic organization’, American Economic Review, 62 (5), 777–95.

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Aoki, Masahiko (1995), Information, Corporate Governance, and Institutional Diversity, Oxford: Oxford University Press. Aoki, Masahiko (2001), Toward a Comparative Institutional Analysis, Boston: MIT Press. Azaridis, Costas (1975), ‘Implicit contracts and underemployment equilibria’, Journal of Political Economy, 83 (6), 1183–202. Baily, Martin N. (1977), ‘On the theory of layoffs and unemployment’, Econometrica, 45 (5), 1043–64. Baker, George P., Michael Gibbs, and Bengt Holmström (1994a), ‘The internal economics of the firm: evidence from personnel data’, Quarterly Journal of Economics, 109 (4), 881–919. Baker, George P., Michael Gibbs, and Bengt Holmström (1994b), ‘The wage policy of a firm’, Quarterly Journal of Economics, 109 (4), 921–55. Becker, Gary (1964), Human Capital: a Theoretical and Empirical Analysis with Special Reference to Education, New York: National Bureau of Economic Research. Carmichael, Lorne (1983), ‘Firm-specific human capital and promotion ladders’, Bell Journal of Economics, 14 (1), 251–58. Cheung, Stephen N.S. (1969), The Theory of Share Tenancy: with Special Application to Asian Agriculture and the First Phase of Taiwan Land Reform, Chicago: University of Chicago Press. Coase, R.H. (1937), ‘The nature of the firm’, Economica, 4 (16), 386–405. Davis-Blake, Alison and Brian Uzzi (1993), ‘Determinants of employment externalization: the case of temporary workers and independent contractors’, Administrative Science Quarterly, 38 (2), 195–223. Dickens, William T., Lorenz Götte, Erika L. Groshen, Steinar Holden, Julian Messina, Mark E. Schweitzer, Jarkko Turunen, and Melanie E. Ward (2006), ‘How wages change: micro evidence from the international wage flexibility project’, European Central Bank Working Paper Series, number 697. FitzRoy, Felix and Kornelius Kraft (1986), ‘Profitability and profit sharing’, Journal of Industrial Economics, 35 (2), 113–30. Freeman, Richard B. (1971), The Market for College-trained Manpower, Cambridge, MA: Harvard University Press. Freeman, Richard B. and Morris M. Kleiner (2005), ‘The last American shoe manufacturers: decreasing productivity and increasing profits in the shift from piece rates to continuous flow production’, Industrial Relations, 44 (2), 307–30. Goette, Lorenz, David Huffman, and Stephan Meier (2006), ‘The impact of group membership on cooperation and norm enforcement: evidence using random assignment to real social groups’, IZA discussion paper 2020. Gordon, Donald F. (1974), ‘A neoclassical theory of Keynesian unemployment’, Economic Inquiry, 12 (1), 431–59. Hashimoto, Masanori (1979), ‘Bonus payments, on-the-job training and lifetime employment in Japan’, Journal of Political Economy, 87 (5), 1086–104. Hashimoto, Masanori (1981), ‘Firm-specific human capital as a shared investment’, American Economic Review, 71 (3), 475–84. Hashimoto, Masanori and Ben T. Yu (1980), ‘Specific capital, employment contracts, and wage rigidity’, Bell Journal of Economics, 11 (2), 536–49. Holmstrom, Bengt (1982), ‘Moral hazard in teams’, Bell Journal of Economics, 13, 324–40. Jacobsen, Joyce P. and Gilbert L. Skillman (2004), Labour Markets and Employment Relationships: a Comprehensive Approach, Malden, MA: Blackwell Publishing. Jensen, Michael C. and William H. Meckling (1992), ‘Specific and general knowledge, and organization structure’, in L. Werin and H. Wijkander (eds), Contract Economics, Oxford: Basil Blackwell, 251–274. Johnson, D. Gale (1950), ‘Resource allocation under share contracts’, Journal of Political Economy, 58 (2), 111–23. Johnson, Simon, Daniel Kaufmann, and Andrei Shleifer (1997), ‘The unofficial economy in transition’, Brookings Papers On Economic Activity, 1997 (2), 159–239.

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Kahn, Shulamit (1997), ‘Evidence of nominal wage stickiness from microdata’, American Economic Review, 87 (5), 993–1008. Kaufman, Bruce E. (2005), ‘Clark Kerr and the founding of the Berkeley IIR: a celebratory remembrance’, Journal of Industrial Relations, 44 (3), 405–15. Kerr, C. (1988), ‘The neoclassical revisionists in labour economics (1940–1960) – R.I.P.’, in Bruce E. Kaufman (ed.), How Labor Markets Work, Lexington, MA: D.C. Heath & Co. Kinnie, Nicholas, Sue Hutchinson, John Purcell, Bruce Rayton, and Juani Swart (2005), ‘Satisfaction with HR practices and commitment to the organisation: why one size does not fit all’, Human Resource Management Journal, 15 (4), 9–29. Kruse, Douglas L. (1993), Profit Sharing: Does it Make a Difference?, Kalamazoo, MI: W.E. Upjohn Institute for Employment Research. Lazear, Edward P. (1979), ‘Why is there mandatory retirement?’, Journal of Political Economy, 87 (6), 1261–84. Lazear, Edward P. (2000), ‘The future of personnel economics’, Economic Journal, 110 (467), 611–39. Lazear, Edward P. and Sherwin Rosen (1981), ‘Rank order tournaments as optimum labour contracts’, Journal of Political Economy, 89 (5), 841–64. Masten, Scott (1988) ‘A legal basis for the firm’, Journal of Law, Economics and Organization, 4 (1), 181–98. Masters, John K. and Grant Miles (2002), ‘Predicting the use of external labour arrangements: a test of the transaction costs perspective’, Academy of Management Journal, 45 (2), 431–42. Medoff, James and Katherine Abraham (1980), ‘Experience, performance and earnings’, Quarterly Journal of Economics, 95 (4), 703–36. Michie, Susan and Michael A. West (2004), ‘Managing people and performance: an evidence based framework applied to health service organizations’, International Journal of Management Reviews, 5–6 (2), 91–111. Milgrom, Paul (1988) ‘Employment contracts, influence activities, and efficient organization’, Journal of Political Economy, 96 (1), 42–60. Miller, Gary J. (1993), Managerial Dilemmas, Cambridge: Cambridge University Press. Mincer, Jacob (1958), ‘Investment in human capital and personal income distribution’, Journal of Political Economy, 66 (4), 281–301. Nalbantian, Haig R. and Andrew Schotter (1997) ‘Productivity under group incentives: an experimental study’, American Economic Review, 87 (3), 314–41. North, Douglass C. (1990), Institutions, Institutional Change and Economic Performance, Cambridge: Cambridge University Press. O’Reilly, Charles A. and Jeffrey Pfeffer (2000), Hidden Value: How Great Companies Achieve Extraordinary Results with Ordinary People, Boston: Harvard Business School Press. Oyer, Paul and Scott Schaffer (2005), ‘Why do some firms give stock options to all employees? An empirical examination of alternative theories’, Journal of Financial Economics, 76 (1), 99–133. Paul, A.K. and R.N. Anantharaman (2003), ‘Impact of people management practices on organizational performance: analysis of a causal model’, International Journal of Human Resource Management, 14 (7), 1246–66. Prendergast, Canice (1999) ‘The provision of incentives in firms’, Journal of Economic Literature, 37 (1), 7–63. Purcell, John, Sue Hutchinson, Nick Kinnie, Juanu Swart, and Bruce Rayton (2003), Understanding the People and Performance Link: Unlocking the Black Box, London: Chartered Institute of Personnel and Development. Purcell, John, Nick Kinnie, Sue Hutchinson, Bruce Rayton, and Juani Swart (2004), Vision and Values: Organisational Culture and Values as a Source of Competitive Advantage, London: Chartered Institute of Personnel and Development. Rogerson, Richard, Robert Shimer, and Randall Wright (2005), ‘Search-theoretic models of the labour market: a survey’, Journal of Economic Literature, 43 (4), 959–88.

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Rosen, S. (1972), ‘Learning and experience in the labour market’, Journal of Human Resources, 7 (3), 326–42. Ross, Stephen A. (1973), ‘The economic theory of agency: the principal’s problem’, American Economic Review, 63 (2), 134–9. Shultz, Theodore (1963), The economic value of education, New York: Columbia University Press. Simon, Herbert (1951), ‘A formal theory of the employment relationship’, Econometrica, 19 (3), 293–305. Wachter, Michael L. (1986), ‘Union wage rigidity: the default settings of labour law’, American Economic Review, 76 (2), 240–244. Williamson Oliver E. (1979), ‘Transaction cost economics: the governance of contractual relations’, Journal of Law and Economics, 22 (2) (October), 233–61. Williamson, Oliver E. (1985), The Economic Institutions of Capitalism, New York: Free Press. Williamson, Oliver E. (1996), The Mechanisms of Governance, New York: Oxford University Press. Williamson, Oliver E., Michael L. Wachter, and Jeffrey E. Harris (1975), ‘Understanding the employment relation: the analysis of idiosyncratic exchange’, Bell Journal of Economics, 6 (1), 250–278.

23 The Chicago school, transaction cost economics, and antitrust Joshua D. Wright

John Roberts’ reign at the US Supreme Court is only in its nascent stages. Already, however, its antitrust activity level has exceeded the Court’s single case average prior to the 2003–04 Term by a significant margin. This flurry of antitrust activity, combined with an apparent willingness to reconsider long-established precedents that conflict with modern antitrust theory, suggests that the Supreme Court will play a relatively significant role in shaping antitrust doctrine for years to come. In the four decades prior to the Roberts Court’s first Term, antitrust jurisprudence could be summarily, but accurately, described as slowly but surely absorbing the insights of the Chicago school and the transaction cost approach: per se prohibitions against vertical restraints gave way to rule-of-reason analysis, the per se rule against tying was softened, hostility to vertical integration and predatory pricing all but disappeared, and the law incorporated a more sophisticated understanding of the procompetitive uses of exclusive dealing contracts. As courts increasingly incorporated the lessons of the Chicago school and transaction cost contributions of the 1960s, 1970s, and 1980s, the hostility toward various business practices was relaxed in favour of a rule-of-reason approach that placed evidentiary burdens on plaintiffs to demonstrate these practices would generate anticompetitive effects (Wright, 2007a). Identifying the economic influences underlying a series of court decisions is a difficult task. But that task is rendered impossible without some guidelines as to what the author intends when he claims that a particular set of decisions is influenced by the Chicago school, transaction cost economics (TCE), or new institutional economics (NIE). In that spirit, some definitions and disclaimers are in order. First, the Chicago school’s history and its influence on antitrust is well documented and will not be recounted here (Bork, 1978; Posner, 1979; Kitch, 1983; Page, 1989; Meese, 1997; Kovacic and Shapiro, 2000). Jonathan Baker and Timothy Bresnahan (2006, pp. 23–6) usefully decompose the Chicago school’s influence on antitrust into two separate components. The first component, ‘the Chicago school of industrial organization economics’, consists of the work in industrial organization economics that aimed, and succeeded, at debunking the 230

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structure-performance-conduct paradigm and its hypothesized relationship between market concentration and price or profitability (see, for example, Goldschmid et al., 1974; Brozen, 1982).1 The second component, ‘the Chicago school of antitrust analysis’, primarily (but not exclusively) contributed empirical work in the form of case studies demonstrating that various business practices previously considered manifestly anticompetitive could be explained as efficient and procompetitive. The second component’s basic features are generally attributable to the work of Aaron Director (see Newman, 1998, pp. 227–33 and pp. 601–5; Peltzman, 2005, p. 313) and others from 1950 to the mid 1970s (see, for example, Bork, 1954; Director and Levi, 1956; Bowman, 1957; McGee, 1958; Tesler, 1960). A group of eminent antitrust scholars, such as Richard Posner, Robert Bork, and Frank Easterbrook, followed in Director’s footsteps, building on these studies and economic analyses and advocating bright-line presumptions, including, but not limited to, per se legality. Antitrust liability rules, Chicago school scholars argued, should reflect the competitive reality and economic consensus that the marketplace produced many contracts, but few that would systematically produce anticompetitive effects. This is not to say that the Chicago school’s contributions to antitrust economics were completed by the 1970s, or to imply inappropriately that they were limited to the ultimate rejection of the structure-conduct-performance paradigm. For example, ‘Chicago school’ industrial organization economists have continued to contribute to our economic understanding of various business practices, despite the fact that developments in industrial organization economics for the past 20 years have relied primarily on game-theoretic modelling techniques. Recent Chicagoan contributions to antitrust economics include work on exclusive dealing (Marvel, 1982; Klein and Lerner, 2007), slotting contracts (Wright, 2006; Klein and Wright, 2007; Wright, 2007b) and vertical restraints theory (Klein and Murphy, 1988). The influence of the Chicago school The Chicago school’s influence on antitrust law and policy has been substantial, particularly in the Supreme Court. Supreme Court decisions such as Continental T.V. v. GTE Sylvania (1977), State Oil Co. v. Khan (1997), Verizon Communications Inc. v. Law Offices of Curtis V. Trinko (2004) and Brooke Group Ltd. v. Brown & Williamson Tobacco Corp. (1993) were influenced by Chicago school thinking, not to mention the development of the 1982 Horizontal Merger Guidelines by Assistant Attorney General William Baxter. Indeed, the 1970s and 1980s were marked by a dramatic shift in antitrust policies, a significant reduction in agency enforcement activity levels, and calls from Chicago school commentators for the use of

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bright line presumptions (for example, Easterbrook, 1984), per se legality of vertical restraints (Posner, 1981), and even repeal of the antitrust laws altogether (for example, Armentano, 1986). Richard Posner (1979, p. 928) has described the key distinguishing feature of Chicago school antitrust analysis as its unique view of antitrust policy ‘through the lens of price theory’. While there is no doubt that neoclassical price theory is a fundamental building block of Chicago school antitrust analysts, it should also be noted that the Chicago school approach has not been limited to applying the model of perfect competition.2 Chicagoans have also incorporated the insights of NIE and its focus on comparative institutional analysis and transaction costs. On the distinction between the Chicago school, TCE, and NIE applications, a few more words of clarification are in order. Classification is a difficult problem in an area of industrial organization economics that has more similarities than differences. For example, Benjamin Klein is generally classified as a Chicagoan working in the tradition of integrating the insights of TCE to explain a number of contractual arrangements such as resale price maintenance, tying, block booking, exclusive dealing, and slotting contracts (Klein, 1980, 1999; Klein and Kenney, 1983; Klein and Saft, 1985; Klein and Murphy, 1988, 1997, 2008; Klein and Lerner, 2007; Klein and Wright, 2007).3 But that tradition is not uniquely Chicagoan. TCE, as Joskow (2002, p. 97) notes, ‘has always had a policy dimension as well, especially applications to antitrust and competition policies’. The most prominent non-Chicagoan contributor to TCE has been the recent Nobel Laureate Oliver Williamson, beginning with his seminal work, Markets and Hierarchies: Analysis and Antitrust Implications (1975), and in later work (Williamson, 1975, 1985, 1996). One could just as easily and without loss of analytical coherence introduce a UCLA school including Armen Alchian, Harold Demsetz, and Benjamin Klein which has had its own impact on antitrust separate from the contributions of prior Chicagoans or the TCE school more generally. For the purposes of this chapter, it is most important to recognize the similarities between these approaches and their collective influence on antitrust jurisprudence, including that of the Roberts Court. For example, both the Chicago school and TCE emphasize that a robust conception of the competitive process, to be of any use for policy analysis, must deviate from the model of perfect competition. Both schools of economic thought are therefore inherently less suspicious of the ‘non-standard’ contractual arrangements that would become the core focus of antitrust enforcement. There are also some important general differences between the Chicago school and TCE contributions to antitrust analysis, with the latter focusing its efforts almost exclusively on how transacting parties mitigate ex

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ante contracting costs associated with the potential for holdup with vertical integration and other non-standard arrangements (Joskow, 2002). These insights have been critical in relaxing some of the hostility antitrust regulators and courts demonstrated toward vertical integration, franchising, and other vertical restraints through the 1960s. One example of key but subtle differences between the Chicago school and TCE approaches to contractual arrangements can be seen in the competing but complementary understandings of the theory of the firm. The ‘rent-seeking’ and ‘adaptation’ theories of the firm developed by Williamson (1971, 1985), Klein et al. (1978), Klein and Murphy (1988, 1997), Klein (1996, 2000), and Klein and Lerner (2007) emphasize the role of integration in preventing socially destructive ‘haggling’ over ‘appropriable quasi-rents’. While these simplifying labels come with some risk of obfuscating important and subtle differences between theories, they are useful for highlighting some of the critical features of the theories. For example, the ‘rent-seeking’ label correctly captures the fact that a holdup involves attempts to redistribute wealth between parties, and that the resources parties expend in attempts to obtain and prevent these transfers also have allocative effects. Of course, the view that the TCE approach focuses exclusively on ex post contracting costs is overstated, as Klein (1996) and others have also emphasized ex ante contracting costs, where transactors engage in a wasteful search for informational advantage over transacting partners during the negotiation process. Nonetheless, while these subtle differences between Chicago school and TCE approaches to understanding various contractual arrangements generate important economic questions, the similarities between the Chicago school and TCE analysts have produced a modern antitrust policy that no longer reflexively condemns non-standard contractual arrangements and novel business practices. The post-Chicago approach However, a growing post-Chicago school (PCS) movement in the economic literature and the antitrust community more broadly has become a strong force that would restore, with more rigorous economics and modelling, at least some of the hostility towards vertical arrangements observed in the 1960s. Joskow (2002, p. 97) describes the tension in the TCE and PCS literatures: At the present time TCE and [PCS] and are like ships passing in the night. The development of sound antitrust legal rules and remedies would benefit from integrating these approaches and realizing that they are complements rather than substitutes. Otherwise [PCS] runs the risk of returning us to the 1960s antitrust treatment of nonstandard vertical arrangements.

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The quote could accurately describe the interaction between PCS economics and both the Chicago school and TCE literatures. Indeed, it is the powerful combination of both Chicago school and TCE insights that have been the driving force behind what I describe here as the ‘Chicago school/ TCE’ revolution in antitrust. Conventional wisdom predicted that the PCS economics movement, which is favoured in most economics departments around the country (and in top economic journals), would soon result in a paradigm shift in antitrust. The PCS is the leading alternative to the Chicago school approach (see Baker, 2002). The PCS challenged the conditions under which well-known Chicago school results, such as the single-monopoly-profit theorem, held. Indeed, authors in the PCS movement produced a series of models in which a monopolist in one market has the incentive to monopolize an adjacent product market (see, for example, Whinston, 1990). PCS economists also created a literature focusing on possible vertical foreclosure. This raising rivals’ costs strand of literature has become the most influential PCS contribution, and has provided a theoretical framework for a number of theories exploring the possibility of anticompetitive effects of various exclusionary business practices (Krattenmaker and Salop, 1986). For example, such theorems have been produced to demonstrate that it is possible for tying (see, for example, Whinston, 1990; Carlton and Waldman, 2002; Kobayashi, 2005), exclusive dealing (Rasmusen et al., 1991; Bernheim and Whinston, 1998; Simpson and Wickelgren, 2007), and predatory pricing (Bolton et al., 2000)4 to generate anticompetitive effects under certain conditions, including an assumed absence of any procompetitive justifications for the conduct examined (Kobayashi, 1997; Evans and Padilla, 2005). It momentarily appeared that the PCS movement would indeed claim its victory in 1992 when the Supreme Court issued its decision in Eastman Kodak Co. v. Image Technical Services, Inc. (1992).5 Kodak allowed an aftermarket tying claim to survive summary judgment based largely on the PCS theory that competition in the equipment market would not be sufficient to protect consumers who did not have complete information in the aftermarket. However, Kodak failed to start a PCS revolution in antitrust jurisprudence and was not more than a hiccup in the Chicago school march. Further, the Supreme Court’s most recent tying decision in Illinois Tool Works, Inc. v Independent Ink, Inc. (2006), which unanimously rejected the presumption that a patent warranted a presumption of antitrust market power in tying cases, failed to cite Kodak or even mention it in passing. The Roberts Court So what would be the economic underpinnings of the Roberts Court’s antitrust jurisprudence? Would the Roberts Court be influenced by the

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newer, game-theoretic PCS scholarship and trigger the regime change that had been anticipated? After all, the country’s top economics departments were producing industrial organization theorists who developed PCS models. The somewhat surprising answer, in my view, is that the Supreme Court’s antitrust jurisprudence has clung tightly to and been heavily influenced by the Chicago school and TCE approaches to antitrust analysis.6 This development is surprising for several reasons. First, the Supreme Court’s jurisprudence, as discussed, has been historically linked to advances in mainstream economics with some time lag. Because recent advances leading up to the Roberts Court’s first term had consisted primarily of the PCS variety, it is somewhat of a surprising development that the Court so strongly embraced Chicago school economics and TCE. Further, despite the fact that Chief Justice Roberts and Justice Alito were presumed to be conservative antitrust thinkers, there was little evidence from their prior judicial output or litigation experience that either would exercise any distinctively ‘Chicagoan’ or TCE influence on the Court’s jurisprudence.7 Finally, PCS theoretical contributions had been becoming increasingly popular in the increasingly international antitrust community, and had caught the eye of foreign regulators, especially in Europe. Despite the convergence of these forces in favour of a ‘post-Chicago revolution’, the Supreme Court’s antitrust output for the 2006–07 Term strongly demonstrates the Chicago and TCE influence in the Court’s analytical approach.8 Consider first the Supreme Court’s most controversial decision, at least if controversy is measured by vote count, in Leegin Creative Leather Products, Inc. v. PSKS, Inc. (2007). Leegin is a typical resale price maintenance (RPM) case involving a terminated dealer. The plaintiff, PSKS, operated a women’s apparel store in Texas. The defendant, Leegin, manufactures and distributes a number of leather goods and accessories including handbags, shoes, and jewellery under the ‘Brighton’ brand name. In 1997, Leegin introduced its RPM program, the ‘Brighton Retail Pricing and Promotion Policy’, a marketing initiative under which it would sell its products exclusively to those retailers who complied with the suggested retail prices. When Leegin learned that PSKS was discounting the Brighton product line below the suggested retail prices, Leegin terminated PSKS and PSKS, in turn, filed suit alleging that Leegin’s new marketing and promotion program violated the Sherman Act. The trial court found Leegin’s policy per se illegal under the standard set forth in the Supreme Court’s Dr. Miles Med. Co. v. John D. Park & Sons Co. (1911) decision. The jury awarded a US$1.2 million verdict that was upheld by the United States Court of Appeals for the Fifth Circuit. Justice Kennedy authored the Supreme Court’s majority opinion,

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reversing the Fifth Circuit. He was joined by Justices Scalia, Thomas, Roberts, and Alito. Justice Kennedy’s analysis largely adopted the argument offered by both the antitrust agencies and a group of economists in amicus briefs filed in support of Leegin and in favour of overturning Dr. Miles and evaluating minimum RPM under a rule of reason standard. Justice Kennedy’s majority opinion offers four central points: (1) per se analysis is reserved for restraints that, echoing the language of Continental T.V. v. GTE Sylvania (1977), ‘always, or almost always, reduce consumer welfare by limiting competition and output’; (2) economic theory strongly suggests that RPM does not meet that stringent standard; (3) empirical evidence comports with economic theory on RPM; and (4) stare decisis rationales for continuation of a per se rule and adhering to Dr. Miles are unpersuasive. The majority launched their attack on Dr. Miles with a reminder that the rule of reason, and not per se analysis, is the appropriate default rule for antitrust analysis of any economic restraint, and deviation from this default is warranted only when the restraint is known to be ‘manifestly anticompetitive’ and ‘would always or almost always tend to restrict competition and decrease output’. Measured against this standard, and after a review of the theoretical justifications for RPM and the empirical evidence concerning its competitive effects, Justice Kennedy found the case for continued application of the per se rule profoundly lacking. Importantly, from an economic perspective, the majority did not limit its discussion of justifications for RPM to the conventional discount dealer free-riding story. Instead, it finds the literature ‘replete with procompetitive justifications’ and notes the consensus on this point amongst economists. Significantly, the majority also recognizes that RPM might be used to encourage retailer services even where inter-dealer free-riding is not possible.9 While recognizing the potential for RPM to produce anticompetitive effects by facilitating collusion, the majority finds that the empirical literature suggests that efficient uses of RPM are not ‘infrequent or hypothetical’, and, therefore, the standard for applying the per se rule has not been satisfied. Leegin at least temporarily symbolizes the end of the era of hostility towards vertical restraints and relies extensively on a Chicago school/ TCE approach, as well as a more general sensitivity to the social welfare consequences of antitrust false positives. However, the per se rule lives on through state antitrust regulation, and federal legislation is pending that would revive Dr. Miles. In Bell Atlantic Corp. v. Twombly (2007), the Roberts Court took the opportunity to clarify the pleading requirements under Section 1 of the Sherman Act. The plaintiff class alleged that four major local exchange

