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Transaction Cost Economics: The Origins
Oliver E. Williamson
University of California, Edgar F. Kaiser Professor Emeritus of Business, Berkeley, United States
Abstract This paper is an autobiographical recollection of how my interest in and work on transaction cost economics progressively developed. It begins with an overview of the transaction cost economics project. A sketch of my undergraduate and graduate education follows. Key events in the 1960s that set the stage for my 1971 paper on “The Vertical Integration of Production” are then described. This paper would turn out to be the entering wedge from which transaction cost economics would take shape and continues today, as set out in the closing pages of the article. © 2010 Published by Elsevier Inc on behalf of New York University.
Keywords: Transaction cost economics; Pre-transaction cost research; Enumeration of the key events
This paper owes its origins to a request that I received from Arne Nygaard, asking me to write an introductory note for this special issue of JR. Rather than leave it at that, however, Arne went on to suggest that I “reveal the story behind the success story of TCE . . .. I would like to know if there is a Newton story of falling apples (actual time and place). . .. I would like to know more about . . . Carnegie Mellon and the group of people there and the other universities where you worked.”1 The answer to the ﬁrst of these is that there was no falling apple, but I did beneﬁt from a series of insights that, individually and collectively, served to unlock the gates to transaction cost economics. I begin by sketching the key moves that led into the transaction cost economics project. I then provide the details and people who participated in various stages of development. An overview As I look back on this project I sometimes think that I was predestined to do transaction cost economics. So many events “lined up” that it cannot be explained any other way. But of course, that is nonsense. It is not that one thing led inexorably to another but rather that my intuitions and interests and makeup were such that it was easy for me to incorporate new knowledge and insights as events unfolded. It could have been otherwise, but there was not a lot of slippage in the various turns in the road that I describe below. I
1 I have addressed these issues before, but in a less personal and less focused way than I attempt herein.
should nevertheless make clear that I owe a great deal to people who took an interest in my career and urged me to widen my horizon and/or reposition. I am especially grateful to my wife Dolores who was continuously supportive and adapted quickly, constructively, and cheerfully to new circumstances. Signiﬁcant events that led me into transaction cost economics include: (1) my undergraduate training at MIT, which provided me with analytical apparatus and grounding that would serve me well in the years ahead; (2) working for three years as a project engineer with large corporations and the U.S. government, which gave me a sense of how large bureaucracies operate, before deciding to do graduate work; (3) enrolling in the PhD program at the Graduate School of Business at Stanford only to discover, with the aid of junior faculty, that my real interests were in economics and that the Graduate School of Industrial Administration at Carnegie was, as it were, tailor made for me; (4) reveling in the excitement of interdisciplinary teaching and research at Carnegie; (5) discovering that “teaching is learning” in my ﬁrst job as Assistant Professor of Economics at Berkeley, where I was presented with many opportunities, as an applied microeconomist with interests in ﬁrm and market organization, to reformulate old issues constructively; (6) ﬁnding even more such opportunities when I left Berkeley to take a job as Associate Professor of Economics at the University of Pennsylvania, to include a “teaching as learning” experience in the newly created School of Public and Urban Policy; (7) serving as Special Economic Assistant to the Head of the Antitrust Division, where I came to appreciate that much of the economic literature that informed antitrust enforcement was wrong-headed; (8) my intuition that vertical integration could be usefully examined from a
0022-4359/$ – see front matter © 2010 Published by Elsevier Inc on behalf of New York University. doi:10.1016/j.jretai.2010.07.006
myself included. 5. on February 6. After one of my visits to his ofﬁce to discuss nuances he pronounced that I had very good intuitions and should be taking courses in the economics department. The quoted phrase is from Frank Knight (1965. 4. I followed his advice and took a microtheory class with Kenneth Arrow. 4 I spent most of the second year in the classrooms of Herman Chernoff. And I was pleased when (a revised version of) this term paper was published in the February 1963 issue of the Quarterly Journal of Economics. Emanuel Parzen. p. to be grounded in this way. three PhD students. Jacques Dreze speaks for me and many others in his statement that “Never since have I experienced such intellectual excitement” (1995. and Hirofumi Uzawa. thought of as objectionable was altogether predictable. for which I was a bit apologetic. The “Selling Expense as a Barrier to Entry” paper that I prepared for Herbert Simon’s class on “Mathematical Social Science” was mainly an exercise in applied price theory.” rather than proﬁts. 