Peter Klein e Michael Sykuta - The Elgar Companion To Transaction Cost Economics PDF
Peter Klein e Michael Sykuta - The Elgar Companion To Transaction Cost Economics PDF
Peter Klein e Michael Sykuta - The Elgar Companion To Transaction Cost Economics PDF
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
Published by
Edward Elgar Publishing Limited
The Lypiatts
15 Lansdown Road
Cheltenham
Glos GL50 2JA
UK
PART I INTRODUCTION
1 Editors’ introduction 3
Peter G. Klein and Michael E. Sykuta
2 Transaction cost economics: an overview 8
Oliver E. Williamson
3 Transaction cost economics and the new institutional
economics 27
Peter G. Klein
4 Ronald H. Coase 39
Michael E. Sykuta
5 Cyert, March, and the Carnegie school 49
Mie Augier
6 Chester Barnard 58
Joseph T. Mahoney
7 Commons, Hurst, Macaulay, and the Wisconsin legal tradition 66
D. Gordon Smith
8 F.A. Hayek 74
Peter G. Klein
9 Herbert Simon 85
Saras Sarasvathy
10 Property rights economics 92
Nicolai J. Foss
v
vi The Elgar companion to transaction cost economics
PART IV APPLICATIONS
Index 307
Contributors
vii
viii The Elgar companion to transaction cost economics
INTRODUCTION
1 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 impor-
tant, 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 cri-
tiques. This volume aims to introduce the novice, and to inform the spe-
cialist, 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
4 The Elgar companion to transaction cost economics
Prize highlighted a continuing tension about the role and place of TCE,
narrowly defined, within the more general field of organizational econom-
ics. 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 con-
tribution 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.
References
Alchian, A.A. and H. Demsetz (1972), ‘Production, information costs, and economic organi-
zation’, 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-the-
nobel-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.
Editors’ introduction 7
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 considera-
tions’, 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 rela-
tions’, 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
Introduction
8
An overview 9
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 class-
room. 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: ‘mutual-
ity 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 gov-
ernance 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 govern-
ance 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
10 The Elgar companion to transaction cost economics
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
An overview 11
Pragmatic methodology
Describing himself as a native informant rather than as a certified method-
ologist, 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 plau-
sible 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 pri-
oritize: ‘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.
12 The Elgar companion to transaction cost economics
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 congru-
ent with the data are more influential.9 Milton Friedman’s reflections on
An overview 13
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 analy-
sis 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 self-
contained 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 reason-
ing 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 pre-
serve 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 pres-
ently, 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
14 The Elgar companion to transaction cost economics
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, admin-
istrative 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 frame-
work’, where the framework ‘never accurately indicates real working rela-
tions, 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 coor-
dinated 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
An overview 17
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
18 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.
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 economiz-
ing 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 externali-
ties (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 effi-
cient 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 whatso-
ever 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
An overview 19
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 under-
going 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 else-
where (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 econom-
ics 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 eco-
nomics 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 text-
book 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 21
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.
2. Jacques Dreze, who was a visitor at Carnegie, speaks for me and many others in recall-
ing his time at Carnegie as follows: ‘Never since have I experienced such intellectual
excitement’ (1995, p. 123).
3. 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 eco-
nomics 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 opera-
tional content into them.
4. ‘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.
5. 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.
6. Jack Muth, in his low-key way, suggested to me (when I was working on my disserta-
tion 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.
7. 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.
8. See Coase (1964) and Harold Demsetz (1967).
9. 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 cumula-
tive 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).
10. Personal communication, 6 February 2006, from Milton Friedman to the author.
11. As I have discussed elsewhere, parts of the ‘resource dependency’ literature are perti-
nent but fail to push the logic to completion. Of special relevance to TCE is the poten-
tially 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.
12. 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.
13. For an early and primitive effort to work up the dynamics of managerial discretion, see
Williamson (1970, Chapter 5).
22 The Elgar companion to transaction cost economics
14. ‘In general, much cruder and simpler arguments will suffice to demonstrate an inequal-
ity between two quantities than are required to show the conditions under which these
quantities are equated at the margin’ (Simon, 1978, p. 6).
15. Corporate governance provides a recent example of the interaction of theory and evi-
dence. 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).
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Appendix
A (unassisted market)
k=0
B (unrelieved hazard)
s =0
C (hybrid
k>0 contracting)
market support
s >0
administrative support
D (internal
organization/firm)
humanly devised constraints that structure political, economic and social inter-
action. They consist of both informal constraints (sanctions, taboos, customs,
traditions, and codes of conduct), and formal rules (constitutions, laws, prop-
erty 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.