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carriers – Bell Atlantic, Bell South, Qwest Communications International, and SBC (known as Incumbent Local Exchange Carriers or ILECs) – colluded to block competitive entry by Competitive Local Exchange Carriers (CLECs) pursuant to the framework established by the 1996 Telecommunications Act, which required the incumbent carriers to sell local telephone services at wholesale rates, lease unbundled network services, and permit interconnection. The allegations themselves consisted of claims that the defendants agreed not to enter each other’s territories as CLECs and to jointly prevent CLEC entry altogether. The district court found that these allegations amounted simply to assertions of parallel conduct and, as such, were vulnerable to dismissal, pursuant to the defendants’ Federal Rule of Civil Procedure 12(b)(6) motions, without allegations of additional ‘plus factors’, such as those required at the summary judgment stage. The Second Circuit reversed unanimously, despite some hesitation and concern regarding the ‘sometimes colossal expense’ of discovery in complex antitrust cases, and held that Federal Rule of Civil Procedure 8(a) did not require allegations of the ‘plus factors’ required to survive summary judgment. Justice Souter authored the 7–2 majority opinion holding that ‘stating [a Section 1 claim] requires a complaint with enough factual matter (taken as true) to suggest that an agreement was made . . . [This requirement] simply calls for enough fact to raise a reasonable expectation that discovery will reveal evidence of illegal agreement’. The majority clarifies that allegations of parallel conduct alone are not sufficient to survive the pleading stage, ‘retiring’ and rejecting the ‘no set of facts’ formulation favoured by Conley v. Gibson (1957), despite the conventional rule disfavouring motions to dismiss in antitrust cases. The Court’s rationale for increasing a plaintiff’s pleading burden in antitrust conspiracy cases is explicitly motivated by the desire to avoid the extraordinary costs of discovery unless there is good reason to believe that an agreement will be unearthed. Applying the new plausibility standard to plaintiffs’ claims was relatively straightforward as the allegations consisted of parallel conduct alone and no independent allegation of an actual agreement among the ILECs. While Twombly’s full implications are yet to be realized, concerns with false positives in Section 1 cases and the massive social costs of discovery motivated the Court to increase an antitrust plaintiff’s pleading burden. Twombly reflects the Roberts Court’s implicit, and correct, view that there were a host of procompetitive reasons why the ILECS would stay out of each other’s territories that had nothing to do with anticompetitive collusion. In Weyerhaeuser Co. v. Ross-Simmons Hardwood Lumber Co. (2007),10 the Court tackled the issue of identifying the appropriate standard for ‘predatory buying’ claims under Section 2 of the Sherman Act. Ross-Simmons, a

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saw mill in the Pacific Northwest, alleged that Weyerhaeuser overpaid for alder saw logs in a scheme designed to drive its rivals out of business. The district court instructed the jury that Ross-Simmons was required to prove that Weyerhaeuser engaged in ‘conduct that has the effect of wrongly preventing or excluding competition or frustrating or impairing the efforts of the firms to compete for customers within the relevant market’. With respect to the ‘predatory buying’ allegation specifically, the district court instructed the jury that finding Weyerhaeuser ‘purchased more logs than it needed or paid a higher price for logs than necessary, in order to prevent Ross-Simmons from obtaining the logs [it] needed at a fair price’ was sufficient to conclude that an anticompetitive act had occurred (Weyerhaeuser, 2007, p. 1073). The jury found in favour of Ross-Simmons and awarded US$78.7 million. The United States Court of Appeals for the Ninth Circuit affirmed the judgment, despite Weyerhaeuser’s contention that the district court erred by not including both the pricing and ‘recoupment’ prongs of the conventional Brooke Group standard in the jury instruction. The Department of Justice and the Federal Trade Commission petitioned the Supreme Court for certiorari and submitted joint amicus briefs recommending that the Court apply the Brooke Group standard to predatory buying. Justice Thomas authored the unanimous decision on behalf of the Supreme Court, agreeing with the position the enforcement agencies advocated and reflecting much of the insight of the Chicago school/TCE learning with respect to predatory pricing. Justice Thomas wrote that in predatory buying cases, plaintiffs must demonstrate both that the buyer’s conduct led to below-cost pricing of the buyer’s outputs and that the buyer ‘has a dangerous probability of recouping the losses incurred in bidding up input prices through the exercise of monopsony power’. (Weyerhaeuser, 2007) Because Ross-Simmons conceded that it had not satisfied the Brooke Group standard, the Court vacated the Ninth Circuit’s judgment and remanded the case. The Supreme Court’s endorsement of the Brooke Group standard appears to rest on three principles that suggest the Court adopted the Chicago school/TCE learning on predatory pricing. First, the Court drew attention to the fact that ‘predatory-pricing and predatory-bidding claims are analytically similar’ as a matter of economic theory, suggesting that similar legal standards are appropriate. Second, the Court espouses a view that the probability of successful predatory buying, like predatory pricing, is very low, in part because of the myriad of explanations for ‘bidding up’ input prices in an effort to increase market share and output or to hedge against price volatility, or as a result of a simple miscalculation. Finally,

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the Court notes that, like low output prices, higher input prices may result in increased consumer welfare as firms increase output. While the Supreme Court does not take the lower court to task for allowing this jury instruction, there is little, if any, doubt that the Supreme Court was correct to reverse the Ninth Circuit’s affirmation of a disastrous jury instruction that would require a determination as to whether a firm purchased more inputs than it ‘needed’ or paid more than ‘necessary’. Rather, the Supreme Court focused almost exclusively on the theoretical similarities between predatory pricing and buying, the attributes of the Brooke Group standard, and why the economic similarity should translate into symmetrical legal treatment. Conclusion These cases, taken together, embody an approach to antitrust analysis that is consistent with the lessons of the Chicago school and TCE approaches. First, the cases clearly favour price theory and NIE over the formal gametheoretic contributions of the PCS literature. Second, the Roberts Court decisions embrace the principle of institutional modesty for antitrust. Each of the three decisions is motivated, at least in part, by the possibility of chilling procompetitive conduct by erroneously assigning liability to efficient conduct. A corollary is that the Court, again in each of the cases but especially Leegin, is sensitive to what is known and unknown about the competitive effects of RPM and other contractual arrangements. The combined affinity for price theory and TCE, emphasis on empiricism and knowledge, and institutional modesty in light of the potential for significant error costs follow directly from Chicago school/TCE analytical principles. The economic rationalization of antitrust is one of the great success stories of the law and economics movement and was motivated, in large part, by the contributions of the Chicago school and TCE. Perhaps the overwhelming analytical and explanatory power of the Chicago school and TCE approaches, in combination with the fact the PCS model has been heavily criticized for its failure to produce testable implications, is responsible for the Supreme Court’s somewhat surprising adherence to these principles in the face of strong forces to abandon them in favour of the PCS model. Nonetheless, antitrust jurisprudence stands at an interesting crossroad as antitrust economics, especially in top economics departments and journals, becomes more mathematically formal and less accessible to generalist judges. These trends might give one reason to believe that the once solid Chicago school and TCE foundations of antitrust analysis might finally be starting to crack. However, the Supreme Court’s antitrust jurisprudence, combined with the relative youth of its

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recent additions, suggests a significant amount of scepticism is appropriate concerning any prediction of the demise of the Chicago school or TCE in antitrust in the coming years. Notes 1.

2. 3. 4. 5. 6. 7.

8.

9.

10.

Especially influential in the dismantling of the structure-conduct-performance hypotheses was UCLA economist Harold Demsetz (1974), whose work was central to exposing the misspecification of this relationship in previous work by Joe Bain and followers, as well as offering efficiency justifications for the observed correlation, which is that firms with large market shares could earn high profits as a result of obtaining efficiencies, exploiting economies of scale, or creating a superior product. The contributions of Demsetz and other participants in the famous Airlie House Conference are discussed by Timothy J. Muris (1997). Chicagoans themselves were among the first to criticize reliance on the model of perfect competition as a useful benchmark for antitrust analysis (Demsetz, 1991). On Klein’s contributions to law and economics more generally, see Wright (2009). These arguments were endorsed by the Department of Justice in United States v. AMR Corp. See Brief for the Appellant United States of America, United States v. AMR Corp. (2003). In aftermarket ‘lock-in’ cases most closely resembling the post-Chicago theories in Kodak, lower courts have ‘bent over backwards to construe Kodak as narrowly as possible’ (Hovenkamp, 2002, p. 8; Klein, 1996). Wright (2007a) elaborates and provides support for this claim. Some disagree. For example, Elhauge (2007) argues that the Roberts Court’s antitrust jurisprudence reflects a distinctively Harvard school approach. In a law review article, Justice Roberts (1994, p. 112) had praised the Supreme Court for ‘regain[ing] its equilibrium after the dizzying Kodak decision of two Terms ago’ with the three decisions in the 1992–93 Term where the Court ‘returned to a regime in which the objective economic realities of the marketplace take precedence over fuzzy economic theorizing or the conspiracy theories of plaintiffs’ lawyers’. This is bad news for professors and lawyers, good news for business. I will discuss three of the four antitrust decisions the Court decided in the 2006–07 Term. I omit Credit Suisse Securities (USA) LLC v. Billing (2007), which involved the Court’s implied preemption of antitrust in favour of securities regulation in the context of allegations involving conspiracy and manipulation of the IPO underwriting process. Wright (2007a) discusses Credit Suisse in greater detail. This argument has long been accepted in the economics literature, first introduced in Klein and Murphy (1988), and later formalized in Mathewson and Winter (1998). Until Leegin, antitrust analysis had focused primarily on Telser’s (1960) pathbreaking but narrow ‘discount dealer’ free-riding analysis which did not explain many uses of RPM observed in practice. The author participated in this case as a signatory to the Law Professors’ Amicus Brief in Support of Petitioner (filed 24 Aug. 2006).

References Armentano, D.T. (1986), Antitrust Policy: The Case for Repeal, Washington, DC: Cato Institute. Baker, Jonathan B. (2002), ‘A preface to post-Chicago antitrust’, in Antonio Cucinotta, Robert Pardolesi, and Roger Van Der Bergh (eds), Post-Chicago Developments in Antitrust Law, Cheltenham, UK and Northampton, MA, USA: Edward Elgar Publishing, pp. 60–75. Baker, Jonathan B. and Timothy F. Bresnahan (2006), ‘Economic evidence in antitrust: defining markets and measuring market power’, Stanford Law School, Working Paper No. 328.

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Bell Atlantic Corp. v. Twombly, 127 S. Ct. 1955 (2007). Bernheim, Douglas and Whinston, Michael (1998), ‘Exclusive dealing’, Journal of Political Economy, 106 (1), 64–103. Bolton, Patrick, Joseph F. Brodley, and Michael H. Riordan (2000), ‘Predatory pricing: strategic theory and legal policy’, Georgetown Law Journal, 88 (4), 2239–329. Bork, Robert H. (1954), ‘Vertical integration and the Sherman Act: the legal history of an economic misconception’, University of Chicago Law Review, 22 (1), 157–201. Bork, Robert H. (1978), The Antitrust Paradox, New York: Basic Books, Bowman, Ward S. (1957), ‘Tying arrangements and the leverage problem’, Yale Law Journal, 67 (1), 19–36. Brooke Group Ltd. v. Brown & Williamson Tobacco Corp., 509 U.S. 209 (1993). Brozen, Yale (with contribution from George Bittlingmayer) (1982), Concentration, Mergers, and Public Policy, New York: Macmillan. Carlton, Dennis and Michael Waldman (2002), ‘The strategic use of tying to preserve and create market power in evolving industries’, RAND Journal of Economics 33 (2), 194–220. Conley v. Gibson, 355 U.S. 41 (1957). Continental T.V. v. GTE Sylvania, 433 U.S. 36 (1977). Credit Suisse Securities (USA) LLC v. Billing, 127 S. Ct. 2373 (2007). Demsetz, Harold (1974), ‘Two systems of belief about monopoly’, in Harvey J. Goldschmid, H. Michael Mann, and J. Fred Weston (eds) (1974), Industrial Concentration: The New Learning, Boston: Little Brown, pp. 164–84. Demsetz, Harold (1991), ‘100 years of antitrust: should we celebrate?’, Brent T. Upson Memorial Lecture, George Mason University School of Law, Law and Economics Center. Director, Aaron and Edward H. Levi (1956), ‘Law and the future of trade regulation’, Northwestern University Law Review, 51 (3), 281–4, reprinted in (2007) Competition Policy International, 3 (2), 253. Dr. Miles Med. Co. v. John D. Park & Sons Co., 220 U.S. 373 (1911). Easterbrook, Frank (1984), ‘The limits of antitrust’, Texas Law Review, 63 (1), 1–40. Eastman Kodak Co. v. Image Technical Services, Inc., 504 U.S. 451 (1992). Elhauge, Einer (2007), ‘Harvard, Not Chicago: which antitrust school drives recent Supreme Court Decisions?’, Competition Policy International, 59 (3), 59–77. Evans, David and Jorge Padilla (2005), ‘Designing antitrust rules for assessing unilateral practices: a neo-Chicago approach’, University of Chicago Law Review, 72 (1), 73–98. Goldschmid, Harvey J., H. Michael Mann, and J. Fred Weston (eds) (1974), Industrial Concentration: The New Learning, Boston: Little Brown. Hovenkamp, Herbert (2002), ‘The reckoning of post-Chicago antitrust’, in Antonio Cucinotta, Roberto Pardolesi, and Roger Van Der Bergh (eds), Post-Chicago Developments in Antitrust Law, Cheltenham, UK and Northampton, MA, USA: Edward Elgar Publishing, pp. 1–32. Illinois Tool Works Inc. v. Independent Ink, Inc., 547 U.S. 28 (2006). Joskow, Paul L. (2002), ‘Transaction cost economics, antitrust rules, and remedies’, Journal of Law, Economics and Organization, 18 (1), 95–116. Kitch, Edmund W. (1983), ‘The fire of truth: remembrance of law and economics at Chicago, 1932–1970’, Journal of Law and Economics, 26 (1), 163–234. Klein, Benjamin (1980), ‘Transaction cost determinants of “unfair” contractual arrangements’, American Economic Review, 70 (2), 356–62. Klein, Benjamin (1996), ‘Market power in aftermarkets’, Managerial and Decision Economics, 17 (2), 143–64. Klein, Benjamin (1999), ‘Market power in franchise cases in the wake of Kodak: applying post-contract hold-up analysis to vertical relationships’, Antitrust Law Journal, 67 (2), 283–326. Klein, Benjamin (2000), ‘Fisher–General Motors and the nature of the firm’, Journal of Law and Economics, 43 (1), 105–41.

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Klein, Benjamin and Roy W. Kenney (1983), ‘The economics of block booking’, Journal of Law and Economics, 26 (3), 497–540. Klein, Benjamin and Andres V. Lerner (2007), ‘The expanded economics of free-riding: how exclusive dealing prevents free-riding and creates undivided loyalty’, Antitrust Law Journal, 74 (2), 473–519. Klein, Benjamin and Kevin M. Murphy (1988), ‘Vertical restraints as contract enforcement mechanisms’, Journal of Law and Economics, 31 (2), 265–97. Klein, Benjamin and Kevin M. Murphy (1997), ‘Vertical integration as a self-enforcing contractual arrangement’, American Economic Review, 87 (2), 415–20. Klein, Benjamin and Kevin M. Murphy (2008), ‘Exclusive dealing intensifies competition for distribution’, Antitrust Law Journal, 75 (2), 433–66. Klein, Benjamin and Lester F. Saft (1985), ‘The law and economics of franchise tying contracts’, Journal of Law and Economics, 28 (2), 345–61. Klein, Benjamin and Joshua D. Wright (2007), ‘The economics of slotting contracts’, Journal of Law and Economics, 50 (3), 421–54. Klein, Benjamin, Robert G. Crawford, and Armen A. Alchian (1978), ‘Vertical integration, appropriable rents, and the competitive contracting process’, Journal of Law and Economics, 21 (2), 297–326. Kobayashi, Bruce H. (1997), ‘Game theory and antitrust, a post-mortem’, George Mason Law Review, 5 (3), 411–22. Kobayashi, Bruce (2005), ‘Does economics provide a reliable guide to regulating commodity bundling by firms? A survey of the economic literature’, Journal of Competition Law and Economics, 1 (4), 707–46. Kovacic, William E. and Carl Shapiro (2000), ‘Antitrust policy: a century of economic and legal thinking’, Journal of Economic Perspectives, 14 (1), 43–60. Krattenmaker, Thomas G. and Steven C. Salop (1986), ‘Anticompetitive exclusion: raising rivals’ costs to achieve power over price’, Yale Law Journal, 96 (2), 209–93. Leegin Creative Leather Products, Inc. v. PSKS, Inc., 127 S. Ct. 2705 (2007). Marvel, Howard P. (1982), ‘Exclusive dealing’, Journal of Law and Economics, 25 (1), 1–25. Mathewson, Frank and Ralph Winter (1998), ‘The law and economics of resale price maintenance’, Review of Industrial Organization, 13, 57–84. McGee, John S. (1958), ‘Predatory price cutting: the standard oil (NJ) case’, Journal of Law and Economics, 1, 137–69. Meese, Alan J. (1997), ‘Tying meets the new institutional economics: farewell to the chimera of forcing’, University of Pennsylvania Law Review, 146 (1), 1–100. Muris, Timothy J. (1997), ‘Economics and antitrust’, George Mason Law Review, 5 (3), 303–12. Newman, Peter (ed.) (1998), The New Palgrave Dictionary of Economics and the Law, New York: Macmillan Reference. Page, William H. (1989), ‘The Chicago school and the evolution of antitrust: characterization, antitrust injury, and evidentiary sufficiency’, Virginia Law Review, 75 (7), 1221–308. Peltzman, Sam (2005), ‘Aaron Director’s influence on antitrust policy’, Journal of Law and Economics, 48 (2), 313–30. Posner, Richard A. (1979), ‘The Chicago school of antitrust’, University of Pennsylvania Law Review, 127 (4), 925–48. Posner, Richard A. (1981), ‘The next step in the antitrust treatment of restricted distribution: per se legality’, University of Chicago Law Review, 48 (1), 6–26. Rasmusen, Eric B., Mark J. Ramseyer, and John Shepard Wiley, Jr (1991), ‘Naked exclusion’, American Economic Review, 81 (5), 1137–45. Roberts, John (1994), ‘Symposium: do we have a conservative Supreme Court?’, Public Interest Law Review, 107–21. Simpson, John and Abraham Wickelgren (2007), ‘Naked exclusion, efficient breach, and downstream competition’, American Economic Review, 97 (4), 1305–20. State Oil Co. v. Khan, 522 U.S. 3 (1997).

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Telser, Lester G. (1960), ‘Why should manufacturers want fair trade?’, Journal of Law and Economics, 3, 86–105. United States v. AMR Corp., 335 F.3d 1109 (10th Cir. 2003). Verizon Communications Inc. v. Law Offices of Curtis V. Trinko, LLP, 540 U.S. 398 (2004). Weyerhaeuser Co. v. Ross-Simmons Hardwood Lumber Co., 127 S. Ct. 1069 (2007). Whinston, Michael D. (1990), ‘Tying, Foreclosure, and Exclusion’, American Economic Review, 80 (4), 837–59. Williamson, Oliver E. (1971), ‘The vertical integration of production: market failure considerations’, American Economic Review, 61 (2), 112–23. Williamson, Oliver E. (1975), Markets and Hierarchies: Analysis and Antitrust Implications, A Study in the Economics of Internal Organization, New York: The Free Press. Williamson, Oliver E. (1985), The Economic Institutions of Capitalism, New York: The Free Press. Williamson, Oliver E. (1996), The Mechanisms of Governance, New York: Oxford University Press. Wright, Joshua D. (2006), ‘Antitrust law and competition for distribution’, Yale Journal on Regulation, 23 (2), 169–208. Wright, Joshua D. (2007a), ‘The Roberts Court and the Chicago school of antitrust: the 2006 term and beyond’, Competition Policy International, 3 (2), 24–57. Wright, Joshua D. (2007b), ‘Slotting contracts and consumer welfare’, Antitrust Law Journal, 74 (2), 439–72. Wright, Joshua D. (2009), ‘Benjamin Klein’s, contributions to law and economics’ in Lloyd R. Cohen and Joshua D. Wright (eds), Pioneers of Law and Economics, Cheltenham, UK and Northampton, MA, USA: Edward Elgar Publishing.

24 Financial-market contracting Dean V. Williamson

Should a firm finance a project with non-recourse debt – that is, with debt that affords creditors recourse to nothing more than the project-specific assets in the event of default? Alternatively, should the firm finance a project with corporate-level debt – that is, with debt that affords creditors recourse to other assets in the firm? Should the firm even finance the project with infusions from equity investors? Finally, should the firm adopt a ‘financial structure’ that features a combination of debt and equity financing? These questions suggest that the firm might perceive tradeoffs in adopting one financial structure over another. While it may be easy enough to pose tradeoffs, characterizing optimal structures is a rich and interesting problem. To begin, the irrelevance theorems of Modigliani and Miller (1958) indicated that one can identify environments in which no particular structure dominates in equilibrium. The results motivated prodigious streams of research about how different structures can dominate, yet, forty years on Hart and Moore (1998, p. 1) could still observe that ‘economists do not yet have a fully satisfactory theory of debt finance (or of the differences between debt and equity)’. To fix ideas, consider the decision of one entity (the ‘firm’, say) to finance a discrete project with a financial contract called ‘debt’ by which the firm yields to another party (the ‘investor’) a non-contingent stream of payments and a right to foreclose – that is, with the right to march in and demand the redeployment of assets in the event of default. Alternative financial contracts might feature state-contingent streams of payments and other control rights in addition to (or in place of) the foreclosure right. The firm might also, at some cost, assemble governance mechanisms such as auditing schemes or accounting schemes to allow investors to monitor streams of payments. Three things (among many) that a fuller theory might yet do in such a context are: (1) characterize the bundling of types of payment streams with particular control rights; (2) characterize the alignment of these bundles with supporting governance mechanisms; and (3) the financial structure question: characterize the selection of debt financing, equity financing, or some combination of financing for a given project. First consider control rights. We traditionally understand ‘debt’ as a contract that bundles a 244

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non-contingent stream of payments with a foreclosure right. Yet, as Hart and Moore (1998) observe, it is not obvious that such a foreclosure right should necessarily be bundled with non-contingent payments schemes. Why not bundle them with state-contingent schemes or dispense with them entirely? Now consider governance mechanisms. Williamson (1996, Chapter 4) suggests that parties to exchange select contracts and support governance mechanisms simultaneously. Financial contracts are no exception (Williamson, 1988). For example, problems of asymmetric information can complicate the implementation of state-contingent payment schemes, because informed parties within the firm might be able to underreport proceeds and cheat investors. Accordingly, the firm might find itself having to assemble costly mechanisms such as auditing schemes so that equity investors may monitor the state-contingent payment streams that attend equity. An advantage of debt is that non-contingent streams require less monitoring; creditors need not know all the details about all streams flowing into the firm. In turn, the firm might choose to dispense with certain costly mechanisms and secure debt financing. Finally consider the selection of debt or equity. If debt requires fewer costly support mechanisms than equity, then why should not debt dominate? Williamson (1988, pp. 579–81) poses an hypothesis by which the selection of debt or equity is driven by asset-specificity – the degree to which the redeployment of assets dedicated to a project would induce the dissipation of surplus. In a stick-figure version of the argument, the debtversus-equity question amounts to a ‘rules-versus-discretion’ tradeoff by which debt corresponds to a more rigid, rules-oriented mode of financing and equity constitutes a more flexible, discretion-oriented mode of financing. In the event of default, control of the underlying assets reverts to the creditor, in which case the creditor may exercise his option to demand redeployment. The creditor may yet exercise some discretion and allow the debtor to ‘work things out’, but the advantage of an equity-based regime is that it features administrative processes that are specifically designed to facilitate ‘working things out’.1 While there would be little demand to work things out in cases involving highly redeployable assets, demands increase as redeployability diminishes. In cases featuring highly specialized assets, equity-based schemes dominate. Note what is going on. Hart and Moore (1998) go some way toward endogenizing the bundling of control rights with payment streams. Williamson (1988) takes such bundles as given but goes some way toward endogenizing the matching of these bundles to supporting governance mechanisms. Along the way Williamson (1988) provides a contract selection hypothesis. In this chapter I describe two empirical exercises in which

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I exploit the contract selection hypothesis of Williamson (1988). One of the exercises is similar to that of Hart and Moore (1998) in one respect: it goes some way toward endogenizing the bundling of particular control rights with either debt or equity financing. A difference is that these particular control rights are indicated in contracts distinct from the financial contracts. Specifically, I examine an environment in which contracting parties commit to (possibly) long-term exchange. They have to line up project-specific financing, and they indicate terms of exchange in separate, long-term contracts. I characterize interactions between types of financing and the structure of the long-term contracts. In both empirical exercises I also do something which is much the converse of the governance hypothesis featured in Williamson (1988). Williamson (1988) suggests that parties actively assemble governance mechanisms to support different types of financial contracts. That is, parties meet demand for governance by actively supplying governance. I examine problems in which parties may sometimes be less equipped to assemble governance mechanisms but rather must exploit features of the institutional environment to govern their relationships. They thus end up adapting demands for governance (by adapting contracts) to the existing supply of governance mechanisms. Note that the idea that parties may sometimes adapt demands for governance to supply of governance instead of adapting supply to meet demand suggests a fourth consideration that a fuller theory of financial structure might accommodate: how do the design of contracts, the design of supporting governance structures, and the selection of contracts interact with the institutional environment? There is some related work on this count. Levy and Spiller (1994) explore how the design of regulatory regimes varies across political environments. Oxley (1999) explores how parties to collaborative R&D adapt governance structures to differences across environments in intellectual property protection. Silva and Azevedo (2007) characterize how parties adapt franchising contracts across legal regimes. All of the discussion in the next three parts of the chapter focuses on the financing of discrete projects with debt or equity-like financing. In the first part I characterize the design of electricity marketing contracts. These contracts are interesting, because they are designed to support the financing of electricity generation projects. In the second part I characterize the financing of overseas trade ventures in the Eastern Mediterranean in the years 1190–1220 and 1300–1400. The financing of trade also posed a debtversus-equity problem. It also constitutes an example of how financial structure could vary with differences across institutional environments. The medieval traders may have had less capacity to actively design mechanisms to support financing, but in some environments they could exploit

