Although characterizing the firm as a production function is a convenient and useful abstraction, such an approach suppresses much of the interesting action that accounts for the high performance features of an enterprise economy. It facilitates marginal analysis within a given institutional framework at the expense of organization and comparative institutional features. The firm as governance structure approach maintains an economizing orientation but makes express provision for organizational innovation and relies more on comparative institutional than on marginal analysis in assessing the alternatives.
Schumpeter, Porter and Livesay, Chandler, Cochran, Cole, and Davis and North have argued persuasively that the American economy has witnessed numerous and significant organizational innovations during the past 150 years. This chapter accepts that judgment and takes the argument a step further. I argue that transaction cost economizing is the previously neglected but key concept for understanding organizational innovation in general and vertical integration in particular.
The study of transaction cost economizing entails an examination of alternative ways by which to govern exchange interfaces. Firms, markets, and mixed modes are recognized as alternative instruments of governance. Which is best suited for mediating a transaction (or related set of transactions) depends on the underlying characteristics of the transaction(s) in question. Di-mensionalizing transactions, with special attention to their asset specificity features, is crucial to the exercise. Since tradeoffs between seale and scope economies on the other are sometimes important, provision for tradeoffs has to be made.
While many of the benefits of successful organizational innovations originally redound to the advantage of the firms that originate them, the benefits accrue to society at large as the competitive process unwinds. That Andrew Carnegie profited greatly and sometimes at the expense of others from the reorganization of steel is undeniable. Of greater economic significance, however, is that the steel industry was rationalized to advantage with lasting benefits realized by society.18 The process of “handing on” always works “through a fall in the price of the product to the new level of costs” (Schumpeter, 1947, p. 155) whenever rivals are-alert to new opportunities and are not prevented by purposive restrictions from adopting them.
Natural selection forces do not always operate quickly, however. Firms that are buffered against product market rivalry, as appears to have been the case in Europe prior to the 1968 tariff reductions within the European Economic Community (Franko, 1972), and against capital market discipline, as was the Ford Motor Company with its concentrated ownership and $600 million Depression bank account (Livesay, 1979, p. 179), can postpone the reckoning. But those would appear to be the exception rather than the rule. Where incumbent managements are not pressed to adopt the new procedures by economic events, successor managements, often in conjunction with the ap- pointment of a new chief executive, commonly will (Chandler, 1962, chap. 7).
The transaction cost approach to the study of vertical integration yields numerous refutable implications, many of which are unique to this approach. The cumulative evidence, which includes mundane, forward, lateral, and backward integration, is broadly corroborative.51 Additional studies are nev- ertheless needed. For one thing, the theoretical apparatus on which transaction cost economics relies is primitive and in need of refinement. The basic tradeoffs need more fully to be worked out; the basic attributes with respect to which transactions differ need more fully to be explicated.
Also, and related, empirical assessments of vertical integration need to acknowledge the complex nature of this condition. If vertical integration is commonly the product of multiple factors, empirical studies ought to make more adequate provision for this.
These precautions notwithstanding, the vertical integration dialogue has been permanently altered by the infusion of transaction cost reasoning. The custom of paying lip service to transaction cost issues—by acknowledging them in principle, thereafter to ignore them in fact (Coase, 1972, p. 63)—has become much less common and, in the judgment of some (e.g. Alchian, 1984; Joskow and Schmalensee, 1983; Stuckey, 1983; Joskow, 1985), even untenable.
Source: Williamson Oliver E. (1998), The Economic Institutions of Capitalism, Free Press; Illustrated edition.