The Economic Institutions of Capitalism: Antecedents from the 1930s

1. Economics 

A significant contribution to the study of economic organization that preceded the 1930s was Frank Knight’s (1965) classic treatment of Risk, Uncertainty, and Profit in 1922. Knight plainly anticipated Percy Bridgeman’s counsel to social, scientists that “the principal problem in understanding the actions of men is to understand how they think—how their minds work” (1955, p. 450). Knight had earlier acknowledged the importance of studying “human nature as we know it” (1965, p. 270) and specifically identified “moral hazard” as an endemic condition with which economic organization must contend (1965, p. 260).2

Knight’s keen behavioral insights never gained prominence, however. Attention was focused instead on the technical distinction between risk and uncertainty that he had introduced. This is partly explained by the fact that Knight’s reference to moral hazard appeared in conjunction with his discussion of insurance, where the term has a well-defined technical meaning. Its more general relevance to the study of economic organization went unnoticed. Had Knight used a nontechnical term, such as “opportunism,” that has broad and recognizable significance to social and economic organization quite generally, that result might have been avoided.

Another economist whose deep understanding of economic organization went largely unrecognized except among a small core of institutionalists was John R. Commons. Commons advanced the proposition that the transaction is properly regarded as the basic unit of analysis (1934, pp. 4-8). The study of trading at a much more microanalytic level of analysis was thus indicated. Commons furthermore recognized that economic organization is not merely a response to technological features—economies of scale; economies of scope; other physical or technical aspects—but often has the purpose of harmonizing relations between parties who are otherwise in actual or potential conflict (Commons, 1934, p. 6). The proposition that economic organization has the purpose of promoting the continuity of relationships by devising specialized governance structures, rather than permitting relationships to fracture under the hammer of unassisted market contracting, was thus an insight that could have been gleaned from Commons. But the message made little headway against the prevailing view that the courts were the principal forum for conflict resolution.

Ronald Coase’s classic 1937 article expressly posed the issue of eco-nomic organization in comparative institutional terms. Whereas markets were ordinarily regarded as the principal means by which coordination is realized, Coase insisted that firms often supplanted markets in performing these very same functions. Rather than regard the boundaries of firms as technologically determined, Coase proposed that firms and markets be considered alternative means of economic organization (1952, p. 333). Whether transactions were organized within a firm (hierarchically) or between autonomous firms (across a market) was thus a decision variable. Which mode was adopted depended on the transaction costs that attended each.

A crucial dilemma nevertheless remained. Unless the factors responsible for transaction cost differences could be identified, the reasons for organizing some transactions one way and other transactions another would necessarily remain obscure. The persistent failure to operationalize transactiorL£flsts was responsible for its tautological reputation (Alchian and Demsetz, 1972, p. 783). Inasmuch as virtually any outcome could be explained by appeal to transaction cost reasoning, recourse to transaction costs gradually acquired “a well-deserved bad name” (Fisher, 1977, p. 322, n. 5). Headway on these matters thus unavoidably awaited operationalization.

2. Law 

The legal literature to which I have reference deals mainly with contract law, although important labor law contributions have since been made. An especially important contribution is Karl Llewellyn’s prescient treatment “What Price Contract?” in 1931. Llewellyn took exception to prevailing contract law doctrine, which emphasized legal rules, and argued that greater attention should be given to the purposes to be served. Lcss-attention to form and more to substance was thus indicated—especially since being legalistic could sometimes stand in the way of getting the job done.2 A concept of contract as framework was advanced. Llewellyn distinguished between “iron rules” and “yielding rules” (1931, p. 729) and held that

… the major importance of legal contract is to provide a framework for well- nigh every type of group organization and for well-nigh every type of passing or permanent relation between individuals and groups…- a framework highly adjustable, a framework which almost never accurately indicates real working relations, but which affords a rough indication around which such relations vary, an occasional guide in cases of doubt, and a norm of ultimate appeal when the relations cease in fact to work. (1931, pp. 736-37]

Such a concept of contract as framework is broadly consonant with process analysis of the type favored by Commons, where the study of working rules and continuity of exchange were emphasized. The convenient assumption, in both law and economics, that court ordering was routinely invoked to enforce contract was plainly challenged. The limited contractual role that Llewellyn assigned to litigation is a precursor to the more recent literature on “private ordering” (Galanter, 1981).

