The Economic Institutions of Capitalism: The Next Thirty Years

Those were auspicious beginnings. A sound basis for further advances had plainly been laid. The comparative institutional analysis of economic organi- zation did not, however, flourish. Attention was concentrated elsewhere.

The prevailing orientation toward economic organization in the thirty- year hiatus between 1940 and 1970 was that technological features of firm and market organization were determinative. The allocation of economic activity as between firms and markets was taken as a datum; firms were characterized as production functions; markets served as signaling devices; contracting was accomplished through an auctioneer; and disputes were disregarded because of the presumed efficacy of court adjudication. The possibility that subtle economizing purposes are served by organizational variety does not arise within—indeed, is effectively beyond the reach of—this orthodox framework. Correspondingly, the prevailing public policy attitude toward unfamiliar or nonstandard business practices during that interval was deep suspicion and even hostility.

That state of affairs was lamented by Ronald Coase in his 1972 essay on the state of industrial organization. Although his 1937 paper, in which trans- action rather than production costs were featured, was much cited, it was little used (Coase, 1972, p. 63). Discontent with exclusive reliance on neoclassical price theory was nevertheless building. Vernon Smith thus boldly declared, only two years later, that orthodoxy was dead and predicted that a new microtheory would arise which “will, and should, deal with the economic foundations of organization and institution, and this will require us to have an economics of information and a more sophisticated treatment of the tech^ nology of transacting” (1974, p. 321).

Indeed, the main tradition notwithstanding, not everyone worked within the framework of received microtheory during the interval 1940 to 1970. To the contrary, significant dissents, of which transaction cost economics has been the special beneficiary, were continuing to appear in law, economics, and organization.

1. Economics 

Friedrich Hayek resisted the main tradition in his insistence that “the economic problem of society is mainly one of rapid adaptation to changes in particular circumstances of time and place” (1945, p. 524). How easy it is, he observed, “for an inefficient manager to dissipate the differentials on which profitability rests, and that it is possible, with the same technical facilities, to produce with a great variety of costs, are among the commonplaces of business experience which do not seem to be equally familiar in the study of the economist” (Hayek, 1945, p. 523).

Hayek further counseled that the study of adaptive systems will be facili- tated not by focusing on statistical aggregates but by recognizing the importance of idiosyncratic knowledge—which, by its nature, cannot be summarized by statistical measures but nevertheless possesses great economic value, in that such knowledge serves as the basis for local adaptive action (Hayek, 1945, p. 523-24). If complexity is deep in the nature of things economic, then that ought to be acknowledged rather than suppressed (Hayek, 1967, chap. 2). An equilibrium approach to economics is thus only preliminary to the study of the main issues (Hayek, 1945, p. 530).

The postwar market failure literature served further to alert economists to the importance of information, its distribution among economic agents, and the difficulties attending its transmission and accurate disclosure.7 Coase’s treatment of social costs (1960) was especially noteworthy. Not only were market failures traced to transaction cost origins, but problems of economic organization were posed in a thoroughly comparative institutional way. The progressive development and refinement of this literature culminated with Kenneth Arrow’s observation that “market failure is not absolute; it is better to consider a broader category, that of transaction costs, which in general impede and in particular cases block the formation of markets” (1969, p. 48)—where by transaction costs Arrow had reference to the “costs of running the economic system” (1969, p. 48).

That microanalytic orientation is reflected in a series of important contri-butions to the study of economic organization made by Arrow. Like Hayek, he emphasized that the needs of equilibrium and disequilibrium economics differ: ‘“Traditional economic theory stresses the sufficiency of the price system as a source of information, and this is correct enough at equilibrium. In conditions of disequilibrium, [however], a premium is paid for the acquisition of information from sources other than the prices and quantities” to which the firm has direct access (Arrow, 1959, p. 47). Arrow subsequently described firms and markets as alternative instruments for organizing economic activity in his 1963 presidential address to the Institute of Management Sciences. He noted in that connection that the boundary of an organization is commonly defined by the line across which only price-mediated transactions take place, but he observed that the economic content of intraorganizational and price-mediated transactions are often similar (1971, p. 232). A common framework that applies to both is therefore indicated. He furthermore acknowledged that the hierarchical structure of internal organization is a decision variable (1971, pp. 226-27). An assessment of the efficacy of internal organization presumably needs to take this into account. Arrow’s treatment of the economics of information disclosed that the ‘ ‘ fundamental paradox ’ ’ of information is traceable to opportunism—“its value for the purchaser is not known until he has the information, but then he has in effect acquired it without cost” (Arrow, 1971, p. 152).5 Finally, Arrow insisted that the problem of economic organization be located in a larger context in which the integrity of trading parties is expressly considered (1974). The efficacy of alternative modes of contracting will thus vary among cultures because of differences in trust (Arrow, 1969, p. 62).

2. The Law and the Evolution of Private Ordering 

Noteworthy developments in the law include assessments of the special at- tributes of collective bargaining contracts by Harry Shulman, Archibald Cox, and Clyde Summers. The relative merits of private ordering in relation to court ordering needed to be assessed in deciding on how to implement the Wagner Act. Shulman urged that the Act be interpreted as a “bare legal framework” within which private ordering between management and labor would operate (1955, p. 1000). The grievance and arbitration procedure was thus favored over judicial disposition of disputes because of the corrosive effects on continuing relationships that adversary proceedings encouraged (Shulman, 1955, p. 1024). Cox likewise held that the collective bargaining agreement should be understood as an instrument of governance, which is in the spirit of Commons, as well as an instrument of exchange: “The collective agreement governs complex, many-sided relations between large numbers of people in a going concern for very substantial periods of time” (1958, p. 22).

