Why can’t a large firm do everything that a collection of small firms can do and more? The basic argument of this chapter is this: Selective intervention, whereby integration realizes adaptive gains but experiences no losses, is not feasible. Instead, the transfer of a transaction out of the market into the firm is regularly attended by an impairment of incentives. It is especially severe in circumstances where innovation (and rewards for innovation) are important. But it appears in all transactions of the non-Nirvana kind to which Austin Robinson (1934, p. 250) made early reference. The market is a marvel, therefore, not merely because of its remarkable signaling properties (under the requisite preconditions), but also because of its remarkable capacity to present and preserve high-powered incentives.
Although the argument is especially transparent in the case where a preacquisition owner-manager is reduced to mere manager status upon ac- quisition, incentive consequences also attend mergers in which preacquisition managers hold no significant ownership position. The problem in the former case is that postmerger efforts to preserve high-powered incentives give rise to distortions and are apt to be corrupted, as a consequence of which low- powered incentives are instituted in their place. The problem in the latter case is that even low-powered (salaried) compensation schemes have contingent reward features in both payment and promotion respects. Those are likewise subject to impairment in the postacquisition condition.
Efforts to “hold incentives constant,” thereby to effect incentive neutrality, thus turn out to be delusional. The problem is that none of the following is costlessly enforceable: promises by division managers to utilize assets with “due care”; promises by owners to reset transfer prices and exercise accounting discretion “responsibly”; promises to reward innovation in “full measure”; promises to preserve promotion prospects “without change”; and agreements by managers to “eschew politics.” Internalizing the incremented transaction leads to incentive disabilities in all of those respects, and as a consequence transactions are apt to be organized in an altogether different way upon merger.
Thus although it is useful to think of markets and hierarchies as alternative modes with many common features, it is also essential to recognize that distinctive strengths and weaknesses are associated with each. Both incentive and governance features have to be acknowledged. As compared with internal transactions, market mediated transactions rely more on high-powered incen- tives and less on the administrative process (including auditing) to accomplish the same result.
Source: Williamson Oliver E. (1998), The Economic Institutions of Capitalism, Free Press; Illustrated edition.