3. Organizations 

The 1930s also witnessed the publication of Chester Barnard’s important study The Functions of the Executive (1938). Whereas organization theorists had previously been preoccupied with creating “principles” of organization—which, it turned out, were often empirically vacuous (March and Simon, 1958, pp. 30- 31)—Barnard was concerned instead with the processes of organization. The study of formal organization was emphasized, but not to the exclusion of informal organization. Cooperation was assigned a central place in the theory of organization that Barnard advanced. Express provision was made for tacit or personal knowledge.

Thus although Barnard approved of the extensive study by social scientists of “mores, folkways, political structures, institutions, attitudes, motives, propensities, instincts,” he regretted that the study of formal organization had been relatively neglected (1938, p. ix); by formal organization he meant “that kind of cooperation among men that is conscious, deliberate, purposeful” (1938, p.4). Barnard wanted greater emphasis placed on intended rationality, due allowance having been made for the limits imposed by physical, biological, and social factors (1938, pp. 12-45). What Herbert Simon subsequently referred to as “bounded rationality” (1957) was anticipated.

Effective adaptation was what distinguished successful cooperative sys- tems from failures:

The survival of an organization depends upon the maintenance of an equilibrium of complex character in a continuously fluctuating environment of physical, biological, and social materials, elements, and forces which calls for readjustment of processes internal to the organization. We shall be concerned with the nature of the external conditions to which adjustment must be made, but the center of our interest is the process by which it is accomplished. [Barnard, 1938, p. 6]

Cooperation is jointly determined by social factors and incentive align- ments: Inasmuch as the “social benefits [of cooperation] are limited . . . , efficiency depends in part on the distributive process in the cooperative system” (1938, p. 58). The study of formal organization needs to make provision, moreover, for the role of informal organization—“formal organizations are vitalized and conditioned by informal organization … ; there cannot be one without the other” (Barnard, 1938, p. 120). Informal organization facilitates communications, promotes cohesiveness, and serves to protect the personal integrity and self-respect of the individual against the disintegrating effects of formal organization (1938, p. 122).

Finally, Barnard, in a very prescient passage, made explicit provision for what Michael Polanyi (1962) later developed in the context of personal knowledge. As Barnard put it:

In the common-sense, everyday, practical knowledge necessary to the practice of the arts, there is much that is not susceptible of verbal statement—it is a matter of know- how. It may be called behavioral knowledge. It is necessary to doing things in concrete situations. It is nowhere more indispensable than in the executive arts. [1938, p. 291]

Barnard’s remarkable discussion of internal organization thus asserts or develops the following: (1) Organization form—that is, formal organization— matters; (2) informal organization has both instrumental and humanizing purposes; (3) bounds on rationality are acknowledged; (4) adaptive, sequential decision-making is vital to organizational effectiveness; and (5) tacit knowledge is important. Albeit lacking in comparative institutional respects—no firm or market comparison, for example, was attempted—a concept of the firm as governance structure was plainly contemplated.

The following propositions had thus been advanced and, in principle, could have been joined in a concerted study of economic organization as of 1940: (1) Opportunism is a subtle and pervasive condition of human nature with whiclTthe study of economic organization must be actively concerned (Knight); (2) the transaction is the basic unit of organizational analysis (Commons); (3) a central purpose of economic organization is to harmonize exchange relations (Commons; Barnard); (4) the study of contract, broadly concèlvëdT is the legal counterpart to, and both stands to benefit from and can help to inform the study of economic organization (Llewellyn); and (5) the study of internal organization and market organization are not disjunct but are usefully joined within a common transaction cost economizing framework (Coase).

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

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