The Theory of the Firm as Governance Structure: From...

The Theory of the Firm as GovernanceStructure From Choice to Contract

Oliver E Williamson

T he propositions that organization matters and that it is susceptible toanalysis were long greeted by skepticism by economists To be sure therewere conspicuous exceptions Alfred Marshall in Industry and Trade

(1932) Joseph Schumpeter in Capitalism Socialism and Democracy (1942) andFriedrich Hayek (1945) in his writings on knowledge Institutional economists likeThorstein Veblen (1904) John R Commons (1934) and Ronald Coase (1937) andorganization theorists like Robert Michels (1915 [1962]) Chester Barnard (1938)Herbert Simon (1957a) James March (March and Simon 1958) and Richard Scott(1992) also made the case that organization deserves greater prominence

One reason why this message took a long time to register is that it is mucheasier to say that organization matters than it is to show how and why1 Theprevalence of the science of choice approach to economics has also been anobstacle As developed herein the lessons of organization theory for economics areboth different and more consequential when examined through the lens of con-tract This paper examines economic organization from a science of contractperspective with special emphasis on the theory of the rm

1 A Behavioral Theory of the Firm (Cyert and March 1963) was one obvious early candidate for an economictheory of organizations It deals however with more ne-grained phenomenamdashsuch as predictingdepartment store prices to the pennymdashthan were of interest to most economists For a discussion seeWilliamson (1999b) The recent and growing interest in behavioral economicsmdashwhich deals more withthe theory of consumer behavior than with the theory of the rmmdashcan be interpreted as a delayedresponse to the lessons of the ldquoCarnegie schoolrdquo associated with Cyert March and Simon

y Oliver E Williamson is Edgar F Kaiser Professor of Business Administration Professor ofEconomics and Professor of Law all at the University of California Berkeley His e-mailaddress is owilliamhaasberkeleyedu

Journal of Economic PerspectivesmdashVolume 16 Number 3mdashSummer 2002mdashPages 171ndash195

The Sciences of Choice and Contract

Economics throughout the twentieth century has been developed predomi-nantly as a science of choice As Lionel Robbins famously put it in his book An Essayon the Nature and Signicance of Economic Science (1932 p 16) ldquoEconomics is thescience which studies human behavior as a relationship between ends and scarcemeans which have alternative usesrdquo Choice has been developed in two parallelconstructions the theory of consumer behavior in which consumers maximizeutility and the theory of the rm as a production function in which rms maximizepro t Economists who work out of such setups emphasize how changes in relativeprices and available resources in uence quantities a project that became theldquodominant paradigmrdquo for economics throughout the twentieth century (Reder1999 p 48)

But the science of choice is not the only lens for studying complex economicphenomena nor is it always the most instructive lens The other main approach iswhat James Buchanan (1964a b 1975) refers to as the science of contract IndeedBuchanan (1975 p 225) avers that economics as a discipline went ldquowrongrdquo in itspreoccupation with the science of choice and the optimization apparatus associatedtherewith Wrong or not the parallel development of a science of contract wasneglected

As perceived by Buchanan (1987 p 296) the principal needs for a science ofcontract were for the eld of public nance and took the form of public orderingldquoPolitics is a structure of complex exchange among individuals a structure withinwhich persons seek to secure collectively their own privately de ned objectives thatcannot be ef ciently secured through simple market exchangesrdquo Thinking con-tractually in the public ordering domain leads into a focus on the rules of the gameConstitutional economics issues are posed (Buchanan and Tullock 1962 Brennanand Buchanan 1985)

Whatever the rules of the game the lens of contract is also usefully brought tobear on the play of the game This latter is what I refer to as private ordering whichentails efforts by the immediate parties to a transaction to align incentives and tocraft governance structures that are better attuned to their exchange needs Theobject of such self-help efforts is to realize better the ldquomutuality of advantage fromvoluntary exchange [that is] the most fundamental of all understandings ineconomicsrdquo (Buchanan 2001 p 29) due allowance being made for the mitigationof contractual hazards Strategic issuesmdashto which the literatures on mechanismdesign agency theory and transaction cost economicsincomplete contracting allhave a bearingmdashthat had been ignored by neoclassical economists from 1870 to1970 now make their appearance (Makowski and Ostroy 2001 pp 482ndash483490ndash491)

Figure 1 sets out the main distinctions The initial divide is between the scienceof choice (orthodoxy) and the science of contract The latter then divides intopublic ordering (constitutional economics) and private ordering parts where thesecond is split into two related branches One branch concentrates on front-end

172 Journal of Economic Perspectives

incentive alignment (mechanism design agency theory the formal property rightsliterature) while the second branch features the governance of ongoing contrac-tual relations (contract implementation) This paper is mainly concerned withgovernance especially with reference to the theory of the rm

Organization Theory through the Lens of Contract

Organization theory is a huge subject Macro and micro parts are commonlydistinguished where the former is closer to sociology and the latter to socialpsychology Also it is common to distinguish among rational natural and opensystems approaches (Scott 1992) My concern is with macro organization theory ofa rational systems kind (with special reference to the contributions of HerbertSimon)

In addition to delimiting organization theory in this way I also examine thelessons of organization theory for economics not through the lens of choice butthrough the lens of contract Whereas those who work out of the dominantparadigm have sometimes been dismissive of organization theory (Posner 1993Reder 1999 pp 46ndash49) the lens of contractprivate ordering discloses thatlessons of organization theory for economics that the dominant paradigm obscuresare sometimes fundamental

Five Lessons from Organization Theory to the Economics of ContractsA rst lesson from organization theory is to describe human actors in more

realistic terms Simon (1985 p 303) is unequivocal ldquoNothing is more fundamentalin setting our research agenda and informing our research methods than our viewof the nature of the human beings whose behavior we are studyingrdquo Social scientists

Figure 1The Sciences of Choice and Contract

Oliver E Williamson 173

are thus invited (challenged) to name the cognitive self-interest and other at-tributes of human actors on which their analyses rest

Bounded rationality is the cognitive assumption to which Simon (1957ap xxiv) refers by which he has reference to behavior that is intendedly rational butonly limitedly so In his view the main lesson for the science of choice is to supplantmaximizing by ldquosatis cingrdquo (1957b p 204)mdashthe quest for an alternative that isldquogood enoughrdquo2

The study of governance also appeals to bounded rationality but the mainlesson for the science of contract is different All complex contracts are unavoidablyincomplete For this reason parties will be confronted with the need to adapt tounanticipated disturbances that arise by reason of gaps errors and omissions in theoriginal contract Such adaptation needs are especially consequential if instead ofdescribing self-interest as ldquofrailty of motiverdquo (Simon 1985 p 303) which is acomparatively benign condition strategic considerations are entertained as well Ifhuman actors are not only confronted with needs to adapt to the unforeseen (byreason of bounded rationality) but are also given to strategic behavior (by reasonof opportunism) then costly contractual breakdowns (refusals of cooperationmaladaptation demands for renegotiation) may be posed In that event privateordering efforts to devise supportive governance structures thereby to mitigateprospective contractual impasses and breakdowns have merit

To be sure such efforts would be unneeded if common knowledge of payoffsand costless bargaining are assumed Both of these conditions however are deeplyproblematic (Kreps and Wilson 1982 Williamson 1985) Moreover because prob-lems of nonveri ability are posed when bounded rationality opportunism andidiosyncratic knowledge are joined (Williamson 1975 pp 31ndash33) dispute resolu-tion by the courts in such cases is costly and unreliable Private orderingmdashthat isefforts to craft governance structure supports for contractual relations during thecontract implementation intervalmdashthus makes its appearance

A second lesson of organization theory is to be alert to all signi cant behavioralregularities whatsoever For example efforts by bosses to impose controls onworkers have both intended and unintended consequences Out of awareness thatworkers are not passive contractual agents naumlve efforts that focus entirely onintended effects will be supplanted by more sophisticated mechanisms whereprovision is made for consequences of both kinds More generally the awarenessamong sociologists that ldquoorganization has a life of its ownrdquo (Selznick 1950 p 10)serves to uncover a variety of behavioral regularities (of which bureaucratization isone) for which the student of governance should be alerted and thereafter factorinto the organizational design calculus

A third lesson of organization theory is that alternative modes of governance

2 Although satis cing is an intuitively appealing concept it is very hard to implement Awaiting furtherdevelopments the satis cing approach is not broadly applicable (Aumann 1985 p 35) Indeed thereis an irony neoclassical economists who use a mode of analysis (maximizing) that is easy to implementand often is good enough for the purposes at hand are analytical satis cers


