The Economic Institutions of Capitalism

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9780684863740: The Economic Institutions of Capitalism

"An extraordinarily impressive achievement and must reading for all serious students of law, economics, and organization".--Paul L. Joskow, Professor of Economics, Massachusetts of Technology.

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About the Author:

Oliver E. Williamson, the author of several books including the acclaimed Markets and Hierarchies (published by the Free Press), is Gordon B. Tweedy Professor of Economics of Law and Organization at Yale University. He is Fellow of the Econometrics Society and the American Academy of Arts and Sciences and Co-editor of the Journal of Law, Economics, and Organization.

Excerpt. © Reprinted by permission. All rights reserved.:

Chapter 1

Transaction Cost Economics

Firms, markets, and relational contracting are important economic institutions. They are also the evolutionary product of a fascinating series of organizational innovations. The study of the economic institutions of capitalism has not, however, occupied a position of importance on the social science research agenda.

Partly this neglect is explained by the inherent complexity of those institutions. But complexity can and often does serve as an inducement rather than a deterrent. The primitive state of our knowledge is at least equally explained by a reluctance to admit that the details of organization matter. The widespread conception of the modern corporation as a "black box" is the epitome of the noninstitutional (or pre-microanalytic) research tradition.

Merely to acknowledge that the microanalytic details of organization matter does not, however, suffice. The salient structural features of market, hierarchical, and quasi-market forms of organization need to be identified and linked to economic consequences in a systematic way. Lack of agreement on (or misconceptions regarding) the main purposes served by economic organization has also been an impediment to research progress.

A chapter in some yet unwritten history of economic thought will be needed to sort those matters out. Whatever the eventual explanation, the fact is that the study of economic institutions has witnessed a renaissance. Thus, whereas the study of institutional economics reached a nadir in the immediate postwar period, a renewal of interest in institutions and a reaffirmation of their economic importance can, with the benefit of hindsight, be traced to the early 1960s. Operational content began to appear in the early 1970s. A common characteristic of the new line of research is that the concept of firm as production function is supplanted (or augmented) by the concept of firm as governance structure. Research of the New Institutional Economics kind had reached a critical mass by 1975. The ensuing decade has witnessed exponential growth.

Transaction cost economics is part of the New Institutional Economics research tradition. Although transaction cost economics (and, more generally, the New Institutional Economics) applies to the study of economic organization of all kinds, this book focuses primarily on the economic institutions of capitalism, with special reference to firms, markets, and relational contracting. That focus runs the gamut from discrete market exchange at the one extreme to centralized hierarchical organization at the other, with myriad mixed or intermediate modes filling the range in between. The changing character of economic organization over time -- within and between markets and hierarchies -- is of particular interest.

Although the remarkable properties of neoclassical markets, where prices serve as sufficient statistics, are widely conceded -- as Friedrich Hayek put it, the market is a "marvel" (1945, p. 525) -- opinions differ in assessing transactions that are organized within quasi-market and nonmarket modes of organization. At best the administrative apparatus and private ordering supports that attend these transactions are messy. Some scholars decline even to deal with them. Others regard the deviations as evidence of a pervasive condition of "market failure." Until very recently the primary economic explanation for nonstandard or unfamiliar business practices was monopoly: "[I]f an economist finds something -- a business practice of one sort or another -- that he does not understand, he looks for a monopoly explanation" (Coase, 1972, p. 67). That other social scientists should regard these same institutions as antisocial is unsurprising. The enforcement of antitrust from 1945 through 1970 reflected that orientation.

To be sure, a net negative social assessment is sometimes warranted. A more subtle and discriminating understanding of the economic institutions of capitalism has nevertheless been evolving. Many puzzling or anomalous practices have been cast into different relief in the process. This book advances the proposition that the economic institutions of capitalism have the main purpose and effect of economizing on transaction costs.

Main purpose is not, however, to be confused with sole purpose. Complex institutions commonly serve a variety of objectives. This is no less true here. The inordinate weight that I assign to transaction cost economizing is a device by which to redress a condition of previous neglect and undervaluation. An accurate assessment of the economic institutions of capitalism cannot, in my judgment, be reached if the central importance of transaction cost economizing is denied. Greater respect for organizational (as against technological) features and for efficiency (as against monopoly) purposes is needed. This theme is repeated, with variation, throughout this book.

