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American Economic Association Transaction Cost Economics: The Natural Progression Author(s): Oliver E. Williamson Source: The American Economic Review, Vol. 100, No. 3 (JUNE 2010), pp. 673-690 Published by: American Economic Association Stable URL: http://www.jstor.org/stable/27871227 . Accessed: 14/06/2013 11:34 Your use of the JSTOR archive indicates your acceptance of the Terms & Conditions of Use, available at . http://www.jstor.org/page/info/about/policies/terms.jsp . JSTOR is a not-for-profit service that helps scholars, researchers, and students discover, use, and build upon a wide range of content in a trusted digital archive. We use information technology and tools to increase productivity and facilitate new forms of scholarship. For more information about JSTOR, please contact support@jstor.org. . American Economic Association is collaborating with JSTOR to digitize, preserve and extend access to The American Economic Review. http://www.jstor.org This content downloaded from 218.69.250.170 on Fri, 14 Jun 2013 11:34:42 AM All use subject to JSTOR Terms and Conditions American Economie Review WO (June 2010): 673-690 http://www.aeaweb.org/articles.php?doi=WJ257/aerJ00.3.673 Transaction Cost Economics: The Natural Progression By Oliver E. Williamson* The research program on which I and others have been working has been variously described as the "economics of governance," the "economics of organization," and "transaction cost eco nomics ." As discussed in Section I, governance is the overarching concept and transaction cost economics is the means by which to breathe operational content into governance and organization. The specific issue that drew me into this research project was the puzzle posed by Ronald Coase in 1937: What efficiency factors determine when a firm produces a good or service to its own needs rather than outsource? As described in Section II, my 1971 paper on "The Vertical Integration of Production" made headway with this issue and invited follow-on research that would eventually come to be referred to as transaction cost economics. The rudiments of transaction cost economics are set out in Section III. Puzzles and challenges that arose and would require "pushing the logic of efficient governance to completion" are examined briefly in Section IV. Concluding remarks follow. I. An Overview For economists, if not more generally, governance and organization are important if and as these are made susceptible to analysis. As described here, breathing operational content into the concept of governance would entail examining economic organization through the lens of con tract (rather than the neoclassical lens of choice), recognizing that this was an interdisciplinary project where economics and organization theory (and, later, aspects of the law) were joined, and introducing hitherto neglected transaction costs into the analysis. A predictive theory of economic organization was the object. The puzzle of vertical integration was an obvious place to start. A. Governance Whereas textbook microeconomic theory was silent on the concept of good governance, John R. Commons, who was a leading institutional economist during the first half of the twentieth century, formulated 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 1932,4). Commons thereafter recommended that "theories of econom ics center on transactions and working rules, on problems of organization, and on the... [ways] the organization of activity is ... stabilized" (Commons 1950, 21). + This article is a revised version of the lecture Oliver E. Williamson delivered in Stockholm, Sweden, on December 8, 2009, when he received the Bank of Sweden Prize in Economic Sciences in Memory of Alfred Nobel. This article is copyright ? The Nobel Foundation 2009 and is published here with the permission of the Nobel Foundation. * Williamson: University of California, Berkeley, Haas School of Business, S545 Student Services Bldg., Berkeley, CA 94720-1900 (e-mail: owilliam@haas.berkeley.edu). This paper has benefited from my presentation of an early draft to my colleagues and students at the University of California, Berkeley and from subsequent discussions with Steven Tadelis. Ongoing support from the Haas School of Business at the University of California. Berkely is grate fully cknowledged. I have grave doubts that i would have undertaken the project described herein but for (i) my inter disciplinary training at Carnegie Mellon University (where economics and organization theory were joined), (ii) my experience as Special Economic Assistant to the Head of the Antitrust Division at the US Department of Justice (which revealed the need within the antitrust enforcement agencies to bring economics and organization theory together), and (iii) the opportunity to work these issues through with my students at the University of Pennsylvania when i resumed teaching. (Teaching is learning, especially if the students buy into the project.) 