(markets hybrids rms bureaus) differ in discrete structural ways (Simon 1978pp 6ndash7) Not only do alternative modes of governance differ in kind but eachgeneric mode of governance is de ned by an internally consistent syndrome ofattributesmdashwhich is to say that each mode of governance possesses distinctivestrengths and weaknesses As discussed below the challenge is to enunciate therelevant attributes for describing governance structures and thereafter to aligndifferent kinds of transactions with discrete modes of governance in an economiz-ing way

A fourth lesson of the theory of organizations is that much of the action residesin the microanalytics Simon (1957a p xxx) nominated the ldquodecision premiserdquo asthe unit of analysis which has an obvious bearing on the microanalytics of choice(Newell and Simon 1972) The unit of analysis proposed by John R Commonshowever better engages the study of contract According to Commons (1932 p 4)ldquothe ultimate unit of activity must contain in itself the three principles ofcon ict mutuality and order This unit is a transactionrdquo

Whatever the unit of analysis operationalization turns on naming and expli-cating the critical dimensions with respect to which the unit varies Three of the keydimensions of transactions that have important rami cations for governance areasset speci city (which takes a variety of formsmdashphysical human site dedicatedbrand namemdashand is a measure of bilateral dependency) the disturbances to whichtransactions are subject (and to which potential maladaptations accrue) and thefrequency with which transactions recur (which bears both on the ef cacy ofreputation effects in the market and the incentive to incur the cost of specializedinternal governance) Given that transactions differ in their attributes and thatgovernance structures differ in their costs and competencies the aforemen-tionedmdashthat transactions should be aligned with appropriate governance struc-turesmdashapplies

A fth lesson of organization theory is the importance of cooperative adapta-tion Interestingly both the economist Friedrich Hayek (1945) and the organiza-tion theorist Chester Barnard (1938) were in agreement that adaptation is thecentral problem of economic organization Hayek (1945 pp 526ndash527) focused onthe adaptations of autonomous economic actors who adjust spontaneously tochanges in the market mainly as signaled by changes in relative prices The marvelof the market resides in ldquohow little the individual participants need to know to beable to take the right actionrdquo By contrast Barnard featured coordinated adaptationamong economic actors working through deep knowledge and the use of admin-istration In his view the marvel of hierarchy is that coordinated adaptation isaccomplished not spontaneously but in a ldquoconscious deliberate purposefulrdquo way(p 9)

Because a high-performance economic system will display adaptive propertiesof both kinds the problem of economic organization is properly posed not asmarkets or hierarchies but rather as markets and hierarchies A predictive theory ofeconomic organization will recognize how and why transactions differ in their

The Theory of the Firm as Governance Structure From Choice to Contract 175

adaptive needs whence the use of the market to supply some transactions andrecourse to hierarchy for others

Follow-on Insights from the Lens of ContractExamining economic organization through the lens of contract uncovers

additional regularities to which governance rami cations accrue Three such reg-ularities are described here the Fundamental Transformation the impossibility ofreplicationselective intervention and the idea of contract laws (plural)

The Fundamental Transformation applies to that subset of transactions forwhich large numbers of quali ed suppliers at the outset are transformed into whatare in effect small numbers of actual suppliers during contract execution and atthe contract renewal interval The distinction to be made is between generictransactions where ldquofaceless buyers and sellers meet for an instant to ex-change standardized goods at equilibrium pricesrdquo (Ben-Porath 1980 p 4) andexchanges where the identities of the parties matter in that continuity of therelation has signi cant cost consequences Transactions for which a bilateral depen-dency condition obtains are those to which the Fundamental Transformation applies

The key factor here is whether the transaction in question is supported byinvestments in transaction-speci c assets Such specialized investments may take theform of specialized physical assets (such as a die for stamping out distinctive metalshapes) specialized human assets (that arise from rm-speci c training or learningby doing) site speci city (specialization by proximity) dedicated assets (largediscrete investments made in expectation of continuing business the prematuretermination of which business would result in product being sold at distress prices)or brand-name capital Parties to transactions that are bilaterally dependent areldquovulnerablerdquo in that buyers cannot easily turn to alternative sources of supply whilesuppliers can redeploy the specialized assets to their next best use or user only ata loss of productive value (Klein Crawford and Alchian 1978) As a result value-preserving governance structuresmdashto infuse order thereby to mitigate con ict andto realize mutual gainmdashare sought3 Simple market exchange thus gives way tocredible contracting which includes penalties for premature termination mecha-nisms for information disclosure and veri cation specialized dispute settlementprocedures and the like Uni ed ownership (vertical integration) is predicted asbilateral dependency hazards build up

The impossibility of combining replication with selective intervention is thetransaction cost economics answer to an ancient puzzle What is responsible forlimits to rm size Diseconomies of large scale is the obvious answer but whereindo these diseconomies reside Technology is no answer since each plant in a

3 Bilateral dependency need not result from physical asset speci city if the assets are mobile since abuyer who owns and who can repossess the assets can assign them to whichever supplier tenders thelowest bid Also site speci c assets can sometimes be owned by a buyer and leased to a supplierNonetheless such ldquosolutionsrdquo will pose user cost problems if suppliers cannot be relied upon to exercisedue care


multiplant rm can use the least-cost technology Might organization provide theanswer That possibility can be examined by rephrasing the question in compara-tive contractual terms Why canrsquot a large rm do everything that a collection ofsmall suppliers can do and more

Were it that large rms could replicate a collection of small rms in allcircumstances where small rms do well then large rms would never do worse Ifmoreover large rms could always selectively intervene by imposing (hierarchical)order on prospective con ict but only where expected net gains could be pro-jected then large rms would sometimes do better Taken together the combina-tion of replication with selective intervention would permit large rms to growwithout limit Accordingly the issue of limits to rm size turns to an examinationof the mechanisms for implementing replication and selective intervention

Examining how and why both replication and selective intervention breakdown is a tedious microanalytic exercise and is beyond the scope of this paper(Williamson 1985 chapter 6) Suf ce it to observe here that the move fromautonomous supply (by the collection of small rms) to uni ed ownership (in onelarge rm) is unavoidably attended by changes in both incentive intensity (incentivesare weaker in the integrated rm) and administrative controls (controls are moreextensive) Because the syndromes of attributes that de ne markets and hierarchieshave different strengths and weaknesses some transactions will bene t from themove from market to hierarchy while others will not

Yet another organizational dimension that distinguishes alternative modes ofgovernance is the regime of contract laws Whereas economic orthodoxy oftenimplicitly assumes that there is a single all-purpose law of contract that is costlesslyenforced by well-informed courts the private ordering approach to governancepostulates instead that each generic mode of governance is de ned (in part) by adistinctive contract law regime

The contract law of (ideal) markets is that of classical contracting accordingto which disputes are costlessly settled through courts by the award of moneydamages Galanter (1981 pp 1ndash2) takes issue with this legal centralism traditionand observes that many disputes between rms that could under current rules bebrought to a court are resolved instead by avoidance self-help and the like That isbecause in ldquomany instances the participants can devise more satisfactory solutionsto their disputes than can professionals constrained to apply general rules on thebasis of limited knowledge of the disputerdquo (p 4) Such a view is broadly consonantwith the concept of ldquocontract as frameworkrdquo advanced by Karl Llewellyn (1931pp 736ndash737) which holds that the ldquomajor importance of legal contract is toprovide a framework which never accurately indicates real working relationsbut which affords a rough indication around which such relations vary an occa-sional guide in cases of doubt and a norm of ultimate appeal when the relationscease in fact to workrdquo This last condition is important in that recourse to the courtsfor purposes of ultimate appeal serves to delimit threat positions The more elasticconcept of contract as framework nevertheless supports a (cooperative) exchangerelation over a wider range of contractual disturbances


What is furthermore noteworthy is that some disputes cannot be brought to acourt at all Speci cally except as ldquofraud illegality or con ict of interestrdquo are showncourts will refuse to hear disputes that arise within rmsmdashwith respect for exam-ple to transfer pricing overhead accounting the costs to be ascribed to intra rmdelays failures of quality and the like In effect the contract law of internalorganization is that of forbearance according to which a rm becomes its own courtof ultimate appeal Firms for this reason are able to exercise at that the marketscannot This too in uences the choice of alternative modes of governance

Not only is each generic mode of governance de ned by an internally consis-tent syndrome of incentive intensity administrative controls and contract lawregime (Williamson 1991a) but different strengths and weaknesses accrue to each

The Theory of the Firm as Governance Structure

As Demsetz (1983 p 377) observes it is ldquoa mistake to confuse the rm of[orthodox] economic theory with its real-world namesake The chief mission ofneoclassical economics is to understand how the price system coordinates the useof resources not the inner workings of real rmsrdquo Suppose instead that theassigned mission of economics is to understand the organization of economicactivity In that event it will no longer suf ce to describe the rm as a black box thattransforms inputs into outputs according to the laws of technology Instead rmsmust be described in relation to other modes of governance all of which haveinternal structure which structure ldquomust arise for some reasonrdquo (Arrow 1999p vii)

