Peter Klein e Michael Sykuta - The Elgar Companion To Transaction Cost Economics PDF

THE ELGAR COMPANION TO
TRANSACTION COST ECONOMICS

The Elgar Companion to
Transaction Cost Economics
Edited by
Peter G. Klein
Associate Professor, Division of Applied Social Sciences and
Associate Director, Contracting and Organizations Research
Institute, University of Missouri, Columbia, USA
and
Michael E. Sykuta
Associate Professor, Division of Applied Social Sciences and
Director, Contracting and Organizations Research Institute,
University of Missouri, Columbia, USA
Edward Elgar
Cheltenham, UK • Northampton, MA, USA
© Peter G. Klein and Michael E. Sykuta 2010
All rights reserved. No part of this publication may be reproduced, stored

in a retrieval system or transmitted in any form or by any means, electronic,
mechanical or photocopying, recording, or otherwise without the prior
permission of the publisher.
Published by
Edward Elgar Publishing Limited
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Cheltenham
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A catalogue record for this book

is available from the British Library
Library of Congress Control Number: 2009941001
ISBN 978 1 84542 766 5
Printed and bound by MPG Books Group, UK

03
Contents
List of contributors vii
PART I INTRODUCTION
1 Editors’ introduction 3
Peter G. Klein and Michael E. Sykuta
2 Transaction cost economics: an overview 8
Oliver E. Williamson
3 Transaction cost economics and the new institutional
economics 27
Peter G. Klein
PART II PRECURSORS AND INFLUENCES
4 Ronald H. Coase 39
Michael E. Sykuta
5 Cyert, March, and the Carnegie school 49
Mie Augier
6 Chester Barnard 58
Joseph T. Mahoney
7 Commons, Hurst, Macaulay, and the Wisconsin legal tradition 66
D. Gordon Smith
8 F.A. Hayek 74
Peter G. Klein
9 Herbert Simon 85
Saras Sarasvathy
10 Property rights economics 92
Nicolai J. Foss
PART III FUNDAMENTAL CONCEPTS
11 The costs of exchange 107

Alexandra Benham and Lee Benham
12 Asset specificity and holdups 120
Benjamin Klein
13 The transaction as the unit of analysis 127
Nicholas Argyres
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vi The Elgar companion to transaction cost economics
14 Bounded rationality and organizational economics 133

Nicolai J. Foss
15 Economizing and strategizing 140
Jackson A. Nickerson and James C. Yen
16 Empirical methods in transaction cost economics 152
Michael E. Sykuta
PART IV APPLICATIONS
17 Vertical integration 165

Peter G. Klein
18 Hybrid organizations 176
Claude Ménard
19 Franchising 185
Steven C. Michael
20 The structure of franchise contracts 194
Emmanuel Raynaud
21 Strategy and transaction costs 205
Laura Poppo
22 Labour economics and human resource management 215
Bruce A. Rayton
23 The Chicago school, transaction cost economics, and antitrust 230
Joshua D. Wright
24 Financial-market contracting 244
Dean V. Williamson
PART V ALTERNATIVES AND CRITIQUES
25 Critiques of transaction cost economics: an overview 263

Nicolai J. Foss and Peter G. Klein
26 Subjectivism, understanding, and transaction costs 273
Fu-Lai Tony Yu
27 Austrian economics and the theory of the firm 281
28 Limits of transaction cost analysis 297
Geoffrey M. Hodgson
Index 307
Contributors
Nicholas Argyres is Vernon W. and Marion K. Piper Professor of Strategy

at the Olin Business School, Washington University, St Louis, USA.
Mie Augier is a Research Associate Professor at the Navy Postgraduate
School, Monterey, California.
Alexandra Benham is a Founder and the Secretary of the Ronald Coase
Institute, St Louis, USA.
Lee Benham is Professor of Economics at Washington University, St
Louis, and a Board Member of the Ronald Coase Institute, St Louis,
USA.
Nicolai J. Foss is Professor and Director of the Centre for Strategic
Management and Globalization at the Copenhagen Business School,
Denmark and a Professor at the Norwegian School of Economics and
Business Administration, Norway.
Geoffrey M. Hodgson is Research Professor in Business Studies at the
University of Hertfordshire, UK.
Benjamin Klein is Professor Emeritus of Economics at the University of
California, Los Angeles, USA.
Peter G. Klein is Associate Professor in the Division of Applied Social
Sciences, University of Missouri, and Associate Director of the Contracting
and Organizations Research Institute, USA.
Joseph T. Mahoney is Investors in Business Education Professor of
Strategy and Director of Graduate Studies, Department of Business
Administration, University of Illinois at Urbana-Champaign, USA.
Claude Ménard is Professor of Economics and Senior Researcher at
the Centre d’Economie de la Sorbonne (CES) at the University Paris
(Panthéon-Sorbonne), France.
Steven C. Michael is Professor of Entrepreneurship and Strategy at the
Department of Business Administration, University of Illinois at Urbana-
Champaign, USA.
Jackson A. Nickerson is Frahm Family Professor of Organization and
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viii The Elgar companion to transaction cost economics
Strategy at the Olin Business School, Washington University, St Louis,

USA.
Laura Poppo is Professor and Fred Ball Faculty Fellow in Business at the
University of Kansas, USA.
Emmanuel Raynaud is Research Fellow at the French National Institute
for Agronomical Research (INRA) and member of the Centre d’Economie
de la Sorbonne (CES), University of Paris I, France.
Bruce A. Rayton is Lecturer in Business Economics at the University of
Bath Management School, UK.
Saras Sarasvathy is Isadore Horween Research Associate Professor of
Business Administration at the University of Virginia’s Darden School
of Business, USA.
D. Gordon Smith is Associate Dean for Faculty and Curriculum and Glen
L. Farr Professor of Law at the J. Reuben Clark Law School, Brigham
Young University, USA.
Michael E. Sykuta is Associate Professor in the Division of Applied Social
Sciences, University of Missouri, and Director of the Contracting and
Organizations Research Institute, USA.
Dean V. Williamson is Research Economist at the US Department of
Justice, Antitrust Division, Washington, DC, USA.
Oliver E. Williamson is Professor of the Graduate School and Edgar
F. Kaiser Professor Emeritus of Business, Economics, and Law at the
University of California, Berkeley, USA and 2009 Nobel Laureate in
Economics.
Joshua D. Wright is Associate Professor of Law at George Mason
University School of Law and Department of Economics, USA.
James C. Yen is Doctoral Candidate in Organization and Strategy at the
Olin Business School, Washington University, St Louis, USA.
Fu-Lai Tony Yu is Professor in the Department of Economics and Finance,
Hong Kong Shue Yan University, Hong Kong.
PART I
INTRODUCTION
1 Editors’ introduction
Peter G. Klein and Michael E. Sykuta
Since its emergence in the 1970s, the transaction cost approach to firms,
contracts, and economic organization has become one of the most impor-
tant, influential, and exciting fields in law, economics, and organization
theory. On applied topics such as vertical integration, the structure of
networks and alliances, franchise contracting, the multinational firm,
parts of antitrust analysis, marketing channels, and more, transaction
cost economics (TCE) has become a dominant, if not the mainstream,
perspective.
The transaction cost approach has its roots in the classic papers by
Coase in 1937 and 1960, which articulated the concepts of transaction costs
and property rights, and took form with the theories of the firm offered
by Williamson (1971, 1979), Alchian and Demsetz (1972), and Klein
et al. (1978), which introduced monitoring costs, relationship-specific
investments (or ‘asset specificity’), and particular notions of governance
and organizational mechanisms into the literature. TCE is expressed
most strongly in Williamson’s books Markets and Hierarchies (1975),
The Economic Institutions of Capitalism (1985), and The Mechanisms of
Governance (1996), though important contributions come from other
diverse sources. As described in the pages that follow, TCE has other
important antecedents, core concepts, applications, extensions, and cri-
tiques. This volume aims to introduce the novice, and to inform the spe-
cialist, about TCE’s fundamental elements, about recent controversies
and new developments, and about the place of TCE in the larger legal,
economic, and managerial literatures on organizations and institutions. It
does not attempt to provide a comprehensive overview of the field, a task
performed well in recent survey papers and volumes such as Williamson
(2000), Ménard and Shirley (2005), Brousseau and Glachant (2008) and
in many contemporary textbooks on industrial organization, managerial
economics, and business strategy.
We were both exposed to TCE in our graduate training and have been
closely associated with the field ever since. Klein studied under Williamson
at Berkeley in the late 1980s and early 1990s, eventually receiving his PhD
under Williamson’s supervision and focusing on the performance effects of
organizational form. Sykuta was trained directly by Douglass North, and
indirectly by Ronald Coase (via Lee Benham and others) at Washington
3
4 The Elgar companion to transaction cost economics
University, St Louis, where he wrote his PhD dissertation on the effects of

market and government institutions on contracting practices and industry
organization. We have both been active members of the International
Society for New Institutional Economics (ISNIE), the academic organi-
zation founded by Coase, North, Williamson, and others in 1998, and
we jointly direct the Contracting and Organizations Research Institute
(CORI) at the University of Missouri. CORI is an interdepartmental,
interdisciplinary research institute focused on empirical research on
contracts and business organization, inspired (and supported) by Coase
and his belief that research on contracts is hampered by a lack of data.
CORI maintains a digital archive of over 600 000 contracts available to
the research and practitioner communities, designed to facilitate research
to better understand how contracts are structured, how they are used and
enforced, and what purposes they serve.
TCE, and the new institutional economics more generally, are particu-
larly important at the University of Missouri. We take turns teaching a
required PhD course, ‘Economics of Institutions and Organizations’, in
the Division of Applied Social Sciences, we organize seminar and working
paper series on contracting and organizations, and we supervise many
graduate students working in this area. We also maintain strong ties with
institutions and organizations around the world focusing on transac-
tion costs and related issues such as the Centre d’Analyse Théorique des
Organisations et des Marchés (ATOM) in Paris, the Centre for Strategic
Management and Globalization (SMG) in Copenhagen, PENSA in São
Paulo, and others.
As we were preparing the manuscript for publication, in the Fall of
2009, we learned that Williamson had been awarded the 2009 Nobel
Prize in economics (shared with Elinor Ostrom). The Nobel citation rec-
ognized Williamson for ‘develop[ing] a theory where business firms serve
as structures for conflict resolution’. Williamson’s and Ostrom’s contri-
butions ‘have advanced economic governance research from the fringe
to the forefront of scientific attention’ (The Royal Swedish Academy of
Sciences, 2009). Indeed, the transaction cost approach, which focuses on
the benefits and costs of alternative institutions of governance, has become
part of the mainstream of economics and management research. Coase,
the most influential figure in the economic theory of the firm, received
the Nobel Prize in 1991, and North was recognized (along with Robert
Fogel) in 1993, giving the New Institutional Economics, of which TCE is
a part, three Nobel Prizes. We are delighted that the study of transactions,
and economic governance more generally, is now acknowledged as a core
element of social science research and policy.
At the same time, the reaction among economists to Williamson’s Nobel
Editors’ introduction 5
Prize highlighted a continuing tension about the role and place of TCE,
narrowly defined, within the more general field of organizational econom-
ics. The day of the Nobel announcement, Steven Levitt (2009) wrote, in his
‘Freakonomics’ blog:
When I was a graduate student at MIT back in the early 1990s, there was a
Nobel Prize betting pool every year. Three years in a row, Oliver Williamson
was my choice. At the time, his research was viewed as a hip, iconoclastic con-
tribution to economics – something that was talked about by economists, but
that students were not actually trying to emulate (and probably would have
been actively discouraged from had they tried to do so). What’s interesting is
that in the ensuing 15 years, it seems to me that economists have talked less and
less about Williamson’s research, at least in the circles in which I run. I suspect
most assistant professors of economics have barely heard of him. Yet I suspect
the older generation of economists will applaud this choice.
Levitt’s comments allude to the fact that the field of organizational

economics, including the theory of the firm, has become increasingly
formal, mainstream, and ‘neoclassical’, in a way that Williamson’s work
has never been. In particular, much (though by no means all) of the recent
theoretical work in the theory of the firm has followed the ‘incomplete
contracting’ approach associated with Oliver Hart (Grossman and Hart,
1986; Hart and Moore, 1990; Hart, 1995; Tirole, 1999; Baker et al., 2002).
The seminar papers by Coase (1937), Williamson (1971, 1979), Alchian
and Demsetz (1972), and Klein et al. (1978) are seen by many economists
as inspirational, suggestive, perhaps speculative pieces that provided the
basic ideas of the modern theory of the firm but in an informal, ‘loose’,
conjectural style that runs against the grain of modern, mainstream
theoretical analysis. Just as graduate students in economics no longer
read Smith, Ricardo, Marx, Keynes, and Hayek – whatever they need to
know about markets is in Debreu (1959), presumably – few of them read
Coase or Williamson to learn about organizations. Those wishing to learn
more about firms are probably encouraged to study some of the latest
incomplete-contracting models.
While we respect and admire the formal contracting literature, we agree
with Williamson (2000) that these models do not, by any means, capture
all the essential and useful features of TCE. We think TCE stands on
its own, and is not merely a preliminary step toward some other theory,
though we agree with Coase and Williamson that there is much more work
to do. As Williamson (2000, p. 595) notes, ‘we are still very ignorant about
institutions’. Interestingly, TCE is still highly influential in the strategic
management field, as evidenced by the collaborative volume, Economic
Institutions of Strategy, produced by a group of Williamson’s former
students (Nickerson and Silverman, 2009). Several of the chapters in this
volume explore the applications of TCE to various topics in strategy and

management.
The chapters in this work are organized into five sections: an intro-
ductory set, a section on precursors and influences, one on fundamental
concepts, another on applications, and a final section on alternatives and
critiques. The authors, established scholars in economics, management,
law, and related disciplines, come from a variety of backgrounds and take
different perspectives on TCE. All share the view, however, that the trans-
action cost perspective offers important, and typically unique, insight into
key organizational, managerial, and social issues of our day.
When Coase visited the University of Missouri in 2002, he spoke of the
need to ‘revolutionize economics’ through the careful, systematic study of
contractual relationships and contract documents. TCE may or may not
be revolutionary, but it stands with other important fields, movements,
or approaches within economics and related disciplines as both a chal-
lenge to orthodoxy and an extension, elaboration, and advance upon the
strongest elements of that tradition. Williamson (1996, p. 13) describes
the development of TCE as ‘modest, slow, molecular, definitive’. We hope
the chapters in this volume will not only inform, but also challenge the
reader to continue this development.
References
Alchian, A.A. and H. Demsetz (1972), ‘Production, information costs, and economic organi-
zation’, American Economic Review, 62 (5), 777–95.
Baker, G., R. Gibbons, and K. Murphy (2002), ‘Relational contracts and the theory of the
firm’, Quarterly Journal of Economics, 117 (1), 39–83.
Brousseau, E. and J.-M. Glachant (eds) (2008), New Institutional Economics: A Guidebook,
Cambridge: Cambridge University Press.
Coase, R.H. (1937), ‘The nature of the firm’, Economica, N.S., 4 (16), 386–405.
Coase, R.H. (1960), ‘The problem of social cost’, Journal of Law and Economics, 3 (October),
1–44.
Debreu, G. (1959), Theory of Value: An Axiomatic Analysis of Economic Equilibrium, New
Haven: Yale University Press.
Grossman, S. and O. Hart (1986), ‘The costs and benefits of ownership: a theory of lateral
and vertical integration’, Journal of Political Economy, 94 (4), 691–719.
Hart, O. (1995), Firms, Contracts and Financial Structure, Oxford: Clarendon Press.
Hart, O. and J. Moore, (1990), ‘Property rights and the nature of the firm’, Journal of
Political Economy, 98 (6), 1119–58.
Klein, B., R.A. Crawford, and A.A. Alchian (1978), ‘Vertical integration, appropriable rents,
and the competitive contracting process’, Journal of Law and Economics, 21 (2), 297–326.
Levitt, Steven D. (2009), ‘What This Year’s Nobel Prize in Economics Says About the Nobel
Prize in Economics’, Freakonomics Blog, 12 October, available at: http://freakonomics.
blogs.nytimes.com/2009/10/12/what-this-years-nobel-prize-in-economics-says-about-the-
nobel-prize-in-economics (accessed 16 November 2009).
Ménard, C. and M. Shirley (eds) (2005), Handbook of New Institutional Economics, New
York: Springer.
Nickerson, J.A. and B.S. Silverman (eds) (2009), Economic Institutions of Strategy, Bingley,
UK: Emerald.
Editors’ introduction 7
The Royal Swedish Academy of Sciences (2009), ‘The Prize in Economic Sciences 2009’, 12
October, available at: http://nobelprize.org/nobel_prizes/economics/laureates/2009/press.
pdf (accessed 16 November 2009).
Tirole, J. (1999), ‘Implicit contracts: where do we stand?’, Econometrica, 67 (4), 741–81.
Williamson, O.E. (1971), ‘The vertical integration of production: market failure considera-
tions’, American Economic Review, 61 (2), 112–23.
Williamson, O.E. (1975), Markets and Hierarchies: Analysis and Antitrust Implications, New
York: Free Press.
Williamson, O.E. (1979), ‘Transaction cost economics: the governance of contractual rela-
tions’, Journal of Law and Economics, 22 (3), 233–61.
Williamson, O.E. (1985), The Economic Institutions of Capitalism, New York: Free Press.
Williamson, O.E. (1996), The Mechanisms of Governance, New York: Oxford University
Press.
Williamson, O.E. (2000), ‘The new institutional economics: taking stock, looking ahead’,
Journal of Economic Literature, 38 (3), 595–613.
2 Transaction cost economics: an overview
Oliver E. Williamson
This overview of transaction cost economics (TCE) differs from prior

overviews to which I have contributed in two respects: it is especially
oriented at students who are new to but curious about the TCE litera-
ture; and it is organized around the ‘Carnegie Triple’ – be disciplined; be
interdisciplinary; have an active mind. It is partly autobiographical on the
latter account.1
The discussion begins with the Carnegie Triple and sets out five key
quotations that anchor the TCE project. The next three sections discuss
how TCE implements each element in the triple. Operationalization is
then examined. The conclusions follow.
Introduction
The Carnegie Triple

It was my privilege to have been a graduate student at the Graduate
School of Industrial Administration (GSIA) at the Carnegie Institute
of Technology (now the Tepper School of Business at Carnegie-Mellon
University) from 1960 through 1963. Those were halcyon years for GSIA.2
The small but accomplished faculty included Herbert Simon, Franco
Modigliani, Merton Miller, Richard Cyert, James March, John Muth,
Allan Meltzer, and William Cooper, the first three being subsequently
awarded Nobel Laureates in Economics. The graduate program was in
three parts: economics, organization theory, and operations research. All
of the graduate students took core courses in all three and subsequently
specialized in one. My major was in economics, but I drew continuously
on my training in organization theory (and selectively on operations
research).
The research atmosphere at Carnegie was exhilarating. Old issues were
revisited and new issues were opened up. Upon reflection, I describe the
training and research at Carnegie in terms of three imperatives: be disci-
plined; be interdisciplinary; have an active mind. It has been my experience
that all applied microeconomists subscribe to the first of these and many
to the third. The imperative ‘be interdisciplinary’ is more controversial.
Many students (mine included) boggle at organization theory.
This is partly because organization theory is an inherently difficult
8
An overview 9
subject. Also, few faculties have the likes of Simon, Cyert, and March to
learn from. However, my advice to students is to go native by removing
their economics cap and putting on an organization theory cap when they
open the organization theory text and enter the organization theory class-
room. What at first appear to be ‘inanities’ take on an altogether different
meaning and significance when they are interpreted not as peculiarities
but as intertemporal regularities of complex organizations. Many of these
regularities are consequential and need to be factored into the study of
economic organization.
Five quotations
James Buchanan distinguishes between the science of choice (the resource
allocation paradigm, which was dominant within economics throughout
the twentieth century) and the science of contract. He furthermore urges
that the science of contract should be given greater prominence: ‘mutual-
ity of advantage from voluntary exchange . . . is the most fundamental
of all understandings in economics’ (Buchanan, 2001, p. 29; emphasis
added).
As I have discussed elsewhere (Williamson, 2002a), the lens of contract
divides into two related branches: public ordering and private ordering.
The latter further divides into ex ante incentive alignment (agency theory,
mechanism design, property rights) and ex post governance branches.
Although these two are related, TCE focuses predominantly on the gov-
ernance of ongoing contractual relations.
This brings me to the second quotation, which is from John R.
Commons, who likewise took exception with the all-purpose adequacy of
the resource allocation paradigm (prices and output; supply and demand)
and reformulated the problem of economic organization as follows: ‘the
ultimate unit of activity . . . must contain in itself the three principles of
conflict, mutuality and order. This unit is a transaction’ (Commons, 1932,
p. 4). This prescient two sentence statement prefigures the study of govern-
ance in two respects:3 not only does the lens of contract/governance take
the transaction to be the basic unit of analysis, but governance is viewed as
the means by which to infuse order, thereby to mitigate conflict and realize
mutual gains. This is a recurrent theme.
The third quotation goes to the importance of economizing, broadly
in the spirit of Frank Knight’s observation that (1941, p. 252; emphasis
added):
Men in general, and within limits, wish to behave economically, to make
their activities and their organization ‘efficient’ rather than wasteful. This fact
does deserve the utmost emphasis; and an adequate definition of the science
of economics . . . might well make it explicit that the main relevance of the
discussion is found in its relation to social policy, assumed to be directed

toward the end indicated, of increasing economic efficiency, of reducing waste.
Of the various forms that economizing can take, TCE is predominantly

concerned with economizing on transaction costs – drawing inspiration
from Ronald Coase (1937; 1960) in this respect.
The fourth quotation is from Herbert Simon: ‘Nothing is more funda-
mental 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’ (1985, p. 303) – especially in cognitive and self-interestedness
respects. Although Simon and I had our differences (see, for example,
Simon, 1997; and Williamson, 2002c), I always pay heed to statements of
his such as this.
The fifth quotation is 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). I not only agree
that much of the relevant action is in the microanalytics, but, by reason
of the overwhelming complexity of the social sciences (Simon, 1957a, p.
89; Wilson, 1999, p. 183), I share Elster’s skepticism with general theories.
Out of respect for such complexity, ‘any direction you proceed in has a
very high a priori probability of being wrong’ on which account ‘it is good
if other people are exploring in other directions’ (Simon, 1992, p. 21).
Accordingly, TCE also subscribes to pluralism.
Be disciplined
General
Although TCE has been an interdisciplinary project from the outset (in
that law, economics, and organization theory are selectively combined),
first and foremost TCE is informed by economics. Standard textbook
economics, where the neoclassical resource allocation paradigm and
game theoretic reasoning are the main constructions, is the obvious place
to begin. TCE takes exception with the former for its failure to make
provision for positive transaction costs, if and as these are believed to
be consequential (Coase, 1937; 1960) – as, for example, in examining the
make-or-buy decision in the context of vertical integration. But this does
not dispute the merits of the neoclassical approach and apparatus as a
place to start – and, for many purposes, a place to finish. TCE shares a
good deal of common ground with game theory (Kreps, 1999, p. 127), in
that the parties to a contract are assumed to have an understanding of the
strategic situation within which they are located and position themselves
accordingly.4 TCE nevertheless differs in that it expressly makes provision
An overview 11
for contractual incompleteness as the limits on rationality become binding

by reason of transactional complexity. Also, TCE views governance as a
means by which to relieve the oppressive logic of ‘bad games’, of which the
prisoners’ dilemma is an exemplar.5
More generally, private ordering plays a prominent role in TCE in
that, if and as contractual hazards are posed, the immediate parties to an
exchange have an incentive to craft contract-specific safeguards – thereby
to realize mutual gains. If, moreover, they are unable to mitigate a hazard,
they can nevertheless price it out. As discussed in the Appendix, goods
and services will be exchanged on better terms with parties who exercise
feasible foresight and introduce credible commitments.
Private ordering is nevertheless implemented in the shadow of public
ordering, as with recourse to the courts for purposes of ultimate appeal.
Changes in the rules of the game should nevertheless be done mindful
of the benefits that accrue to private ordering. With respect to antitrust
enforcement, the public policy lesson is this: non-standard and unfamil-
iar private-ordering contracting practices and organizational structures
can and often do serve valued economizing purposes – whereas, for a
long time, these were presumed to have monopoly purpose and effect.6
If instead the economizing purpose to which Knight referred is the ‘main
case’, then this ought to be featured.
The priority given to economic reasoning does not, however, imply
exclusivity: economics can not do it all. As discussed below, organization
theory and the law also play important roles.
Pragmatic methodology
Describing himself as a native informant rather than as a certified method-
ologist, Robert Solow’s ‘terse description of what one economist thinks he
is doing’ (2001, p. 111) takes the form of three precepts: keep it simple; get
it right; make it plausible. Keeping it simple is accomplished by stripping
away inessentials, thereby to focus on first order effects – the main case,
as it were – after which qualifications, refinements, and extensions can be
introduced. Getting it right entails working out the logic. Making it plau-
sible means to preserve contact with the phenomena and eschew fanciful
constructions.
Solow observes with reference to the simplicity precept that ‘the very
complexity of real life . . . [is what] makes simple models so necessary’
(2001, p. 111). Keeping it simple requires the student of complexity to pri-
oritize: ‘Most phenomena are driven by a very few central forces. What a
good theory does is to simplify, it pulls out the central forces and gets rid
of the rest’ (Friedman, 1997, p. 196). Central features and key regularities
are uncovered by the application of a focused lens.
Getting it right ‘includes translating economic concepts into accurate

mathematics (or diagrams, or words) and making sure that further logical
operations are correctly performed and verified’ (Solow, 2001, p. 112).
Especially in the public policy arena (but also more generally), one of these
further logical operations is to ascertain whether putative ‘inefficiencies’
survive comparative institutional scrutiny. Because any display of inef-
ficiency simultaneously represents an opportunity for mutual gain, the
parties to such transactions have an incentive to relieve inefficiencies (in cost-
effective degree). What are the obstacles? What is the best feasible result?
Because the practice of comparing an actual outcome with a hypo-
thetical (zero transaction cost) ideal has been the frequent source of public
policy confusion and error,7 TCE introduces the remediableness criterion,
to wit: an extant practice for which no superior feasible alternative can be
described and implemented with expected net gain is presumed to be effi-
cient.8 This rebuttable presumption has the merit of forcing the analyst to
confront difficult choices rather than become distracted by and enamored
with unworkable ideals.
Plausible simple models of complex phenomena ought ‘to make sense
for “reasonable” or “plausible” values of the important parameters’
(Solow, 2001, p. 112). Also, because ‘not everything that is logically con-
sistent is credulous’ (Kreps, 1999, p. 125), fanciful constructions that lose
contact with the phenomena are suspect – especially if alternative and
more veridical models yield refutable implications that are congruent with
the data.
This then brings me to a fourth precept: derive refutable implications to
which the relevant (often microanalytic) data are brought to bear. Nicholas
Georgescu-Roegen had a felicitous way of putting it: ‘The purpose of
science in general is not prediction, but knowledge for its own sake’, yet
prediction is ‘the touchstone of scientific knowledge’ (1971, p. 37).
To be sure, new theories rarely appear full blown but evolve through a
progression during which the theory and evidence are interactive (Newell,
1990, p. 14):
Theories cumulate. They are refined and reformulated, corrected and expanded.
Thus, we are not living in the world of Popper – [theories are not] shot down
with a falsification bullet. Theories are more like graduate students – once
admitted you try hard to avoid flunking them out. Theories are things to be
nurtured and changed and built up.
Sooner or later, however, the time comes for a reckoning. All would-be
theories need to stand up and be counted.
Most social scientists know in their bones that theories that are congru-
ent with the data are more influential.9 Milton Friedman’s reflections on
An overview 13
a lifetime of work are pertinent: ‘I believe in every area where I feel that
I have had some influence it has occurred less because of the pure analy-
sis than it has because of the empirical evidence that I have been able to
organize’.10
Be interdisciplinary
Although there are many phenomena for which the application of self-
contained neoclassical reasoning is altogether sufficient (Reder, 1999),
students of complex organization should be alert to the possibility that
some – indeed, many – phenomena deviate from the neoclassical ideal
in consequential ways. Mechanical application of neoclassical reason-
ing can and sometimes does lead to contrived, convoluted, and mistaken
interpretations.
The qualified version of the injunction to ‘be interdisciplinary’ is this: be
prepared to cross disciplinary boundaries if and as this is needed to pre-
serve contact with the phenomena. Being interdisciplinary is conditional,
therefore, on a perceived need and is introduced strictly in a pragmatic
way. Such conditionality notwithstanding, training in one or more of
the contiguous social sciences is instructive for all students of economic
organization. The pragmatic reason for such training is this: economists
who lack an appreciation that some of what is going on out there has
non-economic origins will be neglectful of or will misinterpret forces that
are responsible for consequential regularities that ought to be taken into
account. As hitherto indicated, TCE joins economics with organization
theory and selected aspects of the law (especially contract law).
Organization theory
Organization theory is a vast subject and comes in many flavors (Scott,
1987). My uses of organization theory rely mainly on the ‘rational systems’
approach that is associated with Chester Barnard, Herbert Simon, and
Carnegie in its heyday (March and Simon, 1958).11 As matters stand pres-
ently, the three chief contributions of organization theory to TCE are the
description of human actors, the importance of coordinated adaptation,
and recurrent intertemporal regularities.
Human actors Attributes of human actors that bear crucially on the lens
of contract/governance are cognition, self-interest, and foresight (where
the last can be considered an extension upon cognition).
Human actors are described as boundedly rational, by which I mean
‘intendedly rational, but only limitedly so’ (Simon, 1957b, p. xxiv). So
described, boundedly rational human actors lack hyperrationality but
are neither non-rational nor irrational. Rather, such human actors are
attempting rationally to cope. For TCE purposes, the key ramification of

