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Review
Kenneth J. Arrow Nobel Laureate in Economics Oliver Williamson's work has brought to our attention in a fruitful study the ways that economic and other organizations differ in their behavior from the pure market model? The direct links among individuals and the need to respond in ways which reflect limited ability to cope with uncertainty and complexity has strong implications for the nature of economic contracts, the possibility of markets, and substitution of hierarchical and other direct relations for the price system. I find his work especially important because in introducing a need for new principles in understanding internal organization, he has not lost sight of the importance of external market pressures in the direction of economic activity. The publication of this book is a powerful addition to our knowledge in this area and equally a stimulus to further research.
Administrative Science Quarterly No student of organizations should fail to read this book....ought to provide food for argument and further research for at least the next decade.
Contemporary Sociology ...presents a concise, coherent, and powerful framework that will greatly enhance our thinking about complex organization, corporate conspiracy, public and business policy, and regulation....One of its major strengths is the merger of economic and sociological literature while invoking the information paradigm....highly rewarding.
Challenge ...deserves serious attention from anyone who is interested in public policy toward private enterprise.
About the Author
Oliver E. Williamson is Charles and William L. Day Professor of Economics and Social Science at the University of Pennsylvania and Director of the University's Center for Study of Organizational Innovation? A Guggenheim Fellow and former Special Economic Assistant to the Antitrust Division of the U.S. Department of Justice, he is author of The Economics of Discretionary Behavior and Corporate Control and Business Behavior.
Excerpt. © Reprinted by permission. All rights reserved.
Chapter 1
Toward a New Institutional Economics
A broadly based interest among economists in what might be referred to as the "new institutional economics" has developed in recent years. Aspects of mainline microtheory, economic history, the economics of property rights, comparative systems, labor economics, and industrial organization have each had a bearing on this renaissance. The common threads that tie these various studies together are: (1) an evolving consensus that received microtheory, as useful and powerful as it is for many purposes, operates at too high a level of abstraction to permit many important microeconomic phenomena to be addressed in an uncontrived way; and (2) a sense that the study of "transactions," which concerned the institutionalists in the profession some forty years ago, is really a core matter and deserves renewed attention. Unlike the earlier institutionalists, however, the current group is inclined to be eclectic. The new institutional economists both draw on microtheory and, for the most part, regard what they are doing as complementary to, rather than a substitute for, conventional analysis.
The spirit in which this present book is written very much follows the thinking of these new institutionalists. I hope, by exploring microeconomic issues of markets and hierarchies in greater detail than conventional analysis commonly employs, to achieve a better understanding of the origins and functions of various firm and market structures -- stretching from elementary work groups to complex modern corporations. I focus on transactions and the costs that attend completing transactions by one institutional mode rather than another. While the relation of technology to organization remains important, it is scarcely determinative. I argue in this connection that, but for a few conspicuous exceptions, neither the indivisibilities nor technological nonseparabilities on which received theory relies to explain nonmarket organization are sufficient to explain any but very simple types of hierarchy. Rather I contend that transactional considerations, not technology, are typically decisive in determining which mode of organization will obtain in what circumstances and why.
Central to the analysis is what I refer to as the "organizational failures framework." Its distinction is that it expressly acknowledges the importance played by human factors in attempting to grapple with problems of economic organization. Such considerations usually operate, if at all, only in a vague, background way. Indeed, they are altogether suppressed in many of the conventional models of economic man that populate intermediate theory textbooks. Although references to "human nature as we know it" (Knight, 1965, p. 270) occasionally appear, these rarely occupy an active role in the analysis. I submit, however, that more self-conscious attention to rudimentary human attributes is essential if we are to accurately characterize and more adequately understand many of the problems of markets and hierarchies.
The remainder of this chapter is an overview of the mode of analysis and types of problems that this book is concerned with. Some of the antecedents to the proposed approach are examined in Section 1. A preliminary statement of the basic framework is set out in Section 2. The framework is then applied to three specific examples in Section 3. These applications reveal that a sensitivity to transaction costs is often essential. They also show that the language of studying markets and hierarchies proposed herein often permits microeconomic phenomena of quite diverse kinds to be understood in different and in some respects deeper ways than conventional analysis would otherwise afford.
1. 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.