The contractprivate orderinggovernance (hereafter governance) approachmaintains that structure arises mainly in the service of economizing on transactioncosts Note in this connection that the rm as governance structure is a comparativecontractual construction The rm is conceived not as a stand-alone entity but isalways to be compared with alternative modes of governance By contrast withmechanism design (where a menu of contracts is used to elicit private informa-tion) agency theory (where risk aversion and multitasking are featured) and theproperty rights theory of the rm (where everything rests on asset ownership) thegovernance approach appeals to law and organization theory in naming incentiveintensity administrative control and contract law regime as three critical attributes

It will be convenient to illustrate the mechanisms of governance with referenceto a speci c class of transactions Because transactions in intermediate productmarkets avoid some of the more serious conditions of asymmetrymdashof informationbudget legal talent risk aversion and the likemdashthat beset some transactions in nalproduct markets I examine the ldquomake-or-buyrdquo decision Should a rm make aninput itself perhaps by acquiring a rm that makes the input or should it purchasethe input from another rm


The Science of Choice Approach to the Make-or-Buy DecisionThe main way to examine the make-or-buy decision under the setup of rm as

production function is with reference to bilateral monopoly4 The neoclassicalanalysis of bilateral monopoly reached the conclusion that while optimal quantitiesbetween the parties might be realized the division of pro ts between bilateralmonopolists was indeterminate (for example Machlup and Tabor 1960 p 112)Vertical integration might then arise as a means by which to relieve bargaining overthe indeterminacy Alternatively vertical integration could arise as a means bywhich to restore ef cient factor proportions when an upstream monopolist soldintermediate product to a downstream buyer that used a variable proportionstechnology (McKenzie 1951) Vertical integration has since been examined in acombined variable proportions-monopoly power context by Vernon and Graham(1971) Schmalensee (1973) Warren-Boulton (1974) West eld (1981) and Hartand Tirole (1990)

This literature is instructive but it is also beset by a number of loose ends oranomalies First since preexisting monopoly power of a durable kind is the excep-tion in a large economy rather than the rule what explains vertical integration forthe vast array of transactions where such power is negligible Second why donrsquot rms integrate everything since under a production function setup an integrated rm can always replicate its unintegrated rivals and can sometimes improve onthem Third what explains hybrid modes of contracting More generally if manyof the problems of trading are of an intertemporal kind in which successiveadaptations to uncertainty are needed do the problems of economic organizationhave to be recast in a larger and different framework

Coase and the Make-or-Buy DecisionCoasersquos (1937) classic article opens with a basic puzzle Why does a rm

emerge at all in a specialized exchange economy If the answer resides in entre-preneurship why is coordination ldquothe work of the price mechanism in one case andthe entrepreneur in the otherrdquo (p 389) Coase appealed to transaction costeconomizing as the hitherto missing factor for explaining why markets were usedin some cases and hierarchy in other cases and averred (p 391) ldquoThe main reasonwhy it is pro table to establish a rm would seem to be that there is a cost of usingthe price mechanism the most obvious [being] that of discovering what therelevant prices arerdquo This sounds plausible But how is it that internal procurementby the rm avoids the cost of price discovery

The ldquoobviousrdquo answer is that sole-source internal supply avoids the need toconsult the market about prices because internal accounting prices of a formulaic

4 Although the bilateral monopoly explanation is the oldest explanation and the one emphasized inmost microeconomics textbooks three other price-theoretic frameworks have been used to explain themake-or-buy decision price discrimination barriers to entry and strategic purposes For a summary ofthe arguments on these points see Williamson (1987 pp 808ndash809) For a more complete discussionsee Perry (1989)


kind (say of a cost-plus kind) can be used to transfer a good or service from oneinternal stage to another If however that is the source of the advantage of internalorganization over market procurement the obvious lesson is to apply this samepractice to outside procurement The rm simply advises its purchasing of ce toturn a blind eye to the market by placing orders period by period with a quali edsole-source external supplier who agrees to sell on cost-plus terms In that event rm and market are put on a parity in price discovery respectsmdashwhich is to say thatthe price discovery burden that Coase ascribes to the market does not survivecomparative institutional scrutiny5

In the end Coasersquos profoundly important challenge to orthodoxy and hisinsistence on introducing transactional considerations does not lead to refutableimplications (Alchian and Demsetz 1972) Operationalization of these good ideaswas missing (Coase 1992 pp 716ndash718) The theory of the rm as governancestructure is an effort to infuse operational content Transaction cost economizingis the unifying concept6

A Heuristic Model of Firm as Governance StructureExpressed in terms of the ldquoCommons triplerdquomdashthe notion that the transaction

incorporates the three aspects of con ict mutuality and ordermdash governance is themeans by which to infuse order thereby to mitigate con ict and to realize ldquothemost fundamental of all understandings in economicsrdquo mutual gain from voluntaryexchange The surprise is that a concept as important as governance should havebeen so long neglected

The rudiments of a model of the rm as governance structure are the at-tributes of transactions the attributes of alternative modes of governance and thepurposes served Asset speci city (which gives rise to bilateral dependency) anduncertainty (which poses adaptive needs) are especially important attributes oftransactions The attributes that de ne a governance structure include incentiveintensity administrative control and the contract law regime In this frameworkmarket and hierarchy syndromes differ as follows under hierarchy incentiveintensity is less administrative controls are more numerous and discretionary andinternal dispute resolution supplants court ordering Adaptation is taken to be themain purpose where the requisite mix of autonomous adaptations and coordi-nated adaptations vary among transactions Speci cally the need for coordinatedadaptations builds up as asset speci city deepens

In a heuristic way Figure 2 shows the transaction cost consequences of organ-

5 It does not suf ce to argue that vigilance is unneeded for trade within rms because transfer prices area wash For one thing different transfer prices will induce different factor proportions in divisionalized rms where divisions are held accountable for their bottom lines (unless xed proportions areimposed) Also because incentives within rms are weaker ready access to the pass-through of costs canencourage cost excesses The overarching point is this to focus on transfer pricing to the neglect ofdiscrete structural differences between rm and market is to miss the forest for the trees6 Other purposes include choice of ef cient factor proportions specialization of labor (in both physicaland cognitive respects) and knowledge acquisition and development


izing transactions in markets (M ) and hierarchies (H ) as a function of assetspeci city (k) As shown the bureaucratic burdens of hierarchy place it at an initialdisadvantage (k 5 0) but the cost differences between markets M(k) and hierar-chy H(k) narrow as asset speci city builds up and eventually reverse as the need forcooperative adaptation becomes especially great (k 0) Provision can further bemade for the hybrid mode of organization X(k) where hybrids are viewed asmarket-preserving credible contracting modes that possess adaptive attributes lo-cated between classical markets and hierarchies Incentive intensity and adminis-trative control thus take on intermediate values and Llewellynrsquos (1931) concept ofcontract as framework applies As shown in Figure 2 M(0) X(0) H(0) (byreason of bureaucratic cost differences) while M9 X9 H9 (which re ects thecost of coordinated adaptation)

This rudimentary setup yields refutable implications that are broadly corrob-orated by the data It can be extended to include differential production costsbetween modes of governance which mainly preserves the basic argument thathierarchy is favored as asset speci city builds up ceteris paribus (Riordan andWilliamson 1985) The foregoing relations among governance structures andtransactions can also be replicated with a simple stochastic model where the needsfor adaptation vary with the transaction and the ef cacy of adaptations of autono-mous and cooperative kinds vary with the governance structures Shift parameterscan also be introduced in such a model (Williamson 1991a) More fully formaltreatments of contracting that are broadly congruent with this setup are inprogress

Figure 2Comparative Costs of Governance


Whereas most theories of vertical integration do not invite empirical testingthe transaction cost theory of vertical integration invites and has been the subjectof considerable empirical analysis Empirical research in the eld of industrialorganization is especially noteworthy because the eld has been criticized for theabsence of such work Not only did Coase once describe his 1937 article as ldquomuchcited and little usedrdquo (1972 p 67) but others have since commented upon thepaucity of empirical work on the theory of the rm (Holmstrom and Tirole 1989p 126) and in the eld of industrial organization (Peltzman 1991) By contrastempirical transaction cost economics has grown exponentially during the past 20years For surveys see Shelanski and Klein (1995) Lyons (1996) Crocker andMasten (1996) Rind eisch and Heide (1997) Masten and Saussier (2000) andBoerner and Macher (2001)7 Added to this are numerous applications to publicpolicy especially antitrust and regulation but also to economics more generally(Dixit 1996) and to the contiguous social sciences (especially political science)The upshot is that the theory of the rm as governance structure has become amuch used construction

