Conclusions of Transaction Cost Economics

John R. Hicks advises that since economics is concerned with a changing world, “a theory which illumines the right things now may illumine the wrong things another time. [Accordingly], there is … no economic theory which will do for us everything we want all the time. . . . We may [someday] reject our present theories not because they are wrong, but because they have become inappropriate” (1976, p. 208). By the mid-1960s, if not earlier, the changing world to which Hicks referred was posing strains of two kinds.

One took the form of public policy excesses.1 As Justice Stewart put it in 1966, “The sole consistency that 1 can find is that in [merger] litigation under Section 7, the Government always wins.”2 Although the excesses of both antitrust and regulation in the 1960s are now generally conceded, the limits of public policy were then obscured by the prevailing optimism that “the most intractable problems would give way before the resolute assault of intelligent, committed people” (Morris, 1980, p. 23). The comparative institutional approach admits to and attempts to assess “failures” of all kinds. Transaction cost economics is in that spirit.

Strains were also developing over the growing disjunction between pure theory and applications. George Feiwel quotes from and summarizes Michio Morishima’s position on that as follows

[Morishima] attributes the continuous frustration which has beset the development of economic theory over the last thirty years or more to ‘failure of economic theorists to carry out sweeping, systematic research into the actual mechanisms of the economy and economic organization, despite being aware that their own models are inappropriate to analysis of the actual economy.’ [Feiwel, 1983, p. 48A]

To be sure, Morishima’s advice that economic theorists “make a serious effort in the direction of the institutionalization of economics, in the sense of slowing the speed of all development toward mathematization and developing economic theory in accordance with knowledge of economic organizations, industrial structure and economic history”3 would be disputed by some. Still, there is growing agreement that a better balance will be struck by bringing institutions- more prominently into the picture.4 Transaction cost economics is expressly institutional in character. It nevertheless maintains a strong commit- ment to intended rationality, and it holds out the prospect of progressive formalization. It appears to be broadly consonant with the research enterprise that Morishima contemplates.

1. Rudiments 

Transaction cost economics is a comparative institutional approach to the study of economic organization in which the transaction is made the basic unit of analysis. It is interdisciplinary, involving aspects of economics, law, and organization theory. It has relatively broad scope and application. Virtually any relation, economic or otherwise, that takes the form of or can be described as a contracting problem can be evaluated to advantage in transaction cost economics terms. Most explicit contracting relations qualify; many implicit contracting relations do also.

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) places greater weight on the ex post institutions of contract, with special emphasis on private ordering (as compared with court ordering). A large number of refutable implications obtain upon addressing problems of economic organization in this way.

As indicated, transaction cost economics maintains the rebuttable pre- sumption that organizational variety arises primarily in the service of transaction cost economizing. That approach is to be distinguished not merely from the technological approach to economic organization but also from power approaches, which ascribe nonstandard forms of organization to monopoly purposes or class interests. To be sure, organizational variety sometimes serves several purposes simultaneously. That is not, however, to say that all explanations are on a parity. Assuming that alternative hypotheses are to be evaluated with reference to the touchstone of refutable implications, the trans- action cost hypothesis will presumably be judged according to that comparative standard. The basic strategy for deriving refutable implications— repeated, with variations,   throughout   the   book—is   this;   Transactions,   which   differ in their attributes, are assigned to governance structures, which differ in their organizational costs and competencies, so as to effect a discriminating (mainly transaction cost economizing) match.

Transaction costs of both ex ante and ex post kinds are distinguished. The ex ante costs are those incurred in drafting and negotiating agreements. They vary with the design of the good or service to be produced. The ex post costs include the setup and running costs of the governance structure to which monitoring is assigned and to which disputes are referred and settled; the maladaptation costs that are incurred for failure to restore positions on the shifting contract curve; the haggling costs that attend adjustments (or the lack thereof); and the bonding costs of effecting secure commitments. Although the conditions of uncertainty to which the transactions are subject and the trading context (customs, mores, habits, legal institutions) in which the transactions are located influence both the ex ante and ex post costs of contracting, those features are mainly taken as given. (Further implications can, however, be realized by relaxing that restraint.)

Those simplifications notwithstanding, the resulting approach to contract is enormously complex. That is often reflected in the piecemeal character of the analysis. Repeated efforts are nonetheless made to locate and assess contracts (and the contracting process) in their entirety.