673 This content downloaded from 218.69.250.170 on Fri, 14 Jun 2013 11:34:42 AM All use subject to JSTOR Terms and Conditions 674 THE AMERICAN ECONOMIC REVIEW JUNE 2010 This conception of economics is to be contrasted with the neoclassical resource allocation paradigm in two important respects: first, whereas Commons viewed organization and the con tinuity of contractual relations as important, the resource allocation paradigm made negligi ble provision for either but focused instead on prices and output, supply and demand; second, whereas the price theoretic approach to economics would become the "dominant paradigm" during the twentieth century (Melvin W. Reder 1999, 43), institutional economics was mainly relegated to the history of thought because it failed to advance a positive research agenda that was replete with predictions and empirical testing (Stigler as reported in Edmund W. Kitch 1983, 170). Stalwarts notwithstanding, institutional economics "ran itself into the sand." This does not imply, however, that institutional economics was lacking for good ideas. Indeed, the Commons Triple of conflict, mutuality, and order prefigures the concept of governance as herein employed?in that governance is the means by which to infuse order, thereby to mitigate conflict and realize mutual gain. Furthermore, the transaction is made the basic unit of analysis. James M. Buchanan (1975, 225) subsequently distinguished between lens of choice and lens of contract approaches to economic organization and argued that economics as a discipline went "wrong" in its preoccupation with the science of choice and the optimization apparatus associ ated therewith. If "mutuality of advantage from voluntary exchange is... the most fundamental of all understandings in economics" (Buchanan 2001, 29), then the lens of contract approach is an underused perspective. The past 35 years have witnessed growing interest in the use of the lens of contract, to include both theories that emphasize ex ante incentive alignment (agency theory/mechanism-design, team theory, property rights theory) and those for which the ex post governance of contractual relations is where the main analytical action resides. Transaction cost economics is an ex post governance construction, with emphasis on those transactions to which Commons called atten tion?namely those for which continuity (or breakdown) of the exchange relation is of special importance. How did the attributes of such transactions differ from the ideal transaction, in both law and economics, of simple market exchange (where no such continuity relation was implied)? What were the governance ramifications? Answers to these queries would entail reformulating the problem of economic organization in comparative contractual terms by (i) naming the key attributes with respect to which transac tions differ, (ii) describing the clusters of attributes that define alternative modes of governance (of which markets and hierarchies are two), (iii) joining these parts by appealing to the efficient alignment hypothesis, wherein (iv) predictions would be derived to which empirical tests would be applied, and (v) public policy ramifications would be worked up. Antecedent to the foregoing, the contract relevant attributes of human actors would be named and explicated. B. Organization Whereas the neoclassical theory of the firm treated the firm as a black box for transforming inputs into outputs according to the laws of technology, this was not, as Harold Demsetz (1983, 377) observed, an all-purpose construction. It is a "mistake to confuse the firm of [neoclassical] economic theory with its real-world namesake. The chief mission of neoclassical economics is to understand how the price system coordinates the use of resources, not the inner workings of real firms." Although Demsetz did not make the case that economics and organization theory should be joined in a combined effort to understand firm and market organization of a real world kind, that is nevertheless the research need and opportunity as I perceived it?in no small measure because of my training (1960-1963) in the PhD program at the Graduate School of Industrial Administration, Carnegie Mellon University. This remarkable program in interdisciplinary This content downloaded from 218.69.250.170 on Fri, 14 Jun 2013 11:34:42 AM All use subject to JSTOR Terms and Conditions VOL. 100 NO. 3 WILLIAMSON: TRANSACTION COST ECONOMICS: THE NATURAL PROGRESSION 675 social science made the case that organization theory should both inform and be informed by economics.1 Herbert Simon, James March, and Richard Cyert played especially important roles2 in putting this across. Considerations of bounded rationality, the sp?cification of