Empirical Microeconomics: Another Perspective

Oliver E. Williamson
University of California, Berkeley
owilliam@haas.berkeley.edu

September 2000
 Empirical microeconomics: another perspective

Oliver E. Williamson*

What was obvious to many of us at the time has become even more evident since: the

Graduate School of Industrial Organization at Carnegie-Mellon (then Carnegie Tech) had

assembled an extraordinary group of faculty and students in the 1950s and early 1960s and the

Ph.D. program was an inspiring experience. Studies by the Ford Foundation and the Carnegie
1
Foundation record some of the programmatic successes. Nobel Prizes and other awards for

research that was done by the GSIA faculty at Carnegie also speak to the intellectual vitality of
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those years. As a student of Carnegie, I can only marvel at the project.

Of the many distinguished faculty at Carnegie, none cast a larger shadow than Herbert

Simon. Everything seemed to be within his purview—as he made contributions to economics,

political science, sociology, organization theory, statistics, philosophy, cognitive science and the

list goes on. Then and since, he has expressed concerns that economic theories of the firm

and of consumer choice worked off of implausible cognitive assumptions. Both were deeply

problematic as a consequence. The common response that a theory should be judged not by

the reasonableness of its assumptions but by the ‘comparison of its predictions with experience’

(Friedman 1953, p. 9) does not wash, moreover, if the resulting predictions are few in number

and often bear a weak relation to the phenomena of interest, and if the empirical tests are

limited and/or ambiguous or contradictory.

Simon continues his criticisms of orthodoxy in the recent book, An Empirically Based

Microeconomics (1997). The recent criticisms, moreover, go beyond orthodoxy to indict the

New Institutional Economics, of which transaction cost economics is a part.

Without question, transaction cost economics (TCE) is different from the behavioral

economics program that flourished at Carnegie in the late 1950s/early 1960s. But while TCE is

‘more neoclassical’, it nevertheless relates to the Carnegie project in many respects—or at least

that is my position (as developed elsewhere and repeated here). Also, contrary to Simon,
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transaction cost economics is an empirical success story. I have no illusions, however, that

mine is the last word. TCE always stands to benefit from good critics, of which Simon has been

one and Mark Granovetter (1985) is another. The dialogue will continue and the outcome will

be decided by others.

The Simon critique of orthodoxy and of TCE is briefly summarized in Section 1. The

ways in which the TCE perspective draws on and differs from the work of Simon and Carnegie

are reviewed in Section 2. As set out in Section 3, TCE and Simon/Carnegie deal with different

phenomena and are often complementary. The empirical research accomplishments of TCE

are summarized in Section 4. Concluding remarks follow.

1. The Simon critique

Simon is a self-described ‘scold’ of orthodoxy, going back at least to Models of Man

(1957). Although some mainline economists immediately took issue (Solow 1958), many have

recognized that uncritical use of heroic assumptions (especially hyperrationality) by orthodoxy

could lead to implausible constructions. Not only has Simon received recognition and awards

from economists—witness his publications in leading economics journals, his presentation of

the prestigious 1978 Richard T. Ely Lecture before the American Economics Association and

the award of the Nobel Prize in Economics in 1978—but there is growing appreciation for the

need to find ways to model bounded rationality (Rubinstein 1998; Kreps 1999; Maskin and

Tirole 1999). Simon nevertheless despairs that the applied and theoretical efforts of

economists will truly come to terms with bounded rationality (Simon 1991, 1997; Rubinstein

1998, Chap. 11).

1.1 Core position

If ‘Nothing is more fundamental in setting our research agenda and informing our

research methods than our view of the nature of the human beings whose behavior we are

studying’ (Simon 1985, p. 303), then social scientists should be prepared to name the key
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attributes of human actors. Both the condition of cognition and self-interestedness need to be

addressed.

Simon early took the position that the hyperrationality assumption out of which orthodox

economics works should be supplanted by the less demanding cognitive condition of bounded

rationality—according to which human actors are intendedly rational but only limitedly so. The

issue of self-interest has received less attention, but Simon has described it as ‘frailty of motive’

(1985, p. 303) and has also featured docility, identification, and loyalty in describing human

behavior in organization (Simon 1991, 1997).

1.2 Theory and evidence

Simon distinguishes three uses of economic theory: curiosity; a guide to the

management and operation of firms; and a guide to the operation of the economy (1997, p. 63).

Achieving these three goals (Simon 1997, p. 63):

…requires building an adequate, empirically based, theory of bounded

rationality…. The knowledge that economic actors possess and do not

possess, the computations that economic actors can make and cannot make

must not enter as ad hoc assumptions…but must be shaped and tested by the

sharpest empirical methods that we can devise.

Although both the ‘experience-based tests’ on which Adam Smith relied and more recent

econometric tests are instructive, neither are judged to be adequate to the sharpness needs to

which Simon refers. He therefore recommends that these be supplemented by turning to and

testing ‘the validity of some or all of the specific assumptions that are built into the models as

well as the models as wholes’ (Simon 1997, p. 23). Laboratory experiments and ‘empirical

studies that observe the behavior of consumers or of business firms directly’ are what he

proposes (Simon 1947, p. 23).

He observes in this connection that ‘When we look at organization in the real world, we

find much more structure and complexity than is hinted at in the theory of the firm, whether in its
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classical or its “New Institutional” versions’ (Simon 1997, p. 38). That orthodoxy is remiss in

dealing with ‘real world’ organizations is widely conceded. But Simon’s view that the TCE and

orthodox theories of the firm are two peas in a pod comes not only as a surprise to me but to

many others as well—which includes not only NIE economists but Kenneth Arrow, Avinash

Dixit, Oliver Hart, Bengt Holmstrom, David Kreps, Jean Tirole and the list goes on. That is

because there are truly fundamental differences between the TCE theory of the firm as

governance structure (which is an organizational construction) and the orthodox theory of the

firm as production function (which is a technological construction). I return to these issues in

Section 2.

Simon’s contention that TCE has been remiss in empirical respects—it being his view

that, awaiting empirical testing, ‘the new institutional economics and related approaches as acts

of faith, or perhaps piety’ (Simon 1991, p. 27)—is likewise one with which I (and others) take

exception. Empirical research in behavioral economics and in transaction cost economics is

examined in Sections 3 and 4.

The comparative study of firms and markets requires that the strengths and limitations

of each be identified and explicated. Simon describes the strength of firms as follows: ‘The

need for coordination, along with the possibility of creating organizational loyalties are perhaps

the two most important factors that give organizations an advantage over markets in many

situations, and that accounts for the large role of organizations in the economic activity of a

society like ours’ (Simon 1997, p. 49). That is instructive, but a predictive theory of economic

organization would advise on when and why the needs for coordination and the support of

organizational loyalties vary with the circumstances, whereupon an empirical research program

focused on the key features could be undertaken. (The possibility that some of these features

reside in the microanalytic attributes of transactions is nowhere admitted, whence none are

identified or explicated by Simon.)