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features of the environment to support equity-like schemes. Other environments featured less in the way of institutional supports, and medieval traders found themselves having to resort to debt financing. The last part of the chapter concludes. The financial structure of electricity marketing contracts Firms that develop generation facilities (‘generators’) tell a compelling but incomplete story about how they organize the financing of electricity generation facilities. They line up long-term contracts with electricity ‘marketers’. Contracts generally run as long as the expected life of the generating assets; the parties often specify contract duration longer than 20 years, although there is much variation in contract terms. Marketers trade electricity on wholesale electricity markets, and they often secure ‘dispatch rights’ from generators – rights to make real-time demands for electricity generation as well as demands to cease generation.2 In return, marketers often compensate generators according to two-part schemes. The variable part of the scheme compensates generators for their operating costs, and generators extract profits through the fixed part of the scheme. Marketers end up bearing risk for generators, and generators turn around and appeal to prospective creditors (‘the bank’) for loans in the order of $100 million to finance the construction or acquisition of electricity generation capacity. Indeed, generators report that they need to line up two-part compensation in order to motivate creditors to finance investment in generation capacity that can support timely dispatch demands.3 One reason the story is incomplete is that it does not indicate why assigning the marketing risk to the marketer makes it easier for the generator to secure debt financing. Another reason is that the story does not indicate why debt financing should dominate. Finally, the story does not explain one other common feature of electricity marketing contracts: contracts that include two-part compensation and long terms often feature provisions that allow the marketer to effectively veto the proposals of the generator to add, tune-up, or withdraw generation capacity over the course of long-term exchange. In a project titled ‘Adaptation and Renegotiation in Long-term Exchange Relations: Evidence from Electricity Marketing Contracts’ (Williamson, 2007), I provide both theory and evidence from a dataset of 101 electricity marketing contracts about how generators marketers use four instruments – contract duration, compensation schemes, financial structure, and veto provisions – to support the financing of project-specific assets and to address demands for contract adjustments over the course of long-term exchange. The project joins two types of hypotheses drawn from transaction cost economics (TCE). One is that adapting relationships over the course of

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long-term exchange is an important economic problem. It is economic, because there can be tradeoffs between the ways contracting parties might address demands to adapt the terms of exchange. That leads to an ‘efficient adaptation’ hypothesis in the spirit of those developed in such classic studies as Masten and Crocker (1985), Crocker and Masten (1988), and Crocker and Reynolds (1993). The second exploits the selection hypothesis of Williamson (1988). If one accepts that generation assets are highly redeployable outside of any relationship between a specific generator and specific marketer, then debt financing should dominate. I operationalize the efficient adaptation hypothesis and the selection hypothesis in a reduced form model. That in itself is not interesting. What is interesting is that the modeling exercise suggests a simple narrative about how electricity marketing contracts work, and it provides stark predictions about patterns that should emerge in the contract data. Even more interesting is the fact that these patterns actually obtain. First, consider the narrative: suppose a generator and marketer commit to a 20-year contract by which the marketer secures dispatch rights in exchange for a two-part stream of payments to the generator. Having effectively sold off its generation capacity for a fixed fee, the generator may perceive a private benefit to expanding capacity on site or at a nearby site and selling off that capacity under another contract with a different marketer. A difficulty with expanding capacity is that it could frustrate the ability of the marketer to commercialize the capacity that is already under contract. One way to accommodate this problem is to give the marketer the right to impose renegotiation over the terms of the contract – or at least over the fixed fee in the two-part compensation scheme – whenever the generator proposes to add, withdraw or tune-up capacity. One way to enable the marketer to impose renegotiation is to give it the right to exit the relationship in response to any proposal by the generator. An alternative is to assign to the marketer the right to veto proposals. The key point about veto provisions is not that parties exercise them out of hand but rather that they use them to impose renegotiation. So, for example, if a proposal to add capacity would diminish the vertical rent that the parties collectively perceive, then the marketer should be expected to exercise its veto. In contrast, it is reasonable to expect that over time the parties would collectively perceive opportunities to increase the vertical rent by increasing capacity. In such cases the threat of the veto allows the marketer to impose adjustment of the fixed fee in order to secure its participation. Thus, the veto allows the parties to achieve efficient (rent-increasing) adaptations in capacity and to avoid inefficient (rent-diminishing) changes in capacity. Note that there may be alternatives to veto provisions. If parties can

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anticipate expanding capacity after a short term, then they could replace a long-term contract with a sequence of short term contracts. A problem with short-term contracting, however, is that it amounts to programming a sequence of (possibly) costly renegotiations. Alternatively, parties might choose to dispense with two-part compensation and impose some of the market risk on the generator. Sometimes parties commit to ‘linear’ compensation by which the marketer pays the generator a fee per unit output (kilowatt hour). Linear compensation induces the generator to internalize some of the effects of changing capacity, and the parties may be able to dispense with veto provisions. A difficulty is that linear compensation may complicate the effort to line up debt financing. The question of why linear compensation may complicate debt financing is nontrivial. I pose a monitoring hypothesis in the spirit of ‘delegated monitoring’ (Diamond, 1984) by which contracting parties effectively exploit monitoring mechanisms situated elsewhere in the institutional environment. A marketer may have its hand in a broad portfolio of projects with any number of generators. Pooling streams from different projects amounts to pooling risks, but pooling risks may make it more difficult for outside investors to disentangle and monitor streams, thus creating demands for costly auditing schemes. The generator, however, may separately incorporate each of its production projects. In the language of Hansmann and Kraakman (2000), the generator may be able to ‘partition assets’ across separately incorporated entities so that outside investors may forgo the costs of disentangling any one project’s streams from those of other projects. But risky streams still require monitoring, because generators might cheat investors by misrepresenting their payoffs. However, imposing two-part compensation relieves the generator of project-specific risk and, in turn, relieves outside investors of having to bear incremental monitoring and auditing costs (D. Williamson, 2005). Thus, imposing the residual claims on the marketer still enables risk pooling, but it also enables parties to economize on auditing and monitoring costs; investors need only concentrate the lens of costly auditing and monitoring on the marketer. Taken all together, the discussion suggests that contract duration, financial structure (debt or equity), compensation (two-part or linear), and veto provisions are simultaneously determined. The reduced form model captures interactions between these four instruments and yields two types of results. First, the model yields dominance results. One result is that contracts should not feature both linear compensation and veto provisions. Second, the model yields patterns of complementarity and substitution between the four instruments. Three patterns that are robust over all degrees of redeployability are: (1) contract duration and veto

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Table 24.1

Dominance results

Marketer bears risk Parties share risk Total

Veto provision

No veto

Total

21 – 21

45 29 74

66 29 95

provisions are complements; (2) veto provisions and two-part compensation are complements; (3) two-part compensation and debt financing are complements.4 The dominance result is immediate. Of the 95 contracts in the dataset that exclude wind-driven generation, 21 feature veto provisions and 29 feature linear compensation, but none feature the combination of linear compensation and veto provisions.5 (See Table 24.1.) The complementarity results require more preparation. The first step toward operationalizing analysis was to pose the hypothesis that one can understand the contracting problem as a system composed of a continuous choice (contract duration) and three binary choices (debt or equity, two-part or linear compensation, veto or no veto). The simultaneity of these choices implies a problem of simultaneous discrete choice – a hard econometric problem. I finesse the problem by appealing to various ‘full information’ and ‘singleequation’ methods, each of which has its advantages and drawbacks. First, I impose the ‘linear probability model’ on the discrete choices – that is, I treat each binary choice as a continuous variable. I then apply threestage least squares (3SLS) to the system. I first estimate a system of three equations that features a ‘duration equation’, a ‘compensation equation’, and a ‘veto equation’. I exclude a fourth ‘debt equation’, because all of the generation projects were financed with debt. The system I estimated corresponded to a linearized version of the model: LogTermi 5 aT 1 bTsTwoParti 1 bTvVetoi 1 gTWTi 1 eTi TwoParti 5 as 1 bsTLogTermi 1 bsvVetoi 1 gsWsi 1 esi Vetoi 5 av 1 bvTLogTermi 1 bvsTwoParti 1 gvWvi 1 evi where i = 1, . . ., 101, WTi and Wvi are vectors of variables that reflect demands for adaptation, Wsi includes variables that reflect the feasibility of timely dispatch, and the error terms eTi, esi, and evi indicate potentially non-normal processes. I then demonstrate that the complementarity of contract duration (Term) and veto provisions (Veto) implies bTv . 0 and

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bvT . 0 in the linearized model. The complementarity of veto provisions (Veto) and two-part compensation (TwoPart) implies bsv . 0 and bvs . 0. Applying the linear probability model may induce heteroskedastic residuals. Bootstrap methods can be applied to 3SLS (Freedman and Peters, 1984; MacKinnon, 2002), and boostrapping data directly (‘pairs’ bootstrap), in contrast to bootstrapping residuals from the original estimation, constitutes a method of generating standard errors and confidence intervals that are robust to heteroskedasticity (MacKinnon, 2006, p. S7; Johnston and Dinardo, 1997, p. 369). Nevitt and Hancock (2001) further observe that the bootstrap provides an alternative and often superior means of generating standard errors with small datasets featuring data that may be non-normal. As a robustness check, I also apply single-equation methods such as two-stage least squares (with and without bootstrapped standard errors) and the two-stage conditional maximum likelihood method (2SCML) of Rivers and Vuong (1988).6 As Petrin and Train (2003) observe, 2SCML constitutes an application of the ‘control function’ approach to probit models. (For accessible discussions, see Alvarez and Glasgow, 1999 and Wooldridge, 2002, p. 474.) It is a single equation method that accommodates continuous endogenous explanatory variables and provides simple Hausman-like ‘endogeneity tests’ (Hausman, 1978) of both continuous and discrete explanatory variables (Rivers and Vuong, 1998, p. 358; Wooldridge, 2002, p. 474).7 All of the methods I applied yielded affirmative and statistically significant complementarity results. The results indicate that longer-term contracts tend to feature veto provisions, and veto provisions tend to accompany two-part compensation. These complementarity results and the dominance results are consistent with the larger hypothesis that ‘efficient adaptation’ drives the design of contracts and choice of financial structure. The financial structure of long-distance trade Histories of trade in the Mediterranean in the late Middle Ages assign a pivotal role to equity-like principal–agent contracts known generically as commenda. Commenda would join investors (‘merchants’) and trading agents in seasonal trade ventures. An investor would advance capital in specie or in kind. The agent would often commit to following an itinerary in and around the Mediterranean, trading at ports along the way as he would see fit. Sometimes the investor yielded to the agent complete control over the itinerary. All contracts indicated a term, almost never longer than a year, and usually limited to three months or six months. At termination the agent would be called to account for transactions executed over the

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course of the contract term, and parties would share proceeds according to a compensation scheme. Almost universally, the investor would agree to bear losses from physical losses (for example, shipwreck or piracy) whenever such losses could be ‘clearly proven’.8 The one feature of commenda contracts that continues to be the focus of attention is the equity-like schemes by which the contracting parties would share proceeds from transactions the agent would have executed over the term of the contract. Parties typically shared proceeds in proportions half/ half, two-thirds/one-third, and three-quarters/one-quarter with the larger portion going to the investor. According to the traditional historical narrative, the function of these schemes was to allow parties to share risks; risk-sharing helped mobilize investment in overseas trade; overseas trade drove economic growth; equity-like schemes financed trade at the frontiers of the Mediterranean trade economy. While risk-sharing may have been an important consideration, the traditional narrative as well as any other studies that focus on commenda contracts suffer one great limitation: they fail to recognize a larger contract selection problem. Evidence from contracts between investors and trading agents operating out of Venice from 1190–1220 and out of Venetian Crete from 1300–1400 indicates that more often parties financed trade ventures with simple debt contracts rather than with commenda. Of the 1567 contracts I have reviewed, over 52 percent were loans by which agents assumed the residual claim; investors loaned capital to trading agents thus effectively selling to agents for a fixed fee the right to conduct a particular venture.9 Another debt-versus-equity question obtains. I pose a contract selection hypothesis according to which contracting parties match contingent and non-contingent compensation schemes (commenda and debt contracts, respectively) to features of the institutional environment. While characterizing the selection of compensation schemes is hardly a novel problem,10 it constitutes but one dimension of a much larger problem. Specifically, the investor’s and agent’s contracting problem involved at least three simultaneous, interacting processes: (1) a matching of investors to agents; (2) the selection of ventures; and (3) the selection of compensation schemes. The matching problem involved a complicated ‘many-to-many’ match in that any one party might conduct a venture for some number of investors and could turn around and invest in ventures conducted by other agents. The matching problem likely interacted with the sorting of agents and investors across candidate ventures. At the same time, the selection of ventures likely interacted with the selection of compensation schemes. Finally, insofar as risk-preferences varied across investors and agents, the selection of compensation schemes may have interacted with the matching of investors and agents.

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While there exist many theoretical and empirical studies on matching problems and no fewer studies on the selection of compensation schemes, few studies simultaneously characterize matching and contract selection.11 My focus here is on the contract selection problem. I suggest that one can understand it as a problem of ex post hidden information: both parties to contract would contribute complementary inputs (capital and labour) to the production of a venture; output may have been uncertain, but only one party (the trading agent) could observe output. Thus, there was some prospect that the agent could cheat the investor after the resolution of uncertainty by underreporting output and expropriating the unreported returns. If one poses output as the agent’s ‘type’, then one can understand the contracting problem as one of having to commit to a (possibly) typecontingent compensation scheme before the agent learns his type – hence, ex post rather than the usual ex ante hidden information. By this interpretation, the commenda contract corresponded to type-contingent compensation whereas debt corresponded to compensation that was invariant to the agent’s type. The standard approach to problems of hidden information is to craft contracts that join (potentially) type-contingent compensation schemes with at least one other type-contingent instrument. In contexts involving problems of ex ante hidden information, the contract designers might be able to post a type-contingent menu of contracts that induces agents to reveal their types by self-selecting into different contracts; the contract design problem may feature a well-defined ‘sorting condition’. In contexts involving ex post hidden information, the designer has the appearance of being restricted to posting only a single contract, but interactions between type-contingent compensation and other type-contingent instruments may yet induce agents to sort themselves in a way that reveals their underlying types. So, for example, in the literature on ‘costly state falsification’ inspired by Townsend (1979), auditing schemes constitute the other instrument: contracting parties are endowed with a costly auditing technology, and a contracts map agents’ reports of their types into levels of compensation and into some probability of agents’ reports being subjected to audit. Contracting parties might be able to commit to a schedule of compensation and probablisitic auditing that induces the agent to reveal his type. As a matter of theory, it is easy to come up with mathematically isomorphic instruments that contracting parties might exploit to induce truthful reporting. Faure-Grimaud and Mariotti (1999) observe, for example, that expanding a principal–agent problem featuring one-shot interactions to one that permits follow-on exchange between the contracting parties may allow the parties to operationalize a broad range of other instruments. Crocker and Morgan (1998) indicate a less obvious class of instruments in

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an environment featuring one-shot exchange. Agents might be endowed with costly falsification technologies: an agent might bear some cost in order to misrepresent his type. Insofar as the costs of falsification vary across types, then the parties might want to induce self-selection and support type-contingent compensation schemes. Faure-Grimaud and Mariotti (1999) observe that, as a matter of theory, contracts that feature non-contingent compensation – that is, contracts that look like debt – are not very general given that contracting parties might be able to operationalize any one of a broad range of mathematically isomorphic ‘other’ instruments. Debt-like contracts may yet correspond to optimal contracts even when parties have access to other instruments, but a separate conclusion is that non-contingent compensation obtains in environments in which parties are unable to operationalize other instruments. It is this conclusion I exploit here: in some environments contracting parties could tap into streams of information relevant to an agent’s reported transactions. In these environments, the parties could detect cheating and could, in turn, operationalize other instruments. I am agnostic on what those other instruments are, but reputation mechanisms or probablisitic reward/punishment schemes could support type-contingent compensation. In other environments, contracting parties were denied access to transaction-relevant information and could not operationalize auditing schemes. They were thus denied access to other instruments. In these environments, non-contingent compensation prevailed. Note that the decision of contracting parties to operate in one environment or the other amounts to resolving the venture selection problem. A difficulty is that the contract data alone does not provide a means of subjecting the venture selection problem to econometric analysis. I put that problem aside and note that it does not preclude all analysis of the contract selection problem. I pose a contract selection hypothesis that is conditional on the selection of types of ventures: one can partition the contract data into two sets. One set corresponds to ventures parties conducted in conjunction with regular convoys and trade fairs organized by the state, the Republic of Venice. The other set is composed of all other contracts. State-sponsored convoys traveled between major trade hubs in and around the Eastern Mediterranean. Traveling with a convoy to trade in major hubs amounted to choosing to trade in an information-rich environment – the kind of environment in which one could detect (if not verify) cheating. In such environments, parties had the option of choosing equity-like financing. Deviating from trade along established routes served by regular convoys amounted to choosing to trade in environments that featured little in the way of transaction-relevant information parties could use to police cheating. In such environments, debt contracting prevailed.

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The Republic of Venice managed to assemble a combination of regular convoys and trade fairs in Venice from 1190–1220. The convoys included convoys dedicated to supporting a trade with Egypt that the Republic had already maintained for some centuries. The trade with Egypt focused on agricultural commodities such as pepper. Contrast the experience from 1291 to 1370. In these years the Republic only managed to sporadically organize convoys, if not corresponding trade fairs, to Egypt. In the 1330s and 1340s, Italy suffered severe famines, and then plague (the Black Death) invaded the Mediterranean in 1347. Plague broke out again in the 1360s. The few convoys to Egypt that were organized in these years focused on the acquisition of grain. Post-1370 the convoys to Egypt that the Republic did assemble had become overshadowed by a new convoy route linking Venice to the Levant via Beirut (Ashtor, 1975). The data specific to convoy traffic and to trade with Egypt enable three simple quasi-experiments. The data from 1190–1220 feature ventures organized around regular, state-sponsored convoys and all other ventures. The prediction is that ventures specific to convoys and the Venetian trade fairs could support commenda contracts and that all other ventures would be less likely to support commenda. These same data indicate the family relationships (if any) of the contracting parties. One might speculate that family bonds could support commenda contracts. What one finds, however, is that while related parties tended to select commenda, they also tended to select convoy-specific ventures. Thus, it is not obvious at all that contracting parties appealed to family bonds as a way of policing cheating. Family bonds served other purposes. Finally, the data support a comparison of trade between Venice and Egypt from 1190–1220 – trade that was convoy-specific – to trade between Venetian Crete and Egypt from 1300–1400. The latter trade was less likely to be organized around trade fairs and regular, state-sponsored convoys. The prediction is that parties could support commenda contracts in the convoy-specific trade but that debt should dominate the other trade with Egypt. The results are plain for each experiment. Consider the alignment of contracts with regular, state-sponsored convoys. Table 24.2 indicates the cross-tabulation of a binary variable ‘Convoy’ with type of contract (commenda or debt) for the 56 extant contracts from 1190–1220. Of 33 contracts that parties aligned with a convoy, 32 were commenda and only one was debt. Of the 23 contracts not aligned with a convoy 12 were commenda and 11 were debt. How contracting parties supported these 12 unaligned commenda is unknown, but the data are consistent with the hypothesis that parties could exploit features of the institutional environment (the state-sponsored convoys) to support contracts featuring contingent compensation schemes.

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Table 24.2

Commenda Debt Total

Table 24.3

Commenda Debt Total

Table 24.4

Convoy No convoy Total

The financial structure of contracts organized around the convoys, 1190–1220 Convoy

No convoy

Total

32 1 33

12 11 23

44 12 56

The financial structure of contracts organized around kinship relations, 1190–1220 Family relation

No relation

Total

14 – 14

30 12 42

44 12 56

The distribution of kinship relations and convoys, 1190–1220 Family relation

No relation

Total

10 4 14

23 19 42

33 23 56

Now consider the role of family relations. At first sight, one would be tempted to conclude that contracting parties exploited kinship relations to support contingent compensation schemes. Table 24.3 features the crosstabulation of a binary variable ‘Family relation’ with type of contract. All of the 14 contracts that featured a kinship relation between the contracting parties were commenda contracts. Contracting parties selected the 12 debt contracts only in cases featuring no documented family relationship. If one ‘controls’ for the selection of ventures – specifically, if one controls for the selection of convoys – then a different interpretation emerges. Table 24.4 indicates that of the 14 contracts featuring kinship relations, ten were assigned to convoy-specific ventures and only four were not aligned with convoys. One interpretation consistent with these results is that contracting parties exploited trade coordinated around convoy traffic as a way of training younger family members and as a way of allowing younger members to begin building up some capital of their own for future investments.12 Contracting parties did not rely on kinship relations to police cheating.

Financial-market contracting Table 24.5

Commenda Debt Total

257

The trade with Egypt 1190–1220

1303–1400

15 3 18

6 100 106

Finally, consider differences in the trade with Egypt between 1190–1220 and 1300–1400. Table 24.5 indicates the distribution of contract types over these two intervals. Of the 18 contracts dedicated to trade between Egypt and Venice from 1190–1220, 15 were commenda. In contrast, of the 106 contracts dedicated to trade with Egypt from 1300–1400, 100 were debt contracts and only six were commenda. Conclusion I have suggested that a complete theory of financial structure would simultaneously accommodate the design of contracts, the design of supporting governance structures, and the selection of contracts – a demanding order. On top of that, I have suggested that a complete theory would accommodate interactions between these three factors and the institutional environment. While no one theoretical or empirical study may accommodate all four factors, different studies have taken up at least two factors at a time. In this chapter I have outlined a study on the financing of electricity marketing projects that takes up aspects (albeit not all aspects) of all four factors. The study takes as given the bundling of foreclosure rights with non-contingent payment streams in financial contracts we recognize as ‘debt’. Yet, the study indicates the alignment of debt and equity with control rights indicated in long-term contracts. The study goes on to indicate how contracting parties use these control rights (veto provisions) and other dimensions of contract to manage demands for adaptation over the course of long-term exchange. I have also outlined a second study on the financing of overseas trade in the late Middle Ages. That study features a contract selection hypothesis that lends itself to an interpretation of medieval contracting practices that runs counter to the traditional historical narrative. The traditional narrative focuses on the role of equity-like schemes in mobilizing investment in overseas trade. The narrative suggests that equity financed trade at the frontiers of the trade economy, yet that same narrative fails to characterize, much less recognize, a role for debt financing. An alternative interpretation presented here is that merchants and their trading agents could support equity-like financing in environments that featured external

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supports. At the frontiers, however, contracting parties did not have access to such supports and thus had to appeal to modes of financing that would not require supports. Debt financing required little in the way of institutional supports, and it was thus debt, not equity, that financed trade at the frontiers of the trade economy. Notes 1.

2.

3.

4.

5.

6.

7. 8.

A fuller account, rather than a ‘stick-figure’ account, would address the prospect of the creditor exercising discretion. Williamson’s approach is to appeal to what amounts to a theorem of transaction cost economics, ‘the impossibility of selective intervention’. Williamson observes that ‘to combine rules with discretion will never realize the hypothetical ideal but will always entail compromise’. (See Williamson, 1988, pp. 581–2.) ‘Put differently, the admonition to “follow the rules with discretion” is too facile.’ Certain types of generation capacity (for example, nuclear or coal-fired capacity) are not suited to meeting time-sensitive dispatch demands. The optimal program is to let them continuously pour electrons into the transmission grid to serve ‘baseload’ demands. In contrast, gas-fired generation capacity is better suited to meeting timesensitive demands at the margin. One can understand gas-fired generators as jet engines bolted to the ground, and, indeed, they are manufactured by firms like General Electric that also manufacture jet engines. Contracting parties can get away with a ‘linear’ (one-part) fee per unit output ( kilowatt hour) with baseload capacity. Wind-driven generation is a hybrid case. It depends on the wind and thus cannot be counted on to serve marginal demands; contracting parties use it to serve baseload demands and assign linear compensation to it. These complementarity results derive from the value function implied by the model. It turns out, however, that the value function is not supermodular in the four instruments, so it was not possible to conduct analysis by appealing to monotone comparative statics. Wind-driven generation is a hybrid case that, strictly speaking, lies outside the scope of the model. The dataset does include six contracts that feature wind-driven generation. All six contracts feature linear compensation, and two feature veto provisions. The model does not provide guidance on why contracts pertaining to wind-driven generation might feature veto provisions. One can speculate that the parties include veto provisions to accommodate the fact that wind-driven generation is more dependent on a regime of subsidies, and contracting parties might be sensitive to the prospect of subsidies being withdrawn. 2SCML involves including three new generated variables, ‘LogTerm Residuals’, ‘TwoPart Residuals’, and ‘Veto Residuals’ to single-equation estimation of the contract duration equation and to estimation of probits for TwoPart and Veto. The residuals derive from ordinary least squares regression of reduced-form equations – that is, from separately regressing LogTerm, TwoPart and Veto on all of the exogenous variables featured in the system. Applying 2SCML to the duration equation yields the same coefficient estimates that one would obtain from two-stage least squares and yields virtually the same standard errors (Davidson and MacKinnon, 1993, p. 240). The tests amount to tests of the significance of the coefficients assigned to the generated variables LogTerm Residuals, TwoPart Residuals, and Veto Residuals. Example: in Candia (now Heraklion), Crete on 25 May 1335 Gregorio Langadhioti advanced to Giorgio de Raynaldo capital composed of 483 ‘measures’ of bottled wine valued at 22.5 Cretan hyperpers per 100 measures (almost 109 Cretan hyperpers in all). The agent committed to conducting a round trip from Candia to Rhodes. Rhodes constituted an important commercial hub through which trade from the Eastern Mediterranean and the Aegean flowed. The parties committed to evenly sharing proceeds from transactions Giorgio would conduct in Rhodes. As usual, the investor

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9.