goals,3 intertem poral regularities (wherein organization takes on "a life of its own"), the critical importance of adaptation, the reliance within the operating parts on routines, and, more generally, the "archi tecture of complexity" were all basic concepts that would prove to be pertinent to an understand ing of incomplete contracting and complex organization. Had the governance of contractual relations come under study at Carnegie Mellon, there is no question that this would have been examined in an interdisciplinary way. C. Transaction Costs Ronald Coase, in his classic 1937 paper on "The Nature of the Firm," was the first to bring the concept of transaction costs to bear on the study of firm and market organization. The youthful Coase (then 27 years old) uncovered a serious lapse in the accepted textbook theory of firm and market organization. Upon viewing firm and market as "alternative methods of coordinating production" (1937, 388), Coase observed that the decision to use one mode rather than the other should not be taken as given (as was the prevailing practice) but should be derived. Accordingly, Coase (1937, 389) advised economists that they needed: ... to bridge what appears to be a gap in [standard] economic theory between the assump tion (made for some purposes) that resources are allocated by means of the price mecha nism and the assumption (made for other purposes) that that allocation is dependent on the entrepreneur-coordinator. We have to explain the basis on which, in practice, this choice between alternatives is effected. The missing concept was "transaction cost." The lapse to which Coase referred had little immediate effect (Coase 1988, 23) and failed to take hold over the next 20 years, during which period the implicit assumption of zero transaction costs went unchallenged. Two important articles in the 1960s would upset this state of affairs. Upon pushing the logic of zero transaction costs to completion, the unforeseen implications of this standard assumption were displayed for all to see. The first demonstration was Coase's 1960 article on "The Problem of Social Cost." Upon reformulating the externality problem in contractual terms and pushing the logic of zero transac tion cost reasoning to completion, he realized an astonishing result: "Pigou's conclusion (and that of most economists of that era) that some kind of government action (usually the imposition of taxes) was required to restrain those whose actions had harmful effects on others (often termed negative externalities)" was incorrect (Coase 1992, 717).4That is because if transaction costs are 1 Jacques Dreze speaks for me, and, I am sure, for many others in his statement that "Never since [my visit to Carnegie Mellon] have I experienced such intellectual excitement" (1995,123). Nobel Laureates in economics from the small group of faculty and students at CMU include Herbert Simon, Franco Modigliani, Merton Miller, Robert Lucas, Edward Prescott, and Finn Kydland. 2 Classic books by Carnegie Mellon faculty that feature economics and organization theory include Models of Man (Simon 1957b), Organizations (March and Simon 1958), and the Behavioral Theory of the Firm (Cyert and March 1963). 3 One way to introduce organizational considerations is to change the objective function of the firm by supplanting the neoclassical assumption of profit maximization with various forms of "managerial discretion"?such as sales maxi mization (Baumol 1959), growth maximization (Marris 1964), or expense preference (Williamson 1964). These efforts to introduce "realism in motivation" yielded few predictions and resulted in little empirical testing. 4 Even the Chicago School, which had grave reservations with overreaching uses of externality arguments, was resistant to Coase's claims that externalities vanished under zero transaction cost conditions. For a discussion of Coase versus Chicago, see Edmund Kitch (1983, 220-221). This content downloaded from 218.69.250.170 on Fri, 14 Jun 2013 11:34:42 AM All use subject to JSTOR Terms and Conditions 676 THE AMERICAN ECONOMIC REVIEW JUNE 2010 zero then the parties to tort transactions will costlessly bargain to an efficient result whichever way property rights are assigned at the outset. In that event, the emperor really did have no clothes: externalities and frictions of other kinds would vanish. That being preposterous, the real message was this: "study the world of positive transaction costs" (Coase 1992, 717).5 Kenneth J. Arrow's 1969 examination of "The Organization of Economic Activity: Issues Pertinent to the Choice of Market versus Non-market Allocation" likewise revealed a need to make a place for positive transaction costs, both with respect to market failures and in conjunction with intermedi ate product market contracting: "the existence of vertical integration may suggest that the costs of