Transaction Cost Economics and Property Rights Theory: Compare, Contrast, and Critique

Jeffrey Xiaofei Huang

First Draft: August 2010 Revised: June 2011

Transaction Cost Economics (henceforth TCE, a la Williamson) and Property Rights Theory (henceforth PRT, a la Grossman and Hart) are two largely influential theoretical frameworks in organizational economics. Often regarded as two pillars of modern economics of organization (Barney and Ouchi, 1986), they receive a lot of attention across a wide range of scholarships in economics and other adjacent and allied disciplines 1. In the first section of this essay, I will describe TCE and PRT in a nutshell, and then proceed to compare and contrast them from their origins, assumptions, main arguments and mechanisms, predictions, empirical tests, applications, and their recent developments. Critical insights from each perspective will be explicitly pointed out during the discussion. Section II will mainly focus on the shortcomings of each theory and if possible, critique them in their theoretical foundations as well as their empirical limitations. Section III illustrates some possible integration that is more relevant to the strategy field.

I. TCE versus PRT

1.1 TCE and PRT in a Nutshell A central focus of both TCE and PRT is to study the nature and boundary of the firm. In his seminal 1937 article, Ronald Coase first raised the questions of why we have firms at all in a market economy and how their boundaries are optimally determined. His answer is that, each way of organizing economic activity is costly. When the haggling costs 2 of using the market/price mechanism outweigh the costs of authority inside the firm, organizing economic activities through the firm would become more efficient. This answer is not satisfactory if one realizes that neither haggling nor authority costs could be easily operationalized 3. Having adopted the Coasian contracting perspective, both TCE and PRT have nevertheless sidestepped the issue of haggling costs by introducing new features into the transaction relationship where parties make large relationship-specific investments and cannot write complete contracts. Under this circumstance, one particular transaction cost the contractual enforcement cost plays a central role in parties makeor-buy decisions. Because of this enforcement cost, TCE argues that firms will be
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One of them already won a Nobel Prize after many years of waiting. Economists used the term haggling costs to refer to the costs of discovering the market price and the costs of negotiating contracts for each transaction. 3 As Williamson (1975, p. 3) clearly pointed out, transaction costs are appropriately made the centerpiece of the analysis but these are not operationalized in a fashion which permits one to assess the efficacy of completing transactions as between firms and markets in a systematic way. 1

relatively more efficient than markets because of its alignment with these specific transaction attributes (Williamson, 1975, 1985). PRT, on the other hand, argues that in the presence of relationship-specific investments and incomplete contracts, firms and markets are both costly, and the boundary decision is determined by the relative importance of the parties non-contractible investments (Grossman and Hart, 1986; Hart and Moore, 1990; Hart, 1995). 1.2 Origins We can easily see from above that one common origin of TCE and PRT is the Coasian contracting perspective and the incorporation of transaction costs into the economic analysis of firms and their boundary problems. Other than Coase (1937), TCE also traces its origins to contributions in law (Llewellyn, 1931) and organization theory (Barnard, 1938) because of its heavy emphasis on the legal aspects of institutions and behavioral views of organizations. PRT, on the other hand, does not explicitly incorporate insights from the law and the managerial perspectives except the assumption of a well-functioning legal system. Close to this is its view on how contracts are enforced ex post, which may rely on Coase (1960) where parties can always bargain efficiently and reap the joint surplus. Since asset specificity is first raised in TCE (Klein, Crawford and Alchian, 1978), PRT also relies directly on TCE. 1.3 Theoretical Assumptions Both TCE and PRT have assumed that contracting parties are somewhat bounded rational in that they cannot fully anticipate every possible contingencies in the future, and in this sense, contracts are all incomplete. Second, PRT also explicitly assumes that the state of the world is observable but not verifiable. As we will later reveal, this crucial assumption raises many criticisms, particularly from mechanism design theorists. Putting these complications aside, this assumption alone can be interpreted as equivalent to the premise that there is also bounded rationality for the third party. TCE does not explicitly impose this assumption, and in fact, it has particularly focused on ex post inefficiencies. PRT, on the contrary, explicitly assumes ex post efficiency, i.e., parties can always bargain things out in a twinkling of an eye. Third, although being bounded rational, agents in both models could still anticipate strategic behaviors and their respective outcomes. TCE further assumes that agents are opportunistic 4, which is quite strong and raises a lot of critiques from sociologists and organization theorists. Fourth, as a formal approach of incomplete contracting, PRT has further imposed restrictions on the information structure. In its original model, asymmetric information is simply assumed away. Finally, both TCE and PRT have assumed that the buyer-seller transaction is taken as given, so only the ownership or the governance choice decision becomes the critical issue. But how to
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Opportunism was defined as self-interest seeking with guile in Williamson (1975). 2

