There is widespread agreement, among economists and noneconomists alike, with the proposition that the modem corporation is an important and complex economic institution. Such agreement is mainly explained by the obtrusive size of the largest firms. The economic factors that lie behind the size, shape, and performance of the modem corporation, however, are poorly understood.
The puzzlement is not of recent origin. Edward Mason complained more than twenty years ago that “the functioning of the corporate system has not to date been adequately explained… The man of action may be content with a system that works. But one who reflects on the properties or characteristics of this system cannot help asking why it works and whether it will continue to work” (1959, p. 4). The predicament to which Mason refers is, I submit, largely the product of two different (but not unrelated) inteilectual traditions. The first holds that the structural features of the corporation are irrelevant. The neoclassical theory of the firm that populates intermediate theory text-books is consistent with this view. Structural differences are suppressed as the firm is described as a production function to which a profit maximization objective has been assigned. The second has public policy roots—the inhospitably tradition to which I referred earlier. The distinctive structural features features of the corporation are here believed te be the result of unwanted (anticompetitive) intrusions into market processes.
The transaction cost approach differs from both. Unlike neoclassical analysis, internal organization is specifically held to be important. Unlike the inhospitality tradition, structural differences are presumed to arise primarily in the service of transaction cost economizing.
The progressive evolution of the modem corporation records the imprint of transaction cost economizing at every stage. The railroads, which were the “first modem business enterprises” (Chandler, 1977, p. 120), devised the line-and- staff structure when coordination of end-to-end systems by contract broke down and older and simpler structures were unable to manage the resulting networks. Transaction costs rather than technology were plainly driving those developments. Forward integration out of manufacturing into distribution was widespread at the turn of the century. As discussed in Chapter 5, integration occurred selectively rather than comprehensively and in a manner that is broadly consistent with transaction cost reasoning.
The two leading corporate forms that were in place in 1920 were the functional (or U-form) and holding company (H-form) structures. Both expe- rienced internal inefficiency and managerial discretion distortions as firms grew in size and complexity. Viewing internal organization within a nexus of contract perspective, the implicit contracts were too cumbersome on the one hand (the U-form case) and too incomplete on the other (the H-form condition). Faced with the need either to retrench or to develop a new set of internal contracting relationships, organizational innovators devked the M-form structure.
The resulting structure recognized essential decomposability, thus rec-tifying the overcentralization condition in the U-form enterprise. The M-form furthermore effected a split between operating and strategic decision-making and reserved the latter for the general office. Providing the general office with an internal incentive and control capability was required lest the potential benefits of the division of effort be dissipated. Such a capacity had been lacking in the H-form organization and contributed to problematic performance therein.
This argument bears a resemblance to the two technology problem dis- cussed in earlier chapters. The two technologies under review here are the centralized and decentralized modes of organization. The first corresponds to the U-form; the second can be either H or M. The contractual difference between the latter two is that safeguards against opportunism are more fully developed in the M-form. Investors will presumably be prepared to supply capital on superior terms, therefore, to a large, diversified M-form corporation than they would to an equivalent H-form firm. In the degree to which the M- form is in fact the fitter, natural selection, which includes competition in the capital market, favors this result.
The M-form innovation introduced by General Motors and du Pont (and subsequently imitated by others) thus served both technical and internal gov- ernance purposes—in that it served both to economize on bounded rationality and attenuate opportunism. Specifically, operating decisions were no longer forced to the top but were resolved at the divisional level, which relieved the communication load. Strategic decisions were reserved for the general office, which reduced partisan political input into the resource allocation process. And the internal auditing and control techniques to which the general office had access served to overcome information impactedness conditions and permit fine tuning controls to be exercised over the operating parts.
The M-form structure, which was originally adopted by firms in relatively specialized lines of commerce, was subsequently extended to manage diversified assets (the conglomerate) and foreign direct investments (MNE). A breadth-for-depth tradeoff is involved in the former case, as the firm selectively internalizes functions ordinarily associated with the capital market. MNE activity has also been selective—being concentrated in the more technologically progressive industries where higher rates of R&D are reported and technology transfer arguably poses greater difficulties. This pattern of foreign direct foreign investment cannot be explained by a monopoly hypothesis but is consistent with transaction cost reasoning.
To be sure, the interpretation of the modem corporation set out in this chapter and elsewhere in this book deals only with salient features. There is both room for and need of refinement. It nevertheless makes headway against the rationality puzzlement to which Mason referred and which has troubled other students of the modem corporation. The basic proposition is this: Orga- nization form deserves to be taken seriously. Once that is acknowledged, transaction cost economizing becomes a very large part of the argument.
Source: Williamson Oliver E. (1998), The Economic Institutions of Capitalism, Free Press; Illustrated edition.