2010) 227–231 lens of contract perspective in a combined economics and organization theory way. 270). Howell was a very lucid. We discovered. The graduate students in attendance concluded that when “he says. No one’s position was changed by the arguments that ensued. but it had immediate and lasting effects. shared an ofﬁce with another new faculty appointment. Simon saw it differently: “Anything that advances our understanding of complex phenomena is to be valued. Jack Muth had a way of “pushing the logic to completion” that I had not previously witnessed. on the Gordon-Howell report of the status of U. Having applied for and received a three-year portable fellowship from the Ford Foundation. Things could have gone otherwise. If deviations from normative public policy are not contrived but are the natural result of the circumstances. he/she who has the data has the advantage. Bernard Haley.” I was relieved by his pluralistic view of social science. 2006) that “I believe in every area where I have had some inﬂuence that it has occurred less because of the pure analysis than it has because of the empirical evidence that I have been able to organize. she says” impasses arise. such discretion could also be held in check by internal organization. This immediately registered on me as a research opportunity. but I eventually inquired and quickly recognized that this was a leading-edge program from which I was sure that I would beneﬁt.”2 (It was vital for me and. From engineering to business to economics As indicated.” 6 Managerial discretion is projected to be greater if competition in product and capital markets is weak. my engineering training at MIT provided me with a good toolkit and grounding – where by the latter I mean that although hypothetical ideals are often a good place to start it is necessary thereafter to make provision for friction. have an active mind. Although he did not put it this way. myself being one. 3. to my very great pleasure. In addition to competition in the product market and competition in the capital market arguments on which I had previously relied6 as checks upon managerial discretion.3 and had accepted an assistant professor appointment in the business school at Stanford. Chuck would ask me about my interests periodically. for many other applied microeconomists. 2.5 6. but Friedman had the data and empirical analysis to support his position. at Carnegie and later.S. The playful remark by James March in his organization theory class that large corporations are managed so as to “maximize slack. and he would tell me “You ought to be at Carnegie. 5 Friedman later advised me (by email. mathematics. Melvin Reder.4 Because of an ofﬁce crowding condition. which I was able to do because the second year MBA program was very ﬂexible and allowed me to take courses in economics. be interdisciplinary. Needless to say. who had just ﬁnished his PhD at Carnegie. and statistics outside of the Business School in my second year. business schools. no-nonsense teacher and I found the subject of economics fascinating. to our surprise and delight. He remembers me as “asking good questions” and. was contested at the National Bureau of Economic Research conference on money-macro at Carnegie in 1962. one of which was economics as taught by James Howell. I would describe them. I conjecture. Milton Friedman’s critique of the simple Keynesian model. I read Alfred Chandler’s book. p. Charles Bonini. This class with Ken settled the idea that I should take more economics. resistance. that was an exhilarating experience. This study was sponsored by the Ford Foundation. then understanding rather than misconstruing the origins of the regularities would be vital to the making of public policy. Strategy and Structure sometime in the mid-1960s and was taken aback. 3 2 . 123). Williamson / Journal of Retailing 86 (3. then worked with Aaron Gordon. Dolores and I and our two children arrived in Pittsburgh in September 1960. Highlights. and “human nature as we know it. describes me as one of his students. at Berkeley.228 O. and with the agreement of my wife to leave California for Pennsylvania. Jim had recently received his PhD from Yale. that Pittsburgh was a very nice city. as based on empirical work that he had done jointly with Meisselman.” I knew nothing of the PhD program in the Graduate School of Business at Carnegie. That is the only class that I took with Ken.) I was accepted into the PhD program at the Graduate School of Business at Stanford in 1958 and took a series of MBA courses in the ﬁrst year. Enumeration of the key events The overarching insight that I learned at Carnegie was the “Carnegie Triple”: be disciplined. Allan Meltzer encouraged me to “be my own man” at a critical juncture in my career where there was a divide in the road. include the following: 1. turbulence. and (9) an appreciation that a wide range of other economic and organizational phenomena could be interpreted as variations on a few key transaction cost economizing themes. Pushing the logic would sometimes reveal that behavior that many public policy analysts.E.