10.

11.

12.

259

committed to bearing physical losses. The contract is recorded in the logbook of the notary Giovanni Gerardo in the notarial series Notai in Candia maintained at the State Archives of Venice. The data from 1300–1400 (1511 contracts) derive from the logbooks (‘cartularies’) of 25 notaries maintained at the State Archives of Venice. All of these data pertain to trade ventures that merchants operating out of Crete had organized. The records of only two notaries, Angelo de Cartura and Donato Fontanella, have been published (See Stahl, 2000). One can find all of the records in the archival series Notai in Candia maintained at the State Archives of Venice. The remaining data (56 contracts) from the years 1190–1220 derive from the archival series the Cancelleria Inferiore maintained at the State Archives of Venice. These data do not derive from notaries’ cartularies but derive from contracts that individuals had maintained in family archives. Most of the contracts pertain to trade ventures originating in Venice, although a few ventures originated in other sites such as Constantinople. These contracts have been published in Morozzo della Rocca and Lombardo (1940) and Lombardo and Morozzo della Rocca (1953). See, for example, the introduction of Allen and Lueck (1999) with respect to agricultural tenancy contracts. Sharecropping alone has constituted an important and surprisingly rich context for exploring the design of compensation schemes in principal-agent contracts. Ackerberg and Botticini (2002) is an exception. They examine a one-to-one matching problem involving the matching of tenant farmers to land owners. They suggest that insofar as risk-preferences vary across farmers and land owners, then matching may be important and may interact with the selection of compensation schemes. For example, in September 1217 Bartolomeo Bembo advanced to his son-in-law Domenico Gradonico 200 Venetian lira with which Domenico would conduct transactions in Puglia (the heel of Italy). Bembo would assume three-quarters of the proceeds and would also assume physical losses. The venture was coordinated around the Easterseason convoy. The agent was free to travel on whatever vessel he saw fit. See Morozzo della Rocca and Lombardo (1940, pp. 112–13).

References Ackerberg, D. and M. Botticini (2002), ‘Endogenous matching and the empirical determinants of contract form’, Journal of Political Economy, 110 (31), 564–91. Allen, D. and D. Lueck (1999), ‘The role of risk in contract choice’, Journal of Law, Economics and Organization, 15 (3), 704–36. Alvarez, Michael and Garret Glasgow (1999), ‘Two-stage estimation of nonrecursive choice models’, Political Analysis, 8 (2), 147–65. Ashtor, E. (1975), ‘The volume of Levantine trade in the later Middle Ages (1370–1498)’, Journal of European Economic History, 4 (3), 573–612. Crocker, K. and S. Masten (1988), ‘Mitigating contractual hazards: options and contract length’, RAND Journal of Economics, 19 (3), 327–43. Crocker, K. and J. Morgan (1998), ‘Is honesty the best policy? Curtailing insurance fraud through optimal incentive contracts’, Journal of Political Economy, 106 (2), 355–75. Crocker, K. and K. Reynolds (1993), ‘The efficiency of incomplete contracts: an empirical analysis of air force engine procurement’, RAND Journal of Economics, 24 (1), 126–46. Davidson, Russell and James G. MacKinnon (1993), Estimation and Inference in Econometrics, New York: Oxford University Press. Diamond, P. (1984), ‘Financial intermediation and delegated monitoring’, Review of Economic Studies, 51 (3), 393–414. Faure-Grimaud, A. and T. Mariotti (1999), ‘Optimal debt contracts and the single-crossing condition’, Economics Letters, 65 (1), 85–89. Freedman, D. and S. Peters (1984), ‘Bootstrapping an econometric model: some empirical results’, Journal of Business and Economic Statistics, 2 (2), 150–158.

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Hansmann, H. and R. Kraakman (2000), ‘The essential role of organization law’, Yale Law Journal, 110 (3), 387–440. Hart, O. and J. Moore (1998), ‘Default and renegotiation: a dynamic model of debt’, Quarterly Journal of Economics, 113 (1), 1–41. Hausman, J. (1978), ‘Specification tests in econometrics’, Econometrica, 46 (6), 1251–72. Johnston, Jack and John Dinardo (1997), Econometric Methods, 4th edn, New York: McGraw-Hill. Levy, B. and P. Spiller (1994), ‘The institutional foundations of regulatory commitment: a comparative analysis of telecommunications regulation’, Journal of Law, Economics and Organization, 10 (2), 201–46. Lombardo, Antonino and Raimondo Morozzo della Rocca (eds) (1953), Nuovi Documenti del Commercio Veneto dei Secoli XI-XIII, Venice: Deputazione di storia Patria per le Venezie. MacKinnon, J. (2002), ‘Bootstrap inference in econometrics’, Canadian Journal of Economics, 35 (4), 615–45. MacKinnon, J. (2006), ‘Bootstrap methods in econometrics’, Economic Record, 82, S2–S18. Masten, S. and K. Crocker (1985), ‘Efficient adaptation in long-term contracts: take-or-pay provisions for natural gas’, American Economic Review, 75 (5), 1083–93. Modigliani, F. and M. Miller (1958), ‘The cost of capital, corporation finance and the theory of investment’, American Economic Review, 48 (3), 261–97. Morozzo della Rocca, Raimondo and Antonino Lombardo (eds) (1940), Documenti del Commercia Veneziano nei Secoli XI-XIII, Torino: Editrice Libraria Italiana. Nevitt, J. and G. Hancock (2001), ‘Performance of bootstrapping approaches to model test statistics and parameter standard error estimation in structural equation modeling’, Structural Equation Modeling, 8 (3), 353–77. Oxley, J. (1999), ‘Institutional environment and the mechanisms of governance: the impact of intellectual property protection on the structure of inter-firm alliances’, Journal of Economic Behavior and Organization, 38 (3), 283–309. Petrin, A. and K. Train (2003), ‘Omitted product attributes in discrete choice models’, NBER Working Paper 9452. Rivers, D. and Q. Vuong (1988), ‘Limited information estimators and exogeneity tests for simultaneous probit models’, Journal of Econometrics, 39 (3), 347–66. Silva, V. and P. Azevedo (2007), ‘Interfirm arrangements in different institutional environments: McDonald’s France and Brazil case study’, Journal of Marketing Channels, 14 (3), 103–25. Stahl, A. (2000), The Documents of Angelo de Cartura and Donato Fontanella, Dumbarton Oaks Research Library and Collection. Townsend, R. (1979), ‘Optimal contracts and competitive markets with costly state verification’, Journal of Economic Theory, 21 (2), 265–93. Williamson, D. (2005), ‘The financial structure of commercial revolution: Financing longdistance trade in Venice 1190–1220 and Venetian Crete 1303–1400’, mimeo. Williamson, D.V. (2007), ‘Adaption and renegotiation in long-term exchange relations: evidence from electricity marketing contracts’, unpublished manuscript. Williamson, O. (1988), ‘Corporate finance and corporate governance’, Journal of Finance, 43 (3), 567–91. Williamson, Oliver E. (1996), The Mechanisms of Governance, New York: Oxford University Press. Wooldridge, Jeffery M. (2002), Econometric Analysis of Cross Section and Panel Data, Cambridge: MIT Press.

PART V ALTERNATIVES AND CRITIQUES

25 Critiques of transaction cost economics: an overview Nicolai J. Foss and Peter G. Klein

Ever since its emergence in the early 1970s (for example, Williamson 1971; Alchian and Demsetz, 1972; Furubotn and Pejovich, 1972; Arrow, 1974; Jensen and Meckling, 1976), the new institutional economics (NIE) has been the subject of intense debate. As the most important constituent body of thought in the NIE, transaction cost economics (TCE) is no exception. Much of the debate on TCE has been ‘internal’, in the sense that it has been conducted between scholars generally sympathetic to the approach (for example, Hart, 1995; Kreps, 1996; Furubotn, 2002; MacLeod, 2002). However, there also is a large set of ‘external’ critiques, arising from sociologists, heterodox economists, and management scholars. For instance, early critics argued that TCE ignored the role of differential capabilities in structuring economic organization (Richardson, 1972); neglected power relations (Perrow, 1986), trust, and other forms of social embeddedness (Granovetter, 1985); and overlooked evolutionary considerations, including Knightian uncertainty and market processes (Langlois, 1984). Such critiques have been echoed and refined in numerous more contemporary contributions, and criticizing TCE remains a thriving industry. The incumbents are mainly sociologists (Freeland, 2002; Buskens, et al., 2003) and non-mainstream economists (Hodgson, 1998; Loasby, 1999; Dosi and Marengo, 2000), but new entrants are increasingly recruited from the ranks of management scholars (Kogut and Zander, 1992; Conner and Prahalad, 1996; Ghoshal and Moran, 1996). This chapter offers a brief review and assessment of this critical literature. By no means do we claim to be comprehensive; unavoidably many authors, papers, and insights must be left out. However, we aim to capture what we see as the fundamental critiques. Basic characteristics of TCE Coase and Williamson The foundations of TCE were laid by Coase (1937, 1960). The starting point for a transaction cost approach to governance and organizational 263

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issues is Coase’s (1960) insight that if it were not for transaction costs, all gains to trade would be exhausted and this could take place under any organizational arrangement. This connects to Coase’s earlier paper (Coase, 1937), for the argument in that paper is that the assessment of the net benefits of organizational and governance alternatives must proceed in terms of a comparative analysis of the costs of transacting under the relevant alternatives (Barzel and Kochin, 1992). In a string of influential contributions, Williamson (notably, 1975, 1985, 1996) has built a theory that while built on Coasian foundations also incorporates ideas from psychology and contract law. The behavioural starting points in Williamson’s theorizing are bounded rationality and opportunism. Simon’s (1951) notion of bounded rationality implies the presence of contractual incompleteness and, consequently, a need for adaptive, sequential decision-making. Opportunism is defined as ‘selfinterest seeking with guile’ (Williamson, 1975, p. 255), and its implication is that contracts will often need various types of safeguards, such as ‘hostages’ (for example, the posting of a bond with the other party). The unit of analysis in Williamson’s work is the multi-dimensional transaction. In addition to uncertainty (which is ‘frozen’), the dimensions of transactions that are primarily determinative of the costs of those transactions are frequency and asset specificity. The latter has increasingly become the central independent variable in TCE analysis. Specific assets open the door to opportunism. If contracts are incomplete due to bounded rationality, they must be renegotiated as uncertainty unfolds, and if a party to the contract (say, a supplier firm) has incurred sunk costs in developing specific assets (including human capital), that other party can opportunistically appropriate an undue part of the investment’s pay-off (‘quasi-rents’) by threatening to withdraw from the relationship. This situation leads to an inefficient outcome. Efficiency dictates the internalization within a firm of transactions that involve highly specific assets. More generally, Williamson (1985, p. 68) argues that variety in contracts and governance structures ‘is mainly explained by underlying differences in the attributes of transactions’. The general design principle of discriminating alignment dictates aligning transactions that differ in the dimensions of uncertainty, frequency, and asset specificity with governance structures which differ in the capacities to handle different transactions (compare the earlier discussion of governance structures and governance mechanisms) in a transaction cost economizing way. Thus, specific constellations of (values for) the uncertainty, frequency, and asset specificity variables map directly into specific governance structures. This is the main predictive content of Williamsonian TCE.

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Fundamental characteristics of TCE Here we briefly outline a number of fundamental characteristics of TCE. Other characteristics may be identified; however, the characteristics below are those that the critics have focused on. Cognition Bounded rationality is usually invoked as a necessary part of TCE. ‘But for bounded rationality’, Williamson argues (1996, p. 36), ‘all issues of organization collapse in favor of comprehensive contracting of either Arrow-Debreu or mechanism design kinds’. What Williamson calls ‘comprehensive contracting’ does not allow for ‘governance structures’ in the sense of mechanisms that handle the coordination and incentive problems produced by unanticipated change (Williamson, 1996, Chapter 4). Motivation Motivation is assumed to be extrinsic (Frey, 1997). Hence, stronger monetary incentives call forth more effort (in at least one dimension). Explaining economic organization Problems of economic organization are explained generically in terms of minimizing transaction costs related to incentive conflicts, usually involving the holdup problem. TCE generally disregards coordination type problems; the problem is to align incentives rather than to coordinate actions. Production costs play no direct role in the explanation. Everything is given The choice of efficient economic organization is portrayed as a standard maximization problem in the case of contract design or as a choice between given ‘discrete, structural alternatives’ (Williamson, 1996) in the case of the choice of governance structure. At least in the canonical Williamsonian versions of TCE, learning and innovation are mostly excluded from consideration because of the complexities they raise (Williamson 1985, pp. 141–4). There may be reference to processes (other than the fundamental transformation), but this has the character of pointing to evolutionary processes that are assumed to perform a sorting between organizational forms in favour of the efficient ones (Williamson, 1985). Criticizing TCE Most of the above characteristics are not particular to TCE, but are generally present in game-theoretical microeconomics. Thus, critics of TCE may appear to be really criticizing modern microeconomics. However, while this may indeed be the case for some critics, the reason that TCE has drawn particular fire may lie in its main explanandum, that is, the firm.

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Thus, while some critics may balk at methodological individualism and assumptions of full, instrumental rationality in general, they are likely to find such assumptions particularly objectionable when they are applied to the theory of the firm. Thus, in much of the literature that is critical of the modern theory of the firm, firms are often portrayed in rosy terms as ‘minisocieties’ (Freeland, 2002) that provide ‘identity’ (Kogut and Zander, 1996), ‘higher-order organizing principles’ (Kogut and Zander, 1992), trust relations (Ghoshal and Moran, 1996), and collective learning (Hodgson, 1998) that, purportedly, ‘atomistic’ markets cannot provide. While we are sceptical of such arguments, we acknowledge that they may point to unresolved issues and weak spots in TCE. In the following sections, we discuss and assess a number of critiques of TCE in greater detail. Cognition and motivation While often invoked, the role of bounded rationality in Williamson’s work is mainly to provide a reason why contracts are incomplete. The theory is taken up with comparative institutional exercises, focusing on transaction cost economizing, and hence has no room for the process aspects introduced by more substantive notions of bounded rationality (for example, Furubotn, 2002). However, Dow (1987) argues that it is inconsistent to invoke bounded rationality as a necessary assumption in the analysis of contracts and governance structures, and then assume that substantively rational choices can be made with respect to the contracts and governance structures (that are imperfect because of bounded rationality). In contrast, bounded rationality has long been a central assumption in organization theory (for example, March and Simon, 1958). In fact, recent critics of the theory of the firm have drawn explicitly on these older sources to develop alternative, evolutionary views emphasizing the role of bounded rationality in problem-solving, and the role of firms as cognitive structures around such problem-solving efforts (for example, Dosi and Marengo, 1994). Other critics, also echoing behaviourist organization theory, argue that a key characteristic of firms is that they tend to shape employee cognition (Kogut and Zander, 1996; Hodgson, 1998). While the role of bounded rationality in the theory of the firm has given rise to a fair amount of debate, it is nothing compared to the enormous amount of critical writings on the motivational assumptions in the theory. In particular, opportunism has been a favourite bête-noire. The critique of opportunism takes various forms. Empirically, the relevance of opportunism is dismissed by pointing to the low frequency with which opportunistic action can be observed, for example, in industrial networks or in long-term associations between firms and their suppliers (see, for example, Håkansson and Snehota, 1990). The obvious problem with such

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arguments is that they are based on a misunderstanding of the counterfactual nature of reasoning in the theory of the firm: opportunistic behaviour is seldom observed because governance structures are chosen to mitigate opportunism. Another argument asserts that opportunism is not a necessary assumption in the theory of the firm (for example, Kogut and Zander, 1992), but this line of reasoning fails to provide convincing alternative accounts. According to a more recent and more sophisticated set of arguments, the primary problem with the treatment of motivation in the theory of the firm is not opportunism per se, but rather the assumption that all motivation is of the ‘extrinsic’ type (Ghoshal and Moran, 1996; Osterloh and Frey, 2000). In other words, all behaviour is understood in terms of encouragement from an external force, such as the expectance of a monetary reward. (In contrast, when ‘intrinsically’ motivated, individuals wish to undertake a task for its own sake). These arguments do not necessarily deny the reality of opportunism, moral hazard, and so on, but assert that there are other, more appropriate ways to handle these problems than providing monetary incentives, sanctions, and monitoring. The arguments are often based on social psychological research (notably Deci and Ryan, 1985) and on experimental economics (for example, Fehr and Gächter, 2000). Few transaction cost scholars have reacted to accommodate these critiques. With respect to the bounded rationality point, we suspect this is partly because taking these critiques seriously means questioning fundamental tenets of mainstream economic modelling. For example, taking bounded rationality seriously opens up a Pandora’s box because bounded rationality challenges the game-theoretic foundations underlying the formal literature on the theory of the firm (that is, subjective expected utility theory, the independence of payoff utilities, the irrelevance of labelling, and common prior beliefs (Camerer, 1998)). In our opinion, working with alternative motivational assumptions may be a more fruitful way forward. It is easier to doctor utility functions than cognitive assumptions. There is established social psychology work, the insights of which may be fed relatively directly into modelling efforts. Moreover, the implications for economic organization may also seem more immediate (see Lazear, 1991, and Fehr and Gächter, 2000 for examples). Firm heterogeneity, capabilities, and production costs Many writers within heterodox economics (particularly evolutionary economics) and strategic management embrace ‘capabilities’, ‘dynamic capabilities’, or ‘competence’ approaches (for example, Langlois, 1992; Kogut and Zander, 1992; Dosi and Marengo, 1994; Winter, 1991). These writers have often been fiercely critical of TCE. The critique concerns the

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reliance on opportunism and the neglect of differential capabilities (that is, firm heterogeneity) and dynamics (for example, Winter, 1991; Langlois, 1992; Kogut and Zander, 1992) in TCE. Knowledge-based writers often argue that differential capabilities give rise to different production costs, and that such cost differentials may crucially influence the make or buy decision. Thus, firms may internalize activities because they can carry out these activities at lower production costs (not transactions costs) than other firms. Some writers argue that the firms themselves can be explained in knowledge-based terms, without reference to opportunism (Demsetz, 1988; Kogut and Zander, 1992; Hodgson, 2004). They argue that firms can build capabilities and engage in learning efforts that markets cannot. However, this is postulated rather than shown. Moreover a firm’s ability to cultivate capabilities may depend on transaction cost considerations. Capabilities are firm-specific assets that give rise to an appropriable quasirent, and, hence, should be organized under unified governance. While we are sceptical of the specific knowledge-based explanations for economic organization, we acknowledge that the view does point to some weak points in the theory of the firm. For example, differential capabilities probably do play a role in determining the boundaries of the firm (Walker and Weber, 1984; Monteverde, 1995; Argyres, 1996). However, there are two major problems in this area that may hinder progress. The first is that the nature of the central construct (that is, capabilities) itself is highly unclear. It is not clear how capabilities are conceptualized, dimensionalized, and measured, and it is not clear how capabilities emerge and are changed by individual action (Abell et al., 2008). The second problem partly follows from the first: the mechanisms that link capabilities and economic organization are unclear (Foss, 2005). Process issues The claim that the theory of the firm, because of its emphasis on efficiency at a point of time and on cross-sectional variation, is ahistorical and neglects process has often been made by economists and management scholars within both the knowledge-based and the evolutionary perspective (for example, Winter, 1991, p. 192). One way to interpret this critique is that the theory of the firm seeks to explain the governance of individual transactions (Williamson, 1996), or clusters of attributes (Holmström and Milgrom, 1994), without identifying how the governance of a particular transaction may depend on how previous transactions were governed. Argyres and Liebeskind (1999) term this historical dependency ‘governance inseparability’. Where governance inseparability is present, firms may rely on governance structures that appear inefficient at a particular time, but which make sense as part of a

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longer-term process. Changes in governance structure affect not only the transaction in question, but the entire temporal sequence of transactions. This may make organizational form appear more ‘sticky’ than it really is. This criticism will sound familiar to Austrian and evolutionary economists, who have long argued for a ‘process’ view of economic activity that takes time seriously (Hayek, 1948; Kirzner, 1973). Williamson (1996), recognizing the need to incorporate history into TCE, has introduced the notion of remediableness as a welfare criterion. The outcome of a path-dependent process is suboptimal, he argues, only if it is remediable – that is, an alternative outcome can be implemented with net gains. Merely pointing to a hypothetical superior outcome, if it is not attainable, does not establish suboptimality. Thus, a governance structure or contractual arrangement ‘for which no superior feasible alternative can be described and implemented with expected net gains is presumed to be efficient’ (Williamson, 1996, p. 7, original emphasis). The explanation of economic organization in terms of efficiency has been one of the most frequently criticized characteristics of the theory of the firm: assuming that agents can figure out the efficient organizational arrangements seems to collide with the assumption of bounded rationality (Dow, 1987; Furubotn, 2002). Presumably in response to this problem, early work in the theory of the firm often explicitly assumed that market forces work to cause an ‘efficient sort’ between transactions and governance structures, an assumption that is not in general tenable. The problem is that the efficiency assumption has always been taken as an essential, but untested, background assumption. However, one approach is to see if ‘appropriately’ organized firms – that is, firms organized along the lines recommended by the theory of the firm – outperform the feasible alternatives. Several papers in the empirical TCE literature use a two-step procedure in which organizational form (in particular, the relationship between transactional characteristics and governance structure) is endogenously chosen in the first stage, then used to explain performance in the second stage. By endogenizing both organizational form and performance this approach also mitigates the selection bias associated with OLS regressions of performance on firm characteristics. Conclusion Two decades ago Paul Milgrom and John D. Roberts (1988, p. 450) argued that the ‘incentive-based transaction costs theory has been made to carry too much of the weight of explanation in the theory of organizations’, and predicted that ‘competing and complementary theories’ would emerge, ‘theories that are founded on economizing on bounded rationality

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and that pay more attention to changing technology and to evolutionary considerations’. However, no serious competitors have emerged. One possible reason is that TCE is sufficiently successful, theoretically and empirically, that competitors have a hard time gaining a foothold. Still, as we have stressed throughout this chapter, many of the critiques do in fact point to weaknesses that should ideally be remedied. A further reason is that the critics tend to focus on phenomena that are difficult to model. Innovation, entrepreneurship, bounded rationality, learning, evolutionary processes, and differential capabilities are examples of such phenomena. Finally, the various critiques are not separate but overlapping or complementary. For example, the claim that TCE neglects bounded rationality is very close to the claim that it ignores differential capabilities, learning, and path dependence. In other words, the critiques come in a package, so that embracing one critique may be taken as embracing the rest – which would mean abandoning TCE as we know it. References Abell, P., T. Felin, and N.J. Foss (2008), ‘Building micro-foundations for the routines, capabilities, and performance links’, Managerial and Decision Economics, 29 (6), 489–502. Alchian, A.A. and H. Demsetz (1972), ‘Production, information costs, and economic organization’, American Economic Review, 62 (5), 772–95. Argyres, N.S. (1996), ‘Evidence on the role of firm capabilities in vertical integration decisions’, Strategic Management Journal, 17 (2), 129–50. Argyres, N.S. and J.P.Liebeskind (1999), ‘Contractual commitments, bargaining power, and governance inseparability: incorporating history into transaction cost theory’, Academy of Management Review, 24 (1) 49–63. Arrow, K. (1974), The Limits of Organization, New York: Norton. Barzel, Y. and L. Kochin (1992), ‘Ronald Coase on the nature of social cost as a key to the problem of the firm’, Scandinavian Journal of Economics, 94 (1), 19–31. Buskens, V., W. Raub, and C. Snijders (eds) (2003), The Governance of Relations in Markets and Organizations, Amsterdam: JAI Press. Camerer, C. (1998), ‘Behavioral economics and nonrational organizational decision making’, in J.J. Halpern and R.N. Stern (eds), Debating Rationality, Ithaca: Cornell University Press, pp. 53–77. Coase, R.H. (1937), ‘The Nature of the Firm’, Economica, N.S., 4 (16), 386–405. Coase, R.H. (1960), ‘The problem of social cost’, Journal of Law and Economics, 3, 1–44. Conner, K.R. and C.K. Prahalad (1996), ‘A resource-based theory of the firm: knowledge vs. opportunism’, Organization Science, 7 (5), 477–501. Deci, E.L. and R.M. Ryan (1985), Intrinsic Motivation and Self-Determination in Human Behavior, New York: Plenum. Demsetz, H. (1988), ‘The theory of the firm revisited’, Journal of Law, Economics and Organization, 4 (1), 141–61. Dosi, G. and L. Marengo (1994), ‘Some elements of an evolutionary theory of organizational competences’, in R.W. Englander (ed.), Evolutionary Concepts in Contemporary Economics, Ann Arbor, MI: University of Michigan Press, pp. 154–78. Dosi, G. and L. Marengo (2000), ‘On the tangled discourse between transaction cost economics and competence-based views of the firm: some comments’, in N.J. Foss and V. Mahnke (eds), Competence, Governance, and Entrepreneurship, Oxford: Oxford University Press, pp. 80–91.

