Toward a new institutional economics: Some Antecedents

The materials in this section are in no sense a survey. They merely indi­cate an early concern among some members of the profession of the types of institutional issues that I deal with in this treatise. With the exception of the market failure literature, which is examined briefly in Section 1.4, there is little reason to believe that there was a concerted effort among the successive authors whose work is cited to redefine economic problems in a comple­mentary way. Each was, however, committed to the proposition that econo­mics should expressly address and help assess the transactional properties of alternative modes of organization.

1. Commons on Institutional Economics

As Commons was aware, his treatment of institutional economics was a highly personal effort (1934, p. 1). He was exploring new issues and invent­ing a quasijudicial language as he proceeded. Inasmuch as the transaction was held to be the ultimate unit of economic investigation (1934, pp. 4, 5, 8), he made transfers of legal control and the efficacy of contracting the focus of his studies.

He considered scarcity to be ubiquitous and conflict of interest, natural (1934, p. 6). He saw the central contribution of institutional economics to the study of economics to be the introduction and explication of the impor­tance of collective action. The requisite degree of cooperation for efficiency to be realized arose not from a presupposed harmony of interests but from the invention of institutions that produced order out of conflict, where order was defined as “working rules of collective action, a special case of which is due process of law (1934, p. 6). To the extent that collective action was successful in mitigating conflict, a greater total yield — hence, potentially, a more preferred result for all of the parties — was thereby made feasible.

His treatment of “futurity” is of special significance, where “The concept of futurity is that of expected events, but the principle of futurity is the similarity of repetition, with variability, of transactions and their valuations, performed in the moving Present with reference to future events” (1934, p. 738). The emphasis, as I interpret it, is on (1) recurrent contracting, con­ducted under conditions of (2) uncertainty, and for which (3) successive adaptations are needed to bring the parties into efficient adjustment. As will be apparent, each of these plays an important role in the discussion of transactions in the sections and chapters that follow.

2. Coase on the Nature of the Firm

Coase has characterized his 1937 treatment of the firm as “much cited and little used’ (1972, p. 63). The reason why it is so widely cited, I submit, is that there is a general appreciation among economists that conventional treatments of firms and markets are not really derived from first principles but are instead arbitrarily imposed. Coase’s article makes this fact clear, which qualifies it as a natural in any survey of price theory. But the article is also rather tautological (Alchian and Demsetz, 1972, p. 783), a charac­teristic that explains why it is not more widely used. Transaction costs are appropriately made the center piece of the analysis, but these are not operationalized in a fashion that permits one to assess the efficacy of com­pleting transactions as between firms and markets in a systematic way.

The article is nevertheless an uncommonly insightful treatment of a fundamental problem at an early point in time and can scarcely be faulted because it did not go further. Of special importance for my purposes are its following attributes:

  1. Transactions, and the costs associated therewith, not technology, are the central object of the analysis (1937, pp. 336, 338, 341, 350).
  2. Uncertainty and, implicitly, bounded rationality are key features of the argument (1937, pp. 336-337).

Coase contends that the firm serves to economize on transaction costs in two respects. First, reliance on the price mechanism requires that the relevant prices be discovered (1937, p. 336). The firm becomes a sole source supplier to itself for those transactions that are shifted out of the market and into the firm; relevant prices are known or, in any event, bids are pre­sumably solicited less frequently as a result. Second, the firm substitutes a single incomplete contract (an employment agreement) for many complete ones. Such incomplete contracts purportedly economize on the “cost of negotiating and concluding” separate contracts (1937, p. 336). They also facilitate adaptation to changing market circumstances, because the re­quisite services to be provided are described in the employment agreement in only general terms—the details are to be elaborated at a later date (1937, p. 337).

The underlying factors that explain how and why these economies are realized are not worked out, however, and Coase’s discussion of why internal organization does not fully displace the market is even less complete. Though its discussion here would be premature, I submit that a more complete theory of firms and markets than Coase was able to forge in this seminal study awaits more self-conscious attention to the ramifications of the elementary attributes of human decision makers—of which opportun­ism is one, and bounded rationality is another.