Provision for unforeseeable contingencies is made by writing the contract in general, flexible terms and supplying the parties with a special arbitration machinery. “One simply cannot spell out every detail of life in an industrial establishment, or even of that portion which both management and labor agree is a matter of mutual concern” (Cox, 1958, p. 23).

The technical versus purposive distinction made earlier by Llewellyn was elaborated by Summers, who distinguished between “black letter law” on the one hand and a more circumstantial approach to law on the other. “The epitome of abstraction is the Restatement, which illustrates its black letter rules by transactions suspended in midair, creating the illusion that contract rules can be stated without reference to surrounding circumstances and are therefore generally applicable to all contractual transactions”. (Summers,1969, p. 566). Such a conception does not and cannot provide a “framework for integrating rules and principles applicable to all contractual transactions” (Summers, 1969, p. 566). A broader conception of contract, with emphasis on the affirmative purposes of the law and effective governance relations, is needed if that is  to  be realized. Summers conjectured  in  this connection that “the principles common to the whole range of contractual transactions are relatively few and of such generality and competing character that they should not be stated as legal rules at all” (1969, p. 527).

Other significant legal contributions include Stewart Macaulay’s empirical studies of contract. Macaulay observed that contract execution is normally a much more informal and cooperative venture than legalistic approaches to contracting would suggest. He cited one businessman to the effect that “you can settle any dispute if you keep the lawyers and accountants out of it. They just do not understand the give-and-take needed in business” (1963, p. 61). More generally, Macaulay’s studjes of contractual practices support the view that contractual disputes and ambiguities are more often settled by private ordering than by appeal to the courts—which is in sharp contrast with the neoclassical presumptions of both law and economics.

Transaction costs and comparative institutional analysis were prominently featured in Guido Calabresi’s (1970) pathbreaking work on torts.

3. Organization

Important contributions in organization theory include Herbert Simon’s seminal explication of the Barnard thesis in Administrative Behavior in 1947, Alfred Chandler’s remarkable book Strategy and Structure (1962), and Michael Polanyi’s treatment of Personal Knowledge (1962). Simon carries Barnard’s rationality analysis forward and develops a more precise vocabulary in the process. He traces the central problem of organization to the joining of rational purposes with the cognitive limits of human actors: It “is precisely in the realm where human behavior is intendedly rational, but only limitedly so, that there is room for a genuine theory of organization and administration’’ (1957, p. xxiv). Intended rationality is responsible for the observed purposefulness of economic agents and economic organizations. Interesting economic and organizational choices arise only in a limited (or bounded) rationality context.

Simon makes repeated reference to the criterion of efficiency (1957, pp. 14, 39-41, 172-97), but he also cautions that organizational design should be informed by “a knowledge of those aspects of the social sciences which are relevant to the broader purposes of the organization” (1957, p. 246). A sensitivity to subgoal pursuit, wherein individuals identify with and pursue local goals at the possible expense of global goals (Simon, 1957, p. 13), and the “outguessing” or gaming aspects of human behavior (Simon, 1957, p. 252) are among those aspects.

Chandler’s 1962 book had its origins in business history rather than organization theory. In many respects his historical account of the origins, diffusion, nature, and importance of the multidivisional form of organization ran ahead of contemporary economic and organization theory. Chandler clear-. ly established that organization form had important business performance consequences, which neither economics nor organization theory had done (nor, for the most part, even attempted) before. The mistaken notion that economic efficiency was substantially independent of internal organization was no longer tenable after the book appeared.

Michael Polanyi’s treatment of personal knowledge disclosed that to characterize the firm exclusively in technological terms was bankrupt:

The attempt to analyze scientifically the established industrial arts has everywhere led to similar results. Indeed even in the modern industries the indefinable knowledge is still an essential part of technology. I have myself watched in Hungary a new, imported machine for blowing electric lamp bulbs, the exact counterpart of which was operating successfully in Germany, failing for a whole year to produce a single flawless bulb. [Polanyi, 1962. p. 52]

That theme is carried forward in his discussion of craftsmanship. Polanyi observed that “an art which has fallen into disuse for the period of a generation is altogether lost It is pathetic to watch the endless efforts— equipped with microscopy and chemistry, with mathematics and electronics—to reproduce a single violin of the kind the half-literate Stradivarius turned out as a matter of routine more than 200 years ago” (Polanyi, 1962, p. S3). Idiosyncratic knowledge is likewise important with respect to language:

To know a language is an art, carried on by tacit judgments and the practice of unspccifiable skills. . . . Spoken communication is the successful application by two persons or the linguistic knowledge and skill acquired by such apprenticeship. one person wishing to transmit, the other to receive, information. Relying on what each has learnt, the speaker confidently utters words and the listener confidently interprets them, while they mutually rely on each other’s correct use and understanding of these words. A true communication will take place if, and only if, these combined assumptions of authority and trust are in fact justified. 11962. p. 206]

A coherent theory of economic organization that attempted to draw these several strands together nevertheless remained elusive. Neoclassical economic theories of firm and market organization and the neoclassical legal contracting tradition were left largely unscathed by these nonorthodox treatments. Meanwhile organization theory eschewed further development of the rationality approach in favor of nonrationality and power approaches to the study of organization (Williamson, 1981b, pp. 571-73). The upshot is that Coase’s grim assessment of the state of comparative institutional analysis in 1972 was altogether warranted.

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

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