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Also, if all feasible modes of organization are flawed (Coase 1964; Demsetz 1969;

Williamson 1996), then symmetrical attention to the strengths and weaknesses of each is

needed. Simon is silent on the weaknesses of firms. More generally, Simon’s propensity to

operate at a very high level of generality helps to explain Ariel Rubinstein’s remark that ‘The

book is missing a chapter with a detailed example where Simon demonstrates the

implementation of his approach, starting with data about human reasoning, and ending with its

valuable conclusions’ (1999, p. 1712).

Simon does, however, invite us to ‘consider the hypothesis that failures in skills of

organizing and in enlisting organizational loyalties play a major role in Russian economic

difficulties today, and very likely played such a role before perestroika began. Organizations

are at least as large a part of the story of Russian disorganization and failure as are markets’

(Simon 1997, p. 45). He also discusses the comparative performance of private ownership,

nonprofits and government agencies, where he interprets the evidence on the efficiency of

government providers of public utilities (such as water, electric power and communications

services) as compared with private (usually regulated) firms as inconclusive (Simon 1997,

p. 49). This lack of a ‘consistent relation between forms of ownership and their operational

efficiency’ is explained by the fact that ‘direct participation in profits plays only a small role in

motivating the loyalty of employees to business and other organizations’ (Simon 1997, p. 50).

He therefore expresses skepticism over the need for the privatization of firms in moving from a

centralized to a market economy (Simon 1997, p. 51).

1.3 Conclusion

Simon concludes that the economics profession needs to be more attentive to the needs

of the many students who view ‘mathematical tools with distrust and deplore the necessity of

devoting their research time to formalisms that they regard as mainly sterile’ (1997, p. 90).4

Inasmuch as young scholars ‘desire to explore new paths, including the path of empirical
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research…, we need to revise the curriculum so that students of economics will be exposed to

the range of empirical techniques that I have described’ (Simon 1997, p. 91).

Some of the earlier work at Carnegie to which Simon makes favorable reference

includes (1) an examination of how the policy recommendations of business executives

responding to the same set of facts are strongly influenced by their training and the business

functions (marketing, production, legal, etc.) to which they were assigned (Dearborn and Simon

1958), (2) a study of the size distribution of firms, which takes the form of a Pareto distribution

and can be generated by the assumption that the growth of a firm is proportional to its current

size (Ijiri and Simon 1977), (3) a study of the compensation of executives, according to which

span of control and fairness considerations are combined to predict that the salaries of

executives will vary directly with the logarithm of the number of subordinates (Simon [1947]

1957), and (4) a series of studies of the specific business practices of individual business firms,

of which the department store pricing study by Richard Cyert and James March (1963) is an

example.

Examples from cognitive and experimental psychology include tests of the postulates of

rationality by Daniel Kahneman and Amos Tversky (1973), which demonstrate that human

actors are poor Bayesians, and the use of verbal protocols and computer simulation of thinking

to produce ‘an extensive and well-tested theory of human cognitive performance over a wide

range of tasks”, both laboratory and practical (Simon 1997, p. 80). Other empirical work to

which Simon makes favorable reference include the laboratory experiments on markets by

Vernon Smith (1991) and his colleagues, experimental game theory, Alfred Chandler’s studies

of business story (1962), and survey techniques by George Katona (1951) and others.

Econometric tests of macroeconomic theory using quantitative data are also mentioned, with

special emphasis on the limits of the data and the estimating procedures (Simon 1997, pp. 23,

72-74, 96-97).
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2. The transaction cost economics perspective

Transaction cost economics can be variously described. I describe it as an

interdisciplinary joinder of law, economics and organization theory, where the organization

theory is predominantly of a Simon/Carnegie kind and economics is the first among equals.

Although TCE and Carnegie may divide on how closely to hew to the ‘rational spirit’ to which

Arrow refers (1974, p. 16), there is no question but that TCE draws extensively on organization
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theory—although some have questioned the value added.

I begin with a sketch of the Carnegie contributions on which TCE rests and then turn to

some of the significant respects in which Carnegie and TCE differ.

2.1 Carnegie origins

First and foremost, Carnegie featured interdisciplinary social science. Even if

economics is the queen of the social sciences (opinions differ), no single social science is able,

by itself, to explain the range of complex organizational phenomena with which Carnegie was

concerned.

As I have described it elsewhere, the imperative at Carnegie was to be disciplined, be

interdisciplinary and have an active mind (Williamson, 1996). Rather than pronounce ‘This is

the law here”, Carnegie encouraged the student of organization to ask ‘What’s going on here?’

Not only does TCE ask that question but it is furthermore indebted to Carnegie by subscribing

to the following: (1) bounded rationality; (2) process matters; (3) near-decomposability;

(4) discrete structural analysis; and (5) adaptation. Also, TCE works out of

(6) weak-form selection. Consider each.

(a) Bounded rationality

TCE subscribes to the proposition that human behavior is intendedly rational but only

limitedly so (Simon [1947] 1961, p. xxiv). Economic actors are thus assumed to be attempting

effectively to cope but lack the wits to maximize.

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To concede bounded rationality is one thing. What to make of it is another. TCE holds

that the principal ramification of bounded rationality for the study of economic organization is

that all complex contracts are unavoidably incomplete. ‘New questions’ are swept in by the

move from complete to incomplete contracts. Posing and answering these new questions is

where the distinctive TCE contributions reside (Arrow 1987, p. 734).

(b) Process matters

If organization, like the law, has a life of its own, then intertemporal process

transformations that predictably recur need to be discovered and the ramifications for

organizational design wrung out. Unintended consequences and the imperatives of

bureaucracy (March and Simon 1958) are among the more important conditions of which the

student of economic organization needs to be apprised. Failing to be alert to the chief

intertemporal propensities of organization, students and practitioners will fail to make allowance

for unrecognized costs and benefits. As Robert Michels puts it in the context of oligarchy,

‘nothing but a serene and frank examination of the oligarchical dangers of democracy will

enable us to minimize these dangers’ (1962, p. 370). This serenity and candor apply to the

study of organization more generally.

(c) Near-decomposability

The now widely recognized importance of modularity was anticipated by Simon’s work

on nearly-decomposable systems. The main ideas here are these (Simon 1962, p. 129):

(a) in a nearly decomposable system, the short-run behavior of each of the

component subsystems is approximately independent of the short-run behavior

of the other components; (b) in the long-run, the behavior of any one of the

components depends in only an aggregative way on the behavior of the other

subcomponents.

Near-decomposability is a widely observed design principle in complex social systems and

reflects respect for the cognitive overload (bounded rationality) and ease of disclaiming
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responsibility (opportunism) in fully connected systems. Given near-decomposability, the

microanalytic mechanisms of governance, rather than an overarching theory of organization,

become the object of analysis, which is broadly congruent with Jon Elster’s dictum that

‘explanations in the social sciences should be organized around (partial) mechanisms rather

than (general) theories’ (1994, p. 75; emphasis in original).

