Transaction Cost in Organization

Unlike economists, sociologists have long been concerned with the puzzle, “Why are there so many kinds of organization?” (Hannan and Freeman, 1977, p. 936). Although numerous interesting explanations for organizational variety have resulted, the explanation favored here—namely, organizational variety arises in the service of transaction cost economizing—was not natural to and is still resisted by many organization theory specialists.

I nevertheless submit that transaction cost economics is pertinent to many of the matters of interest to organization theory.151 A richer theory of organization would appear to be in prospect by harnessing, refining, and delimiting transaction cost analysis. But gains also flow in the reverse direction. Transaction cost economics stands to benefit from the infusion of greater organizational content. More generally, economics should both speak and listen to organization theory.

Coase’s remarks on economics and contiguous disciplines are germane. He observes that the “success of economists in moving into the other social sciences is a sign that they possess certain advantages in handling the problems of those disciplines. One is, I believe, that they study the economic system as a unified interdependent system” (1978, p. 209). He goes on, however, to remark: “Once some of these practitioners have acquired the simple, but valuable, truths which economics has to offer . . . economists who try to work in the other social sciences will have lost their main advantage and will face competitors who know more about the subject matter than they do” (Coase, 1978, p. 210).

The research opportunities sketched out below are ones for which organi- zation theory specialists would appear to enjoy the advantage.

1. Observational Advantages 

The empirical needs of transaction cost economics are much more micro- analytic than those of applied price theory. Taking microanalytic observations can be tiresome, however, and requires special skills. Koopmans nevertheless maintains that

… we have to exploit all the evidence we can secure, direct and indirect. If, in comparison with some other sciences, economics is handicapped by severe and possibly insurmountable obstacles to meaningful experimentation, the opportunities for direct introspection by, and direct observation of, individual decision makers are a much needed source of evidence which in some degree offsets the handicap. [Koopmans, 1957, p. 140]

Organization theory specialists who are trained in making microanalytic ob- servations plainly enjoy the advantage for such an effort.

Implementing that in a way responsive to the needs of transaction’ cost economics may not be easy, however. For one thing, organization theory frequently emphasizes organizational pathologies to the neglect of anatomy and physiology. To be sure, all are important. Furthermore, transaction cost economics has to be sensitized in pathological respects. But if efficiency plays the central role that I ascribe to it, then the anatomy and physiology of organization will require greater attention. Second, the microanalytic features of organization that are of special interest to transaction cost economics involve asset specificity, information asymmetry, uncertainty (especially surprise), formal and informal governance apparatus, and incentives. Few studies of organization address those matters with the needs of transaction cost economics in mind. Is a remedy feasible? Is the effort warranted?

2. Incentive Disabilities 

The question, Why can’t a large firm do everything that a collection of small firms can do and more? is posed in Chapter 6. The answer 1 advance is that internal organization is unable to replicate the high-powered incentives of markets and is subject to bureaucratic disabilities. The factors that lie behind those conditions, however, are only scratched. The ways in which firms can improve their incentive and bureaucratic competencies in relation to markets also warrant more self-conscious attention.

The question of who manages the managers (Dalton, 1959) is germane, but it is also important to inquire into such mundane matters as how the accounting conventions and procedures are decided. Are the incentive align- ments right? What biases do they introduce? What assumptions about infor- mation and its processing are maintained? Are they reasonable? What tradeoffs are set up? Are they recognized? What is the effective limit of incentive differentials within a firm? Why ? What are the organizational ramifications?

Those are plainly matters with which economists (including specialists in comparative systems) have a great interest but for which organization theory specialists would appear to enjoy the advantage.

3. Organizational Innovation 

Although perceptions are changing, the study of organizational innovation has never been more than a poor second cousin to the study of technological innovation. To be sure, Joseph Schumpeter included organizational innovation among the driving forces of capitalism: “The fundamental impulse that sets and keeps the capitalist engine in motion comes from the new consumers’ goods, the new methods of production or transportation, the new markets, the new forms of industrial organization that capitalist enterprise creates” (Schumpeter, 1942, p. 83). And Arrow observes, “Truly among man’s innovations, the use of organization to accomplish his ends is among both his greatest and his earliest” (1971, p. 224). Arthur Cole, moreover, held that “if changes in business procedures and practices were patentable, the contributions of business change to the economic growth of the nation would be as widely recognized as the influence of mechanical innovations or the inflow of capital from abroad” (Cole, 1968, pp. 61-62). Chandler evidently agrees. In his judgment, “far more economies result from the careful coordination of flow through the processes of production and distribution than from increasing the size of producing or distributing units in terms of capital facilities or number of workers” (Chandler, 1977, p. 490). Aside, however, from the Research Center in Entrepreneurial History at Harvard, which was established in 1948 and closed its doors a decade later, there has not been a concerted effort to work through and establish the importance of organizational innovation.