that was disconcerting. “I approach territorial and customer restrictions not hospitably in the common law tradition. The transaction cost economics project Pre-transaction cost research My response to Jim March’s remark that managers maximize slack was to interpret this as “expense preference” and embed it in a managerial utility function that had three arguments: expenditures for staff. all were presumed to be anticompetitive.7 (As the Head of the Antitrust Division pronounced.Y. The main response of the managers. expenditures for emoluments.” I organized a graduate 9 There is. and the ﬁfth originated in an undergraduate IO class that I taught in 1964 when an outside speaker disputed the possibility that wage rates would be used as a barrier to entry. 11 The ﬁrst of these had its origins in my undergraduate IO class in the spring of 1964. p. What to do? 10. Since reality told us that externalities and vertical integration were part of the economics landscape. It has been my experience as an academic that “teaching is learning. 1967). Working off of the premise that “teaching is learning. the second at the Center for Advanced Study at Princeton). the third was my ﬁrst effort to solve the puzzle of ﬁrm size (as posed by Frank Knight and Ronald Coase). “The Economics of Discretionary Behavior: Managerial Objectives in a Theory of the Firm. Yet others were unpersuaded. Transaction cost economics Given my dissatisfaction with antitrust enforcement on vertical integration/vertical market restrictions. The ﬁrst was my work on New York Mayor John Lindsay’s CATV task in 1969–70. there was one for which there was no good explanation: exchange agreements. which had been told. 8. Indeed. 29. “Social Choice: A Probabilistic Approach” (with Thomas Sargent. had quickly produced a laundry list of objectionable practices. “Economies as an Antitrust Defense: The Welfare TradeOffs” (1968b). but inhospitably in the tradition of antitrust law. management was both the problem and (within limits) the solution. when I had an opportunity to put two years of research back-to-back (the ﬁrst at the Behavioral Sciences Center at Stanford.” was completed in the spring of 1963 and. as was Robin Marris’s growth maximization model (1964). that this could be realized by having each company report surpluses and deﬁcits to a central market. positive transaction costs were everywhere. 10 This formulation was inspired in part by William Baumol’s sales maximization hypothesis (1959). on short notice. I nevertheless found that teaching new courses usually presented me with new research opportunities and I was disappointed when a new course did not turn out this way. 7.”)8 I knew from my training at Carnegie that the “prevailing thinking” (Posner 1977. In that event. The major problem was this: except as nonstandard and unfamiliar contracting practices and organizational structures had a technological justiﬁcation. as a winner of the Ford Foundation dissertation competition. Antitrust Symposium. Although most did not withstand scrutiny. I resolved to examine the economic literature on these topics when I returned to teaching at the University of Pennsylvania in 1967. That was disconcerting. and “Wage Rates as a Barrier to Entry: The Pennington Case in Perspective” (1968a). State Bar Association. Upon opening the black box of ﬁrm and market organization. My dissertation. When I observed. 9. as able and conscientious as the leadership and staff of the Antitrust Division was. although Chandler never put it this way. “Hierarchical Control and Optimum Firm Size” (1967). the second was a product of teaching a graduate class on “The Pricing of Public Services” in the spring of 1965. Williamson / Journal of Retailing 86 (3. was published by Prentice Hall in 1964. which follows. 2010) 227–231 229 Speciﬁcally. engineers.”9 This is a common theme in Section 4. p. That was chaos. Evidently the standard assumption by economists that transaction costs were zero would have 7 This was because antitrust enforcement relied on applied price theory and the structure-conduct-performance paradigm. to undertake an antitrust inquiry. neither of which made provision for the importance of organization (broadly construed to include both the mechanisms of interﬁrm contract and internal organization). and discretionary investment. Two consulting assignments that I had in the late 1960s and early 1970s would prove to be important. and lawyers was that they did not like the question. The Federal Trade Commission. this was met by silence. The second was a consulting assignment that my Penn colleague Almarin Phillips and I took with one of the major petroleum companies after the ﬁrst oil crisis. When Coase (1960) and Arrow (1969) pushed the thenstandard assumption of zero transaction costs to completion – Coase with respect to externalities and Arrow with respect to vertical integration – both reached a similar result: externalities and vertical integration both vanished when the logic of zero transaction costs was taken to completion. signiﬁcant parts of antitrust enforcement were wrong-headed. My experience as Special Economic Assistant to the Head of the Antitrust Division in 1966–67 convinced me that. to go.10 Post-dissertation research of mine that served to credentialize me as a journeyman economist included “Peak Load Pricing and Optimal Capacity under Indivisibility Constraints” (1966). I declined the latter. The utility function where these three favored types of expenditures appeared was then maximized subject to a minimum proﬁt constraint.11 But my applied micro research would soon undergo what for me was an irreversible change. .E. however. 8 The quotation appears in the 1968 N.O. however. 1) upon which antitrust enforcement then rested was seriously truncated. of course. a tradeoff between teaching multiple sections of one course (with one preparation) and teaching multiple courses. The common justiﬁcation was that exchange agreements saved on cross-hauling expenses. the fourth originated when I was with the Antitrust Division. the move from a functionally organized and centralized (unitary form) corporation to a divisionalized corporation where the central ofﬁce had a planning and internal resource allocation capability (multidivisional form) could also attenuate managerial discretion.