bounded rationality for the study of contract is that all complex contracts
are unavoidably incomplete. The analytically convenient fiction of com-
plete contracting is thus disallowed.
Self-interest is described in a two-part way. Routine events are described
as benign – in that most people will do what they say most of the time and
some will do more. Outliers, however, pose tensions. The spirit of coopera-
tion that facilitates ongoing adaptations to routine disturbances prospec-
tively gives way to a more calculative orientation as the stakes increase.
The hazard of opportunism – defection from the spirit of cooperation in
favor of the letter of the contract – thus arises.
Such defection poses a hazard for interfirm contracts if one or both
parties make specialized (nonredeployable) investments in support of
the contract. The resulting condition of bilateral dependency need not,
however, imply that interfirm contracting is no longer viable. To the
contrary, the capacity for ‘feasible foresight’ permits the parties to look
ahead, uncover possible hazards, work out the mechanisms, and there-
after craft credible commitments. Boundedly rational human agents who
possess feasible foresight will thus attempt to mitigate contractual hazards
in a cost-effective degree, as a result of which the efficacy of contracting is
extended over a wider range. Fewer transactions are taken out of markets
and organized internally on this account.
Coordinated adaptation Adaptation is taken to be the main problem of

economic organization, of which two kinds are distinguished: autonomous
adaptations in the market that are elicited by changes in relative prices, as
described by the economist F.A. Hayek (1945), and coordinated adapta-
tions of a ‘conscious, deliberate, purposeful kind’ accomplished with the
support of hierarchy, as described by the organization theorist Chester
Barnard (1938). Conditional on the attributes of transactions, adaptations
of both kinds are important – which is to say that TCE examines markets
and hierarchies in a combined way (rather than persist with the old ideo-
logical divide between markets or hierarchies). Explicating the differential
efficacy of alternative modes of governance – whereby markets enjoy the
advantage in autonomous adaptation respects, the advantage shifts to
hierarchy as transactions pose a greater need for consciously coordinated
adaptations, and hybrid modes are a compromise mode that displays
adaptive capacities of both kinds (albeit in an intermediate degree) – is
central to a predictive theory of governance.
Intertemporal regularities As Philip Selznick has observed, organization,

like the law, has a ‘life of its own’ (1966, p. 10). If and as intertemporal
An overview 15
regularities have a significant impact on the organization of economic

activities, such regularities need to be uncovered, interpreted, and the eco-
nomic ramifications worked out. Among the significant regularities that
bear on the economics of governance are the entrenchment advantages
that accrue to leadership. Both in politics (Michels, 1962) and more gener-
ally, ‘there is a tendency for decisions to be qualified by the special goals
and problems of those to whom [leadership is delegated]’ (Selznick, 1966,
p. 258).
The special goals to which Selznick refers often take the form of goal
distortions (managerial discretion) and career concerns (influence costs)
while many of the problems take the form of bureaucratic costs. In the
degree to which these are consequential, intertemporal effects of all three
kinds are properly factored into the comparative governance calculus.
Most economic theories of firm and market organization nevertheless
ignore these and/or regard them as outside the ambit. Thus although Oskar
Lange described bureaucratization rather than resource allocation as the
‘real danger of socialism’, he chose to set bureaucratization aside because
it ‘belongs to the field of sociology rather than . . . economic theory’ (1938,
p. 109). This reluctance to cross interdisciplinary boundaries, if and as the
phenomena warrant, is still widespread.
The Fundamental Transformation is perhaps the most distinctive inter-
temporal regularity within the TCE setup. It refers to the transformation
of a large numbers bidding competition at the outset into a small numbers
supply relation during contract implementation and at contract renewal
intervals for transactions that are supported by significant investments in
transaction specific assets. Such bilateral dependencies present the parties
with contractual hazards for which, as discussed above, governance sup-
ports are introduced to effect hazard mitigation in cost-effective degree.
Going public with a high-tech start-up firm or leveraged buyout is also
attended by significant intertemporal transformations. Start-ups are high-
risk undertakings that combine venture capitalists with entrepreneurial,
technical, and legal talent in a race to be first. Real-time responsiveness is
of the essence. Leveraged buyouts respond to financial and organizational
misalignments by mobilizing finance, replacing the incumbent management,
and reshaping the firm and its financing by substituting debt for equity (as
appropriate) and selling or spinning off unrelated parts. The big rewards for
each are concentrated in the ‘going public’ transaction, after which the high-
powered incentives and real-time responsiveness of the entrepreneurial
actors give way to a business-as-usual enterprise in which routines set in.
Also, the array of phenomena that cluster under the rubric of ‘path
dependency’ all involve intertemporal transformations of one type or
another. Whereas many of these transformations are commonly interpreted
as unfair or anticompetitive from an orthodox perspective, TCE interprets

all path-dependent practices with reference to the aforementioned reme-
diableness criterion. Awaiting a demonstration that superior feasible and
implementable alternatives can be devised, social scientists need to come to
terms with, rather than denounce, unwanted path-dependent outcomes.
Finally, although some students of economic organization aver that
TCE is remiss in ‘dynamic’ respects, I would observe that TCE has been an
exercise in adaptive, intertemporal economic organization from the outset
(Williamson, 1971; 1975; 1985; 1991).12 To be sure, featuring adaptive dif-
ferences among alternative modes of governance and making provision
for intertemporal transformations are primitive forms of dynamics. Critics
who would push beyond are invited to do so – mindful of the fact that it is
easier to say, rather than do, dynamics.13
Contract law
Whereas the details of firm and market organization are scanted under
the lens of choice setups, the lens of contract/governance describes each
generic mode of governance (market, hybrid, hierarchy) as a distinct
syndrome of attributes, each of which differs in incentive intensity, admin-
istrative control, and contract law respects. These differences give rise to
different adaptive strengths and weaknesses.
Of these attribute differences, I call attention here principally to the
way in which contract law regimes vary across modes. By contrast with
economic orthodoxy, which implicitly assumes that there is a single,
all-purpose law of contract that is costlessly enforced by well-informed
courts, the lens of contract treats court ordering as a special case and
holds that the operative law of contract varies among alternative modes
of governance.
Thus, whereas the contract law of markets is legalistic (corresponds to
the ideal transaction in both law and economics, whereby disputes are
settled by court-ordered money damages, after which each party goes its
own way), hybrid transactions and, especially, hierarchical transactions
are ones for which continuity is valued. The common view of contract as
legal rules thus gives way to the more elastic concept of ‘contract as frame-
work’, where the framework ‘never accurately indicates real working rela-
tions, but . . . affords a rough indication around which such relations vary,
an occasional guide in cases of doubt, and a norm of ultimate appeal when
the relations cease in fact to work’ (Llewellyn, 1931, p. 736).
Whereas contract as framework applies to hybrid transactions, the coor-
dinated adaptations of the conscious, deliberate, purposeful kind to which
Barnard referred are realized through administration. This entails taking
transactions out of markets and organizing them internally – to which yet
An overview 17
another law of contract, the contract law of internal organization, applies.

Except when fraud, illegality or conflict of interest is shown, the courts
have the good sense to refuse to hear interdivisional disputes that arise
within firms – with respect, for example, to transfer pricing, overhead,
accounting, the costs to be ascribed to intrafirm delays, failures of quality,
and the like. In effect, the contract law of internal organization is that of
forbearance, according to which the firm becomes its own court of ulti-
mate appeal (Williamson, 1991). Firms for this reason are able to exercise
fiat that markets cannot. Whereas such fiat differences between firm and
market were long recognized by organization theorists, Armen Alchian
and Harold Demsetz (1972), among others, held that firm and market are
indistinguishable in fiat respects. Not only does TCE hold otherwise, but
the contract law differences that TCE associates with alternative modes
of governance are among the reasons why governance structures differ in
discrete structural ways.
Have an active mind

In the degree to which interdisciplinary training opens windows and
promotes curiosity, which it often does, the Carnegie program encour-
aged the student of economic organization to have an active mind. Roy
D’Andrade (1986) captures the spirit in his contrast between authoritative
and inquiring research orientations. Whereas the former is characterized
by an advanced state of development, is self-confident, and declares that
‘this is the law here’, the latter is more tentative, pluralist, and exploratory
and poses the question, ‘What is going on here?’ The first is commonly of
a top-down kind; the latter favors bottom-up constructions. Theoretical
physics is widely regarded as the exemplar of the imperial tradition, but
parts of economics also have these aspirations – as witness Solow’s obser-
vation that ‘there is a lot to be said in favor of staring at the piece of reality
you are studying and asking, just what is going on here? Economists who
are enamored of the physics style seem to bypass that stage’ (Solow, 1997,
p. 57; emphasis added).
To be sure, few economists have no curiosity whatsoever about the
phenomena. The readiness, however, to impose preconceptions – rather
than to get close to the phenomena by asking and attempting to answer
the question, ‘What is going on here?’ – is nevertheless widespread, as John
McMillan notes in contrasting his research strategy and that of others
(2002, p. 225; emphasis added):
To answer any question about the economy, you need some good theory to
organize your thoughts and some facts to ensure that they are on target. You
have to look and see how things actually work or do not work. That might seem
so trite as not to be worth saying, but assertions about economic matters that
are based more on preconceptions than on the specifics of the situation are still
regrettably common.
Those who have an abiding interest in economic organization are thus

advised to combine detailed knowledge of the phenomena, to which
the ‘look and see’ contributions of organization theorists are frequently
pertinent, with a focused lens. Indeed some economists, myself included,
subscribe to pluralism – in that a deeper understanding of complex phe-
nomena will sometimes benefit from the application of several focused
lenses (some of which may be rival but others complementary).
Note, moreover, that the imperial and inquiring research traditions
can coexist, sometimes sequentially. To illustrate, whereas the vast trans-
formation in corporate finance that was accomplished when Franco
Modigliani and Merton Miller (1958) pushed the logic of zero transaction
cost contracting to completion, many of the follow-on qualifications to
the Modigliani–Miller theorem assumed, implicitly if not explicitly, that
transaction costs are positive. For students at Carnegie when Modigliani,
Miller, Muth, Simon, March, and others were all on the faculty, this was
a constructive tension.
Operationalization
Ronald Coase’s 1937 paper on ‘The Nature of the Firm’ expressly
confronted an embarrassing lapse: whereas the distribution of activity
between firm and market had been taken as given by economists, the
boundary of the firm should be derived from the application of economiz-
ing reasoning to the make-or-buy decision. Coase traced this lapse to the
prevailing assumption within economics that transaction costs were zero.
Even more embarrassing was his subsequent demonstration that externali-
ties (more generally, market failures) would vanish when the logic of zero
transaction costs is pushed to completion (Coase, 1960), since the parties
would everywhere realize mutual gains by costlessly bargaining to an effi-
cient outcome.
Although transaction cost reasoning began to take hold during the
1960s, such costs were often invoked in a one-sided way – as with
the argument that, given the presumed efficacy of costless bargaining,
the role of the government reduced to defining and enforcing property
rights (Coase, 1959). Also, transaction costs were frequently invoked in a
tautological way, thereby to ‘explain’ any puzzling phenomenon whatso-
ever after the fact. Ready recourse to such reasoning earned transaction
costs a ‘well-deserved bad name’ (Fischer, 1977, p. 322, n. 5).
Both the longstanding neglect of transaction costs and ad hoc uses of
An overview 19
transaction cost reasoning were unsatisfactory. What to do? The unmet

need was to operationalize the concept of transaction cost, broadly with
reference to the four precepts of pragmatic methodology. Addressing
the issues in a comparative institutional way with applications to specific
phenomena facilitated operationalization efforts. Comparative analysis,
moreover, relieves the need to take absolute measures of transaction cost,
since the object is to ascertain the factors that are responsible for differential
transaction costs as between alternative modes of governance.14 Such efforts
were begun in the 1970s and continue to this day. As elaborated elsewhere,
key operationalizing moves include the following:
1. Rather than proceed in a fully general way, TCE focuses on specific

phenomena, of which vertical integration (the make-or-buy decision)
is the paradigm problem. This choice had two advantages: it expressly
addresses the puzzle to which Coase (1937) referred; and transactions
in intermediate product markets are less beset by contractual compli-
cations (such as asymmetries of information, resources, expertise, and
risk aversion) than are other transactions.
2. The transaction is made the basic unit of analysis and is thereafter
dimensionalized (with emphasis on asset specificity, contractual dis-
turbances (uncertainty), and frequency).
3. Alternative modes of governance are described as internally consistent
syndromes of attributes to which distinctive strengths and weaknesses
– in autonomous and coordinated adaptation respects – accrue.
4. Economizing on transaction cost is taken to be the cutting edge, where
this is implemented through 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 outcome.
5. The basic regularities are captured in the simple contractual schema
(see the Appendix), through which many other contractual phenom-
ena can be interpreted as variations on a theme. Indeed, any issue that
arises as or can be reconceptualized as a contracting problem can be
interpreted to advantage in transaction cost economizing terms.
6. Empirical tests of the predictions of the theory have ensued. By con-
trast with theories of economic organization that yield few refutable
implications and/or are very nearly nontestable, TCE invites and has
benefited from empirical testing. Indeed, ‘despite what almost 30 years
ago may have appeared to be insurmountable obstacles to acquiring
the relevant data [which are often microanalytic and require primary
data], today transaction cost economics stands on a remarkably broad
empirical foundation’ (Geyskens et al. 2006, p. 531). There is no
question that TCE is more influential because of the empirical work

that it has engendered.
7. Public policy has been transformed by working up the efficiency/
inefficiency ramifications of TCE for complex contract and economic
organization.15
Conclusions
As compared with most contributions to the rapidly growing literature
on contract and economic organization, TCE is more interdisciplinary,
insistently emphasizes refutable implications, invites empirical testing, and
is more concerned with public policy ramifications. Although still under-
going development in fully formal modeling respects (Bajari and Tadelis,
2001; Tadelis, 2002; Levin and Tadelis, 2005; Tadelis and Williamson,
2007), the combination of semi-formal models (Riordan and Williamson,
1985), diagrams (such as the simple contractual schema), and a widely
shared verbal understanding of the logic of discriminating alignment have
provided the impetus for the numerous TCE applications described else-
where (Williamson, 1990, pp. 192–4; 2005b; Macher and Richman, 2006).
Indeed, the move from words to diagrams to mathematical models is what
the natural progression contemplates.
Headway in the future will be realized as it has in the past – not by the
creation of a general theory but by proceeding in a modest, slow, molecular,
definitive way, placing block upon block until the value added cannot be
denied. It is both noteworthy and encouraging that so many young scholars
have found productive ways to connect. TCE, moreover, has benefited from
rival and complementary perspectives – especially those that subscribe to the
four precepts of pragmatic methodology. Such pluralism brings energy to the
elusive ambition of realizing the ‘science of organization’ to which Chester
Barnard (1938) made reference over 70 years ago. As the Handbook of
Organizational Economics (Gibbons and Roberts, 2010) reveals, the econom-
ics of organization, of which TCE is a part, is a vibrant research agenda.
Notes
1. Overviews that I have done previously have gone more thoroughly into the mechanisms
of governance and applications of the lens of contract/governance (Williamson, 1989,
1998, 2002b, 2005a). See also the recent overviews of Claude Ménard (2004) as well as
the forthcoming paper by Steven Tadelis (2010).
The target audience for this chapter is students who have completed their second year
of a PhD program in economics, business, or the contiguous social sciences and are
considering whether to take courses in the economics of organization and/or the eco-
nomics of institutions preparatory to doing their dissertations. The common features
that I associate with success of these students are these: they have a good grasp of text-
book microeconomic theory and of the core courses in their respective fields; they have
interdisciplinary interests; they have an abiding curiosity in understanding the purposes
An overview 21
served by complex economic (and noneconomic) organizations; and, because the action
resides in the details, they are prepared to engage the microanalytics in theoretical,
empirical, and public policy respects.
2. Jacques Dreze, who was a visitor at Carnegie, speaks for me and many others in recall-
ing his time at Carnegie as follows: ‘Never since have I experienced such intellectual
excitement’ (1995, p. 123).
3. This and other insights of older style institutional economics would nevertheless remain
dormant for many years, primarily for lack of a positive research agenda (Stigler, 1983,
p.170) – which I take to mean lack of operationalization. Older style institutional eco-
nomics did not, however, lack for good ideas, views to the contrary notwithstanding
(Coase, 1984, pp. 229–30). The New Institutional Economics, of which TCE is a part,
draws selectively on the insights of Commons and others and seeks to breathe opera-
tional content into them.
4. ‘Speaking as a tool-fashioner interested in developing tools that better deal with the
world-as-it-is, I believe game theory (the tool) has more to learn from transaction cost
economics than it will have to give, at least initially’ (Kreps, 1999, p. 122; emphasis
added). But Kreps plainly contemplates give-and-take.
5. Rather than assume that players are accepting of the coercive payoffs that are associated
with the prisoners’ dilemma – according to which each criminal is induced to confess,
whereas both would be better off if they could commit not to confess – TCE assumes
that the criminals (or their handlers, such as the mafia) can, upon looking ahead, take
ex ante actions to alter the payoffs by introducing private ordering penalties to deter
defections. This latter is a governance move, variants of which can be introduced into
many other bad games.
6. Jack Muth, in his low-key way, suggested to me (when I was working on my disserta-
tion on managerial discretion at Carnegie) that since shareholders were not ignorant
of deviations from single-minded profit maximization, they would adjust the terms of
trade for equity capital accordingly.
7. As Ronald Coase observed of economic thinking in the 1970s, ‘If an economist finds
something – a business practice of one sort or another – that he does not understand, he
looks for a monopoly explanation. And as in this field we are very ignorant, the number
of ununderstandable practices tends to be very large, and the reliance on a monopoly
explanation frequent’ (1972, p. 67). Such knee-jerk public policy nevertheless persisted.
Here, as elsewhere, it takes a theory to beat a theory.
8. See Coase (1964) and Harold Demsetz (1967).
9. As Dr Stephen Strauss, who directs the National Center for Complementary and
Alternative Medicine, puts it, ‘Things that are wrong are ultimately put aside, and
things that are right gain traction. There are the conflicting tides of belief and fact,
and each has its own chronology. Things don’t change quickly, but over time a cumula-
tive body of evidence becomes compelling’ (as quoted by Jerome Groopman, 2006, p.
A12). There is no question that TCE has been more influential because of the large and
growing body of empirical research that it has generated (Shelanski and Klein, 1995;
Macher and Richman, 2006).
10. Personal communication, 6 February 2006, from Milton Friedman to the author.
11. As I have discussed elsewhere, parts of the ‘resource dependency’ literature are perti-
nent but fail to push the logic to completion. Of special relevance to TCE is the poten-
tially important concept of embeddedness (Granovetter, 1985). Regrettably, 20 years
later and counting, this concept still suffers for lack of operationalization. Be that as
it may, economics needs to be informed by those contributions of organization theory
that withstand the test of time.
12. TCE implements the proposition that adaptation (of autonomous and coordinated
kinds) is the central purpose of economic organization – which is an intertemporal
construction to which refutable implications accrue.
13. For an early and primitive effort to work up the dynamics of managerial discretion, see
Williamson (1970, Chapter 5).
14. ‘In general, much cruder and simpler arguments will suffice to demonstrate an inequal-
ity between two quantities than are required to show the conditions under which these
quantities are equated at the margin’ (Simon, 1978, p. 6).
15. Corporate governance provides a recent example of the interaction of theory and evi-
dence. Thus whereas the initial application of the lens of contract to equity finance led
into an interpretation of the board of directors as monitor, thereby to safeguard the
interests of shareholders, an examination of boards in practice suggests a dual-purpose
interpretation whereby the board serves two credible contracting purposes: monitoring
and delegation (Williamson, 2007).
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Tadelis, Steven (2010), ‘Transaction cost economics’, unpublished manuscript, University of
California, Berkeley.
Williamson, Oliver E. (1970), Corporate Control and Business Behavior, Englewood-Cliffs,
NJ: Prentice-Hall.
Williamson, Oliver E. (1971), ‘The vertical integration of production: market failure consid-
erations’, American Economic Review, 61 (2), 112–23.
Williamson, Oliver E. (1975), Markets and Hierarchies: Analysis and Antitrust Implications,
New York: Free Press.
Williamson, Oliver E. (1985), The Economic Institutions of Capitalism, New York: Free
Press.
Williamson, Oliver E. (1989), ‘Transaction cost economics’, in Richard Schmalensee and
Robert Willig (eds), Handbook of Industrial Organization, Amsterdam: North Holland,
pp. 135–82.
Williamson, Oliver E (1990), ‘Chester Barnard and the incipient science of organization’, in
Oliver E. Williamson (ed.), Organization Theory: From Chester Barnard to the Present and
Beyond, New York: Oxford University Press, pp. 172–206.
Williamson, Oliver E. (1991), ‘Comparative economic organization: the analysis of discrete
structural alternatives’, Administrative Science Quarterly, 36 (2), 269–96.
Williamson, Oliver E. (1998), ‘Transaction cost economics: how it works, where it is headed’,
De Economist, 146 (1), 23–58.
Williamson, Oliver E. (2002a), ‘The lens of contract: private ordering’, American Economic
Review, 92 (2), 438–43.
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to contract’, Journal of Economic Perspectives, 16 (3), 171–95.
Williamson, Oliver E. (2002c), ‘Empirical microeconomics: another perspective,’ in Mie
Augier and James March (eds), The Economics of Choice, Change, and Organization,
Cheltenham, UK and Northampton, MA, USA: Edward Elgar Publishing, pp. 419–41.
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95 (2), 1–18.
Williamson, Oliver E. (2005b), ‘Transaction cost economics and business administration’,
Scandinavian Journal of Management, 21 (1), 19–40.
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perspective’, unpublished manuscript, University of California, Berkeley.
Wilson, Edward O. (1999), Consilience, New York: Alfred Knopf.
Appendix
The simple contractual schema

The paradigm transaction for TCE is vertical integration (or, in more
mundane terms, the make-or-buy decision). Not only is vertical integra-
tion the obvious candidate transaction (Coase, 1937), but, because it is less
beset with asymmetries of information, budget, legal talent, risk aversion,
and the like than are many other transactions, it is simpler. Not only are
transaction cost features more transparent for the make-or-buy decision,
but the simple contractual schema described below applies (with varia-
tion) to the study of transactions more generally.
Thus assume that a firm can make or buy a component and assume
An overview 25
A (unassisted market)
k=0
B (unrelieved hazard)
s =0
C (hybrid
k>0 contracting)
market support
s >0
administrative support
D (internal
organization/firm)
Figure 2.1 Simple contractual schema
further that the component can be supplied by either a general purpose

technology or a special purpose technology. Letting k be a measure of
asset specificity, the transactions in Figure 2.1 that use the general purpose
technology are ones for which k = 0. In this case, no specific assets are
involved and the parties are essentially faceless. Transactions that use
the special purpose technology are those for which k > 0. Such transac-
tions give rise to bilateral dependencies, in that the parties have incentives
to promote continuity, thereby to safeguard specific investments. Let s
denote the magnitude of any such safeguards, which include penalties,
information disclosure and verification procedures, specialized dispute
resolution (such as arbitration) and, in the limit, integration of the two
stages under unified ownership. An s = 0 condition is one for which no
safeguards are provided; a decision to provide safeguards is reflected by
an s > 0 result.
Node A in Figure 2.1 corresponds to the ideal transaction in law
and economics: there being an absence of dependency, governance is
accomplished through competition and, in the event of disputes, by court
awarded damages. Node B poses unrelieved contractual hazards, in that
specialized investments are exposed (k > 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.
Added contractual supports (s > 0) are provided at Nodes C and D. At
Node C, these contractual supports take the form of interfirm contractual
safeguards. Should, however, costly breakdowns continue in the face of
best bilateral efforts to craft safeguards at Node C, the transaction may be

taken out of the market and organized under unified ownership (vertical
integration) instead. Because added bureaucratic costs 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, try hybrids, and have recourse to the firm only when all else
fails. Node D, the unified firm, thus comes in only as higher degrees of
asset specificity and added uncertainty pose greater needs for cooperative
adaptation.
Note that the price that a supplier will bid to supply under Node C
conditions will be less than the price that will be bid at Node B. That is
because the added security features at Node C serve to reduce the con-
tractual hazard, as compared with Node B, so the contractual hazard
premium will be lowered. One implication is that suppliers do not need to
petition buyers to provide safeguards. Because buyers will receive goods
and services on better terms (lower price) when added security is provided,
buyers have the incentive to offer credible commitments.
3 Transaction cost economics and the new
institutional economics
Peter G. Klein
The concept of transaction costs is central to the modern economic analysis

of organizations and institutions, and transaction cost economics (TCE)
is often regarded as a subset of what has been called the new institutional
economics. The term ‘new institutional economics’ (NIE), introduced into
the literature by Williamson (1975), emerged in the 1970s and 1980s as a
convenient label encompassing TCE, parts of the ‘new’ economic history
(particularly the contributions of Douglass North), positive political
economy, and related developments in applied social science. Klein (2000,
p. 456) describes the NIE as:
an interdisciplinary enterprise combining economics, law, organization theory,

political science, sociology and anthropology to understand the institutions of
social, political and commercial life. It borrows liberally from various social-
science disciplines, but its primary language is economics. Its goal is to explain
what institutions are, how they arise, what purposes they serve, how they
change and how – if at all – they should be reformed.1
Institutions and the economics of institutions

North (1991, p. 97) defines institutions as:
humanly devised constraints that structure political, economic and social inter-
action. They consist of both informal constraints (sanctions, taboos, customs,
traditions, and codes of conduct), and formal rules (constitutions, laws, prop-
erty rights). . . . Together with the standard constraints of economics they define
the choice set and therefore determine transaction and production costs and
hence the profitability and feasibility of engaging in economic activity.
This definition places institutional analysis squarely within the ‘rational’

or optimizing framework of conventional economics. Just as economic
actors think, act, and choose while constrained by resource availability,
technical and practical knowledge, the behaviour of other actors, and so
on, they are also constrained by informal and formal institutions. Some
of these, such as characteristics of the legal and political system, lan-
guage, culture, and social conventions, are taken by actors as exogenous
(though they may ultimately be explainable in terms of purposeful human
27
behaviour – what Hayek (1967, 1973–79) calls the ‘result of human action
but human design’). Other constraints, such as contractual arrangements,
are designed by particular actors to achieve specific purposes (namely,
exploiting gains from trade).
What is ‘new’ about the NIE? Until the 1980s, ‘institutional economics’
usually referred to the writings of Thorstein Veblen, John R. Commons,
Wesley C. Mitchell, Clarence Ayres, and their followers. This is a diverse
group, but their work reflects several common themes, mostly criticisms
of orthodox economics: (1) a focus on collective rather than individual
action; (2) a preference for an ‘evolutionary’ rather than mechanistic
approach to the economy; and (3) an emphasis on empirical observation
over deductive reasoning.2 Whatever their contributions, the older insti-
tutionalists are little known to most contemporary economists. Coase’s
(1984, p. 230) dismissal is typical: ‘Without a theory they had nothing to
pass on except a mass of descriptive material waiting for a theory, or a
fire’. The NIE, by contrast, eschews the holism of the older school, sharing
the methodologically individualist outlook of Max Weber, the Austrians,
and most neoclassical economists (Udehn, 2002). Of course, NIE appreci-
ates social phenomena like corporate culture, organizational memory, and
so on. Still, the NIE takes these as explananda, not explanans, couching
its explanations in terms of the goals, plans, and actions of individuals.
Examples include Menger’s (1892) analysis of the origin of money or more
recent game-theoretic or rational-choice explanations for the emergence
of norms, conventions, and customary law (Ullman-Margalit, 1977;
Schotter, 1981; Sugden, 1986; Benson, 1990; Ellickson, 1991).
New institutional economists typically work with a broader, or looser,
notion of ‘rationality’ than their neoclassical counterparts, however. While
Williamson’s (2000, p. 600) claim that there is ‘close to unanimity within
the NIE on the idea of limited cognitive competence – often referred to
as bounded rationality’ may be an exaggeration, there is certainly more
sensitivity to cognitive and behavioural issues in the NIE than in most of
applied economics (see Chapter 14 by Foss in this volume on bounded
rationality for details). There is also an attention to evolution and process.
Institutions, writes North (1991, p. 97), ‘evolve incrementally, connecting
the past with the present and the future; history in consequence is largely
a story of institutional evolution in which the historical performance of
economies can only be understood as a part of a sequential story.’
Another distinction of the NIE is its insistence that policy analysis be
guided by what has become known as ‘comparative institutional analysis’.
Orthodox welfare analysis typically compares real-world outcomes with
the hypothetical benchmark of perfectly competitive general equilibrium.
It is unsurprising, then, that actual market outcomes will come up short.
New institutional economics 29
The relevant question, Coase (1964, p. 195) explains, is whether a feasible

alternative can be devised:
Contemplation of an optimal system may provide techniques of analysis that
would otherwise have been missed and, in certain special cases, it may go far
to providing a solution. But in general its influence has been pernicious. It has
directed economists’ attention away from the main question, which is how
alternative arrangements will actually work in practice. It has led economists
to derive conclusions for economic policy from a study of an abstract of a
market situation. It is no accident that in the literature . . . we find a category
‘market failure’ but no category ‘government failure’. Until we realise that we
are choosing between social arrangements which are all more or less failures, we
are not likely to make much headway.3
As Demsetz (1969, p. 1) puts it, ‘[t]he view that now pervades much
public policy economics implicitly presents the relevant choice as between
an ideal norm and an existing “imperfect” institutional arrangement. This
nirvana approach differs considerably from a comparative institution
approach in which the relevant choice is between alternative real institu-
tional arrangements’.
Levels of analysis
The NIE can be divided into two branches following Davis and North’s
(1971) distinction between the ‘institutional environment’ and ‘institu-
tional arrangements’. The former refers to the background constraints, or
‘rules of the game’, that guide individuals’ behaviour. These can be both
formal, explicit rules (constitutions, laws, property rights) and informal,
often implicit rules (social conventions, norms). While these background
rules are the product of – and can be explained in terms of – the goals,
beliefs, and choices of individual actors, the social result (the rule itself) is
typically not known or ‘designed’ by anyone.4 Institutional arrangements,
by contrast, are specific guidelines – what Williamson (1985, 1996) calls
‘governance structures’ – designed by trading partners to mediate par-
ticular economic relationships. Business firms, long-term contracts, public
bureaucracies, nonprofit organizations, and other contractual agreements
are examples of institutional arrangements.
Williamson (2000) distinguishes further between four levels of analy-
sis: embeddedness (informal institutions, customs, traditions, norms,
religion); the institutional environment (formal rules of the game such as
property law); governance (the play of the game, as manifest in contracts
and organizations); and resource allocation and employment (prices and
quantities, incentive alignment). Decisions about resource allocation,
focusing on equating benefits and costs at the margin, are made moment-
by-moment, while changes in governance, aiming to align governance
structures with transactional characteristics, occur more slowly. Changes

to, and the evolution of, the institutional environment and embedded
norms take place even more gradually, and are (particularly in the case
of embedded norms) typically the ‘spontaneous’ result of unintended
consequences.
What is the relationship among levels? How does the institutional envi-
ronment affect institutional arrangements? This is an under-researched
area in the NIE and in TCE. Evidence on firm boundaries suggests that
firms internalize transactions as a response to weaknesses in the institu-
tional environment. In countries with stable legal institutions, relatively
efficient courts, and reasonable default rules for contract terms, for
example, contracts tend to be less complete. If contracting parties can trust
the courts to fill in the gaps, why bother to write out every contingency?
Likewise, if a country has an efficient external capital market, firms can be
small and specialized, relying on the capital markets to allocate resources
among business units, but if the external capital market performs poorly,
diversified business groups may arise to exploit their internal capital
markets (Khanna and Palepu, 1999, 2000).5 Aggarwal et al. (2008) find,
however, that firms tend to establish better mechanisms for corporate gov-
ernance in countries that already have strong rules for investor protection,
suggesting a complementary, rather than substitute, relationship between
aspects of the institutional environment and firms’ preferred institutional
arrangements. Moreover, while the NIE typically takes the institutional
environment as exogenous, firms can, in some cases, choose the institu-
tional environment they prefer, through foreign expansion or relocation,
by ‘forum shopping’ (conducting legal affairs in the most favourable juris-
diction, as in US firms incorporating in Delaware, the state perceived to
have the best corporate-chartering and dispute-resolution rules).6
The role of transaction costs and property rights