Variations on a Theme

Vertical integration turns out to be a paradigm Although many of the empir-ical tests and public policy applications have reference to the make-or-buy decisionand vertical market restrictions this same framework has application to contractingmore generally Speci cally the contractual relation between the rm and itsldquostakeholdersrdquomdash customers suppliers and workers along with nancial investorsmdashcan be interpreted as variations on a theme

The Contractual SchemaAssume that a rm can make or buy a component and assume further that the

component can be supplied by either a general purpose technology or a specialpurpose technology Again let k be a measure of asset speci city The transactionsin Figure 3 that use the general purpose technology are ones for which k 5 0 Inthis case no speci c assets are involved and the parties are essentially faceless If

7 I would note parenthetically that the GM-Fisher Body example (Klein Crawford and Alchian 1978)that is widely used to illustrate the contractual strains that attend bilateral dependency has come undercriticism (see the exchange in the April 2000 issue of the Journal of Law and Economics) My responses aretwo First and foremost even if the GM-Fisher Body anecdote is factually awed transaction costeconomics remains an empirical success story (see text and Whinston 2001) Second the main purposeof an anecdote is pedagogical to provide intuition That is what the confectioner and physician cases dofor externalities (Coase 1959) what QWERTY does for path dependency (David 1985) what themarket for lemons does for asymmetric information (Akerlof 1970) and what the tragedy of thecommons does for collective organization (Hardin 1968) It is better to be sure if anecdotes arefactually correct Unless however the phenomenon described by the anecdote is trivial or bogus (whichconditions may not be evident until an empirical research program is undertaken) an anecdote thathelps to bring an abstract condition to life has served its intended purpose


instead transactions use the special purpose technology k 0 As hithertodiscussed bilaterally dependent parties have incentives to promote continuity andsafeguard their speci c investments Let s denote the magnitude of any suchsafeguards which include penalties information disclosure and veri cation proce-dures specialized dispute resolution (such as arbitration) and in the limit inte-gration of the two stages under uni ed ownership An s 5 0 condition is one forwhich no safeguards are provided a decision to provide safeguards is re ected byan s 0 result

Node A in Figure 3 corresponds to the ideal transaction in law and economicsthere being an absence of dependency governance is accomplished throughcompetitive market prices and in the event of disputes by court-awarded damagesNode B poses unrelieved contractual hazards in that specialized investments areexposed (k 0) for which no safeguards (s 5 0) have been provided Suchhazards will be recognized by farsighted players who will price out the impliedrisks

Added contractual supports (s 0) are provided at nodes C and D At nodeC these contractual supports take the form of inter rm contractual safeguardsShould however costly breakdowns continue in the face of best bilateral efforts tocraft safeguards at node C the transaction may be taken out of the market andorganized under uni ed ownership (vertical integration) instead Because addedbureaucratic costs accrue upon taking a transaction out of the market and orga-nizing it internally internal organization is usefully thought of as the organizationform of last resort That is try markets try hybrids and have recourse to the rmonly when all else fails Node D the uni ed rm thus comes in only as higherdegrees of asset speci city and added uncertainty pose greater needs for cooper-ative adaptation

Note that the price that a supplier will bid to supply under node C conditionswill be less than the price that will be bid at node B That is because the addedsecurity features serve to reduce the risk at node C as compared with node B so

Figure 3Simple Contracting Schema


the contractual hazard premium will be reduced One implication is that suppliersdo not need to petition buyers to provide safeguards Because buyers will receiveproduct on better terms (lower price) when added security is provided buyers havethe incentive to offer credible commitments Thus although such commitmentsare sometimes thought of as a user-friendly way to contract the analytical actionresides in the hard-headed use of credibility to support those transactions whereasset speci city and contractual hazards are an issue Such supports are withoutpurpose for transactions where the general purpose production technology isemployed

The foregoing schema can be applied to virtually all transactions for which the rm is in a position to own as well as to contract with an adjacent stagemdash backwardinto raw materials laterally into components forward into distribution8 But forsome activities ownership is either impossible or very rare For example rmscannot own their workers nor their nal customers (although worker cooperativesand consumer cooperatives can be thought of in ownership terms) Also rmsrarely own their suppliers of nance Node D drops out of the schema in caseswhere ownership is either prohibited by law or is otherwise rare I begin withforward integration into distribution after which relationships with other stake-holders of the rm including labor nance and public utility regulation aresuccessively considered

Forward Integration into DistributionI will set aside the case where mass marketers integrate backward into manu-

facturing and focus on forward integration into distribution by manufacturers ofproducts or owners of brands Speci cally consider the contractual relation be-tween a manufacturer and large numbers of wholesalers or especially of retailersfor the good or service in question

Many such transactions are of a generic kind Although branded goods andservices are more speci c some require only shelf space since advertising promo-tion and any warranties are done by the manufacturer Since the obvious way totrade with intermediaries for such transactions is through the market in a node Afashion what is to be inferred when such transactions are made subject to verticalmarket restrictions such as customer and territorial restrictions service restrictionstied sales and the like

Price discrimination to which allocative ef ciency bene ts were ascribed wasthe usual resource allocation (science of choice) explanation for such restrictionsSuch bene ts however were problematic once the transaction costs of discoveringcustomer valuations and deterring arbitrage were taken into account (Williamson1975 pp 11ndash13) Moreover price discrimination does not exhaust the possibilities

Viewed through the lens of contract vertical market restrictions often have the

8 Closely complementary activities are commonly relegated to the ldquocore technologyrdquo (Thompson 1967pp 19ndash23) and are effectively exempt from comparative institutional analysis it being ldquoobviousrdquo thatthese are done within the rm


purpose and effect of infusing order into a transaction where the interests of thesystem and the interests of the parts are in con ict For example the Schwinnbicycle company imposed non-resale restrictions upon franchisees The concernwas that the integrity of the brand which was a system asset would be compromisedby franchisees who perceived local opportunities to realize individual gain byselling to discounters who would then sell a ldquobike in a boxrdquo without service orsupport (Williamson 1985 pp 183ndash189) More generally the argument is this Incircumstances where market power is small where simple market exchange (atnode A) would compromise the integrity of differentiated products and whereforward integration into distribution (at node D) would be especially costly the useof vertical market restrictions to effect credible commitments (at node C ) hasmuch to recommend it

Relationship with LaborBecause the rm is unable to own its labor node D is irrelevant and the

comparison comes down to nodes A B and C Node A corresponds to the casewhere labor is easily redeployed to other uses or users without loss of productivevalue (k 5 0) Thus although such labor may be highly skilled (as with manyprofessionals) the lack of rm speci city means that transition costs aside neitherworker nor rm has an interest in crafting penalties for unwanted quitstermina-tions or otherwise creating costly internal labor markets (ports of entry promotionladders) costly information disclosure and veri cation procedures and costly rm-speci c dispute settlement machinery The mutual bene ts do not warrant thecosts

Conditions change when k 0 since workers who acquire rm-speci c skillswill lose value if prematurely terminated (and rms will incur added training costsif such employees quit) Here as elsewhere unrelieved hazards (as at node B) willresult in demands by workers for a hazard premium and recurrent contractualimpasses by reason of con ict will result in inef ciency Because continuity hasvalue to both rm and worker governance features that deter termination (sever-ance pay) and quits (nonvested bene ts) and that address and settle disputes in anorderly way (grievance systems) to which the parties ascribe con dence have a lotto recommend them These can but need not take the form of ldquounionsrdquo Whateverthe name the object is to craft a collective organizational structure (at node C ) inwhich the parties have mutual con dence and that enhances ef ciency (Baron andKreps 1999 pp 130ndash138 Williamson 1975 pp 27ndash80 1985 pp 250ndash262)9

9 The emphasis on collective organization as a governance response is to be distinguished from theearlier work of Gary Becker where human asset speci city is responsible for upward-sloping age-earnings pro les (Becker 1962) Beckerrsquos treatment is more in the science of choice tradition whereasmine views asset speci city through the lens of contract These two are not mutually exclusive They dohowever point to different empirical research agenda


Relationship with Sources of FinanceViewed through the lens of contract the board of directors is interpreted as a

security feature that arises in support of the contract for equity nance (William-son 1988) More generally debt and equity are not merely alternative modes of nance which is the law and economics construction (Easterbrook and Fischel1986 Posner 1986) but are also alternative modes of governance

Suppose that a rm is seeking cost-effective nance for the following series ofprojects general purpose mobile equipment a general purpose of ce buildinglocated in a population center a general purpose plant located in a manufacturingcenter distribution facilities located somewhat more remotely special purposeequipment market and product development expenses and the like Supposefurther that debt is a governance structure that works almost entirely out of a set ofrules 1) stipulated interest payments will be made at regular intervals 2) thebusiness will continuously meet certain liquidity tests 3) principal will be repaid atthe loan-expiration date and 4) in the event of default the debtholders willexercise preemptive claims against the assets in question In short debt is unfor-giving if things go poorly