(d) Discrete structural

Simon’s idea of discrete structural, as against marginal, analysis is also one to which

TCE subscribes. Because alternative modes of organization differ in kind rather than degree,

marginal analysis plays a less significant role in the choice among alternative modes of

governance than it does in the analysis of market equilibria (Simon 1978, p. 449).

Not only does TCE view alternative modes of governance—markets, firms, bureaus,

etc.—in discrete structural terms, but it takes three additional steps. It asks (1) what are the

principal attributes with respect to which governance structures differ, (2) how is each generic

mode of organization (market, hybrid, firm, bureau, etc.) defined in terms of these attributes

and (3) what resulting strengths and weaknesses accrue to each generic mode (Williamson

1991). The rudiments of a predictive theory of comparative economic organization reside in the

answers to these.

(e) Adaptation

TCE also subscribes to the view that ‘Interdependence by itself does not cause difficulty

if the pattern of interdependence is stable and fixed. For, in that case, each subprogram can be

designed to take into account all the subprograms with which it interacts’ (March and Simon

1958, p. 159). This argument is akin to one expressed earlier by Frank Knight, to the effect

that, but for unanticipated disturbances (uncertainty), organization reduces to repetition ([1921]

1957, pp. 267-268).

The central problem of organization on which TCE focuses is that of adaptation, of

which two kinds are distinguished: autonomous and cooperative. The first of these was
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featured by Friedrich Hayek (1945), who emphasized spontaneous adaptation realized through

markets. Chester Barnard, by contrast, emphasized cooperative adaptation of a ‘conscious,

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deliberate, purposeful’ kind (1938, p. 4), working through administration. TCE makes provision

for adaptations of both kinds and holds that alternative modes of governance differ in their

capacities to deliver autonomous and cooperative adaptations (Williamson 1991).

(f) Weak-form selection

TCE relies in a general, background way on competition to perform a sort between more

and less efficient modes of governance. As against selection of the fittest, it subscribes instead

to weak-form selection: ‘in a relative sense, the fitter survive, but there is no reason to suppose

that they are fittest in any absolute sense’ (Simon 1993, p. 69; emphasis in original).

In all six of these respects, TCE is an exercise in close reasoning (which I take to be the

Carnegie tradition) as opposed to the tight reasoning of mathematical economic theory—which

routinely sacrifices plausibility in the name of logical consistency and mathematical rigor. Albeit

worthy values, ‘not everything that is logically consistent is credulous’ (Kreps 1999, p. 125).

TCE, like Carnegie, gives greater priority to plausibility.7

Interestingly, Tjalling Koopmans also has a broad (Carnegie-like) conception of the

economic enterprise. Thus Koopmans describes the four ‘skills within the economics

profession’ as follows: (1) detailed knowledge of the realities of economic life, thereby to link

observations with concepts, (2) the logical and mathematical skills of reasoning from postulates

to conclusions, (3) subtle procedures of statistical inference to perform empirical testing and

(4) ‘most important of all, the appraisal of postulates with regard to their plausibility, their

realism and the relevance or usefulness of the conclusions they lead to’ (Koopmans 1957,

p. 145). As discussed elsewhere (Williamson 2000), the close reasoning out of which TCE

works is acutely attuned to the detailed knowledge to which Koopmans refers, is very conscious

about the plausibility of postulates and the relevance of conclusions, invites empirical testing,
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and encourages logical and mathematical reasoning. Also, in the spirit of Koopmans, this last

(full formalism) does not trump all others (Kreps 1999).

2.2 Some differences

The significant reliance of TCE on Carnegie notwithstanding, there are also

differences. The most consequential of these are (1) choice and operationalization of the unit

of analysis, (2) the main lesson for economic analysis of bounded rationality, (3) the description

of self-interest, (4) the condition of foresight and (5) the role of informal organization. By

reason of these differences, TCE gives different and more prominent attention to contract. One

of the consequences is that TCE and Simon/Carnegie often deal with different microanalytic

phenomena and inform different issues of public policy.

(a) Unit of analysis: decision premise or transaction

Both the choice of a unit of analysis and the subsequent dimensionalization thereof are

important to a progressive research agenda. Of these two steps, naming a unit is easier than

dimensionalization, whence the latter is often scanted. Simon, for example, notes that while the

concept of role has been proposed as a sociological unit of analysis, ‘the term has never been

given sufficiently precise definition’ (1957b, p. xxx). He recommends instead that the decision

premise be made the unit of analysis and avers that ‘Behavior can be predicted…when the

premises of the decision are known (or can be predicted) in sufficient detail’ (Simon 1957b,

p. xxx). Although subsequent work on human problem solving by Simon (in collaboration with

Alan Newell) is in this spirit, in that the human actor is postulated to behave as an information

processing system (Newell and Simon 1972), the systematic application of the decision premise

as the unit of analysis has yet to produce a widely applicable theory of organization to which

predictions about firm and market organization accrue and the data have been applied.

A more composite variant of the decision premise is to treat the ‘routine’—the decision

rules and procedures—as the unit of analysis. Not only do the computer simulation models of A

Behavioral Theory of the Firm (Cyert and March 1963) operate out of routines, but Richard
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Nelson and Sidney Winter make the bold claim that routines are to the evolutionary theory of

the firm what genes are to the biological evolutionary theory (1982, p. 14). That sounds very

fundamental, and may prove to be precisely that. To date, however, neither A Behavioral

Theory of the Firm nor evolutionary economic theory has seriously addressed itself to the

daunting challenge of dimensionalizing the routine.

The unit of analysis out of which transaction cost economics works is the transaction—

which John R. Commons features in his overarching statement on the study of economic

organization: ‘The ultimate unit of activity…must contain in itself the three principles of conflict,

mutuality, and order. This unit is a transaction’ (1932, p. 4). Not only does TCE view

governance as the means by which to infuse order, thereby to mitigate conflict and realize

mutual gains, but it takes the transaction to be the basic unit of analysis and names asset

specificity (in its various forms), uncertainty, and frequency as the critical dimensions with

respect to which transactions differ.

This effort to dimensionalize transactions in combination with the aforementioned effort

to name the principal attributes with respect to which governance structures differ become the

basis for the discriminating alignment hypothesis, to wit: transactions, which differ in their

attributes, are aligned with governance structures, which differ in their cost and competence, so

as to effect a transaction cost economizing result. The large and growing body of empirical

research discussed in Section 4 involves the application of this hypothesis to a wide range of

phenomena.