Transaction costs and property rights play a role in all levels of analy-
sis. Transaction costs include both the costs resulting from the transfer
of property rights (what Allen (2000) calls the ‘neoclassical’ concept of
transaction costs) and the costs of establishing and maintaining property
rights.7 Coase’s (1937) famous analysis of the firm takes transaction costs
– defined there as the costs of search, communication, and bargaining – as
the main determinant of firm existence, boundaries, and organizational
structure. In his 1960 paper on social cost, Coase suggests that parties’
ability to rearrange property rights in ways that maximize economic value
depends on transaction costs, particularly the costs of drafting, monitor-
ing, and enforcing contractual agreements. As Coase (1988, p. 34) later
wrote: ‘Transaction costs were used in the one case to show that if they are
not included in the analysis, the firm had no purpose, while in the other I
showed, as I thought, that if transaction costs were not included into the
analysis, for the range of problems considered, the law had no purpose’.
Likewise, the economic analysis of legal rules and property rights figures
prominently in studies of the institutional environment and institutional
arrangements. Beginning with the early literature on the efficiency of the
common law (Rubin, 1977; Priest, 1977), economic analysis has been used
to study not only the character and effects of law but the mechanisms by
which legal rules change. In this sense, law and economics may therefore
be considered a part of NIE, although it is customary to speak of law and
economics and NIE as separate movements. NIE has been particularly
interested in contract law (Llewellyn, 1931; Macneil, 1974, 1978, 2001)
and property law (Alchian, 1961; Demsetz, 1967; Barzel, 1989, 1997).
However, unlike the ‘legal centralism’ tradition, which holds that disputes
are primarily settled by the courts as official agents of the state, NIE often
focuses on ‘private ordering’ (Galantner, 1981), private solutions achieved
through arbitration, negotiation, and custom and enforced through repu-
tation and social sanction.8
Property rights are also central to the incomplete-contracting (or
‘property-rights’) approach to the firm associated with Grossman and
Hart (1986), Hart and Moore (1990), and Hart (1995). In this approach,
the boundaries of the firm are determined by comparing the economic
value created by alternative arrangements of property rights, where these
rights are defined in terms of residual rights of control over alienable
assets. While distinct from Williamson’s version of TCE (Williamson,
2000, pp. 605–6; Whinston, 2003), this ‘new’ property-rights approach
shares with TCE an emphasis on ownership, asset specificity, and contrac-
tual incompleteness. (See Chapter 10 in this volume by Foss on property-
rights economics for more detail.)
Questions about the new institutional economics

Not surprisingly, scholars working within the broad NIE tradition disagree
on the field’s exact boundaries and defining characteristics. Some see the
NIE as a different kind of economics, providing an alternative perspective
on a variety of applied fields such as industrial organization, regulation,
economic development, trade policy, and so on. Others view it as simply
another applied field, the economic analysis of institutions and organiza-
tions. Similarly, is TCE a general theory of economic organization – as
Williamson puts it, ‘[a]ny problem that can be posed directly or indirectly
as a contracting problem is usefully investigated in transaction cost
economizing terms’ (Williamson, 1985, p. 41) – or is TCE simply the
asset-specificity approach to vertical integration? Are NIE and TCE part
of ‘neoclassical economics’ broadly defined (today’s ‘old institutional’

economists strongly believe so), or does their attention to bounded ration-
ality, complexity, evolution, and the like earn a heterodox label?9 Different
scholars working inside (and outside) the NIE give different answers.
Newcomers sometimes see the NIE as a pot-pourri of diverse, only
weakly connected, topics: the legal environment and property rights;
norms, culture, and social conventions; economic history, growth, and
development; political economy; Coase and the nature of the firm; moral
hazard and agency; TCE; the property-rights approach; resource-based
theories; and innovation and organizational change. One way to unify the
literature on these topics is to stress common methods and core assump-
tions (adherence to methodological individualism, reliance on compara-
tive institutional analysis, an attention to interdisciplinary concerns).
Another is to focus on common core concepts such as property rights and
transaction costs. Yet another is to emphasize North’s (1991) definition
of institutions as man-made rules, or constraints, that guide individu-
als’ behaviour, viewing the institutional environment and institutional
arrangements (or Williamson’s (2000) four levels of analysis) as variations
on a theme. One problem with the latter approach is that it is often difficult
to draw sharp distinctions between the categories or levels. Much of what
is usually considered part of the institutional environment, for instance
(for example, political decision making), is clearly the result of human
design (for example, in legislatures), while many functions or routines that
take place within institutional arrangements have an unplanned, ‘sponta-
neous’ aspect (Langlois, 1995). Clearly, further work is needed to sort out
these distinctions. For this reason and more, the NIE, and its TCE subsidi-
ary, remain exciting areas for future research and application.
Notes
1. For recent surveys of the field see two edited volumes, Handbook of New Institutional
Economics (Ménard and Shirley, 2005) and New Institutional Economics: A Guidebook
(Brousseau and Glachant, 2008).
2. For a sampling of the secondary literature see Seckler (1975); Rutherford (1983);
Langlois (1989); and Hodgson (1998). On the German roots of American institutional-
ism, see Richter (1996). See also the Journal of Economic Issues, the Cambridge Journal
of Economics, and the Journal of Institutional Economics.
3. Coase’s own investigation of British lighthouses (Coase, 1974), finding that most were
– contrary to the standard public-goods explanation – actually privately owned, is an
oft-cited example of the kind of comparative institutional analysis Coase has in mind.
More recently, Coase has complained that economists have not done the careful, system-
atic, historical research needed to understand key cases of vertical integration, such as
General Motors’ (GM’s) acquisition of Fisher Body in 1926:
If it is believed that their theory tells us how people would behave in different cir-
cumstances, it will appear unnecessary to many to make a detailed study of how they
did in fact act. This leads to a very casual attitude toward checking the facts. If it is
believed that certain contractual arrangements will lead to opportunistic behavior, it

is not surprising that economists misinterpret the evidence and find what they expect
to find (Coase, 2006, p. 275).
Ironically, however, Coase’s history of the lighthouse has been challenged on the grounds
that his concepts of ‘government’ and ‘private’ are too coarse (Van Zandt, 1993), and
that the nominally private lighthouse firms were actually state-chartered, quasi-public
entities (Bertrand, 2006).
4. The huge literature on ‘law and finance’ is a well-known example of recent economic
research on the institutional environment. La Porta et al. (1998) argued for a strong
correlation between a nation’s financial-market development and the origin of its legal
system (primarily, common law or civil law). This paper, and a series of follow-up studies
by the same authors, established a new strand of literature on economic development
using large, cross-country panel datasets containing various measures of legal, political,
social, and cultural institutions. Critics argue that financial-market development and
overall economic performance are driven not by legal origin but by politics, culture, and
geography, among other factors, and that La Porta et al. oversimplify the causal rela-
tionships between institutions and growth. See Beck and Levine (2005) and La Porta et
al. (2008) for recent overviews.
5. Within a particular country, firms may diversify or refocus in response to the relative
effectiveness of external capital markets. For instance, the divestiture wave of the 1980s
among US corporations, a partial ‘undoing’ of the conglomerate mergers of the 1960s,
can be explained as a consequence of the rise of takeovers by tender offer rather than by
proxy contest, the emergence of new financial techniques and instruments like leveraged
buyouts and high-yield bonds, and the appearance of takeover and breakup specialists
like Kohlberg Kravis Roberts which themselves performed many functions of the con-
glomerate’s corporate staff (Bhide, 1990; Williamson, 1992).
6. Eisenberg and Miller (2009) show that US firms most often choose New York as the
venue for commercial contracting, arguing that New York lawmakers have deliber-
ately designed a contract-law regime that is favourable to commercial transactions, in
the same way that Delaware lawmakers created a superior environment for corporate
chartering.
7. See Chapter 10 in this volume by Foss on ‘property rights economics’ for more on the eco-
nomic analysis of property rights and its relationship to transaction cost approaches.
8. See Chapter 7 in this volume by Smith on the legal origins of transaction cost economics
and Chapter 10 in this volume by Foss on the property-rights approach.
9. Avner Greif’s game-theoretic work on the emergence of long-distance trade is an
example of ‘neoclassical’ work in the new institutional tradition (for example, Greif,
2006). See also Aoki’s (2008) game-theoretic interpretation of Douglass North.
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Seckler, D.W. (1975), Thorstein Veblen and the Institutionalists: A Study in the Social
Philosophy of Economics, Boulder, CO: Colorado Associated University Press.
Sugden, R. (1986), The Economics of Rights, Cooperation, and Welfare, Oxford: Basil
Blackwell.
Udehn, L. (2002), ‘The changing face of methodological individualism’, Annual Review of
Sociology, 28, 479–507.
Ullman-Margalit, E. (1977), The Emergence of Norms, Oxford: Clarendon Press.
Van Zandt, D.E. (1993), ‘The lessons of the lighthouse: “government” or “private” provision
of goods’, Journal of Legal Studies, 22 (1), 47–72.
Whinston, M.D. (2003), ‘On the transaction cost determinants of vertical integration’,
Journal of Law, Economics, and Organization, 19 (1), 1–23.
York: Free Press.
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perspective’, Journal of Economic Behavior and Organization, 17 (3), 335–52.
Press.
PART II
PRECURSORS AND
INFLUENCES
4 Ronald H. Coase
Michael E. Sykuta
As a student at the London School of Economics (LSE), Ronald Coase

posed a seemingly naïve question that would, in time, fundamentally
change the face of economics and earn him the Nobel Prize: ‘Why do
firms exist?’ The import of this simple question derived not only from the
response Coase proposed, that is, that firms exist to economize on the
costs of using the market, but also from the analytic perspective under-
lying both the question and the process by which Coase arrived at his
conclusion. Coase’s insight and approach to understanding the economic
system provided the theoretical foundation for transaction cost economics
(TCE) and much of organizational economics more generally.1
Much has been written of Coase’s days as a student at the LSE and
lecturer at the Dundee School of Economics and Commerce, most notably
Coase’s (1991) autobiographical lectures on the origin, meaning and influ-
ence of his 1937 paper, ‘The Nature of the Firm’. One of the most striking
realizations for many students is that the basic ideas contained in the 1937
paper had been developed in 1932 when Coase traveled to the United
States as a mere 21-year-old, having received a scholarship to study ‘verti-
cal and lateral integration in industry’ (Coase, 1991, p. 38). That the ideas
of such a young person with very little formal economics training could
have such significant implications for an entire discipline should be an
encouragement to students and young professionals. It should also serve
as a reminder to the profession as a whole to be careful of overlooking the
most basic of its assumptions.
The basic question

Coase’s basic question arose from the apparent conflict between the lessons
of neoclassical microeconomics and the observed reality. Coase attributes
his appreciation for and understanding of the efficacy of the market system
to his studies under Arnold Plant and his interactions with colleagues,
notably Robert Fowler. In particular, Plant reinforced in Coase’s mind the
idea that markets (and businesses) are, in the main, competitive and rela-
tively efficient in directing the allocation of resources. However, Coase also
observed that an enormous amount of economic activity (that is, resource
allocation) occurred not at the direction of the price mechanism, per se,
but under the direction of managers within firms. Despite the obviously
39
important role that firms play in the economy, Coase pointed out that the
concept of the firm was poorly defined in the economics literature of the
time. He argues (Coase, 1937, p. 386), ‘[s]ince there is apparently a trend
in economic theory towards starting analysis with the individual firm and
not with the industry, it is all the more necessary . . . that a clear definition
of the word “firm” be given’.
At the same time, Coase observed the reaction of economists in the
west to the introduction of national economic planning in Russia. Many
economists (including the likes of Lionel Robbins, Ludwig von Mises, and
F.A. Hayek) maintained that running the economy as one big factory was
impossible. Yet Coase observed large factories and firms in England and
the US, prompting the question of how one could ‘reconcile the impos-
sibility of running Russia as one big factory with the existence of factories
in the western world’ (Coase, 1991, p. 39).
Thus, Coase’s basic question existed in two complementary and neces-
sary parts to begin developing a definition, and theory, of the firm. First,
if the market is such an effective mechanism for governing the allocation
of resources, why do we observe the existence of firms that, in effect,
subsume resource allocation decisions within the scope of managerial fiat?
Second, given there is an economic rationale for the existence of firms,
that is, for managerial rather than market-based resource allocations, why
would such an organizational form not be effective in allocating resources
on a much larger, for instance national, scale? Put another way, what
is the source of the natural limits of managerial control that dictate the
boundary of the firm? In the process of addressing these two issues, Coase
proposed to identify a definition of the ‘firm’ that was both realistic in
reflecting the real-world nature of firms and tractable using the principle
tools of economic analysis.
The ‘simple’ answer

Coase argued the defining characteristic of the ‘firm’ is the supercession
of the price mechanism in allocating resources. The traditional view of the
‘firm’ as production function, Coase argued, failed as a defining trait since
the steps of production could as easily be completed by successive stages
governed by the price mechanism. Given this defining trait, Coase quickly
concludes the ‘main reason why it is profitable to establish a firm would
seem to be that there is a cost of using the price mechanism. The most
obvious cost of “organizing” production through the price mechanism is
that of discovering what the relevant prices are’ (Coase, 1937, p. 390).
Having answered the first part of his query concerning the existence of
firms, Coase then turned to the second part: the limits to the size and scope
of the firm. If the higher cost of the price mechanism relative to the cost of
Ronald H. Coase 41
managerial control provides the rationale for establishing a firm, then the
converse must define the boundary of adding one additional transaction to
the scope of managerial control. Coase argued that as the size of the firm
(number of allocations) grows and as the manager’s ability to effectively
manage a larger or more diverse set of resource allocations diminishes,
the costs of managerial control would increase. Thus, the firm will expand
until the point where the marginal cost of arranging one more transaction
by managerial control equals the cost of allocating that transaction using
the price mechanism.
Some scholars have criticized this simple answer as being too simple,
even tautological. For instance, Alchian and Demsetz (1972, p. 738), while
among the first to intentionally expand upon Coase’s insight, take issue
with its usefulness for analysis:
We do not disagree with the proposition that, ceteris paribus, the higher is the
cost of transacting across markets the greater will be the comparative advan-
tage of organizing resources within the firm; it is a difficult proposition to
disagree with or to refute. We could with equal ease subscribe to a theory of the
firm based on the cost of managing, for surely it is true that, ceteris paribus, the
lower is the cost of managing the greater will be the comparative advantage of
organizing resources within the firm. To move the theory forward, it is neces-
sary to know what is meant by a firm and to explain the circumstances under
which the cost of ‘managing’ resources is low relative to the cost of allocating
resources through market transaction.
In a slightly more positive assessment, Oliver Williamson (1975, p. 3)

wrote that ‘[t]ransaction 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’. The theory roughly sketched by Coase thus
became the springboard from which Williamson launched his work to
develop a more operational framework of TCE for analyzing the com-
parative efficacy of firms and markets.
Beyond the simple answer

Although the simple answer outlined above is perhaps the most common
characterization of Coase’s theory of the firm, it belies the fact that Coase
laid out a much richer and more useful set of hypotheses concerning
‘the circumstances under which the cost of “managing” resources is low
relative to the cost of allocating resources through market transaction’. In
particular, Coase identifies several themes which are developed more fully
within the context of TCE, but which of themselves would lead to testable
hypotheses for differentiating which transactions might be most efficiently
organized through the price mechanism versus managerial control.
Transaction frequency
Beyond the cost of price discovery itself, Coase describes the cost of
‘negotiating and concluding’ each contract as reason for consolidating
the number of individual transactions among the various factor suppliers
into a smaller set of contracts with one entrepreneur (Coase, 1937, pp.
390–391). While Coase first considers this consolidation in the context
of coordinating across multiple factors of production (what Jensen and
Meckling (1976) refer to as the firm as a ‘nexus of contracts’), the same
logic applies to multiple transactions between a given set of parties to
the transaction. As Coase writes, ‘It may be desired to make a long-term
contract . . . due to the fact that if one contract is made for a longer period
instead of several shorter ones, then certain costs of making each contract
will be avoided’ (Coase, 1937, p. 391).
Bounded rationality
While Coase makes no explicit assumption about the rationality of deci-
sion makers, he does recognize the limited ability of decision makers
to make effective decisions. In explaining the limits to the firm size, he
writes ‘it may be that, as the transactions which are organized increase,
the entrepreneur fails to place the factors of production in the uses where
their value is highest’ (Coase, 1937, pp. 394–5). More specifically, ‘it would
appear that the costs of organizing and the losses through mistakes will
increase with an increase in the spatial distribution of the transactions
organized, in the dissimilarity of the transactions, and in the probability
of changes in the relative prices’ (ibid., p. 397). While not using the term
‘bounded rationality’, it seems clear that Coase had in mind something
akin to the limited capabilities of rational decision making that feature so
prominently in TCE.
Uncertainty and contractual incompleteness

In addition to the limited cognitive ability implied above, Coase also impli-
cates individuals’ lack of perfect foresight and uncertainty about future
states of the world in affecting the costs and completeness of contracting
and the decision to internalize transactions within the firm. ‘Now owing
to the difficulty in forecasting, the longer the period of the contract is . . .
the less possible and, indeed, the less desirable it is . . . to specify what the
other contracting party is expected to do. . . . Therefore, the service which
is being provided is expressed in general terms, the exact details being left
until a later date’ (ibid., pp. 391–2). This early hypothesis was echoed more
than 50 years later in studies by Crocker and Masten (1991), Crocker and
Reynolds (1993), Saussier (2000) and others. For example, Saussier (2000,
p. 193) argues ‘the greater the uncertainty level of the transaction, the
Ronald H. Coase 43
more difficult, expensive, and risky it will be to establish a contract that

aims for completeness (particularly because of the potential costs of being
“trapped” in a bad contract)’.
The institutional environment

Besides foreshadowing several of the transaction characteristics underly-
ing TCE, Coase also recognized the importance of the institutional envi-
ronment in affecting the relative costs of contracting and the decision to
internalize transactions in the firm. ‘Another factor that should be noted is
that exchange transactions on a market and the same transactions organ-
ized within a firm are often treated differently by governments or other
bodies with regulatory powers’ (Coase, 1937, p. 393). While Coase uses
tax policy as his example, the general point has much broader implica-
tion. Williamson (1991) extended the point by focusing instead on how the
courts view and enforce interfirm versus intrafirm transaction agreements
and disputes, arguing that neoclassical contract law governs the former
while a forbearance regime governs the latter. These differences have con-
sequences for the costs of enforcing ex post disputes.
Beyond the ‘nature of the firm’

Thus far, I have focused on the contributions of Coase’s seminal 1937
paper in establishing the economic foundation for TCE. However, Coase
continued to offer profound insights throughout his career that changed
the nature not only of economics, but of several related social sciences.
Many of these contributions revolve around a common, or at least similar,
theme; namely, employing the principles of economic analysis to examine
the relative efficacy of using the price mechanism rather than alternate
organizational forms, whether firms or government, to solve resource
allocation problems.
In his 1946 paper on marginal costs, Coase proposed the use of multi-
part pricing as an alternate to subsidized or rate-of-return regulated pricing
for firms – specifically utilities – characterized by decreasing average costs.
He argued that a multi-part pricing structure that allocated costs across
consumers of such firms would be preferable to the use of taxpayer funds
to subsidize optimal levels of production or to the use of average cost
pricing, which would result in an undersupply of production. Similarly,
his 1959 paper ‘The Federal Communications Commission’ takes issue
with arguments that the radio frequency spectrum is unique among com-
munication media in requiring regulated allocations of spectrum property
rights rather than allowing those rights to be allocated using the price
mechanism – a practice adopted 35 years later.
In his 1960 paper ‘The Problem of Social Cost’, Coase expounded
upon the arguments introduced in the FCC paper (Coase, 1959), as well
as the concept of transaction costs, to once again take to task the prevail-
ing presumption that government regulation was the necessary means
for addressing problems of externalities. Perhaps best known for what
Stigler (1966, p. 113) termed the ‘Coase Theorem’, Stigler’s paper not only
launched the field of law and economics, but made significant contribu-
tions to the theory of the firm by making more concrete the concept of
transaction costs introduced in ‘The Nature of the Firm’ (Coase, 1937).
Barzel and Kochin (1992, p. 29) argue ‘[f]or quite some time economists
have been aware of the effects of the costs of transacting . . . Only after
the publication of “The Problem of Social Cost” in 1960, however, did
economists start to realize how to make the analysis of transaction costs
operational’.
Coase and transaction cost economics

As noted above, Williamson (1975, p. 3) viewed TCE as providing a
framework by which to operationalize the concept of transaction costs in
a manner that would allow systematic analyses of the choice of organiza-
tional form. Despite the close relation between Coase’s original contribu-
tions and Williamson’s construction of TCE, fundamental differences
exist between Coase’s understanding of the problems of transacting and
the assumptions underlying TCE. In particular, Coase has always been
suspect of the reliance of TCE on the concept of asset specificity and the
behavioral assumption of opportunistic holdup.
In his autobiographical lectures, Coase (1991, pp. 43–5) recounts some
of his correspondence with Robert Fowler from 1932. The letters reveal
that even then Coase had considered the issue of ‘bilateral monopoly’, or
what Williamson termed asset specificity, and the resulting risk of appro-
priation as a motivation for integration. However, Coase (2006, p. 259)
writes:
I ultimately came to reject the existence of this risk as an important reason for
vertical integration as a result of discussions I had with businessmen. They were
unimpressed by my argument. They pointed out that if equipment was required
solely for one particular customer, the cost would normally be reimbursed by
that customer. They told me of other contractual devices that could be used to
handle the problem.
Combined with his observation of relations between A.O. Smith and

General Motors, among others, involving significant investments in spe-
cific assets that were maintained by contractual arrangements, Coase con-
tinues to reject the idea of asset specificity and opportunism as a general
theory of firm integration.
Ronald H. Coase 45
The Fisher Body debate

In their paper ‘Vertical Integration, Appropriable Rents, and the
Competitive Contracting Practice’, Klein et al. (1978) briefly refer to
General Motors’ acquisition of Fisher Body in 1926 as an example of
vertical integration as a solution for contractual holdup problems. The
Fisher example was but one of several offered to illustrate the authors’
argument. Klein (1984) provided a more thorough and detailed discussion
of the Fisher Body case, again reinforcing the idea that the acquisition of
Fisher Body was motivated by contractual holdup problems under the
terms of Fisher’s contract as the sole provider of closed-body chassis for
General Motors.
Coase (1991) took issue with this story as having any meaningful import
for a general theory of the firm. Having rejected the argument almost 60
years earlier, Coase discounted the relevance of the opportunism argument
as an errant deviation from his original ideas. Klein responded in kind,
writing ‘Coase’s rejection of the opportunism analysis is based upon too
simplified a view of the market contracting process and too narrow a view
of the transaction costs associated with that process’ (Klein, 1991, p. 213).
This exchange focused increased attention on the case of Fisher Body.
In April 2000, the Journal of Law and Economics published three inde-
pendently initiated critiques of Klein’s portrayal of the Fisher Body acqui-
sition, including one by Coase (2000). The issue also contained a rebuttal
by Klein (2000), in which he provided yet another detailed discussion of
the contractual relationship between Fisher Body and General Motors
and attempted to deflect the arguments of his critics. But the saga had not
yet reached its climax.
Following this barrage of articles, Klein was asked to produce a copy
of the contract at the focal point of the case. As it turns out, Klein had
not been in possession of the actual contract, nor had he actually seen
the document prior to having it recovered from the archives of General
Motors in the early 2000s. The details described in his earlier publications,
going all the way back to the 1978 piece with Crawford and Alchian, were
derived from second-hand descriptions in court transcripts. However, the
actual terms of the contract reflected the very types of protections that
Coase had learned of and reported on during his visit to the US in 1932.
This revelation prompted Coase to write a critique titled ‘The Conduct of
Economics’ (Coase, 2006), taking this entire debate as a launching point to
urge economists to exercise more care in their empirical research.2
The validity of TCE does not hinge on the accuracy of the Fisher
Body–GM story, of course. One less example does not take away from
the abundance of empirical work which is largely consistent with TCE’s
testable implications. However, there is also evidence that asset specificity
is not sufficient to explain vertical integration and that contractual mecha-

nisms may be capable of preventing opportunistic behavior. The challenge
remains to more fully explain under what conditions the malincentives
associated with asset specificity may be insurmountable by contractual
means; or to put it in the language of Coase, under what conditions asset
specificity may cause the cost of using the price mechanism to be suffi-
ciently high to warrant an alternate organizational form.
Concluding thoughts
In the prologue to The Mechanisms of Governance, Williamson (1996)
argues that TCE differs from economic orthodoxy in at least six significant
ways: (1) behavioral assumptions; (2) the unit of analysis; (3) considera-
tion of the firm as a governance structure; (4) the idea that property rights
and contracts are problematic; (5) reliance on discrete structural alterna-
tives; and (6) what Williamson calls the ‘remediableness criterion’, an
insistence that comparative analysis be limited to feasible alternatives. On
every point, Coase’s work foreshadows, if not directly addressing, these
defining characteristics:
1. the concept of decision makers as limited in their rational capability

to make maximizing decisions, or bounded rationality, which features
prominently in Coase’s explanation for the limits on the size of the
firm;
2. a focus on the marginal transaction as the defining point of the bound-
ary of the firm, where the characteristics of the transaction and the
relative costs of organizing the transaction determine the mode of
governance;
3. recognition that the firm and market are alternative modes of transac-
tional governance;
4. identifying the costs of contracting as creating potential problems
for market exchange, thereby highlighting the importance and conse-
quence of property right allocations for the efficiency of production;
5. considering discrete structural differences of firm, market and govern-
ment as means for allocation of property rights and resources; and
6. insisting that economists should focus on the real world, the world in
which transaction costs exist and must be taken into account if we are
to understand the workings of the economic system.
On the fiftieth anniversary of the publication of ‘The Nature of the

Firm’ (Coase, 1991, p. 73) Coase, concluded his autobiographical reflec-
tion with a summary that reflects not only the state of the literature today,
but his passion to see it move forward:
Ronald H. Coase 47
It has been said that young men have visions and old men have dreams. My
dream is to construct a theory which will enable us to analyze the determinants
of the institutional structure of production. In ‘The Nature of the Firm’ the job
was only half done – it explained why there were firms but not how the func-
tions which are performed by firms are divided up among them. My dream
is to help complete what I started fifty-five years ago and to take part in the
development of such a comprehensive theory. . . . I intend to set sail once again
to find a route to China, and if this time all I do is to discover America, I won’t
be disappointed.
Notes
1. Foss and Klein (2009, p. 23) assert that, in essentially following the line of inquiry out-
lined in Coase’s 1937 paper, ‘most organizational economics is fundamentally Coasian’.
2. The debate over Fisher Body may not yet be over. Goldberg (2008) argues that the
contract could not have been legally enforceable, and that General Motors’ lawyers
must have known that, suggesting that contractual holdup would not have been tenable.
Again, Klein (2008) provides a rebuttal defending the enforceability of the contract, but
further argues that whether the contract was enforceable is irrelevant given the way in
which the alleged dispute played out.
References
Alchian, A. and H. Demsetz (1972), ‘Production, information costs, and economic organiza-
tion’, American Economic Review, 62 (5), 777–95.
Barzel, Y. and L. Kochin (1992), ‘Ronald Coase on the nature of social cost as a key to the
problem of the firm’, The Scandinavian Journal of Economics, 94 (1), 19–31.
Coase, R.H. (1946), ‘The marginal cost controversy’, Economica, 13 (50), 169–82.
Coase, R.H. (1959), ‘The Federal Communications Commission’, Journal of Law and
Economics, 2 (1), 1–40.
Coase, R.H. (1960), ‘The problem of social cost’, Journal of Law and Economics, 3 (1), 1–44.
Coase, R.H. (1991), ‘The nature of the firm: origin, meaning and influence’, in O. Williamson
and S. Winter (eds), The Nature of the Firm: Origins, Evolution and Development, Oxford:
Oxford University Press, pp. 34–74.
Coase, R.H. (2000), ‘The acquisition of Fisher Body by General Motors’, Journal of Law and
Economics, 43 (1), 15–31.
Crocker, K. and S. Masten (1991), ‘Pretia ex Machina? Prices and process in long-term con-
tracts’, Journal of Law and Economics, 34 (1), 69–84.
Crocker, K. and K. Reynolds (1993), ‘The efficiency of incomplete contracts: an empirical
analysis of Air Force engine procurement’, RAND Journal of Economics, 24 (1), 126–46.
Foss, N. and P. Klein (2009), ‘Organizational governance’, in R. Wittek, T. Snijders and
V. Nee (eds), Handbook of Rational Choice Social Research, New York: Russell Sage
Foundation, forthcoming.
Goldberg, V. (2008), ‘Lawyers asleep at the wheel? The GM–Fisher Body contract’, Industrial
and Corporate Change, 17 (5), 1071–84.
Jensen, M. and W. Meckling (1976), ‘Theory of the firm: managerial behavior, agency cost
and ownership structure’, Journal of Financial Economics, 3 (4), 305–60.
Klein, B. (1984), ‘Contract costs and administered prices: an economic theory of rigid wages’,
American Economic Review, 74 (2), 332–8.
Klein, B. (2000), ‘Fisher-General Motors and the Nature of the Firm,’ Journal of Law and
Economics, 43 (1), 105–41.
Klein, B. (1991), ‘Vertical integration as organizational ownership: the Fisher Body–General