27
28 The Elgar companion to transaction cost economics
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 insti-
tutionalists 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 appreci-
ates 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.
New institutional economics 29
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 institu-
tional arrangements’.
Levels of analysis
The NIE can be divided into two branches following Davis and North’s
(1971) distinction between the ‘institutional environment’ and ‘institu-
tional 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 par-
ticular 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 analy-
sis: 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 moment-
by-moment, while changes in governance, aiming to align governance
30 The Elgar companion to transaction cost economics
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 repu-
tation 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 contrac-
tual incompleteness. (See Chapter 10 in this volume by Foss on property-
rights economics for more detail.)
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 institutional-
ism, 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, system-
atic, 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 cir-
cumstances, 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
New institutional economics 33
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).
4. 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 rela-
tionships between institutions and growth. See Beck and Levine (2005) and La Porta et
al. (2008) for recent overviews.
5. 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 con-
glomerate’s corporate staff (Bhide, 1990; Williamson, 1992).
6. 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 deliber-
ately 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.
7. See Chapter 10 in this volume by Foss on ‘property rights economics’ for more on the eco-
nomic analysis of property rights and its relationship to transaction cost approaches.
8. 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.
9. 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.
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Cambridge Journal of Economics, 30 (3), 389–402.
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3 (2), 70–81.
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Cambridge: Cambridge University Press.
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New institutional economics 35
PRECURSORS AND
INFLUENCES
4 Ronald H. Coase
Michael E. Sykuta
39
40 The Elgar companion to transaction cost economics
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 impos-
sibility 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 neces-
sary 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.
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 advan-
tage 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 neces-
sary 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.
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 deci-
sion 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.
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 prevail-
ing 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 contribu-
tions 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’.
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.
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) considera-
tion of the firm as a governance structure; (4) the idea that property rights
and contracts are problematic; (5) reliance on discrete structural alterna-
tives; 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:
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 func-
tions 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 out-
lined 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.
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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.
48 The Elgar companion to transaction cost economics
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 (hyperrational-
ity 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
50 The Elgar companion to transaction cost economics
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 (origi-
nally 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 engi-
neering 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 busi-
ness 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 depart-
ment 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 dif-
ferent 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, rou-
tines, learning, and satisficing. They used ideas from social science more
broadly to advance understanding of economics and, in the process, con-
tributed 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
Cyert, March, and the Carnegie school 51
on ‘A Behavioral Theory of the Firm’ (see below) and was on the econom-
ics of managerial discretion.
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.
52 The Elgar companion to transaction cost economics
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 reflect-
ing experienced or anticipated dissatisfaction.
Cyert, March, and the Carnegie school 53
Behavioral assumptions
From the outset, TCE has consciously been aware of the significance
of the behavioral assumptions (contrary to much of neoclassical eco-
nomics) (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 par-
ticular 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 politi-
cal 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):
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), pro-
cedures 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 rou-
tines 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.
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 mana-
gerial 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 self-
interest. 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 con-
ditions 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 organiza-
tional 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).
Cyert, March, and the Carnegie school 57
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 considera-
tions’, 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 struc-
tural 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 pur-
poses; (3) bounds on rationality are acknowledged; (4) adaptive, sequen-
tial 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 prac-
tice; 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, judg-
ment, stewardship and professionalism, and connects ethical and practical
teachings. Barnard’s (1938) impact on organization theory is well docu-
mented (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 insti-
tutional 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, phi-
losophy, political science, psychology, and sociology. It presents a systems
view of organizations containing a psychological theory of motivation and
58
Chester Barnard 59
Structural concepts
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 manage-
ment. 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
60 The Elgar companion to transaction cost economics
Informal organization
Barnard maintains ‘“learning the organization ropes” in most organiza-
tions as chiefly learning who’s who, what’s what, why’s why, of its infor-
mal 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 indi-
vidual, which is central in managing personnel where hypocrisy is identi-
fied 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 obli-
gations: ‘the idea of free will is inculcated in doctrines of personal respon-
sibility, 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 effec-
tively in language, oral and written (Barnard, 1938, p. 89). Tacit under-
standings are often essential (ibid., pp. 301–22).
nothing but the balance sheet keeps these non-economic motives from running
wild. Yet without all these incentives, I think most business would be a lifeless
failure (1948, p. 15).
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).
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 respon-
sibility. 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 execu-
tive. Responsibility means honor and faithfulness in the manner that man-
agers 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:
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).