(b) Bounded rationality: satisficing or incomplete contracting

Simon holds that ‘the replacement of the goal of maximizing by the goal of satisficing, of

finding a course of action that is good enough…is an essential step in the application of the

principle of bounded rationality’ (1957b, pp. 204-205; emphasis in original). Such a

reformulation appeals to reason and has broad analytical ramifications. Simon’s 1955 article, ‘A

Behavioral Model of Rational Choice’—which appeared in the Quarterly Journal of Economics

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and has been described by Simon as his ‘chief epistle to the economists’ (1985, p. 293)—uses

a satisficing setup and potentially heralded a new era. Alas, the apparatus out of which

satisficing works is very cumbersome, which helps to explain Robert Aumann’s conclusion that

the satisficing approach is not presently broadly applicable (Aumann 1985). Awaiting satisficing

apparatus that is easier to implement, economists can be thought of as analytical satisficers:

they use a short-cut form of analysis (maximizing) that often qualifies as ‘good enough.’8

As hitherto indicated, TCE holds that the chief lesson of bounded rationality for the study

of economic organization is that all complex contracts are unavoidably incomplete. Faced with

contractual incompleteness, the question is how best to cope when unanticipated disturbances

arise. Such disturbances push the parties to an incomplete contract off of the contract curve,

whence inefficiency arises for which relief is sought. But while inefficiency invites its own

demise, that can be costly. Among other things, the appropriate corrective action can be

delayed or defeated by a propensity to bargain over the disposition of the potential gains (see

the discussion of self-interest, which follows). The upshot is that an issue of efficient

governance is posed. If, conditional on the attributes of transactions, some governance

structures have superior adaptive properties than others, then the mitigation of contractual

hazards through the ex ante choice of a better mode of governance will yield efficiency gains.

The discriminating alignment hypothesis thus applies. In contrast with satisficing, numerous

refutable implications accrue thereto.9

(c) Self-interest: frailty of motive or opportunism

My interpretation of Simon’s description of self-interest seeking as ‘frailty of motive’

(Simon 1985, p. 303) is that most people will do what they say (and some will do more) without

self-consciously asking whether the effort is justified by expected discounted net gains. If they

slip, it is a normal friction and often a matter of bemusement. The proposition that routines

describe the behavior of most individuals most of the time contemplates (nonstrategic) benign

behavior.
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But while accurate descriptions of what is going on ‘most of the time’ are plainly

essential, much of what is interesting about human behavior in general and organizations in

particular has reference not to routines but to exceptions. Indeed, once good routines have

been developed, the chief role of management is to deal with the exceptions. Such exceptions

arise from contractual incompleteness in combination with the disturbances referred to above,

the effects of which are to push the parties to an agreement off of the contract curve. Strategic

considerations—which arise by reason of information asymmetries, bilateral dependencies,

weaknesses of property rights, the costliness of court enforcement of contracts, etc.—will now

come into play if, rather than frailty of motive, opportunism is the operative condition.

To be sure, opportunism is an unflattering behavioral assumption. Serenity and candor

nevertheless require us to entertain the possibility that foreseeable contractual hazards will be

missed or suppressed by frailty of motive. Opportunism, I submit, takes us into the deep

structure of contract and organization in ways that frailty of motive does not. Accordingly, even

if frailty of motive describes day-to-day activity most of the time, candid reference to

opportunism serves to uncover strategic issues that are ignored only at peril.

Rather, therefore, than pose the issue as frailty of motive (routines) or opportunism

(strategic behavior), provision needs to be made for both. Note, moreover, that the odium

associated with opportunism is relieved by the main lesson of opportunism, which is not to

celebrate this condition but to mitigate it. Recall that Michels’ Iron Law of Oligarchy had its

origins in his efforts to understand democracy: ‘It is [hierarchical] organization which gives birth

to the dominion of the elected over the electors, of the mandatories over the mandators, of the

delegates over the delegators. Who says organization, says oligarchy’ (Michels 1962, p. 365).

One response to unwanted oligarchical outcomes would be to eschew all proposals to introduce

democracy in favor of the status quo, but that is extreme. A more constructive and deeper

lesson is to make allowance for all such predictable regularities at the outset, whereupon it may

be possible to mitigate foreseeable oligarchical propensities at the initial design stage.

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That very same lesson applies more generally, whence an important part of the study of

economic organization is to look ahead, perceive hazards and fold these back into the

organizational design—in all significant contractual contexts whatsoever (intermediate product

market, labor market, capital market, etc.). Attenuating the ex post hazards of opportunism

through the ex ante choice of governance is central to the transaction cost economics exercise.

Michels had it right: nothing but a serene and frank examination of the hazards of opportunism

will enable us to mitigate these hazards.

(d) Foresight: myopic or farsighted

Degrees of foresight can be placed on a continuum. At one extreme is myopia—as

postulated by A Behavioral Theory of the Firm (Cyert and March 1963): local search, trial-and-

error learning, fire-department model of firm behavior. At the other extreme is the

comprehensive contracting model, which entails ‘a single gigantic once-for-all forward

“higgle-haggle” in which all contingent goods and services (i.e., all goods and services at each

possible time-cum-environmental condition) are bought and sold once and for all now for money

payments made now’ (Meade 1971, p. 166). TCE postulates ‘feasible foresight”, which is

located in between.

The proposition that ‘The future influences the present…[may seem] like a violation of

the laws of causality, but what is really meant is that our expectations of the future affect what

we do in the present’ (Arrow 2000, p. 12; emphasis omitted). George Schultz’s reflection on the

importance of his training in economics is pertinent: ‘my training in economics has had a major

influence on the way I think about public policy tasks, even when they have no particular

relationship to economics. Our discipline makes one think ahead, ask about indirect

consequences, take note of variables that may not be directly under consideration’ (Schultz

1995, p. 1). Similar skills have value elsewhere. As the businessman Rudolf Spreckels once

put it, ‘Whenever I see something badly done or not done at all, I see an opportunity to make a

fortune.’ Alert practitioners, consultants and public policy analysts who are alert to the lessons
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of experience and who possess the skills for and practice the art of feasible foresight will

frequently be able to implement discriminating alignment by looking ahead, recognizing

10
potential hazards and choosing governance structures appropriately. That is the TCE

construction.11

Again, a forced choice is unneeded. Theories of the firm that deal with short-run

operating behavior will feature myopia, while theories that are more concerned with periodic

governance alignments will invoke foresight.

(e) Informal organization

Barnard argued that formal and informal organization always and everywhere coexist

(1938, p. 20) and that informal organization contributes to the viability of formal organization in

three significant respects: ‘One of the indispensable functions of informal organization in formal

organizations…[is] that of communication…. Another function is that of maintaining the

cohesiveness in formal organizations through regulating the willingness to serve and the

stability of objective authority. A third function is the maintenance of the feeling of personal

integrity, of self-respect, and independent choice’ (Barnard 1938, p. 122).