Motors relationship revisited’, in O. Williamson and S. Winter (eds), The Nature of the
Firm: Origins, Evolution and Development, Oxford: Oxford University Press, pp. 213–26.
Klein, B. (2008), ‘The enforceability of the GM–Fisher Body contract: comment on
Goldberg’, Industrial and Corporate Change, 17 (5), 1085–96.
Klein, B., R. Crawford and A. Alchian (1978), ‘Vertical integration, appropriable rents, and
the competitive contracting process’, Journal of Law and Economics, 21 (2), 297–326.
Saussier, S. (2000), ‘Transaction costs and contractual incompleteness: the case of Électricité
de France’, Journal of Economic Behavior and Organization, 42 (2), 189–206.
Stigler, G. (1966), The Theory of Price, 3rd edn, New York: Macmillan.
Williamson, O. (1975), Markets and Hierarchies: Analysis and Antitrust Implications, New
York: Free Press.
Williamson, O. (1991), ‘Comparative economic organization: the analysis of discrete struc-
tural alternatives’, Administrative Science Quarterly, 36 (2), 269–96.
Williamson, O. (1996), The Mechanisms of Governance, New York: Oxford University
Press.
5 Cyert, March, and the Carnegie school
Mie Augier
The ‘Carnegie school’ is one of the important intellectual roots of transac-

tion cost economics (TCE), at least (and in particular) as developed and
practiced by Oliver Williamson, and Williamson has written about his
Carnegie connections on several occasions (1996b, 2002). As Williamson
notes in the prologue to The Mechanisms of Governance (1996a), it was a
direct result of his background as a student at Carnegie that he became
interested in the idea of combining economics with organization theory, so
central to today’s transaction cost theory (Williamson, 1996a, p. 18). The
interdisciplinary spirit was ‘in the air’ at Carnegie at that time. ‘Those were
exciting days’, Williamson recalls, ‘Orchestrating cutting-edge interdisci-
plinary research and teaching are never easy. . . . [b]ut in the late 1950s and
early 1960s, Carnegie was the place to be’ (1996a, p. 21). The ‘Carnegie
school’ is often identified with the pioneering work in behavioral econom-
ics done by Herbert Simon, James G. March, and Richard Cyert in the
1950s and 1960s (Earl, 1988). The Carnegie behavioralists are known for
their interest in understanding how individuals and organizations act and
make decisions in the real world, and their challenges to the neoclassical
theory of optimization and maximization in decision making and organi-
zations. Concepts such as bounded rationality and satisficing were devel-
oped to describe individuals and organizations acting in the face of ‘the
uncertainties and ambiguities of life’ (March and Simon, 1958, p. 2). Many
of these concepts were first discussed in the book Organizations (March
and Simon, 1958), and none of them have lost currency. Williamson
(1996a, p. 351) developed bounded rationality into transaction cost theory
and was early on attracted to the basic idea:
Bounded rationality seemed to me, then and since, as a useful way to go. James
March’s course in organization theory revealed that one did not need to think
about organizations in classical (machine model) or fanciful (hyperrational-
ity or nonrationality) terms but could address these matters in a behaviorally
informed and scientific way. I learned about the behavioral theory of the firm
from Richard Cyert – the famous Cyert and March (1963) being in the late
stages of completion.
The background for the Carnegie school was the Ford Foundation’s
mission to establish a broad and interdisciplinary behavioral social
49
science in the late 1940s and early 1950s, and much of their efforts
were directed at supporting the early set up of the Graduate School of
Industrial Administration (GSIA) at Carnegie Mellon University (origi-
nally Carnegie Institute of Technology), where Simon, March, and Cyert
worked. The Carnegie Institute of Technology had been founded in 1912
by Andrew Carnegie and had established itself as one of the better engi-
neering schools in the country. The early President Robert Doherty, who
had come from Yale, wanted Carnegie Tech to be a leader in research and,
hence, to break with the traditional mechanical engineering view of busi-
ness education and include broader, social, and interdisciplinary aspects.
As a result of his ambitions, the first dean of what came to be known as the
GSIA, George Leland Bach, was hired. Bach wanted to staff his depart-
ment with economists who combined intellectual skills and experience in
applying theory to real world situations and he wanted to put Carnegie at
the forefront of US business schools. Simon, March, and Cyert all came to
Carnegie to help develop this view.
The behavioral group at Carnegie was embedded in a larger group
of scholars, which included innovative economists such as Franco
Modigliani, John Muth, Charles Holt, and Merton Miller. The spirit at
Carnegie was that everybody interacted with everybody else, discussed
each other’s research and discussed science, so collaborative teams
worked together as well as across each other’s projects. Consisting of dif-
ferent people with different interests, these teams always worked together
in a friendly way, despite different disciplines and despite varying degrees
of admiration for the idea of rationality. It was an environment in which
people were united by their deep and intense interest for doing science.
The Carnegie school tried to develop the rudiments of process-oriented
understandings of how economic organization and decision making
take place. They did so in an interdisciplinary way, linking economics
to organization theory, cognitive science, sociology and psychology, and
centering around concepts such as uncertainty, ambiguity, norms, rou-
tines, learning, and satisficing. They used ideas from social science more
broadly to advance understanding of economics and, in the process, con-
tributed to the strands that came to be called behavioral economics (Day
and Sunder, 1996). The ideas initiated by the Carnegie school helped to
establish a foundation for modern ideas on bounded rationality, adaptive
and evolutionary economics, and transaction cost theory, among other
areas. According to Williamson, Carnegie was an ‘enormously exciting’
environment, in which organization theory served as linking theory to real
problems (without loss of discipline) and in which behavioral economics
existed ‘cheek by jowl’ with rational expectation theory (1996a, p. 353).
Williamson’s dissertation (1967) grew out of the Ford Foundation project
Cyert, March, and the Carnegie school 51
on ‘A Behavioral Theory of the Firm’ (see below) and was on the econom-
ics of managerial discretion.
Key ideas and theories

The behavioral research of Simon, Cyert, and March aimed at making
understandable how individuals make decisions and behave in the real
world. They found that neoclassical economics gave too little attention
to the institutional and cognitive constraints on economic and organi-
zational behavior and on individual decisions, and too little room for
human mistakes, foolishness, the complications of limited attention,
and other results of bounded rationality. As a result, they proposed to
include the whole range of limitations on human knowledge and human
computation that prevent organizations and individuals in the real world
from behaving in ways that approximate the predictions of neoclassi-
cal theory. For example, decision makers are sometimes confronted by
the need to optimize several, sometimes incommensurable, goals (Cyert
and March, 1963 [1992]). Furthermore, instead of assuming a fixed set
of alternatives among which a decision maker chooses, the Carnegie
school postulated a process for generating search and alternatives and
analyzing decision processes through the idea of aspiration levels (March
and Simon, 1958), a process that is regulated in part by variations in
organizational slack (Cyert and March, 1963 [1992]). Finally, individuals
and organizations often rely on routines or rules of thumb learned from
experience or from others, rather than seek to calculate the consequences
of alternatives.
One of the first major results of the Carnegie school’s work was a
propositional inventory of organization theory, involving Herbert Simon,
James March, and Harold Guetzkow, which led to the book Organizations
(March and Simon, 1958). The book was intended to provide the inventory
of knowledge of the (then almost nonexisting) field of organization theory,
and also a more proactive role in defining the field. Results and insights
from studies of organizations in political science, sociology, economics,
and social psychology were summarized and codified. The book expanded
and elaborated ideas on behavioral decision making, search and aspira-
tion levels and elaborated the idea of the significance of organizations as
social institutions in society. March and Simon wrote (1958, p. 151):
The basic features of organization structure and function derive from the
characteristics of rational human choice. Because of the limits of human
intellective capacities in comparison with the complexities of the problems
that individuals and organizations face, rational behavior calls for simplified
models that capture the main features of a problem without capturing all its
complexities.
March and Simon also wanted to unite empirical data-gathering research

with rigorous theorizing in order to create a rigorous empirical theory
that could organize and so give meaning to empirical facts with legitimate
theory. Science, they believed, was the product of the organization of
empirical facts into conceptual schemes, and the progress of science was
based on the development of more sophisticated and elegant theoretical
systems, but not necessarily the discovery of new facts.
The Ford Foundation also supported a larger project on behavioral
theories of organizations which was carried out by Richard Cyert and
James March (along with their students, including Julian Feldman,
Edward Feigenbaum, William Starbuck – and Oliver Williamson). This
project originated in the works of Cyert and March to develop improved
models of oligopoly pricing by using organization theory. The research
on the behavioral theory of the firm aimed at investigating how the char-
acteristics of business firms as organizations affect important business
decisions. Integrating theories of organizations with existing (mostly eco-
nomic) theories of the firm, they developed an empirical theory rather than
a normative one and focused on classical problems in economics (such as
pricing, resource allocation, and capital investment) to deal with the proc-
esses for making decisions in organizations.
At the center of ‘A Behavioral Theory of the Firm’ is the idea of the firm
as an adaptive political coalition (Cyert and March, 1963 [1992]), a coali-
tion between different individuals and groups of individuals in the firm,
each having different goals and hence the possibility of conflict of interest.
Cyert and March (1963 [1992], p. 28) said:
Since the existence of unresolved conflict is a conspicuous feature of organiza-

tions, it is exceedingly difficult to construct a useful positive theory of organi-
zational decision-making if we insist on internal goal consistency. As a result,
recent theories of organizational objectives describe goals as the result of a
continuous bargaining-learning process. Such a process will not necessarily
produce consistent goals.
The firm is therefore seen as an adaptive system that through learning and
experimentation adapts to its environment. The experience of the firm is
embodied in a number of standard operating procedures (for instance,
solutions that have served the firm well in the past will be included in
the organizational repertoire and will be easily reactivated in the face of
similar problems in the future). As time passes and experience changes, so
standard operating procedures change through processes of search and
learning. In other words, the firm is not an unchangeable entity – it is a
system of rules, driven to change by current aspirations and targets reflect-
ing experienced or anticipated dissatisfaction.
Influence on transaction cost economics (TCE)

In several respects, Williamson’s work and contributions to TCE are
shaped by his Carnegie connection (Williamson, 1996b, 2002), including
the emphasis on the behavioral assumptions, on process, on adaptation,
and on discrete structural analysis.1
Behavioral assumptions
From the outset, TCE has consciously been aware of the significance
of the behavioral assumptions (contrary to much of neoclassical eco-
nomics) (Williamson, 1996a, p. 55). This awareness reflects beyond any
doubt that Williamson had been influenced by the behavioral economics
group during his years at Carnegie, where discussion and questioning of
the behavioral assumptions were an important part of the research. In
particular, Williamson has adopted and elaborated the idea that people
are ‘intendedly rational, but only limitedly so’ (Williamson, 1985, p. 21),
reflecting the influence of Herbert Simon’s idea of bounded rationality.
Another assumption of Williamson’s program is the idea of opportunism;
the conviction that people are ‘self-interest seeking with guile’ (ibid., p.
87). This assumption can be seen as reflecting Williamson’s early (1963a,
1967) managerial theory of discretionary behavior where he tried to
incorporate managerial objectives (maximization of private utility) into
the neoclassical framework of the firm. Among the implications that
follow from these behavioral assumptions are the existence of incomplete
contracting and the importance of contractual trust (Williamson, 1996a,
pp. 56–7).
Process analysis
The emphasis on process is yet another Carnegie idea, reflecting in par-
ticular ideas connected to Organizations (March and Simon, 1958) and A
Behavioral Theory of the Firm (Cyert and March, 1963 [1992]).2 Perhaps in
particular consistent with Cyert and March’s view of the firm as a politi-
cal coalition, Williamson has been cautious about excesses of managerial
control (1996a, p. 226). Seeing the firm as a coalition among different
individuals and groups of individuals in the firm, each having different
goals, conflict of interest is a central idea. As Cyert and March note (1963
[1992], p. 28):
Since the existence of unresolved conflict is a conspicuous feature of organiza-

tions, it is exceedingly difficult to construct a useful positive theory of organi-
zational decision-making if we insist on internal goal consistency. As a result,
recent theories of organizational objectives describe goals as the result of a
continuous bargaining-learning process. Such a process will not necessarily
produce consistent goals.
The firm is seen as an adaptive system, which through learning, search, and
experimentation adapts to its environment. The experience of the firm is
embodied in a number of ‘standard operating procedures’ (routines), pro-
cedures for solutions to problems which the firm in the past has managed
to solve. As time passes by and experiences change, so do the firm’s rou-
tines change through processes of organizational search and learning. As a
result, the firm is seen not as a static entity, but as a system of rules, driven
by its level of aspiration persistently being different from actual outcomes.
Such a process view of organizations – including what Williamson refers
to (1996a, p. 226) as intertemporal transformations – has important side
effects such as producing the possibility of further bureaucratization of the
organization (Williamson, 1996a, p. 228).
Organizational adaptation
The theme of organizational adaptation also follows quite naturally from
the behavioral theory of the firm (although Williamson combines this with
Hayek’s emphasis on spontaneous coordination of economic activities).
Following March and Simon’s (1958, p. 190) idea that ‘the basic features
of organization structure and function derive from the characteristics of
human problem solving and rational human choices’, the organization
is an adaptive entity which has evolved through a series of responses to
people’s decision making problems. But for Williamson the key idea is
to combine spontaneous order in markets with intentional order in firms
to yield a predictive theory of economic organization. Adaptations of both
types are vital to a high performance system.
Discrete structural analysis

Williamson also sides with Simon (1978) when it comes to choosing the
central mode of explanation.3 In keeping with the Carnegie perspective,
Williamson sees the need to ‘always study first order (discrete structural)
effects before examining second order (marginalist) refinements’ (1996a,
p. 232). Applying discrete, structural analysis is difficult to implement, for
it relies on the idea that moves between organizational forms are attended
by certain discontinuities (Williamson, 2000, p. 14). Williamson sees the
main differences between the organization of markets and firms as being
a matter of incentive intensity, administrative control, contract law and
adaptation (ibid., p. 15).
Williamson beyond Carnegie and Conclusion

While Williamson went beyond Carnegie in his contributions to and devel-
opment of TCE (see for instance Williamson, 2002, 2004), he integrated
the behavioral ideas with more ‘rational’ theories. For example, whereas
Williamson attempted to use the idea of organizational slack in his thesis,

his 1970 book opened with the confession that ‘[s]ome will regard as para-
doxical the fact that support for the neoclassical hypothesis should result
from a study that has managerialist origins’ (1970, p. xiii). Williamson
sees the M-form innovation as an intentional response by management to
overcome control loss in a large organization and to strengthen the profit-
orientation of management. He insists on bounded rationality throughout
the book, but also sees the M-form as more consistent than the U-form
with the neoclassical idea of maximization (1970, p. 134) and thus opts for
the M-form on efficiency grounds.
After the publication of Corporate Control and Business Behavior
(1970), Williamson turned towards studying contracting practices. His
1971 paper ‘The Vertical Integration of Production’ signaled a truly
fundamental turn in the road. Rather than examine the firm as a produc-
tion function, Williamson treated it as a governance structure – to be
compared with markets for managing transactions. Rather than dealing
with final goods and services, intermediate product markets came under
examination. This reformulation of the vertical integration problem in
transaction cost economizing terms became a paradigm problem, in that
many other issues could be interpreted as variations on the very same con-
tractual theme. The problems of writing interfirm contracts stem in part
from the combination of bounded rationality and uncertainty. While the
1971 paper does mention bounded rationality (if only once), it became an
important paper in featuring the hitherto neglected issue of unique assets
although Williamson does not (yet) mention asset specificity. In such situ-
ations, bilateral dependency develops, indicating the need for long-term
contracts or vertical integration. Vertical integration is a response to
contractual incompleteness and opportunism – which is very behavioral
(in the Carnegie tradition). Williamson later argues that ‘transactions are
assigned to and organized within governance structures in a discriminat-
ing (transaction-cost economizing) way’ (1981, p. 1564). The focus on the
transaction gradually became clear, and Williamson made in the early
1970s a distinction between transactional factors (such as small-numbers,
uncertainty, and information impactness) and human factors (bounded
rationality, opportunism, and organizational atmosphere) underlying
vertical integration (1971, 1973, 1974).4 These factors would explain the
organization of economic activities and the degree of vertical integration.
Williamson also took steps towards making the transaction cost
treatment of economic organization more general and to combine his
institutional/transaction cost economics with aspects of contract law
and organization theory to identify and explicate the key differences that
distinguish forms of economic organization (1983, 1991). Beginning with
his work on credible commitments (1983), Williamson emphasized the

importance of credibility and the mechanisms which drive it, as these
relate to the efficiency of economic organization. In 1991, Williamson
demonstrated that the different forms of economic organization are
distinguished by different coordinating and control mechanisms and by
different abilities to adapt to disturbances. Williamson’s work on apply-
ing contract law to economic organization suggests (again) a middle-
way between neoclassicism and a more behavioral approach, suggesting
‘relational contracting’ which is typically unenforceable in courts and
dependent on arbitration and enforcement by private parties. Written
as an ‘ambitious effort to operationalize transaction cost economics’
(Williamson, 1996a, p. 89), the 1991 paper also appeals to the interdisci-
plinary thinking that Williamson learned at Carnegie, and urges further
developments along these lines (Williamson, 1996a, p. 119). This indi-
cates that further integration of TCE and Carnegie ideas might lead to
fruitful work in the future.
Notes
1. Additionally, Williamson (1996a, p. 229) mentions also the issue of politics and of
embeddedness and networks, and in (2002) he also mentions near-decomposability and
weak-form selection as being part of the Carnegie contributions upon which his work
rests; and the importance of reality testing.
2. Cyert and March, in the epilogue to the second edition of A Behavioral Theory of the
Firm, acknowledge Williamson’s program as being ‘broadly consistent’ with their own
work (Cyert and March, 1963 [1992], pp. 219–20), referring to Williamson’s use of
opportunism and bounded rationality. But whereas Williamson later featured the idea of
bounded rationality more prominently, he talks in his early work about ‘rational mana-
gerial behavior’, defending the idea of maximization (of utility functions that include
other things than profits). Williamson notes that profit maximization works only in cases
with strong competition and warns against ‘uncritical’ application of the assumption of
profit maximization in cases where competition is weak (Williamson, 1963, p. 238). But
the real crux of his thesis is the idea that maximization can be defended on other grounds
as well, namely through the assumption of self-interest (Williamson, 1963, p. 239).
Thus, managers in Williamson’s theory are not maximizing profits, but managerial self-
interest. Williamson calls his model of managerial behavior ‘behavioral’ and summarizes
its properties as including that his model uses the same basic assumption of rationality
as mainstream economics – people are self-interest seeking – and that under certain con-
ditions his model converges to the profit maximization hypothesis (Williamson, 1963,
p. 252).
3. Simon (1978, p. 6) was introducing the term ‘discrete structural analysis’ into organiza-
tional economics in the following way: ‘As economics expands beyond its central core
of price theory, and its central concern with quantities of commodities and money, we
observe in it . . . [a] shift from a highly quantitative analysis, in which equilibration at the
margin plays a central role, to a much more qualitative institutional analysis, in which
discrete structural alternatives are compared’.
4. Although references to Simon in the 1973 paper are missing, Williamson defines bounded
rationality as referring to ‘the rate and storage limits on the capacities of individuals to
receive, store, retrieve, and process information without error’ (Williamson, 1973,
p. 317).
References
Cyert, R. and J.G. March (1963), A Behavioral Theory of the Firm, 2nd edn (1992), Oxford:
Blackwell.
Day, R. and S. Sunder (1996), ‘Ideas and Work of Richard M. Cyert’, Journal of Economic
Behavior and Organization, 31 (2), 139–48.
Earl, P. (ed.) (1988), Behavioral Economics, Aldershot, UK and Brookfield, VT, USA:
Edward Elgar Publishing.
March, J.G. and H.A. Simon (1958), Organizations, 2nd edn (1993), Oxford: Blackwell.
Simon, H.A. (1978), ‘Rationality as process and product of thought’, American Economic
Review, 68 (2), 1–16.
Williamson, O.E. (1963), ‘A model of rational managerial behavior’, in R. Cyert and J.G.
March, A Behavioral Theory of the Firm, Oxford: Blackwell, pp. 237–52.
Williamson, O.E. (1967), The Economics of Discretionary Behavior: Managerial Objectives in
a Theory of the Firm, Englewood Cliffs, NJ: Prentice-Hall.
Williamson, O.E. (1970), Corporate Control and Business Behavior, Englewood Cliffs, NJ:
Prentice Hall.
Williamson, O.W. (1971), ‘The vertical integration of production: market failure considera-
Williamson, O.E. (1973), ‘Markets and hierarchies: some elementary considerations’,
Williamson, O.E. (1974), ‘The economics of antitrust: transaction cost considerations’,
University of Pennsylvania Law Review, 122 (6), 1439–66.
Williamson, O.E. (1981), ‘The modern corporation: origins, evolution, attributes’, Journal of
Economic Literature, 19 (4), 1537–68.
Williamson, O.E. (1983), ‘Credible commitments: using hostages to support exchange’,
Williamson, O.E. (1991), ‘Comparative economic organization: the analysis of discrete struc-
Williamson, O.E. (1996a), The Mechanisms of Governance, Oxford: Oxford University
Press.
Williamson, O.E. (1996b), ‘Transaction cost economics and the Carnegie Connection’,
Journal of Economic Behavior and Organization, 31, 149–55.
Williamson, O.E. (2000), ‘Why Law, Economics and Organization?’, University of California,
Berkeley, Business and Public Policy Working Paper 81.
Williamson, O.E. (2002), ‘Empirical microeconomics: another perspective’, in Mie Augier
and James March (eds), The Economics of Choice, Change and Organization, Cheltenham,
UK and Northampton, MA, USA: Edward Elgar Publishing.
Williamson, O.E. (2004), ‘Herbert Simon and organization theory’, in Mie Augier and James
March (eds), Models of a Man: Essays in Memory of Herbert A. Simon, Cambridge, MA:
MIT Press, pp. 279–95.
6 Chester Barnard1
Joseph T. Mahoney
Oliver Williamson did his doctoral training at Carnegie and it is clear that
the behavioral theory of the firm – originating from the Carnegie School
(Cyert and March, 1963; March and Simon, 1958; Simon, 1947) – is an
important building block to transaction cost theory (Williamson, 1975).
The most important antecedent of the Carnegie School was Chester
Barnard’s (1938) The Functions of the Executive. Indeed, Barnard wrote
the foreword to Simon’s (1947) Administrative Behavior, and Barnard
(1938) foreshadowed the concepts of authority and bounded rationality
(Simon, 1947). According to Williamson, Barnard (1938) developed the
following: ‘(1) Organization form – that is, formal organization matters;
(2) informal organization has both instrumental and humanizing pur-
poses; (3) bounds on rationality are acknowledged; (4) adaptive, sequen-
tial decision-making is vital to organizational effectiveness; and (5) tacit
knowledge is important’ (Williamson, 1985, p. 6).
Andrews maintains that ‘The Functions of the Executive [is] the most
thought-provoking book on organization and management ever written
by a practicing executive’ (Andrews, 1968, p. xxi), and attributes its
endurance to Barnard’s (1) capacity for abstract thought; (2) ability to
apply reason to professional experiences; (3) probable expertness in prac-
tice; and (4) simultaneous exercise of reason and competence. Barnard’s
aspiration was contributing to a ‘science of organization’ (Barnard, 1938,
p. 290).
Barnard’s (1938) The Functions of the Executive emphasizes skills, judg-
ment, stewardship and professionalism, and connects ethical and practical
teachings. Barnard’s (1938) impact on organization theory is well docu-
mented (Scott, 1987; Williamson, 1995), and even those taking vigorous
exception concede its vast influence: ‘This . . . remarkable book contains
within it the seeds of three distinct trends of organizational theory that
were to dominate the field for the next three decades. One was the insti-
tutional theory as represented by Philip Selznick [1957]; another was the
decision-making school as represented by Herbert Simon [1947]; the third
was the human relations school’ (Perrow, 1986, p. 63).
Barnard (1938) reflects readings in anthropology, economics, law, phi-
losophy, political science, psychology, and sociology. It presents a systems
view of organizations containing a psychological theory of motivation and
58
Chester Barnard 59
behavior, a sociological theory of cooperation and complex interdepend-

encies, and an ideology based on meritocracy.
Barnard (ibid.) provides organizational theory based on structural
concepts of: the individual and bounded rationality; cooperation; formal
organization; and informal organization. Dynamic concepts include: free
will; communication; a consent theory of authority; the decision process;
dynamic equilibrium and the inducement–contributions balance; and
leadership and executive responsibility. We consider each of these con-
cepts in turn.
Structural concepts
The individual and bounded rationality

Persons have power of choice, capacity of determination, and possession
of free will. But, individuals are limited in terms of biological faculties and
capacities (Barnard, 1938, p. 23). Organizations as cooperative systems are
seen as overcoming physical and cognitive limitations (bounded rational-
ity) of individuals.
Cooperation
Barnard submits that cooperation means: genuine restraint of self; service
for no reward; courage to fight for principles; and genuine subjection
of personal to social interests. When a cooperative system’s purpose is
attained, cooperation is effective (ibid., p. 43). Cooperative effort is greatly
limited if confidence is lacking in the sincerity and integrity of manage-
ment. Barnard (1948, p. 11) maintains that:
When a condition of honesty and sincerity is recognized to exist, errors of
judgment, defects of ability, are sympathetically endured. They are expected.
Employees don’t ascribe infallibility to leaders or management. What does
disturb them is insincerity and the appearance of insincerity when the facts are
not in their possession.
Formal organization
Formal organization is viewed as ‘that kind of cooperation . . . that is
conscious, deliberate, purposeful’ (Barnard, 1938, p. 4) and as ‘a system
of consciously coordinated activities . . . of two or more persons’ (ibid., p.
73) in which the ‘creative side of organization is coordination’ (ibid., p.
256). Scott submits that Barnard (1938) contains ideas consistent with a
‘rational system conception of organizations; what sets them apart is his
insistence on the nonmaterial, informal, interpersonal, and, indeed, moral
basis of cooperation’ (Scott, 1987, p. 63).
Barnard reminds us of the difficult task of achieving and maintaining
cooperative systems: ‘successful cooperation in or by formal organization

is the abnormal, not the normal condition. What are observed from day
to day are the successful survivors among innumerable failures’ (Barnard,
1938, p. 5). Within formal organization, Barnard (1938) believed in
genuine planning – a process of developing and applying knowledge and
intelligence to business problems.
Informal organization
Barnard maintains ‘“learning the organization ropes” in most organiza-
tions as chiefly learning who’s who, what’s what, why’s why, of its infor-
mal society’ (Barnard, 1938, p. 121), and sees informal organization as
complementary to formal organization. Informal organization improves
communication, enhances cohesiveness within formal organization, and
protects the integrity of individuals. Informal organization ‘is to be
regarded as a means of maintaining the personality of the individual
against certain effects of formal organizations which tend to disintegrate
the personality’ (ibid., p. 122). The responsibility of management is to
balance improving organizational effectiveness and maintaining the indi-
vidual, which is central in managing personnel where hypocrisy is identi-
fied as fatal (Barnard, 1948, p. 9).
Dynamic concepts
Free will
Free will is central to Barnard’s (1938) behavioral theory derived from
moral and legal doctrines emphasizing personal responsibility for actions.
Endorsement of the free will doctrine underpins management’s moral obli-
gations: ‘the idea of free will is inculcated in doctrines of personal respon-
sibility, of moral responsibility, and of legal responsibility. This seems
necessary to preserve a sense of personal integrity’ (ibid., p. 13).
Communication
Barnard emphasizes that common organizational purpose can only be
achieved if it is commonly known, and thus must be communicated effec-
tively in language, oral and written (Barnard, 1938, p. 89). Tacit under-
standings are often essential (ibid., pp. 301–22).
Consent theory of authority

Barnard (1938) maintains that management’s authority requires ability to
persuade rather than command, and legitimate authority is based on func-
tional skills and not hierarchical position. Organization personnel accept a
communication as authoritative when they: understand it; believe it is not
Chester Barnard 61
inconsistent with organizational purpose; believe it compatible with their

personal interest as a whole; are able mentally and physically to comply
with it; and have a zone of indifference within which it is acceptable (ibid.,
pp. 165–7). Barnard notes that: ‘Either as a superior officer or as a subor-
dinate, however, I know nothing that I actually regard as more “real” than
“authority”’ (ibid., p. 170).
Decision-making and the decision process

Although organization theory on decision-making from Simon (1947) to
the present is expansive, Barnard provides this unique perspective:
The making of decisions, as everyone knows from personal experience is a

burdensome task. Offsetting the exhilaration that may result from correct and
successful decision and the relief that follows the terminating of a struggle to
determine issues is the depression that comes from failure or error of decision
and the frustration which ensues from uncertainty (1938, p. 189).
Barnard (1938) warns of a tendency for personnel to avoid responsibil-

ity (due in part to fear of criticism) and that an executive must distribute
responsibility, or otherwise run the risk of being overwhelmed with the
burdens of decision: ‘The fine art of executive decision consists in not
deciding questions that are not pertinent, in not deciding prematurely, in
not making decisions that cannot be made effective, and in not making
decisions that others should make’ (ibid., p. 194). Barnard returns to this
theme in a 1961 interview: ‘You put a man in charge of an organization
and your worst difficulty is that he thinks he has to tell everybody what to
do; and that’s almost fatal if it’s carried far enough’ (Wolf, 1973, p. 30).
Dynamic equilibrium and the inducement–contributions balance

