Firm, Organization, Transaction Cost – OE Williamson

The most cited books written by Williamson are:

Markets and hierarchies: analysis and antitrust implications: a study in the economics of internal organization– 1975
The economic institutions of capitalism – 1985 **
– The mechanisms of governance – 1996 **

While a dozen of papers are also frequently mentioned:

The vertical integration of production: market failure considerations – The American Economic Review, 1971
Transaction-cost economics: the governance of contractual relations – The journal of Law and Economics, 1979
– The economics of organization: The transaction cost approach  – American journal of sociology, 1981
– Credible commitments: Using hostages to support exchange OE Williamson – The American Economic Review, 1983
– Transaction cost economics  – Handbook of industrial organization, 1989
– Comparative economic organization: The analysis of discrete structural alternatives  – Administrative science quarterly, 1991 **
Strategizing, economizing, and economic organization – Strategic management journal, 1991 *
Calculativeness, trust, and economic organization  – The Journal of Law and Economics, 1993 *
Strategy research: governance and competence perspectives  – Strategic management journal, 1999 *
– The new institutional economics: taking stock, looking ahead – Journal of economic literature, 2000
The theory of the firm as governance structure: from choice to contract  – The Journal of Economic Perspectives, 2002
More recently with less citations
– The economics of governance  – The American Economic Review, 2005
Transaction cost economics – S Tadelis, OE Williamson – The Handbook of Organizational Economics 2010
– Theories of Firm and Market Organization: Focal Transactions, Empirical Testing, and Scaling Up – S Tadelis, OE Williamson – 2011

My review will begin from the recent papers that review the transaction cost theory, and the go through the most representative work The economic institutions of capitalism 1985. After that the target will be 1990s papers on the Strategic management journal.

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Theories of Firm and Market Organization: Focal Transactions, Empirical Testing, and Scaling Up – S Tadelis, OE Williamson – 2012

Examines:
1) why it took so long form tc and economic organization to take hold
2) theories of firm and market organization since 1970s which differ from Coase and among themselves in i) conceptual, ii) empirical and iii) scaling up respects

Background – main papers:

Coase: though broadly in the spirit of marshallian marginal analysis (deminishing returns to management), tc is not a mtter for neoclassical concept of firm + the expansive conceptive of tc was so elastic as to permit any anomaly to be explained after the fact -tautological (Alchian and Demsetz (1972) )

1960s: Coase and Arrow showed that externalities and vertical integration would vanish if zero-transaction costs
1970s: conceptual papers about economics of governance  by Williamson (1971, 1979), Alchian and Demsetz (1972), and Klein Crawford and Alchian (1978)
1980s&90s: a) modern Property Rights Theory of the firm (PRT) by Grossman&Hart (1986) and Hart&Moore (1990), b) Agency approach to organizational design: Holmstrom&Milgrom (1991, 1994)

However, while formal modeling of TCE is challenging, prior theories aiming in uncovering the costs and benefits of different modes of organization did not always led to clear connections between theory and practice:

1) the choice of employment as the “focal transaction” by Coase and others

– focus on markets and hierarchies, without reference to intermediate levels of control (see Williamson (1983, 1991) for more on hybrid transactions)

– Whereas TCE views the relation between buyer and seller symmetrically, Coase put the purchaser in control (entrepreneur & employee: contract under certain limits to power), similar to Barnard(1938)’s “zone of acceptance” and Simon(1951)’s definition of employment (authority restricted to some given subset)
=> emphasis on employment relation → firm and market organization = authority and hierarchy

– Williamson (1971) first laid out the rudiments of TCE, as further developed in Williamson (1975, 1976, 1979, 1985) and in Klein, Crawford, and Alchian (1978), the intermediate product market transaction was made focal for 4 reasons:

a) employment relation is too encompassing: not clear buy-or-make problem as the supplier firms also produce those components with hired labor / employees are used in both of these scenarios

b) the intermediate product market transaction is simpler and better directs to central forces: instructive logic of make-or-buy

c) the intermediate product market transaction focuses especially on transactions as exchanges between technologically separable stages → directs to interface management within and between firms (as between make-or-buy)

e.g. Large firms outsource IT services to specialized providers, regardless of procured through market or within firm, employees are the ones performing the job

d) the employment relation limits the scope of analysis and precludes a more general understanding of the costs and benefits of different modes of organization as they relate to non-labor transactions and less tractable

TCE applied not only to vertical integration Williamson (1971):
– horizontal integration (organization form, to which Chandler (1962) is relevant)
– franchise bidding for natural monopoly (Williamson (1976))
– regulation (Goldberg (1976))
– corporate finance (Williamson (1988); Woodward(1988))
– corporate strategy (Nickerson and Silverman (2009))
– marketing (Gatignon and Gatignon (2010), John and Reve (2010))
– political economy (Dixit (1996), Levy and Spiller (1994))
– procurement (Bajari and Tadelis (2001))
– privatization (Levin and Tadelis (2010))
more than 900 empirical tests of TCE in economics, business, and the contiguous social sciences (Jeffrey Macher and Barak Richman (2008))