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 depersonal-
ized; forming purposes and being forced to change them, searching for limita-
tions 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 cooper-
ate; that only as they choose to work together can they achieve the fullness of
Chester Barnard 65
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 con-
dition 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 contempo-
rary 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, nega-
tive 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 transac-
tion 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.
66
Commons, Hurst, Macaulay, and the Wisconsin legal tradition 67
history of labour in the United States. Commons suggested that the col-
lection 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 transac-
tions’ (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 con-
tracts, 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
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 sys-
tematic 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 71
2. Asked about the influence of Commons on his own thinking, Stewart Macaulay com-
mented, ‘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 communica-
tion, 5 May 2009).
3. 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:
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.
5. 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).
6. 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. 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).
8. Despite Macaulay’s focus on non-contractual relations, he does not argue that con-
tracts are irrelevant. Indeed, he observed that ‘many business exchanges reflect a high
degree of planning’ (Macaulay, 1963a, p. 60).
9. 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
72 The Elgar companion to transaction cost economics
sue in these negotiations. Even where the parties have a detailed and carefully planned
agreement which indicates what is to happen if, say, the seller fails to deliver on time,
often they will never refer to the agreement but will negotiate a solution when the
problem arises apparently as if there had never been any original contract.
10. Macaulay (1963a) ranks fifteenth on Shapiro’s (1996) list of all-time most highly cited
law review articles.
11. 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).
12. 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 fun-
damental nature of the theory, and I would worry more if there had been no changes’
(Macneil, 1987, p. 273, n. 4).
13. Notable exceptions include Ellickson (1991), Bernstein (1992), and Crocker and Masten
(1991).
14. For a survey of empirical studies of contracts, see Smith and King (2009, pp. 19–24).
15. 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 scholar-
ship” 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.
Commons, Hurst, Macaulay, and the Wisconsin legal tradition 73
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
74
F.A. Hayek 75
for his work on knowledge in the 1930s and 1940s (Hayek, 1937, 1945).
Specialists in business-cycle theory recognize his early work on indus-
trial 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 empha-
sis 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 busi-
ness 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 individu-
als 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).
order and can never be deliberately made over in the way that the opera-
tors 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.
on. Within the firm, the entrepreneur may be able to reduce these ‘transac-
tion 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 infor-
mation 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
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 pro-
duced 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 spe-
cialization 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, verti-
cal 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
82 The Elgar companion to transaction cost economics
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 alloca-
tion 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 eco-
nomic 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 macroeco-
nomics’, American Economic Review, 86 (2), 181–6.
F.A. Hayek 83
85
86 The Elgar companion to transaction cost economics
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 argu-
ments 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 understand-
ing 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 spon-
taneous 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 assump-
tion 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
Herbert Simon 87
More recently, Knudsen (2003) has argued for the role of docility in the
emergence of altruism in biological populations. The case for the evolu-
tionary dominance of intelligent altruists is also well-argued from perspec-
tives 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 behav-
iour. 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 per-
suade which so much prevails in human nature . . . We ought then to mainly cul-
tivate 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)
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 custom-
ers 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 oppor-
tunism, 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) Laboratory subjects tend to follow the advice of naïve advisors (i.e. advi-
sors who are hardly more expert in the task at hand than they are).
(ii) This advice changes their behavior in the sense that subjects who play
Herbert Simon 89
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 contrib-
utes 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 theo-
rized 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 fun-
damental 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 com-
petition 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.
90 The Elgar companion to transaction cost economics
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 con-
tribute 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.
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Herbert Simon 91
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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.
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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
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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
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York: Free Press.
Williamson, O.E. (1985), The Economic Institutions of Capitalism, New York: Free Press.
10 Property rights economics
Nicolai J. Foss
92
Property rights economics 93
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 funda-
mental 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 utility-
maximization 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 spe-
cific 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 think-
ing 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
94 The Elgar companion to transaction cost economics
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:
[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 deal-
ings with others. These expectations find expression in the laws, customs, and
mores of a society. An owner of property rights possesses the consent of fellow-
men 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 prop-
erty 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 distin-
guishing 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 property-
rights arrangements in the form of contracts and organizations and the
96 The Elgar companion to transaction cost economics
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 refer-
ence 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 non-
human 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 impor-
tance of non-human assets derives from their (potential) function as bar-
gaining 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 non-
cooperation (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
100 The Elgar companion to transaction cost economics
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 publica-
tion of Grossman and Hart, 1986), property rights have received attention
mainly because of the new PRE. It might thus appear that the old PRE
Property rights economics 101
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 rela-
tively 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 pat-
terns 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
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The Public Stake in Union Power, Charlottesville, VA: University of Virginia Press, pp.