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Dow, G.K. (1987), ‘The function of authority in transaction cost economics’, Journal of Economic Behavior and Organization, 8 (1), 13–38. Fehr, E. and S. Gächter (2000), ‘Fairness and retaliation: the economics of reciprocity’, Journal of Economic Perspectives, 14 (3), 159–82. Foss, N.J. (2005), Strategy and Economic Organization in the Knowledge Economy, Oxford: Oxford University Press. Freeland, R.F. (2002), ‘The firm as a minisociety’, draft manuscript. Frey, B. (1997), Not Just for the Money: An Economic Theory of Personal Motivation, Cheltenham, UK and Lyme, NH, USA: Edward Elgar Publishing. Furubotn, E. (2002), ‘Entrepreneurship, transaction-cost economics, and the design of contracts,’ in E. Brousseau and J.-M. Glachant (eds), The Economics of Contracts, Cambridge: Cambridge University Press, pp. 72–98. Furubotn, E. and S. Pejovich (1972), ‘Property rights and economic theory: a survey of recent literature’, Journal of Economic Literature, 4 (4), 1137–62. Ghoshal, S. and P. Moran (1996), ‘Bad for practice: a critique of the transaction cost theory’, Academy of Management Review, 21 (1), 13–47. Granovetter, M.S. (1985), ‘Economic action and social structure: the problem of embeddedness’, American Journal of Sociology, 91 (3), 481–510. Håkansson, H. and I. Snehota (1990), ‘No business is an island: the network concept of business strategy’, Scandinavian Journal of Management, 5 (3), 187–200. Hart, O. (1995), Firms, Contracts, and Financial Structure, Oxford: Oxford University Press. Hayek, F.A. von (1948), Individualism and Economic Order, Chicago: University of Chicago Press. Hodgson, G.M. (1998), ‘Competence and contract in the theory of the firm’, Journal of Economic Behavior and Organization, 35 (2), 179–201. Hodgson, G.M. (2004), The Evolution of Institutional Economics: Agency, Structure and Darwinism in American Institutionalism, London and New York: Routledge. Holmström, B. and P. Milgrom (1994), ‘The firm as an incentive system’, American Economic Review, 84 (4), 972–91. Jensen, M.C. and W. Meckling (1976), ‘Theory of the firm: managerial behaviour, agency costs and ownership structure’, Journal of Financial Economics, 3 (4), 305–60. Kirzner, I.M. (1973), Competition and Entrepreneurship, Chicago: University of Chicago Press. Kogut, B. and U. Zander (1992), ‘Knowledge of the firm, combinative capabilities, and the replication of technology’, Organization Science, 3 383–97. Kogut, B. and U. Zander (1996), ‘What firms do? Coordination, identity and learning’, Organization Science, 7, 502–18. Kreps, D.M. (1996), ‘Markets and hierarchies and (mathematical) economic theory’, Industrial and Corporate Change, 5, 561–95. Langlois, R.N. (1984), ‘Internal organization in a dynamic context: some theoretical considerations’, in M. Jussawalla and H. Ebenfield (eds), Communication and Information Economics: New Perspectives, Amsterdam: North-Holland, pp. 23–49. Langlois, R.N. (1992), ‘Transaction cost economics in real time’, Ind. Corp. Change, 1 (1), 99–127. Lazear, E.P. (1991), ‘Labor economics and the psychology of organizations’, Journal of Economic Perspectives, 5 (2), 89–110. Loasby, B.J. (1999), Knowledge, Institutions, and Evolution in Economics, London: Routledge. MacLeod, W.B. (2002), ‘Complexity and contract’, in E. Brousseau and J.-M. Glachant (eds), The Economics of Contracts, Cambridge: Cambridge University Press, pp. 213–40. March, J.G. and H.A. Simon (1958), Organizations, New York: Wiley. Milgrom, P.J. and J.D. Roberts (1988), ‘Economic theories of the firm: past, present, and future’, Canadian Journal of Economics, 21 (3), 444–58. Monteverde, K. (1995), ‘Technical dialog as an incentive for vertical integration in the semiconductor industry’, Management Science, 41 (10), 1624–38.

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Osterloh, M. and B. Frey (2000), ‘Motivation, knowledge transfer and organizational form’, Organization Science, 11 (4), 538–50. Perrow, C. (1986), Complex Organizations: a Critical Essay, 3rd edn, New York: McGrawHill. Richardson, G.B. (1972), ‘The organisation of industry’, Economic Journal, 82 (327), 883–96. Simon, H.A. (1951), ‘A formal theory of the employment relationship,’ Econometrica, 19 (2), 293–305. Walker, G. and D. Weber (1984), ‘A transaction cost approach to make-or-buy decisions’, Administrative Science Quarterly, 29 (2), 373–91. Williamson, O.E. (1971), ‘The vertical integration of production: market failure considerations’, American Economic Review, 61 (2), 112–23. Williamson, O.E. (1975), Markets and Hierarchies: Analysis and Antitrust Implications, New York: Free Press. Williamson, O.E. (1985), The Economic Institutions of Capitalism, New York: Free Press. Williamson, O.E. (1996), The Mechanisms of Governance, Oxford: Oxford University Press. Winter, S.G. (1991), ‘On Coase, competence, and the corporation’, in O.E. Williamson and S.G. Winter (eds), The Nature of the Firm: Origins, Evolution, and Development, Oxford: Basil Blackwell, pp. 179–95.

26 Subjectivism, understanding, and transaction costs Fu-Lai Tony Yu

Since Ronald Coase’s ‘The Nature of the Firm’ (1937), the concept of transaction costs has been applied to a wide range of economic and management issues. The transaction cost paradigm, though widely accepted and increasingly integrated into the mainstream neoclassical analysis, does not lack criticisms. A major drawback of the transaction cost paradigm is that the role of the entrepreneur is missing. Foss and Klein (2008, p. 428) rightly point out that: modern theories of the firm portray decision situations as always unambiguous and ‘given’. The choice of efficient economic organization is portrayed as a standard maximization problem . . . There is no learning, no need for entrepreneurial creation or discovery, and explicit room for the emergence of new contractual or organizational forms . . . [T]he strategy spaces are fully specified ex ante.

The transaction cost theory of institutional change, as presented by Washington School economists including Steven Cheung, Douglass North, and Yoram Barzel, has also been charged with circular reasoning. Sven-Erik Sjöstrand (1995, p. 34) notes: in this paradigm, the institutional setting represents the individuals’ incentive to act. At the same time, the institutions provide the standards for eliminating ‘failing’ attempts. We then ask what explains the possible motive for an individual to do something new, something that is not part of the incentives built into the existing institutions. To put differently, how is it possible to develop new paths and institutions, when institutions themselves (as constraints) define both incentives and outcomes?

Therefore, given a level of transaction costs, the transaction cost theory at best indicates the direction of institutional change, but fails to explain the origin of the change. This shortcoming is partly attributed to the fact that scholars in the new institutional economics (NIE), like their neoclassical economist counterparts, do not in general put human agency at the centre of analysis. The roles of creative and proactive entrepreneurs in the formation of institutions are largely ignored. This chapter outlines an alternative approach based on methodological 273

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individualism, subjectivism, time, and process, particularly as those elements have been developed by the Austrian school of economics. The subjectivist approach has important implications for the analysis of property rights, transaction costs, and the firm. A subjectivist approach to social cost, externalities, and transaction costs In 1960 Ronald Coase published ‘The Problem of Social Cost’. The term ‘social cost’ can make readers think that cost can be aggregated as the concept of ‘social product’ in the Pigouvian paradigm. Corresponding to James Buchanan (1969), cost can be viewed in both an objective and a subjective dimension. Objectively, cost is measured directly in terms of resource outlays. It is the market value of the alternative product that might be produced by rational allocation of resources. Cost in this dimension is given and can be objectively identifiable. It is defined in the mechanistic model of pure economic man or woman. The man or woman inside this model does not choose, but behaves predictably in response to objectively measurable changes in their environment (Buchanan, 1969, p. 42). This cost concept is backward-looking in the sense that it can be calculated by a third party such as an accountant, economist, or policy-maker. Viewed subjectively, cost is defined as the perceived benefit lost by the actor upon sacrificing a rejected alternative. This cost can only be perceived and borne exclusively by the decision-maker and it is impossible for the individual to shift cost to others (Buchanan, 1969, p. 49). Cost exists only in the mind of the decision-maker and cannot be measured by someone else. In this sense, ‘social cost’ and ‘social benefit’ can hardly exist and be calculated by a third party. Because benefit is subjectively felt, it is quite possible that benefits forsaken will be wrongly perceived, leading to ex post regret. Thus, unlike what economics textbooks claim, ‘sunk costs’ can influence decision-making. If an entrepreneur realizes he or she has made a wrong decision, though he or she knows the decision cannot be reversed, this wrongdoing experience will influence his or her future outlook and choices. An alternative way to deal with problems of social cost or externalities is the subjectivist approach, or ‘first-person’ perspective (Addleson, 1995), associated with the Austrian school of economics. Subjectivism as an economic method does not deny the existence of objective facts. However, all objective facts must go through the conscious mind of human agency for interpretation or classification when formulating a plan or making a choice. The ‘first-person’ approach in tackling the problems of externalities becomes the issue of why the individual does not internalize the external effects. It is the individual who assesses the problem situation and perceives

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the cost associated with an action to internalize the external effect. The subjectivist research program stresses difficulties and constraints encountered by the actor in dealing with negative externalities. Solving externalities is thus a matter of experimentation and learning involving contractual negotiations and arrangements. This process includes defining property rights that have not yet been established. In the case of positive externalities, many individuals simply never think of asking for compensation, for example for maintaining a beautiful front yard. Similar considerations apply to the analysis of transaction costs. In the modern theory of the firm, transaction costs are objectively given and computable. The economist’s job is to explain, given the nature and size of the relevant transaction costs, the appropriate organization form or institutional choice. In other words, economists attempt to understand, ex post, why one form of contract or organization supersedes another form. In the human-agency perspective, transaction costs are not treated as static and given. Instead, they too are subjective in the sense that they must be perceived and discovered by the entrepreneur. In the real world, the entrepreneur perceives the level of transaction costs associated with a new form of organization or contractual arrangement. Hence, transaction costs can be defined as the subjective benefit forgone or utility lost by an individual from sacrificing a rejected contractual arrangement or organizational option. These costs include persuasion. Often, the entrepreneur initially has a very vague concept about the new form of contract he or she imagines. The entrepreneur experiments and evaluates different kinds of imagined organizations in terms of perceived transaction costs. In doing so, human agents create institutions that have not existed before. A subjectivist approach can also be a good complement to the NIE in understanding economic change. Max Weber and Alfred Schutz argue that an action has a meaning attached to it as human agents make sense of their everyday life. Making sense of the external world requires interpretation. Coordination involves understanding of actions and interpretation of the meaning of other actors. Human agents interact with other people in their everyday life; as they communicate with each other, they share meaningful constructs with others in the social world. Hence, action is intersubjective. Experiences from everyday life are accumulated into a stock of knowledge that can be used to interpret incoming events and to anticipate things to come (Schutz, 1970, p. 74). Whenever we encounter a problem, we utilize our stock of knowledge or interpretive framework to classify the situation and formulate a plan to deal with the problem. This stock of knowledge grows with experience and is by no means homogeneous. Each stock has ‘a particular history’ (Schutz, 1970, p. 74). Due to diverse experiences, human agents will respond differently to the same

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objectively defined stimulus. In short, the interpretation framework allows actors to make sense of the world and to solve problems. Without such a framework, economic understanding, problem-solving, and strategic management would be impossible. The interpretation framework, originating from the actor’s lived experiences, is a device of receiving external information and organizing it into patterns. As soon as actors perceive an event, they can follow the established interpretative channel and access all knowledge (meaning) about that event. If incoming events are repeated and familiar, human agents can utilize rules of thumb to solve problems. Economic activities are then coordinated. However, if incoming events are novel, the established interpretative framework may fail to give an adequate account of the new environment – in other words, the stock of knowledge in the agent’s mind is inapplicable to the new event. The agent then enters into a state of conflicting experience. Given this situation, the agent may devise new methods to solve the new problem. Agents learn to adopt new methods by trial and error. Encountering uncertainty, they cope with their knowledgedeficiency by creating temporary expectations that serve as knowledge surrogates (White, 1977, p. 80). Schutz (1970) refers to this process as projected action in the future perfect tense. In other words, the individual projects and plans as if his or her action were already completed. This knowledge surrogate will be tried out in the market. If it works, the method will be adopted and routinized as a rule of thumb. The new stock of knowledge can once again serve as an interpretative framework for the agent to anticipate things to come and to coordinate economic activities. Applications of subjectivism to firm structure, strategy, and institutional change The subjectivist, first-person approach outlined here has several implications for theoretical and applied research in transaction cost economics (TCE) and related approaches to the firm and firm strategy. Vertical integration Building on the concept of dynamic transaction costs (Langlois and Robertson, 1995, p. 35), the subjectivist perspective provides a useful argument for vertical integration in the case of Schumpeterian innovation. Given radical innovation, the stocks of knowledge of market participants are unable to tackle new problems. Knowledge taken for granted becomes problematic. The success of a radical innovation requires combination and adaptation of complementary activities. In an economy in which people interpret external events in routine manners, it is difficult for innovators to make suppliers understand novel and idiosyncratic ideas. Accordingly, it

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is costly to inform and persuade contracting parties to invest in specialized assets. In many cases, suppliers may refuse to comply with the innovator’s vision, and market coordination fails. Hence the entrepreneur may need to integrate the cospecialized activities and employ those parties with relevant skills rather than contracting them out (Langlois and Robertson, 1995). Within the integrated firm, the entrepreneur provides a set of rules, which generally lay down clear lines of authority and communication with the intention of ensuring that the entrepreneurial goal may be attained (Silverman, 1970, p. 14). By asking its members to subordinate their own motives to the officially defined goals, the firm ‘attempts de facto to substitute an objective context of meaning for the subjective configuration in which the individual actor discovers the meaning of his or her action’ (Jehenson, 1973, p. 227). The world taken for granted inside the firm is thus composed of individuals following typical courses of action prompted by a set of common motives. Consequently, members of the firm are able to catch the meanings associated with the actions of other people and form a self-view based on the responses of others (Jehenson, 1973, p. 229). In essence, they conform to a set of shared values, which is central to the existence of a firm (Silverman, 1970, p. 131). In this regard, the firm is a common environment for facilitating communication (Schutz, 1970). Management of innovation The human-agency perspective also sheds light on innovation policy, especially regarding consumer–producer interaction. Innovation strategies can be explained in terms of knowledge creation and exploitation. Knowledge can be classified as tacit or articulable (Cohen and Levinthal, 1990). Tacit knowledge is personal, not easily formalized and communicable, and rooted in a specific context. Articulable knowledge is explicit, codifiable, and transmittable with a formal or systematic language. Knowledge creation is a social process that transforms tacit into articulable knowledge (Cohen and Levinthal, 1990). This process requires direct and continual dialogues between people who are grounded in the same situation (Nonaka, 1994). From the Schutzian perspective, knowledge arises from the social construction of shared understandings, within a context of previously constructed understandings. In other words, transmission of an innovative idea will be facilitated if the parties share the same social construction. Moreover, the world of knowledge is incoherent, only partially clear, and not free from contradiction (Schutz, 1970, pp. 80–81). One difficulty in the innovative process is that customers may not be able to articulate their needs clearly and those needs may change as they learn to use the product. This implies that the product’s attributes cannot be easily specified and can change over time (Dougherty, 1992, p. 78). At the

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same time, the product or technology may be new, meaning that technical problems may appear unexpectedly. This explains why entrepreneurs must experiment with sets of attributes, work closely with customers, and pursue multiple paths as they craft the comprehensive package of market and technological characteristics into a viable product. Often, producers have to imagine the product in use and develop a subjective sense for the problem the product will solve for customers. They also examine how customers perceive value, appreciate customers’ preferences and decisionmaking processes, and try to understand how to specify customer needs (Dougherty, 1992, pp. 78–81). Producers in this case are just like explorers. They are engaged in an expedition with the aim of transferring tacit knowledge into articulated knowledge. In doing so, they immerse themselves in the community of their potential customers. They often use fieldwork to help conceive the ways they can create value for potential customers by synthesizing the firm’s technologies and capabilities into a variety of performance possibilities or other product features. Face-to-face interaction (Schutz, 1970, p. 189) with customers is an effective way of visualizing the product (Dougherty, 1992, p. 82). Advertising and persuasion The most significant feature of advertising in modern society is its persuasive power. In neoclassical economics, advertising is explained as information provision that can be bought and sold. In this paradigm, the (optimal) amount of information can be calculated and delivered by the advertising industry in response to consumers’ desires. Neoclassical economists conclude that extensive advertising to persuade potential customers under rivalrous conditions is duplicative and wasteful. This argument ignores the subjective evaluation of a commodity by consumers and fails to explain the persuasive role of advertising. While mental activity at the knowledge stage is mainly cognitive (or knowing), the main type of thinking at the persuasion stage is affective (or feeling) (Rogers, 1983, p. 170). Until consumers know about the new product or idea, they cannot form an attitude towards it. In developing an attitude towards the innovation, individuals may apply the new idea mentally to their present or anticipated future situations before deciding whether to try it. In Rogers’ words (1983, p. 170), ‘the ability to think hypothetically and counter-factually and to project into the future is an important mental capacity at the persuasion stage where forward planning is involved’. The function of an innovating firm is not only to present consumers with a particular buying opportunity, but to present it to them so that they cannot fail to ‘notice’ its availability. In other words, the supplier must get consumers to notice and absorb that information. In this regard, it is therefore

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unsurprising to find that a piece of information is repeated in top-rated TV shows. More importantly, through persuasive promotion, consumers’ tastes are altered. Advertising has the power to change the knowledge consumers believe and possess concerning the factual state of the world. As mentioned, human agents often take their experiences for granted (Schutz, 1970). Very often, consumers’ perceptions of the external world are ‘locked in’ by their experiences and therefore consumers show no interest in new consumption opportunities even though they know of their existence. Advertising helps consumers unlock their preoccupied knowledge and perceptions. It is a process of unlearning. Furthermore, many products can be furnished with new images through the use of famous celebrities. To consumers, the product that has been promoted by a superstar is different from the product that has not been so promoted. The former becomes another product with a new perception and value. Advertising, when explained from the subjectivist perspective, is not a waste. Institutional change Institutions emerge as a result of human agents attempting to reduce uncertainty. In the case of adaptive responses, institutions gradually evolve as human agents modify their plans to coordinate economic activities better. Thus, most of the time, institutions are fairly stable and can serve the function of coordination. However, institutions can change drastically. The instability of institutions is attributable to creative responses exerted by transformative entrepreneurs. Human agents on one hand attempt to mitigate uncertainty. On the other hand, they also create uncertainty by venturing into uncharted frontiers. Using their imaginative powers, entrepreneurs initiate a disturbing impact on institutions and create uncertainty in the market, which in turn alters the transaction costs of economic activities and requires new property-rights systems. Facing this situation, market participants will find that their stocks of knowledge are inadequate to interpret the novel events. The existing institutional frameworks are incapable of coordinating economic activities because the meanings attached to them have changed significantly. The creative response creates confusion in the market. Thus, new institutions are needed for coordination. Before new institutions emerge, gaps appear between the technical and economic structure of the market and the institutions’ need for coordinating new activities. This implies profit opportunities (Cheah, 1994). It follows that if market participants can devise new methods to improve coordination, they can reap rewards. Before this happens, opportunities in the market remain unexploited. Given new technologies, new relative prices and tastes, adaptive entrepreneurs soon identify and capitalize upon

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these new opportunities by refining production methods, modifying and improving models. In short, adaptive response follows creative response. At the beginning, entrepreneurs are experimenting with various methods to deal with the new situations. By trial and error, through learning, some methods are found superior to others and therefore rewarded with profits. Once an idea originally grasped by pioneering entrepreneurs has been tested and found successful, it can be safely employed as a means to success by imitative entrepreneurs. Imitators flock in as long as profit opportunities remain. Under keen competition, imitators modify their production or transaction methods with the aim of improving profit margins. Gradually, successful plans crystallize into new institutions and once again serve as social coordinators. References Addleson, Mark (1995), Equilibrium Versus Understanding: Towards the Restoration of Economics as Social Theory, London: Routledge. Buchanan, James (1969), Cost and Choice, Chicago: Markham. Cheah, H.B. (1994), ‘Creativity in the Entrepreneurial Process’, in S. Dingli (ed.), Creative Thinking: A Multifaceted Approach, Malta: Malta University Press, pp. 134–49. Coase, R.H. (1937), ‘The nature of the firm’, Economica, N.S., 4 (16), 386–405. Coase, R.H. (1960), ‘The problem of Social Cost’, Journal of Law and Economics, 3 (1), 1–64. Cohen, W.M. and D.A. Levinthal (1990), ‘Absorptive capacity: a new perspective on learning and innovation’, Administrative Science Quarterly, 35 (1) 128–52. Dougherty, D. (1992), ‘A practice-centered model of organization renewal through product innovation’, Strategic Management Journal, 13 Supplement (1), 77–92. Foss, Nicolai J. and Peter G. Klein (2008), ‘The theory of the firm and its critics: a stocktaking and assessment’, in Jean-Michel Glachant and Eric Brousseau (eds), New Institutional Economics: A Textbook, Cambridge: Cambridge University Press, pp. 419–36. Jehenson, R. (1973), ‘A phenomenological approach to the study of the formal organisation’, in G. Psathas (ed.), Phenomenological Sociology Issues and Applications, New York: John Wiley, pp. 219–47. Langlois, R.N. and P.L. Robertson (1995), Firms, Markets and Economic Change: A Dynamic Theory of Business Institutions, London: Routledge. Nonaka, I. (1994), ‘A dynamic theory of organizational knowledge creation’, Organization Science, 5 (1), 14–37. Rogers, E.M. (1983), Diffusion of Innovations, 3rd edn, New York: Free Press. Schutz, A. (1970), On Phenomenology and Social Relations, Chicago: University of Chicago Press. Silverman, D. (1970), The Theory of Organisations, London: Heinemann. Sjöstrand, S.E. (1995), ‘Towards a theory of institutional change’, in John Groenewegen, Christos Pitelis, and Sven-Erik Sjöstrand (eds), On Economic Institutions: Theory and Applications, Aldershot, UK and Brookfield, VT, USA: Edward Elgar Publishing, pp. 19–44. White, L.H. (1977), ‘Uncertainty and entrepreneurial expectation in economic theory’, Unpublished Senior Honours Thesis, Harvard College, 31 March.