Such rules-based governance is well suited to investments of a generic kind(k 5 0) since the lender can redeploy these to alternative uses and users with littleloss of productive value Debt thus corresponds to market governance at node ABut what about investment projects of more speci c (less redeployable) kinds

Because the value of holding a preemptive claim declines as the degree of assetspeci city deepens rule-based nance of the kind described above will be made onmore adverse terms In effect using debt to nance such projects would locate theparties at node B where a hazard premium must be charged The rm in thesecircumstances has two choices sacri ce some of the specialized investment featuresin favor of greater redeployability (move back to node A) or embed the specializedinvestment in a governance structure to which better terms of nance will beascribed What would the latter entail

Suppose that a nancial instrument called equity is invented and assume thatequity has the following governance properties 1) it bears a residual claimant statusto the rm in both earnings and asset liquidation respects 2) it contracts for theduration of the life of the rm and 3) a board of directors is created and awardedto equity that a) is elected by the pro-rata votes of those who hold tradable sharesb) has the power to replace the management c) decides on management com-pensation d) has access to internal performance measures on a timely basis e) canauthorize audits in depth for special follow-up purposes f) is apprised of importantinvestment and operating proposals before they are implemented and g) in otherrespects bears a decision-review and monitoring relation to the rmrsquos management(Fama and Jensen 1983) So construed the board of directors is awarded tothe holders of equity so as to reduce the cost of capital by providing safeguardsfor projects that have limited redeployability (by moving them from node B tonode C )


Regulation and Natural MonopolyThe market-oriented approach to natural monopoly is to auction off the

franchise to the highest bidder (Demsetz 1968 Posner 1972) But whether thisworks well or poorly depends on the nature of the transaction and the particularsof governance Whereas some of those who work out of the science of choice setupbelieve that to ldquoexpound the details of particular regulations and propos-als would serve only to obscure the basic issuesrdquo (Posner 1972 p 98) thegovernance structure approach counsels that much of the action resides in thedetails

Going beyond the initial bidding competition (ldquocompetition for the marketrdquo)the governance approach insists upon including the contract implementationstage Transactions to which the Fundamental Transformation appliesmdashnamelythose requiring signi cant investments in speci c assets and that are subject toconsiderable market and technological uncertaintymdashare ones for which the ef -cacy of simple franchise bidding is problematic

This is not to say that franchise bidding never works Neither is it to suggestthat decisions to regulate ought not to be revisitedmdashas witness the successfulderegulation of trucking (which never should have been regulated to begin with)and more recent efforts to deregulate ldquonetwork industriesrdquo (Peltzman and Whin-ston 2000) I would nevertheless urge that examining deregulation through thelens of contracting is instructive for bothmdashas it is for assessing efforts to deregulateelectricity in California where too much deference was given to the (assumed)ef cacy of smoothly functioning markets and insuf cient attention to potentialinvestment and contractual hazards and appropriate governance responses theretoAs Joskow (2000 p 51) observes ldquoMany policy makers and fellow travelers havebeen surprised by how dif cult it has been to create wholesale electricity mar-kets Had policy makers viewed the restructuring challenge using a TCE [trans-action cost economics] framework these potential problems are more likely to havebeen identi ed and mechanisms adopted ex ante to x themrdquo

Here as elsewhere the lesson is to think contractually Look ahead recognizepotential hazards and fold these back into the design calculus Paraphrasing RobertMichels (1915 [1962] p 370) on oligarchy nothing but a serene and frankexamination of the contractual hazards of deregulation will enable us to mitigatethese hazards

Recent Criticisms

Many skeptics of orthodoxy have also been critics of transaction cost eco-nomicsmdashincluding organization theorists (especially Simon 1991 1997) sociolo-gists (for a recent survey see Richter 2001) and the resource-basedcore compe-tencedynamic capabilities perspective Having responded to these arguments


elsewhere10 I focus here on critiques from within economicsmdashespecially those thatdeal with issues concerning the boundary of the rms11

Property Rights TheoryThe property rights theory of rm and market organization is unarguably a

path-breaking contribution (Grossman and Hart 1986 Hart and Moore 1990Hart 1995) Prior to this work the very idea that incomplete contracts could beformally modeled was scorned That has all changed

The accomplishments of the property rights theory notwithstanding I never-theless take exception in two related respects First the view that the property rightstheory ldquobuilds on and formalizes the intuitions of transaction cost economics ascreated by Coase and Williamsonrdquo (Salanie 1997 p 176) is only partly correct Tobe sure property rights theory does build on (or at least tracks) transaction costeconomics in certain respects complex contracts are incomplete (by reason ofbounded rationality) contract as mere promise is not self-enforcing (by reason ofopportunism) court ordering of con icts is limited (by reason of nonveri ability)and the parties are bilaterally dependent (by reason of transaction-speci c invest-ments) But whereas transaction cost economics locates the main analytical actionin the governance of ongoing contractual relations property rights theory of the rm annihilates governance issues by assuming common knowledge of payoffs andcostless bargaining As a consequence all of the analytical action is concentrated atthe incentive alignment stage of contracting Since the assumptions of commonknowledge of payoffs (Kreps and Wilson 1982) and costless bargaining are deeplyproblematic my interpretation of property rights theory is that it is ldquoimperfectlysuited to the subject matter [because it] obscures the key interactions instead ofspotlighting themrdquo (Solow 2001 p 112)

Second I take exception with the allegation of property rights theory thattransaction cost economics offers no explanation why a bilaterally dependenttransaction is subject to ldquoless haggling and hold-up behavior in a merged rmrdquoHart (1995 p 28) writes that ldquo[t]ransaction cost theory as it stands does notprovide the answerrdquo evidently in the belief that property rights theory does

Since property rights theory rests only on asset ownership what Hart andothers of this persuasion could say is that they dispute the logic of replicationselective intervention and each of the associated regularities on which transactioncost economics relies to describe why rms and markets differ in discrete structuralways Speci cally property rights theory disputes all four of the following propo-sitions of transaction cost economics 1) that rms enjoy advantages over markets

10 On my response to Simon see Williamson (2002) on sociology see Williamson (1981 1993 1996)on core competence see Williamson (1999b)11 Other criticisms include those of Fudenberg Holmstrom and Milgrom (1990 p 21 emphasisomitted) who contend ldquoIf there is an optimal long-term contract then there is a sequentially optimalcontract which can be implemented via a sequence of short-term contractsrdquo My response is that theproof is elegant but rests on very strong and implausible assumptions that fail the test of feasibleimplementation (Williamson 1991b)


in cooperative adaptation respects (it being the case under property rights theorythat all ownership con gurations costlessly adapt in the contract implementationinterval) 2) that incentive intensity is unavoidably compromised by internal orga-nization 3) that administrative controls are more numerous and more nuanced in rms12 and 4) that the implicit contract law of internal organization is that offorbearance whence the rm is its own court for resolving disputes Inasmuch as allfour of these differences can be examined empirically the veridicality of propertyrights theory in relation to transaction cost economics can be established byappealing to the data What cannot be said is that transaction cost economics issilent or inexplicit on why rms and markets differ

As it stands property rights theory makes limited appeal to data because ityields very few refutable implications and is indeed very nearly untestable (Whin-ston 2001) Transaction cost economics by contrast yields numerous refutableimplications and invites empirical testing

Boundaries of the FirmHolmstrom and Roberts (1998 p 91) contend and I agree that ldquothe theory

of the rm has become too narrowly focused on the hold-up problem and therole of asset speci cityrdquo Contractual complications of other (possibly related) kindsneed to be admitted and the rami cations for governance worked out But while Iagree that more than asset speci city is involved I hasten to add that assetspeci city is an operational and encompassing concept

Asset speci city is operational in that it serves to breathe content into the ideaof transactional ldquocomplexityrdquo Thus although it is intuitively obvious that complexgovernance structures should be reserved for complex transactions wherein do thecontractual complexities reside Identifying the critical dimensions with respect towhich transactions differ of which asset speci city is especially important has beencrucial for explicating contractual complexity (Williamson 1971 1979 p 239)mdashwhich is not to suggest that it is exhaustive

As for asset speci city being an encompassing concept consider the Holm-strom and Roberts (1998 p 87) complaint that multi-unit retail businesses (such asfranchising) cannot be explained in terms of asset speci city This complaintignores brand name capital (Klein 1980) as a form of asset speci city the integrity