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zation’, 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
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Allen, D. and D. Lueck (1998), ‘The nature of the farm’, Journal of Law and Economics, 41
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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.
102 The Elgar companion to transaction cost economics
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
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resource’, Journal of Law and Economics, 13 (1), 49–70.
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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.
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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.
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of efficient allocation in a capitalist economy’, Journal of Institutional and Theoretical
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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.
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Jones, G.R. (1983), ‘Transaction costs, property rights, and organizational culture: an
exchange perspective’, Administrative Science Quarterly, 28 (3), 454–67.
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Property rights economics 103
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erations’, American Economic Review, 61 (2), 112–23.
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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)
Definitions of costs
Transaction costs
Transaction costs are frequently invoked to explain economic phenom-
ena.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
108 The Elgar companion to transaction cost economics
[T]ransaction costs include the costs of resources utilized for the creation, main-
tenance, 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 exist-
ing 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 transac-
tion 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).
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 non-
competitive 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.
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
Table 11.1 Bulgaria 2000: How did you register your firm, how many
days did that take, and how much did it cost?
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 substan-
tially 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 econo-
mists 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 cred-
ible 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
The costs of exchange 115
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 measur-
ing opportunity costs are likely to be especially high. In a study of corrupt
regulatory practices faced by business owners in Ukraine, expensive inter-
views that guaranteed anonymity yielded substantially different estimates
of the costs of corruption than studies using more conventional interview-
ing 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 aux-
iliary 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 price-
theoretic model will be enhanced by considering as the relevant price the
opportunity costs that individuals actually face.
Notes
1. Substantial portions of this chapter are adapted from Benham and Benham (2000).
2. 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.
3. 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.
4. Eggertsson continues (1990, p. 15):
5. the enforcement of a contract and the collection of damages when partners fail
to observe their contractual obligations;
6. the protection of property rights against third-party encroachment – for
example, protection against pirates or even against the government in the case
of illegitimate trade.
5. 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.
6. See for example the discussion of personal and impersonal exchange in North et al.
(2009).
7. 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 vari-
ables explain this, or that there is a bias resulting from other unobserved growth deter-
rents. They find that resource-abundant countries tend to be high-price economies and
to miss out on export-led growth.
8. An individual possessing what Hayek (1945) termed ‘local knowledge’ can typically
accomplish things faster, better, and cheaper than individuals without that local knowl-
edge. This means lower transaction costs in that domain for that individual. Local
knowledge differs across individuals and is much less transparent than market price.
9. 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 infor-
mal 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.
10. 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 neces-
sary exchanges to start producing in the informal sector, different groups would likely
have a comparative advantage in that setting.
11. ‘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 trans-
action 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).
12. Big Mac Index from The Economist, 4 February 2009.
13. 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).
14. 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).
15. 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.
16. Djankov et al. (2000) use the officially stated number of steps, fees, and times required
to obtain permission to open a new business.
17. Among the few exceptions is the work by Stone et al. (1996).
The costs of exchange 117
18. 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 transac-
tions 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.
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The costs of exchange 119
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12 Asset specificity and holdups
Benjamin Klein
Specific assets are assets that have a significantly higher value within a par-
ticular 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 Motors-
specific 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
Asset specificity and holdups 121
any automobile body supply contract. Rather than attempt to specify per-
formance 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
The major problem here is a semantic one because of the misleading con-
notation 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
Asset specificity and holdups 125
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 lit-
erature 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 specifi-
city, physical asset specificity, human asset specificity, temporal specificity, and brand
name capital (Williamson, 1991). We now know that the important General Motors-
specific 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 Motors-
specific 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 expi-
ration of the Trust General Motors could not use its 60 percent ownership share to uni-
laterally 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 prop-
erty rights theory of the firm originally proposed by Grossman and Hart (1986).
126 The Elgar companion to transaction cost economics
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 organiza-
tion 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 incen-
tives 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.
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13 The transaction as the unit of analysis
Nicholas Argyres
127
128 The Elgar companion to transaction cost economics
its entirety. That is, it is important to recognize that while actors’ ration-
ality 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 far-
sightedness 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 sta-
tistical inferences, altruistic feelings towards strangers, and other behav-
iors 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
130 The Elgar companion to transaction cost economics
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 sequen-
tial 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 gov-
erned. That is, it becomes subject to firm-wide policies that do not distin-
guish 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 indus-
try 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 acquir-
ing 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 tra-
ditional research areas who act (or threaten to act) out of envy or concern
for relative income and status. Whatever the precise underlying motiva-
tion, 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 oth-
erwise difficult to explain using the tools of neoclassical economics. On
the other hand, there appear to be cases where the transaction is not the
132 The Elgar companion to transaction cost economics
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14 Bounded rationality and organizational
economics
Nicolai J. Foss
133
134 The Elgar companion to transaction cost economics
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 exag-
geration. The fact remains that very large parts of organizational econom-
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paradigm of agency theory (Holmström, 1979) rules out BR.