27 Austrian economics and the theory of the firm Nicolai J. Foss and Peter G. Klein

As the transaction cost theory of the firm was taking shape in the 1970s, another important movement in economics was emerging: a revival of the ‘Austrian’ tradition in economic theory associated with such economists as Ludwig von Mises and F.A. Hayek (Dolan, 1976; Spadaro, 1978). As Oliver Williamson has pointed out, Austrian economics is among the diverse sources for transaction cost economics (TCE) (Klein, 2010, pp. 187–193). In particular, Williamson frequently cites Hayek (for example, Williamson, 1985, p. 8; 1991, p. 162), particularly Hayek’s emphasis on adaptation as a key problem of economic organization (Hayek, 1945). Following Williamson’s lead, a reference to Hayek’s ‘The Use of Knowledge in Society’ (Hayek, 1945) has become almost mandatory in discussions of economic organization (for example, Ricketts, 1987, p. 59; Milgrom and Roberts, 1992, p. 56; Douma and Schreuder, 1991, p. 9). However, there are many other potential links between Austrian economics and TCE that have not been explored closely and exploited. This chapter argues that characteristically Austrian ideas about property, entrepreneurship, economic calculation, tacit knowledge, and the temporal structure of capital have important implications for theories of economic organization, TCE in particular. Austrian economists have not, however, devoted substantial attention to the theory of the firm, preferring to focus on business-cycle theory, welfare economics, political economy, comparative economic systems, and other areas. Until the 1990s the theory of the firm was an almost completely neglected area in Austrian economics, but since then, a small Austrian literature on the firm has emerged.1 While these works cover a wide variety of theoretical and applied topics, their authors share the view that Austrian insights have something to offer students of firm organization. The Austrian school of economics The Austrian school was born with the publication of Viennese Professor Carl Menger’s Grundsätze der Volkwirtschaftslehre (Menger, 1871), making the Austrian school one of the three great ‘marginalist’ traditions (along with the approaches of William Stanley Jevons and Léon Walras). Menger 281

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offered a unique account of the pricing process, the structure of capital, and the causes of economic fluctuations, along with an emphasis on explaining institutions, that differed substantially from the Marshallian, Walrasian, and Keynesian approaches that came to dominate the economics profession. Like Jevons and Walras, Menger emphasized subjectively held consumer wants as the source of economic value (as opposed to the classical view that production costs determined value). Unlike the neoclassical approach, however, Menger’s approach to economics was causal and realistic, seeking to explain real-world prices and institutions in terms of the subjective values, plans, and actions of market participants. The Austrian school rose to prominence in the late nineteenth and early twentieth centuries in Europe and the US under the influence of Menger, Eugen von Böhm-Bawerk, Frank A. Fetter, Herbert J. Davenport, Philip Wicksteed, Mises, Lionel Robbins, and Hayek, but fell into obscurity by the end of the 1930s. Important contributions to the Austrian tradition were added later by Mises (1949), Rothbard (1956, 1962, 1963a, 1963b), Kirzner (1966, 1973), and Lachmann (1956), but at least publicly, the Austrian tradition lay dormant. When the 1974 Nobel Prize in economics went to Hayek, interest in the Austrian school was suddenly and unexpectedly revived. Already that year an ‘Austrian revival’ was underway, led by students and followers of Rothbard and Kirzner (Dolan, 1976; Vaughn, 1994; Salerno, 2002). Since then, the modern Austrian school has become an important ‘heterodox’ tradition within the milieu of contemporary economics, now featuring its own academic journals, professional societies, graduate programs, and sponsoring organizations. Throughout its history, the Austrian school has developed many of its key ideas as alternatives to other, more dominant perspectives. Menger’s subjectivist, marginalist approach challenged the classical theory of value, and Menger later engaged the German Historical School in a lengthy debate on the proper scope and method of economics. Mises refined his views on monetary calculation during the socialist calculation debate, and Hayek developed and extended his and Mises’s theory of business cycles in the course of several encounters with Keynes. Similarly, the Austrian literature on the firm challenges important aspects of other, more popular perspectives on economic organization, entrepreneurship, and strategic management. The Austrians as precursors to TCE While the Austrians until recently had little to say about the theory of the firm per se, problems of economic organization and its institutional embodiment have always occupied centre stage within the Austrian tradition. This includes, most obviously, issues in comparative systems such as

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the socialist calculation debate (for example, Mises, 1920, 1936; Hayek, 1935, 1945; Lavoie, 1985). Indeed, it is surprising that the Austrians had so many necessary ingredients for a theory of the firm and yet it was left to non-Austrian Ronald Coase to frame and analyse the problem of the existence, boundaries, and internal organization of the firm. Kinds of orders Perhaps the most pertinent overall distinctions to be made in a discussion of economic organization are the ones between ‘pragmatic’ and ‘organic’ institutions (Menger, 1883) or ‘planned’ and ‘spontaneous orders’ (Hayek, 1973). While pragmatic institutions are the results of ‘socially teleological causes’, organic institutions are ‘the unintended result of innumerable efforts of economic subjects pursuing individual interests’ (Menger, 1883, p. 158). Menger’s discussion aims primarily to explain the different ways institutions arise, not how they are preserved, or their principles of operation once established. Hayek’s (1973) distinction between planned and spontaneous orders supplements Menger’s discussion in this regard, because his distinction is based on the different organizing rules these orders comprise. The rules supporting spontaneous order are abstract, purpose-independent, and general, while the rules (or commands) supporting a planned order are designed and specific in nature. Although Hayek tends to distinguish sharply not only between spontaneous and planned orders, but also between the relevant rules that direct them – nomos and thesis, respectively – precise distinctions are difficult to draw: spontaneous orders may be more or less general, planned orders may comprise elements of spontaneous orders, and so on. Obviously, the overall distinction between planned and spontaneous orders closely parallels that between ‘markets and hierarchies’ (Williamson, 1975), or ‘spontaneous’ and ‘intentional governance’ (Williamson, 1991). The socialist calculation debate Of course, the interwar debate on the economic efficiency of socialism is a prime example of contrasting ‘spontaneous’ and ‘intentional’ modes of governance, albeit on an economy-wide level. However, the debate yielded numerous insights that have been important to later developments in the theory of economic organization, including TCE, such as: (1) the insight that welfare assessments of institutions and outcomes should not be based on a ‘Nirvana approach’ (Demsetz, 1969); (2) the importance of change to economic organization; (3) the understanding that an economic organization should be sensitive to the knowledge and rationality that agents possess; and (4) an understanding of the principal–agent relationship and the importance of incentives more generally (see Foss, 1994). Thus,

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it is apparent already from Mises’s (1920) opening salvo in the debate that what really irritated the Austrians was their socialist opponents’ use of unrealistic and unattainable standards of comparison. Naturally, on such standards, capitalism would appear inefficient and wasteful. To the Austrians, socialist economists (including the proponents of market socialism) neglected the role of incentives (Mises, 1936; Hayek, 1940); made unrealistic assumptions about the amounts of knowledge that agents can possess (particularly the planning authorities); and formulated their reasoning within static models that obscured all significant economic problems. Mises, on the other hand, insisted that ‘the problem of economic calculation is of economic dynamics; it is no problem of economic statics’ (Mises, 1936, p. 121), and Hayek later added that ‘economic problems arise always and only in consequence of change’ (Hayek, 1945, p. 82). In Salerno’s (1994, p. 121) words, Mises ‘makes it crystal clear that the static prices mathematically imputed from perfect knowledge of the economic data would not lead to a dynamically efficient allocation of resources. The latter can only be achieved by the entrepreneurially appraised prices that are generated by the historical market process’. One way to interpret this Austrian insight is that absent change there are no transaction and information costs; that is, in the absence of the knowledge and appraisement problems introduced by economic change there would be no costs of identifying contractual partners, drafting and executing contracts, monitoring production, constructing contractual safeguards, judging quality, and so on. In the absence of transaction costs the choice between price-mediated market transactions and firm hierarchies is indeterminate. This indicates a link between Austrian insights in the calculation debate and Coasian insights in economic organization, though these links were not recognized either by the Austrians or by Coase, probably because they were focusing on different institutions: when Hayek (1945) praised ‘the marvel’ of the price system, Coase had eight years earlier established that the reason firms existed was that the ‘telecommunications system’ of prices did not perform costlessly. Indeed, some commentators have seen the analysis of Coase and that of Hayek as strongly opposed. Instead, however, it is only in the kind of dynamic economic reality visualized by the Austrians that Coase’s argument acquires its full force. Incentives and property rights One of the rapidly expanding areas in the theory of economic organization is principal–agent theory. The Austrians made several arguments that in important ways anticipate this theory. They pointed to agency problems under socialism such as risk allocation (for example, Hayek, 1940). Under socialism, they noted, managers would be either inefficiently risk averse or

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risk loving, in the face of career concerns and the presence of an institution (the planning authorities) that could act as an insurance institution and take over the moral hazard of individual managers (Mises, 1936, p. 122; Hayek, 1940, pp. 141–2). Moreover, the Austrians pointed out that socialist economic organization would encourage rent seeking (Mises, 1936, 1944, 1949). A primary virtue of a market system organized on the basis of private ownership, as Mises saw it, is the strong mitigation of potential principal– agent problems: In the capitalist economy, the operation of the market [does] not stop at the doors of a big business concern . . . [It] permeate[s] all its departments and branches . . . It joins together utmost centralisation of the whole concern with almost complete autonomy of the parts, it brings into agreement full responsibility of the central management with a high degree of interest and incentive of the subordinate managers (Mises, 1944, p. 47).

Breaking the corporation into separate profit centres is the way that top management monitors subordinate managers. Anticipating Fama (1980), Mises (1944, pp. 42–7) points to career concerns as important forces mitigating manager shirking. To be sure, both principal–agent theory and the specific Austrian incentive arguments in the calculation debate rest on more general property-rights reasoning. For example, it is fundamentally because agents usually do not have property rights to residual income streams from the productive activities they engage in that they may shirk their duties. While Austrian thinking about the economic function of property rights begins with Menger (for example, 1871, p. 97, p. 100), the most advanced Austrian thinking on the matter is represented by Mises’s work. For example, Mises (1936, p. 182) clearly explains that property rights are composite rights, and he argues that well-defined residual-income rights are crucial to the efficient working of the economy. A central reason why the ‘artificial market’ of market socialists will not work is precisely because the transfer of goods between socialist managers is not equivalent to the transfer of goods in a capitalist economy: under socialism it is not full property rights that are transferred; prices and incentives are accordingly perverse. Where Mises perhaps most explicitly anticipates modern developments, specifically work on the market for corporate control, is where he describes the critical role of capital markets for the efficient functioning of the economy. Securities markets facilitate the most important kind of economic calculation in a dynamic economy through ‘dissolving, extending, transforming, and limiting existing undertakings, and establishing new undertakings’ (Mises, 1936, p. 215).2

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Capital theory and business-cycle theory Capital and business-cycle theory seem less-closely connected to the theory of economic organization. However, they supply the last component in the set of concepts needed to make a coherent statement about economic organization in general and the firm in particular. The relevant component is the intertemporal structure of production highlighted in Austrian capital and business-cycle theory (for example, Hayek, 1931, 1941; Lachmann, 1956). To the Austrians, the economy’s production process represents a series of stages of production, each of which bears a temporal relationship to final consumption (Menger, 1871; Hayek, 1931, 1941; Lachmann, 1956). In other words, there are important complementarities among production processes. Moreover, credit expansion introduces maladjustments in the structure of production that have to be worked out over time (Hayek, 1931), which means that some resources or activities are specific to each other and to particular production processes (see also Lachmann, 1956). These relationships can only be understood fully in a framework that emphasizes the time structure of production, like Austrian capital and business-cycle theory (ibid.); they are obscured in the usual production-function view of economic activity in which capital is homogeneous and production is timeless. Vertical integration is also much easier to portray and comprehend in a sequential framework than the atemporal framework of neoclassical microeconomics. As recent work in the theory of the firm has demonstrated, notions of complementarity and specificity are needed to tell a coherent story about the firm (Hart, 1995; Williamson, 1996). Austrian economics and the contractual perspective on the firm There is some debate within the Austrian literature about the basic Coasian approach and its compatibility with the Austrian perspective. O’Driscoll and Rizzo (1985, p. 124), while acknowledging Coase’s approach as an ‘excellent static conceptualization of the problem’, argue that a more evolutionary framework is needed to understand how firms respond to change. Some Austrian economists have suggested that the Coasian framework may be too narrow, too squarely in the general-equilibrium tradition to deal adequately with Austrian concerns (Boudreaux and Holcombe, 1989; Langlois, 1994). However, as Foss (1993) has pointed out, there are ‘two Coasian traditions’. One tradition, the moral-hazard or agency-theoretic branch associated with Alchian and Demsetz (1972), studies the design of ex ante mechanisms to limit shirking when supervision is costly. Here the emphasis is on monitoring and incentives in an (exogenously determined) agency relationship. The above criticisms may apply to this branch of the modern literature, but they do not apply to the

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other tradition, the governance or asset-specificity branch, especially in Williamson’s more heterodox formulation. Williamson’s transaction cost framework incorporates non-maximizing behaviour (bounded rationality); true, ‘structural’ uncertainty or genuine surprise (complete contracts are held not to be feasible, meaning that all ex post contingencies cannot be contracted upon ex ante); and process or adaptation over time (trading relationships develop over time, typically undergoing a ‘fundamental transformation’ that changes the terms of trade). In short, ‘at least some modern theories of the firm do not at all presuppose the “closed” economic universe – with all relevant inputs and outputs being given, human action conceptualized as maximization, etc. – that [some critics] claim are underneath the contemporary theory of the firm’ (Foss, 1993, p. 274). Stated differently, one can adopt an essentially Coasian perspective without abandoning the Misesian view of the entrepreneur as an uncertaintybearing, innovating decision-maker.3 Economic calculation and the limits to the firm One approach to developing a uniquely ‘Austrian’ approach to the firm is to start with the basic contractual approach, and the Coasian explananda of the firm’s existence, boundaries, and internal organization, and add concepts of entrepreneurship, economic calculation, the time-structure of production, and other elements of the Austrian tradition. For example, the limits to firm size can be understood as a special case of the arguments offered by Mises (1920) and Hayek (1937, 1945) about the impossibility of rational economic planning under socialism (Klein, 1996). Kirzner (1992, p. 162) adopts this approach in interpreting the costs of internal organization in terms of Hayek’s knowledge problem: In a free market, any advantages that may be derived from ‘central planning’ . . . are purchased at the price of an enhanced knowledge problem. We may expect firms to spontaneously expand to the point where additional advantages of ‘central’ planning are just offset by the incremental knowledge difficulties that stem from dispersed information.

What, precisely, drives this knowledge problem? The mainstream literature on the firm focuses mostly on the costs of market exchange, and much less on the costs of governing internal exchange. The new research has yet to produce a fully satisfactory explanation of the limits to firm size (Williamson, 1985, Chapter 6). Existing contractual explanations rely on problems of authority and responsibility (Arrow, 1974); incentive distortions caused by residual ownership rights (Grossman and Hart, 1986; Holmström and Tirole, 1989; Hart and Moore, 1990); and the costs of attempting to reproduce market governance features within the

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firm (Williamson, 1985, Chapter 6). Rothbard (1962, pp. 544–50) offers an explanation for the firm’s vertical boundaries based on Mises’s claim that economic calculation under socialism is impossible. Rothbard argues that the need for monetary calculation in terms of actual prices not only explains the failures of central planning under socialism, but places an upper bound on firm size. Rothbard’s account begins with the recognition that Mises’s position on socialist economic calculation, as noted above, is not about socialism per se, but the role of prices for capital goods. Entrepreneurs allocate resources based on their expectations about future prices, and the information contained in present prices. To make profits, they need information about all prices, not only the prices of consumer goods but the prices of factors of production. Without markets for capital goods, these goods can have no prices, and hence entrepreneurs cannot make judgments about the relative scarcities of these factors. In any environment, then – socialist or not – where a factor of production has no market price, a potential user of that factor will be unable to make rational decisions about its use. Stated this way, Mises’s claim is simply that efficient resource allocation in a market economy requires well-functioning asset markets. To have such markets, factors of production must be privately owned. Rothbard’s contribution is to generalize Mises’s analysis of this problem under socialism to the context of vertical integration and the size of the organization. Rothbard writes in Man, Economy, and State (1962) that up to a point, the size of the firm is determined by costs, as in the textbook model. However, ‘the ultimate limits are set on the relative size of the firm by the necessity for markets to exist in every factor, in order to make it possible for the firm to calculate its profits and losses’ (Rothbard, 1962, p. 536, original emphasis). This argument hinges on the notion of ‘implicit costs’. The market value of opportunity costs for factor services – what Rothbard calls ‘estimates of implicit incomes’ – can be determined only if there are external markets for those factors (Rothbard, 1962, pp. 542–4). For example, if an entrepreneur hires himself or herself to manage the business, the opportunity cost of his or her labour must be included in the firm’s costs. Yet without an actual market for the entrepreneur’s managerial services, he or she cannot know his or her opportunity cost; his or her balance sheets will therefore be less accurate than they would if he or she could measure his or her opportunity cost. The same problem affects a firm owning multiple stages of production. A large, integrated firm is typically organized into semi-autonomous profit centres, each specializing in a particular final or intermediate product. The central management of the firm uses the implicit incomes of the business

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units, as reflected in statements of divisional profit and loss, to allocate physical and financial capital across the divisions. To compute divisional profits and losses, the firm needs an economically meaningful transfer price for all internally transferred goods and services. If there is an external market for the component, the firm can use that market price as the transfer price. Without a market price, however, the transfer price must be estimated, either on a cost-plus basis or by bargaining between the buying and selling divisions; such estimated transfer prices contain less information than actual market prices. The use of internally traded intermediate goods for which no external market reference is available thus introduces distortions that reduce organizational efficiency. This gives us the element missing from contemporary theories of economic organization, an upper bound: the firm is constrained by the need for external markets for all internally traded goods. In other words, no firm can become so large that it is both the unique producer and user of an intermediate product; for then no marketbased transfer prices will be available, and the firm will be unable to calculate divisional profit and loss and therefore unable to allocate resources correctly between divisions.4 Of course, internal organization does avoid the holdup problem, which the firm would face if there were a unique outside supplier; conceivably, this benefit could outweigh the increase in ‘incalculability’ (Rothbard, 1962, p. 548). Like Kirzner (1992), Rothbard viewed his contribution as consistent with the basic Coasian framework. In a later elaboration of this argument, Rothbard states that his own treatment of the limits of the firm: serves to extend the notable analysis of Professor Coase on the market determinants of the size of the firm, or the relative extent of corporate planning within the firm as against the use of exchange and the price mechanism. Coase pointed out that there are diminishing benefits and increasing costs to each of these two alternatives, resulting, as he put it, in an ‘“optimum” amount of planning’ in the free market system. Our thesis adds that the costs of internal corporate planning become prohibitive as soon as markets for capital goods begin to disappear, so that the free-market optimum will always stop well short not only of One Big Firm throughout the world market but also of any disappearance of specific markets and hence of economic calculation in that product or resource (Rothbard, 1976, p. 76).

‘Central planning’ within the firm, then, is possible only when the firm exists within a larger market setting. Ironically, the only reason the Soviet Union and the communist nations of Eastern Europe could exist at all is that they never fully succeeded in establishing socialism worldwide, so they could use world market prices to establish implicit prices for the goods they bought and sold internally (Rothbard, 1991, pp. 73–4).

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Entrepreneurship and Austrian capital theory The close relationship between the Misesian concept of entrepreneurship as action under uncertainty and the ownership and control of resources suggests a bridge between entrepreneurship and the mundane activities of establishing and maintaining a business enterprise. Foss and Klein (2005) and Foss et al. (2007b) offer an entrepreneurial theory of the economic organization that combines the Knight–Mises concept of entrepreneurship as ‘judgment’ and the Austrian approach to capital heterogeneity. In Knight’s formulation, entrepreneurship represents judgment under ‘true’ uncertainty that cannot be assessed in terms of its marginal product and which cannot, accordingly, be paid a wage (Knight, 1921, p. 311). In other words, there is no market for the judgment that entrepreneurs rely on, and therefore exercising judgment requires the person with judgment to start a firm. As Mises (1949, p. 585) puts it, ‘the real entrepreneur is a speculator, a man eager to utilize his opinion about the future structure of the market for business operations promising profits. This specific anticipative understanding of the conditions of the uncertain future defies any rules and systematization’. Of course, judgmental decision-makers can hire consultants, forecasters, technical experts, and so on. However, in doing so they are exercising their own entrepreneurial judgment. Judgment thus implies asset ownership, for judgmental decision-making is ultimately decision-making about the employment of resources. The entrepreneur’s role, then, is to arrange or organize the capital goods he or she owns. As Lachmann (1956, p. 16) puts it: ‘We are living in a world of unexpected change; hence capital combinations . . . will be ever changing, will be dissolved and reformed. In this activity, we find the real function of the entrepreneur’. Austrian capital theory provides a unique foundation for an entrepreneurial theory of economic organization. Neoclassical production theory, with its notion of capital as a permanent, homogeneous fund of value, rather than a discrete stock of heterogeneous capital goods, is of little help here. Transaction cost, resource-based, and property-rights approaches to the firm do incorporate notions of heterogeneous assets, but they tend to invoke the needed specificities in an ad hoc fashion to rationalize particular trading problems – for TCE, asset specificity; for capabilities theories, tacit knowledge; and so on. The Austrian approach, starting with Menger’s (1871) concepts of higher- and lower-order goods and extending through Böhm-Bawerk’s (1889) notion of roundaboutness, Lachmann’s (1956) theory of multiple specificities, and Kirzner’s (1966) formulation of capital structure in terms of subjective entrepreneurial plans, offers a solid foundation for a judgment-based theory of entrepreneurial action. One way to operationalize the Austrian notion of heterogeneity is to

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incorporate Barzel’s (1997) idea that capital goods are distinguished by their attributes. Attributes are characteristics, functions, or possible uses of assets, as perceived by an entrepreneur. Assets are heterogeneous to the extent that they have different, and different levels of, valued attributes. Attributes may also vary over time, even for a particular asset. Given Knightian uncertainty, attributes do not exist objectively, but subjectively, in the minds of profit-seeking entrepreneurs who put these assets to use in various lines of production. Consequently, attributes are manifested in production decisions and realized only ex post, after profits and losses materialize. Entrepreneurs who seek to create or discover new attributes of capital assets will want ownership titles to the relevant assets, both for speculative reasons and for reasons of economizing on transaction costs. These arguments provide room for entrepreneurship that goes beyond deploying a superior combination of capital assets with ‘given’ attributes, acquiring the relevant assets, and deploying these to producing for a market: entrepreneurship may also be a matter of experimenting with capital assets in an attempt to discover new valued attributes. Such experimental activity may take place in the context of trying out new combinations through the acquisition of or merger with another firm, or in the form of trying out new combinations of assets already under the control of the entrepreneur. The entrepreneur’s success in experimenting with assets in this manner depends not only on his or her ability to anticipate future prices and market conditions, but also on internal and external transaction costs, the entrepreneur’s control over the relevant assets, how much of the expected return from experimental activity he or she can hope to appropriate, and so on. Moreover, these latter factors are key determinants of economic organization in modern theories of the firm, which suggests that there may be fruitful complementarities between the theory of economic organization and Austrian theories of capital heterogeneity and entrepreneurship. Foss et al. (2007b) show how this approach provides new insights into the emergence, boundaries, and internal organization of the firm. Firms exist not only to economize on transaction costs, but also as a means for the exercise of entrepreneurial judgment, and as a low-cost mechanism for entrepreneurs to experiment with various combinations of heterogeneous capital goods. Changes in firm boundaries can likewise be understood as the result of processes of entrepreneurial experimentation. And internal organization can be interpreted as the means by which the entrepreneur delegates particular decision rights to subordinates who exercise a form of ‘derived’ judgment on his behalf (Foss et al., 2007a). Witt (1998, 1999) offers another approach to combining an Austrian

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concept of entrepreneurship with the theory of the firm. Entrepreneurs require complementary factors of production, he argues, which are coordinated within the firm. For the firm to be successful, the entrepreneur must establish a tacit, shared framework of goals – what Casson (2000) calls a ‘mental model’ of reality – which governs the relationships among members of the entrepreneur’s team. As Langlois (1998) points out, it is often easier (less costly) for individuals to commit to a specific individual, the leader, rather than an abstract set of complex rules governing the firm’s operations. The appropriate exercise of charismatic authority, then, facilitates coordination within organizations (Witt, 2003). This approach combines insights from economics, psychology, and sociology, and leans heavily on Max Weber. Leaders coordinate through effective communication, not only of explicit information, but also tacit knowledge – plans, rules, visions, and the like. The successful entrepreneur excels at communicating such models. Here, as in Coase (1937), the employment relationship is central to the theory of the firm. The entrepreneur’s primary task is to coordinate the human resources that make up the firm. Foss et al. (2007b), by contrast, focus on alienable assets, as in Knight (1921). They define the firm as the entrepreneur plus the alienable resources the entrepreneur owns and thus controls. Each approach has strengths and weaknesses. The cognitive approach explains the dynamics among team members but not necessarily their contractual relationships. Must the charismatic leader necessarily own physical capital, or can he or she be an employee or independent contractor? Formulating a business plan, communicating a corporate culture, and the like are clearly important dimensions of business leadership. But are they attributes of the successful manager or the successful entrepreneur? Even if top-level managerial skill were the same as entrepreneurship, it is unclear why charismatic leadership should be regarded as more ‘entrepreneurial’ than other, comparatively mundane managerial tasks such as structuring incentives, limiting opportunism, administering rewards, and so on. On the other hand, the judgment approach does not generalize easily from the one-person firm to the multi-person firm. Conclusion TCE, while firmly rooted in the neoclassical economics tradition, has always drawn upon a broad range of sources in law, organization theory, economic sociology, political science, history, as well as a diverse set of economists from behavioural, ‘old’ institutional, and other ‘heterodox’ traditions. The Austrian school, while providing some direct influence mainly through Hayek, has not had as much influence as one might imagine, given the Austrians’ rich heritage in the areas of property rights,

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knowledge, incentives, and institutions. This chapter highlights some possible bridges between the Austrian and new institutional literatures and points to the emerging Austrian literature on the theory of the firm. We expect this to be a growth area in the years to come. Notes 1. Examples include Langlois (1992, 1995, 2002); Minkler (1993a, 1993b); Foss (1994, 1997, 1999, 2001); Klein (1996, 1999, 2008); Young et al. (1996); Lewin (1998); Dulbecco and Garrouste (1999); Ionnanides (1999); Witt (1999); Yu (1999); Sautet (2000); Foss and Foss (2002a, 2002b); Lewin and Phelan (2000); Foss and Christensen (2001); Klein and Klein (2001); Foss and Klein (2002); Foss et al. (2002); Adelstein (2005); Ng (2005); Foss et al. (2007a); Pongracic (2009); and Walsh (2009). 2. See also Klein (1999). 3. Foss and Foss (2000) argue, more generally, that contractual and knowledge-based theories of the firm are fundamentally complements, not rivals. For more on the Misesian theory of the entrepreneur see Foss et al. (2007b), Klein (2008), and Salerno (2008). 4. Note that in general, Rothbard is making a claim only about the upper bound of the firm, not the incremental cost of expanding the firm’s activities (as long as external market references are available). As soon as the firm expands to the point where at least one external market has disappeared, however, the calculation problem exists. The difficulties become worse as more and more external markets disappear, as ‘islands of noncalculable chaos swell to the proportions of masses and continents. As the area of incalculability increases, the degrees of irrationality, misallocation, loss, impoverishment, etc., become greater’ (Rothbard, 1962, p. 548).