1.1 Commons on Institutional Economics
As Commons was aware, his treatment of institutional economics was a highly personal effort (1934, p. 1). lie 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.
1.2 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.
1.3 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).
d
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 knowledge, 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.
1.4 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.
1.5 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.
1.6 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.
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) I 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.
1.6.2 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.
2. A Preliminary Statement of the Organizational Failures Framework
Although I shall defer a more complete statement of the organizational failures framework until Chapter 2 (indeed, some of the elements that appear in it are not even identified here), a sketch of the basic approach, set out early, will not only provide an overview of what will follow but also permit some immediate applications of the framework to be made.
The general approach to economic organization employed here can be summarized compactly as follows: (1) Markets and firms are alternative instruments for completing a related set of transactions; (2) whether a set of transactions ought to be executed across markets or within a firm depends on the relative efficiency of each mode; (3) the costs of writing and executing complex contracts across a market vary with the characteristics of the human decision makers who are involved with the transaction on the one hand, and the objective properties of the market on the other; and (4) although the human and environmental factors that impede exchanges between firms (across a market) manifest themselves somewhat differently within the firm, the same set of factors apply to both. A symmetrical analysis of trading thus requires that we acknowledge the transactional limits of internal organization as well as the sources of market failure. Basic to such a comparative analysis is the following proposition: Just as market structure matters in assessing the efficacy of trades in the marketplace, so likewise does internal structure matter in assessing internal organization.
The markets and hierarchies approach attempts to identify a set of environmental factors which together with a related set of human factors explain the circumstances under which complex contingent claims contracts will be costly to write, execute, and enforce. Faced with such difficulties, and considering the risks that simple (or incomplete) contingent claims contracts pose, the firm may decide to bypass the market and resort to hierarchical modes of organization. Transactions that might otherwise be handled in the market are thus performed internally, governed by administrative processes, instead.
The environmental factors that lead to prospective market failure are uncertainty and small-numbers exchange relations. Unless joined, however, by a related set of human factors, such environmental conditions need not impede market exchange. The pairing of uncertainty with bounded rationality and the joining of small numbers with what I shall refer to as opportunism are especially important.
Consider first the pairing of bounded rationality with uncertainty. The principle of bounded rationality has been defined by Herbert Simon as follows:" The capacity of the human mind for formulating and solving complex problems is very small compared with the size of the problems whose solution is required for objectively rational behavior in the real world" (1957, p. 198, emphasis in original). It refers to neurophysiological limits on the one hand and language limits on the other. If, in consideration of these limits, it is very costly or impossible to identify future contingencies and specify, ex ante, appropriate adaptations thereto, long-term contracts may be supplanted by internal organization. Recourse to the latter permits adaptations to uncertainty to be accomplished by administrative processes in a sequential fashion. Thus, rather than attempt to anticipate all possible contingencies from the outset, the future is permitted to unfold. Internal organization in this way economizes on the bounded rationality attributes of decision makers in circumstances in which prices are not "sufficient statistics" and uncertainty is substantial.
Explicating the relation between opportunism and a small numbers exchange condition is somewhat involved and is accordingly deferred to the examples in Section 3 and to Chapter 2. Suffice it to observe here that (1) opportunism refers to a lack of candor or honesty in transactions, to include self-interest seeking with guile; (2) opportunistic inclinations pose little risk as long as competitive (large-numbers) exchange relations obtain; (3) many transactions that at the outset involve a large number of qualified bidders are transformed in the process of contract execution, so that a small-numbers supply condition effectively obtains at the contract renewal interval; and (4) recurrent short-term contracting is costly and risky when opportunism and transactions of this latter kind are joined.
In consideration of the problems that both long- and short-term contracts are subject to -- by reason of bounded rationality and uncertainty in the first instance and the pairing of opportunism with small-numbers relations in the second -- internal organization may arise instead. Issues here are dealt with as they arise rather than in an exhaustive contingent-planning fashion from the outset. The resulting adaptive, sequential decision-making process is the internal organizational counterpart of short-term contracting and serves to economize on bounded rationality. Opportunism does not pose the same difficulties for such internal sequential supply relations that it does when negotiations take place across a market because (1) internal divisions do not have pre-emptive claims on profit streams (but more nearly joint profit maximize instead); and (2) the internal incentive and control machinery is much more extensive and refined than that which obtains in market exchanges. The firm is thereby better able to take the long view for investment purposes (and hence is more prepared to put specialized plant and equipment in place) while simultaneously adjusting to changing market circumstances in an adaptive, sequential manner.