3. Hayek on Information

Hayek’s discussion of the rational economic order is of interest in several respects. For one thing, he was especially anxious to dispel the notion that central planning is a realistic alternative to competitive market systems (1945, p. 521). Although I shall not be concerned with this issue here, the transactional approach developed herein and the firm or market issues that I address in the chapters that follow have an obvious bearing on the plan or market controversies that have occupied the attention of the profession for many years. More germane to the purposes of this book, however, are Hayek’s observations of the following general kind:

  1. The problem of a rational economic order is trivial in the absence of bounded rationality limits on human decision makers. It is accordingly essential at the outset to appreciate that bounds on rationality do exist and must be expressly taken into account if organizational issues are to be addressed in operational terms (1945, pp. 519, 527).
  2. Much of the knowledge required to make efficient economic decisions cannot be expressed as statistical aggregates but is highly idiosyncratic in nature: “practically every individual has some advantage over all others in that he possesses unique information of which beneficial use might be made, but of which use can be made only if the decisions depending on it are left to him or are made with his active cooperation. We need to remember how valuable an asset in all walks of life is knowledge of people, of local conditions, and of special circumstances” (1945, pp. 521- 522).
  3. The economic problem is relatively uninteresting except where economic events are changing and sequential adaptations to chang­ing market circumstances are called for (1945, pp. 523-524).
  4. The “marvel” of the economic system is that prices serve as suf­ficient statistics, thereby economizing on bounded rationality (1945, pp. 525-528).

Although each of these observations is important to the argument of this book, I use them in a somewhat different way than does Hayek— mainly because I am interested in a more microeconomic level of detail than he. Given bounded rationality, uncertainty, and idiosyncratic knowl- edge, I argue that prices often do not qualify as sufficient statistics and that a substitution of internal organization (hierarchy) for market-mediated exchange often occurs on this account. Also, unlike Hayek, the alternative organizational modes examined here are strictly firm and market; central planning boards never expressly enter the picture.

4. Market Failure

The postwar market failure literature is also an important antecedent literature that poses many of the same types of issues that arise in the markets and hierarchies discussion. As will be apparent, the insurance problem, as described by Arrow (1971, pp. 134-43) and examined in Section 3.1, below, is really a paradigm for studying the employment relation, vertical integration, and competition in the capital market, all of which are developed in the chapters that follow. Similarly, public goods issues (Samuelson, 1954; Hurwicz, 1972), including option demand dis­cussions (Weisbrod, 1964; Cicchetti and Freeman, 1971), are variants of the price discrimination problem (see section 3.2, below). The extensive literature on externalities has long been linked with the question of vertical integration (Davis and Whinston, 1962). Akerlof’s (1970) and Arrow’s (1969) treatments of the effects of information asymmetries on market ex­change are intimately connected with what I refer to as the information impactedness problem.

I draw, directly and indirectly, on this literature throughout the book. At the same time I find it instructive to apply the microanalytic contracting approach herein proposed to reinterpret aspects of the market failure litera­ture. Commonalities among types of failures that are not otherwise apparent are thereby disclosed.

5. A Summing Up

My debts to Commons are principally that he defined the economic problem in a spirit that is very much akin to my own. I do not borrow more in detail from what he did because his is a highly personalized analysis and there have been significant developments in the economics and organization theory literatures of the past forty years that are more apposite. Coase’s remarkable article on the nature of the firm is instructive in that he both posed the firm and market issues in a direct way and identified transaction costs and contractual relations as the critical factors to be investigated. Hayek’s examination of the rational economic order, though directed to­ward central planning rather than firm and market issues, is very much con­cerned with problems similar to those found in this book. An appreciation for bounded rationality and idiosyncratic knowledge is essential if the study of markets and hierarchies is to proceed in an operationally engaging way. Finally, the market failure literature raises many of the same types of issues that are of interest here. The context and details differ, but the underlying phenomena are very much the same.