identify which transactions should be engaged or not is still left open and hence needs further examination. 1.4 Main Arguments and Mechanisms Transactions and contracting costs are made the centerpiece for both TCE and PRT. As we pointed out earlier, TCE and PRT have introduced new features into the transaction relationship where parties make large relationship-specific investments and cannot write complete contracts. Under this circumstance, there could be potential holdup problems where one party reneges on the initial contract and tries to renegotiate and appropriate quasi-rents from its partner. Although sharing similar contracting features, their solutions to the holdup problem are different. TCE argues that firms will be relatively more efficient than markets under this circumstance because of its alignment with these specific transaction attributes. PRT, on the other hand goes further, it argues that firms and markets are both costly, and the boundary decision is determined by the relative importance of the parties non-contractible investments. While the benefits of integration come from the increased incentives for the integrating party to make relational specific investments, the costs of integration comes exactly from the opposite force the incentive for investing in the relationship for the integrated party is dampened. Some may argue that PRT formalizes TCE, others may believe that the two approaches are quite different (see Gibbons, 2005). I would argue that they are inherently different, at least from two aspects. First, while PRT focuses on ex ante allocation of ownership rights, TCE stresses on the ex post adaptation process to avoid inefficiency. Close related to this, PRT focuses on parties decision making on relationship specific investments, while TCE emphasizes parties governance choice that could potential be aligned with particular transaction attributes. Since both TCE and PRT study the (downstream) buyer - (upstream) seller relationship, the boundary problem they focus on is clearly the vertical boundary rather than horizontal boundary. Recent advancement in PRT also works in the direction of lateral integration and the optimal firm scope problem (Hart and Holmstrom, 2010). 1.5 Predictions Due to their wide applicability, many testable predictions might be drawn from each theory. To keep our comparison consistent and tractable, I will focus on their main predictions regarding the boundary of the firm. Both TCE and PRT would predict that vertical integration is more likely in the presence of large relationship-specific investment. However, whereas TCE may not have particular implications on the directionality of integration, PRT may imply that the party whose relationship-specific investments are more important to the transactions tends to be the integrating party.

Both theories can also offer competing predictions. For example, TCE may predict that vertical integration is more likely if there is more uncertainty since a higher level of uncertainty makes contracting even more difficult. PRT, on the contrary, may predict less likely of vertical integration because under an uncertain environment, efforts and hence initiatives for contracting parties become more important. 1.6 Empirics While TCE is generally considered as an empirical success story (Williamson, 1996, pp. 55), PRT faces several notable challenges in deriving its empirical predications, particularly because the non-contractibility issue is by definition hard to be operationalized empirically5. Whinston (2003: 2, 20), noting that TCE had significant predictive power, also concludes that the existing empirical evidence that is supportive of the TCE sheds little light on the empirical relevance of the PRT and that both theories offer rich predictions that deserve empirical scrutiny in future research. More discussions on the empirical predictions particularly how to conduct a horserace test between these two approaches can be found in the critique part. 1.7 Applications Both approaches have a wide range of applications. TCE is arguably one of the most influential theoretical frameworks among all social sciences 6, including sociology, political sciences, business and management, law and public policy, and so on. PRT is mainly influential within the mainstream economic disciplines and in law and economics. TCE attracts much attention from sociologists and other related disciplines because it in part arose from, and therefore spoke to, concerns articulated in these allied disciplines, particularly sociology and organization theory. These social scientists tend to accept the basic behavioral assumptions of bounded rationality in TCE, that economic agents are intentedly rational, but only limitedly so (Simon, 1957, pp. xxiv). However, PRT does not have that much wide popularity, in part because it is still too close to the school of rational economic decision making (although a bit flavor of bounded rationality is added), and also because the idea of ownership rights is not emphasized in many of these adjacent areas (except for legal scholars). Having formalized property rights in a simple and elegant way, the main application of PRT is still in economics 7.
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There has been a growing body of empirical literature in testing PRT. Most notably are, venture capital Kaplan and Strombergs (2001, 2003, 2004) studies on VC contracting and Baker and Hubbard (2003, 2004) on make-or-buy in the trucking industry. 6 See Macher and Richman (2008) for a detailed assessment of applications of TCE in many social science disciplines. 7 PRTs main applications include: the formal analysis of joint ventures (JVs), strategic alliances and other hybrid forms (Baker, Gibbons and Murphy, 2008); innovation in firms (Aghion and Tirole, 1994); power delegation and authority in firms (Aghion and Tirole, 1997); financial contracting (Aghion and Bolton,1992; 4

1.8 Recent Developments Partly as a response to various criticisms (see below), one similarity between TCE and PRT regarding their recent advancement is their emphasis on incorporating social and behavioral factors into their model, such as envy and social comparison (Nickerson and Zenger, 2008; dealing with organizational failure), or self-serving, aggrievement and shading (Hart and Moore, 2008; dealing with ex post inefficiency). How to further sharpen these ideas and how to operationalize them and test them are still left as open and challenging questions.