But whichever way the assignment of transactions to firm or market is made initially, the choice ought not to be regarded as fixed. Both firms and markets change over time in ways that may render inappropriate an initial assignment of transactions to firm or market. The degree of uncertainty associated with the transactions in question may diminish; market growth may support large-numbers supply relations; and information disparities between the parties often shrink. Also, changes in information processing technology may occur which alter the degree to which bounded rationality limits apply, with the result that a different assignment of activities between markets and hierarchies than was selected initially becomes appropriate later. Thus, we ought periodically to reassess the efficacy of completing transactions by one mode rather than another.
3. Three Illustrations
Whether the proposed approach leads to a better understanding of or to implications different from those found in received microtheory can best be established by addressing it to particular economic phenomena. Three are examined here: price discrimination, the insurance problem, and Stigler's life cycle treatment of vertical integration. Although the first of these does not ordinarily entail market and hierarchy choices, price discrimination has the advantage of being familiar and does raise transaction cost issues. Except to the extent that self-insurance is a viable alternative, neither does the insurance problem expressly pose market and hierarchy issues. It is, however, a paradigmatic problem, the attributes of which will recur in a variety of contracting contexts in the chapters that follow. Stigler's treatment of vertical integration is directly concerned with market and hierarchy issues.
3.1 Price Discrimination
The differences between received microtheory and the transaction cost approach can be illustrated by examining the familiar problem of price discrimination. As will be evident, the transaction cost approach does not abandon but rather augments the received microtheory model.
Assume that the market in question is one for which economies of scale are large in relation to the size of the market, in which case the average cost curve falls over a considerable output range. Assume, in particular, that demand and cost conditions are as shown in Figure 1. The unregulated monopolist who both maximizes profits and sells his output at a single, uniform price to all customers will restrict output below the social optimum (shown by Q* in Figure 1), at which marginal cost equals price. Instead, the monopolist will restrict his output to Qm, where marginal cost equals marginal revenue and an excess of price over marginal cost obtains.
It is sometimes argued, however, that price discrimination will correct the allocative efficiency distortion referred to. In particular, the monopolist who segregates his market in such a way that each customer is made to pay his full valuation (given by the demand curve) for each unit of output has the incentive to add successive units of output until the price paid for the last item sold just equals the marginal cost. The fully discriminating monopolist will thus be led to expand output from Qm to Q*. Although income distribution will be affected in the process (in possibly objectionable ways), the output distortion noted earlier is removed and an allocative efficiency gain is realized.
Evaluating this allocative efficiency claim gives us our first opportunity to contrast the conventional analysis of received microtheory with a transactions cost approach. Implicit in the above conventional microtheory argument is an assumption that the costs of both discovering true customer valuations for the product and enforcing restrictions against resale (so that there can be no arbitrage) are negligible and can be disregarded. Such costs vanish, however, only if either (1) customers will honestly self-reveal preferences and self-enforce nonresale promises (no opportunism); or (2) the seller is omniscient, a possibility that requires unbounded rationality of an especially strong kind. Inasmuch as assumptions of both kinds are plainly unrealistic, the question naturally arises: Does an allocative efficiency gain obtain when nontrivial transaction costs must be incurred to discover true customer valuations and/or to police nonresale restrictions? Unfortunately for received microtheory, the outcome is uncertain if these transaction costs are introduced.
To see this, assume (for simplicity) that the transaction costs of accomplishing full price discrimination are independent of the level of output: The costs are either zero, in which event no effort to price discriminate is made, or T, in which case customer valuations become fully known and enforcement against cheating is complete. Price discrimination will of course be attractive to the monopolist if a net profit gain can be shown -- a situation that will obtain if the additional revenues (which are given by the two shaded regions, A1 and A2, in Figure 1) exceed the costs of achieving discrimination, T. Interesting for social welfare evaluation purposes is the fact that an incremental gross welfare gain is realized only on output that exceeds Qm. This gain is given by the lower triangle (A2). Consequently, the net social welfare effects will be positive only if A2 exceeds the transaction costs, T. An allocative efficiency loss, occasioned by high transaction costs, but a private monopoly gain, derived from price discrimination applied to all output, is therefore consistent with fully discriminatory pricing in circumstances where nontrivial transaction costs are incurred in reaching the discriminatory result. More precisely, if T is less than A1 plus A2 but more than A2 alone, the monopolist will be prepared to incur the customer information and policing costs necessary to achieve the discriminatory outcome, because his profits will be augmented (A1+A2 > T), but these same expenditures will give rise to a net social welfare loss (A2 < T).