The informal effects to which Barnard refers occur spontaneously, as a consequence of

or in conjunction with formal organization. Because firm and market organization differ in these

respects, informal differences should be taken into account in the decision to use one or the

other. According to Simon, organizational loyalties are one of the two most important factors

that give firms an advantage over markets (the other being coordination). ‘When we speak of

organization as having high morale, a principal criterion we have in mind is the loyalty and

devotion of the employees to the organizational goals’ (Simon 1997, p. 44). He goes on to

observe that ‘Loyalty has not only a motivational component—internalization of the

organization’s goals—but also a cognitive component’ (Simon 1997, p. 44). The latter has its

origins in bounded rationality, whereupon the enterprise is factored into manageable parts in

which ‘an employee…acquires the goals appropriate to the position’ (Simon 1997, p. 44).
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‘Because organizational attachments have this powerful cognitive component, as well as a

motivational one, it is customary to speak of organizational identification rather than loyalty’

(Simon 1997, p. 45).

The benefits of identification notwithstanding, there is also a ‘dark side’ to the subgoal

pursuit that arises from functional specialization and career concerns: the overarching goals of

the organization can be and sometimes are subverted. No less of an authority than Philip

Selznick—who has a deep and abiding interest in identification—treats ‘Michels’ theory about

democratic organization…as a special case of the general recalcitrance of the human tools of

action. The tendency for goals to be subverted through the creation of new centers of interest

and motivation inheres in all organizations’ (Selznick 1950, p. 162; emphasis added). In that

event, provision for beneficial identification and subversive subgoal pursuit are both needed.

The TCE response to loyalty/identification comes down to this: (1) yes, these

considerations are unarguably important; (2) awaiting a more complete description of the

mechanisms through which they work, they remain vague; and (3) because loyalty and

identification can have both benefits and costs, efforts to ascertain the factors that influence the

net effects are needed. In the end, considerations of loyalty and identification should be

incorporated within the economizing calculus.12

3. Phenomena of Interest

Both Carnegie and TCE subscribe to bounded rationality and advance the proposition

that organization matters. Both deal with more microanalytic phenomena than orthodoxy. As is

apparent from the foregoing, however, Carnegie and TCE also differ from one another in

consequential ways. Some of the phenomena of interest to Carnegie are therefore different

from those dealt with by TCE.

By way of locating these phenomena on a continuum, Carnegie is interested in very

micro phenomena (individual decision making), some issues of price and output, very few

issues of firm and market organization (and public policy that pertains thereto), and some
 18

macro economic issues. TCE, by contrast, had its origins with the vertical integration problem

and antitrust lessons that accrue thereto, thereafter studying the governance of contractual

relations more generally—including the lessons for regulation/deregulation, corporate

governance and corporate finance, labor market organization, vertical market restrictions and

public policy more generally (Dixit 1996).

As compared with Carnegie, TCE has focused on semi-microanalytic contractual

phenomena, many of them of long-standing interest and puzzlement among applied

microeconomists.

3.1 Microanalytics

(a) Individual decision making

According to Simon, ‘The most important data that could lead us to an understanding of

economic processes and to empirically sound theories of them reside inside human minds….

[Accordingly,] we must seek to discover what went on in the heads of those who made the

relevant decision’ (Simon 1997, pp. 70-71). One example is the aforementioned study by

Dewitt Dearborn and Simon (1958) of the reactions of 23 executives enrolled in an executive

training program. The basic finding was that executives responded to the case study that was

presented to them very much in line with their functional responsibilities—legal, accounting,

production, marketing, etc. This ‘is a vivid demonstration of how strongly identifications by

particular functions…focus attention on some phenomena and away from others’ (Simon 1997,

p. 64).

Experimental tests of the postulate of rationality, along the lines of work by Daniel

Kahneman and Amos Tversky (1973), and laboratory studies of human problem solving, as in

Newell and Simon (1972), also operate at the level of the individual. Simon summarizes as

follows: experimental tests show that ‘people do not make consistent judgments about

uncertain events, violating the axioms of utility maximization and frequently violating the laws of
 19

probability’ (1997, p. 78); and computer simulations of cognitive process ‘provide little

evidence…[for] utility maximization’ (1997, p. 81).

These are noteworthy findings, but evolutionary psychologists have begun to challenge

the way in which probability events have been posed in the laboratory. Whereas the usual

practice is to model the mind as a general purpose problem solver, evolutionary psychology

works differently (Cosmides and Tooby 1994, p. 328):

By identifying and modeling the adaptive problems humans faced during their

evolution, researchers can make educated guesses about the designs of the

complex computational devices the human brain embodies, and about many of

the specific design features they required to be able to solve these problems.

Armed with these models, researchers can then design experiments that can

detect and map the features of these complex devices-features that no one

would otherwise have thought to test for.

That it makes a difference whether we view the mind as a specialized problem-solver,

as against a general-purpose system (using methods drawn from logic, mathematics and

probability theory), is evident from alternative ways of posing probabilistic problems, some of

which are more transparent and arguably relate more to evolutionary success than do others

(see especially the exchange between Gerd Gigerenzer (1996) and Kahneman and Tversky

(1996)). For example, many individuals perform better when probabilities are expressed in

frequentist rather than point estimate terms. Leda Cosmides and John Tooby observe in this

connection that (1996, pp. 15-16):

What was available in the environment in which we evolved was the

encountered frequencies of actual events—for example, that we were

successful 5 out of the last 20 times that we hunted in the north canyon. Our

homonid ancestors were immersed in a rich flow of observable frequencies

 20

that could be used to improve decision-making, given procedures that could

take advantage of them....

There are advantages to storing and operating on frequentist representations

because they preserve important information that would be lost by conversion

to a single-event probability.

That is, 5 out of 20 contains more information and is easier to update than is .25. Cosmides

and Tooby thereafter ‘suggest that the human mind may contain a series of well-engineered

competences capable of being activated under the right conditions, and that a frequentist

competence is prominent among these’ (1996, p. 17). Given that ‘framing’ plays such a

prominent role in laboratory experiments, the puzzle is that experimental psychologists framed

their experiments in nonintuitive (point estimate) ways.

The possibility that many of the limitations of individuals are relieved by specialization

also warrants remark. If mind is a scarce resource, then organizing so as to deploy this scarce

resource to best advantage has a lot to recommend it. Edwin Hutchins expresses ‘surprise that

the division of cognitive labor has played such a very minor part in cognitive anthropology’

(1995, p. 176) and subsequently observes that ‘the cognitive properties of groups are produced

by interaction between structures internal to individuals and structures external to

individuals...[and that] the performance of cognitive tasks that exceed individual abilities is

always shaped by a social organization of distributed cognition’ (1995, p. 262; emphasis

added). The division of cognitive labor is also underdeveloped in economics. Mean, variance,

variety and group interaction effects are all relevant. The obvious propositions here are these:

(1) very complex problems can sometimes be broken down into ‘subassemblies”, within which

specialization can take place and composite solutions worked up (March and Simon 1958,

p. 151); (2) upon recognizing that individuals differ in raw ability and expertise, better than

average results can be realized by conferring ‘leadership’ (through delegation or imitation) on

 21

those with greater ability; and (3) because cognitive ability can take various forms, such

variations should be factored in.