12 Grossman and Hart (1986 p 695) for example assume that ldquoany audits that an employer can havedone of his [wholly] owned subsidiary are also feasible when the subsidiary is a separate companyrdquo Notonly does transaction cost economics hold otherwise (Williamson 1985 pp 154ndash155) but transactioncost economics also recognizes that accounting is not fully objective but can be used as a strategicinstrument (chapter 6) Furthermore accounting will be used as a strategic instrument if integration isas prescribed by property rights theory (directional) rather than as prescribed by transaction costeconomics (uni ed) The upshot is that the high-powered incentives that property rights theoryassociates with directional integration will be compromisedmdashin that control over accounting by theacquiring stage will be exercised to redistribute pro ts in its favor by manipulating transfer pricesuser-cost charges overhead rates depreciation amortization inventory rules and the like AlthoughHart (1995 pp 64ndash66) appears to concede these effects the basic model of the property rights theory(chapter 2) disallows them


of which can be compromised (as discussed in relation to the Schwinn case above)Also asset speci city would be less ldquooverusedrdquo if other would-be explanations forcomplex economic organization (such as technological nonseparability or the ideathat agents have different levels of risk aversion) either had wider reach andorwere not contradicted by the data I would furthermore observe that many of theHolmstrom and Roberts (1998 p 75) arguments and illustrations for ldquotaking amuch broader view of the rm and the determination of its boundariesrdquo are oneswith which transaction cost economics not only concurs but has actively discussedeven featured previously

I am puzzled for example by their claim (1998 p 77) that ldquo[i]n transactioncost economics the functioning market is as much a black box as is the rm inneoclassical economic theoryrdquo Plainly node C in the earlier Figure 3 is a marketgovernance mode supported by conscious efforts by the parties to craft intertem-poral contractual safeguards for transactions where identity matters and continuityis important Node C is a black box only for those who refuse to take a look atthe mechanisms through which hybrid governance works Also moving beyondthe one-size- ts-all view of contract law to ascertain that contract law regimesdiffer systematically across modes of governancemdashin that contract as legal rulescontract as framework and forbearance law are the contract laws of market hybridand hierarchy respectivelymdashis not and should not be construed as a black boxconstruction

Holmstrom and Roberts (1998 p 81) offer the case of Japanese subcontract-ing as ldquodirectly at odds with transaction cost theoryrdquo Relying in part upon theresearch of Banri Asanuma (1989 1992) Holmstrom and Roberts (pp 80ndash82)report that Japanese subcontracting uses ldquolong-term close relations with a limitednumber of independent suppliers that mix elements of market and hierar-chy [to protect] speci c assetsrdquo These close relations are supported by carefulmonitoring a two-supplier system (as at Toyota) rich information sharing and soas to deter automakers from behaving opportunistically a ldquosupplier associationwhich facilitates communication and [strengthens] reputation [effects]rdquo

As it turns out Professor Asanuma and I visited several large Japanese auto rms (Toyota included) in the spring of 1983 and I reported on all of the abovepreviously (Williamson 1985 pp 120ndash123 1996 pp 317ndash318) InterestinglyBaron and Kreps (1999 pp 542ndash543) also interpret Toyota contracting practices asconsistent with the transaction cost economics perspective

I would nevertheless concede that the roles of organizational knowledge andlearning mentioned by Holmstrom and Roberts (1998 pp 90ndash91) are ones withwhich transaction cost economics deals with in only a limited way This does nothowever mean that transaction cost economics does not or cannot relate to theseissues I would observe in this connection that transaction cost economics madeearly provision for rm-speci c learning by doing and for tacit knowledge (Wil-liamson 1971 1975) and that the organization of ldquoknowledge projectsrdquo that differin their needs for coordination are even now being examined in governance


structure respects (Nickerson and Zenger 2001) Still the study of these and otherissues to which Holmstrom and Roberts refer are usefully examined from severallenses of which the lens of transaction cost economics is only one

Conclusion

The application of the lens of contractprivate orderinggovernance leadsnaturally into the reconceptualization of the rm not as a production function inthe science of choice tradition but instead as a governance structure The shiftfrom choice to contract is attended by three crucial moves First human actors aredescribed in more veridical ways with respect to both cognitive traits and self-interestedness Second organization matters The governance of contractual rela-tions takes seriously the conceptual challenge posed by the ldquoCommons triplerdquo ofdealing with issues of con ict mutuality and order Third organization is suscep-tible to analysis This last move is accomplished by naming the transaction as thebasic unit of analysis identifying governance structures (which differ in discretestructural ways) as the means by which to manage transactions and joining thesetwo Speci cally transactions which differ in their attributes are aligned withgovernance structures which differ in their cost and competencies in an econo-mizing way Implementing this entails working out of the logic of ef cientalignment

Not only does the resulting theory of the rm differ signi cantly from theneoclassical theory of the rm but the governance branch of contract alsodiffers from the incentive branch where more formal mechanism designagency and property rights theories are located These latter theories all con-centrate the analytical action on the incentive alignment stage of contractingDifferences among governance structures with respect to adaptation in thecontract implementation interval are thus suppressed Intertemporal regulari-ties to which organization theorists call our attention (and to which I selectivelyappeal) as well as the added contractual complications that I describemdashtheFundamental Transformation the impossibility of replicationselective inter-vention and contract law regimesmdash have little or no place in any of theseincentive alignment literatures

Parsimony being a virtue such added complications need to be justi ed Icontend that a different and for many purposes richer and better understandingof rm and market organization results Not only does the transaction cost eco-nomics theory of rm and market organization afford different interpretations ofnonstandard and unfamiliar forms of contract and organization but it yields manyrefutable implications A large and growing empirical research agenda and selec-tive reshaping of public policy toward business have resulted from supplanting theblack box conception of the rm by the theory of the rm as governance structureDixit (1996) moreover ascribes public policy bene ts to the use of transaction cost


reasoning to open up the black box of public policymaking and explain howdecisions are actually made13

Pluralism has much to recommend it in an area like economic organizationthat is beset with bewildering complexity Such pluralism notwithstanding thegovernance approach has been a productive and liberating way by which toexamine economic organization It has been productive in all of the conceptualand public policy ways described above with more insights in prospect It has beenliberating in that it has breathed life into the science of contract and in the processhas served to stimulate other workmdashpart rival part complementary A recurrenttheme is that recourse to the lens of contract as against the lens of choicefrequently deepens our understanding of complex economic organization with asuggestion that this same strategy can inform applied microeconomics and thecontiguous social sciences more generally

y The helpful advice of Timothy Taylor and Michael Waldman in revising this manuscriptis gratefully acknowledged

13 Krepsrsquos (1999 p 123) assessment of full formalism also signals precaution ldquoMost economists andespecially and most critically new recruits in the form of graduate students learn transaction-costeconomics as translated and renamed (incomplete) contract theory [Awaiting new tools] we shouldbe clear on how (in)complete the translations are to ght misguided tendencies to put Markets andHierarchies away on that semi-accessible shelfrdquo

References

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Alchian Armen and Harold Demsetz 1972ldquoProduction Information Costs and EconomicOrganizationrdquo American Economic Review De-cember 62 pp 777ndash95

Arrow Kenneth 1999 ldquoForwardrdquo in FirmsMarkets and Hierarchies The Transaction CostEconomics Perspective G Carroll and D Teeceeds New York New York University Press ppviindashviii

Asanuma Banri 1989 ldquoManufacturer-Suppli-er Relationships in Japan and the Concept ofRelationship-Speci c Skillsrdquo Journal of Japaneseand International Economies 31 pp 1ndash30

Asanuma Banri 1992 ldquoManufacturer-Suppli-er Relationships in International Perspective

The Automobile Caserdquo in International Adjust-ment and the Japanese Firm Paul Sheard ed StLeonards NSW Allen and Unwin pp 99 ndash124

Aumann Robert J 1985 ldquoWhat is Game The-ory Trying to Accomplishrdquo in Frontiers of Econom-ics K Arrow and S Hankapohja eds OxfordBasil Blackwell pp 28ndash78

Bajari Patrick and Steven Tadelis 2001 ldquoIn-centives Versus Transaction Costs A Theory ofProcurement Contractsrdquo Rand Journal of Econom-ics Autumn 32 pp 387ndash407

Barnard Chester I 1938 The Functions of theExecutive Cambridge Harvard University Press

Baron James N and David M Kreps 1999Strategic Human Resources Frameworks for GeneralManagers New York John Wiley

Becker Gary 1962 ldquoInvestment in HumanCapital Effects on Earningsrdquo Journal of PoliticalEconomy October 70 pp 9ndash49


Ben-Porath Yoram 1980 ldquoThe F-ConnectionFamilies Friends and Firms and the Organiza-tion of Exchangerdquo Population and DevelopmentReview March 6 pp 1ndash30

Boerner C S and J Macher 2001 ldquoTransac-tion Cost Economics A Review and Assessmentof the Empirical Literaturerdquo UnpublishedManuscript

Brennan Geoffrey and James Buchanan1985 The Reason of Rules Cambridge Cam-bridge University Press

Buchanan James M 1964a ldquoWhat ShouldEconomists Dordquo Southern Economic Journal Jan-uary 30 pp 312ndash22