Of course, in circumstances in which T is zero or negligible, this contradiction does not arise. Such may obtain if the product or service is costly to store (for example, electricity supply, telephone service), in which case arbitrage is made difficult and, whatever the opportunistic inclinations of buyers may be, promises not to resell become unimportant. The problem of discovering true valuations still remains, but this can often be approximated if customer classes can be segregated and low-cost metering devices are employed. I nevertheless emphasize that the conventional welfare gain associated with price discrimination rests crucially on the assumption that transaction costs of both valuation and policing kinds are negligible. If these cannot be so characterized, such transaction costs need expressly to be taken into account before a welfare assessment is ventured.
3.2 The Insurance Example
As indicated, the insurance example is interesting not merely for its own sake but also because the parameters of the insurance problem can be reinterpreted in such a way as to expose the problems that employment contracts, vertical integration, and competition in the capital market confront. It is also interesting because it poses what may be referred to as the "information impactedness" problem. (Information impactedness is a derivative condition in the organizational failures framework. It is mainly attributable to the pairing of uncertainty with opportunism. It exists in circumstances in which one of the parties to an exchange is much better informed than is the other regarding underlying conditions germane to the trade, and the second party cannot achieve information parity except at great cost -- because he cannot rely on the first party to disclose the information in a fully candid manner.)
Risk aversion will be assumed and the question is whether a group of individuals who are exposed to independent risks will be able to pool these successfully with an insurer. Assume further that the members of the group are uniformly distributed over the risk interval p1 to p2, where p1 < p2, and p denotes the probability for a particular individual that the contingency to be insured will eventuate. (Because this probability will vary depending on the risk-mitigating actions taken by an individual, assume that p reflects efficient risk mitigation.) Whereas individuals will be assumed to know their risk characteristics exactly, the insurer is unable, at low cost, to distinguish one member of the group from another. Information impactedness thus obtains. Assume also that the highest premium that an individual of risk class p will pay is (p + e)D, where e < (p2 - p1)/2, and D is the (common) damage that will be incurred if the contingency obtains.
In the absence of other information, and assuming transactions costs to be negligible, insurers would break even if they could sell insurance to all members of this group at a premium of [(p1 + p2)/2]D, which is the mean loss. Such a premium will regarded as excessive, however, by those good-risk types for whom p + < (p1 + p2 )/2. Inasmuch as these preferred risks cannot easily establish that they are honestly entitled to a lower premium -- because (opportunistic) poor-risk types can make the same representations and insurers are unable (except at great cost) to distinguish between them -- they will withdraw. Breakeven then requires that remaining parties be charged a higher premium; the system will stabilize eventually at a premium of (p2 - e)D. Information impactedness and opportunism thus result in what is commonly referred to as the "adverse selection" problem.
Moreover, the matter does not end here if the extent of the losses incurred is influenced by the degree to which insured parties take steps designed to mitigate losses. If promises were self-enforcing, insurers need merely extract a promise from insureds that, once insured, they will behave "responsibly." Alternatively, if it could easily be discerned ex post whether efficient contingency-mitigating practices had or had not been followed, insurers could supply insureds with appropriate incentives to behave responsibly by paying only those claims that fell within the terms of the agreement. If, however, such determinations can be made only at great.cost and (some) insureds exploit ex post information differentials opportunistically, the problem referred to in the insurance literature as "moral hazard" (Arrow, 1971, pp. 142, 202, 243) obtains. Premiums will be increased on this account as well. Note also that responsible parties who would otherwise be prepared to self-enforce promises to take efficient loss-mitigating actions may find that such behavior is not competitively viable and will consequently be induced to imitate opportunistic types by underinvesting in loss mitigation. A sort of Gresham's Law of Behavior obtains.