2. A Digression on Risk Neutrality 

The two behavioral assumptions to which transaction cost economics makes repeated reference are bounded rationality and opportunism. The first maintains that human agents are intendedly rational but only limitedly so. That is manifestly true and massively influences the manner in which the subject of contract is conceived. The second holds that human agents will not reliably self- enforce promises but will defect from the letter and the spirit of an agreement when it suits their purposes. That somewhat dismal view of human nature alerts contracting parties (and those who would study contracting practices) to be wary of the hazards. To be sure, suspicions and precautions can be and sometimes are taken to excess (see 1.3b below). But a healthy regard for opportunism is essential to an understanding of the purposes served by complex modes of economic organization.

A third behavioral assumption that is also employed but to which reference is less frequently made warrants separate attention. That is the assumption of risk neutrality. Unlike the other two assumptions, this one is patently counterfactual.

Counterfactual assumptions are commonly justified by the fruitfulness of the resulting model (Friedman, 1953). That is part of the justification here. But the main argument is really different.

Indeed, there arc really three defenses for the assumption of risk neutrality. For one thing, this book places a great deal of emphasis on intermediate product markets. Those are transactions between firms rather than individuals. Not only do most firms diversify in some degree, but owners of firms can usually diversify their financial holdings easily. At least with respect to this class of activity, therefore, the risk neutrality assumption may be a close approximation.5 Second, and related, if the penalties for incapacity to bear risk are great, parties have strong incentives to craft structures with superior risk-bearing properties. Where the assumption of risk neutrality both facilitates analysis and captures central tendencies, outliers can presumably, or at least often, be dealt with separately.

But third, and the most compelling reason for invoking risk neutrality, is that this assumption helps to disclose core efficiency features that unnoticed or are misconstrued when risk aversion assumptions are employed. Contrast, for example, the transaction cost approach to labor market organization with that of the implicit contracting tradition (Az.ariadis, 1975; Baily, 1974; Gordon, 1974). The latter invokes risk aversion to explain sticky wages but is completely silent regarding the manner in which labor markets are organized and has no parallel explanation for sticky prices in intermediate product markets. The risk neutral/transaction cost account treats wages and prices symmetrically and addresses itself, as it must, to the governance structures of wage and price determination (Wachter and Williamson, 1978).

Or consider Robert Townsend’s (1982) interesting treatment of multiperiod contracts in intermediate product markets. He introduces the basic model as follows: “Consider an economy with just two . . . agents, one risk averse” (p. 1170). Absent differential risk aversion, multiperiod contracting in his model vanishes.6 Plainly, however, multiperiod contracting will appear in a risk neutral world in which specific assets are placed at risk.7 The governance structures that arise in support of multiperiod contracts are also brought under scrutiny when the attributes of transactions, rather than the risk attitudes of transactors, are made the focus of attention. It is not accidental that studies of legal doctrine (Landes and Posner, forthcoming) and of economic organization that eschew the assumption of risk aversion and employ transaction cost reasoning are more concerned with institutional features than those that do not.

The third justification thus comes down to this: Risk aversion often deflects attention from core efficiency purposes and related institutional features that are more readily discerned and more accurately assessed if, at this early stage in the development of the New Institutional Economics at least, a risk neutrality assumption is maintained.

3. Some Limitations 

Limitations of three kinds are noteworthy: transaction cost economics is crude, it is given to instrumentalist excesses, and it is incomplete. Consider each seriatim.


The crudeness of transaction cost economics shows up in at least four ways: The models are very primitive, the tradeoffs are underdeveloped, mea- surement problems are severe, and there are too many degrees of freedom.

That the models are primitive is partly explained by the fact that com- parative institutional analysis often requires that only basic distinctions be made and that simple comparisons be performed. Formal models of verbal arguments that lose in the translation are scarcely to be counted as gains (Simon, 1978, pp. 8-9). Formalization is not wanted at any cost.

Sometimes, however, efforts at formalization disclose gaps or ambiguities that the verbal argument did not. The tradeoffs between production cost economies (where the market often enjoys the advantage), governance cost economies (where the advantage accrues to internal organization as commitments to bilateral trading progressively deepen) and high-powered incentives (where the market again moves to the fore) have to be addressed not sequentially but in a fully simultaneous fashion. Although efforts along those lines have been progressing (Masten, 1982; Riordan and Williamson, forthcoming; Grossman and Hart, 1984; Mann and Wissink, 1984; Hart and Moore, 1985), much more remains to be done. The factors that are responsible for tradeoff differences— technology (economies of scale or scope); the nature of rivalry, including progressiveness; customer attributes, including competencies to evaluate product; incentive and control efficacy; market vagaries and uncertainties—all, at some stage, must be taken into account.