Buchanan James M 1964b ldquoIs Economics theScience of Choicerdquo in Roads to Freedom Essays inHonor of F A Hayek E Streissler ed LondonRoutledge amp Kegan Paul pp 47ndash64

Buchanan James M 1975 ldquoA ContractarianParadigm for Applying Economic Theoryrdquo Amer-ican Economic Review May 65 pp 225ndash30

Buchanan James M 1987 ldquoThe Constitutionof Economic Policyrdquo American Economic ReviewJune 77 pp 243ndash50

Buchanan James M 2001 ldquoGame TheoryMathematics and Economicsrdquo Journal of Eco-nomic Methodology March 8 pp 27ndash32

Buchanan James M and Gordon Tullock1962 The Calculus of Consent Logical Foundationsof Constitutional Democracy Ann Arbor Universityof Michigan Press

Coase Ronald H 1937 ldquoThe Nature of theFirmrdquo Economica November 4 pp 386ndash405

Coase Ronald H 1959 ldquoThe Federal Com-munications Commissionrdquo Journal of Law andEconomics October 3 pp 1ndash40

Coase Ronald H 1972 ldquoIndustrial Organiza-tion A Proposal for Researchrdquo in Policy Issuesand Research Opportunities in Industrial Organiza-tion V R Fuchs ed New York National Bureauof Economic Research pp 59ndash73

Coase Ronald H 1992 ldquoThe InstitutionalStructure of Productionrdquo American Economic Re-view September 82 pp 713ndash19

Commons John R 1932 ldquoThe Problem ofCorrelating Law Economics and Ethicsrdquo Wiscon-sin Law Review 8 pp 3ndash26

Commons John R 1934 Institutional Econom-ics Madison University of Wisconsin Press

Crocker Keith and Scott Masten 1996 ldquoReg-ulation and Administered Contracts RevisitedLessons from Transaction-Cost Economics forPublic Utility Regulationrdquo Journal of RegulatoryEconomics January 91 pp 5ndash39

Cyert Richard and James March 1963 A Be-havioral Theory of the Firm Englewood Cliffs NJPrentice-Hall

David Paul 1985 ldquoClio in the Economics ofQWERTYrdquo American Economic Review May 75pp 332ndash37

Demsetz Harold 1968 ldquoWhy Regulate Utili-tiesrdquo Journal of Law and Economics April 11 pp55ndash66

Demsetz Harold 1983 ldquoThe Structure ofOwnership and the Theory of the Firmrdquo Journalof Law and Economics 262 pp 275ndash90

Dixit Avinash K 1996 The Making of EconomicPolicy A Transaction-Cost Politics Perspective Bos-ton Mass MIT Press

Easterbrook Frank and Daniel Fischel 1986ldquoClose Corporations and Agency Costsrdquo StanfordLaw Review January 38 pp 271ndash301

Fama Eugene F and Michael C Jensen 1983ldquoSeparation of Ownership and Controlrdquo Journalof Law and Economics June 26 pp 301ndash26

Fudenberg Drew Bengt Holmstrom and PaulMilgrom 1990 ldquoShort-Term Contracts andLong-Term Agency Relationshipsrdquo Journal of Eco-nomic Theory June 51 pp 1ndash31

Galanter Marc 1981 ldquoJustice in Many RoomsCourts Private Ordering and Indigenous LawrdquoJournal of Legal Pluralism 191 pp 1ndash47

Grossman Sanford J and Oliver Hart 1986ldquoThe Costs and Bene ts of Ownership A Theoryof Vertical and Lateral Integrationrdquo Journal ofPolitical Economy August 94 pp 691ndash719

Hardin Garrett 1968 ldquoThe Tragedy of theCommonsrdquo Science December 162 pp 1243ndash248

Hart Oliver 1995 Firms Contracts and Finan-cial Structure New York Oxford University Press

Hart Oliver and John Moore 1990 ldquoPropertyRights and the Nature of the Firmrdquo Journal ofPolitical Economy December 98 pp 1119ndash158

Hart Oliver and Jean Tirole 1990 ldquoVerticalIntegration and Market Foreclosurerdquo in Brook-ings Papers on Economic Activity MicroeconomicsMartin Neil Baily and Clifford Winston edsWashington DC Brookings Institution pp205ndash76

Hayek Freidrich 1945 ldquoThe Use of Knowl-edge in Societyrdquo American Economic Review Sep-tember 35 pp 519ndash30

Holmstrom Bengt and John Roberts 1998ldquoThe Boundaries of the Firm Revisitedrdquo Journalof Economic Perspectives Fall 123 pp 73ndash94

Holmstrom Bengt and Jean Tirole 1989ldquoThe Theory of the Firmrdquo in Handbook of Indus-trial Organization R Schmalensee and R Willigeds New York North Holland pp 61ndash133

Joskow Paul L 2000 ldquoTransaction Cost Eco-nomics and Competition Policyrdquo UnpublishedManuscript

Klein Benjamin 1980 ldquoTransaction Cost De-


terminants of lsquoUnfairrsquo Contractual Arrange-mentsrdquo American Economic Review May 70 pp356ndash62

Klein Benjamin Robert A Crawford and Ar-men A Alchian 1978 ldquoVertical Integration Ap-propriable Rents and the Competitive Contract-ing Processrdquo Journal of Law and EconomicsOctober 21 pp 297ndash326

Kreps David M 1999 ldquoMarkets and Hierar-chies and (Mathematical) Economic Theoryrdquo inFirms Markets and Hierarchies G Carroll and DTeece eds New York Oxford University Presspp 121ndash55

Kreps David M and Robert Wilson 1982ldquoReputation and Imperfect Informationrdquo Jour-nal of Economic Theory August 272 pp 253ndash79

Llewellyn Karl N 1931 ldquoWhat Price Con-tract An Essay in Perspectiverdquo Yale Law JournalMay 40 pp 704ndash51

Lyons Bruce R 1996 ldquoEmpirical Relevance ofEf cient Contract Theory Inter-Firm Con-tractsrdquo Oxford Review of Economic Policy 124 pp27ndash52

Machlup Fritz and M Tabor 1960 ldquoBilateralMonopoly Successive Monopoly and Vertical In-tegrationrdquo Economica May 27 pp 101ndash19

Makowski Louis and Joseph Ostroy 2001ldquoPerfect Competition and the Creativity of theMarketrdquo Journal of Economic Literature June 32pp 479ndash535

March James and Herbert Simon 1958 Orga-nizations New York John Wiley

Marshall Alfred 1932 Industry and TradeLondon Macmillan

Masten Scott and Stephane Saussier 2000ldquoEconometrics of Contracts An Assessment ofDevelopments in the Empirical Literature onContractingrdquo Revue drsquoEconomie Industrielle Sec-ond and Third Trimesters 92 pp 215ndash36

McKenzie L 1951 ldquoIdeal Output and theInterdependence of Firmsrdquo Economic JournalDecember 61 pp 785ndash803

Michels Robert 1915 [1962] Political PartiesGlencoe Ill Free Press

Newell Allen and Herbert Simon 1972 Hu-man Problem Solving Englewood Cliffs NJPrentice-Hall

Nickerson Jackson and Todd Zenger 2001ldquoA Knowledge-Based Theory of GovernanceChoice A Problem Solving Approachrdquo Unpub-lished Manuscript

Peltzman Sam 1991 ldquoThe Handbook of In-dustrial Organization A Review Articlerdquo Journalof Political Economy February 991 pp 201ndash17

Peltzman Sam and Clifford Whinston 2000Deregulation of Network Industries WashingtonDC Brookings Institution Press

Perry Martin 1989 ldquoVertical Integrationrdquoin Handbook of Industrial Organization RSchmalensee and R Willig eds AmsterdamNorth-Holland pp 183ndash255

Posner Richard A 1972 ldquoThe AppropriateScope of Regulation in the Cable Television In-dustryrdquo Bell Journal of Economics Spring 3 pp98ndash129

Posner Richard A 1986 Economic Analysis ofLaw Third Edition Boston Little Brown

Posner Richard A 1993 ldquoThe New Institu-tional Economics Meets Law and EconomicsrdquoJournal of Institutional and Theoretical EconomicsMarch 149 pp 73ndash87

Reder Melvin W 1999 Economics The Cultureof a Controversial Science Chicago University ofChicago Press

Richter Rudolph 2001 ldquoNew Economic Soci-ology and New Institutional Economicsrdquo Un-published Manuscript

Rind eish Aric and Jan Heide 1997 ldquoTrans-action Cost Analysis Past Present and FutureApplicationsrdquo Journal of Marketing October 61pp 30ndash54

Riordan Michael H and Oliver E William-son 1985 ldquoAsset Speci city and Economic Or-ganizationrdquo International Journal of Industrial Or-ganization December 34 pp 365ndash78

