Markets and Hierarchies: Analysis and Antitrust Implications A Study in the Economics of Internal Organization Oliver E. Williamson University of Pennsylvania THE FREE PRESS A Division of Macmillan Publishing Co., Inc. ~ NEW YORK Collier Macmillan Publishers LONDON ...... 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 profes­ sion 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 comple­ mentary to, rather than a substitute for, conventional analysis. The spirit in which this present book is written very much follows the ~hinking 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 ele­ ~entary work groups to complex modern corporations. I focus on transac­ tions and the costs that attend completing transactions by one institutional t. Among the studies that deal. directly or indirectly, with the new institutional economics are AlchianandDemsetz( 1972, 1973), Arrow ( 1969, 1974), Davis and North ( 1971), Doeringer andPiore(1971), Kornai (1971), Nelson and Winter(1973), and Ward (1971). Earlier efforts of my own to move in this direction are reported in Williamson ( 1971, 1973). For a recent S}'mposium "On the Economics of Internal Organization," in which many of the market and hierarchy issues are raised, see the Spring and Fall1975 issues of the Bell Journal of Economics. TOWARD A NEW INSTITUTIONAL ECONOMICS 3 2 MARKETS AND HIERARCHIES mode rather than another. While the relation of technology to organization remains important, it is scarcely determinative. I argue in this connection 1.1 Commons on Institutional Economics that, but for a few conspicuous exceptions, neither the indivisibilities nor technological nonseparabilities on which received theory relies to explain As Commons was aware, his treatment of institutional economics was nonmarket organization are sufficient to explain any but very simple types a highly personal effort (1934, p. 1). He was exploring new issues and invent­ of hierarchy. Rather I contend that transactional considerations, not tech­ ing a quasijudiciallanguage as he proceeded. Inasmuch as the transaction nology, are typically decisive in determining which mode of organization was held to be the ultimate unit of economic investigation (1934, pp. 4, 5, 8), will obtain in what circumstances and why. he made transfers of legal control and the efficacy of contracting the focus Central to the analysis is what I refer to as the "organizational failures of his studies. framework." Its distinction is that it expressly acknowledges the importance He considered scarcity to be ubiquitous and conflict of interest, natural played by human factors in attempting to grapple with problems of economic (1934, p. 6). He saw the central contribution of institutional economics to organization. Such considerations usually operate, if at all, only in a vague, the study of economics to be the introduction and explication of the impor­ background way. Indeed, they are altogether suppressed in many of the con­ tance of collective action. The requisite degree of cooperation for efficiency ventional models of economic man that populate intermediate theory text­ to be realized arose not from a presupposed harmony of interests but from books. Although references to "human nature as we know it" (Knight, 1965, the invention of institutions that produced order out of conflict, where order p. 270) occasionally appear, these rarely occupy an active role in the analysis. was defined as "working rules of collective action, a special case of which I submit, however, that more self-conscious attention to rudimentary human is 'due process of law"' (1934, p. 6). To the extent that collective action was attributes is essential if we are to accurately characterize and more ade­ successful in mitigating conflict, a greater total yield- hence, potentially, quately understand many of the problems of markets and hierarchies. a more preferred result for all of the parties- was thereby made feasible. The remainder of this chapter is an overview of the mode of analysis and His treatment of "futurity" is of special significance, where "The concept types of problems that this book is concerned with. Some of the antecedents of futurity is that of expected events, but the principle of futurity is the to the proposed approach are examined in Section 1. A preliminary state­ similarity of repetition, with variability, of transactions and their valuations, ment of the basic framework is set out in Section 2. The framework is then performed in the moving Present with reference to future events" (1934, applied to three specific examples in Section 3. These applications reveal P. 738). The emphasis, as I interpret it, is on (1) recurrent contracting, con­ that a sensitivity to transaction costs is often essential. They also show that ducted under conditions of (2) uncertainty, and for which (3) successive the language of studying markets and hierarchies proposed herein often adaptations are needed to bring the parties into efficient adjustment. As permits microeconomic phenomena of quite diverse kinds to be understood will be apparent, each of these plays an important role in the discussion of in different and in some respects deeper ways than conventional analysis transactions in the sections and chapters that follow. would otherwise afford. 1.2 Coase on the Nature of the Firm 1. Some Antecedents Coase has characterized his 1937 treatment of the firm as "much cited :md little used" (1972, p. 63). The reason why it is so widely cited, I submit, The materials in this section are in no sense a survey. They merely indi­ IS that there is a general appreciation among economists that conventional cate an early concern among some members of the profession of the types of .tr~atments of firms and markets are not really derived from first principles institutional issues that I deal with in this treatise. With the exception of the b':it are instead arbitrarily imposed. Coase's article makes this fact clear, market failure literature, which is examined briefly in Section 1.4, there is ·thich qualifies it as a natural in any survey of price theory. But the article little reason to believe that there was a concerted effort among the successive ·. :-ts~ rather tautological (Alchian and Demsetz, 1972, p. 783), a charac authors whose work is cited to redefine economic problems in a comple­ .~~sttc that explains why it is not more widely used. Transaction costs mentary way. Each was, however, committed to the proposition that econo­ .~ appropriately made the center piece of the analysis, but these are not mics should expressly address and help assess the transactional properties ~~~ationalized in a fashion that permits one to assess the efficacy of com­ of alternative modes of organization. Pleting transactions as between firms and markets in a systematic way. 4 MARKETS AND HIERARCHIES TOWARD A NEW INSTITUTIONAL ECONOMICS 5 The article is nevertheless an uncommonly insightful treatment of a 1. The problem of a rational economic order is trivial in the absence fundamental problem at an early point in time and can scarcely be faulted of bounded rationality limits on human decision makers. It is because it did not go further. Of special importance for my purposes are accordingly essential at the outset to appreciate that bounds on its following attributes: rationality do exist and must be expressly taken into account if 1. Transactions, and the costs associated therewith, not technology, organizational issues are to be addressed in operational terms (1945, pp. 519, 527). are the central object of the analysis (1937, pp. 336, 338, 341, 350). 2. Uncertainty and, implicitly, bounded rationality are key features of 2. Much of the knowledge required to make efficient economic the argument (1937, pp. 336-337). decisions cannot be expressed as statistical aggregates but is highly idiosyncratic in nature: "practically every individual has some Coase contends that the firm serves to economize on transaction costs advantage over all others in that he possesses unique information in two respects. First, reliance on the price mechanism requires that the of which beneficial use might be made, but of which use can be relevant prices be discovered ( 1937, p. 336). The firm becomes a sole source made only if the decisions depending on it are left to him or are supplier to itself for those transactions that are shifted out of the market made with his active cooperation. We need to remember ... and into the firm; relevant prices are known or, in any event, bids are pre­ how valuable an asset in all walks of life is knowledge of people, sumably solicited less frequently as a result. Second, the firm substitutes a of local conditions, and of special circumstances" (1945, pp. 521- single incomplete contract (an employment agreement) for many complete 522). ones. Such incomplete contracts purportedly economize on the "cost of 3. The economic problem is relatively uninteresting except where negotiating and concluding" separate contracts (1937, p.