I submit that the full range of organizational innovations that mark the development of the economic institutions of capitalism over the past 150 years warrant reassessment in transaction cost terms. The proposed approach adopts a contracting orientation and maintains that any issue that can be formulated as a contracting problem can be investigated to advantage in transaction cost economizing terms. Every exchange relation qualifies. Many other issues which at the outset appear to lack a contracting aspect turn out, upon scrutiny, to have an implicit contracting quality. (The cartel problem is an example.) The upshot is that the actual and potential scope of transaction cost economics is very broad.

As compared with other approaches to the study of economic organization, transaction cost economics (1) is more microanalytic, (2) is more self-conscious about its behavioral assumptions, (3) introduces and develops the economic importance of asset specificity, (4) relies more on comparative institutional analysis, (5) regards the business firm as a governance structure rather than a production function, and (6) place greater weight on the ex post institutions of contract, with special emphasis on private ordering (as compared with court ordering). A large number of additional implications arise upon addressing problems of economic organization in this way. The study of the economic institutions of capitalism, as herein proposed, maintains that the transaction is the basic unit of analysis and insists that organization form matters. The underlying viewpoint that informs the comparative study of issues of economic organization is this: Transaction costs are economized by assigning transactions (which differ in their attributes) to governance structures (the adaptive capacities and associated costs of which differ) in a discriminating way.

Given the complexity of the phenomena under review, transaction cost economics should often be used in addition to, rather than to the exclusion of, alternative approaches. Not every approach is equally instructive, however, and they are sometimes rival rather than complementary.

The nature of transaction costs is developed in section 1. A cognitive map of contract, in which alternative approaches to economic organization are described and with respect to which transaction cost economics is located, is set out in section 2. The relation between behavioral assumptions and alternative conceptions of contract is presented in section 3. A rudimentary contracting schema on which the argument in the book repeatedly relies is developed in section 4. Contractual issues that arise in organizing the company town are examined in section 5. Other applications are sketched in section 6. Concluding remarks follow.

1. Transaction Costs

1.1 Frictionlessness

Kenneth Arrow has defined transaction costs as the "costs of running the economic system" (1969, p. 48). Such costs are to be distinguished from production costs, which is the cost category with which neoclassical analysis has been preoccupied. Transaction costs are the economic equivalent of friction in physical systems. The manifold successes of physics in ascertaining the attributes of complex systems by assuming the absence of friction scarcely require recounting here. Such a strategy has had obvious appeal to the social sciences. Unsurprisingly, the absence of friction in physical systems is cited to illustrate the analytic power associated with "unrealistic" assumptions (Friedman, 1953, pp. 16-19).

But whereas physicists were quickly reminded by their laboratory instruments and the world around them that friction was pervasive and often needed to be taken expressly into account, economists did not have a corresponding appreciation for the costs of running the economic system. There is, for example, no reference whatsoever to transaction costs, much less to transaction costs as the economic counterpart of friction, in Milton Friedman's famous methodological essay (1953) or in other postwar treatments of positive economics. Thus although positive economics admitted that frictions were important in principle, it had no language to describe frictions in fact.

The neglect of transaction costs had numerous ramifications, not the least of which was the way in which nonstandard modes of economic organization were interpreted. Until express provision for transaction costs was made, the possibility that nonstandard modes of organization -- customer and territorial restrictions, tie-ins, block booking, franchising, vertical integration, and the like -- operate in the service of transaction cost economizing was little appreciated. Instead, most economists invoked monopoly explanations -- be it of the leverage, price discrimination, or entry barriers kinds-when confronted with nonstandard contracting practices (Coase, 1972, p. 67). Donald Turner's views are representative: "I approach customer and territorial restrictions not hospitably in the common law tradition, but inhospitably in the tradition of antitrust." As discussed below, the research agenda and public policy toward business were massively influenced by that monopoly predisposition. The prevailing view of the firm as production function was centrally implicated in that situation.