2) the lack of empirically measureable variables (review on main theories)

Coase: apply tc into reasoning of substitution at the margin:
a) transaction by entrepreneur organization v.s. by price mechanism
b) size is measured by transaction under firm v.s. market
→ measurable margin that determine firm size: diminishing return of management with increasing return of transaction cost
→ however, which transactions should be organized in the firm and which through the market (not so clear empirical hook) / how firms and markets differ in the way each mediates exchange

Williamson (1971):
a) focus on management of adaptation + b) market and hierarchy each deal with adaptation in different ways
=> contractual incompleteness (if complete then there is no advantage of internal organization over market transactions + a series of short-term contracts can in principle deal with the need for adaptation but pose problems on) → investment on a higher degree of specificity (specific assets/knowledge/skills) + bargain power change as the winner of the original contract acquires a cost advantage by ‘first mover’ advantages  → intermediate product market transactions → governance by hierarchy (inside the firm). 

=>> i) the different exchange/adaptation mechanism

スクリーンショット 2017-07-31 17.47.56

Market: exchange takes place between independently owned and operated stages / “high-powered incentives” in the agency literature
Hierarchy: coordinated adaptation promoted by unified ownership of the two stages coupled with the creation of a new actor, the interface coordinator(each stage reports to + subject to administrative direction and control + the absence of outside legal appeal) / low-powered incentives within stages 

=> ii) comparative statics: different kinds of transactions are better mediated through the form or the market: specificity: 
→ transactions with high levels of specificity are those for which organizing inside the firm is less costly than through the market + transactions become less specific, the benefit or organizing the transaction inside the firm drops

Property Rights Theory of the firm (PRT) by Grossman&Hart (1986) and Hart&Moore (1990):
– firm as being composed of the assets (e.g., machines, inventories) that it owns (1986, p. 692)
–  which stage has residual rights of control over the assets matters between two independent stages of production → directional integration/ (TCE: integration implies unified ownership and the use of hierarchy to implement coordinated adaptation at the interface)
=> joint ownership of assets is not optimal + firm with more important ex ante investments in specific human capital should acquire the other = directional inefficiency as weakened incentives to invest in ex ante specific human capital
=>> how market incentives operate

weakness of PRT:
a) difficult to measure directly or proxy measures for marginal variations in which party’s investment is more important (Whinston (2001, 2003),Holmstrom (1999)p. 87)
b) Hart-Moore model that joint production never is optimal is counterfactual given joint ventures (Holmstrom (1999)) / = PRT’s assumption: two separate managers are needed for the two stage v.s. one manager be in charge of both stages to maximize joint output (“interface coordinator” and creates separate managers to operate each stage → directional inefficiency relieved, albeit at the cost of an interface coordinator)
c) the action in PRT is at the individual level, and assets are owned by these individuals ← There are neither firms nor workers, organizational affiliations did not matter for transactions (the same critique directed at Alchian and Demsetz’ vision of the firm)

Agency theory of governance and organizations Holmstrom&Milgrom (1991, 1994):
– investigates the consequences of incomplete information (in that measuring the transaction there have zero costs of contracting while others have infinite cost)
– limited as being silent about how transactions differ with specificity or contractual incompleteness 
– contributions to multi-task agency and its applications are noteworthy, but has offered little insights on the function of hierarchy and governance → in stead valuable in understanding the employment relation (how individuals ought to be compensated, and how tasks should be allocated to individuals)

3) the challenge that the theories have in “scaling up” to correspond with the real-world organizations 

theory abstracts from many real and complex issues → simplify by focusing on central forces and key features → can be taken back / not limited to the caricature it depicts = scale up

Holmstrom’s criticisms of PRT as the inability of PRT to scale up:
– “there really are no firms in these [formal] models, just representative entrepreneurs.” (1999, p. 100)
– “firms are poorly defined in property rights models and it is not clear how one actually should interpret the identities of [the parties].” (Holmstrom and Roberts (1998), p. 79)
The same criticisms towards the Agency Theory models:
– these models are concerned more with design of incentive schemes and task allocations to employees than with how to coordinate and organize transactions within and between firms
– it is hard to see how one takes the results and conclusions of PRT to real world firms, either to explain or to prescribe the multitude of organizational design choices that are made by private sector firms and public sector bureaucracies

TCE’s scaling up:
– unlike PRT or Agency theory, where individuals/entrepreneur are at the center of attention, TCE deals with “mini-firms” – namely a series of producing stages, of within each of which the activity is technologically non-separable but between which stages the activities are technologically separable
– describe the boundary of the firm as technologically separable boundaries, as a series of interfaces which should be controlled and organized within a firm’s hierarchy by a series of interface coordinators, and which should be procured through the market

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The theory of the firm as governance structure: from choice to contract  – The Journal of Economic Perspectives, 2002

 

 

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