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Foss, N.J. (1993), ‘More on Knight and the theory of the firm’, Managerial and Decision Economics, 14, 269–76. Foss, N.J. (1994), The theory of the firm: the Austrians as precursors and critics of contemporary theory’, Review of Austrian Economics, 7(3), 31–64. Foss, N.J. (1997), ‘Austrian insights and the theory of the firm’, in P.J. Boettke and S. Horwitz (eds.), Advances in Austrian Economics, Greenwich, CT: JAI Press, pp. 175–98. Foss, N.J. (1999), ‘The use of knowledge in firms’, Journal of Institutional and Theoretical Economics, 155 (3), 458–86. Foss, N.J. (2001), ‘Misesian ownership and Coasian authority in Hayekian settings: the case of the knowledge economy’, Quarterly Journal of Austrian Economics, 4 (4), 3–24. Foss, N.J. and J.F. Christensen (2001), ‘A market process approach to corporate coherence’, Managerial and Decision Economics, 22 (4–5), 213–26. Foss, N.J. and K. Foss (2000), ‘Competence and governance perspectives: how much do they differ? And how does it matter?’ in N.J. Foss and V. Mahnke (eds), Competence, Governance, and Entrepreneurship, Oxford, Oxford University Press, pp. 55–79. Foss, N.J. and K. Foss (2002a), ‘Economic organization and the trade-off between destructive and productive entrepreneurship’, in N. Foss and P.G. Klein (eds), Entrepreneurship and the Firm: Austrian Perspectives on Economic Organization, Cheltenham, UK and Northampton, MA, USA: Edward Elgar Publishing, pp. 102–27. Foss, N.J. and K. Foss (2002b), ‘Organizing economic experiments: property rights and firm organization’, Review of Austrian Economics, 15 (4), 297–312. Foss, N.J. and P.G. Klein (eds.) (2002), Entrepreneurship and the Firm: Austrian Perspectives on Economic Organization, Cheltenham, UK and Northampton, MA, USA: Edward Elgar Publishing. Foss, N.J. and P.G. Klein (2005), ‘Entrepreneurship and the economic theory of the firm: any gains from trade?’, in R. Agarwal, S.A. Alvarez, and O. Sorenson (eds), Handbook of Entrepreneurship Research: Disciplinary Perspectives, Dordrecht: Springer, pp. 55–80. Foss, K., N.J. Foss, and P.G. Klein (2007a) ‘Original and derived judgment: an entrepreneurial theory of economic organization’, Organization Studies, 28 (12), 1893–912. Foss, K., N.J. Foss, P.G. Klein, and S.K. Klein (2002) ‘Heterogeneous capital, entrepreneurship, and economic organization’, Journal des Economistes et des Etudes Humaines, 12 (1), 79–96. Foss, K., N.J. Foss, P.G. Klein, and S.K. Klein (2007b), ‘The entrepreneurial organization of heterogeneous capital’, Journal of Management Studies, 44 (7), 1165–86. Grossman, Sanford J. and Oliver D. Hart. (1986), ‘The costs and benefits of ownership: a theory of vertical and lateral integration’, Journal of Political Economy, 94, 691–719. Hart, O.D. (1995), Firms, Contracts, and Financial Structure, Oxford: Oxford University Press. Hart, O.D. and J. Moore (1990), ‘Property rights and the nature of the firm’, Journal of Political Economy, 98, 1119–58. Hayek, F.A. (1931), Prices and Production, London: Routledge and Sons. Hayek, F.A. (ed.) (1935), Collectivist Economic Planning, London: Routledge and Sons. Hayek, F.A. (1937), ‘Economics and knowledge’, Economica, 4 (13), 33–54. Hayek, F.A. (1940), ‘Socialist calculation: the competitive solution’, Economica, 7 (25) 125–49. Hayek, F.A. (1941), The Pure Theory of Capital, London: Routledge and Sons. Hayek, F.A. (1944), The Road to Serfdom, London: Routledge and Kegan Paul. Hayek, F.A. (1945), ‘The use of knowledge in society,’ American Economic Review, 35 (4), 519–530. Hayek, F.A. (1973), Law, Legislation and Liberty, vol. 1, Rules and Order, Chicago: University of Chicago Press. Holmström, B. and J. Tirole (1989), ‘The theory of the firm’, in R. Schmalensee and R.D. Willig (eds), Handbook of Industrial Organisation, Amsterdam: North-Holland, pp. 61–133.

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Ionnanides, S. (1999), ‘Towards an Austrian perspective on the firm’, Review of Austrian Economics, 11(1–2), 77–98. Kirzner, I.M. (1966), An Essay on Capital, New York: Augustus M. Kelley. Kirzner, I.M. (1973), Competition and Entrepreneurship, Chicago: University of Chicago Press. Kirzner, I.M. (1992), The Meaning of Market Process: London: Routledge. Klein, P.G. (1996), ‘Economic Calculation and the Limits of Organization’, Review of Austrian Economics, 9 (2), 51–77. Klein, P.G. (1999), ‘Entrepreneurship and corporate governance’, Quarterly Journal of Austrian Economics, 2 (2), 19–42. Klein, P.G. (2008) ‘Opportunity discovery, entrepreneurial action, and economic organization’, Strategic Entrepreneurship Journal, 2 (3), 175–90. Klein, P.G. (2010), The Capitalist and the Entrepreneur:Essays on Organizations and Markets, Auburn, AL: Ludwig von Mises Institute. Klein, P.G. and S.K. Klein (2001), ‘Do entrepreneurs make predictable mistakes? Evidence from corporate divestitures’, Quarterly Journal of Austrian Economics, 4 (2), 3–25. Knight, F.H. (1921), Risk, Uncertainty and Profit, Boston: Houghton Mifflin. Lachmann, Ludwig M. (1956), Capital and Its Structure, Kansas City: Sheed Andrews and McMeel. Langlois, R.N. (1992), ‘Orders and organizations: toward an Austrian theory of social institutions’, in Bruce Caldwell and Stephan Boehm (eds), Austrian Economics: Tensions and New Directions, Boston: Kluwer, pp. 165–83. Langlois, R.N. (1994), ‘The boundaries of the firm’, in P.J. Boettke (ed.), The Elgar Companion to Austrian Economics, Aldershot, UK and Brookfield, VT, USA: Edward Elgar Publishing, pp. 173–8. Langlois, R.N. (1995), ‘Do firms plan?’, Constitutional Political Economy, 6(3), 247–61. Langlois, R.N. (1998), ‘Personal capitalism as charismatic authority: the organizational economics of a Weberian concept’, Industrial and Corporate Change, 7 (1), 195–214. Langlois, R.N. (2002), ‘Modularity in technology and organization’, Journal of Economic Behavior and Organization, 49 (1), 19–37. Lavoie, D. (1985), Rivalry and Central Planning: The Socialist Calculation Debate Reconsidered, Cambridge: Cambridge University Press. Lewin, P. (1998), ‘The firm, money and economic calculation: considering the institutional nexus of market production’, American Journal of Economics and Sociology, 57 (4), 499–512. Lewin, P. and S. Phelan (2000), ‘An Austrian theory of the firm’, Review of Austrian Economics, 13 (1), 59–79. Menger, C. (1871), Principles of Economics, Auburn, AL: Ludwig von Mises Institute, 2007. Menger, C. (1883), Investigations into the Method of the Social Sciences, with Special Reference to Economics, Louis Schneider (ed.), Francis J. Nock, trans., New York: New York University Press, 1985. Milgrom, P. and J.R. Roberts (1992), Economics, Organization, and Management, Englewood Cliffs, NJ: Prentice-Hall. Minkler, A.P. (1993a), ‘The problem with dispersed knowledge: firms in theory and practice’, Kyklos, 46 (4), 569–87. Minkler, A.P. (1993b), ‘Knowledge and internal organization’, Journal of Economic Behavior and Organization, 21 (1) 17–30. Mises, L. von (1920), ‘Economic calculation in the socialist commonwealth’, S. Adler, trans., Auburn, AL: Ludwig von Mises Institute, 1990. Mises, L. von (1936), Socialism: An Economic and Sociological Analysis, J. Kahane, trans., London: Jonathan Cape. Mises, L. von (1944), Bureacracy, New Haven: Yale University Press. Mises, L. von (1949), Human Action: A Treatise on Economics, New Haven: Yale University Press. Ng, D. (2005), ‘The discovery of and coordination of resource complements in a

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28 Limits of transaction cost analysis Geoffrey M. Hodgson

Transaction cost economics (TCE) is one of the most influential approaches in the social sciences today. In reality, transaction costs exist. Yet they were neglected in economic theory until Ronald Coase (1937) and Oliver Williamson (1975) explored their implications. Nevertheless, there are many unanswered questions of a conceptual, theoretical and empirical nature. Even the term ‘transaction cost’ awaits an adequately precise definition. As Williamson (1995, p. 33) himself notes: ‘There is nonetheless a grave problem with broad, elastic and plausible concepts – of which “transaction costs” is one and “power” is another – in that they lend themselves to ex post rationalization. Concepts that explain everything explain nothing’. The critical literature on TCE is almost as large as the TCE literature itself. This chapter examines some of the issues requiring attention. The following section looks at claims concerning the empirical evidence. The two remaining sections look at some central theoretical problems. The argument is not that TCE has to be junked, but that it has to be significantly extended to deal with some of the major problems and omissions. Evidence and alternatives Williamson has been hugely instrumental in the rise to prominence of TCE. His operationalization of TCE avoids direct measurement of transaction costs themselves, to focus instead on other variables, such as uncertainty and asset specificity. Reviewing empirical work in the area, Williamson (1985, p. 130; 1999, p. 1092; 2000, pp. 605–7) upholds that the ‘cumulative evidence’ for TCE is ‘broadly corroborative’ and it is ‘an empirical success story’. If valid, these important claims would suggest that transaction cost approaches have triumphed over rival explanations of the nature of the firm, particularly over competence-based approaches.1 In fact, the evidence is more equivocal. A systematic evaluation by Robert David and Shin-Kap Han (2004) of 304 statistical tests of Williamson’s TCE framework, found in 63 journal articles, reaches the conclusion that the results are ‘mixed’.2 Richard Carter and Geoffrey Hodgson (2006) adopt a different methodology and focus on a smaller number of the most influential and highly 297

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cited studies. They considered prominent empirical studies of both vertical integration and hybrid relationships. Regarding vertical integration, they found no more than a partial and qualified consistency with Williamson’s analysis. The hybrid relationship studies provide even less support, with the majority being inclusive in their tests of Williamson’s TCE. This concurs with the ‘mixed’ verdict of David and Han. Carter and Hodgson further argue that the results of tests of the role of asset specificity, which seem to be among the more successful for TCE in empirical terms, are also consistent with the competence-based approach. In dealing with the empirical evidence it is important to be clear about what is being tested, whether the broad and viable claim that transaction costs are important (Macher and Richman, 2008) or the more specific claims of particular approaches to TCE. Williamson’s (1979, p. 245) particular analytical approach focuses on: ‘(1) uncertainty, (2) the frequency with which transactions recur, and (3) the degree to which durable transaction-specific investments are incurred’. Williamson’s framework predicts that: (a) trilateral governance mechanisms (or ‘neoclassical’ contracting) will be efficient for transactions that are occasional, have intermediate levels of uncertainty and have either idiosyncratic or mixed investment characteristics, and (b) bilateral governance mechanisms (or obligational contracting) will be efficient for transactions that are recurrent, have intermediate levels of uncertainty and have mixed investment characteristics. In practice, testing this form of TCE has faced several major problems. As Scott Masten et al. (1991, p. 17) argue: ‘Because of difficulties in observing and measuring transaction costs, analysts have had to rely on estimations of reduced-form relationships between observed characteristics and organizational forms’. But, ‘such indirect tests are unable to distinguish whether observed patterns of organization resulted from systematic, but as yet unexplored, variations in the costs incurred organizing production internally’ (ibid.). More than one type of theoretical explanation could be consistent with the data. In particular, and especially in the absence of direct measures of transaction costs, a non-transaction cost explanation might be viable (Masten, 1996). Kirk Monteverde reinterprets TCE empirical studies from a resourcebased perspective, arguing that the human asset-specificity construct should be reinterpreted as a set of firm-specific communication codes (or competences). Monteverde (1995) constructs his empirical model to account for the openness of the human asset-specificity concept to alternative interpretations and finds empirical support for his resource-based hypotheses. Monteverde argues that the findings of Monteverde and Teece (1982), Masten et al. (1991), and Anderson and Schmittlein (1984) can all

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be reinterpreted in this way. Of the 12 vertical integration studies assessed in Carter and Hodgson (2006), 11 employed Williamson’s reduced form model and nine of those studies found support for a separate human assetspecificity variable. Hence no less than nine of these 12 most highly cited studies could be reinterpreted as being consistent with a competence or resource-based perspective. Masten (1996, pp. 51–2) noted that ‘reduced-form estimates do not disclose the magnitude of transaction costs’ and consequently that ‘without additional information, the magnitude of transaction cost differentials and the effects of organizational form on performance cannot be inferred from standard empirical tests of transaction cost hypotheses’. In simple terms, even if empirical results are consistent with the predictions of Williamson’s model, this does not in itself demonstrate that transaction costs are being minimized. This concern has been raised by a number of empirical researchers (Heide and John, 1990, 1992; Noordewier et al., 1990; and Osbourn and Baughn, 1990). Indeed Heide and John (1990) take the issue further by arguing that the observed governance form could have been chosen for strategic as opposed to transaction cost economizing reasons. Given the plausibility of alternative interpretations of even the positive results in favour of Williamson’s TCE, there is an obvious need for tests that can discriminate between these rival (or possibly complementary) interpretations. Although there are several hundred empirical studies of TCE, many of which claim to be corroborative, only four conjoint tests of competencebased and Williamsonian approaches have come to my notice. All four point to the viability of a hybrid explanation for the existence of the firm, involving both competences and transaction costs, and are broadly consistent with the argument here (Argyres, 1996; Poppo and Zenger, 1998; Combs and Ketchen, 1999; Jacobides and Hitt, 2005). Another empirical study compares the transaction cost approach with property rights theory, with inconclusive results (Whinston, 2003). A prominent conclusion is that an integration of TCE and competencebased explanations represents perhaps the most productive area for development. Instead of premature declarations of scientific victory, innovative theoretical development, and careful conceptual refinement, leading to more thorough joint testing, is the best approach for the future. Back to basics While TCE has been criticized for inadequate definitions of key terms and ‘catch-all’ concepts, similar accusations can be made against rival theories. Throughout the TCE literature and that of its rivals there is still lacking a consensus on basic definitions such as the firm. When the defining features

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of this basic entity are beyond agreement, derivative issues such as the boundaries of the firm, the nature of ‘hybrids’ and the ‘make-or-buy’ decision become hopelessly clouded by terminological confusion. Further theoretical and conceptual work is required, as well as the more inclusive approach to empirical testing highlighted in the preceding section. In many ways it is useful to return to Ronald Coase’s (1937) seminal thought experiment. Following Coase it is useful to distinguish between just two governance forms, the firm and the market. This heuristic simplification precedes later complications of the picture. The Coasean thought experiment compares the costs of using the price mechanism in a market-like relationship with the costs of grouping together transactions under the single organizational umbrella of the firm. When costs of organizational arrangements within the firm are less than the cost of using the price mechanism in a market arrangement, then the existence of the firm is viable. The boundary of the firm is where the marginal costs of the firm or market mode are equivalent. This is an extremely powerful framework that has inspired TCE throughout its existence. But the thought experiment involves some challengeable assumptions. First, in the comparison of the two modes, technology and production routines are assumed to be constant. This implies a separability of production and technology from governance structures or transaction costs. Paul Milgrom and John Roberts (1992, pp. 33–4) highlight some of the theoretical problems involved in trying to separate production and governance, and their corresponding costs. The transaction costs argument assumes that production costs are given and do not differ across governance or transaction modes. However, technologies are often linked to transaction modes and structures of governance. Second, the methodology adopted by Coase, and likewise adopted and acknowledged by Williamson (1985, pp. 143–4), is one of comparative statics. As a number of authors have pointed out, this downplays the vital issues of learning, innovation, and dynamic change (Langlois, 1992; Nooteboom, 1992, 2004; Pagano, 1992). Third, the analysis assumes that individual productive capabilities and amenabilities of individuals are unchanged by any transition from one mode to another. As Mary Douglas (1990, p. 102) put it, Williamson ‘believes firms vary, but not individuals. He has the same representative rational individual marching into one kind of contract or refusing to renew it and entering another kind for the same set of reasons, namely, the cost of transactions in a given economic environment’. This omission leads to a neglect of context-specific processes of individual transformation, development and learning, as well as an overly narrow focus on presumed invariant human attributes such as opportunism.3

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All three of these limitations are highlighted in a simple heuristic model devised by Geoffrey Hodgson and Thorbjørn Knudsen (2007). Harold Demsetz (1988, p. 144) has pointed out that ‘writings on the theory of the firm sometimes use transaction costs to refer indiscriminately to organizational costs and whether these arise from within the firm or across the market’. Accordingly, Hodgson and Knudsen (2007) separate two types of cost that have been gathered under the ‘catch-all’ transaction cost label. On the one hand, there are costs associated with the definition, negotiation, monitoring or enforcement of the employment contract. They include the costs involved in hiring, organizing, monitoring or managing the human resources within the firm. On the other hand, there are costs of defining, negotiating, monitoring or enforcing contracts for other services and goods, in the sphere of markets or exchange. Hodgson and Knudsen (2007) use the term ‘transaction costs’ to refer exclusively to the costs of defining, negotiating, monitoring or enforcing contracts for goods and services, in the sphere of markets or exchange. The costs of monitoring and managing workers within the firm are referred to as ‘monitoring costs’. What happens if ‘transaction costs’ are lower than ‘monitoring costs’? A simple Coasean model would predict that the firm would not exist, because there would be no advantage in cost terms. But this argument overlooks another significant possibility. The key point is that the firm can provide an organizational environment, consisting of routines, images, artefacts, and information, which can enhance the capabilities of workers. Some routines, images, and stored information depend on the existence of the organization per se, and hence may not be found in a market context. The market has different attributes and benefits. Accordingly, even if knowledge is regarded as an individual phenomenon, existing solely in the memory traces of individuals, the organization provides a structured environment consisting of interactions and routinized practices that can augment individual skills. The organizational whole is more than the sum of its individual parts. Consequently, through individual relations and interactions, the organization can enhance overall productivity, more than the total productivity of workers performing in isolation.4 This point underlines that individual interactions and their outcomes are context specific. The average productivity of individuals can be enhanced in specific organizational and cultural environments (Hodgson, 1998). Some organizational environments can enhance individual productivity through learning, additional to the incentive effects and contracting economies that are at the centre of the transaction cost explanation. It is possible (but neither universal nor inevitable) that interactions

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between one set of workers in one context will yield higher productivity than the interaction of the same set of workers in another. Pursuing this possibility, Hodgson and Knudsen (2007) demonstrate in their simple model that the firm can be more profitable than the ‘market’ mode of organization, even if ‘monitoring costs’ are positive and ‘transaction costs’ are zero. Hodgson and Knudsen (2007) develop their model and bring in the dynamic feature of learning. This strengthens the result. The firm can become viable in the future even if it is not so at present. The boundary of viability between the firm and the market shifts through time. In some circumstances, markets have the capacity to create learning effects that may counterbalance the learning effects within firms. There are good reasons why markets exist. The Hodgson and Knudsen (2007) model depends on possible rather than universal effects. In reality, comparisons of the net benefits of firms and markets have to take into account the learning effects of both market and firm institutions, as well as transaction costs. The model assumes firm-specific productivity effects. It is asserted that if such effects exist, then they may be sufficient to explain the existence of the firm. Admittedly, if such effects are small, then the burden of the explanation for the existence of the firm may shift back to transaction costs. The onus is on supporters of the argument that all firms are always explained by transaction costs alone to show that firm-specific effects are generally insignificant. No basis is evident for such a general statement. Another response may be simply to deny the existence of any firmspecific productivity effects. Or it may be argued that if there were such productivity advantages, then they could be replicated in the ‘market’ mode, by the free bargaining of independent producers. But a market is not a firm. Hence these responses are another way of saying that any such productivity advantages are not firm-specific, and thereby denying the assumption. This denial goes against immense evidence to the contrary in organization studies and elsewhere. Other critics might acknowledge the existence of these firm-specific effects but insist that they are generally less important than transaction costs. This question cannot be decided on a priori grounds because it is an empirical issue. It requires a comparison between measures that directly capture learning effects and transaction costs. This is an important agenda for future research. Context, evolution, and causal explanation The preceding section considered a simple Coasean world with two ways of organizing production – the firm and the ‘market’. It was pointed out that the Coasean thought experiment paid insufficient attention to the

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ways in which structured relations between individuals may affect their capabilities or dispositions. Context matters. Williamson’s theoretical structure is more complex, with several alternative governance modes. He makes major advances in searching for explanations of different organizational forms, including different kinds of hierarchy and the viability of cooperative versus more hierarchical firms. The issue of context is also important with Williamson’s theory. The literature on institutional complementarities is relevant here (Amable, 2000; Aoki, 2001; Boyer, 2005). This theoretical and empirical literature addresses the possibility that the performance of one institution may depend on the nature of other institutions to which it relates. Accordingly, Japanese firms may perform well in the context of Japanese-style state or financial institutions, but less well in other institutional contexts (Gagliardi, 2009). The performance of cooperative firms, for example, may be dependent on the type of banking system that prevails, thus helping to explain why cooperatives are more numerous in some countries rather than others. Consequently, and contrary to Williamson (1985), one cannot infer that cooperatives are a universally inferior form of organization. Their efficiency may depend on their institutional context. A further limitation of the Coase–Williamson approach is that comparative statics detract attention from the mechanisms that lead to different possible outcomes. If governance forms tend to minimize transaction costs, it is not clear how this occurs. Are managers to some extent aware of these costs and do they consciously reduce them? Or are costs reduced through some process of competitive evolutionary selection of the less costly over the costlier firms? With his emphasis on information problems and bounded rationality, Williamson does not suggest that managers have sufficient information. Instead Williamson (1975) hints at an evolutionary process of selection, but never develops this argument. If he did, he would have to address the well-established theoretical limitations to an (near) optimal evolutionary process of selection, including frequency effects and other context-dependent outcomes (Winter, 1964; Hodgson, 1996). Also in evolution, context matters. To make further progress we do not need to dispense with the achievements of TCE. Instead we have to overcome the limitations of the comparative statics approach and develop a more dynamic theory. Even in the statics case, contextual effects have been under-appreciated. In a dynamic theory they also must play a major part. Prominent items on the theoretical agenda for TCE include the development of evolutionary approaches and the exploration of possible syntheses with competence-based theories.

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Notes 1. Including competence, capabilities, knowledge-based, resource-based and evolutionary approaches (Penrose, 1959; Nelson and Winter, 1982; Rumelt, 1984; Foss, 1993; Montgomery, 1995; Foss and Knudsen, 1996; Nooteboom, 2004). 2. Other TCE empirical review studies are cited and analysed in Carter and Hodgson (2006). For an extensive but unprobing review see Macher and Richman (2008), which covers several different forms of transaction cost analysis. 3. Opportunism is a central concept in Williamson’s but not Coase’s analysis. In a critique of Williamson, Hodgson (2004) does not deny the existence and importance of opportunism but argues that there are additional important reasons why contracts may not be fulfilled and monitoring may be required. Hence an explanatory emphasis on opportunism is both theoretically and strategically misleading. 4. Alchian (1991, p. 233) has argued that ‘cooperative activity with a “firm” yields an output greater than could otherwise be achieved and . . . the underlying factor in that source of gain in the firm is “teamwork’’’. See also Argyris and Schön (1996) and other works on organization theory.