(b) Transactions/governance

TCE is predominantly concerned with choice of governance structures by organizations

(some of which are very large) rather than by individuals. Economies of specialization thereby

arise. As compared with individual consumers, intermediate product market transactions differ

in the following respects: (1) firms can be presumed to be more nearly on a parity in

information respects and can employ specialists (e.g., engineers, lawyers) to represent their

interests more effectively; (2) considerations of differential risk aversion are of second order

importance; (3) end games aside, reputation effects can be presumed to be more effective; and

(4) experienced as they are with a wide variety of transactions to which differential hazards

accrue, firms can be presumed to craft contractual safeguards in differential degree.

The canonical problem of vertical integration out of which TCE works is illustrated by the

simple contractual schema shown in Figure 1. Thus assume that a good or service can be

supplied by either of two alternative technologies. One is a general purpose technology, the

other a special purpose technology. The special purpose technology requires greater

investment in transaction-specific durable assets and is more efficient for servicing steady-state

demands. Contractual complications prospectively arise when there is a need to adapt to

disturbances.

Using h as a measure of contractual hazards, transactions that use the general purpose

technology are ones for which h = 0. If instead transactions use the special purpose

technology, an h > 0 condition exists. Assets here are specialized to the particular needs of the

parties. Productive values would therefore be sacrificed if h > 0 transactions were to be

prematurely terminated. A bilateral dependency condition applies to such transactions. Parties

have an incentive to devise safeguards to protect investments for transactions of the latter kind.
 22

Let s denote the magnitude of any such safeguards. An s = 0 condition is one in which no

safeguards are provided; a decision to provide safeguards is reflected by an s > 0 result.

Safeguards can take either of two forms. One would be to provide interfirm contracts

with added support: penalties to deter breach are introduced, added information disclosure is

provided and specialized dispute settlement machinery (e.g., arbitration) is devised. This is the

credible interfirm commitment option. A second would be to take transactions out of markets

and organize them under unified ownership within which hierarchy (to include fiat) is used to

effect coordination.

Node A corresponds to the ideal transaction in law and economics: there being an

absence of dependency (h = 0), such transactions benefit from the safeguard of competition.

Node B poses contractual hazards, in that specialized investments are exposed (h > 0) for

which no safeguards (s = 0) have been provided. Such hazards will be recognized by

farsighted players, who will price out the implied risks. Nodes C and D are those for which

additional contractual support has been provided (s > 0), either in the form of contractual

safeguards (node C) or unified ownership (node D).

That an outside supplier will supply on better terms (supply at a lesser price) at node C

than node B is not because it has received ‘simple assurances’ that the buyer will adapt

cooperatively should an adverse state realization materialize during the contract implementation

interval. Rather, suppliers are viewed as hard-headed businessmen who will respond to what

they perceive to be credible commitments, of which the use of hostages to support exchange is

an example (Williamson 1983).

In the event that problems of crafting credible interfirm commitments are perceived to be

especially great, the transaction may be taken out of the market and organized under unified

ownership (vertical integration) instead. In consideration, however, for the added bureaucratic

costs that accrue upon taking a transaction out of the market and organizing it internally,

internal organization is usefully thought of as the organization form of last resort: try markets,
 23

try hybrids and have recourse to the firm only when all else fails. Node D, the firm, thus comes

in only as higher degrees of asset specificity and added uncertainty pose greater needs for

cooperative adaptation.

The schema, moreover, applies not merely to intermediate product market contracts but

much more generally. Friedrich Hayek’s assessment applies: ‘whenever the capacity of

recognizing an abstract rule which the arrangement of those attributes follows has been

acquired in one field, the same master mould will apply when the signs for those attributes are

evoked by altogether different elements’ (1967, p. 50). Labor markets, capital markets,

regulation/deregulation, and, more generally, any issue that arises as or can be restated as a

contracting problem are variations on a theme.

Whereas the unifying theme for TCE is that of discriminating alignment, for Simon it is

bounded rationality. The latter has broad scope and, possibly for that reason, does not name a

canonical problem to which variations on a theme can be referred.

3.2 Theory of the firm

If, as Arrow has observed, ‘Any standard theory, not only the neoclassical, starts from

the existence of firms’ (1999, p. vii), then would-be theories of economic organization should be

expected to name the theory of the firm out of which they work.

(a) Carnegie

Simon’s theory of the employment relation (1951) relates closely to Coase’s (1937)

earlier treatment. That has been instructive but, awaiting further work, some of which is in

progress (Baron and Kreps 1999), the employment relation is more in the nature of an incipient

theory of the firm.

Two other theories that have Carnegie origins or connections are the ‘behavioral theory

of the firm’ and the more recent work on ‘competence.’ Both differ from orthodoxy.

Harold Demsetz contends that ‘It is a mistake to confuse the firm of economic theory

with its real-world namesake. The chief mission of neoclassical economics is to understand
 24

how the price system coordinates the use of resources, not to understand the inner workings of

real firms’ (Demsetz 1983, p. 377). Attention is thus focused on supply and demand, prices

and output.

Because Carnegie was plainly interested in the inner workings of real firms, it might be

expected to deemphasize price and output. The first research commitment listed by Cyert and

March, however, reads as follows (1963, p. 2; emphasis in original):

Focus on a small number for key economic decisions made by the firm. In the

first instance, these were price and output decisions; subsequently they

included internal allocation and market strategy decisions.

As against the orthodox prescription to set prices on the basis of marginal costs and

demand elasticities, Cyert and March maintain that they are set by simple routines. Their

department store pricing study correctly predicts prices ‘to the exact penny’ for 384 out of 404

items, which is astonishing (Cyert and March 1963, Chap. 7). Yet despite their view that their

computer model ‘lends itself to further elaboration and testing’ (Cyert and March 1963, p. 148),

few economists or organization theorists have followed that empirical lead.

The reason for this, I believe, is that few economists are interested in exact prices.

Rather, economists are more interested in comparative statics: What changes in the

parameters will move prices how and why? Awaiting a display of why they should be interested

in pricing routines that predict to the exact penny, such results simply do not change the way in

which economics gets done.

As I have discussed elsewhere (Williamson 1999), the core competence perspective

draws inspiration from Edith Penrose’s influential book on The Theory of the Growth of the Firm

(1959) and Joseph Schumpeter’s earlier work on Capitalism, Socialism, and Democracy (1942),

especially as it relates to technical and organizational innovation. George Richardson’s article

on ‘The Organization of Industry’ (1972) is seminal. The Cyert and March book (1963) makes

the case for a ‘realism in process’ approach to the study of organization, as does Richard
 25

Nelson and Sidney Winter’s book on An Evolutionary Theory of Economic Change (1982). All

have had a significant influence on the strategy literature, the overarching theme of which is the

importance of process. It is not obvious, however, how to bring the more important processes

together in a coherent way. Not only is process analysis hard to do, but there are many

important processes. What are the priorities?

Awaiting operationalization, the concept of core competence suffers from a tautological

reputation (Porter 1994; Mosakowski and McKelvey 1997). As matters stand presently, the

competence perspective relies primarily on success stories to make its case.

