It is elementary that analysis influences the way the world is perceived, including the power to delude and misguide as well as to illuminate and instruct (Nelson, 1974, p. 3). It is also widely agreed that if mechanism B, not mechanism A, is thought to be generating the phenomena of interest, the intellectually respectable thing to do is to build theory B (Koopmans, 1957, p. 140). The heavy emphasis on the development of mathematical economics during the past thirty years, however, has often favored theory A constructions. Transactional frictions, which do not yield easily to formal analysis, have been relatively neglected in the process.1 Although this may have been necessary, as a transitional measure, to reach the present level of refinement of economic theory, it has sometimes been at the expense of being artificial.
Inasmuch, however, as high theory is necessarily entitled to extreme abstractions, whence the occasion for concern? The test of “relevance,” for theorists, is frequently obscure. But the commitment of theory to frictionless systems has encouraged a limited or selective sensitivity to frictions by applied types as well. To the extent that public policy prescriptions have suffered as a result — which I believe has sometimes been the case — this, plainly, has been unfortunate.
I attempt here to set out some of the differences between the proposed approach and alternative ways of addressing applied microeconomic issues. For those who, like myself, are inclined to be eclectic, no comprehensive commitment to one approach rather than another needs to be made. What is involved, rather, is the selection of the approach best suited to deal with the problems at hand. Although the matching of models to problems is not always easy, I find the alternative of forcing one model to handle all the issues to be even less satisfactory — for the reasons given by Nelson and Koopmans at the outset.
1. Some Alternative Modeling Approaches
The following review of alternative models is brief and, perforce, in- complete. In some respects it is even a caricature. While regrettable, rectifying this would require a much more expansive discussion. The purposes of the exercise will be realized if the major differences between existing approaches to the study of firm and market structures and that proposed in this book are made evident.
1.1. RECEIVED MICROTHEORY
It is widely felt that “the economic background required for understand- ing antitrust issues seldom requires detailed mastery of economic refine- ments” (Areeda, 1967, p. 4)—by which is meant, presumably, that the standard economic models of firms and markets that are found in inter- mediate microtheory textbooks will normally be sufficient for antitrust purposes. I doubt that this is the case. Conventional analysis needs sometimes to be augmented and at other times supplanted by expressly considering transactional problems.
Demand curves (average revenue curves), average cost curves, and the marginal curves of revenue and cost drawn to each of these constitute the basic modeling apparatus for most antitrust treatments of firms and markets. Implicit in most of these models are efficiency assumptions of two kinds. First, it is assumed that the firm operates on its production function, which shows the maximum output of product that can be realized from each feasible combination of factor inputs (mainly labor and capital). Failure to operate on the production function would imply wasteful use of inputs; this is assumed away. Second, given factor prices, it is assumed that the firm chooses the least- cost factor combinations for each possible level of output. The total cost curve, from which average and marginal cost curves are derived, is constructed in this way.
Whether the competitive or monopolistic model of the firm is most appropriate depends on whether economies of scale are large in relation to the market. But whichever model is employed, the prevailing behavioral assumption is one of profit maximization. The nature of the firm with respect to what it will make and what it will buy is normally taken as given; matters of internal organization (hierarchical structure, internal control processes) are likewise ignored. Conformably, competition in the capital market issues rarely surface, much less are probed in depth. That many interesting problems of firms and markets are suppressed or bypassed by reducing the firm to a production function to which a profit maximization objective has been assigned should come, perhaps, as no surprise.
1.2. THE STRUCTURE-CONDUCT-PERFORMANCE PARADIGM
The industrial organization tradition that has developed around the structure-conduct-performance paradigm employs the received microtheory model of the firm as a building block, but the principal unit of analysis is the industry. The influence of market structure and of interfirm conduct on economic performance occupies the center stage.
The resulting study of firm and market activities is even less micro- analytic than are the models of received microtheory referred to above. However useful this approach has been for many purposes, it is necessarily limited in others. Policy analysts of this tradition, including especially many economists at the Federal Trade Commission, often impute anticompetitive purposes to complex or unfamiliar business practices when instead the principal object of the practices is transactional efficiency. A hostility to complex business organization — be it vertical integration, conglomerate organization, novel credit or leasing arrangements, and the like — commonly obtains.