Robbins Lionel 1932 An Essay on the Natureand Signicance of Economic Science New YorkNew York University Press

Salanie Bernard 1997 The Economics of Con-tracts Cambridge Mass MIT Press

Schmalensee Richard 1973 ldquoA Note on theTheory of Vertical Integrationrdquo Journal of Politi-cal Economy MarchApril 81 pp 442ndash49

Schumpeter Joseph A 1942 Capitalism Social-ism and Democracy New York Harper amp Row

Scott Richard W 1992 Organizations Engle-wood Cliffs NJ Prentice-Hall

Selznick Philip 1949 TVA and the Grass RootsBerkeley University of California Press

Selznick Philip 1950 ldquoThe Iron Law of Bu-reaucracyrdquo Modern Review 3 pp 157ndash65

Shelanski Howard A and Peter G Klein1995 ldquoEmpirical Research in Transaction CostEconomics A Review and Assessmentrdquo Journal ofLaw Economics and Organization October 11pp 335ndash61

Simon Herbert 1957a Administrative Behav-ior Second Edition New York Macmillan

Simon Herbert 1957b Models of Man Socialand Rational Mathematical Essays on Rational Hu-man Behavior in a Social Setting New York Wiley

Simon Herbert 1978 ldquoRationality as Processand as Product of Thoughtrdquo American EconomicReview May 68 pp 1ndash16


Simon Herbert 1983 Reason in Human Af-fairs Stanford Stanford University Press

Simon Herbert 1985 ldquoHuman Nature in Pol-itics The Dialogue of Psychology with PoliticalSciencerdquo American Political Science Review June792 pp 293ndash304

Simon Herbert 1991 ldquoOrganizations andMarketsrdquo Journal of Economic Perspectives Spring52 pp 25ndash44

Simon Herbert 1997 An Empirically Based Mi-croeconomics New York Cambridge UniversityPress

Solow Robert 2001 ldquoA Native InformantSpeaksrdquo Journal of Economic Methodology March8 pp 111ndash12

Stigler George J 1951 ldquoThe Division of La-bor is Limited by the Extent of the MarketrdquoJournal of Political Economy June 59 pp 185ndash93

Thompson James D 1967 Organizations inAction Social Science Bases of Administrative TheoryNew York McGraw-Hill

Veblen Thorstein 1904 The Theory of BusinessEnterprise New York Charles Scribnerrsquos Sons

Vernon John M and Daniel A Graham 1971ldquoPro tability of Monopolization by Vertical Inte-grationrdquo Journal of Political Economy JulyAugust79 pp 924ndash25

Warren-Boulton Frederick 1974 ldquoVerticalControl With Variable Proportionsrdquo Journal ofPolitical Economy JulyAugust 824 pp 783ndash802

West eld Fred 1981 ldquoVertical IntegrationDoes Product Price Rise or Fallrdquo American Eco-nomic Review 713 pp 334ndash46

Whinston Michael 2001 ldquoAssessing PropertyRights and Transaction-Cost Theories of theFirmrdquo American Economic Review May 912 pp184ndash99

Williamson Oliver E 1971 ldquoThe Vertical In-tegration of Production Market Failure Consid-erationsrdquo American Economic Review May 612pp 112ndash23

Williamson Oliver E 1975 Markets and Hier-archies Analysis and Antitrust Implications NewYork Free Press

Williamson Oliver E 1976 ldquoFranchise Bid-ding In General and with Respect to CATVrdquo BellJournal of Economics 71 pp 73ndash104

Williamson Oliver E 1979 ldquoTransaction CostEconomics The Governance of Contractual Re-lationsrdquo Journal of Law and Economics October22 pp 233ndash61

Williamson Oliver E 1981 ldquoThe Economicsof Organization The Transaction Cost Ap-proachrdquo American Journal of Sociology November87 pp 548ndash77

Williamson Oliver E 1983 ldquoCredible Com-mitments Using Hostages to Support Ex-changerdquo American Economic Review September734 pp 519ndash40

Williamson Oliver E 1985 The Economic Insti-tutions of Capitalism New York Free Press

Williamson Oliver E 1987 ldquoVertical Integra-tionrdquo in The New Palgrave A Dictionary of Econom-ics Volume IV J Eatwell et al eds LondonMacmillan pp 807ndash12

Williamson Oliver E 1988 ldquoCorporate Fi-nance and Corporate Governancerdquo Journal ofFinance July 43 pp 567ndash91

Williamson Oliver E 1991a ldquoComparativeEconomic Organization The Analysis of Dis-crete Structural Alternativesrdquo Administrative Sci-ence Quarterly June 36 pp 269ndash96

Williamson Oliver E 1991b ldquoEconomic Insti-tutions Spontaneous and Intentional Gover-nancerdquo Journal of Law Economics and Organiza-tion Special Issue 7 pp 159ndash87

Williamson Oliver E 1993 ldquoCalculativenessTrust and Economic Organizationrdquo Journal ofLaw and Economics April 36 pp 453ndash86

Williamson Oliver E 1996 The Mechanisms ofGovernance New York Oxford University Press

Williamson Oliver E 1998 ldquoTransaction CostEconomics How it Works Where it is HeadedrdquoDe Economist April 146 pp 23ndash58

Williamson Oliver E 1999a ldquoPublic and Pri-vate Bureaucracies A Transaction Cost Econom-ics Perspectiverdquo Journal of Law Economics andOrganization April 15 pp 306ndash42

Williamson Oliver E 1999b ldquoStrategy Re-search Governance and Competence Perspec-tivesrdquo Strategic Management Journal December20 pp 1087ndash108

Williamson Oliver E 2000 ldquoThe New Institu-tional Economics Taking Stock LookingAheadrdquo Journal of Economic Literature Septem-ber 383 pp 595ndash613

Williamson Oliver E 2002 ldquoEmpirical Micro-economics Another Perspectiverdquo in The Econom-ics of Choice Change and Organization Mie Augierand James March eds Brook eld Vt EdwardElgar Forthcoming


The Sciences of Choice and Contract

Economics throughout the twentieth century has been developed predomi-nantly as a science of choice As Lionel Robbins famously put it in his book An Essayon the Nature and Signicance of Economic Science (1932 p 16) ldquoEconomics is thescience which studies human behavior as a relationship between ends and scarcemeans which have alternative usesrdquo Choice has been developed in two parallelconstructions the theory of consumer behavior in which consumers maximizeutility and the theory of the rm as a production function in which rms maximizepro t Economists who work out of such setups emphasize how changes in relativeprices and available resources in uence quantities a project that became theldquodominant paradigmrdquo for economics throughout the twentieth century (Reder1999 p 48)

But the science of choice is not the only lens for studying complex economicphenomena nor is it always the most instructive lens The other main approach iswhat James Buchanan (1964a b 1975) refers to as the science of contract IndeedBuchanan (1975 p 225) avers that economics as a discipline went ldquowrongrdquo in itspreoccupation with the science of choice and the optimization apparatus associatedtherewith Wrong or not the parallel development of a science of contract wasneglected

As perceived by Buchanan (1987 p 296) the principal needs for a science ofcontract were for the eld of public nance and took the form of public orderingldquoPolitics is a structure of complex exchange among individuals a structure withinwhich persons seek to secure collectively their own privately de ned objectives thatcannot be ef ciently secured through simple market exchangesrdquo Thinking con-tractually in the public ordering domain leads into a focus on the rules of the gameConstitutional economics issues are posed (Buchanan and Tullock 1962 Brennanand Buchanan 1985)

Whatever the rules of the game the lens of contract is also usefully brought tobear on the play of the game This latter is what I refer to as private ordering whichentails efforts by the immediate parties to a transaction to align incentives and tocraft governance structures that are better attuned to their exchange needs Theobject of such self-help efforts is to realize better the ldquomutuality of advantage fromvoluntary exchange [that is] the most fundamental of all understandings ineconomicsrdquo (Buchanan 2001 p 29) due allowance being made for the mitigationof contractual hazards Strategic issuesmdashto which the literatures on mechanismdesign agency theory and transaction cost economicsincomplete contracting allhave a bearingmdashthat had been ignored by neoclassical economists from 1870 to1970 now make their appearance (Makowski and Ostroy 2001 pp 482ndash483490ndash491)

Figure 1 sets out the main distinctions The initial divide is between the scienceof choice (orthodoxy) and the science of contract The latter then divides intopublic ordering (constitutional economics) and private ordering parts where thesecond is split into two related branches One branch concentrates on front-end









































































































Recent Criticisms


























Conclusion









References




























































































































































































































Recent Criticisms


























Conclusion









References












































































































































Conclusion









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References





















































































































The Theory of the Firm as Governance Structure: From...

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Transcript of The Theory of the Firm as Governance Structure: From...