1.2 Explication

Transaction cost economics poses the problem of economic organization as a problem of contracting. A particular task is to be accomplished. It can be organized in any of several alternative ways. Explicit or implicit contract and support apparatus are associated with each. What are the costs?

Transaction costs of ex ante and ex post types are usefully distinguished. The first are the costs of drafting, negotiating, and safeguarding an agreement. This can be done with a great deal of care, in which case a complex document is drafted in which numerous contingencies are recognized, and appropriate adaptations by the parties are stipulated and agreed to in advance. Or the document can be very incomplete, the gaps to be filled in by the parties as the contingencies arise. Rather, therefore, than contemplate all conceivable bridge crossings in advance, which is a very ambitious undertaking, only actual bridge-crossing choices are addressed as events unfold.

Safeguards can take several forms, the most obvious of which is common ownership. Faced with the prospect that autonomous traders will experience contracting difficulties, the parties may substitute internal organization for the market. This is not, to be sure, without problems of its own (see Chapter 6). Moreover, ex ante interfirm safeguards can sometimes be fashioned to signal credible commitments and restore integrity to transactions. The study of "nonstandard" contracting is centrally concerned with such matters.

Most studies of exchange assume that efficacious rules of law regarding contract disputes are in place and are applied by the courts in an informed, sophisticated, and low-cost way. Those assumptions are convenient, in that lawyers and economists are relieved of the need to examine the variety of ways by which individual parties to an exchange "contract out of or away from" the governance structures of the state by devising private orderings. Thus arises a division of effort whereby economists are preoccupied with the economic benefits that accrue to specialization and exchange, while legal specialists focus on the technicalities of contract law.

The "legal centralism" tradition reflects the latter orientation. It maintains that "disputes require 'access' to a forum external to the original social setting of the dispute [and that] remedies will be provided as prescribed in some body of authoritative learning and dispensed by experts who operate under the auspices of the state" (Galanter, 1981, p. 1). The facts, however, disclose otherwise. Most disputes, including many that under current rules could be brought to a court, are resolved by avoidance, self-help, and the like (Galanter, 1981, p. 2).

The unreality of the assumptions of legal centralism can be defended by reference to the fruitfulness of the pure exchange model. That is not disputed here. My concern is that the law and economics of private ordering have been pushed into the background as a consequence. That is unfortunate, since in "many instances the participants can devise more satisfactory solutions to their disputes than can professionals constrained to apply general rules on the basis of limited knowledge of the dispute" (Galanter, 1981, p. 4).

The issues here are akin to those that were of concern to Karl Llewellyn in his discussion of contract in 1931 but have been systematically evaded since. But for the limitations of legal centralism, the ex post side of contract can be disregarded. Given the very real limitations, however, with which court ordering is beset, the ex post costs of contract unavoidably intrude. Transaction cost economics insists that contracting costs of all kinds be accorded parity.

Ex post costs of contracting take several forms. These include (1) the maladaption costs incurred when transactions drift out of alignment in relation to what Masahiko Aoki refers to as the "shifting contract curve" (1983), (2) the haggling costs incurred if bilateral efforts are made to correct ex post misalignments, (3) the setup and running costs associated with the governance structures (often not the courts) to which disputes are referred, and (4) the bonding costs of effecting secure commitments.

Thus suppose that the contract stipulates x but, with the benefit of hindsight (or in the fullness of knowledge), the parties discern that they should have done y. Getting from x to y, however, may not be easy. The manner in which the associated benefits are divided is apt to give rise to intensive, self-interested bargaining. Complex, strategic behavior may be elicited. Referring the dispute to another forum may help, but that will vary with the circumstances. An incomplete adaptation will be realized if, as a consequence of efforts of both kinds, the parties move not to y but to y'.

A complicating factor in all of this is that the ex ante and ex post costs of contract are interdependent. Put differently, they must be addressed simultaneously rather than sequentially. Also, costs of both types are often difficult to quantify. The difficulty, however, is mitigated by the fact that transaction costs are always assessed in a comparative institutional way, in which one mode of contracting is compared with another. Acc

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