(b) TCE

TCE views the firm as a governance structure (which is an organizational construction)

rather than as a production function (which is a technological construction). Also, rather than

‘consist primarily of giving new answers to the traditional questions of economics—resource

allocation and the degree of utilization…it consists of [asking and] answering new questions,

why economic institutions have emerged the way they did and not otherwise; it merges into

economic history, but brings sharper nanoeconomic…reasoning to bear than as been

customary’ (Arrow 1987, p. 734; emphasis added).

One of the lessons of Carnegie is that firms have structure and that this structure arises

for some reason (Arrow 1999, p. vii). Always and everywhere, TCE examines governance

structures comparatively, whereby each discrete mode of governance is described as a

syndrome of attributes to which distinctive strengths and weaknesses accrue. The decision to

take a transaction out of the market and organize it hierarchically follows from the logic of the

simple contractual schema set out above. More generally, the discriminating alignment

hypothesis invites and has benefitted from empirical testing.13

 26

3.3 Public policy toward business

(a) General

The governance structure approach to economic organization has numerous

ramifications for public policy toward business: vertical integration, vertical market restrictions,

nonstandard forms of contracting more generally (to include exchange agreements, reciprocity,

take-or-pay agreements), corporate governance and corporate finance, labor market

organization, the limits of legal centralism, aspects of economic development and reform, the

modern corporation (both domestic and multinational) and public policy toward business

(antitrust and regulation/deregulation) more generally. Note that these nonstandard practices

are very different from the resource allocation issues with which the orthodox theory of the firm

was concerned (Demsetz 1983). Neither individually nor collectively does orthodox appeal to

price theoretic ‘wrinkles’—double-marginalization, price discrimination, differential risk

aversion—deal with these matters in a systematic way.

TCE has responded to this lapse by examining nonstandard and unfamiliar organization

and contractual practices through the lens of transaction cost economizing. Simon (and

Carnegie) express little interest in public policy as it relates to such matters.

(b) Public and private

March and Simon’s famous book on Organizations opens as follows: ‘This book is

about the theory of formal organizations…. The United States Steel Corporation is a formal

organization; so is the Red Cross, the corner grocery store, the New York State Highway

Department’ (March and Simon 1958, p. 1). They thereafter observe that ‘Transactions that

take place within organizations, far more than in markets, are preplanned and precoordinated’

and that ‘the high specificity of structure and coordination within organizations…marks off the

individual organization as a sociological unit comparable in significance to the individual

organism in biology’ (March and Simon 1958, p. 4).

 27

Differences among private for-profit firms, nonprofits, regulated firms, public bureaus,

etc. get short shrift in this quest for a common theory of formal organizations. Simon’s views

that public and private firms are indistinguishable in supplying public utility services (1997,

p. 49), that the ‘managers of charitable organizations are subject to the same discipline as the

managers of the profit-making firm’ (1997, p. 50), and that ‘in the transfer from centralized

planning to a market economy it is not obvious to what extent the production organizations

need to be privatized’ (1997, p. 51) are plainly in the common theory tradition.

TCE, by contrast, views markets, firms, regulation, and public bureaus as discrete

structural modes of organization that differ in their attributes. Because, moreover, transactions

also differ, the choice of mode will be contingent on the transactions to be organized

(Williamson 1991, 1999).

TCE furthermore holds that public utility transactions are intrinsically difficult to organize

(as Milton Friedman has put it, there is ‘no good solution’ for natural monopoly (1962, p. 128)),

whence the lack of sharp differences between public and private operation of public utilities is

not altogether surprising (although, upon making provision for variation in the institutional

environment—polity, judiciary, bureaucracy—differences appear (Levy and Spiller 1994, 1996)).

By contrast, a finding that public and private ownership has no impact on the manufacture of

personal computers or the operation of grocery stores would be a big surprise to TCE (if not to

Simon). Relatedly, TCE holds that competition in both product and capital markets does have

disciplinary consequences, whence charitable organizations will be reserved for a subset of

transactions different from profit-making enterprise (Hansmann 1996).

Finally, TCE concurs with Oskar Lange that ‘the real danger of socialism is that of a

bureaucratization of economic life’ (1935, p. 109). Lange, however, relegated bureaucratization

to the field of sociology rather than economic theory and bureaucratic differences between

capitalism and socialism were neglected by economists for the next 50 years. Given an

institutional environment in which property and contract enjoy legal and constitutional supports,
 28

the idea that privatization encourages economizing (discourages bureaucratizing) is now

14
broadly conceded.

(c) Macroeconomics

One of the reasons that Simon advances for ‘building an adequate, empirically based,

theory of bounded rationality’ is to better ‘understand and guide the operation of the economy’

(1997, p. 63). Neoclassical theory, in his judgment, is ‘grossly inadequate…for either

understanding the events that occur in the whole economy or providing a basis for macro-

economic policy’ (Simon 1997, p. 89). I do not disagree, but a unified theory from micro

through macro is very ambitious.

This is not, however, to say that we cannot make piecemeal progress in this direction.

Persistent application of the comparative contractual approach to economic organization holds

promise for such a purpose. My paper with Michael Wachter on ‘Obligational Markets and the

Mechanics of Inflation’ (Wachter and Williamson 1978) is illustrative of how this can be done.

But there has been little effort to date—by Wachter, me, or others—to follow this up with

empirical work.

4. Empirical TCE

Bengt Holmstrom and Jean Tirole once described the theory of the firm as a field where

‘the evidence/theory ratio…is currently very low’ (1989, p. 126). Sam Peltzman (1991) holds a

similar view of Industrial Organization more generally. Simon’s statement that, awaiting

empirical testing, TCE was an act of faith or perhaps piety (1991, p. 27) is broadly in this spirit.

Those who are closer to empirical TCE (have done empirical work) have a different

opinion. Thus Scott Masten remarks that whereas ‘Ronald Coase could justifiably lament the

dearth of research on the organization of industry in 1972…, the transaction cost literature

today [1995] contains scores of empirical studies on the topics Coase viewed as central to our

understanding of industrial organization—studies of the allocation of activities among firms, of

the structure of contractual arrangements between firms, and of the role and extent of
 29

participation by government agencies in industry’ (1995, p. xi). It could have been otherwise,

but the theory and evidence display a remarkable congruity: ‘Progress in the application and

testing of transaction cost economics can only be described as phenomenal’ (Masten 1995,

p. xi). Subsequent empirical surveys—by Howard Shelanski and Peter Klein (1995), Bruce

Lyons (1996), Keith Crocker and Scott Masten (1996) and Aric Rindfleisch and Jan Heide

(1997), where this last focuses on empirical applications of transaction cost economics to

marketing—agree.