The record of organizational innovations is therefore sparse. Much of it is linked to and focuses on technology. A systematic effort to identify organi- zational innovations—both successes and failures—would be an enormous research resource.

Note the reference to successes and failures. Neglect of the latter is altogether understandable. Failures are unlikely to be long-lived or widely imitated; and innovators may prefer to bury their mistakes rather than have them recorded. Focusing attention on failures, however, would help to avoid the mistaken conclusion that the modem business enterprise is an uninterrupted sequence of successful refinements. What were the aberrations? Were the failures predictable, in that organizational flaws could have been identified ex ante, or were the innovations undone by events of an unforeseeable kind? The role of competition in sorting out innovations according to their economic merits also warrants more complete treatment. The link to evolutionary economics (Nelson and Winter, 1983) will be especially instructive.

4. Dignitary Values and Trust 

Both lawyers and organization theory specialists are more sensitive to dignitary values, especially as they are embedded in the governance process, than are most economists. Although dignity is enormously difficult to operationalize, the importance of deepening our knowledge of economic organization in dignitary respects is enormous.

Instrumentalist excesses of two kinds are of concern. One is that capitalist man is a nonhumanist. That is not a flattering or fully accurate description of human nature. The second is that transaction cost economics must be placed in perspective, lest it become dehumanizing. Thinking about economic organization exclusively in an instrumentalist way can spill over into a treat- ment of individuals as instruments. Such excesses of instrumentalism have to be checked.

For one thing, as Leon Mayhew puts it in his interpretation of Talcott Parsons, “behind utilitarian markets stand an authentic society, a society that is prior to and regulates utilitarian contracts between individuals The social arrangements behind utilitarian agreements justify criticizing and limiting—that is, constraining—private contracts in the name and in the interests of a larger society” (Mayhew, 1984, p. 1289). Economizing, after all, is a means not an end.

Second, calculativeness can get in the way of trust. As Arrow has repeat-edly argued, trust has an important bearing on economic organization (1969, p. 62; 1971, p. 207; 1973, p. 24; 1974, p. 23). Thus he observes that

. . . ethical elements enter in some measure into every contract; without them, no market could function. There is an element of trust in e\ery transaction; typically, one object of value changes hands before the other one does, and there is confidence that the countervalue will in fact be given up. It is not adequate to argue that there are enforcement mechanism, such as police and the courts; these are themselves services bought and sold, and it has to be asked why they will in fact do what they have contracted to do. [Arrow, 1973, p. 24]

He furthermore observes: “Trust and similar values, loyalty or truthtelling, are . . . not commodities for which trade on the open market is technically possible or even meaningful” (1974, p. 23).

Those are important observations. But operationalizing trust has proved inordinately difficult. A noncalculative orientation may help to unpack the issues. Organization theorists would appear to be well suited to the task.

5. Labor Contracting 

The study of the employment relation is complicated by family considerations that are not expressly included in the transaction cost economics calculus. If workers with generalized skills are not really mobile, because of the dislocation costs that moving would impose on other members of the family, then workers may develop demands for job security, due process, and the like that the earlier job calculus disregarded. To be sure, firms have incentives to respect security preferences of every kind—whether these have job or family origins. But the problem of studying labor organization in a discriminating way is plainly more complicated when family considerations are introduced.

A second difficulty concerns the efficacy of reputation effects. There are several potential problems. The most obvious is whether contemporary observers and successor generations are apprised of contracting difficulties in sufficient detail to make informed assessments. Idiosyncratic experience between buyer and seller that is known only to the immediate parties plainly poses a serious impediment. A second problem is competency bias. If, with the benefit of hindsight, observers can “see through” the particular difficulties of the transaction in question, and if they believe themselves to be too clever to make such a mistake themselves, then observers may discount the experience of others excessively.

Still more difficult problems arise if penalties for poor conduct in contract execution must be exacted not by contemporaries but by future genera-tions. Breakdowns of at least three kinds can be described. One is due to simple failure of memory. Reputation effects are at best imperfect if the relevant institutional memories are embedded in players who have retired or have otherwise been relocated. Also, successor generations of sellers may ask, sometimes with cause, that they not be held accountable for the sins of their fathers. But if those to whom forgiveness is warranted cannot be distinguished from false claimants, and if there is a propensity to err on the side of charity, then forgiveness may permit contracting errors to be repeated.23 Finally, successor generations may depend on leaders to represent them. If the leaders have been co-opted or corrupted, wherein do the reputation effect penalties obtain?

The upshot is that if human nature as we know it is subject to propensities of the kinds described above, then sellers can and sometimes will escape the penalties of opportunistic behavior during contract execution. Accordingly, appeal to reputation effects does not obviously warrant that private ordering outcomes be regarded as determinative. The issues need to be delimited.

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

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