1.3. THE PROPERTY RIGHTS TRADITION
The property rights approach to economic organization is much more recent. Furubotn and Pejovich ( 1974) trace its origins to the work of Armen Alchian in the 1950’s. Several different strands of this approach can be identified.
The frictionlessness variant is a rather extreme, albeit provocative and often instructive, member of the property rights family. The strong version of the “Coase theorem,” namely, that allocative efficiency will obtain, whatever the assignment of proeperty rights, if bargaining costs are negligible, is illustrative.176 That this may now be obvious or even trivial is one thing.177 But it was scarcely obvious when Coase first advanced the proposition in 1960 and has since spawned a huge literature. It sensitized many to the proposition that the existence of spillover need not occasion intervention by the state.
The assumption of frictionlessness is severely at odds with the approach taken herein. Instead of being omniscient,178 contractual participants in my scheme are limited in bounded rationality respects. Instead of costless bargaining, my negotiations are characterized by information impacted- ness, opportunism, and the sacrifice of valuable resources as parties seek strategic advantage and thereafter engage in haggling.
A second strand of the property rights argument is that institutions evolve in the service of efficiency ( Alchian, 1969; Demsetz, 1967). This is closer to the approach taken here, in that transaction costs are admitted and efficiency considerations are emphasized, but the human and environmental factors, and particularly the interactions that exist between these factors, which are responsible for transaction costs are incompletely developed.
My analysis differs in that transaction costs are expressly traced to the human and enviornmental factors that appear in the organizational failures framework. It also differs in that I am inclined to be somewhat more in- terventionist than are many of those who are associated with this second tradition. Rather than regard all noncollusive private sector economic outcomes to be “good,” if only the government would permit the private sector to function,6 I am plainly prepared to upset some of them —as my treatment of vertical and conglomerate organization and of the dominant firm problem illustrates.
A third approach that comes out of the property rights literature is that it is “effective control” that matters. My initial work on managerial discretion ( Williamson, 1964) is an example. A managerial utility function is postulated and the implications of information impactedness, which prevents stockholders from exercising comprehensive controls, are explored. Attempts to generalize the approach to universities and hospitals (Newhouse, 1970) have since been made.
While this approach moves usefully in the direction of “realism in moti- vation,” it pays scant attention to “realism in process.”7 It simply employs too high a level of aggregation to address transaction-specific issues of the kinds that I have been concerned with in this book — and which I feel are of greater economic importance.
2. Distinctive Features of the Markets and Hierarchies Approach
The principal features of the markets and hierarchies analysis developed in this book are:
- It makes evident that it is transactions rather than technology that underlie the interesting issues of microeconomic organization.
- A comparative institutional attitude is maintained: markets and hierarchies are regarded as alternative contracting modes.
- It makes explicit provision for rudimentary attributes of human nature (bounded rationality and opportunism) and relates these to a set of environmental factors (complexity/uncertainty and small numbers) in the context of an organizational failures framework.
- It is much more microanalytic than previous treatments, focusing as it does on the transactional details of recurrent contracting under alternative modes of organization. Reducing, as it does, to a study of contracting means that the contracting expertise of lawyers developed in other contexts can be drawn upon.
- However useful the fiction of frictionless is for some purposes, it is an impediment to the study of the efficiency properties of alternative modes of economic organization. The frictionless fiction is accordingly abandoned.
- Organization form, which is concerned with the decomposition principles of hierarchy, is introduced as an internal organizational counterpart to the familiar market structure measures of industrial organization.
- New questions or a different slant on old questions is afforded across a wide range of issues — including peer group organization, the em- ployment relation, vertical integration, conglomerate organization, technological progress, dominant firms, and oligopoly.
- The approach is comparatively value-free — it is biased neither for nor against unfettered market modes of organization.
- Supplying a satisfying exchange relation is made part of the economic problem by introducing the notion of atmosphere. The disregard for attitudinal interaction effects, among transactions and within groups, that is associated with quid pro quo modes of analysis in which separability is implicitly assumed is thereby avoided.
Source: Williamson Oliver E. (1975), Markets and hierarchies: Analysis and antitrust implications, A Study in the Economics of Internal Organization, The Free Press.