References Alchian, Armen A. (1991), ‘Development of economic theory and antitrust: a view from the theory of the firm’, Journal of Institutional and Theoretical Economics, 147 (1), 232–4. Amable, Bruno (2000), ‘Institutional complementarity and diversity of social systems of innovation and production’, Review of International Political Economy, 7 (4), 645–87. Anderson, Erin and David C. Schmittlein (1984), ‘Integration of the sales force: an empirical examination’, RAND Journal of Economics, 15 (3), 385–95. Aoki, Masahiko (2001), Toward a Comparative Institutional Analysis, Cambridge, MA: MIT Press. Argyres, Nicholas S. (1996), ‘Evidence on the role of firm capabilities in vertical integration decisions’, Strategic Management Journal, 17 (1), 129–50. Argyris, Chris and Donald A. Schön (1996), Organizational Learning II: Theory, Method, and Practice, Reading, MA: Addison-Wesley. Boyer, Robert (2005), ‘Coherence, diversity, and the evolution of capitalisms – the institutional complementarity hypothesis’, Evolutionary and Institutional Economics Review, 2 (1), 43–80. Carter, Richard and Geoffrey M. Hodgson (2006), ‘The impact of empirical tests of transaction cost economics on the debate on the nature of the firm’, Strategic Management Journal, 27 (5), 461–76. Coase, Ronald H. (1937), ‘The nature of the firm’, Economica, N.S., 4 (16), 386–405. Combs, James G. and David J. Ketchen, Jr (1999), ‘Explaining interfirm cooperation and performance: toward a reconciliation of predictions from the resource-based view and organizational economics’, Strategic Management Journal, 20 (9), 867–88. David, Robert J. and Shin-Kap Han (2004), ‘A systematic assessment of the empirical support for transaction cost economics’, Strategic Management Journal, 25 (1), 39–58. Demsetz, Harold (1988), ‘The theory of the firm revisited’, Journal of Law, Economics, and Organization, 4 (1), 141–62. Douglas, Mary T. (1990), ‘Converging on autonomy: anthropology and institutional economics’, in Oliver E. Williamson (ed.), Organization Theory: From Chester Barnard to the Present and Beyond, Oxford: Oxford University Press, pp. 98–115. Foss, Nicolai Juul (1993), ‘Theories of the firm: contractual and competence perspectives’, Journal of Evolutionary Economics, 3 (2), 127–44. Foss, Nicolai Juul and Christian Knudsen (eds) (1996), Towards a Competence Theory of the Firm, London and New York: Routledge. Gagliardi, Francesca (2009), ‘Financial development and the growth of cooperative firms’, Small Business Economics, 32(4), 439–64. Heide, J.B. and G. John (1990), ‘Alliances in industrial purchasing: the determinants of joint

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venture action in buyer–supplier relationships’, Journal of Marketing Research, 27 (1), 24–36. Heide, J.B. and G. John (1992), ‘Do norms matter in marketing relationships?’, Journal of Marketing, 56 (1), 32–44. Hodgson, Geoffrey M. (1996), ‘Organizational form and economic evolution: A critique of the Williamsonian hypothesis’, in Ugo Pagano and Robert E. Rowthorn (eds), Democracy and Efficiency in Economic Enterprises, London and New York: Routledge, pp. 98–115. Hodgson, Geoffrey M. (1998), ‘Competence and contract in the theory of the firm’, Journal of Economic Behavior and Organization, 35 (2), 179–201. Hodgson, Geoffrey M. (2004), ‘Opportunism is not the only reason why firms exist: why an explanatory emphasis on opportunism can mislead management strategy’, Industrial and Corporate Change, 13 (2), 403–20. Hodgson, Geoffrey M. and Thorbjørn Knudsen (2007), ‘Firm-specific learning and the nature of the firm: why transaction costs may provide an incomplete explanation’, Revue Économique, 58 (2), 331–50. Jacobides, Michael G. and Lorin M. Hitt (2005), ‘Losing sight of the forest for the trees? Productive capabilities and gains from trade as drivers of vertical scope’, Strategic Management Journal, 26 (13), 1209–27. Langlois, Richard N. (1992), ‘Transaction cost economics in real time’, Industrial and Corporate Change, 1 (1), 99–127. Macher, Jeffrey T. and Barak D. Richman (2008), ‘Transaction cost economics: an assessment of empirical research in the social sciences’, Business and Politics, 10 (1), 1–63. Masten, Scott E. (1996), ‘Empirical research in transaction cost economics’, in John Groenewegen (ed.), Transaction Cost Economics and Beyond, Boston: Kluwer, pp. 43–64. Masten, Scott E., James W. Meehan, and Edward A. Snyder (1991), ‘The Costs of Organization’, Journal of Law and Economic Organization, 7 (1), 1–25. Milgrom, Paul and John Roberts (1992) Economics, Organisation, and Management, Englewood Cliffs and London: Prentice-Hall. Monteverde, Kirk (1995), ‘Technical dialog as an incentive for vertical integration in the semiconductor industry’, Management Science, 41 (10), 1624–38. Monteverde, Kirk and David J. Teece (1982), ‘Supplier switching costs and vertical integration in the automobile industry’, Bell Journal of Economics, 13 (1), 206–13. Montgomery, Cynthia A. (ed.) (1995), Resource-Based and Evolutionary Theories of the Firm: Towards a Synthesis, Boston: Kluwer. Nelson, Richard R. and Sidney G. Winter (1982), An Evolutionary Theory of Economic Change, Cambridge, MA: Harvard University Press. Noordewier, T.G., G. John, and J.R. Nevin (1990), ‘Performance outcomes of purchasing arrangements in industrial buyer-vendor relationships’, Journal of Marketing, 54 (4), 80–93. Nooteboom, Bart (1992), ‘Towards a dynamic theory of transactions’, Journal of Evolutionary Economics, 2 (4), 281–99. Nooteboom, Bart (2004), ‘Governance and competence: how can they be combined?’, Cambridge Journal of Economics, 28 (4), 505–25. Osborn, R.N. and C.C. Baughn (1990), ‘Forms of interorganizational governance for multinational alliances’, Academy of Management Journal, 33 (3), 503–19. Pagano, Ugo (1992), ‘Authority, co-ordination and disequilibrium: an explanation of the coexistence of markets and firms’, Structural Change and Economic Dynamics, 3 (1), 53–77. Penrose, Edith T. (1959), The Theory of the Growth of the Firm, Oxford: Basil Blackwell, reprinted, Oxford: Oxford University Press, 1995. Poppo, Laura and Todd Zenger (1998), ‘Testing alternative theories of the firm: transaction cost, knowledge-based, and measurement explanations for make-or-buy decisions in information services’, Strategic Management Journal, 19 (2), pp. 853–77. Rumelt, Richard P. (1984), ‘Towards a strategic theory of the firm’, in R.B. Lamb (ed.), Competitive Strategic Management, Englewood Cliffs, NJ: Prentice-Hall, pp. 56–70.

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Whinston, Michael D. (2003), ‘On the transaction cost determinants of vertical integration’, Journal of Law, Economics and Organization, 19 (1), 1–23. Williamson, Oliver E. (1975), Markets and Hierarchies: Analysis and Anti-Trust Implications: A Study in the Economics of Internal Organization, New York: Free Press. Williamson, Oliver E. (1979), ‘Transaction-cost economics: the governance of contractual relations’, Journal of Law and Economics, 22 (2), 233–61. Williamson, Oliver E. (1985), The Economic Institutions of Capitalism: Firms, Markets, Relational Contracting, London: Macmillan. Williamson, Oliver E. (1995), ‘Hierarchies, markets and power in the economy: an economic perspective’, Industrial and Corporate Change, 4 (1), 21–49. Williamson, Oliver E. (1999), ‘Strategy research: governance and competence perspectives’, Strategic Management Journal, 20 (12), 1087–108. Williamson, Oliver E. (2000), ‘The new institutional economics: taking stock, looking ahead’, Journal of Economic Literature, 38 (3), 595–613. Winter, Sidney G., Jr (1964), ‘Economic “natural selection” and the theory of the firm’, Yale Economic Essays, 4 (1), 225–72.

Index Ackerberg, D. 259 active mind (Carnegie Triple) 17–18 adaptation 14, 79–80 advertising 278–9 Aggarwal, R. 30 Akerlof, G.A. 221, 226 Alchian, A.A. 3, 17, 41, 82, 94, 94–5, 96, 97–8 Allen, D. 259 Allen, D.W. 30 Allen, W.R. 94–5 alliances 207–12 Anderlini, L. 134 Anderson, E. 168 Andrews, K.R. 58 antitrust and Chicago school 230–40 and franchising 202 Aoki, M. 224–5 Argyres, N.S. 130, 131, 144–5, 148, 156, 268 Armour, H.O. 144 Arrow, K.J. 108 Arruñada, B. 200 asset ownership 98–100 transfer costs 111 vertical integration 157–8 asset specificity 80–81, 143, 167, 264 empirical challenges 158–9 and franchising 196 and governance structures 154 and hold-ups 120–25 types 168 attributes of capital goods 291 Augier, M. 85 Austrian school 281–93 and entrepreneurship 290–92 history 281–2 and transaction cost economics 282–6 autonomous adaptation 14 Azevedo, P. 246 Babcock, L. 138 Bach, G.L. 50

Bai, C.E. 197 Baker, G.P. 223 Barnard, C. 14, 20, 58–65 Barzel, Y. 44, 94, 95, 97, 108, 291 Beard, C.A. 68 Beard, M.R. 68 behavioral assumptions and transaction cost analysis 53 Behavioral Theory of the Firm 52, 53 Bell Atlantic Corp. v. Twombly 236–7 Bercovitz, J. 201 Bergen, M. 197 Big Mac Index 114 Bigelow, L. 144–5, 156 biotechnology industry 131 Blair, R.D. 186 Bolton, P. 79 Botticini, M. 259 boundary conditions economizing perspective 148 strategizing perspective 146–7 bounded rationality 42, 49, 59, 128–9, 264, 265 criticism of 266, 267 of individuals 59 and organizational economics 133–8 Bradach, J. 197, 202 Brickley, J.A. 200, 202 Brousseau, E. 3 Buchanan, J. 9 Burt, R. 90 business cycle theory and Austrian school 286 business format franchising 185–92 business strategy 140–41, 145–9 economizing approach 143–9 strategizing approach 141–3, 145–9 Camerer, C.F. 140 capital theory, Austrian school 286 entrepreneurship 290–92 Carmichael, L. 219 Carnegie Institute of Technology 8, 50 Carnegie school 49–56

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Carnegie triple 8–9, 10–18 Carrington, P.D. 71 Carter, R. 206–7, 297–8, 299 Casson, M. 292 Caves, R.E. 186 Chandler, A.D. 140 Chicago school and antitrust law 230–40 Coase, R.H. 3, 6, 18, 21, 28, 29, 30–31, 32–3, 39–47, 93–4, 97, 98, 124, 152, 153, 157, 159, 165, 171, 172–3, 263–4, 274, 300 Hayek’s influence on 77–8 Coase theorem 97 cognition 265, 266–7 Combs, J.G. 186, 191 commenda contracts 251–7 Committee on Social Thought, University of Chicago 75 Commons, J.R. 9, 66–7 communication, Barnard’s organizational theory 60 company towns 129 Conduct of Economics, The 45 consent theory of authority 60–61 context, effect on productivity 301–3 contract law 16–17 and franchising 190 and University of Wisconsin 66–70 contract selection hypothesis 245, 246, 248 long-distance trade, Middle Ages 252–7 Contracting and Organizations Research Institute (CORI) 4 contracts ex post problems 122–4 franchises 194–202 hybrid arrangements 180 incompleteness 166 solutions to potential holdups 121 structure dynamics 156 franchises 194–202 termination, franchises 201–2 terms 155 effect on franchise survival 191 cooperation 59 coordinated adaptation 14, 79–80

Corporate Control and Business Behavior 55 cosmos 77 cost, social, subjectivist approach 274–6 costly state falsification 253 costs, definitions 107–9 costs of exchange 107–15 cross-country variations 109–10, 111–12 definition 108–9 reasons for variations 109–10 variations across individuals 110, 112–13 variations in money prices 113–14 Crocker, K.J. 155, 168, 253–4 cultural factors and human resource management 226 Cyert, R. 49–53 D’Andrade, R. 17 David, R.J. 206, 297 Davis, L.E. 29 Dawes, R.M. 88 debt versus equity financing 244–58 electricity generation 247–51 trade, Middle Ages 251–7 deception and holdups 124 decision-making, Barnard’s organizational theory 61 Demsetz, H. 3, 17, 29, 41, 82, 94, 95, 97, 98, 240, 301 Dickens, W.T. 221 Director, A. 231 discipline 10–13 discrete structural analysis 54 discriminating alignment 143–5 Dixit, A.K. 142 Djankov, S. 112, 116 docility 87–90 Documentary History of American Industrial Society 67 Doherty, R. 50 Douglas, M.T. 300 Dow, G.K. 266 Dr Miles Med. Co. v. John D. Park & Sons Co. 235–6 Dreze, J. 21 Du, J. 172

Index dual distribution 196–8 Dyer, J.H. 209, 211 dynamics of contract structure 156 Eastman Kodak Co. v. Image Technical Services, Inc. 234 Economic Institutions: Spontaneous and Intentional Governance 79–80 Economic Institutions of Capitalism, The 3, 74 Economic Institutions of Strategy 5–6 Economics and Knowledge 76 economizing 9–10 economizing approach to business strategy 143–9 efficiency of organizations 269 efficient adaptation hypothesis 248 Eggertsson, T. 108, 115 Eigen-Zucchi, C. 115 Eisenberg, T. 33 electricity marketing contracts 247–51 Elster, J. 10 Ely, R. 66–7 embedded ties, disadvantages 210 empirical research, TCE 19–20, 152–6 employment relationships as rental agreements 218–19 entrepreneurship and Austrian capital theory 290–92 missing from TCE 273 Ernst, D.R. 68 ex post contractual problems 122–4 exchange costs see costs of exchange 108–9 Fan, J.P.H. 157, 158 Farrell, J. 79 Fatal Conceit, The 75 Faure-Grimaud, A. 253, 254 Federal Communications Commission 43 Felli, L. 134 Ferguson, A. 77 financial-market contracting 244–58 financial structures electricity marketing contracts 247–51 long-distance trade 251–7

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firm size limits 287–9 firm strategy and subjectivism 276–80 firm theory see theory of the firm Fischer, S. 18 Fisher Body, acquisition by General Motors 45–6, 120–24, 171 Ford Foundation 50–51, 52 foresight 128–9 formal organization 59–60 Foss, K. 100 Foss, N.J. 47, 100, 146, 273, 286, 290, 291, 292 Fowler, R. 44 franchising 185–92 franchise contracts 194–202 and free-riding 188–9 incentives 187–8, 191, 198–201 Frankfurter, F. 68 free-riding and franchising 188–9 free will, Barnard’s organizational theory 60 Freeman, R.B. 222 frequency see transaction frequency Friedman, M. 11, 12–13 Functions of the Executive, The 58 Fundamental Transformation 15 funding, franchises 195 Furubotn, E.G. 97, 108 Gallini, N.T. 197 game theory and business strategy 141–3 and transaction cost economics 10–11, 128 Garrison, L. 68 General Motors acquisition of Fisher Body 45–6, 120–24, 171 governance inseparability 130–31 Georgescu-Roegen, N. 12 Geyskens, I. 19 Ghemawat, P. 142–3 Ghosh, M. 146 Gibbons, R. 20 Gifford, S. 134 Gilson, R.J. 72 Glachant, J.-M. 3 Goerzen, A. 210 Goldberg, V. 47

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governance 9 and trust 209–10 governance inseparability 129–31 governance mechanisms 245 hybrid arrangements 180–81 governance structures 166–7 franchising 195–8 Graduate School of Industrial Administration, Carnegie Institute 8, 50 Greif, A. 33, 183 Grossman, S. 31, 79 Guetzkow, H. 51 Han, S. 206, 297 Hancock, G. 251 Handbook of Organizational Economics 20 Hansmann, H. 249 Harris, R. 71 Hart, O. 5, 31, 96, 100, 134, 244, 245 Hashimoto, M. 219 Haskel, J. 114 Hayek, F.A. 14, 28, 74–82, 281, 283, 284 He, D. 172 Heide, J.B. 299 Hennessy, D. 196 Hill, C.A. 156 Hill, C.W.L. 88, 211 History of Labor in the United States 67 Hodgson, G.M. 206–7, 297–8, 299, 301, 302 holdups 120–25, 166 contractual solutions 121 franchising 196 reasons for 124–5 Hubbard, R.G. 159 human actors 13–14 human resource management and TCE 222–6 Hurst, J.W. 67–9, 71 hybrid organizations 153–4, 167, 170, 176–83 definitions 176–8 governance mechanisms 180–81 reasons for 179–80 and transaction cost framework 206 typology 181–3

IKEA, cross-country price comparison 114 Illinois Tool Works, Inc. v. Independent Ink, Inc. 234 incentives and Austrian school 284–5 and franchising 187–8, 191, 198–201 inducement-contributions balance 61–2 informal organization 60 innovation policy, subjectivist perspective 277–8 institutional arrangements 29–30 and employment transaction costs 219 and organizational performance 221–2 institutional change, subjectivist perspective 279–80 institutional economics 28, 67 institutional environment 29–30 and costs of contracting 43 institutions 27–8, 224–5 intelligent altruism 87–90 interdisciplinary approach 13–17 intertemporal regularities 14–16 Jacobsen, J.P. 216 Jensen, M.C. 42, 222 John, G. 146, 299 Joskow, P.L. 155, 159, 168, 233 Kahn, S. 220 Kaufman, B.E. 215 Kaufmann, P.J. 200 Kennedy, A.M. (Justice) 235–6 Keynes, J.M. 75 King, B.G. 72 King, E. 71 Kirzner, I.M. 78, 287 Klein, B. 3, 45, 47, 125, 171, 172, 188, 232 Klein, P.G. 3–4, 27, 47, 273, 290 Kleiner, M.M. 222 Knight, F.H. 9–10, 290 Knudsen, T. 88, 301, 302 Kochin, L. 44 Kraakman, R. 249 Kranton, R.E. 226 Kreps, D. 21, 128

Index La Porta, R. 33 labour economics and TCE 216–22 labour markets 215–16 Lachmann, L.M. 81, 290 Lafontaine, F. 186, 188, 189, 197, 200 Lang, L. 157 Lange, O. 15 Langlois, R.N. 292 law legal processes to open new businesses 112 and new institutional economics 31 and ownership 98–9 see also antitrust; contract law; property rights Law and the Conditions of Freedom 69 Lazear, E.P. 223 leadership, Barnard’s organizational theory 62–4 Leegin Creative Leather Products, Inc. v. PSKS, Inc. 235–6 Legal Realists 67, 68 Levitt, S. 5 Levy, B. 246 Liebeskind, J.P. 130, 131, 148, 268 linear compensation 249 Llewellyn, K.L. 16 Loewenstein, G. 138 London School of Economics and Political Science 75 long-distance trade, Middle Ages, financial structure 251–7 long-standing ties, disadvantages of 210 Lueck, D. 259 Lutz, N. 196, 197 M-form hypothesis 144 Macaulay, S. 69–70, 71–2, 180 Macher, J.T. 152 Macneil, I.R. 66, 70, 72 Madhok, A. 207, 211 make-or-buy decision 153–4, 165–72 see also vertical integration maladaptation costs 166 Maness, R. 196 March, J.G. 49–54, 56, 85 Mariotti, T. 253, 254 Markets and Hierarchies 3, 78 Mas-Colell, A. 141

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Maskin, E. 137 Masten, S.E. 144, 155, 156, 159, 168, 170, 298, 299 Mayer, K.J. 144, 156 McMillan, J. 17–18 Mechanisms of Governance, The 3, 46, 49 Meckling, W.H. 42, 222 Ménard, C. 3 Menger, C. 81, 281–2, 283 menu costs 221 Michael, S.C. 188, 189, 191, 200 Milgrom, P.J. 135, 220, 269–70, 300 Miller, G.P. 33 Miller, M. 18, 244 Mises, L. von 74, 284, 285, 290 Missouri, University of 4 Modigliani, F. 18, 244 monetary incentives, franchising 198–9 money price variations 113–14 Monteverde, K. 298 Mookerji, S. 134 Moore, H.J. 188, 200 Moore, J. 31, 244, 245 moral commitment 63–4 Morgan, J. 253–4 motivation 265, 266–7 employees 219–20 multi-unit ownership, franchises 201 Murphy, W.F. 186 Muth, J. 21 Nalbantian, H.R. 222 Nalebuff, B.J. 142 Nature of the Firm, The 18, 39 neoclassical contract law 190 neoclassical economics 127 network governance 211 Nevitt, J. 251 new institutional economics 27–32 Newell, A. 12 Nickerson, J.A. 144, 146, 156, 172 Nobel Prizes 3–4 nominal wage dynamics 220–21 Non-Contractual Relations in Business: A Preliminary Study 70 North, D.C. 27, 28, 29, 32, 87, 95–6, 115, 224, 225 Norton, S.W. 190

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O’Driscoll, G.P. 286 O’Reilly, C.A. 222 Occam’s Razor 85 operationalization 18–20 opportunism 14, 86–7, 264, 266–7 orders 81, 283 organization theory 8–9, 13–16 inventory of 51 organizational adaptation 54 organizational design, effect on performance 155–6 organizational economics and bounded rationality 133–8 organizational performance see performance organizational theory 58–64 Organizations 49, 51, 53 Ostrom, E. 4 ownership see asset ownership Oxley, J. 246 Oyer, P. 220 Parcell, J. 155 path dependencies 15–16 Pejovich, S. 97 people management224–5 per se rule 236 performance and institutional arrangements 221–2 and organization form 155–6 Perrow, C. 58 personnel economics 223 persuasion 278–9 Petrin, A. 251 Pfeffer, J. 222 Pirrong, S.C. 159 planned orders 283 Plant, A. 39 plausibility 12 plural form, franchising 196–8 Poppo, L. 210 Porter, M.E. 140, 141 Posner, R.A. 232 post-Chicago school (PCS) 233–4 predatory pricing 238–9 Prendergast, C. 223 principle-agent theory 284–5 private ordering 11, 66–70 Problem of Social Cost, The 43–4

process analysis 53–4 productivity, effect of context 301–3 property rights 93–6 and Austrian school 284–5 and institutional economics 31 and transaction costs 96–8 property rights economics 92–101 and transaction cost economics 97–8 public authorities and hybrid arrangements 181 Pure Theory of Capital, The 75 quasi-rents 158–9 Ramsey, J. 69 Raushenbush, E.B. 71 relationship-specific investments 207–8 remediableness 12, 269 remote company towns 129 rental agreements, employment relationships as 218–19 Richman, B.D. 152 Richter, R. 108 Rise of American Civilization 68 Rivers, D. 251 Rizzo, M.J. 286 Roberts, J. 20 Roberts, J. (Justice) 230, 234–9, 240 Roberts, J.D. 135, 269–70, 300 Roberts Court 230, 234–9 Robertson, D.H. 77 Rogers, E.M. 278 Rothbard, M.N. 82, 288–9 Rubin, P.H. 186, 195 Sachs, J.D. 116 Salerno, J.T. 284 Saloner, G. 148 Saussier, S. 42–3, 155, 159 Schaffer, S. 220 Schotter, A. 88–9, 222 Schutz, A. 275, 276 Scott, F.A. 197 Scott, W.R. 59 Segal, I.R. 125 self-enforcement, franchise contracts 199–200 self-interest 14 Selznick, P. 14, 15, 58

Index Shapiro, C. 142 Shaw, K.L. 197 Shirley, M. 3 Silva, V. 246 Silverman, B.S. 144, 156 Simon, H.A. 10, 49, 51–2, 56, 58, 85–90, 183, 219, 264 simple contractual schema 24–6 simplicity 11 Singh, H. 209 Sjöstrand, S.-E. 273 Skillman, G.L. 216 Slade, M.E. 186 Smith, A. 86, 88 Smith, D.G. 72 social cost, subjectivist approach 274–6 socialist economics and Austrian school 283–4 Solow, R. 11–12, 17 Souter, D.H. (Justice) 237 specific investments 145 specificity 80–82 and transaction costs, labour contracts 218 see also asset specificity Spiller, P. 246 spontaneous orders 79, 283 Stigler, G. 44 Stiglitz, J.E. 79 strategic alliances 207–10 strategic commitment 142 strategizing approach to business strategy 141–3, 145–9 strategy and transaction costs 205–12 Strauss, S. 21 subjectivism 273–80 sunk costs 145 Sykuta, M.E. 3–4, 155 tacit knowledge 76 Tallman, S.B. 207 Tao, Z. 197 taxis 77 Teece, D.J. 141, 144, 146–7 termination franchise contracts 201–2 Thaler, R.H. 88 Theory of Industrial Organization, The 142 Theory of Moral Sentiments, The 86–7

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theory of the firm 39–44, 233 and Austrian school 281–93 Chicago School and TCE approaches 233 critiques of 265–9 thin and thick notions of bounded rationality 135–6 Thomas, C. (Justice) 238 Tirole, J. 137, 142, 145 Townsend, R. 253 Train, K. 251 transaction as unit of analysis 127–32 limitations 129–31 transaction cost economics characteristics 263–5 criticisms of 265–9, 273, 297–302 empirical analysis 152–60, 206–7, 297–9 and human resource management 222–6 and labour economics 216–22 limitations 129–31, 297–303 and new institutional economics 30–31 transaction costs definition 107–8 and institutional economics 30–31 and labour contracts 217–20 and property rights 96–8 see also costs of exchange transaction frequency 42, 264 labour contracts 217–18 trust 209–10, 208 two-stage conditional maximum likelihood method (2SCML) 251, 258 uncertainty 42–3, 264 and labour contracts 218 union wage rigidities 221 Use of Knowledge in Society, The 76 value creation and alliances 207–9 Vanden Bergh, R. 146 Veblen, T. 67 vertical integration 19, 165–72 empirical challenges 157–8 preventing holdups 123–4 and social networks 211 subjectivist perspective 276–7

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Vertical Integration, Appropriable Rents, and the Competitive Contracting Practice 45 Vertical Integration of Production, The 55 veto provision 248 Vuong, Q. 251 Wachter, M.L. 221 wage rigidities 220–21 Wallis, J.J. 115 Warner, A.M. 116 Wealth of Nations, The 86 Weber, M. 275 Weyerhaeuser Co. v. Ross-Simmons Hardwood Lumber Co. 237–9 Whinston, M.D. 125, 126

Williamson, D.V. 247 Williamson, O.E. 3, 4, 5, 28, 29, 31, 41, 43, 44, 46, 49, 50–51, 54–6, 64, 66, 70, 74, 85, 87, 96, 124, 125, 129, 134, 136, 143, 147, 148, 149, 152, 154, 155, 166–7, 168, 169, 172, 186–7, 191, 197, 205, 206, 208, 210, 221, 224, 232, 245, 264, 265, 269, 281, 287, 297, 298, 303 influence of Hayek 78–81 Wisconsin, University of 66–70 Witt, U. 291–2 Wolf, R. 114 Wolf, W.B. 61 Yellen, J.L. 221 Yu, B.T. 219