Williamson, "The Economics of Organizations: The Transaction Cost Approach," 1981

This approach is the study of organizations using the transaction (I buy a loaf of bread from your organization for $1.25, I hand you the money and you give me the bread) as the basic unit of analysis, and that understanding transactions is central to the study of organizations, rather than an analysis of commodities themselves. Also, governance structures (firms and markets being the leading alternatives) have different capacities to economize transaction costs- they must also be included in the study.

This approach has three levels of analysis:

1.) the overall structure of the enterprise: "This takes the scope of the enterprise as given and asks how the operating parts should be related to one another."

2.) the middle level of analysis, focusing on "operating parts:" which activities should be performed within and outside the firm, and why. The development of criteria for and defining of "efficiency boundaries" of an operating unit.

3.) the micro-level, the manner in which human assets are organized. "The object here is to match internal governance structures with the attributes of work groups in a discriminating way."

Only the latter two are used in this article. The paper has five major sections: section one is the background of this approach; section two is the "rudiments" of transaction cost analysis; section three is the application of transaction cost analysis to the study of efficiency boundaries; section four takes up the topic of employment relation issues; and section five is about "power" and its relation to transaction cost analysis.

Section one: Antecedents.

Three literatures make up the roots of t.a. analysis: economics, organizational theory, and (less obviously) law, specifically contract law. The summary he gives of each is brief and admittedly incomplete, but here they are:

The 1930s saw advances in all three areas of literature. The economists began with John Commons in 1934, who recognized that a variety of governance structures mediated exchanges between "technologically separable entities" (e.g, tire manufactures from car manufacturers). Ronald Coase in 1937 wrote his book, the Nature of the Firm where he observed that "the production of final goods and services involved a succession of early stage processing and assembling activities."

In orgs studies, purposive organization was emphasized, but the bounded rationality of actors limited this perspective (actors within orgs were purposive actors, but could only act purposively and rationally within the limits of what they could understand or what they knew at a given moment in time). This stream of research was expanded by Authors like March, Simon, and Cyert in the late 50s and early 60s (the "Carnegie School"): now, orgs have become problem facing and problem solving entities, but org efforts are often myopic and dysfunction is common. Chandler in 1962 proposed the termination of the idea that economic efficiency was largely independent of internal organizational structure, and Thompson built on all his predecessors in 1967 when he fixed attention on efforts to economize transaction costs: core technology, boundaries of organized action, and the powers and limits of the market were recognized.

The legal literature is of two types: "hard contracting" (where all details of the transaction are explicit) and "soft contracting" (where the contract serves as a modus operandi only). Karl Llewellyn's 1931 essay addressed these topics: he observed that transactions have many forms, and that highly-legalistic approaches (contracts with lots of tedious details) can often reduce efficiency, and firms prefer to avoid them, especially when multiple transactions are likely over long periods of time. Steward Macaulay (1963) expanded on this idea of contracts as "dead weights" which orgs prefer to avoid (the Macaulay article is a classic- if you can find a way to work his name into any exam question, Laumann is guaranteed to be pleasantly surprised since he (M.) is not on our reading list).

All of these literatures reflects an increasing awareness over time of the importance of transaction costs. To date (1981), "transaction cost economizing needs to be located within a larger economizing framework and the relevant tradeoffs need to be recognized."

Section Two: Rudiments

"A transaction occurs when a good or service is transferred across a technologically separable interface." Like so much of org studies, that sounds much more complex than it is. Put another way, a transaction occurs when, for example, I, the lumber yard, transfer wood to you, the construction company: I do not build houses (I don't deal with that technology), and you do not harvest trees (that's my technology), but together we make houses. Loosely, technology is the skills, tools and raw materials through which you manufacture your goods or services. Transaction cost analysis replaces the usual concern with technology and production expenses with an examination of the costs of planning, adapting, and monitoring task completion.

Complex contracts are costly to write and enforce, but why? To understand this, the author asserts that we should focus more on "human nature as we know it" (a good phrase to throw into an exam question, with quotes): acknowledging that 1.) people are subject to bounded rationality (defined as "behavior that is intendedly rational, but only limitedly so"), and 2.) some people are opportunistic.

Bounded rationality needs to be separated from hyperrationality and irrationality. "Economic man" is hyperrational: "he" makes perfectly rational decisions with complete information; "organizational man" makes the best choices "he" can with the tools he has, but he is not irrational; he makes mistakes, but not because he didn't try to avoid them. He is "intendedly rational." By this logic, "irrational man" makes decisions outside of the tenants of rational choice theory; he is ignored in this analysis.

Because hyperrationality is a theoretical construct, all contracts are limited by bounded rationality, just as people are. All contracts are inherently incomplete. If people never behaved opportunistically, this would never be a problem... But they do. "Good faith" is a weak mechanism when considered in isolation. Instead, if we consider transactions has having three dimensions, uncertainty (will you provide the goods specified in the contract), frequency (are we likely to have more transactions in the future), and "asset specificity"(are the goods I am providing to you ones that you could just as well get elsewhere), we can account for contract patterns. This paper focuses especially on asset specificity.