Europe. I nevertheless knew that this was an important paper – going so far as to tell Dan McFadden in the spring of 1971 that I felt that I was the ﬁrst person in the world to understand vertical integration. What appears in Markets and Hierarchies as “The Organizational Failures Framework” (1975. p. franchising. strategy. (4) the standard assumption of zero transaction costs is supplanted by a focus on positive transaction cost differences. to market and hierarchy) is taken to be the main problem of organization. depending on whether the investments made in supporting assets were generic or speciﬁc) and disturbances to which adaptations were needed. This would be repeated. multinational ﬁrms. however.230 O. C. as acquired from working on the New York City project that I mentioned earlier. moreover. regulation and deregulation. Knee-jerk monopoly reasoning is bankrupt. this literature could neither explain the wide degree to which vertical integration was practiced in the United States. as reported in the study on The State of Competition in the Canadian Petroleum Industry (Quebec 1981). Director of Investigation and Research. I viewed the offer as an opportunity to bring economics and organization theory together on the possibility that a combined effort would lead to a deeper understanding of vertical organization (and. and the economics of trust – qualify. This paper differed from orthodoxy in the following respects: (1) the orthodox lens of choice is supplanted by the lens of contract/governance (which leads into an examination of phenomena in microanalytic detail). and law were also numerous and growing. The challenge was to work up a constructive response. and other progressive countries nor justify the inhospitality tradition in antitrust. coordinated the eight-volume study. Although I had never taught an organization theory course before. where applications of transaction cost economics to marketing.E. Another fortuitous development would facilitate that: the University of Pennsylvania hired Jules Margolis as the ﬁrst dean of the new School of Public and Urban Policy. by exclusive reliance on the former. As. directly or indirectly. (5) adaptation (of autonomous and coordinated kinds. was presented at the annual meeting of the American Economic Association in January 1971. That.12 Language that can (and was) interpreted as evidence of anticompetitive purpose and effect when examined through the orthodox lens of applied price theory could and often did take on an altogether different interpretation when examined through the lens of contract/governance. Applications within the contiguous social sciences. ﬁnance. But it did not instantly register on me that this approach had ramiﬁcations for the study of economic organization more generally. That was a lot of novelty to pack into one paper and understandably took a while to register. conditional on the attributes of transactions. labor market organization. Bertrand. in the business schools. however. permitted me to address the question of “Franchise Bidding for Natural Monopoly – in General and with Respect to CATV” (1976) in a more nuanced way than it had been addressed previously (Posner 1972). chap. Williamson / Journal of Retailing 86 (3. roughly. the organization of work. and (6) much of the comparative institutional action is shown to reside in the condition of bilateral dependency (which could vary from slight to great. (3) a narrow view of simple self-interest seeking is expanded to include strategic behavior during the contract implementation interval. 33). and was published in the Papers and Proceedings of the AEA in the May 1971 issue of the American Economic Review. My experience with the CATV industry. to economic organization more generally). vertical market restrictions. Public policy is poorly served. So I gave the class the assignment (and took it myself) to work through the basic regularities over the weekend. Combines Investigation Act. My paper on “The Vertical Integration of Production: Market Failure Considerations” took shape during my teaching of organization theory during the spring and fall of 1970. which correspond. My position is that transaction cost economics is one of the informative lenses with which to study complex economic organization. The seeds of a predictive theory of ﬁrm and market resided therein. organizational behavior. A huge number of economic phenomena – including vertical integration.. with luck. operations management. 1981). This is not to say that the latter lens is right and the earlier lens is obsolete. we were continuously appealing to several recurring themes. Transaction cost economics got underway as I and others discovered that any issue that arises as or can be reformulated as a contracting problem can be examined to advantage in transaction cost economizing terms. was a negative conclusion. The fact that certain regularities keep recurring is responsive to Friedman’s observation that “a fundamental hypothesis in science is that appearances are deceptive and that there is a way of looking at or interpreting or organizing the evidence that will reveal superﬁcially disconnected and diverse phenomena to be manifestations of a more fundamental and relatively simple structure” (1953. The 35 years from Markets and Hierarchies (1975) to Robert J. Q. Jules had an inspired vision for an interdisciplinary PhD program at SPUP and asked me to participate by teaching a two semester sequence in organization theory. 2010) 227–231 student seminar in which the students and I went methodically through the literature. Although there were good and thoughtful price theoretic treatments of these issues. Likewise the puzzle of exchange agreements in the petroleum industry that I had ﬁrst encountered in the early 1970s was one that I could interpret in credible contracting terms in “Credible Commitments: Using Hostages to Support Exchange” (1983) once I read the “incriminating memoranda” on such agreements. family ﬁrms. corporate ﬁnance and corporate governance. as between markets and hierarchies. 12 . however. The State of Competition in the Canadian Petroleum Industry (Quebec. and accounting would be made. (2) the assumption of hyperrationality is supplanted by bounded rationality (on which account all complex contracts are incomplete). 2) had its origins in this class. This reformulation revealed that the decision to outsource a technologically separable good or service or to integrate (produce to one’s own needs) turned on transaction cost differences. the class and I continued to wrestle with the problems of economic organization I recognized that.
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