operating competitive markets are not zero, as is usually assumed in our theoretical analysis" (Arrow 1969, 48). But whereas pushing the logic of zero transaction costs to completion would reveal the need to make provision for positive transaction costs, there were three problems. First, upon opening the "black box" of firm and market organization and looking inside, the black box turned out to be Pandora's Box: positive transaction costs were perceived to be everywhere. That would prove to be a curse, in that some form of transaction cost could be invoked to explain any condi tion whatsoever after the fact, as a result of which appeal to transaction costs acquired a "well deserved bad name" (Stanley Fischer 1977, 322). Second, it does not suffice to show that some types of transaction costs are demonstrably great. Unless these costs differ among modes (say, as between markets and hierarchies), such a demonstration lacks comparative contractual signifi cance. Third, transaction costs that pass the test of comparative contractual significance need to be embedded in a conceptual framework from which predictions can be derived and empirically tested. The unmet need was to focus attention on key features and provide operational content for the intriguing concept of positive transaction costs. II. The Vertical Integration of Production What I have referred to as the "Carnegie Triple" (Williamson 1996, 25) is this: be disciplined; be interdisciplinary; have an active mind. Being disciplined means to take your core discipline seriously and work at it on its own terms. Being interdisciplinary means to appeal to the contigu ous social sciences?if and as the phenomena under study cross disciplinary lines. Having an active mind entails asking the question, "What is going on here?" rather than pronouncing "This is the law here."6 The Carnegie Triple would serve me well when I named industrial organization as my field, even though I had never taken an industrial organization course at Carnegie Mellon (or elsewhere), and I went on the job market. Coase (1972, 62) described the leading industrial organization textbooks in the 1960s as "applied price theory"?with which I agree, but with a caveat: the structure-conduct-perfor mance paradigm also played an important role in the "Harvard School" approach to the field. The organization of markets (especially with respect to the number and size distribution of firms and the condition of entry) thus figured prominently, but the organization of firms was ignored. Because firms were production functions for transforming inputs into outputs accord ing to the laws of technology, the 10 public policy lesson was this: except as contracting prac tices and organizational structures had a physical or technical basis, nonstandard and unfamiliar 5 Not everyone agrees. Some economists take the "Coase Theorem" (the first 15 pages of Coase 1960) to imply that costless renegotiation accurately describes contracting in practice. However, the following 29 pages in Coase (1960) reveal that the zero transaction cost assumption is not only wrong but undermines our understanding of complex eco nomic phenomena. Express provision for positive transaction costs would thereafter need to be made if externalities and other real world contractual phenomena are to be accurately understood. Coase reaffirmed that this was his purpose in his Nobel Prize Lecture (Coase 1992, 712). 6 For a discussion of these distinctions, see Roy D'Andrade (1986). This content downloaded from 218.69.250.170 on Fri, 14 Jun 2013 11:34:42 AM All use subject to JSTOR Terms and Conditions VOL. 100 NO. 3 WILLIAMSON: TRANSACTION COST ECONOMICS: THE NATURAL PROGRESSION 677 forms of contract and organization were regarded as deeply problematic and presumptively anticompetitive.7 By contrast with this one-sided interpretation of deviations from the norm under the prevail ing IO orientation, the Carnegie Mellon perspective on contractual and organizational variety was that such could also serve efficiency purposes. This difference in perspectives would force fully register when I served in 1966-67 as the Special Economic Assistant to the Head of the Antitrust Division of the US Department of Justice, especially when I was asked to comment on an early draft of the Schwinn brief. The issue was one of vertical market restrictions, and the brief advanced the argument that the franchise restrictions imposed by the bicycle manufacturer Schwinn on its (nonexclusive) franchisees were anticompetitive. My view was more cautious. Not only was it unclear to me that the restrictions had anticompetitive effects, but a case could be made that the restrictions in question served the purpose of preserving the integrity of the fran chise system?additionally or instead (Williamson 1985, 183-189). Alas, the principal architects of the Schwinn brief viewed the ca