The efficiency and effectiveness of an organization depends upon what the
organization secures and the personnel produce (the contributions) and
how the organization distributes its resources (the inducements), and these
contributions and inducements are dynamic (Barnard, 1938, pp. 57–9).
Inducements include material inducements, personal non-material oppor-
tunities, desirable physical conditions, ideal benefactions, associational
attractiveness, opportunities for enlarged participation, and the condi-
tion of communion (ibid., p. 142). Barnard emphasized non-economic
motives:
Prestige, competitive reputation, social philosophy, social standing, philan-

thropic interests, combativeness, love of intrigue, dislike of friction, technical
interest, Napoleonic dreams, love of accomplishing useful things, desire for
regard of employees, love of publicity, fear of publicity – a long catalogue of
non-economic motives actually condition the management of business, and
nothing but the balance sheet keeps these non-economic motives from running
wild. Yet without all these incentives, I think most business would be a lifeless
failure (1948, p. 15).
Leadership, executive responsibility and moral codes

For Barnard much is given to leaders and much is expected, and leader-
ship is the key factor in cooperation. While cooperation is the creative
process, leadership is the ‘indispensable fulminator of its forces’ (Barnard,
1938, p. 259). The fundamental function of a leader is to create meaning
for followers facilitating their commitment and identification: ‘The incul-
cation of belief in the real existence of a common purpose is an essential
executive function’ (ibid., p. 87). Leadership is:
connected with knowing whom to believe, with accepting the right suggestions,
with selecting appropriate occasions and times . . . an understanding that leads
to distinguishing effectively between the important and the unimportant in
the particular concrete situation, between what can and what cannot be done,
between what will probably succeed and what will probably not, between what
will weaken cooperation and what will increase it (Barnard, 1948, pp. 86–7).
Leadership must go beyond deciding the right thing to do, and to the
job of getting it done. Barnard states that:
An executive is a teacher; most people don’t think of him that way, but that’s
what he is. He can’t do very much unless he can teach people. . . . You can’t just
pick out people and stick them in a job and say go ahead and do it. You’ve got
to give them a philosophy to work against, you’ve got to state the goals, you’ve
got to indicate the limitations and the methods (Wolf, 1973, pp. 7–8).
Leadership involves guiding others. Leaders must effectively convey

meanings and intentions and receive them with sympathetic understand-
ing (Barnard, 1948, pp. 97–9). Barnard describes the nature of leadership:
It is in the nature of a leader’s work that he should be a realist and should

recognize the need for action, even when the outcome cannot be foreseen, but
also that he should be idealist and in the broadest sense pursue goals some of
which can only be attained in a succeeding generation of leaders. Many leaders
when they reach the apex of their powers have not long to go, and they press
onward by paths the ends of which they will not themselves reach. In business,
in education, in government, in religion, again and again, I see men who, I am
sure, are dominated by this motive, though unexpressed, and by some queer
twist of our present attitudes often disavowed. Yet, ‘Old men [and old women]
plant trees’ . . . to shape the present for the future by the surplus of thought and
purpose which we now can muster seems the very expression of the idealism
which underlies such social coherence as we presently achieve, and without this
idealism we see no worthy meaning in our lives, our institutions, or our culture
(ibid., pp. 109–10; emphasis added).
Chester Barnard 63
In the expression, ‘old men [and old women] plant trees’ Barnard (1948)
indicates that the moral factor is real and that faith in others is supported
by observation. Within the cooperative system, the moral factor finds
its expression and suggests the necessity of leadership and ‘the power of
individuals to inspire cooperative personal decision by creating faith: faith
in common understanding, faith in the probability of success, faith in the
ultimate satisfaction of personal motives, faith in the integrity of objective
authority, faith in the superiority of common purpose as a personal aim of
those who partake in it’ (Barnard, 1938, p. 259; emphasis added).
The part of leadership that determines the quality of action is respon-
sibility. Responsibility is the ‘quality which gives dependability and
determination to human conduct, and foresight and ideality to purpose’
(Barnard, 1938, p. 260) and is the most important function of the execu-
tive. Responsibility means honor and faithfulness in the manner that man-
agers carry out their duties and is defined as an ‘emotional condition that
gives an individual a sense of acute dissatisfaction because of failure to do
what he feels he is morally bound to do or because of doing what he thinks
he is morally bound not to do, in particular concrete situations’ (Barnard,
1948, p. 95). Carrying out this function builds the character of executives
who must decide and act under the burden of responsibility. Barnard in
1961 evaluates his 1938 classic:
In my opinion, the great weakness of my book is that it doesn’t deal adequately

with the question of responsibility and its delegation. The emphasis is too
much on authority, which is the subordinate subject. . . . The emphasis is put
on authority which, to me now, is a secondary, derivative setup (Wolf, 1973,
p. 15).
Barnard maintains that:
nearly everything depends upon the moral commitment. I’m perfectly confident
that, with occasional lapses, if I make a date with you, whom I have never met,
you’ll keep it and you’ll feel confident that I’ll keep it; and there’s absolutely
nothing binding that makes us do it. And yet the world runs on that – you just
couldn’t run a college, you couldn’t run a business, you couldn’t run a church,
couldn’t do anything except on the basis of the moral commitments that are
involved in what we call responsibility. You can’t operate a large organization
unless you can delegate responsibility, not authority but responsibility (Wolf,
1973, p. 35).
Ethical practice determines management’s moral authority and the

capability of managers to pass their power to the next generation: ‘respon-
sibility is the property of an individual by which whatever morality exists
in him becomes effective in conduct’ (Barnard, 1938, p. 267).
The survival of organizations as going concerns depends on moral

commitment: ‘Organizations endure . . . in proportion to the breadth of
morality by which they are governed. This is only to say that foresight,
long purposes, high ideals are the basis for the persistence of cooperation’
(Barnard, 1938, p. 282). Barnard recommended combining the two cul-
tures of management – its science and art, calling for ‘a social anthropol-
ogy, a sociology, a social psychology, an institutional economics, a treatise
on management’ (ibid., p. 293). However, we should not deceive ourselves
that a science of organization will be enough: ‘Inspiration is necessary
to inculcate the sense of unity, and to create common ideals. Emotional
rather than intellectual acceptance is required’ (ibid., p. 293).
Conclusions
Williamson (1996, pp. 41–2) articulates the uses of Barnard (1938) to
transaction cost economics including that the formal organization is
important; the central problem of organization is adaptation; and the
study of induced cooperation deserves a prominent place on the research
agenda. In addition, I emphasize here that management requires both art
and science and Barnard (1938) achieves this balance. Barnard (ibid.) is
enriching when read for the practical purpose of understanding the science
of management, but it is an aesthetic reading that explains the intensity
of responses to this classic. Barnard (ibid.) offers an intense, structured
and coherent work that depends on students using their capacities to
apprehend the aesthetic experience of management based on the author’s
intimate habitual interested experience. Barnard dedicates his book to his
father: ‘At a crisis in my youth, he taught me the wisdom of choice: to try
and fail is at least to learn; to fail to try is to suffer the inestimable loss of
what might have been’. Toward the purpose of conveying the aesthetic
experience of management, Barnard (ibid.) did not fail.
Barnard’s finale is an exemplar of the poetic and provocative nature of
his work:
This study, without the intent of the writer or the expectation of the reader, had
at its heart this deep paradox and conflict of feelings in the lives of men. Free
and unfree, controlling and controlled, choosing and being chosen, inducing
and unable to resist inducement, the source of authority and unable to deny it,
independent and dependent, nourishing their personalities, and yet depersonal-
ized; forming purposes and being forced to change them, searching for limita-
tions in order to make decisions, seeking the particular but concerned with the
whole, finding leaders and denying their leadership, hoping to dominate the
earth and being dominated by the unseen – this is the story of man in society
told in these pages. Such a story calls finally for a declaration of faith. I believe
in the power of the cooperation of men of free will to make men free to cooper-
ate; that only as they choose to work together can they achieve the fullness of
Chester Barnard 65
personal development; that only as each accepts a responsibility for choice can
they enter into the communion of men from which arise the higher purposes
of individual and of cooperative behavior alike. I believe that the expansion
of cooperation and the development of the individual are mutually dependent
realities, and that a due proportion or balance between them is a necessary con-
dition of human welfare. Because it is subjective with respect both to society as
a whole and to the individual, what this proportion is I believe science cannot
say. It is a question for philosophy and religion (ibid., p. 296).
Note
1. This chapter draws from Mahoney (2002).
Bibliography
Andrews, K.R. (1968), ‘Introduction to the thirtieth anniversary edition of The Functions of
the Executive’, Cambridge, MA: Harvard University Press.
Barnard, C.I. (1938), The Functions of the Executive, Cambridge, MA: Harvard University
Press.
Barnard, C.I. (1948), Organization and Management: Selected Papers, Cambridge, MA:
Harvard University Press.
Cyert, R.M. and J.G. March (1963), A Behavioral Theory of the Firm, Englewood Cliffs, NJ:
Prentice-Hall.
Mahoney, Joseph T. (2002), ‘The relevance of Chester I. Barnard’s teachings to contempo-
rary management education: communicating the aesthetics of management’, International
Journal of Organization Theory and Behavior, 5 (1–2), 159–72.
March, J.G. and H. Simon (1958), Organizations, New York: John Wiley and Sons.
Perrow, C. (1986), Complex Organizations: A Critical Essay, New York: Random House.
Scott, W.R. (1987), Organizations: Rational, Natural, and Open Systems, Englewood Cliffs,
NJ: Prentice-Hall.
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CA: University of California Press.
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Relational Contracting, New York: Free Press.
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Williamson (ed.), Organization Theory: From Chester Barnard to the Present and Beyond,
New York: Oxford University Press, pp. 172–206.
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and Labor Relations: Cornell University, ILR Paperback Number Twelve.
7 Commons, Hurst, Macaulay, and the
Wisconsin legal tradition
D. Gordon Smith
In art ‘negative space’ is the space between, around, and behind the
positive forms in a visual composition (Rockman, 2000, p. 22). While our
brains are conditioned to recognize, name and categorize objects, nega-
tive space helps to define those objects, and artists consider both positive
shapes and negative space in arranging a composition (Edwards, 1989, pp.
98–100). Perhaps the most famous illustration of negative space is Rubin’s
vase, an optical illusion in which a white vase is formed by opposing black
silhouettes. When first presented with the composition, most people see
the opposing faces, but when the shading is reversed – so that the vase is
black and the faces are white – the vase is easily perceived.
Over a period of a half century, scholars at the University of Wisconsin
focused our attention on the negative space surrounding contract law
(Gilmore, 1974, p. 3, n. 1). What they found there was a fascinating world
of contracting behaviour – or, in more modern parlance, private ordering
– that Ian Macneil (1974, 2000) subsequently explored in developing his
relational theory of contracts. Oliver Williamson was aware of the work of
the Wisconsin scholars (Williamson, 1985, p. 3) and Macneil (Williamson,
1996, p. 355), and in this chapter I trace the legal precursors of transac-
tion cost economics (TCE) by focusing on three prominent faculty of the
University of Wisconsin: John Commons, Willard Hurst, and Stewart
Macaulay. This focus necessarily omits some of the connective tissue in
the intellectual history, from Oliver Rundell and Jacob Beuscher in the
first half of the twentieth century to Lawrence Friedman, Marc Galanter,
and William Whitford in the second half. Nevertheless, by focusing on the
development of private ordering from Commons to Hurst to Macaulay, I
hope to show in broad brushstrokes the evolution of private ordering from
negative space to positive shape.
John R. Commons: the law as positive shape

By the 1920s, John R. Commons had already solidified his reputation as
a labour economist. After a disappointing start to his academic career,
Commons joined Richard Ely at the University of Wisconsin in 1902,
when Ely enlisted Commons in a project to collect records relating to the
66
Commons, Hurst, Macaulay, and the Wisconsin legal tradition 67
history of labour in the United States. Commons suggested that the col-
lection be printed for the benefit of scholars, and A Documentary History
of American Industrial Society was later published in a ten-volume set
(Commons and Ely, 1910). Commons then turned his attention to the
four-volume History of Labor in the United States, which contained a
series of articles by various scholars examining the labour movement from
the colonial period to 1920.
In assembling these massive works, Ely and Commons collaborated with
professors in the University of Wisconsin Law School, who were stationed
in the same building as the economists on the University of Wisconsin’s
campus (Carrington and King, 1997). This collaboration extended beyond
the collection of records to the drafting of legislation and lobbying of
legislatures. To this day, these activities remain the best exemplar of ‘The
Wisconsin Idea’ – the notion that the resources of the University should
promote the practical welfare of the state and its citizens.
After World War I, Commons shifted his attention to institutional
economics, which focused on the ‘collective control of individual transac-
tions’ (Commons, 1934, pp. 5–6). Building on earlier work by Thorstein
Veblen (1899), this so-called ‘old’ institutional economics was designed to
respond to the shortcomings of neoclassical economics, which assumed
frictionless markets and complete contracts. By contrast Veblen and
Commons described a world with imperfect markets and incomplete con-
tracts, sometimes referred to as a ‘socialized’ view of economic behaviour
(Kaufman, 2006, pp. 11–12). While neoclassical economics had no room
for law, institutional economics treated law as central to the development
and maintenance of markets.
In a critical move for purposes of our story, Commons treated the
‘transaction’ as the fundamental unit of measurement in economic theory
(Kaufman, 2006, p. 24). While Legal Realists were transforming the
way in which lawyers viewed the adjudication process (Leiter, 2005),
Commons was directing our attention to the behaviour of contracting
parties and inquiring about the role of law in influencing their behaviour.
Unfortunately, most legal scholars paid more attention to the Realists
than to Commons.1
Willard Hurst: using negative space to define the law

Commons retired from the University of Wisconsin in 1934, and Willard
Hurst did not join the faculty of the University of Wisconsin Law School
until 1937, but Hurst was certainly acquainted with Commons and his
work.2 Perhaps more importantly, Hurst arrived at a law school that was
significantly shaped by Commons and his colleagues on the law faculty.3
Those who have explored the scholarly intellectual history of Hurst have
debated the extent of Commons’ influence on Hurst, but it seems fair to

assume that the core of the so-called ‘Hurstian Revolution’ in legal history
– namely, placing the historical study of law in a broader social, economic,
and political context – was influenced to a large extent by Commons’
legacy, both direct and indirect.4
Although Hurst himself was at a loss to describe the source of his inspi-
ration, he typically pointed to his undergraduate studies in economics and
history at Williams College as a potential wellspring (Hurst, 1981, p. 18).
A particularly formative experience for Hurst at this time was his study
of Charles and Mary Beard’s Rise of American Civilization. According to
Daniel Ernst (2000, pp. 5–6), Hurst was inspired by ‘[t]he Beards’ project
of creating a usable past for a modernizing society’.
Given this foundation, it’s no surprise that Hurst found much of his first
year at the Harvard Law School of the early 1930s intellectually arid. He
later remembered his classes being ‘as abstractly doctrinal as it is possible
to get,’ and said that his law professor Samuel Williston treated contracts
‘like an exercise in Euclid’s geometry’ (Hartog, 1994, p. 372).
During his Harvard years, Hurst found respite in reading the works of
Karl Llewellyn and other Legal Realists. Despite his admiration, Hurst
recognized that the Legal Realists were interested primarily in the work of
judges, while Hurst – during the rise of the New Deal – was increasingly
drawn to the study of the administrative state.
Hurst’s interest in legislation and regulation brought him within the
orbit of Felix Frankfurter, who specialized in teaching administrative
law at Harvard. Hurst worked extensively with Frankfurter on issues of
administrative law as a student, law review editor, and research assistant
(Ernst, 2000, p. 12). Then, after graduation, Hurst served as Frankfurter’s
research fellow, a job that paved the way for Hurst’s clerkship with Justice
Louis Brandeis on the United States Supreme Court. While each of these
experiences imbued Hurst with important new insights on the role of law
in society, his mentors remained lawyers who were primarily interested in
the role of courts in the development of law.
Hurst was eager for a more expansive view of law, and he was attracted
to Lloyd Garrison, then Dean at the University of Wisconsin Law School.
Garrison had assumed the position of Dean in 1932, when John R.
Commons and other professors in the Economics Department still had
offices alongside law professors in the Law Building (Labor Law Studies,
1982, p. 7).5 Hurst (1981, p. 17) later recalled that Garrison ‘had very
ambitious ideas about extending the intellectual range of legal education,
particularly in the direction of involving it more with the social sciences
and with knowledge about social structure and process’.6 Hurst had
discovered a kindred spirit, and the two collaborated on materials for a
course entitled ‘Law in Society’, which included substantial materials on

legislation and administrative agencies.
In his well-known book, Law and the Conditions of Freedom (1956),
Hurst stated that he ‘seek[s] to understand the law not so much as it may
appear to philosophers, but more as it had meaning for workaday people
and was shaped by them to their wants and vision’ (Hurst, 1956, p. 5).
This pursuit led Hurst far beyond the examination of traditional legal
sources. Although Hurst used social context to illuminate law, the focus
remained on law. Others have suggested that Hurst conceived of law as a
dependent variable, and this method of legal analysis came to define the
Wisconsin tradition of socio-legal scholarship (Garth and Sterling, 1998,
pp. 439–40).
Stewart Macaulay: the law as negative space

It would be difficult to overstate Hurst’s influence on Stewart Macaulay.
Writing a tribute to Hurst in 1997, Macaulay (1997, p. 1163) called
Wisconsin ‘Willard’s Law School’, but Hurst’s influence on Macaulay
was not merely institutional. Hurst was a hands-on mentor. He advised
Macaulay and other junior members of the faculty to ‘plan a career and
think in terms of five to ten year projects if not more’, and said they ‘should
not waste time responding eclectically to the latest appellate decision or
big event in the New York Times’ (Macaulay, 1997, p. 1170). Hurst told
them that ‘law could not be studied as a system apart from the society
that created it’, and he encouraged them to ‘take risks, think broadly
and make connections with worlds of ideas outside of the law schools’
(Macaulay, 1997, p. 1170). Hurst also ‘taught [them] not to be afraid
of studying legal events in Wisconsin as case studies of law in context’
(Macaulay, 1997, p. 1172). In crafting his iconic study of non-contractual
relations in business, Macaulay (1963a) followed Hurst’s advice to the
letter and changed forever the way legal scholars approached the study
of contracts.7
When Stewart Macaulay began teaching Contracts at the University of
Wisconsin Law School in 1957, he was 26 years old (Macaulay, 1995, p.
248). He had never practised law, and he did the sensible thing by adopting
the casebook used by his more experienced colleagues: Lon Fuller, Basic
Contract Law (1947). Macaulay’s father-in-law – Jack Ramsey, the retired
General Manager of S.C. Johnson and Son – was not impressed with
the casebook. According to Macaulay, Ramsey ‘thought that much of it
rested on a picture of the business world that was so distorted that it was
silly’ (Macaulay, 1995, p. 249).
To assist Macaulay in gaining real-world perspectives on contracts,
Ramsey arranged for a series of meetings with corporate executives
that became the basis of Macaulay’s seminal article, ‘Non-Contractual

Relations in Business: A Preliminary Study’ (Macaulay, 1963a). As indi-
cated by the title, Macaulay focused on non-contractual relations – how
parties regulated their behaviour without the assistance of written con-
tracts.8 During the course of his interviews, Macaulay found that ‘many,
if not most, exchanges reflect no planning, or only a minimal amount of
it, especially concerning legal sanctions and the effect of defective per-
formances’ (Macaulay, 1963a, p. 60). If problems arose, the parties often
negotiated to a solution without relying explicitly on the written contracts
or threats of legal sanctions.9
Ian Macneil (1985, p. 509) later referred to Macaulay’s famous article as
a ‘demolition effort’ that cleared the way for relational contract theory.10
When Macaulay and Macneil first met at a summer workshop for young
contracts teachers held at New York University in 1962, Macaulay
already had written ‘Non-Contractual Relations in Business’ (1963a), and
Macneil was writing doctrinal pieces about contract law (Macneil, 1962,
1963, 1964).11 Macneil’s renowned work on ‘relational contracts’ did not
begin to emerge for several years, with the earliest pieces emanating from
his work in Africa (Macneil, 1968) and his ‘first systematic formulation’
(Macneil, 1987, p. 273, n. 4) of relational contract theory appearing in
1974 (Macneil, 1974).12
Conclusion
Not surprisingly, legal scholars did not know what to make of Macaulay
and Macneil. Enthralled by courts, many law professors searched in vain
for the legal doctrinal implications of this work (Smith and King, 2009,
p. 10). The study of private ordering would not have occurred to most
of them, as that would hardly seem like the study of law.13 Thus, the sys-
tematic examination of private ordering was left to economists, mostly
inspired by Ronald Coase, as interpreted and expanded by Benjamin
Klein and Oliver Williamson.14 Recently, however, legal scholars have
begun to return to transactions in scholarship and teaching,15 and one
hopes that the future collaboration of disciplines will shine new light on
transactions.
Notes
1. Williamson (1985, p. 3) noted:
The proposition that economic organization has the purpose of promoting the
continuity of relationships by devising specialized governance structures rather
than permitting relationships to fracture under the hammer of unassisted market
contracting, was . . . an insight that could have been gleaned from Commons. But
the message made little headway against the prevailing view that the courts were the
principal forum for conflict resolution.
2. Asked about the influence of Commons on his own thinking, Stewart Macaulay com-
mented, ‘I certainly read Commons when I was beginning, at Willard’s suggestion. But
I was reading Frank Knight at the same time. Probably, I got my dose of Commons and
progressive law making from reading and talking with Willard’ (personal communica-
tion, 5 May 2009).
3. Note Carrington and King (1997, p. 324):
One effect of the Wisconsin Idea was to bring the university’s new, young law teachers
into contact not only with public affairs, but also with academic colleagues in other
disciplines who possessed useful expertise. . .. Between 1904 and 1910 law faculty . . .
collaborated with economics faculty such as John Commons and Richard Ely in a
large-scale endeavor to document the history of labor in America.
4. Harris (2003, p. 326) notes that ‘[r]ecent research suggests that institutional economics,
by way of John Commons . . . and his disciples, was not as important to Hurst as some
scholars previously believed’. Prior to Hurst, the writing of legal history was dominated
by lawyers. Harris (2003, pp. 323–4) describes the resulting focus on legal doctrine:
These lawyer-legal historians were primarily interested in studying change in legal

doctrine. They considered the judges of the supreme courts and the courts of appeals
to be the agents of doctrinal change. Therefore lawyers’ legal history focused on them;
on their sources of influence, in the form of earlier decisions and elite legal literature;
and on their products, appeal courts’ case law, and the evolving formal legal doctrine.
Hurst was inclined to study ‘law in society’ long before he arrived at Wisconsin
(Hartog, 1994, p. 372). See Ernst (2000) for a description of his intellectual development
prior to arriving at Wisconsin, including Hurst’s work as a research assistant to Felix
Frankfurter at Harvard Law School.
5. Among the economics professors in that space was Elizabeth Brandeis Raushenbush,
daughter of Justice Brandeis, who taught economics at Wisconsin for 42 years.
Raushenbush made the connection between Hurst and Garrison after meeting Hurst
while visiting her father in Washington DC (Hurst, 1981, p. 17).
6. What Hurst found when he arrived at Wisconsin was a Law School that reflected
Garrison’s ambitious ideas:
[I]t was apparent right from the very outset that this was a law school unlike most
law schools, that did not exist in isolation from all the rest of the university. It was
just taken for granted that we would have working contact with the economics
department, with sociologists, only later with historians, because legal history was
still regarded as not really history. But economics and sociology, it was taken for
granted that people there were interested in the law school, and the law school was
interested in them.
7. Macaulay’s article (1963a) was published in the American Sociological Review, not in
a student-edited law review, and Macaulay attributes the placement to Hurst. ‘That
article was published in the American Sociological Review, largely because Robert
Merton, the great sociologist, told the editor to print it. Merton knew about my work
because he was Willard’s friend from their days together on the Social Science Research
Council’ (Macaulay, 1997, p. 1170).
8. Despite Macaulay’s focus on non-contractual relations, he does not argue that con-
tracts are irrelevant. Indeed, he observed that ‘many business exchanges reflect a high
degree of planning’ (Macaulay, 1963a, p. 60).
9. Macaulay (1963a, p. 61) observed:
Disputes are frequently settled without reference to the contract or potential for
actual legal sanctions. There is a hesitancy to speak of legal rights or to threaten to
sue in these negotiations. Even where the parties have a detailed and carefully planned
agreement which indicates what is to happen if, say, the seller fails to deliver on time,
often they will never refer to the agreement but will negotiate a solution when the
problem arises apparently as if there had never been any original contract.
10. Macaulay (1963a) ranks fifteenth on Shapiro’s (1996) list of all-time most highly cited
law review articles.
11. Macaulay presented the paper at a meeting of the American Sociological Association
held in Washington DC immediately following the New York University workshop
(personal communication from Stewart Macaulay, 3 October 2006). In this formative
stage, Macneil developed a ‘general dissatisfaction with the classical law’ of contracts
(Campbell, 2001, volume 3, p. 6).
12. Macneil continued to develop relational contract theory after 1974, partly in response
to critiques of the 1974 article, and he later wrote, ‘None of these changes alters the fun-
damental nature of the theory, and I would worry more if there had been no changes’
(Macneil, 1987, p. 273, n. 4).
13. Notable exceptions include Ellickson (1991), Bernstein (1992), and Crocker and Masten
(1991).
14. For a survey of empirical studies of contracts, see Smith and King (2009, pp. 19–24).
15. The seminal piece of scholarship in this transactional awakening among legal scholars
is Gilson’s (1984) ‘Value Creation by Business Lawyers: Legal Skills and Asset Pricing’.
As suggested by the title, Gilson’s work was inspired by economic theory. Smith and
King (2009, pp. 2–3) ‘highlight the dominant role of economic theories in framing
empirical work on contracts’ and express the desire ‘to enrich the empirical study of
contracts through application of four organizational theories’.
In the summer of 2009, the Association of American Law Schools sponsored a
Workshop on Transactional Law as part of the Association’s mid-year meeting in Long
Beach, California. Perhaps a sign of the embryonic state of transactional studies among
law professors, one of the goals of the conference was to ‘define “transactional scholar-
ship” in a way that accurately captures the potential breadth and depth of transactional
law, and how transactional scholarship differs from traditional legal scholarship’.
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8 F.A. Hayek
Peter G. Klein
Oliver Williamson dedicates his 1985 book, The Economic Institutions

of Capitalism, to four ‘teachers’: Kenneth Arrow, Alfred D. Chandler,
Jr, Ronald Coase, and Herbert Simon. Another influential teacher, or
predecessor, is F.A. Hayek, the 1974 Nobel laureate and best-known
representative of the modern ‘Austrian’ school. Hayek began his career as
a specialist in monetary and business-cycle theory but also made impor-
tant contributions to the economics of knowledge and competition, legal
and constitutional theory, evolutionary economics, and the theory of
economic change. Hayek’s emphasis on the ubiquity of dispersed, tacit
knowledge, the importance of adaptation, and the function of abstract
rules have significantly influenced Williamson’s understanding of markets
and hierarchies. More generally, Hayekian ideas about knowledge, com-
petition, discovery, and complexity figure prominently in the transaction
cost approach to economic organization.
Hayek’s life and work

Hayek’s life spanned the twentieth century, and he made his home in
some of the great intellectual communities of the period.1 Born Friedrich
August von Hayek in 1899 to a distinguished family of Viennese intellectu-
als, Hayek attended the University of Vienna, earning doctorates in 1921
and 1923. Hayek came to the University of Vienna just after World War
I, when it was one of the three best places in the world to study economics
(the others being Stockholm and Cambridge, England). Though Hayek
was enrolled as a law student, his primary interests were economics and
psychology. He studied with Friedrich von Wieser and was also influenced
by Ludwig von Mises, particularly Mises’s 1922 book Socialism. Hayek
began attending Mises’s Privatseminar along with Gottfried Haberler,
Fritz Machlup, Oskar Morgenstern, Paul Rosenstein-Rodan, Richard
von Strigl, and other promising young Viennese economists and social
theorists.
Mises was known at this time primarily as a monetary theorist, and
Hayek began working on the theories of money, capital, interest, and
the business cycle. Following Mises, Hayek explained the origin of the
business cycle in terms of bank credit expansion and its transmission in
terms of capital malinvestments (Hayek, 1931, 1933a). His work in this
74
F.A. Hayek 75
area eventually earned him an invitation to lecture at the London School

of Economics and Political Science and then to occupy its Tooke Chair
in Economics and Statistics, which he accepted in 1931. There Hayek
found himself among a vibrant and exciting group: Lionel Robbins, J.R.
Hicks, Arnold Plant, Dennis Robertson, T.E. Gregory, Abba Lerner,
Kenneth Boulding, and George Shackle, to name only the most promi-
nent. Gradually, the ‘Austrian’ theory of the business cycle became known
and accepted and, until Keynes’s General Theory appeared in 1936, was
becoming the preferred explanation for the Great Depression.
Hayek and Keynes had sparred in the early 1930s in the pages of the
Economic Journal, over Keynes’s A Treatise on Money (1930). As one
of Keynes’s leading professional adversaries, Hayek was well situated
to provide a full refutation of the General Theory, but he never did. One
reason, as Hayek later explained, was that Keynes was constantly chang-
ing his theoretical framework, and Hayek saw no point in working out
a detailed critique of the General Theory, if Keynes might change his
mind again (Hayek, 1963 [1995], p. 60; 1966 [1995], pp. 240–241). Hayek
thought a better course would be to produce a fuller elaboration of Böhm-
Bawerk’s capital theory (1884–1909 [1959]), and he began to devote his
energies to this project. Unfortunately, The Pure Theory of Capital was
not completed until 1941, and by then the Keynesian macro model had
become firmly established.
In 1950 Hayek joined the Committee on Social Thought at the University
of Chicago. There he again found himself among a dazzling group: the
economics department, led by Frank Knight, Milton Friedman, and later
George Stigler, was one of the best anywhere, and Aaron Director at the
law school soon set up the first law and economics program. While Hayek
had taught graduate-level theory courses for many years at the London
School of Economics (LSE), he became disenchanted with the positivism
and formalism of postwar neoclassical economics, and began working
primarily in adjacent fields such as psychology, philosophy, politics, and
the history of ideas.
Hayek’s receipt of the 1974 Nobel Prize (shared with Gunnar Myrdal,
whose work was very different from Hayek’s) helped spur a revival of the
Austrian tradition, which had remained largely dormant since the 1930s
(Vaughn, 1994; Salerno, 2002). Hayek continued to write, producing The
Fatal Conceit in 1988, at the age of 89. Hayek died in 1992 in Freiburg,
Germany, where he had lived since leaving Chicago in 1961.
Hayek’s contributions to economics