More generally, most contemporary organizational economics research
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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
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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
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stream 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).
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 formal-
izing 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 condi-
tions 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 regulari-
ties 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
138 The Elgar companion to transaction cost economics
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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
140
Economizing and strategizing 141
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 speak-
ing, 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.
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 deci-
sions. One is capacity expansion in the titanium dioxide industry for the
purpose of pre-emption, and the other is capacity reduction in the declin-
ing chemical industry (Ghemawat, 1997).
and Richman, 2008; Masten, 1995; Shelanski and Klein, 1995), most
empirical studies on TCE are preoccupied with testing whether the dis-
criminating 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 (pipefit-
ting). 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 outsourc-
ing or insourcing. This asymmetric impact on profits shows that for differ-
ent 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 pre-
shakeout stage and during the post-shakeout phase. They found that
Economizing and strategizing 145
et al. (1997, p. 513) argue that strategizing ‘is most relevant when competi-
tors 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 com-
petitors within an industry. The relevance of game-theoretical predictions
decreases as the number of market participants increases because develop-
ing 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.
Conclusion
In this chapter we introduced the literature on economizing and strate-
gizing 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 intersec-
tion of strategizing and economizing of business strategy and their bound-
ary 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.
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Economizing and strategizing 151
152
Empirical methods in transaction cost economics 153
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.)
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 agree-
ments 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 repre-
sent 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 vari-
able. 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 pro-
vides 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 survi-
vorship 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
Empirical methods in transaction cost economics 155
[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.
little work has been done directly examining the performance (or transac-
tion cost) implications of governance design and the dynamics of govern-
ance 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 chal-
lenges 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 perform-
ance, 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 persist-
ence of poorly written contract documents, explaining how judicial insti-
tutions 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.
Empirical methods in transaction cost economics 157
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 inte-
gration is not well defined either in the NIE or in the traditional industrial
organization literature. The unanswered question regarding vertical inte-
gration 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 impli-
cations. 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 verti-
cally 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 consec-
utive 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 neces-
sary nor sufficient condition for managerial (or non-price) coordination
158 The Elgar companion to transaction cost economics
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 oppor-
tunistic 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
Empirical methods in transaction cost economics 159
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
160 The Elgar companion to transaction cost economics
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PART IV
APPLICATIONS
17 Vertical integration
Peter G. Klein
165
166 The Elgar companion to transaction cost economics
by which organizations adapt and change, along with the costs of mis-
alignment 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 amend-
ments or an overprotective bankruptcy code. In short, efficient alignment
between transactions and governance should be expected only if the selec-
tion 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 organi-
zation, 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 inter-
nal 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 underin-
vestment problem associated with specific assets and market governance is
fairly well understood.
Conclusion
Despite these and other challenges, the transaction cost theory of the firm
has had remarkable success in explaining the vertical structure of the enter-
prise. Indeed, the empirical literature on the make-or-buy decision is gen-
erally 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,
172 The Elgar companion to transaction cost economics
p. 55) that TCE is ‘an empirical success story’. But even the negative atten-
tion TCE sometimes draws is a testament to its influence in the theory and
practice of vertical boundaries.
Notes
1. 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).
2. This contrasts with the agency-theoretic literature (for example, on franchise contracts),
which generally works within a complete-contracting perspective.
3. 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).
4. More generally, contractual difficulties can arise from several sources: ‘(1) bilateral
dependence; (2) weak property rights; (3) measurement difficulties and/or oversearch-
ing; (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.
5. Most of the literature assumes that, for each transaction or class of transactions, there
exists a uniquely optimal governance structure. Sometimes, however, we observe bi-
sourcing, 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.
6. 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.
7. 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).
8. 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).
9. 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).
10. 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 exag-
gerated 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
Vertical integration 173
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 cir-
cumstances, 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.
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of learning and transaction cost perspectives’, Academy of Management Review, 32 (4),
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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:
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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.
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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 verti-
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174 The Elgar companion to transaction cost economics
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Vertical integration 175
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18 Hybrid organizations
Claude Ménard
176
Hybrid organizations 177
a unifying theory that could properly identify the nature of these arrange-
ments and the logic underlying their diversity.