Revising the terms of a contract to reflect the additional information gleaned from experience may be referred to as experience rating. The prospect that this will be done serves to curb opportunism in contract execution. Inferior agents will nevertheless be able to exploit information impactedness, however, unless original terms are relatively severe (that is, no bargains are to be had on joining) or parties are unable easily to opt out when terms are adjusted adversely against them.
One way to accomplish the latter is that markets pool their experience so that opportunistic types cannot secure better terms by "quitting" and turning elsewhere. This pooling requires that a common language be devised for describing agent characteristics, which will be greatly facilitated if the behavior in question can be easily quantified. If, instead, the judgments to be made are highly subjective, the costs of communication needed to support a collective experience rating system are apt to be prohibitive in relation to the gains -- if the organizational mode is held constant.
Experience-rating is also of interest to superior risk/responsible types. Good risks and/or those who would be prepared to self-enforce promises to mitigate losses efficiently may be induced to join at a high premium by the assurance that premiums will subsequently be made on a more discriminating basis as information accumulates. This offer will be especially attractive if, rather than merely revise a priori probabilities on the basis of claim experience, performance audits are also made -- because, without a performance audit, the true explanation for outcomes that are jointly dependent on the state of nature that obtains and the behavior of the economic agent cannot be accurately established (Arrow, 1969, p. 55). Monitoring thus helps restore markets that are otherwise beset with opportunistic distortions to more efficient configurations -- albeit that some degree of imperfection, in a net benefit sense, is irremediable (the costs of complete information parity are simply prohibitive).
3.3 Stigler on Vertical Integration
Stigler's explication, as it applies to vertical integration, of Adam Smith's theorem that "the division of labor is limited by the extent of the market" leads to his deduction of the following life cycle implications: Vertical integration will be extensive in firms in young industries; disintegration will be observed as an industry grows; and reintegration will occur as an industry passes into decline (1968, pp. 129-141). These life cycle effects are illustrated by reference to a multiprocess product, each of which processes involves a separable technology and hence has its own distinct cost function. Some of the processes display individually falling cost curves, others rise continuously, and still others have U-shaped cost curves.
Stigler then inquires: Why does not the firm exploit the decreasing cost activities by expanding them to become a monopoly? He answers by observing that, at the outset, the decreasing cost functions may be "too small to support a specialized firm or firms" ( 1968, p. 133). But, unless the argument is meant to be restricted to global or local monopolies, for which there is no indication, resort to a specialized firm does not exhaust the possibilities. Assuming that there are at least several rival firms in the business, why does not one of these exploit the available economies, to the mutual benefit of all the parties, by producing the entire requirement for the group? The reasons, I submit, turn on transaction cost considerations.
If, for example, the exchange of specialized information between the parties is involved (Stigler specifically refers to "market information" as one of the decreasing cost possibilities), strategic misrepresentation issues are posed. The risk here is that the specialist firm will disclose information to its rivals in an incomplete and distorted manner. Because the party buying the information can establish its accuracy only at great cost, possibly only by collecting the original data itself, the exchange fails to go through. If, however, rivals were not given to being opportunistic, the risk of strategic distortion would vanish and the (organizationally efficient) specialization of information could proceed.
The exchange of physical components that experience decreasing costs is likewise discouraged where both long-term and spot market contracts prospectively incur transactional difficulties. Long-term contracts are principally impeded by bounded rationality considerations: Given bounded rationality, the extent to which uncertain future events can be expressly taken into account -- in the sense that appropriate adaptations thereto are costed out and contractually specified -- is simply limited. Because, given opportunism, incomplete long-term contracts predictably pose interest conflicts between the parties, other arrangements are apt to be sought.
Spot market (short-term) contracting is an obvious alternative. Such contracts, however, are hazardous if a small-numbers supply relation obtains -- a condition that, by assumption, holds for the circumstances described by Stigler. The buyer then incurs the risk that the purchased product or service will, at some time, be supplied under monopolistic terms. Industry growth, moreover, need not eliminate the tension of small-numbers bargaining if the item in question is one for which learning by doing is important and if the market for human capital is imperfect. Delaying own-production until own-requirements are sufficient to exhaust scale economies would, considering the learning costs of undertaking own-production at this later time, incur substantial transition costs. It may, under these conditions, be more attractive from the outset for each firm to produce its own requirements -- or, alternatively, for the affected firms to merge. Without present or prospective transaction costs of the sorts described, however, specialization by one of the firms (that is, monopoly supply), to the mutual benefit of all, would presumably occur. Put differently, technology is no bar to contracting; it is transactional considerations that are decisive.