Hayek’s legacy in economics is complex. Among mainstream economists,
he is mainly known for his popular The Road to Serfdom (1944) and
for his work on knowledge in the 1930s and 1940s (Hayek, 1937, 1945).
Specialists in business-cycle theory recognize his early work on indus-
trial fluctuations, and modern information theorists often acknowledge
Hayek’s work on prices as signals, although his conclusions are typically
disputed (Grossman and Stiglitz, 1976; Grossman, 1980, 1989). Hayek’s
work is also known in political philosophy (Hayek, 1960), legal theory
(Hayek, 1973–79), and psychology (Hayek, 1952). Within the Austrian
school of economics, Hayek’s influence, while undeniably immense,
has very recently become the subject of some controversy. His empha-
sis on spontaneous order and his work on complex systems have been
widely influential among many Austrians. Others have preferred to stress
Hayek’s work in technical economics, particularly on capital and the busi-
ness cycle, citing a tension between some of Hayek’s and Mises’s views on
the social order.
In ‘Economics and Knowledge’ (1937) and ‘The Use of Knowledge in
Society’ (1945) Hayek argued that the central economic problem facing
society is not, as is commonly expressed in textbooks, the allocation of
given resources among competing ends:
It is rather a problem of how to secure the best use of resources known to any of
the members of society, for ends whose relative importance only those individu-
als know. Or, to put it briefly, it is a problem of the utilization of knowledge not
given to anyone in its totality (Hayek, 1945, pp. 519–20).
Much of the knowledge necessary for running the economic system,

Hayek contended, is in the form not of ‘scientific’ or technical knowledge
– the conscious awareness of the rules governing natural and social phe-
nomena – but of tacit knowledge, the idiosyncratic, dispersed bits of under-
standing of ‘particular circumstances of time and place’ (Hayek, 1945, p.
521). This tacit knowledge is often not consciously known even to those
who possess it and can never be communicated to a central authority. The
market tends to use this tacit knowledge through a type of ‘discovery pro-
cedure’ (Hayek, 1968), by which this information is unknowingly transmit-
ted throughout the economy as an unintended consequence of individuals’
pursuing their own ends. Indeed, Hayek’s (1948) distinction between the
neoclassical notion of ‘competition’, identified as a set of equilibrium condi-
tions (number of market participants, characteristics of the product, and
so on), and the older notion of competition as a rivalrous process has been
widely influential in Austrian economics (Kirzner, 1973; Machovec, 1995).
Most commentators view Hayek’s work on knowledge, discovery, and
competition as an outgrowth of his participation in the socialist calcula-
tion debate of the 1920s and 1930s. The socialists erred, in Hayek’s view,
in failing to see that the economy as a whole is necessarily a spontaneous
F.A. Hayek 77
order and can never be deliberately made over in the way that the opera-
tors of a planned order can exercise control over their organization. This
is because planned orders can handle only problems of strictly limited
complexity. Spontaneous orders, by contrast, tend to evolve through a
process of natural selection, and therefore do not need to be designed or
even understood by a single mind.
Hayek’s influence on Coase

Ronald Coase was a student at the LSE in the late 1920s and early 1930s.
Coase reports that Hayek’s concept of the time-structure of capital, or
‘structure of production’, was ‘the subject which dominated the discussion
of economics at LSE’ (Coase, 1988, p. 7). Coase’s own interest lay in a
related but distinct concept, the ‘organizational structure of production’
(Coase, 1988, p. 7). His main influences were his teacher Arnold Plant
and a fellow student, Ronald Fowler (Coase, 1988). Coase was familiar,
however, with Mises’s and Hayek’s arguments in the socialist calculation
debate, and cites Hayek’s ‘Trend of Economic Thinking’ (1933b) when
describing, in his own work ‘The Nature of the Firm’ (1937), the idea
of ‘the economic system as being coordinated by the price mechanism’,
making society ‘not an organisation but an organism’ (Coase, 1937, p.
387). ‘Indeed’, he adds, again citing Hayek, ‘it is often considered to be an
objection to economic planning that it merely tries to do what is already
done by the price mechanism’ (Coase, 1937, p. 387).
Here Coase is alluding to Hayek’s claim that market competition gener-
ates a particular kind of order – an order that is the product ‘of human
action, but not . . . human design’ (a phrase Hayek borrowed from Adam
Smith’s mentor Adam Ferguson) (Ferguson, 1767, p. 187). This ‘sponta-
neous order’ is a system that comes about through the independent actions
of many individuals, and produces overall benefits unintended and mostly
unforeseen by those whose actions bring it about. To distinguish between
this kind of order and that of a deliberate, planned system, Hayek (1933b)
initially used the terms ‘organism’ for a spontaneous order and ‘organiza-
tion’ for a planned one, switching later to the Greek terms cosmos and
taxis, respectively (Hayek, 1973–79, pp. 35–54). Examples of a cosmos
include the market system as a whole, money, the common law, and even
language. A taxis, by contrast, is a designed or constructed organization,
like a firm or bureau; these are the ‘islands of conscious power in [the]
ocean of unconscious cooperation like lumps of butter coagulating in a
pail of buttermilk’ (D.H. Robertson, quoted in Coase, 1937, p. 388).
Coase’s argument, of course, is that reliance on the spontaneous order
of the market imposes particular costs: searching for trading partners, dis-
covering the relevant prices, negotiating and enforcing contracts, and so
on. Within the firm, the entrepreneur may be able to reduce these ‘transac-
tion costs’ by coordinating these activities himself. Coase recognizes that
there are limits to the firm – he refers in his 1937 paper to ‘diminishing
returns to management’ (Coase, 1937, p. 395) – but does not spell out these
limits in detail. The modern theory of the firm tends to conceptualize the
optimal boundary by comparing the transaction costs of using the market
with what might be called internal transaction costs: problems of infor-
mation flow, incentives, monitoring, and performance evaluation. The
boundary of the firm, then, is determined by the tradeoff, at the margin,
between the relative transaction costs of external and internal exchange.
Hayek’s ‘Economics and Knowledge’ appeared in 1937, the same year
as Coase’s ‘The Nature of the Firm’, and there are obvious connections
between Coase’s and Hayek’s understandings of the market. Kirzner (1992,
p. 162), for example, describes Coase’s argument in Hayekian terms:
In a free market, any advantages that may be derived from ‘central planning’
. . . are purchased at the price of an enhanced knowledge problem. We may
expect firms to spontaneously expand to the point where additional advantages
of ‘central’ planning are just offset by the incremental knowledge difficulties
that stem from dispersed information.2
Hayek and Williamson

Williamson has been influenced more directly by Hayek’s approach
to knowledge, adaptation, and coordination. In the early pages of
Williamson’s Markets and Hierarchies (1975, pp. 4–5), he describes four
key Hayekian observations:
1. The problem of a rational economic order is trivial in the absence of

bounded rationality limits on human decision makers. It is accordingly
essential at the outset to appreciate that bounds on rationality do exist
and must be expressly taken into account if organizational issues are to be
addressed in operational terms ([Hayek] 1945, pp. 519, 527).
2. Much of the knowledge required to make efficient economic decisions
cannot be expressed as statistical aggregates but is highly idiosyncratic in
nature: ‘practically every individual has some advantage over all others in
that he possesses unique information of which beneficial use might be made,
but of which use can be made only if the decisions depending on it are left
to him or are made with his active cooperation. We need to remember . . .
how valuable an asset in all walks of life is knowledge of people, of local
conditions, and of special circumstances’ ([Hayek] 1945, pp. 521–522).
3. The economic problem is relatively uninteresting except where economic
events are changing and sequential adaptations to changing market cir-
cumstances are called for ([Hayek] 1945, pp. 523–524).
4. The ‘marvel’ of the economic system is that prices serve as sufficient sta-
tistics, thereby economizing on bounded rationality ([Hayek] 1945, pp.
525–528).
F.A. Hayek 79
Williamson (1975, p. 5) then notes that he uses these observations:
in a somewhat different way than does Hayek – mainly because I am interested

in a more microeconomic level of detail than he. Given bounded rationality,
uncertainty, and idiosyncratic knowledge, I argue that prices often do not
qualify as sufficient statistics and that a substitution of internal organization
(hierarchy) for market-mediated exchange often occurs on this account.
As I read Williamson, he is not referring here to the welfare properties of

prices, the issue that concerns Grossman and Stiglitz (1976), Grossman
(1980, 1989), and Bolton and Farrell (1990), who argue that contrary to
Hayek, real-world market prices are not ‘sufficient statistics’ for changes
in tastes and technology, and that in general only perfectly competitive
prices convey useful information. Rather, Williamson is simply following
Coase in arguing that direct coordination of factors by an entrepreneur,
inside a firm, can be an effective way of organizing production in the face
of dispersed, tacit knowledge in markets, knowledge that is not always
parameterized effectively in prices.3
Besides bounded rationality, tacit knowledge, and the informational
role of prices, at least two other Hayekian concepts appear in Williamson’s
work. One is Hayek’s (1967) emphasis on the role of general, abstract
rules, rather than particular mandates, and Hayek’s claim that social sci-
entists should study patterns, rather than specific outcomes. Williamson
sees his own general model of contractual relationships or ‘simple con-
tracting schema’, in which contractual hazards pose problems that require
safeguards such as incentive alignment, specialized governance mecha-
nisms (like vertical integration), or reputation through repeated deal-
ings (Williamson, 1985, pp. 32–5), as an example of a Hayekian general
rule: ‘Although the particulars differ, vertical integration, nonstandard
contracting for intermediate goods, the employment relation, corporate
governance, and regulation are all, according to the argument developed
[here], variations on a theme’ (Williamson, 1985, p. 348). Transaction cost
economics, in Williamson’s view, is a highly general theory of economic
organization.
The other important Hayekian concept in Williamson’s work is the idea
of spontaneous order, in the context of adaptation to unanticipated change.
In ‘Economic Institutions: Spontaneous and Intentional Governance’
(Williamson, 1991), Williamson argues that economists, following Adam
Smith and Hayek, have tended to focus on ‘spontaneous governance’, the
ability of decentralized market systems to evolve in response to changes
in resource availability, technical knowledge, demand characteristics, and
the like. The study of coordinated or intra-firm adaptation, Williamson
argued, has received less attention, though it was a chief concern of earlier
scholars of administrative behaviour such as Chester Barnard (1938) and

Herbert Simon (1947). Barnard too argued for the importance of adapta-
tion, but in a bureaucratic context. Williamson (1991, pp. 163–4) attempts
to reconcile Hayek and Barnard in this way:
I submit that adaptability is the central problem of economic organization and
that both Hayek and Barnard are correct. That both are correct is because they
are referring to adaptations of different kinds, both of which are needed in a
high-performance system. The adaptations to which Hayek referred could be
implemented autonomously: each party examined prices in relation to his own
opportunities and responded autonomously. Accordingly, such adaptations
will be referred to as adaptations A, where A denotes autonomous. By con-
trast, the adaptations with which Barnard was concerned involved ‘that kind
of cooperation among men that is conscious, deliberate, purposeful’ (Barnard,
1938, p. 4) and were realized through formal organization – especially hier-
archy. Adaptations of a consciously coordinated kind will be referred to as
adaptations C, where C denotes cooperative. Recourse to fiat provides better
assurance that adaptations of the latter kind will be performed in a coordinated
way. Contrary opinions notwithstanding, markets and hierarchies are not
indistinguishable in fiat respects. Hierarchy is superior to the market in bilateral
adaptability respects – precisely because of its differential access to fiat.
The ability to effect bilateral adaptation is, in Williamson’s framework,

an advantage of internal organization. And yet, firms cannot mimic spon-
taneous adaptation through internal markets, due to the ‘impossibility
of selective intervention’, the inability of a firm’s central management to
commit credibly not to intervene in the affairs of subunits and subordi-
nates, which attenuates the incentives of the latter. Williamson illustrates
with an extensive, and nuanced, discussion of the socialist calculation
debate (Williamson, 1991, pp. 176–83). Williamson does not, ultimately,
accept the arguments of Mises and Hayek that socialism fails because
of the lack of monetary calculation (Mises) or the inability of socialist
planners to obtain the necessary specific knowledge (Hayek), placing
emphasis instead on the incentive effects of state control of resource allo-
cation: specifically, state apparatchiks cannot make credible commitments
not to appropriate the gains created by other agents in the system. But
Williamson’s discussion of the problem, in both a static and a dynamic
context, displays considerable familiarity with the Austrian arguments.
Curiously, Williamson does not make the link, in his writings, between
the core transaction cost economics concept of asset specificity and
Hayek’s theory of capital, despite close similarities and complementari-
ties. Asset specificity refers to ‘durable investments that are undertaken in
support of particular transactions, the opportunity cost of which invest-
ments are much lower in best alternative uses or by alternative users should
the original transaction be prematurely terminated’ (Williamson, 1985, p.
F.A. Hayek 81
55). Like Klein et al. (1978), Williamson emphasizes the ‘holdup’ problem
that can follow such investments, and the role of contractual safeguards in
securing the returns to those assets.
Hayek’s (1931, 1933a, 1941) theory of capital focuses on a different
type of specificity, namely the extent to which resources are specialized to
particular places in the time structure of production. Carl Menger (1871),
founder of the Austrian school, famously characterized goods in terms
of orders: goods of the lowest order are those consumed directly; tools
and machines used to produce those consumption goods are of a higher
order; and the capital goods used to produce the tools and machines
are of an even higher order. Building on his theory that the value of all
goods is determined by their ability to satisfy consumer wants (that is,
their marginal utility), Menger showed that the value of the higher-order
goods is given or ‘imputed’ by the value of the lower-order goods they
produce. Moreover, because certain capital goods are themselves pro-
duced by other, higher-order capital goods, it follows that capital goods
are not identical – at least by the time they are employed in the production
process. The claim is not that there is no substitution among capital goods,
but that the degree of substitution is limited. As Lachmann (1956) put it,
capital goods are characterized by ‘multiple specificity’. Some substitution
is possible, but only at a cost.
Mises and Hayek used this concept of specificity to develop their
theory of the business cycle. Williamson’s asset specificity focuses on spe-
cialization not to a particular production process but to a particular set of
trading partners. Williamson’s aim is to explain the business relationship
between these partners (arm’s-length transaction, formal contract, verti-
cal integration, and so on). The Austrians, in other words, focus on assets
that are specific to particular uses, while Williamson focuses on assets
that are specific to particular users. But there are obvious parallels, and
opportunities for gains from trade. Austrian business-cycle theory can be
enhanced by considering how vertical integration and long-term supply
relations can mitigate, or exacerbate, the effects of credit expansion on the
economy’s structure of production. Likewise, transaction cost economics
can benefit from considering not only the time-structure of production,
but also Kirzner’s (1966) refinement that defines capital assets in terms of
subjective, individual production plans – plans that are formulated and
continually revised by profit-seeking entrepreneurs.
A few recent works apply asset specificity to macroeconomics (Caballero
and Hammour, 1996, 1998; Caballero, 2007; Agarwal et al., 2009)
and other aggregate phenomena such as economy-wide restructuring
(Caballero, 2007) and international trade (Nunn, 2007; Antràs and
Rossi-Hansberg, 2009), and this may signal the start of a promising
new direction in contemporary macroeconomics, particularly now that

‘Austrian’ concerns about industry-specific effects of boom and bust are
gaining attention (for example, Oppers, 2002).
Notes
1. For biographical treatments see Hayek (1994), Klein (1999), Ebenstein (2001), and
Caldwell (2003).
2. Murray Rothbard, one of the most influential twentieth-century Austrian economists,
states that his own treatment of the limits of the firm
serves to extend the notable analysis of Professor Coase on the market determinants
of the size of the firm, or the relative extent of corporate planning within the firm as
against the use of exchange and the price mechanism. Coase pointed out that there are
diminishing benefits and increasing costs to each of these two alternatives, resulting,
as he put it, in an ‘“optimum” amount of planning’ in the free market system. Our
thesis adds that the costs of internal corporate planning become prohibitive as soon
as markets for capital goods begin to disappear, so that the free-market optimum will
always stop well short not only of One Big Firm throughout the world market but also
of any disappearance of specific markets and hence of economic calculation in that
product or resource (Rothbard, 1976, p. 76).
See also Klein (1996).
3. Coase and Williamson do not mean, as is sometimes assumed, that firms are not part of the
market. They are talking about a completely different issue, namely the distinction between
types of contracts or business relationships within the larger market context. The issue is
simply whether the employment relationship is different from, say, a spot-market trade or
a procurement arrangement with an independent supplier. Alchian and Demsetz (1972)
famously argued that there is no essential difference between the two – both are voluntary
contractual relationships, there is no coercion involved, no power, and so on. Coase,
Williamson, Herbert Simon, Grossman and Hart (1986), Foss et al. (2007), and most of
the modern literature on the firm argues that there are important, qualitative differences,
based on differences in court enforcement of internal and external agreements, the alloca-
tion of residual control rights, and the judgment that accompanies asset ownership.
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9 Herbert Simon
Saras Sarasvathy
In a series of published and unpublished exchanges toward the end of the

twentieth century, Herbert Simon and Oliver Williamson argued about
the relationship between transaction cost economics (TCE) and behav-
ioural economics. The exchange derived from personal biography as well
as intellectual history and attested to differences not only of ideas but of
world views. Augier and March (2001) provide one explanation for the
disagreement in terms of a family quarrel about the degree to which one
ought to assume unbounded rationality, opportunism, and conflict in the
creation and sustenance of human organizations.
Another aspect to the quarrel consists in the fact that Simon was
not merely or even primarily an economist or social scientist. He was a
Renaissance man, a polymath – deeply interested in how the human mind
works and how that coheres with how the universe works. Opportunism,
like unbounded rationality and conflict, did not make sense to him as
fundamentals of human behaviour either empirically or historically and
certainly not in terms of what we know about biological evolution. These
concepts also did not make sense to him normatively, as guides for future
action, for creatures consciously engaged in ‘designing’ their own environ-
ments, nor for scientists studying such creatures – scientists of ‘the artifi-
cial’ (Simon, 1996).
Concepts such as bounded rationality, docility, and intelligent altruism
were more interesting and fundamental to him, even if they were ‘messier’
because (i) they were empirically-based, and (ii) they were necessary to hold
together a larger, more general tapestry of what we know about human
evolution and history within which organizations and markets play smaller
roles. Simon explicitly stated that he was not in favour of sacrificing an
empirical understanding of how actual humans behaved even if this meant
sacrificing simplicity and elegance in the theories that ensued. His argu-
ment about Occam’s razor is telling in this regard (Simon, 1979, p. 495):
The application of the principle of satisficing to theories is sometimes defended

as an application of Occam’s Razor. But Occam’s Razor has a double edge.
Succinctness of statement is not the only measure of a theory’s simplicity.
Occam understood his rule as recommending theories that make no more
assumptions than necessary to account for the phenomena (essentia non sunt
multiplicanda praeter necessitatem).
85
Throughout a career spanning over six decades, Simon inveighed against

economists’ penchant for ignoring facts on the ground and clinging to an
edifice of economic ‘laws’ built on increasingly shaky behavioural founda-
tions. In a full-scale argument on this topic in 1997, in a published version
of the Raffaele Mattioli Lectures, Simon (1997b, p. 21) emphasized the
importance of getting the empirics right:
The [neoclassical] model itself is manipulated with great mathematical formal-
ity, and if it is tested with quantitative data, high standards of sophistication
are imposed on the statistical methods employed. What is omitted is any
serious testing of the validity of the assumptions of the model itself, even the
kind of historical, experiential and anecdotal testing that we find in Smith and
Marshall. This might be all right if the quantitative, econometric tests were
generally sharp and decisive. Almost always, they are not.
The literature of modern economics is full of examples of the sensitivity of
models to small changes of assumptions – many, if not most of them beyond the
limits of accuracy of statistical tests.
For the most part, Simon has won the argument with regard to bounded
rationality, but his challenges continue with regard to other assumptions.
One such assumption of particular importance to TCE is opportunism.
Opportunism in TCE
Just as Simon’s early decades were focused on convincing economists
and others that ‘the major reason why we humans do not behave in a
globally rational way was because we cannot’, in the latter decades, he
began to focus on the fact that ‘we are highly dependent on those around
us’ (Simon, 1997b, p. 40). Both empirical findings and evolutionary argu-
ments led Simon to conclude that pure self-interest, or its stronger cousin,
opportunism, was an inappropriate assumption in models of transactions,
not to say inaccurate and even normatively dangerous for our understand-
ing and design of organizations.
We can trace back TCE’s behavioural assumptions about opportunism
and the ensuing lack of trust in concepts such as altruism, loyalty, and
organizational identification, to a partial reading of Adam Smith. For
example, economists often cite and build upon The Wealth of Nations
(Smith, 1776 [1981]), in which Smith developed his ideas about the spon-
taneous benefits of selfishness, an idea he got from Mandeville (1714). The
oft-quoted but mostly misunderstood passage from Smith’s book (1776
[1981]) concerning the butcher and baker (Baumol, 2002) forms the basis
for economists’ generalization of the fundamental behavioural assump-
tion about human self-interest. But Smith’s (arguably) most important
work, The Theory of Moral Sentiments (Smith, 1759 [2000]), needs to be
consulted if we are to have a complete picture of Smith’s position on the
Herbert Simon 87
matter (Werhane, 1991; Sen, 1985). By ignoring The Theory of Moral

Sentiments, economists have set the stage for a continuing debate between
their own normative theorizing and the observed empirical experience of
human transactions, both within and outside organizations.
The notion of opportunism, defined as ‘self-interest seeking with guile’
is rather recent and can be found in Williamson (1975). It is important
to note here that Williamson is not saying that opportunism is always at
work; he is only saying that contracts should be made on the assumption
that it could be at work. In other words, contracts should be made with an
eye to the opportunistic potential they offer (Williamson, 1985).
The work of Douglass North (1978) in economic history illustrates well
both the potential for and limits to economic analysis built on assump-
tions of opportunism. In using opportunism-driven transaction costs as
prime movers in economic history, North had to provide an explanation
for the observed evidence of successful collective action such as the voting
paradox, the absence of free riding in various human organizations, the
pervasiveness of charity, and so on. In seeking to explain these manifest
phenomena, North introduces the notion of ‘ideology’ as the missing
factor in economic analyses. However, North does not have an underly-
ing explanation why people should buy into ‘ideology.’ Similarly, scholars
who argue in a more strictly neoclassical vein, such as Stigler and Becker
(1977), Becker (1976), and Gauthier (1984), all have the problem of being
unable to explain why rational actors would acquire beliefs and behav-
iours that are not in their narrow self-interest. While North’s conclusions
also cohere with those of Arrow (1974) and Sen (1985), others have posited
other exogenous factors such as the Protestant ethic (Weber, 1905 [2001]).
Docility and intelligent altruism

Simon has a different explanation, a behavioural construct that brings
together experimental evidence and formal evolutionary models to provide
an alternative assumption for transactional and organizational econom-
ics. That construct is docility. Simon defined it as: ‘The tendency to depend
on suggestions, recommendation, persuasion, and information obtained
through social channels as a major basis of choice’ (1993, p. 156). Docility
follows directly from the limitations of human cognition. Through a series
of articles, essays and lectures, Simon developed a notion of ‘intelligent’
altruism based on this notion of docility to argue that bounded rational-
ity not only limits our ability to undertake the computational demands of
highly opportunistic behaviour, but also selects such behaviour out (in an
evolutionary sense) and selects in those who are willing and able to depend
on others and help sustain others in a group – that is, intelligent altruists
(Simon, 1997a, 1997b).
More recently, Knudsen (2003) has argued for the role of docility in the
emergence of altruism in biological populations. The case for the evolu-
tionary dominance of intelligent altruists is also well-argued from perspec-
tives other than those resting on docility. Hill (1990) for example, shows
that under the normal assumptions of neoclassical economics, the invisible
hand of the market will tend to weed out persistently opportunistic behav-
iour. Interestingly enough, without resorting to evolutionary arguments,
Adam Smith himself had made the case for the fundamental behavioural
assumption of persuasion in all economic exchanges:
Different genius is not the foundation of this disposition to barter which is the
cause of the division of labour. The real foundation of it is that principle to per-
suade which so much prevails in human nature . . . We ought then to mainly cul-
tivate the power to persuasion, and indeed we do so without intending it. Since
the whole life is spent in the exercise of it, a ready method of bargaining with
each other must undoubtedly be attained. (Smith, 1776 [1981], pp. 493–494)
Game-theoretic and behavioural-economic evidence of all kinds has

been accumulating over the last two or more decades pressing us to
rethink the assumption of pure opportunism. In fact, what we know about
self-interest based on empirical evidence, both in the lab (see Rabin, 1998,
for a comprehensive review) and in the field, suggests that neither oppor-
tunism nor altruism or trust can possibly form clear bases for predictions
about human behaviour. Both are not only confounded by heterogeneity
in behavioural traits and choices, but are situated and change over time.
Dawes and Thaler (1988, p. 195) capture this in an eloquent passage:
In the rural areas around Ithaca it is common for farmers to put some fresh
produce on the table by the road. There is a cash box on the table, and custom-
ers are expected to put money in the box in return for the vegetables they take.
The box has just a small slit, so money can only be put in, not taken out. Also,
the box is attached to the table, so no one can (easily?) make off with the money.
We think that the farmers have just about the right model of human nature.
They feel that enough people will volunteer to pay for the fresh corn to make
it worthwhile to put it out there. The farmers also know that if it were easy
enough to take the money, someone would do so.
Besides the negative evidence against any default propensity for oppor-
tunism, there is also direct positive evidence for the construct of docility
– the fact that human beings are prone both to give and take advice. In a
summary of findings on the subject, Schotter (2003, p. 196) concludes:
(i) Laboratory subjects tend to follow the advice of naïve advisors (i.e. advi-
sors who are hardly more expert in the task at hand than they are).
(ii) This advice changes their behavior in the sense that subjects who play
Herbert Simon 89
games or make decisions with naïve advice play differently than those
who play identical games without such advice.
(iii) The decision made in games played with naïve advice are closer to the
predictions of economic theory than those made without it.
(iv) If given a choice between getting advice or the information upon which
that advice was based, subjects tend to opt for the advice, indicating a
kind of underconfidence in their decision-making abilities that is counter
to the usual egocentric bias or overconfidence observed by psychologists.
(v) The reason why advice increases efficiency or rationality is that the
process of giving or receiving advice forces decision-makers to think
about the problem they are facing in a way different from the way they
would if no advice were offered.
For Simon the important point was that most of what we do we have
learned from those around us because ‘[b]ehaving in this fashion contrib-
utes heavily to our fitness because . . . the information on which this advice
is based is far better than the information we could gather independently.
As a result, people exhibit a very large measure of docility’ (Simon, 1993,
p. 157, italics in original). By fitness, Simon meant our biological fitness,
that is, the effectiveness with which we produced progeny. Simon theo-
rized that social information contributes so heavily to our fitness – it is
such an adaptive trait – that docile human beings drove out non-docile
human beings in actual evolutionary competition. He believed that ‘[t]he
farther the complexities of the real world extend beyond our capabilities
for knowledge and calculation, the more valuable is docility, to enable us
to benefit from the collective knowledge and skill of our society’ (Simon,
1997b, p. 41).
From a gene’s-eye perspective, docility would be strongly selected for
because it enhances the reproductive fitness of each human being. In other
words, docility is the individual’s way of leveraging the advantages of social
living (including the rudimentary division of labour, which is thought to
extend a million years into human history (Ridley, 1997)). As a result of
being fitness-enhancing at the level of the gene, the population of human
beings that now walks the planet exhibits a large degree of docility.
It is interesting to speculate what a TCE that took docility as its fun-
damental behavioural assumption would look like. Perhaps we would
need to go beyond bargaining to negotiation – and not merely distributive
negotiation (aimed at dividing the pie) but integrative negotiation to grow
the pie under negotiation (Pruitt, 1981; Pruitt and Lewis, 1975; Pruitt and
Rubin, 1986). In other words, TCE could be incorporated into growth
models and into the economics of innovation in new ways – not only com-
petition but also cooperation could serve as a discovery procedure (Hayek,
1945, 1968). In fact, the results summarized by Schotter (2003) suggest an
explicit role for docility in coming up with creative solutions to problems.
Similarly docility-based TCE might provide ways to move beyond static

models of social networks to dynamic ones. In a world view in which
opportunism is not such a big hurdle and the ability and willingness to
persuade and be persuaded is a dominant characteristic, humans will be
able to build new relationships more easily and grow their networks faster.
This could bring to the fore interesting challenges to current static models
such as Burt’s (1992) structural holes.
Simon the man

