Although I shall defer a more complete statement of the organizational failures framework until Chapter 2 (indeed, some of the elements that appear in it are not even identified here), a sketch of the basic approach, set out early, will not only provide an overview of what will follow but also permit some immediate applications of the framework to be made.
The general approach to economic organization employed here can be summarized compactly as follows: (1) Markets and firms are alternative instruments for completing a related set of transactions; (2) whether a set of transactions ought to be executed across markets or within a firm depends on the relative efficiency of each mode; (3) the costs of writing and executing complex contracts across a market vary with the characteristics of the human decision makers who are involved with the transaction on the one hand, and the objective properties of the market on the other ; and (4) although the human and environmental factors that impede exchanges between firms (across a market) manifest themselves somewhat differently within the firm, the same set of factors apply to both. A symmetrical analysis of trading thus requires that we acknowledge the transactional limits of internal organization as well as the sources of market failure. Basic to such a comparative analysis is the following proposition: Just as market structure matters in assessing the efficacy of trades in the marketplace, so likewise does internal structure matter in assessing internal organization.
The markets and hierarchies approach attempts to identify a set of environmental factors which together with a related set of human factors explain the circumstances under which complex contingent claims contracts will be costly to write, execute, and enforce. Faced with such difficulties, and considering the risks that simple (or incomplete) contingent claims contracts pose, the firm may decide to bypass the market and resort to hierarchical modes of organization. Transactions that might otherwise be handled in the market are thus performed internally, governed by administrative processes, instead.
The environmental factors that lead to prospective market failure are uncertainty and small-numbers exchange relations. Unless joined, however, by a related set of human factors, such environmental conditions need not impede market exchange. The pairing of uncertainty with bounded rationality and the joining of small numbers with what I shall refer to as opportunism are especially important.
Consider first the pairing of bounded rationality with uncertainty. The principle of bounded rationality has been defined by Herbert Simon as follows: “The capacity of the human mind for formulating and solving complex problems is very small compared with the size of the problems whose solution is required for objectively rational behavior in the real world” (1957, p. 198, emphasis in original). It refers to neurophysiological limits on the one hand and language limits on the other. If, in consideration of these limits, it is very costly or impossible to identify future contingencies and specify, ex ante, appropriate adaptations thereto, long-term contracts may be supplanted by internal organization. Recourse to the latter permits adaptations to uncertainty to be accomplished by administrative processes in a sequential fashion. Thus, rather than attempt to anticipate all possible contingencies from the outset, the future is permitted to unfold. Internal organization in this way economizes on the bounded rationality attributes of decision makers in circumstances in which prices are not “sufficient statistics” and uncertainty is substantial.
Explicating the relation between opportunism and a small numbers exchange condition is somewhat involved and is accordingly deferred to the examples in Section 3 and to Chapter 2. Suffice it to observe here that (1) opportunism refers to a lack of candor or honesty in transactions, to include self-interest seeking with guile; (2) opportunistic inclinations pose little risk as long as competitive (large-numbers) exchange relations obtain; (3) many transactions that at the outset involve a large number of qualified bidders are transformed in the process of contract execution, so that a small-numbers supply condition effectively obtains at the contract renewal interval; and (4) recurrent short-term contracting is costly and risky when opportunism and transactions of this latter kind are joined.
In consideration of the problems that both long- and short-term contracts are subject to — by reason of bounded rationality and uncertainty in the first instance and the pairing of opportunism with small-numbers relations in the second— internal organization may arise instead. Issues here are dealt with as they arise rather than in an exhaustive contingent-planning fashion from the outset. The resulting adaptive, sequential decision-making process is the internal organizational counterpart of short-term contracting and serves to economize on bounded rationality. Opportunism does not pose the same difficulties for such internal sequential supply relations that it does when negotiations take place across a market because (1) internal divisions do not have pre-emptive claims on profit streams (but more nearly joint profit maximize instead); and (2) the internal incentive and control machinery is much more extensive and refined than that which obtains in market exchanges. The firm is thereby better able to take the long view for investment purposes (and hence is more prepared to put specialized plant and equipment in place) while simultaneously adjusting to changing market circumstances in an adaptive, sequential manner.
But whichever way the assignment of transactions to firm or market is made initially, the choice ought not to be regarded as fixed. Both firms and markets change over time in ways that may render inappropriate an initial assignment of transactions to firm or market. The degree of uncertainty associated with the transactions in question may diminish; market growth may support large-numbers supply relations; and information disparities between the parties often shrink. Also, changes in information processing technology may occur which alter the degree to which bounded rationality limits apply, with the result that a different assignment of activities between markets and hierarchies than was selected initially becomes appropriate later. Thus, we ought periodically to reassess the efficacy of completing transactions by one mode rather than another.
Source: Williamson Oliver E. (1975), Markets and hierarchies: Analysis and antitrust implications, A Study in the Economics of Internal Organization, The Free Press.