Aspects of the above argument can be illustrated with the help of Figure 2. The average costs of supplying the item in question by a specialized outside supplier at time 1 are shown by the curve AC1s. Firms that are already in the industry can supply the same item at the average costs shown by AC1x. The curve AC1s is everywhere above the curve AC1x because firms already in the industry avoid the setup costs that a specialized outside supplier would incur. Each of the firms in the industry generates requirements for the
item at time 1 of Q1i. The total industry requirements at time 1 is Q1t.
The implicit comparison that Stigler makes in his explanation for vertical integration is point A versus point B. Thus, although having a specialized supplier service the whole industry (produce Q1t) would permit economies of scale to be more fully exploited, the declining cost advantage is more than offset by the setup costs -- on which account the average costs of the specialized supplier (at B) exceed the average costs that each individual firm would incur by supplying its own requirements (at A). My argument, however, is that point A should also be compared with point C -- where point C shows the average costs of supplying the requirements for the entire industry by one of the firms that is already in the industry. Such a firm does not incur those setup costs which disadvantage the outside specialist supplier. Given the decreasing cost technology that Stigler assumes, the average costs at C are necessarily less than those at A. Why then not have one of the firms already in the industry supply both itself and all others? The impediments, I submit, are the above described hazards of interfirm contracting (of both long-term and spot market types), which is to say, transaction cost considerations, not technology, explain the outcome.
The comparison, moreover, can be extended to include a consideration of the curve AC2x, which represents the average costs that will be incurred by an integrated firm at time 2 which has been supplying the product or service continuously during the interval from time 1 to time 2. The curve AC2x is everywhere lower than AC1x by reason of learning-by-doing advantages. To the extent that such learning advantages are firm-specific, they will accrue only to firms that have undertaken own-production during the supply interval in question. Thus, if one of the firms in the industry becomes the monopoly supplier to all others at time 1 and if at time 2 the other firms become dissatisfied with the monopoly supplier's terms, these buying firms cannot undertake own-supply at a later date on cost parity terms -- because they have not had the benefit of learning-by-doing.
Note finally the arrow that points away from point A toward point D. If the industry is expected to grow, which plainly is the case for the circumstances described by Stigler, and if each of the firms in the industry can be expected to grow with it, then each firm, if it supplies its own requirements (Q1i) at time 1 and incurs average costs of A, can, by reason of both growth and learning-by-doing, anticipate declining own-supply costs -- perhaps to the extent that each substantially exhausts the economies of scale that are available. Because own-supply avoids the transactional hazards of small-numbers outside procurement, vertical integration of the decreasing cost technology items to which Stigler refers is thus all the more to be expected.
Copyright © 1975 by The Free Press
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Markets and Hierarchies by Oliver Williamson
By Dovev Lavie
Markets and Hierarchies is considered a most influential contribution to the institutional economics approach in the strategy literature. Introducing a transaction-cost dimension, it bridges economics and organization theory. Hence, both economists and researchers from the fields of social sciences can find this book appealing. Williamson begins by claiming that conventional economic analysis makes unnecessary assumptions and is too abstract to capture the characteristics of economic exchange and its effect on the transaction consummation mechanism, namely the preference of intrafirm versus interfirm trade. Then he introduces concepts of bounded rationality and opportunism to expand the discussion of organizational forms. He suggests the transaction as the appropriate unit of analysis to evaluate hierarchies and markets. The main argument in the book is presented in the Organizational Failures Framework (OFF), which is designed to specify which mode will be relatively efficient in formulating and executing contracts based on a combination of environmental and human factors. The OFF offers two combinations, a derived condition and a general system effect to explain organizational failures: (1) Bounded Rationality and Uncertainty/Complexity - Faced with conditions of uncertainty and complexity, where the decision tree is not clear, bounded rationality poses information processing and communication problems. A hierarchy would be preferred to a market in this case because internal organization can economize on bounded rationality. (2) Opportunism and Small Numbers - Williamson extends the self-interest assumption in microeconomics to suggest opportunistic behavior. Under such conditions, participants in transactions are expected to reveal partial or distorted information and provide self-disbelieved promises. A small numbers situation at the outset or renewal of a contract induces the risks of opportunistic behavior, which cannot be detected ex