The three main dimensions in describing transactions are frequency, uncertainty, and the condition of asset specificity. None of them is easy to measure, although empirical researchers have found crude or proxy measures for each. Even should experience disclose ways by which to utilize accounting and other business or government records to better advantage, a great deal of original data collection will be needed. (As between breadth more observations—and depth—fewer but more relevant data—the needs of transaction cost economics, at least in the near term, are apt to be better served by the latter.)                                                                                                       „ ,

Each of the above features—primitive models, underdeveloped tradeoffs, measurement difficulties—contributes to the excessive degrees of freedom enjoyed by transaction cost economics. One way of dealing with that is to eschew appeal to omitted or unmeasured factors when confronted by conditions where the data and the models do not line up. Anomalies and contradictions can and should push those who employ transaction cost analysis to develop better models.


As with economic models more generally, the human agents who populate transaction cost economics are highly calculate. That is plainly not an attractive or even an accurate view of human nature. Economics is thought to be a dismal science partly for that reason. But insistence on rationality is also the great strength of economics (Arrow, 1974). To be sure, rationality can be and sometimes is overdone. Hyperrationality is mainly a fiction and/or a pathology. But one does not need to assert that the only reliable human motive is avarice to recognize that much of the success of economics in relation to the other social sciences occurs because calculativeness is presumed to be present in nontrivial degree.

As compared with orthodoxy, the human agents of transaction cost economics are both less and more calculative. They are less calculate in the capacity to receive, store, retrieve, and process information. They are more calculative in that they are given to opportunism. Taken together, that appears to correspond more closely with human nature as we know it. Still, it is plainly a narrow prescription. It makes little provision for attributes such as kindness, sympathy, solidarity, and the like. Indeed, to the extent that such factors are acknowledged, their costs, rather than their benefits, are emphasized. (Thus, as discussed in Chapter 6, propensities for forgiveness are held to be responsible for limitations on firm size.) The human agents who populate the economic institutions of capitalism are lacking in compassion.

This unattractive view of human nature nevertheless generates numerous refutable implications. The view that individuals are opportunistic does not, moreover, preclude the possibility that they will forge durable alliances. Large numbers of otherwise anomalous contracting and organizational practices predictably appear upon imputing a capacity for semi-farsightedness to opportunistic parties who are engaged in trade. Upon realization that the benefits of cooperation will reliably come about only if alliances are buttressed by mutual assurances, efforts to provide credible commitments will predictably be made.

To be sure, those alliances are imperfect and sometimes break down. Also, they are more costly to forge in a low-trust than in a high-trust society. But bounded rationality plus opportunism does not imply myopia. A great deal of “middle range” credible contracting is consonant with 20-50 (or even 20—500) foresight.8 As discussed in section 4 below, however, a richer theory of economic organization awaits deeper behavioral insights.


Transaction cost economics is incomplete in at least three significant respects. For one thing, the models arc very partial rather than general. Here, as elsewhere, general models are to be preferred to special models, ceteris paribus. But where the cetera are not paria, and if prediction is the touchstone to which we insistently refer, then General Theories of Action that make vague reference to utility maximization, property rights foundations, and the like, but which arc largely tautological, come at an unacceptably high cost. By contrast, more general models that yield more and deeper implications are always to be encouraged.

Another aspect of incompleteness to which 1 would call special attention is the underdeveloped state of the theory of bureaucracy. As compared with the market failure literature, the study of bureaucratic failure is very primitive. What are the biases and distortions to which internal organization is given? Why do they arise? How do they vary with organization form? An adequate understanding of economic organization plainly requires more atten-tion to those issues. Again, however, 1 would emphasize that comparative institutional standards should be maintained.

Although transaction cost economics insistently addresses both ex ante and ex post conditions of contract (sometimes referred to as the study of contracting in its entirety), it normally examines each trading nexus separately. Albeit useful for displaying the core features of each contract, interdependencies among a series of related contracts may be missed or undervalued as a consequence. Greater attention to the multilateral ramifications of contract is sometimes needed. (The discussion of unbargained-for risk shifting in Chapter 12 is an illustration.)

Source: Williamson Oliver E. (1998), The Economic Institutions of Capitalism, Free Press; Illustrated edition.

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