To fix ideas about what can be assembled under the term ‘hybrid organi-
zations’, 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, par-
ticularly 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 contract-
ing 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 arrange-
ment 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 specifi-
city. Strategic alliances in the airline industry, groups of producers com-
mitting 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 implement-
ing 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
178 The Elgar companion to transaction cost economics
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 temp-
tations. 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 asym-
metries 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 transla-
tion of protocols at low cost. Although information technologies play
an important role in that respect, numerous studies also show the signifi-
cance 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 tighten-
ing 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
Hybrid organizations 181
Formal
authority
Monitoring centre
leadership
Relational-
Informational based
networks agreements
Benefits of coordination/control
Notes
1. This terminology is convenient in that it embeds hybrid types of organizational arrange-
ments in a well-defined framework, as argued below. It also has its drawbacks in sug-
gesting 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 connota-
tion 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 informa-
tion channels in a particularly challenging institutional environment.
5. Ryall and Sampson (2006) illustrate this aspect well.
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184 The Elgar companion to transaction cost economics
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Theoretical Economics, 160 (3), 345–76.
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tractuels et ordre privé, PhD dissertation, Université de Paris (Panthéon-Sorbonne).
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Evidence from technology alliance contracts’, in A. Arino and J. Reuer (eds), Strategic
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tural alternatives’, Administrative Science Quarterly, 36 (2), 269–96.
19 Franchising
Steven C. Michael
185
186 The Elgar companion to transaction cost economics
Research contribution
Franchising has two characteristics that distinguish it from other interor-
ganizational 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 geographi-
cally. 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 hypoth-
eses. And franchise chains exist in numbers large enough for statistical
analysis.
Franchising has been a subject of interest for students of the econom-
ics 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 com-
bining 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:
in both the restaurant and hotel industries. These two studies uniquely
compared franchised chains and chains that do not franchise. In addi-
tion, Lafontaine (1999) showed that prices are higher at franchised outlets
than company-owned outlets in restaurant chains. Thus, while franchis-
ing 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 free-
riding.
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 advertis-
ing were negatively related (presumably the chain is advertising lower
prices) among firm-owned chains as recommended by marketing prac-
tice. 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 adver-
tising 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.
Conclusion
Franchising research has largely supported the research program of the
incipient science of organization. Moreover, the use of a different theo-
retical 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, franchis-
ing 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 success-
fully 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 con-
tinue to be a valuable subject for transaction cost economics research.
192 The Elgar companion to transaction cost economics
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.
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Franchising 193
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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, fran-
chised 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 franchis-
ing. 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 miti-
gate 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 fran-
chised units within the same chain. While this sequence might not corre-
spond to the real decision-making process, it is a useful expository device.
Moreover, if a chain decides to rely partly on franchising as an alterna-
tive to vertical integration, it must still decide what the (formal) contract
should look like (see James, 2000, for a distinction similar in spirit).
194
The structure of franchise contracts 195
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 com-
bined 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 devi-
ating 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 expira-
tion, the value of ‘cooperative behaviour’ must include not only this rent,
but also rent associated with future additional outlets, and with the prob-
ability of contract renewal.6
In this context, specific contract terms play different roles (Klein, 1995).
Some terms specify certain franchisee obligations, for example, manda-
tory 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
200 The Elgar companion to transaction cost economics
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 indi-
vidual outlets. First, the chain decides on the extent of vertical integration.
Second, the chain designs the contractual provisions of franchise agree-
ments. Monetary as well as non-monetary provisions respond to incen-
tives and coordination issues. More generally, these margins are largely
explained by expected contractual hazards, either vertical (between fran-
chisees 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 theo-
retical 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 real-
world 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 essen-
tial parts of the enforcement mechanism needed to mitigate opportunistic
202 The Elgar companion to transaction cost economics
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 requir-
ing 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.
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21 Strategy and transaction costs
Laura Poppo
205
206 The Elgar companion to transaction cost economics
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
Strategy and transaction costs 211
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214 The Elgar companion to transaction cost economics
Kaufman (2005) suggests that the practice of labour economics and indus-
trial 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 con-
tracting failures suggest that fashions are changing. Transaction cost eco-
nomics (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 manage-
ment? This chapter offers some answers to this question by first enumer-
ating 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.
215
216 The Elgar companion to transaction cost economics
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 maximiza-
tion, 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 calcula-
tion 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.
improvements in the value of human capital and any returns to this capital
that are generated outside the rental agreement (either after its termina-
tion 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 employ-
ment 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 relation-
ship 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 pro-
ductivity 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 relation-
ship. For example, the pay mechanism may be altered to reflect the needs
of a particular environment. Several authors show that deferred compen-
sation (for example, pensions) can provide worker motivation (Lazear,
1979; Medoff and Abraham, 1980). Others show that relative performance
220 The Elgar companion to transaction cost economics
[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
Labour economics and human resource management 223
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.