II. Critique
2.1 Foundations The main skepticism on TCE is about one of its behavioral assumptions, that agents are opportunistic. For example, as Granovetter (1985) has argued, this assumption only suggested an undersocialized view of economic life. He further argues that, individuals are usually embedded in networks of social relationships, even risky transactions can often take place through markets rather than alternative mechanisms, such as firms. Mainstream economists also hold skepticisms on the arguments of TCE, since there is no formal model has been written down. With no exact assumptions and mechanisms being explicitly specified, the application of TCE in many areas might be limited. However, Gibbons (2005) recently argues that not only the rent-seeking perspective, but the adaptation aspect of TCE can be potentially formalized. Criticisms on PRT, as we noted earlier, have been focused on its validity of its main assumption that the state of the world is observable but not verifiable. Mechanism design theorists (a la Maskin) have argued that various ingenious mechanisms could make the state of the world verifiable (for two subgame perfect implementation schemes, see Moore and Repullos (1988) and Maskin and Tirole (1999)) and hence can be used to implement the first-best results; others argue that we could also use options contracts to solve the holdup problems and implement first-best outcomes (see Noldecke and Schmidt, 1995; Lyon and Rasmusen, 2004). Responding to these critiques, PRT scholars have shown some powerful counter-arguments. For example, Che and Haush (1999) have forcefully shown that under cooperative investments, an ex ante null contract is actually optimal. Moreover, if we further impose the behavioral assumption of short-run
Aghion, Hart and Moore,1992; Hart, 2001; for evidence, see Kaplan and Stromberg, 2001, 2003, 2004); government ownership and privatization (Schmidt,1996; Hart, Shleifer and Vishny, 1997); international trade and outsourcing (Antras, 2003; Grossman and Helpman, 2005; Spencer, 2005; for evidence, see Feenstra and Hanson, 2005); relational contracts (Baker, Gibbons and Murphy, 2002; Levin, 2003); and even in behavioral economics (explaining endowment effects, see MacLeod, 2007). 5

commitment, both the options contract and many ingenious mechanisms could be rendered valueless (Hart and Moore, 2004). Aside from the attack by mechanism design school, there are many other critiques regarding PRTs assumptions and its theoretical arguments. Due to time and space constraints, I will elaborate some of these criticisms, but only briefly. First, PRT explicitly assumes that ex post bargaining is efficient. However, this is often not the case in reality. A second problem is that this framework describes owner-managed firms better than large companies, therefore it doesnt lead naturally to a theory of delegation. A third problem, as pointed out by Holmstrom (1999), is that there is no real firms in this model, only managers. So why firms own assets still needs to be further discussed. Finally, like TCE, PRT also relies too much on asset specificity as the locomotive for contracting choice, and moreover, PRT puts too much emphasis on the role of nonhuman assets. However, in reality, many professional service firms, such as law and accounting firms, are often not physical assets intensive. Although we may certainly treat some of their valuable assets as physical (e.g., lists of clients), most of their routine work is characterized by utilizing either their general or firm-specific human capital. So theoretically, we may ask, whats the nature of the professional service firms and whats the role of human assets in determining these firms optimal boundaries? Another related question maybe more relevant to the make-or-buy decisions is that, for professional services, like legal services, when should a firm outsource its legal cases to an outside law firm, and when should a firm deal with them using their own lawyers? Even as PRT prescribed, a firm could be characterized by the nonhuman assets it owns, under some particular circumstances, the firm may not completely and perfectly exercise its residual rights of control over these assets. One such real world case is when a firms physical assets are offsite, or even at the site of their outsourced companies. For example, companies choose to outsource some of their IT functions, like data storage, or network maintenance, to an outside specialized company, rather than using their own IT departments to do the job. In some cases, companies have to buy the physical assets in this case, the servers but also have to leave them on the site of the outsourced company. In TCE, assets could be used as hostages in order to facilitate transaction relationships. However, in this case, it is not clear why they need such a hostage. To me, its more likely that the IT firm may hold up the outsourcing company ex post. In PRT, the firm who owns the servers should have the residual rights of control over these assets. However, it occurs to me that these residual rights are no longer absolute in this particular case in that they might not be carried out very smoothly. As the future contingency resolves (e.g., the server is not kept under the right temperature etc. 8) and the owners interests are at stake, how could the owner really exercise its residual rights of control? By taking the server
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The temperature example may not be entirely appropriate since it seems to be verifiable and hence contractible. However, there could be other unforeseen events that could not be contracted on ex ante. 6