6. Some Differences

Despite my considerable reliance on prior literature, this book differs from earlier treatments of markets and hierarchies in significant respects. Even more striking are the differences between my approach to industrial organization issues and the familiar structure-conduct-performance para­digm. Some of the main dissimilarities are indicated here.

6.1. Differences from Earlier Firm and Market Literature

The markets and hierarchies approach is interdisciplinary in that it draws extensively on contributions from both economics and organization theory. In addition to the literature referred to above, the contingent claims contracting (Arrow, 1971, pp. 121-134; Meade, 1971, pp. 147-188) and recent organizational design (Hurwicz, 1972) literatures supply the requisite eco­nomic background. The administrative man (Simon, 1957) and strategic behavior (Goffman, 1969; Schelling, 1960) literatures are the main organiza­tion theory inputs.

The principal differences between the earlier literature and the ap­proach taken here are that: (1)1 am much more concerned than are prior treatments with tracing out the ramifications of bounded rationality; (2) I expressly introduce the notion of opportunism and am interested in the ways that opportunistic behavior is influenced by economic organization; and (3) I emphasize that it is not uncertainty or small numbers, individually or together, that occasion market failure but it is rather the joining of these factors with bounded rationality on the one hand and opportunism on the other that gives rise to exchange difficulties.

The human factors that are included in the framework nowhere appear, to my knowledge, as a set of key attributes in prior studies of economic organization. Not that discussions of bounded rationality and opportunism have never previously appeared. But these have never previously been identified as key attributes and no prior effort has been made to link each to uncertainty and small-numbers in the way that I do.

Furthermore, although opportunism is a variety of self-interest seeking assumption, and thus is akin to the prevailing behavioral assumption em­ployed throughout microeconomics, the consequences of opportunism are incompletely developed in conventional economic models of firms and markets. As Diamond has noted, standard “economic models . . . [treat] individuals as playing a game with fixed rules which they obey. They do not buy more than they know they can pay for, they do not embezzle funds, they do not rob banks ’ (1971, p. 31). But, whereas behavior of these kinds is disallowed under conventional assumptions, opportunism, in a rich variety of forms, is made to play a central role in the analysis of markets and hierarchies herein.

6.2 Differences with the Structure-Conduct-Performance Paradigm

The structure-conduct-performance paradigm has characterized much of the industrial organization research during the past forty years [see Bain (1956, 1968) and Caves (1967)]. A goal of profit maximization is ordinarily imputed to the firm, internal organization is largely neglected, and the outer environment is described in terms of market structure measures such as concentration, barriers to entry, excess demand, and so forth. The distribu­tion of transactions between firm and market is mainly taken as a datum.

The present approach differs from this in that the assignment of transac­tions to one mode or another is taken to be intrinsically interesting and, in a loose way at least, something to be “derived” — somewhat in the spirit of Coase’s recent reflections on the state of industrial organization (1972, pp. 62-66). I furthermore regard organization form — by which I mean the hierarchical structure of the firm, the way in which internal economic activities are decomposed into operating parts subject to internal controls — to be distinctly interesting and warranting separate attention. Indeed, I anticipate that measures of internal organizational structure will eventually be joined with measures of market structure in attempting to explain con­duct and performance in industrial markets and subdivisions thereof.

I furthermore conjecture that attention to internal organization will prove fruitful in attempting to study the conduct and performance of quasimarket and nonmarket organizations (nonprofits, such as hospitals, universities, foundations, and so forth; and government bureaus). It is generally agreed that the conventional paradigm has been of limited utility in attempting to assess organizations of these kinds. Internal organizational analysis promises to have greater application for the study of nonmarket institutions.

Source: Williamson Oliver E. (1975), Markets and hierarchies: Analysis and antitrust implications, A Study in the Economics of Internal Organization, The Free Press.

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