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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 procompeti-
tive 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 anti-
competitive 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 guide-
lines 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 defini-
tions 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
The Chicago school, transaction cost economics, and antitrust 231
ante contracting costs associated with the potential for holdup with verti-
cal 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, franchis-
ing, 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 ‘appropri-
able 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 quote could accurately describe the interaction between PCS econom-
ics 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 contri-
bution, 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 the-
orems 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 suf-
ficient 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.
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 influ-
enced 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 pri-
marily 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 commu-
nity, 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 ana-
lytical 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 main-
tenance (RPM) case involving a terminated dealer. The plaintiff, PSKS,
operated a women’s apparel store in Texas. The defendant, Leegin, manu-
factures and distributes a number of leather goods and accessories includ-
ing 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 sug-
gested 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,
236 The Elgar companion to transaction cost economics
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 pre-
venting 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 suffi-
cient 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 recom-
mending 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,
The Chicago school, transaction cost economics, and antitrust 239
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 instruc-
tion, 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 preda-
tory 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 game-
theoretic 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 sig-
nificant 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 econom-
ics 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 anti-
trust analysis might finally be starting to crack. However, the Supreme
Court’s antitrust jurisprudence, combined with the relative youth of its
240 The Elgar companion to transaction cost economics
Notes
1. Especially influential in the dismantling of the structure-conduct-performance hypoth-
eses 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).
2. Chicagoans themselves were among the first to criticize reliance on the model of perfect
competition as a useful benchmark for antitrust analysis (Demsetz, 1991).
3. On Klein’s contributions to law and economics more generally, see Wright (2009).
4. 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).
5. 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 pos-
sible’ (Hovenkamp, 2002, p. 8; Klein, 1996).
6. 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.
7. 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 profes-
sors and lawyers, good news for business.
8. 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.
9. 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.
10. The author participated in this case as a signatory to the Law Professors’ Amicus Brief
in Support of Petitioner (filed 24 Aug. 2006).
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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 credi-
tors 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 adopt-
ing 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 particu-
lar 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 differ-
ences 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
Financial-market contracting 245
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’ com-
pensation 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 financ-
ing 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 cre-
ating 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 gen-
erators 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
250 The Elgar companion to transaction cost economics
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
Financial-market contracting 251
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) when-
ever 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 nar-
rative, 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 tra-
ditional narrative as well as any other studies that focus on commenda con-
tracts 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 institu-
tional 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 inter-
acted with the sorting of agents and investors across candidate ventures.
At the same time, the selection of ventures likely interacted with the selec-
tion 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.
Financial-market contracting 253
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 cross-
tabulation 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 train-
ing 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 257
1190–1220 1303–1400
Commenda 15 6
Debt 3 100
Total 18 106
Conclusion
I have suggested that a complete theory of financial structure would simul-
taneously 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 accom-
modate interactions between these three factors and the institutional envi-
ronment. 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 electric-
ity 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 indi-
cate 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 hypoth-
esis 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 invest-
ment 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
258 The Elgar companion to transaction cost economics
Notes
1. 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 hypo-
thetical 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.’
2. 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 time-
sensitive 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.
3. 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.
4. 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.
5. 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 gen-
eration 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.
6. 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 coef-
ficient estimates that one would obtain from two-stage least squares and yields virtually
the same standard errors (Davidson and MacKinnon, 1993, p. 240).
7. The tests amount to tests of the significance of the coefficients assigned to the generated
variables LogTerm Residuals, TwoPart Residuals, and Veto Residuals.
8. 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
Financial-market contracting 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.
9. 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).
10. See, for example, the introduction of Allen and Lueck (1999) with respect to agricul-
tural tenancy contracts. Sharecropping alone has constituted an important and surpris-
ingly rich context for exploring the design of compensation schemes in principal-agent
contracts.
11. 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.
12. For example, in September 1217 Bartolomeo Bembo advanced to his son-in-law
Domenico Gradonico 200 Venetian lira with which Domenico would conduct transac-
tions 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 Easter-
season convoy. The agent was free to travel on whatever vessel he saw fit. See Morozzo
della Rocca and Lombardo (1940, pp. 112–13).
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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 ‘inter-
nal’, 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 contribu-
tions, 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.