back or just renegotiate things out? 9 In this situation, I think both parties adapt to bargain things out may be the right direction, although this process could be costly. 2.2 Empirical Limitations It is argued that the original TCE model is always good to vertical integration, but not disintegration, and that there is no particular implications the directionality of integration 10. For PRT, the main challenges come from the measurement problems of non-contractible investments. Although being difficult, there has been accumulated a growing body of literature that have provided some empirical support for PRT 11. The current literature has another important limitation in the sense that little research has focused on a horserace test between these two approaches. How to do this is also an open issue. It occurs to me that if we can test the original PRT under some specific contexts, it is always possible to run such a horserace test. Although it is not so difficult to find appropriate proxies for the level of asset-specificity and hence the level of quasi-rents, it is more severe a problem to measure the marginal returns to investment. One possible way to look at is to find good natural experiments that can potentially do this job. For example, there could be natural experiments which include investments that are cooperative between two parties. Under this circumstance, an increase in the marginal returns to these types of investments under non-integration will increase the probability of integration in PRT, however, since such changes reduce quasi-rents, they would be predicted to reduce integration in TCE. A less stringent horserace test may possibly be found if the level of uncertainty changes, as we suggested earlier.

III. Application to Strategy: Integration of PRT and Capabilities View

Although TCE has been quite influential in the strategy field, it seems to me that PRT has been more or less underutilized. Some scholars have already noticed this and started working in this direction (see some of Mahoney and Foss's recent work), but their discussions are more inclined to a static synthesis. Instead, following Argyres and Zenger (2009)s integration of TCE and capabilities-based view, we may also take a look at PRT and comparative capabilities in an intertemporal setting. However, unlike Argyres and Zenger (2009), where the capability of a firm in the second period results from the transaction-costs economizing governance choice in the first period, I would argue that a firm's capability in the second period may also derive from a first-period allocation of ownership rights. Here is a synopsis of the mechanism I may conceive of: in the first period, the standard story applies. Given a particular transaction, there could be potential
Maybe my version of the story is quite speculative, but it definitely needs some further scrutiny over the possible case of what would happen when the physical assets of a firm are not on the site of the owner but on the site of the outsourced party. 10 See footnote 5. 11 See footnote 7. 7
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hold-up problems in the presence of incomplete contracting and relationship-specific investments. Expecting this, parties will choose how to allocate ownership rights so that the optimal investment incentives could be achieved. But whats the standard story isnt clear about is what would happen after the allocation of ownership rights. We would argue that the relative capability may emerge in this context. If parties choose to integrate, then the party who has the ownership over all the co-specialized assets will invest more time and resources to learn and utilize these assets and discover their unique and complementary functions. Through a constant thinking of how to combine and recombine these co-specialized assets, and how to make innovations out of them, the capability of utilizing these assets might be developed during the process. Moreover, as some behavioral economics literature has argued, people tend to value an asset more if the ownership to it has been established. This endowment effect may further enhance the learning and utilization of the co-specialized assets and hence the capability could be further enhanced. The acquired party, on the other hand, although its incentive to make its own investments is dampened, it is now subject to the authority of the acquiring party and could simply be asked to engage in the combination, recombination and innovation process. If the acquired party chooses not to, it could simply be replaced by someone who is willing to do so. While if the parties choose not to integrate in the first place, then the co-specialized assets are now separated and owned by different parties. Each party may only be able to learn and utilize their own current assets and develop capabilities around these assets in the next period, or they may seek further opportunities to combine or recombine their current assets with potentially unique and complementary ones. Whether future transactions will be integrated or not may directly depend on these capabilities, but initially, it is the allocation of ownership that is the driving force for developing these capabilities. While the potential integration of PRT and capabilities view may share important similarities with Argyres and Zenger (2009), we dont have a clear view on how to test each integrative framework empirically. Particularly how to test their specific mechanisms, not only their direct implications and predictions? These questions also open up important new directions and challenges for future empirical research.

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