Asset specificity can have three forms: site specificity (is the forest near the lumbar yard, is the yard near the furniture shop, etc.), physical specificity (can my die make anything other than the one tool you need), and human asset specificity (my secretary knows where all the files are in my office, making him/ her extremely valuable to me but to no one else). Where asset specificity is great, buyer and seller will make special efforts to design an exchange that has good continuity properties (i.e., that covers everyone's butts): if I am going to spend millions of dollars in R&D developing an obscure piece of medical equipment, I am going to be damned sure that you are going to buy a lot of them.

Section Three: Efficiency Boundaries

Succinctly: either a firm makes a component itself, or buys it from an autonomous supplier. Different types of contracting will prevail under different conditions of asset specificity: classical "market" contracting holds when assets are non-specific (i.e., buy the best goods for the cheapest price from anyone who sells them), bilateral or "obligational" contracting develops when assets are semi-specific (I could get my lumber for less from Oregon, but not as conveniently or reliably as I can from Vermont), and internal organization displaces the market entirely as assets become highly specific (I keep one secretary in my office every day for several years rather than hire a series of temp workers- I "buy out" the secretary, making him/ her part of the org rather than an autonomous agent). The author graphs out these relationships; it is complex, and not critical for the paper.

Section Four: Managing Human Assets: Employment Relations

Discussion is in two parts: organization of human assets at the staff level and at the production level.

With human assets, goods are not transferred across any boundaries. In this sense, all "contracts" are with persons, not with goods or services. Continued employment within an org is dependent upon human asset specificity: simply being an engineer or a lawyer does not guarantee continued employment; becoming familiar with a particular org's functions, history, and management increases human asset specificity.

If I teach my secretary to type, investing resources in a skill that is useful to me, I may risk losing that secretary to other businesses because his/ her skills have increased. To forestall this, I must agree to pay him/ her more money- now I have paid for training and for increased wages. This is wasteful: better to have hired a good typist in the first place. OR, better to contract with the secretary: "I will train you to type, but for the next six months you must work for me at your regular wage; then I will increase your wages to make them comparable to your skills." If, in the process of developing these skills, the secretary also develops skills particular to my office, I do not want him/ her to leave (training someone new takes more time and energy) and he/she will not want to leave (the skills are non-transferable). This symbiotic relation must be protected by contracts for both actors' sakes.

Human assets are often ambiguous in value. They can be described in terms of how firm-specific they are, and in terms of how easily production can be measured. The author proposes a four-cell relationship of these terms (high and low specificity, simple and ambiguous measurement of production) to fully capture the complexities of human asset specificity. I do not include it here (it is long, complex, and of limited use).

Section Five: Some Comparisons, and Power

The transaction cost approach is usefully compared with the population ecology model, with Thompson's work on organizations, and with the "posterior rationality perspective" (the p.r.p. is not in our readings). The Hannan and Freeman pop ecology model poses this question, "why are there so many kinds of organizations?". The transaction cost approach offers this partial answer: "because transactions differ so greatly and efficiency is realized only if governance structures are tailored to the specific needs of each type of transaction."

The pop. ecology model emphasized adaptive fitness, and is highly abstract, offering few specific predictions. The t.c.a. emphasizes commercial orgs, in which natural selection pressures are present in the forms of market and product competition, though utilities can still be studied in this way.

T.c.a. has "numerous" points of contact with Thompson's work: both emphasize bounded rationality constraints and the basic problem of adapting to uncertainty. Both are interested in "efficiency boundaries" (what Thompson calls the "domain") and both contend that economizing on "coordination costs" is crucial to the definition of the boundary and the way in which internal relations are ordered. There is some use in both of the concept of the "technical core." But they differ in that Thompson does not make allowances for trade offs between production economies and transaction economies; the author does. Also, T. does not "dimensionalize transactions." As a result, most of T.'s propositions remain untestable.

Those parts of an enterprise that are more critical to org. viability will be assigned possession (power) over other critical resources, will have preferential access to information, and will be dealing with critical organizational uncertainties. Just where power rests may vary depending on the nature of the industry and the org. "Power theory" must confront two troublesome facts in explaining shifts in power over time: first, why should one group ever permit another to get power? and second, why does power "leak out" selectively- i.e., why does it tend to go to some places and not others? The transaction cost approach explains both in terms of efficiency: "power theory, as an overall approach to the study of organizational change, is a pied piper whose enticements are better resisted in favor of more mundane efficiency considerations."

Concluding comments:

The t.c.a. has the following propositions: "governance structures that have better transaction cost economizing properties will displace those that have worse, generally." The approach straddles the methodological boundary between "optimizing" and "satisficing" by focusing on economizing arguments and substituting comparative institutional procedures in place of optimizing procedures. It relies on the operation of natural selection forces. It is a semimicroanalytic level of analysis.

Key terms and phrases:

-efficiency boundary

-"human nature as we know it"

-asset specificity