263
264 The Elgar companion to transaction cost economics
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 behav-
ioural 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 ‘self-
interest seeking with guile’ (Williamson, 1975, p. 255), and its implica-
tion 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 trans-
action. 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 increas-
ingly 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 invest-
ment’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 trans-
actions that differ in the dimensions of uncertainty, frequency, and
asset specificity with governance structures which differ in the capaci-
ties 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.
Critiques of transaction cost economics 265
Criticizing TCE
Most of the above characteristics are not particular to TCE, but are gen-
erally 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.
266 The Elgar companion to transaction cost economics
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 perspec-
tive (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 identify-
ing 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
Critiques of transaction cost economics 269
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 organiza-
tions’, and predicted that ‘competing and complementary theories’ would
emerge, ‘theories that are founded on economizing on bounded rationality
270 The Elgar companion to transaction cost economics
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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 semi-
conductor industry’, Management Science, 41 (10), 1624–38.
272 The Elgar companion to transaction cost economics
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: McGraw-
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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 considera-
tions’, American Economic Review, 61 (2), 112–23.
Williamson, O.E. (1975), Markets and Hierarchies: Analysis and Antitrust Implications, New
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Williamson, O.E. (1985), The Economic Institutions of Capitalism, New York: Free Press.
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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 man-
agement 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:
273
274 The Elgar companion to transaction cost economics
the cost associated with an action to internalize the external effect. The
subjectivist research program stresses difficulties and constraints encoun-
tered by the actor in dealing with negative externalities. Solving externali-
ties 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 externali-
ties, 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 organi-
zational 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 interpreta-
tion. 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 homogene-
ous. Each stock has ‘a particular history’ (Schutz, 1970, p. 74). Due to
diverse experiences, human agents will respond differently to the same
276 The Elgar companion to transaction cost economics
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
Subjectivism, understanding, and transaction costs 277
Management of innovation
The human-agency perspective also sheds light on innovation policy, espe-
cially 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, codifi-
able, and transmittable with a formal or systematic language. Knowledge
creation is a social process that transforms tacit into articulable knowl-
edge (Cohen and Levinthal, 1990). This process requires direct and con-
tinual 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 par-
tially 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
278 The Elgar companion to transaction cost economics
same time, the product or technology may be new, meaning that techni-
cal 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 decision-
making 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 knowl-
edge 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 per-
formance 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).
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 activi-
ties better. Thus, most of the time, institutions are fairly stable and can
serve the function of coordination. However, institutions can change dras-
tically. 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 imagina-
tive 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 coordi-
nating 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
280 The Elgar companion to transaction cost economics
References
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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 econom-
ics and TCE that have not been explored closely and exploited.
This chapter argues that characteristically Austrian ideas about prop-
erty, 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 econom-
ics, 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.
281
282 The Elgar companion to transaction cost economics
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 teleologi-
cal causes’, organic institutions are ‘the unintended result of innumer-
able 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) sup-
porting 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 com-
prise 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).
risk loving, in the face of career concerns and the presence of an institu-
tion (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 responsi-
bility 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 miti-
gating 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 devel-
opments, 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, extend-
ing, transforming, and limiting existing undertakings, and establishing
new undertakings’ (Mises, 1936, p. 215).2
286 The Elgar companion to transaction cost economics
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.
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 con-
tained 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 oppor-
tunity 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
Austrian economics and the theory of the firm 289
serves to extend the notable analysis of Professor Coase on the market determi-
nants 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 dis-
appear, 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).
290 The Elgar companion to transaction cost economics
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,
Austrian economics and the theory of the firm 293
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 theo-
ries 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, impoverish-
ment, etc., become greater’ (Rothbard, 1962, p. 548).
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Hayek, F.A. (1937), ‘Economics and knowledge’, Economica, 4 (13), 33–54.
Hayek, F.A. (1940), ‘Socialist calculation: the competitive solution’, Economica, 7 (25)
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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.
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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.
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61–133.
Austrian economics and the theory of the firm 295
297
298 The Elgar companion to transaction cost economics
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
300 The Elgar companion to transaction cost economics
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 simpli-
fication 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 mar-
ginal 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 produc-
tion and technology from governance structures or transaction costs. Paul
Milgrom and John Roberts (1992, pp. 33–4) highlight some of the theoret-
ical 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
Limits of transaction cost analysis 301
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 possibil-
ity, 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 explana-
tion 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 firm-
specific 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.
Notes
1. Including competence, capabilities, knowledge-based, resource-based and evolution-
ary 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 oppor-
tunism but argues that there are additional important reasons why contracts may not be
fulfilled and monitoring may be required. Hence an explanatory emphasis on opportun-
ism 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.
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Index
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