A still more recent review of the relative contributions of agency theory and TCE to the

empirical literature on contracting also bears remark. The theoretical TCE and agency theory

literatures both took shape in the 1970s and both have undergone refinements since. But

where TCE has advanced numerous refutable implications, agency theory is notable for ‘its

failure to generate testable hypotheses…[or even] to account for…the more basic features of

real world contracts’ (Masten and Saussier 2000, p. 10). Not only are there few empirical tests

of agency theory, but ‘evidence from transaction cost economics, where variables of interest in

the [two] theories overlap, offers little support for agency theory’ (Masten and Saussier 2000,

p. 10).15

A survey of empirical TCE currently in progress (Boerner and Macher 2000) estimates

that the cumulative number of empirical TCE studies has grown from 200 in 1994 to over 600 in

the year 2000. Econometric refinements, moreover, are being introduced as this work has

progressed. To be sure, transaction cost economics, like everything else, will benefit from

more and better empirical work. I have no hesitation, however, in declaring that transaction

cost economics is an empirical success story. Judged comparatively, ‘this empirical work is in

much better shape than much of the empirical work in industrial organization generally’ (Joskow

1991, p. 81).

It is furthermore noteworthy that those who have done this empirical TCE work have

often collected original data specifically attuned to the microanalytic phenomena in question.
 30

Progress in science is normally attended by the collection of new and original data (Kuhn 1970),

yet that is demanding work—for which TCE empirical researchers deserve enormous credit.

But for this empirical research, TCE would merely join the list of plausible but conjectural
16
theories of firm and market organization.

5. Conclusions

TCE aspires to be both a ‘rational spirit’ and a ‘Carnegie spirit’ construction.

Economizing on transaction costs is on the rational spirit side of the ledger. Feasible foresight,

sometimes buttressed by learning from own-experience and that of others, also supports the

idea of efficient alignment (as does weak form selection). Furthermore, TCE addresses itself to

many of the long-standing puzzles of orthodoxy. It is one thing to tell economists that their

framework is self-limiting. It is another to tell economists something different and consequential

about phenomena that are of interest to them. Economists being very pragmatic people, the

latter will get their attention.

Carnegie has had a powerful influence on TCE efforts to understand nonstandard

structures and practices for which orthodoxy was poorly suited (Coase 1972). For one thing,

TCE subscribes to bounded rationality whence focuses on incomplete contracting. Also, and

related, TCE eschews hypothetical ideals in favor of feasible alternatives, all of which are

flawed and need to be examined comparatively. Such comparative institutional analysis invites

the description of alternative modes of governance not in technological but in organizational

terms. Given the limits of legal centralism, much of the action resides in the mechanisms of

private ordering, to which the lessons of organization theory apply. Also, like Carnegie, TCE

moves to a more microanalytic unit of analysis. But the unit of analysis for TCE is the

transaction, rather than the decision premise or the routine.

Although TCE does not attempt to implement the program described by Simon, I would

nevertheless describe it as an empirically based microeconomics. It deals always and

everywhere with feasible modes of organization; it yields numerous refutable implications on a

 31

wide range of real-world issues; the data have been generally corroborative. I am confident

that those who have been working the transaction cost economics domain will continue their

‘modest, slow, molecular, definitive’ efforts—piling block upon block until the value added

cannot be denied.
 Footnotes

*The author is Edgar F. Kaiser Professor of Business Administration, Professor of Economics,

and Professor of Law at the University of California, Berkeley. This paper has benefitted from

the helpful remarks of James March and Mie Augier, for which I am grateful.

It will not go unnoticed that the paper deals almost entirely with Simon, vis-à-vis transaction

cost economics. The larger Carnegie project, in which A Behavioral Theory of the Firm (Cyert

and March 1963) played a central role, is dealt with only in part and often only in passing. To

address this larger project would require a much longer and more ambitious paper. Suffice it

to observe here that four of the central ideas of the ‘Carnegie tradition’—bounded rationality,

intra-firm conflict and strategic action, rule-based action and organizational learning—have

been important to modern economic thinking about the firm. All four are featured prominently

by Cyert and March (1963). Of these four, transaction cost economics works principally off of

the first two (but concedes merit to all (Williamson 1999)).

1. The Ford Foundation study was done by Robert Aaron Gordon and James Howell (1959).

The Carnegie Foundation study was done by Franklin Pierson (1959).

2. Nobel Prizes in Economic Science were awarded to Herbert Simon (1978), Franco

Modigliani (1985), Merton Miller (1990) and Robert Lucas (1995) for work they did while

on the faculty at GSIA.

3. Although economics is an expansive enterprise, ‘Any standard economic theory, not just

neoclassical, starts from the existence of firms’ (Arrow 1999, p. vii).

4. These views differ from those he took much earlier (Simon 1957, pp. 89-90) and

presumably reflect his assessment of the way in which mathematical social science has

taken shape over the period 1957 to 1997.

5. See the exchange between Richard Posner (1993) and myself (1993) on this issue.
 2

6. Recall that cooperation is one of the two chief advantages that Simon ascribes to

organizations in relation to markets (1997, p. 49).

7. For a broader discussion of close reasoning, see Williamson (2000).

8. To be sure, short-cut forms of analysis can be and are sometimes used uncritically. See

Tjalling Koopmans (1957, pp. 140-141). Overuse of maximizing, like overuse of natural

selection, is a chronic hazard. Both work well in some circumstances but break down in

others, whence there is a need to delimit the use of such methods to the ‘appropriate

subset.’

9. Neither Aumann’s (1985) negative assessment of satisficing nor Arrow’s judgment that

TCE has made headway where the Simon agenda and older-style institutional economics

did not (1987, p. 734) are dispositive, but both Aumann and Arrow are thoughtful students

of economic organization.

10. As Richard Dawkins observes, it is the ‘capacity to simulate the future in

imagination…[that saves] us from the worst consequences of the blind replicators’ (1976,

p. 200).

11. Learning through experience and imitation are also relevant. Both benefit from a

reflective rather than myopic interpretation of events.

12. As matters stand presently, my efforts to curtail the excesses of calculativeness to which

zealous economic reasoning leads have mainly been limited to ‘the economics of

atmosphere’ (Williamson 1975, pp. 37-39, 79; 1996, pp. 270-272).

13. Whereas Simon has given prominent attention to the size distribution of firms (Simon and

Bonini 1959; Ijiri and Simon 1977), TCE has been concerned with the boundary of the

firm. Both are interesting questions. As between the two, boundary issues are closer to

the subject of firm structure.

14. Interestingly, Richard Pipes holds that ‘the very principles of Communism violated

everything that we have learned from sociobiology, anthropology, and the psychology of
 3

human nature, the building blocks of every social order”, whereupon he focuses on ‘the

abolition of private property…[as] the quintessence of [the] movement’ (1996, p. 36).

15. Michael Whinston made similar observations in comparing TCE with the ‘property rights

theory of the firm’ (2000).

16. There being many plausible theories, there is a need to sort the sheep from the goats.

That is accomplished by asking each candidate theory to advance refutable implications

and ascertain whether the data are corroborative or not. Theories that cannot pass this

test are eventually relegated to the history of economic thought.

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