It is perhaps appropriate to conclude with a biographical sketch of the
scholar’s personal stance on the subject of behavioural assumptions at
the heart of our choices in building a better society. In terms of personal
political preference, Simon was a New Deal Democrat. In a characteristi-
cally profound yet simple way, he explained his choice as follows (Simon,
1991, p. 133):
The reason is depressingly simple, and has little to do with the wisdom or
unwisdom of specific policies of either political party. Among the fundamental
problems in every society, two stand out. People have to be motivated to con-
tribute to the society, to produce. At the same time, they have to be protected
if they are unable to take care of themselves adequately. You can think of it as
the balance between incentives and distributive justice. Too much concern with
the latter may weaken the former, and vice versa.
Using this simple-minded dichotomy, you can classify people (roughly) into
two groups by their answers to the following question: Is it more important
that (a) all chiselers be detected and removed from the welfare lists, or (b) no
sparrow should fall from Heaven unseen and uncared for? If the answer is (a),
the respondent is a Republican; if (b), a Democrat. Either answer is rationally
defensible. I just happen to prefer the second one.
In a world where ‘liberal’ has become a bad word that current American
politics is striving to re-define, it is perhaps time for economists too to
rethink the fundamental assumption about human behaviour that is used
to explain and inform the design of our social and political institutions.
It is cause for comfort to know that while Simon, the scientist, urged this
from an empirical standpoint, Simon, the person, also believed it would be
a good guiding principle for building a better society.
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Chicago Press.
Herbert Simon 91
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Perspectives, 2 (3), 187–97.
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York: Free Press.
10 Property rights economics
Nicolai J. Foss
The 1960s were extraordinarily fertile in applied as well as formal micro-

economics. Thus the decade witnessed fundamental breakthroughs in the
economics of uncertainty and information and in human capital theory,
the first stabs at what would later be called ‘agency theory’ and ‘mecha-
nism design’, and other advances in mathematical economics.
One of the important breakthrough theories of the 1960s was property
rights economics (PRE). ‘First-generation’ property-rights economists
such as Armen Alchian, Ronald Coase, Harold Demsetz, and (Coase
student) Steven Cheung developed a refined but mainly verbal approach
to an economic explanation that they saw, and advertised, as fundamen-
tally neoclassical but with a much wider explanatory reach. Their work
served as direct inspiration for the slightly later work of the ‘second-
generation’ PRE theorists such as Louis De Alessi, Yoram Barzel, Eirik
Furubotn, Douglass North, Steven Pejovich, and John Umbeck. Modern
(third-generation) representatives of the PRE are Douglas Allen, Lee
Alston, Thrainn Eggertson, Gary Libecap, Dean Lueck, Ellinor Ostrom,
and others. A different approach, emerging in the mid 1980s (Grossman
and Hart, 1986), growing out of formal contract theory as well as key
ideas in transaction cost economics (TCE), and associated with the work
of Oliver Hart and his colleagues and students, is often also referred to
as the ‘property-rights approach’. This approach will be briefly discussed
towards the end of the chapter.
PRE has been directly and strongly influential in law and economics
(Coase, 1960), economic history (Alchian and Demsetz, 1973; North,
1990), the theory of the firm (Alchian and Demsetz, 1972), contract eco-
nomics (for example, Cheung, 1970; Allen and Lueck, 1995), early com-
parative systems research (see Furubotn and Pejovich, 1972), and resource
and agricultural economics (for example, Cheung, 1969; Libecap, 1989;
Allen and Lueck, 1998). It has had a large, but less direct, influence on
industrial organization, agency theory, and corporate governance (includ-
ing the ‘Yugoslav firm’ debate as well as the debate on ‘co-determination’,
see Furubotn and Pejovich, 1972).
The basic analytical category proffered by the PRE is, of course, that of
property rights, and the main explanatory aims have consistently been to
investigate how the delineation, exchange, and enforcement of property
92
Property rights economics 93
and ownership rights influence resource allocation, and how this frames an
economic approach to institutions and organizations. Thus, in a number
of ways, the PRE is akin in its aims to TCE. Both acknowledge a funda-
mental debt to the thinking of Coase (1937, 1960) (Barzel and Kochin,
1992; Williamson, 1996), both place the notion of transaction costs centre
stage in the explanatory structure of the theory, and there is some overlap
in terms of explanandum phenomena. However, there are also important
differences, most obviously that the PRE is more directly situated within
neoclassical economics than TCE.
Property rights
Property-rights theorists often portray the PRE as fundamentally an
extension of neoclassical economics, in the sense that: (1) the utility-
maximization hypothesis is applied to virtually all choices (Alchian, 1958,
1965; Barzel, 1997); (2) it considers all of the constraints implied by the
prevailing structure of property rights and transaction costs (for example,
Demsetz, 1964; Alessi, 1990); and (3) it explicitly considers the contractual,
organizational, and institutional implications of (1) and (2) (Eggertson,
1990). In sum, introducing the notion of property rights very significantly
extends the reach of economic thinking because it expands and refines the
understanding of individuals’ opportunity sets.
While true, this is also something of a retrospective rationalization.
The PRE actually begins by introducing a new unit of analysis in a spe-
cific context, namely the analysis of externalities in Coase (1960), and the
three characteristics above unfolded only gradually over the following
decade. For example, the full implications of the zero-transaction-costs
assumption – for example, that if transaction costs are zero monopolies do
not influence resource allocation (Demsetz, 1964) and that all institutional
alternatives are efficient (Cheung, 1969) – were not present in PRE think-
ing from the beginning, and are indeed still under debate (for example,
Furubotn, 1991; Barzel, 1997).
Thus, the unit of analysis in PRE is the property right. As indicated
already, the first paper to put forward the property right explicitly as a
meaningful unit of analysis is Coase (1960), although the property-rights
ideas in that famous paper are anticipated in Coase’s 1959 paper on the
allocation of radio frequencies (Coase, 1959) and a paper by Alchian
(1958). Coase (1960) examines the economic implications of allocating
legally delineated rights (liability rights) to a subset of the total uses of an
asset, namely those that have external effects on the value of other agents’
abilities to exercise their use rights over assets. As part of his critique of the
Pigouvian tradition in welfare economics, Coase (1960, p. 155) notes that
a reason for its failure to come fully to grips with externality issues lies in
its ‘faulty concept of a factor of production’, which, according to Coase,

should be seen not as a physical entity but as a right to perform certain
actions. These rights are property rights.
A fundamental insight emerging from Coase’s work is that transactions
involve the exchange of property rights (rather than goods and services
per se). As Coase explained, property rights to an asset can be partitioned
in various ways. Much subsequent work within PRE refined this insight,
applying it to issues like public ownership and the public corporation.
Yoram Barzel’s (1997) work in particular has been taken up with examin-
ing the consequences of the multi-attribute nature of most assets. It had
long been recognized, of course, that some rights may be held in common,
with open access, while other rights are held in private (Knight, 1924).
However, unfolding the concept of property rights and its application
to the public–private spectrum revealed that the range of property rights
is very extensive indeed (Alessi, 1990). This led to a highly sophisticated
analysis of how the property rights associated with an asset impact indi-
vidual incentives, because property rights are fundamentally about who
should bear the consequences of choices involving the relevant asset. Like
the rest of economics, PRE assumes that behaviours vary predictably as a
consequence of such incentives.
Characteristics of property rights

The analysis of the nature of property rights has clearly evolved within the
PRE. Coase (1960) was mainly interested in the allocation of use rights
to assets. Demsetz (1964) and Alchian (1965) went beyond this, defining
property rights as individuals’ rights to the use, income, and transfer-
ability of assets, a definition corresponding to the partition in Roman law
between usus, fructus, and abusus, respectively.1 The relation to property
law was also debated. It became increasingly clear that property rights can
be analysed conceptually apart from legal considerations (some scholars
therefore talk about ‘economic rights’, for example, Barzel, 1997). In
fact, it was recognized that property rights may exist in the absence of the
state, that is, under wholly anarchic conditions (Bush and Mayer, 1974;
Umbeck, 1981). Physical force or strong social norms may guarantee de
facto control over the uses of and income from a resource. It also became
clear that property rights have an inherently forward-looking dimension
and that, therefore, uncertainty is an important aspect of property rights.
Finally, it became clear that from an economic perspective property rights
can be understood in value terms and that agents seek to maximize the
value of the control they hold over assets.
In line with such ideas, Alchian and Allen (1969, p. 158) offered a highly
compact definition of property rights as ‘the expectations a person has
that his decision about the uses of certain resources will be effective’ (see
also Cheung, 1970). Barzel (1994, p. 394; emphasis in original) explains
property rights as:
an individual’s net valuation, in expected terms, of the ability to directly

consume the services of the asset, or to consume it indirectly through exchange.
A key word is ability: The definition is concerned not with what people are
legally entitled to do but with what they believe they can do.
Essentially, property rights in such definitions refer to an individual’s

expected opportunity set, and they imply that even Robinson Crusoe
would hold property rights. They also suggest that the definition of a prop-
erty right is independent of legal considerations; to the extent that he holds
effective control over an asset, a thief holds property rights to that asset
(Barzel, 1997). However, although property rights may thus exist poten-
tially in the absence of law, in reality they have legal counterparts and the
value of property rights is influenced by legal sanction and enforcement
(Barzel, 1997). Not surprisingly, many property-rights scholars have
strongly stressed the fundamentally social nature of property rights. Thus,
Demsetz (1967, p. 347) argues that:
[i]n the world of Robinson Crusoe property rights play no role. Property rights
are an instrument of society and derive their significance from the fact that they
help a man form those expectations which he can reasonably hold in his deal-
ings with others. These expectations find expression in the laws, customs, and
mores of a society. An owner of property rights possesses the consent of fellow-
men to allow him to act in particular ways. An owner expects the community to
prevent others from interfering with his actions, provided that these actions are
not prohibited in the specifications of his rights.
Levels of analysis
Such definitions direct attention to ‘macro’ determinants of property
rights such as norms, customs, and law. Of course, norms defining prop-
erty rights can exist on lower levels, such as within or between firms. Thus,
corporate culture (Jones, 1983) and relational contracting (Williamson,
1996) serve to delineate and enforce property rights. Moreover, property
rights are, of course, allocated in formal contracts. This suggests distin-
guishing various analytical levels at which property rights can be enforced.
(Of course, property rights also exist on various levels; for example, both
natural and corporate persons can hold property rights). Indeed such a
distinction has been made in the PRE literature, notably in the work of
Douglass North (1990), whose distinction between organizations and
institutions captures the difference between the more micro property-
rights arrangements in the form of contracts and organizations and the
macro property regimes embodied in laws, customs, and the coercive

machinery of the state.
Property rights and transaction costs

Transaction costs were introduced by Coase in his 1937 paper on the firm
(Coase, 1937), well before the 1960 paper on social cost (Coase, 1960).
Arguably, one reason so little progress was made on the analysis in the
first paper is that transaction costs are difficult to define without a clear
conception of property rights (Barzel and Kochin, 1992). However, Coase
(1960) does not systematically derive transaction costs from property
rights. Instead, he defines the former as search costs, communication
costs, bargaining costs, contract drafting costs, and contract monitoring
costs (Coase, 1960, p. 15). Thus, transaction costs in Coase (1960) are a
more refined version of the ‘costs of using the price mechanism’ intro-
duced by Coase (1937) (Cheung, 1969). Indeed, the link between property
rights and transaction costs that interests Coase (1960) is the fact that
when transaction costs are positive, property rights are ill-defined, which
reduces attainable output. Of course, this link between inputs, ‘organiza-
tion’, and allocative consequences provided a vital overall framing that
was crucially important for future thinking on the theory of the firm
(Barzel and Kochin, 1992).
Alchian’s (1958) almost simultaneous examination of the absence of
private property rights in government links transaction costs and property
rights in a different way. Alchian develops a general argument that govern-
ment assets are insufficiently protected and that this leads to a failure of
marginal pricing and use of government services. Thus, insecure property
rights induce costly racing to capture wealth, an argument later refined in
several contributions to the PRE (for example, Anderson and Hill, 1990;
Lueck, 1995). Thus, transaction costs as waste result from ill-defined or
ill-protected property rights.
Actually, both causal processes (that is, transaction costs leading to ill-
defined property rights, and ill-defined and ill-protected property rights
leading to transaction costs) take place, and the overall PRE perspec-
tive on contracts, organizations, and institutions is that these exist to
minimize the allocative distortions implied by both processes (Eggertson,
1990; Lueck, 1995). Thus, in terms of the property-rights view of Hart
(1995) transaction costs of drafting contracts make contracts incomplete
(that is, property rights are ill-defined). This gives rise to a loss in terms
of inefficient investments, which may also be seen as transaction costs,
because it is an allocative distortion induced by direct transaction costs.
In Williamson’s (1996) thinking, ill-defined contractual rights give rise to
processes of costly ex post haggling.
Still, transaction costs are probably most conveniently defined in terms

of property rights, and most of the PRE has done exactly this. Thus,
transaction costs can be defined as the resources spent on delineating,
protecting, and capturing control over resources in use and in exchange
(Eggertson, 1990; Barzel, 1997). A particular case of transaction costs
is the measurement costs of inspecting attributes of goods and services
elegantly analysed by Barzel (1982). A famous benchmark case obtains
when transaction costs are zero: in what has become known as the ‘Coase
theorem’ (Stigler, 1966), Coase (1960) shows that if transaction costs
are zero – so that any property right can be costlessly delineated and
protected – any allocation of property rights results in the same pattern of
economic activities under which maximum value is created from the use of
resources.2 The mechanisms underlying this remarkable result are that: (1)
property rights to all possible uses of resources are delineated; (2) all prop-
erty rights are priced; and (3) all property rights can be traded – all at zero
cost. Maximizing agents will have incentives to trade property rights so
that resources end up in those uses where their contribution to value crea-
tion is maximized. The Coase theorem is no doubt one of the most exten-
sively debated pieces of economic thinking (for example, Cooter, 1982;
Usher, 1998). While it is surely warranted to devote resources to clarifying
key benchmark constructs, the Coase theorem is, as Coase emphatically
insists (Coase, 1988), just that: a benchmark designed to serve as a starting
point for analysis involving transaction costs.
The PRE and TCE

Of course, transaction costs are also central to Williamsonian TCE and
PRE and TCE share many important features. The PRE emerged first;
Furubotn and Pejovich’s (1972) and Alchian and Demsetz’s (1973) stock
takings of accomplishments since Coase (1960) were published when TCE
was in its infancy (Williamson, 1971). However, the influence of the PRE
on Williamson’s thinking seems fairly limited. He does not use property-
rights terminology, is critical of specific PRE papers (for example, see the
critique of Alchian and Demsetz, 1972, in Williamson, 1985), characterizes
the PRE as a distinct approach (for example, characterizing Barzel’s work
as the ‘measurement approach’ in Williamson, 1985), and sees property
rights lying on a higher analytical level than his own concern with levels of
analysis that involve the firm (Williamson, 2000). Moreover, certain dis-
tinct features set Williamson’s thinking apart from that of most property-
rights economists. In particular, Williamson’s insistence on bounded
rationality does not resonate with all scholars associated with PRE (for
example, Barzel and Kochin, 1992). On the other hand, key PRE scholar
Armen Alchian is one of the originators of the emphasis on the problems
caused by asset specificity in the context of incomplete contracting (Klein

et al., 1978). The treatment of this problem and its remedies is a key
concern in TCE, and is not inconsistent with the PRE.
Property rights economics: old and new

Much work in PRE has focused on differences between property-rights
systems as alternative ownership arrangements (collective versus private
ownership). However, the economic meaning of asset ownership does
not seem to be pinned down precisely in PRE. Coase (1960) thinks of
private ownership as possession of ‘the right to carry out a circumscribed
list of actions’; that is, private ownership of an asset is the possession of
a vector of use rights for that asset. However, ownership per se is what
primarily interests Coase; his major concern is the allocation of use
rights. Conceptually, this allocation can be separated from the owner-
ship, because one can imagine that all possible uses (including future
ones) of assets are known and can be contracted for (indeed, this is one
possible interpretation of the Coase theorem). Under this interpretation,
the concept of ownership and the issue of who owns an asset are unim-
portant if transaction costs are zero. Even when Coase relaxes the zero-
transaction-cost assumption, his interest lies more in understanding the
allocative consequences of different legal arrangements of use rights than
ownership issues. Thus, a major problem left unaddressed by Coase is how
far one needs to ‘relax’ the assumptions underlying the Coase theorem to
produce a role for ownership.
Coase’s understanding also left unresolved the role played by other
types of economic rights besides use rights, such as income and alienability
rights, in the function of ownership. What economic considerations deter-
mine the allocation of these rights? The PRE only partially succeeded in
giving answers to the puzzles left by Coase. In fact, Demsetz (1988, p. 19)
argues that the meaning of ownership is inherently ‘vague’ because there
is no bound to the number of attributes, uses, and so on of an asset that
can be owned, although he thinks that ‘certain rights of action loom more
important than others. Exclusivity and alienability are among them’.3
Perhaps because of the perceived vagueness of the notion of ownership,
PRE scholars have been more concerned with the efficiency consequences
of property-rights allocation across agents when transaction costs are
positive than the issue of ‘who owns an asset’.
At the same time, ownership has a concrete meaning in the law: both
legislation and jurisprudence distinguish the law relating to contract from
the law relating to asset ownership. The law relating to ownership is more
than simply part of a low-cost enforcement institution; it provides default
rules or a ‘standard contract’ that reduces information and communication
costs and has allocative consequences for this reason. Moreover, legal
ownership is a low-cost way of allocating hitherto undiscovered uses of
assets. For example, giving people legal ownership implies that they hold
the legal right to future, as yet undiscovered, attributes of assets, in the
sense that courts will not interfere with the use of these assets by the parties
identified as the owners. In fact, the overall thrust in economics thinking
about property rights has changed from the focus of the PRE (that is, the
allocation of rights to an asset across multiple agents) to the issue of who
owns an asset and why this matters, the key concern of what may be called
the ‘new’ PRE (Grossman and Hart, 1986; Hart, 1995).
Historically and theoretically, the new PRE has been developed in the
context of the theory of the firm, more precisely the analysis of the vertical
boundaries of the firm (Grossman and Hart, 1986), the key explanandum
of TCE. Indeed, while contributors to the new PRE routinely make refer-
ence to Williamson, references to the old PRE are conspicuous by their
absence from the new PRE.
The new PRE approach begins with the idea that ownership of non-
human assets is what defines the firm; if two different assets are owned by
one person, there is one firm, while if the same two assets are owned by
different persons, there are two firms. The assets that are relevant here are
non-human assets, because human assets are non-alienable. The impor-
tance of non-human assets derives from their (potential) function as bar-
gaining levers in situations not covered by contract. This may be crucially
important when parties invest in specific assets – notably, investments in
the parties’ own human capital – and these assets are complementary to
specific non-human assets. Crucially, the parties’ investments in human
assets are assumed to be non-contractible. All bargaining after the parties
have made their investments in human assets is assumed to be efficient
(in marked contrast to, for example, Williamson, 1996). Therefore, the
model revolves around the effect of ownership of non-human assets on the
incentives to invest in human assets. Specifically, bargaining determines
the allocation of returns from investments, so that each party gets his or
her opportunity cost plus a share (assumed equal) of the (verifiable) profit
stream. Since in this setup individual returns differ from social returns,
and agents are sufficiently farsighted to foresee this, investments will be
inefficient.
It is possible to influence the investment of one of the parties positively
by reallocating ownership rights to non-human assets. A reallocation of
ownership of physical assets alters the parties’ opportunity costs of non-
cooperation (the status quo) after specific investments have been made,
and thus the expected pay-offs from the investments. However, this comes
only at the cost of reducing one of the parties’ investment incentives
(excepting the situation in which the parties’ marginal costs of investment

are equal). This trade-off determines allocation of ownership and hence
the efficient boundaries of the firm. Thus, the central issue of who owns an
asset or a bundle of assets. Underlying this focus is the idea that it is pos-
sible to identify unambiguously the owner of an asset.
A central idea in the new PRE is the distinction between specific rights
of control and residual rights of control. The former can be delineated and
directly allocated through contract, while the latter are obtained through
the legal ownership of assets and imply the ‘right to decide usages of the
asset in uncontracted-for contingencies’ (Hart, 1996, p. 371). However,
residual control rights encompass not only the rights to use assets, but
also to ‘decide when or even whether to sell the asset’ (Hart, 1995, p. 65).
In the new PRE ownership is defined as the legally enforced possession of
an asset. The economic importance of ownership stems from the owner’s
ability to exercise residual rights of control over the assets. This economic
conception is thus explicitly derived from the juristic conception. In other
words, the function of ownership is to allocate residual rights of control.
Thus, the meaning of ownership and its relation to property rights and the
legal system are addressed straightforwardly.
At first glance the new PRE notion of residual rights of control appears
to be a conceptual sword cutting through the Gordian knot of the meaning
of ownership in the old PRE literature. However, it does so by means of
some drastic simplifications (Foss and Foss, 2001). Recall that a key point
in the old PRE is an explicit distinction between the formal, legal title to
an asset and the economic rights to that asset (for example, Coase, 1960;
Alchian, 1965; Barzel, 1997). In the presence of transaction costs (particu-
larly measurement and enforcement costs), this distinction is important for
any asset, whether human capital or non-human capital. While these two
asset categories are treated symmetrically in the old PRE, the new PRE
treats them differently. In the new PRE ownership to, and contracts over,
physical assets are assumed to be fully and costlessly enforced by the legal
system, but contracts involving investments in human capital are assumed
to be completely unenforceable because of an asserted non-verifiability.
Foss and Foss (2001) argue that this asymmetry underlies the difficulty in
the new PRE in conceptualizing the difference between quasi-vertical and
vertical integration and in explaining the employment contract.
Conclusion
Relatively few economists today define themselves as working in the old
PRE tradition. Over the last two decades or so (that is, since the publica-
tion of Grossman and Hart, 1986), property rights have received attention
mainly because of the new PRE. It might thus appear that the old PRE
is essentially defunct, that its largely verbal mode of discourse has been
supplanted by the heavily formal approach of the new PRE. This view is
naïve, however. First, the new PRE is a considerably narrower approach
in terms of the phenomena it investigates. Second, the reason that rela-
tively little old PRE research appears in today’s economics journals may
be the old PRE’s success: property-rights reasoning has penetrated applied
price theory, the theory of economic organization, agricultural economics,
and many other fields, changing these fields in the process. Still, creative
work lying directly in the old PRE tradition continues to be carried out
by scholars such as Doug Allen, Yoram Barzel, Thrainn Eggertson, Dean
Lueck, and others.
Notes
1. Legal scholars may distinguish between ‘property’ (that is, having usus, fructus, and
abusus rights) and ‘possession’ (that is, having only usus and abusus rights). However,
PRE theorists think of all these rights as ‘property rights’. See Foss and Foss (2001).
2. And there are no ‘wealth effects’, that is, individuals do not change their consumption pat-
terns and firms do not change their investment patterns when they obtain more wealth.
3. Typically, ownership has been defined in this literature depending on the analytical
purpose. For example, Demsetz (1988) and Alchian (1965) both put much emphasis on
the rights to exclude and alienate as the relevant criteria of private ownership in their
work on systems of property rights, and see owners as those agents who can exercise
these rights. However, they slightly change these latter criteria when they analyse the
organization of the firm and corporate governance, where owners become defined as
those possessing control rights (Demsetz, 1967) or residual income rights (Alchian and
Demsetz, 1972).
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The Public Stake in Union Power, Charlottesville, VA: University of Virginia Press, pp.
350–371.
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Alchian, A.A. and W.R. Allen (1969), Exchange and Production: Theory in Use, Belmont:
Wadsworth.
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History, 33 (1), 16–27.
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(2), 343–86.
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Economics, 25 (1), 27–48.
Barzel, Y. (1994), ‘The capture of wealth by monopolists and the protection of property
rights’, International Review of Law and Economics, 14 (4), 393–409.
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resource’, Journal of Law and Economics, 13 (1), 49–70.
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the Market and the Law, Chicago: University of Chicago Press, pp. 157–85.
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Ownership, Control, and the Firm, Oxford: Basil Blackwell, pp. 104–16.
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Control, and the Firm, Oxford: Basil Blackwell, pp. 12–27.
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the Economics of Business, 8 (1), 19–37.
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PART III
FUNDAMENTAL
CONCEPTS
11 The costs of exchange1
Alexandra Benham and Lee Benham
What determines what goods and services are traded on markets and therefore
priced? What determines the flow of real goods and services and therefore the
standard of living? (Ronald Coase, 1999)
The law of one price is a fundamental assumption in economics. It states

that in a competitive market all individuals face the same price. Our thesis
here is that if the appropriate price is measured, different individuals often
face different prices for the same good, even in a competitive market. These
price variations affect what is produced and what exchanges take place in
and out of the market, which organizations and specialties survive, and
which rules of the game persist.
What is the appropriate price? Consider an individual making choices
based on prices and budget constraints. The relevant price the individual
faces is the full set of opportunity costs associated with those choices,
including the prices of the goods themselves plus the transaction costs of
obtaining the goods. Even if the money price of a particular good varies
little across individuals, the opportunity cost of engaging in the transac-
tion to obtain the good often varies substantially. This opportunity cost
will be affected by the individual’s personal knowledge, personal network,
transaction skills, time costs, location, organization, institutional setting,
and so on. Only in very exceptional cases will all active participants in a
transaction face identical opportunity costs. And even more rarely will all
potential participants face identical opportunity costs.
Definitions of costs
Transaction costs
Transaction costs are frequently invoked to explain economic phenom-
ena.2 Yet direct empirical estimates of transaction costs are rare.3 The
benefits of having better estimates are clear. Why does better information
not currently exist?
One problem is that there is no standard terminology. Many different
definitions of transaction costs appear in the literature. They often serve
as heuristic devices that are not used actually to measure transaction
costs. These definitions offer powerful conceptual insights, but they have
107
not been translated into widely accepted operational standards. Kenneth

Arrow has defined transaction costs as ‘the costs of running the economic
system’ (Arrow, 1969, p. 48, as noted in Furubotn and Richter, 1997, p.
40). Yoram Barzel defines transaction costs as ‘the costs associated with
the transfer, capture, and protection of rights’ (Barzel, 1997, p. 4). Thrainn
Eggertsson observes, ‘In general terms, transaction costs are the costs that
arise when individuals exchange ownership rights to economic assets and
enforce their exclusive rights. A clear-cut definition of transaction costs
does not exist, but neither are the costs of production in the neoclassical
model well defined’ (Eggertsson, 1990, p. 14).4
Eirik Furubotn and Rudolf Richter examine transaction costs in the
following terms:
[T]ransaction costs include the costs of resources utilized for the creation, main-
tenance, use, change, and so on of institutions and organizations. . . . When
considered in relation to existing property and contract rights, transaction costs
consist of the costs of defining and measuring resources or claims, plus the costs
of utilizing and enforcing the rights specified. Applied to the transfer of exist-
ing property rights and the establishment or transfer of contract rights between
individuals (or legal entities), transaction costs include the costs of information,
negotiation, and enforcement (Furubotn and Richter, 1997, p. 40).
Typical examples of transaction costs are the costs of using the market [market
transaction costs] and the costs of exercising the right to give orders within
the firm [managerial transaction costs]. . . . [There is also] the array of costs
associated with the running and adjusting of the institutional framework of a
polity [political transaction costs]. . . . For each of these three types of transac-
tion costs, it is possible to recognize two variants: (1) ‘fixed’ transaction costs,
that is, the specific investments made in setting up institutional arrangements;
and (2) ‘variable’ transaction costs, that is, costs that depend on the number or
volume of transactions (Furubotn and Richter, 1997 p. 43).
A second problem is that estimating transaction costs separately is

highly problematic because production and transaction costs are jointly
determined. Both theory and evidence suggest that changes in transaction
costs have a first-order impact on the production frontier. Lower transac-
tion costs mean greater specialization, more trade, changes in produc-
tion costs, and increased output. Changes in production costs also alter
transaction costs. Thus the impediments to isolating transaction costs are
formidable.
The costs of exchange

To overcome some of these difficulties, we propose to examine a related
measure that we call the costs of exchange. We measure the costs of
exchange in terms of the opportunity cost faced by an individual to
The costs of exchange 109
obtain a specified good using a given form of exchange within a given

institutional setting. More specifically, we define the costs of exchange
Cijkm as the opportunity cost in total resources – money, time, and goods
– for an individual with characteristics i to obtain a good j using a given
form of exchange k in institutional setting m.5 The costs of exchange
therefore include both the cost of the good itself and the transaction
costs incurred by the individual in obtaining the good. While we cannot
decompose the costs directly into these components, in comparative con-
texts this approach focuses attention on the total cost consequences of
differing transaction costs.
Where transaction costs are very high, many transactions do not take
place at all. Even when a specific transaction does occur, it may not take
place in an open market context with money prices. Hence only a small
subset of all potential transactions actually occur, and of these only a
subset appear as market transactions. Knowledge of the opportunity costs
of alternatives is obviously important in ascertaining why a particular
individual undertakes a particular transaction. To understand the choices
made, we may need to estimate the costs of those potential transactions
that did not actually occur.
Why costs of exchange vary

The costs of exchange can be expected to vary across individuals, groups,
and countries, both for some well understood reasons and for some less
explored. In the economics literature, it is well accepted that transaction
costs vary with tariffs, taxes, price controls, monopoly, price discrimina-
tion, information asymmetries, asset specificity, strategic behavior, and
opportunism. However, actual estimates of the direct effects are rare.
Furthermore, there are indirect effects. Tariffs, taxes, and price controls
require regulations, monitoring, and a bureaucratic process that can alter
transaction costs beyond the sectors that are directly regulated. Other
elements likely to contribute significantly to variation include personal
networks, formal and informal rules, and norms.
Across countries and over time

Many of the factors discussed above vary significantly across countries.
Taxes and tariffs are obvious sources of price variation. The institutions
of a country – the formal and informal rules of the game, including con-
stitutional constraints, regulations, and norms, plus their enforcement
characteristics, the mix of personal versus impersonal exchange – all vary
enormously and are likely fundamentally to affect the costs of exchange.6
Elements such as corruption, social capital, and constitutional constraints
have received attention (for example, see Knack and Keefer, 1997; Keefer,
2001), but systematic analysis of their relationship to actual cost conse-

quences is generally limited (see Benham and Benham, 1997).
The types of organizations in a country – private, public, and cooperative
– influence the costs of exchange. For example, state-owned enterprises
typically have different incentive structures than their private counter-
parts, and this can be expected to have an impact not only on the price of
goods but also on waiting times, forms of exchange, and the overall costs
of exchange (The World Bank, 1995). Political connections are likely to
assume greater importance in this case.
Some economic models assume that countries with substantial natural
endowments will have a comparative advantage in those products, and will
have higher output. However, countries with abundant and readily acces-
sible natural resources are often poor. The explanation here is straightfor-
ward: resource-rich countries are subject to greater rent-seeking, which in
turn leads to higher costs of exchange. In addition, government decision-
makers there have less incentive to support transaction-cost-reducing
institutions like the rule of law, because they can obtain funds directly by
appropriating natural resources.7
Across individuals and groups