ante. Here again, hierarchies would be preferred to markets because in internal organization it is harder to appropriate gains from opportunistic behavior, and because monitoring and conflict resolution mechanisms are more effective. (3) Information Impactedness (asymmetric information) - Under conditions of opportunism and uncertainty, one party can find it costly to achieve information equality. Hierarchies will be preferred to markets because they reduce opportunistic tendencie encourage information sharing and effective communication. (4) Atmosphere - OFF assigns value not only to the outcomes of the transaction but also to the economic exchange process. Internal organization provides more encouraging atmosphere in terms of the development of reciprocal social relationships. Williamson offers several applications to illustrate his arguments and discuss antitrust implications. The replacement of markets by nonmarket alternatives first considers cooperative peer groups. Relative to hierarchies, peer groups are vulnerable to free rider problems and have inefficient communication and decision-making mechanisms. In hierarchies, centralized decision making, auditing procedures and experience rating enable more efficient organization relative to both markets or peer groups. Another application of the transactional perspectives considers the rationale for preferring internal employment relation to markets for idiosyncratic tasks. Transactional difficulties arise in both contingent claims and sequential spot market contracting, thus suggesting an authority relation of internal labor market as a possible solution. The most interesting application of the markets and hierarchies approach refers to vertical integration. The author tries to specify when production components will take place within the firm and when across intermediate product markets. Vertical integration, which leads to the creation of complex hierarchy is justified because: (1) successive processes are more efficient under common ownership; (2) it reduces required monitoring costs; (3) assures efficient factor combinations when one component is under monopolistic supply; (4) reduces bargaining costs to determine ownership of spillovers; and (5) economizes on the acquisition of information relevant to multiple stages. Williamson suggests three ways in which internal transactions can be organized: (1) sales contracts for component supply include contingent claims, incomplete long-term and sequential spot contracts, (2) Unified ownership of plant and equipment extends the simple hierarchy, (3) A complex hierarchy extends the employment relation to including department managers and achieves higher cooperation. An employment relation provides advantages over the other two. Williamson attempts to offer some qualifications to vertical integration. For instance, he claims that when recurrent transactions in the market are characterized by norms of trustworthy, valuable reputation and advanced evaluation mechanisms - incomplete contracts with informal enforcement may become a possible alternative to vertical integration. Furthermore, because vertical integration in highly concentrated industries can create price discrimination and barriers to entry, antitrust concerns may rise where there is a certain degree of monopoly. In addition to the antisocial consequences, vertical integration, can also result in preserved nonviable activities, cross-subsidization, distortion of procurement decisions and uneconomic reciprocity, inefficiencies due to policing costs, managerial commitment to unproductive or obsolete projects, communication distortion and other consequences of opportunism paired with small numbers and information impactedness. Hence, the size of the hierarchical organization is limited by bounded rationality, bureaucratic insularity, discouragement of innovativeness and atmospheric consequences. The reminder of the book is devoted to discussion of the multidivisional structure, conglomerates, dominant firms and oligopolies. These issues raise antitrust questions, and it seems that Williamson offers an unconventional perspective that better scrutinizes the situations that require government interference. In the discussion of market structure and organizational innovation, the author divides innovation to three stages: invention, development and final supply. Williamson suggests that the optimal path is that independent investors and small firms will engage in innovation and initial development, while successful developments will be acquired and be marketed by large M-form firms. In the last few chapters the OFF provides some insights to the evolution of monopolies. Williamson opposes governmental intervention in the case that a monopoly position results from incompetent competitors or from historic accident. Williamson also refutes the convention that oligopoly is no better than monopoly because of maximization of joint profit and collusion. In the OFF view, oligopolists will find it difficult to reach, implement and enforce agreements even when contracts are lawful. Only in highly concentrated mature industries with homogeneous products and exceptional barriers to entry, oligopolistic behavior may turn successful, but exactly in these cases it will be subject to antitrust reaction.
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incredible. this product is very good. thanks a lot. it comes faster than expect. Markets and hierarchies : Analysis and Antitrust Implications is perfect
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