There are some conventional and relatively well-explored reasons for
different individuals (and groups) to face different costs of exchange.
Long-standing reasons are variations in transportation costs and in the
opportunity cost of time.
Many other factors will also affect individuals’ costs of exchange. These
include specialization in the exchange (and frequency of conducting this
kind of exchange), skill in negotiating, local knowledge,8 personal net-
works, including elements of trust and social capital, political connections,
and ethnic membership. For individuals possessing different characteris-
tics, price controls or other state regulations will likely differentially alter
their costs of exchange.
Empirical illustrations of cost variations

If different individuals face different costs of exchange, estimating these
costs empirically requires a standardized methodology to gather infor-
mation at the micro–micro level. We require information which specifies
particular transactions in terms of the characteristics of the individual, the
good to be obtained, the form of exchange, and the setting. Our approach
is to select and specify some transactions in detail so that researchers
can measure the time and money costs incurred when the transaction
takes place. Individuals with designated characteristics (and by group or
country) can then be interviewed concerning the full time and money costs
they have actually incurred in engaging in the transaction. These will serve
as our proxies for the costs of exchange.9
The fact that the money price paid for a good can vary across non-
competitive groups is recognized. The same is also true if the commodity
is non-tradable. However, as the examples below show, transaction costs
can be large and highly variable compared to variability in money price.
Let us consider the following examples.
Variations in costs of exchange across countries

First, consider the simple transaction of obtaining a land-line business
telephone. The costs here affect the size of the telephone communications
network, the extent of use, the overall size of the market, and the extent of
specialization, particularly so prior to the introduction of cell phones. In
the early 1990s, we investigated the cost of obtaining a business telephone
in several countries. The actual price to obtain a telephone installed within
two weeks ranged from US$130 in Malaysia to US$6000 in Argentina. In
Egypt in l996, the official published price for a telephone was US$295 and
the official published ‘urgent response’ price was US$885. To proxy for
the opportunity cost, we compared the purchase prices for similar Cairo
apartments with and without a telephone already installed. This differ-
ence, which reflects the expected spot market price for a telephone for
someone not well-connected in this market, was approximately US$1180
to US$1770.
The costs of transferring ownership provide another example. Efficient
transfer of ownership of assets is fundamental to a modern market
economy. The costs associated with transferring ownership of an apart-
ment can be examined in this context. In Cairo, an individual who bought
an apartment in the 1990s and registered the transfer of ownership paid
an additional 12 percent of the apartment price to third parties: 6 percent
for taxes and 6 percent for a lawyer to register the transfer as required by
law. The services of a real estate agent, which were optional, cost about
1.5 percent of the sale price. In St Louis, Missouri, USA, the cost of legally
transferring ownership was approximately 1.5 percent of the sale price. If
the services of a real estate agent were used there, they cost 6 percent of the
sale price. The differences across these rates are striking. Within the state-
controlled sector, fees were eight times as high in Cairo as in St Louis, but
within the competitive sector, they were only one-fourth as high (Benham,
1997).
Transactions across national borders are important indicators of the
extent of the market. To look at variation across countries, we examined
the costs of exchange associated with importing a crankshaft for a large
earthmoving tractor. In Peru in 1989, formally obtaining such a crankshaft
cost four times as much in money price and over 280 times as much in
waiting time (41 weeks versus one day) as in the USA. In Argentina, the
money price was twice that in the USA, and the waiting time was up to
30 days. In contrast, in Malaysia the money price and waiting time were
essentially the same as in the USA. In Hungary, before currency and
import regulations were liberalized around 1989, it took 30–48 weeks to
replace a crankshaft for a western-made tractor; after liberalization, this
wait dropped to two weeks. A related measure during this period was the
average waiting time to clear items already in port. In Singapore this was
15 minutes, while in Tanzania it was 7–14 days, with waits of up to 91 days
reported (The Services Corporation, 1998). The 14 days’ wait in Tanzania
was more than 1300 times the average waiting time in Singapore.
Obtaining legal permission to open a new business is another arena of
interest. A study of these costs using a simulation approach is included in
Hernando de Soto’s book, The Other Path (1989). In Lima, Peru, in 1983
it took 289 days of full-time work by a team of researchers to go through
all the legal steps to obtain all the permits necessary to open a small textile
firm, without paying (many) bribes or using political connections (de
Soto, 1989).10 It is not clear that anyone in Peru other than de Soto’s team
ever went through this entire process to obtain a permit, but this estimate
of opportunity cost was entirely consistent with the choices individuals
were making at that time. Those without political connections typically
remained in the informal sector, not legally registered. When de Soto
repeated the simulation in Tampa, Florida, USA, it took only two hours
to obtain a permit to open a small business. Thus in Peru the time cost was
over 1000 times as high as in Florida. In this kind of highly bureaucratized
environment, the costs of not being physically located in the capital city
can be daunting. For example, in Tanzania a business partnership based
in Mwanza outside the capital spent five to ten times as long to register as
a business partnership based in Dar-es-Salaam (The Services Corporation,
1998).
A study by Djankov et al. (2000) examined the regulation of business
entry in 75 countries by tabulating the number of steps officially required
to open a new business. They found wide variations, for example two
days, two procedures, and US$280 fees in Canada versus 154 days, 12
procedures, and US$11 612 fees in Austria. The World Bank has expanded
this approach to obtain some measures of costs across 183 countries (The
World Bank, 2010).11
Variations in costs of exchange across individuals

When we ask individuals within a given setting what it costs to do some-
thing, we often find substantial heterogeneity in responses. A survey of
Table 11.1 Bulgaria 2000: How did you register your firm, how many
days did that take, and how much did it cost?
How many days did How much did

it take? it cost? (levs)
Registered without an (N = 81) (N = 59)
intermediary
Median 15 100
Mean 22 211
Minimum 1 6
Maximum 90 5000
Registered through an (N = 34) (N = 25)

intermediary
Median 14 140
Mean 20 157
Minimum 1 1
Maximum 90 500
Source: Adapted from Gancheva (2000).
Bulgarian business owners illustrates large variability in time and money

costs to register a new firm. Results are shown in Table 11.1.
As in any survey, some respondents may have under- or overestimated
their actual experience here, but it is most unlikely that this range of
reported experience is due wholly to measurement error. Classifying all
variation in reports as measurement error assumes that all face the same
price. It is also important to note that only established businesses were
queried, so this example captures only the variability across individuals
who successfully registered their firms. No information is provided here
on the perceived costs faced by those who were deterred from actually reg-
istering. Obviously, these latter costs are highly relevant for many issues,
and not including them biases the overall expected costs of exchange.
However, estimating these non-incurred costs is very difficult.
Variations in money prices

The variations in the costs of exchange discussed above are large com-
pared with variations commonly reported in money prices.
In economic theory and textbooks, monopolies are considered to be a
principal source of price distortion. Yet in developed countries, monopo-
lies rarely sustain long-run money prices more than 20 percent above the
competitive level.
To get a sense of the magnitude of international price variations for a

standardized good that is locally produced and consumed, consider the
variation across countries in the money cost of a McDonald’s Big Mac,
as reported by The Economist in 2009.12 The highest price observed was
US$5.60 in Switzerland, and the lowest was US$1.52 in Malaysia. The
ratio of the highest to lowest price observed is 3.68.
As another illustration, across 44 countries, the price of electricity per
kilowatt-hour for industry in 1999 varied from 1.8 US cents in Kazakhstan
to 16.3 US cents in Grenada, a ratio of 9.06.13
For more clearly tradable goods, price variation should – according to
the standard analysis – be smaller. Haskel and Wolf examined more than
100 manufactured household items sold by IKEA, a Swedish furniture
retailer, across 25 countries for the years 1995–1998 (Haskel and Wolf,
2001). They found the median differences across countries in catalog
prices were 20–30 percent for most goods. The price difference between the
cheapest and the most expensive stores in the sample exceeded 50 percent
for most goods, with ranges up to 900 percent. The variation in these
money prices – although smaller than the variations discussed above for
costs of exchange – are nevertheless surprisingly large.
Price data are typically collected and reported in ways that do not
capture or investigate fully the variation in the money prices which indi-
viduals face. The emphasis is generally on estimating and comparing mean
prices, and when substantial variation appears this is often seen as grounds
for rejecting outliers or the whole sample.14 Haskel and Wolf and a few
other researchers are exceptions in systematically examining money price
variations across outlets and countries in great microeconomic detail.
This is an important step. However, it still misses much of the variation in
opportunity costs facing different individual buyers.
Conclusions
The costs of exchange that individuals incur to obtain a specific good or
service – that is, the money price plus the transaction costs – vary substan-
tially across individuals and across countries. We have observed costs in
some countries that are ten times, 100 times, even 1000 times as great as
in other countries.15 These variations are far greater than those reported in
the published data on money prices. The published price data that econo-
mists typically use often poorly represent the opportunity costs facing
individuals who are deciding what exchanges to undertake.
The expense of obtaining data to measure the costs of exchange is a
major deterrent to the undertaking. Given the difficulty of collecting cred-
ible market price data (for example, determining if the posted price is what
people actually pay), how realistic is it to advocate the use of an even more
costly metric? In some cases, low-cost proxies may emerge for measuring
these costs,16 but in general the data are expensive to collect in both time
and money (see Timoshenkov and Nashchekina, 2006). In cases where all
parties to transactions want to suppress information, the costs of measur-
ing opportunity costs are likely to be especially high. In a study of corrupt
regulatory practices faced by business owners in Ukraine, expensive inter-
views that guaranteed anonymity yielded substantially different estimates
of the costs of corruption than studies using more conventional interview-
ing and sampling techniques. The economics profession has by and large
avoided the effort of gathering such primary data, particularly at this level
of micro detail.17
The standard unadorned price-theoretic model, elegant and powerful as
it is, explains only a modest share of phenomena that economists address.
Economists augment this standard model by invoking a variety of aux-
iliary concepts such as asymmetric information, imperfect competition,
social capital, and institutions.18 These concepts can be characterized in
terms of transaction costs, but the lack of clear definitions and empirical
measures often hinders efforts to assess their impact. Indeed, standard
analysis frequently assumes that certain transaction costs are infinite (for
example, that it is prohibitively costly to exchange information), while
the other transaction costs are zero. Rarely are attempts made to measure
the actual transaction costs. We suggest that the power of the basic price-
theoretic model will be enhanced by considering as the relevant price the
opportunity costs that individuals actually face.
Notes
1. Substantial portions of this chapter are adapted from Benham and Benham (2000).
2. Searching EconLit for the year 2007 (American Economic Association, 2007), we found
3467 publications with ‘transaction cost(s)’ mentioned in the text. For comparison,
4231 articles mentioned ‘imperfect’ in the text, as in imperfect market or imperfect
information.
3. For an alternative methodology to estimate the size of the transaction cost sector, see
Wallis and North (1986). Eigen-Zucchi (2001) has been developing an indicator of
transaction costs using a variety of cross-country indices including stability of money
supply, corruption, and communication variables.
4. Eggertsson continues (1990, p. 15):
When information is costly, various activities related to the exchange of property

rights between individuals give rise to transaction costs. These activities include:
1. the search for information about the distribution of price and quality of com-
modities and labour inputs, and the search for potential buyers and sellers and
for relevant information about their behavior and circumstances;
2. the bargaining that is needed to find the true position of buyers and sellers when
prices are endogenous;
3. the making of contracts;
4. the monitoring of contractual partners to see whether they abide by the forms
of contract;
5. the enforcement of a contract and the collection of damages when partners fail
to observe their contractual obligations;
6. the protection of property rights against third-party encroachment – for
example, protection against pirates or even against the government in the case
of illegitimate trade.
5. The form of exchange refers to the type of market (formal vs informal) in which the
exchange takes place, or to dimensions such as pecuniary versus barter exchange.
6. See for example the discussion of personal and impersonal exchange in North et al.
(2009).
7. Sachs and Warner (2001) summarize and extend research showing that countries with
great natural resource wealth tend to grow more slowly than resource-poor countries.
They find that there is little direct evidence that omitted geographical or climate vari-
ables explain this, or that there is a bias resulting from other unobserved growth deter-
rents. They find that resource-abundant countries tend to be high-price economies and
to miss out on export-led growth.
8. An individual possessing what Hayek (1945) termed ‘local knowledge’ can typically
accomplish things faster, better, and cheaper than individuals without that local knowl-
edge. This means lower transaction costs in that domain for that individual. Local
knowledge differs across individuals and is much less transparent than market price.
9. Note that this framework focuses on the opportunity cost faced by an individual
seeking to enact a specified form of exchange (for example, via formal contract or infor-
mal arrangement, money or barter compensation) in a specified institutional setting.
It does not include the costs of building market institutions, the costs of setting the
political framework in place, or the cost to the individual of creating personal networks,
establishing a reputation, or developing transaction-related skills.
10. This option was open to everyone, but the costs were prohibitive to most individuals
in the society. These costs vary depending on the social and political position of the
persons involved in the transaction. If we simulated the process of conducting the neces-
sary exchanges to start producing in the informal sector, different groups would likely
have a comparative advantage in that setting.
11. ‘Doing Business’, The World Bank (2010). The methodology used here is to estimate
costs by making inquiries of the experts in the subject area, for example lawyers or
accountants. The actual costs that individuals encounter when involved in the trans-
action are not collected. This has the merit of much lower costs of obtaining the
information as compared to the survey of individuals involved in the transaction. For
a discussion of some of the measurement and application issues with this method, see
Arruñada (2007).
12. Big Mac Index from The Economist, 4 February 2009.
13. The mean is 7.05 cents and the standard deviation is 3.44 cents, measured in US dollars
per kilowatt-hour; see International Energy Agency (2001).
14. For example, a recent international price comparison study of branded and generic
consumer items across four countries was commissioned by the Department of Trade
and Industry in the UK. Given the goal of producing estimates of average prices with
a margin of error within certain prescribed boundaries, the report comments: ‘As a
guideline, we have considered a coefficient of variation greater than 20% to indicate
inherently high variability in the price data collected’. Under some circumstances high
variability led to items being rejected for reporting purposes; see UK Department of
Trade and Industry (2000).
15. Visas to enter the host country are an important intermediate good for attendance at
international conferences. In the process of helping several participants to obtain visas
for a conference in France in 1998, we observed that the time price was easily 100 times
as high in some cases as in others.
16. Djankov et al. (2000) use the officially stated number of steps, fees, and times required
to obtain permission to open a new business.
17. Among the few exceptions is the work by Stone et al. (1996).
18. Transaction cost economics is among the most successful approaches within the field
of industrial organization. ‘The primary objective of transaction cost economics
(TCE) is to understand how variations in certain basic characteristics of transac-
tions lead to the diverse organizational arrangements that govern trade in a market
economy’ (Joskow, 2001). Good examples of work in this area are Joskow (1985) and
Williamson (1985). For reviews of the literature see Shelanski and Klein (1995), and
Boerner and Macher (2001), who provide a discussion of the methodology within the
field. Numerous studies classify firms by, say, their degree of asset specificity and from
that predict and examine governance structures, degree of vertical integration, and
contractual forms.
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12 Asset specificity and holdups
Benjamin Klein
Specific assets are assets that have a significantly higher value within a par-
ticular transacting relationship than outside the relationship. To illustrate,
consider the classic Fisher Body–General Motors case.1 In 1919 Fisher
Body undertook a very large expansion in its capacity to supply bodies to
General Motors. Automobile bodies, like many other productive inputs,
are not sold in a spot market. Therefore, if General Motors decided to stop
purchasing from Fisher after Fisher Body made its capacity investments,
the Fisher capacity used to produce bodies for General Motors could not
immediately and costlessly be transferred to the production and sale of
bodies to other automobile companies. Consequently, once Fisher Body
made the investment, the plants Fisher built to supply General Motors
had a higher value within the General Motors relationship than outside
the General Motors relationship. The difference in value within and
outside the General Motors relationship is equal to the General Motors-
specific element of the assets.2
The economic relevance of specific assets is that they create the potential
for holdups. Once a transactor makes a relationship-specific investment,
its transacting partner has the ability to take advantage of the specificity
to appropriate some of the rents the transactor expects to earn on the
investment. For example, after Fisher Body made its somewhat General
Motors-specific capacity investments General Motors could threaten to
stop purchasing bodies from Fisher and impose a capital cost on Fisher
Body equal to the value of the General Motors-specific element of Fisher’s
capacity investments. Therefore, General Motors could, in principle,
negotiate to obtain part (often assumed in theoretical models to be half) of
the value of Fisher’s General Motors-specific assets, by demanding either
a lump-sum payment or a reduction in future body prices. Consequently,
because transactors expect that they may lose a share of the return on
their specific investments when a holdup occurs, one of the economic costs
associated with holdups involves the reduced incentive of transactors to
make efficient relationship-specific investments. These costs, however, are
reduced because transactors, aware of the risks associated with specific
investments, design contractual arrangements that avoid the likelihood of
holdups. Asset specificity and the associated holdup potential, therefore, is
an important economic determinant of contractual arrangements.
120
Asset specificity and holdups 121
Contractual solutions to potential holdups

When transactors plan to make significant relationship-specific invest-
ments they often adopt explicit contract terms that, in combination with
transactor reputational capital, reduce the ability and economic incentive
for transactors to engage in a holdup. This use of a contractual arrange-
ment to control the holdup potential associated with specific invest-
ments is illustrated by the Fisher Body–General Motors case, where a
long-term contract was used to control the anticipated potential holdup
problems. In particular, before Fisher made its General Motors-specific
capacity investments, General Motors contracted to purchase all its
closed auto bodies from Fisher Body over the next ten years. By making
this long-term exclusive dealing commitment General Motors gave up
the ability to hold up Fisher Body since General Motors could no longer
threaten to switch its purchases to another body manufacturer. The
contract therefore protected Fisher Body’s large General Motors-specific
investments.3
Of course, General Motors would not make such an exclusive purchase
commitment without also receiving contractual price protection. In the
absence of price protection Fisher Body could take advantage of the long-
term General Motors exclusive commitment to raise body prices without
worrying about General Motors switching its purchases to another sup-
plier. The exclusive contract therefore included provisions whereby the
price of bodies was set on a cost-plus basis that permitted Fisher Body to
earn a normal rate of return on its capital investments in plant and equip-
ment required to supply bodies to General Motors.4
Contractual solutions to holdup problems may include other ways to
control long-term prices, with or without the presence of exclusive dealing,
such as most-favored customer clauses or indexing to independently pub-
lished price indices where appropriate. But these and other contractual
devices designed to prevent holdup problems are inherently incomplete,
in the sense that contracts do not accurately cover every possible future
contingency or fully define all aspects of transactor performance in a
court-enforceable way. Consequently, there may be significant contract
negotiation costs associated with the presence of relationship-specific
investments, as transactors attempt to negotiate advantageous contract
terms that both reduce the probability they will be held up and increase the
probability they will be able to take advantage of imperfect contract terms
to engage in a holdup. In addition, transactors recognize that when they
make specific investments and enter imperfect contracts they may bear
rent-dissipating economic costs during a transitional contract renegotia-
tion process when ex post conditions that are not covered by the contrac-
tual arrangement develop and a holdup occurs.
Ex post contractual problems

Because real world contracts are inherently imperfect, there is a possibil-
ity in all contractual arrangements that a transactor will be able to take
advantage of the agreed-upon contract to appropriate some of the return
on its transacting partner’s relationship-specific investments. When this
occurs the imperfect long-term contract terms used to solve potential
holdup problems in the face of specific investments may actually induce
holdups. This is vividly illustrated by the changes that occurred over time
in the Fisher Body–General Motors contractual relationship.
In particular, the Fisher Body–General Motors contract did not cover
the unexpected contingency that arose in 1922 when General Motors
asked Fisher Body to build smaller body-producing plants co-located with
General Motors assembly plants. Fisher resisted General Motors’ demand
for co-located body plants and used this development to negotiate a highly
favorable adjustment in the contractual arrangement, whereby General
Motors made half of Fisher Body’s required additional capital invest-
ments. This resulted, under the unchanged cost-plus body pricing formula
originally designed to provide Fisher Body with a competitive return on
its capital investments, in a large wealth transfer from General Motors
to Fisher Body. General Motors had little choice because it was operat-
ing under a long-term exclusive dealing contract, and therefore could not
switch its purchases of bodies to an alternative supplier. Consequently,
the exclusive dealing contract designed to protect Fisher Body’s original
General Motors-specific capacity investments against a holdup threat by
General Motors created conditions whereby Fisher Body held up General
Motors.
The Fisher Body–General Motors case demonstrates, however, that
there are economic reasons to expect that a holdup, if it occurs, may not
involve very significant rent-dissipating costs. Although Fisher Body
clearly conveyed to General Motors in 1922 its reluctance to make efficient
co-located plant investments, all the new Fisher Body plants built during
1922–24 were co-located with General Motors assembly facilities (Coase,
2000). However, this does not mean that Fisher Body did not engage in a
holdup during this period. One must distinguish between how a transactor
may threaten to hold up its transacting partner (Fisher refusing to make
co-located plant investments) and how a holdup is actually accomplished
(Fisher negotiating a highly favorable contract adjustment in return for
agreeing to make the co-located plant investments).
If contract rights are clearly specified and transaction costs are low,
as they generally will be with only two transactors who have similar
information, we would expect a negotiated solution to be reached and
contract terms adjusted to the new, post-holdup equilibrium in a way that
minimizes rent-dissipating transitional economic inefficiencies. Therefore,

it is not surprising that the holdup was accomplished in the Fisher Body–
General Motors case without an inefficient increase in transportation and
other costs from mislocated plants. Instead, the holdup was accomplished
by Fisher Body renegotiating the contract so that General Motors made
a significant part of the required new plant investments. This decreased
Fisher Body’s capital relative to its sales and, under the pricing terms of
the contract, increased Fisher’s profitability and General Motors’ cost of
bodies while avoiding any inefficiencies. In this way the total pie continued
to be maximized while Fisher Body’s share of the pie increased.5
However, in contrast to the rapid contractual adjustment made by
Fisher Body and General Motors in 1922, a contractual impasse between
Fisher Body and General Motors persisted during 1925–26 over the
terms of a new adjusted Fisher Body–General Motors relationship and a
required new Buick body plant investment in Flint. This resulted in tran-
sitional inefficiencies, as Fisher Body continued to supply Buick bodies
from Detroit rather than from the more efficient proposed Flint location.
These difficulties arose because General Motors also was negotiating to
acquire the remaining 40 percent interest of Fisher Body it did not already
own. General Motors firmly believed that these acquisition terms should
not reflect the increased profit Fisher Body had been earning since 1922 on
the renegotiated General Motors body supply contract. In 1926 General
Motors, in fact, successfully concluded these negotiations on terms that
did not provide Fisher Body any continuing financial return for its past
holdup (Klein, 2007, pp. 20–22). Increased General Motors control associ-
ated with vertical integration also largely eliminated the possibility of any
future Fisher Body holdup.
The economic benefit of increased control achieved by General Motors
with vertical integration entailed the economic cost of a reduced Fisher
profit incentive. It is this reduction in economic incentives associated with
vertical integration that presumably explains why General Motors and
Fisher Body did not adopt a full vertical integration type of contractual
arrangement in 1919 when they initially entered their relationship. They
expected the particular long-term, fixed-price formula, exclusive dealing
contractual arrangement they designed could handle holdup problems
while also preserving increased Fisher Body economic incentives. However,
the analysis of the Fisher Body–General Motors case illustrates that
because long-term contracts may create, as well as solve, potential holdup
problems, vertical integration sometimes is the contractual arrangement
that prevents potential holdup problems most cheaply. Integration avoids
the difficulties that were created with the imperfect long-term, fixed-price
formula body supply contract. In fact, integration eliminated the need for
any automobile body supply contract. Rather than attempt to specify per-
formance contractually, General Motors, as the employer/owner of Fisher
Body, could now more flexibly organize production since it possessed the
legal power to unilaterally make important investment and management
decisions. And these control benefits associated with vertical integration at
this point in time outweighed the costs of reduced Fisher incentives.6
Why does a holdup occur?

Some economists are skeptical regarding the economic importance of asset
specificity and associated holdups as a determinate of vertical integration.
For example, Coase claims that ‘the incentive for opportunistic behavior
is usually checked by the need to take account of the effect on future busi-
ness’ and that there are ‘contractual devices that could be used to handle
the problem’ (Coase, 2006, pp. 259–60). Transactors do employ their repu-
tational capital and contract terms to design contractual arrangements
whereby holdups are avoided. In fact, the exclusive dealing contractual
arrangement initially adopted by Fisher Body and General Motors can be
explained in terms of these two economic forces. However, the fact that
holdup problems are usually successfully handled with a combination of
contract terms and transactor reputations does not mean that holdups
never occur. Because contract terms are inherently imperfect and transac-
tor reputational capital is limited, transactors know when they design their
contractual arrangements that there is some probability that they will be
placed in a position where unanticipated events push the contractual rela-
tionship outside what I have called ‘the self-enforcing range’ and that a
holdup will occur (Klein, 1996).7
This probabilistic view of holdups should be contrasted with the view
that a holdup involves deceptive or fraudulent behavior. Coase, for
example, claims that ‘[o]pportunism is analogous to fraud’ (Coase, 2006,
p. 260). Williamson has also misleadingly defined a holdup in terms of
deception:
By opportunism I mean self-interest seeking with guile. This includes but is
scarcely limited to more blatant forms, such as lying, stealing and cheating.
Opportunism more often involves subtle forms of deceit. . . . More generally,
opportunism refers to the incomplete or distorted disclosure of information,
especially to calculated efforts to mislead, distort, obfuscate, or otherwise
confuse (Williamson, 1985, p. 47).
The major problem here is a semantic one because of the misleading con-
notation of ‘holdup’. All that is necessary for a holdup to occur is that the
contract governing a relationship with specific investments does not cover
some unanticipated change in market conditions, and that reputational
capital is insufficient to prevent one transactor from taking advantage

of these circumstances to shift rents in its favor by appropriating some
portion of the relationship-specific assets. The existence of a holdup does
not mean that a transactor has deceived its transacting partner. In fact, the
possibility of holdup behavior understood in this way pervades and funda-
mentally influences all market exchange and the contractual arrangements
chosen by transactors.
Notes
1. This highly cited case was first described in Klein et al. (1978). There has been an ongoing
debate regarding the facts and interpretation of events surrounding the case, with the
most recent and complete statement of the facts provided in Klein (2007).
2. Fisher Body’s capacity investments to serve General Motors are referred to in the lit-
erature as ‘dedicated assets’. See Williamson (1983, p. 526) and Joskow (1987, pp. 168,
170–172). Williamson describes five other different types of asset specificity: site specifi-
city, physical asset specificity, human asset specificity, temporal specificity, and brand
name capital (Williamson, 1991). We now know that the important General Motors-
specific Fisher Body investments did not consist of Fisher Body investments in General
Motors tools and dies. Although tools and dies necessary for the production of General
Motors bodies were highly General Motors-specific, General Motors merely purchased
and owned these physical assets. See Klein (2007).
3. Segal and Whinston (2000) mistakenly claim that exclusive dealing did not protect Fisher
Body’s General Motors-specific investments. In the Segal and Whinston model the only
effect of exclusive dealing is to prevent a buyer from free-riding by using a seller’s specific
investments when transacting with other sellers. Since Fisher Body’s General Motors-
specific capacity investments could not be used by General Motors with another body
supplier, General Motors free-riding could not occur and exclusive dealing is asserted
to serve no economic purpose. Segal and Whinston recognize that once a seller makes
specific investments a holdup problem exists because the buyer can threaten to stop
buying from the seller and thereby substantially reduce the value of the seller’s specific
investments. But Segal and Whinston maintain that exclusive dealing does not protect
against such holdups because the penalty that can be imposed by the seller on the buyer
with exclusive dealing can be imposed independent of buyer behavior. However, this
unrealistically assumes that Fisher Body could legally enforce the exclusive deal and
also decide not to supply General Motors whether or not General Motors attempted a
holdup by threatening to purchase elsewhere. Once one more realistically assumes that
Fisher Body can impose a penalty on General Motors only if General Motors attempts a
holdup, exclusive dealing can be used to protect Fisher Body’s General Motors-specific
investments from the threat of a General Motors holdup. See Klein (2007, pp. 7–9).
4. General Motors also acquired a 60 percent ownership of Fisher Body at the same
time it entered into this contractual arrangement. However, the shares of Fisher Body
common stock owned by General Motors were placed in a five year Voting Trust over
which Fisher had veto power and therefore did not prevent Fisher Body from holding up
General Motors in 1922, as described in the following section. Furthermore, after expi-
ration of the Trust General Motors could not use its 60 percent ownership share to uni-
laterally abrogate the Fisher Body contract and reverse the holdup because it could not
legally vote its Fisher Body shares without respecting the minority Fisher Body economic
interests. The negotiated agreement that resulted in the vertical integration of General
Motors and Fisher Body in 1926, however, involved terms that clearly eliminated any
continuing Fisher Body holdup return. See discussion below and Klein (2007).
5. This result is related to the costless holdup renegotiation assumption made in the prop-
erty rights theory of the firm originally proposed by Grossman and Hart (1986).
6. The likelihood that vertical integration will be used by transactors to solve potential
holdup problems in any particular case will depend not only on the extent to which
specific investments are present, but also on a number of other factors, including the
difficulty of contractually specifying performance, the uncertainty associated with
future performance, and the level of reputational capital possessed by transactors.
However, holding these other factors constant, integration is more likely the greater the
relationship-specific investments made by transactors. Empirical confirmation of this
proposition has been described as ‘one of the great success stories in industrial organiza-
tion over the last 25 years’ (Whinston, 2001, pp. 184–5).
7. The goal of contractual specification in this context often is not to create optimal incen-
tives on some imperfect court-enforceable proxy for performance, but to economize on
the reputational capital necessary to make a contractual relationship self-enforcing in the
widest range of post-contract circumstances.
Bibliography
Coase, Ronald H. (2000), ‘The acquisition of Fisher Body by General Motors’, Journal of
Law and Economics, 43 (1), 15–32.
Coase, Ronald H. (2006), ‘The conduct of economics: the example of Fisher Body and
General Motors’, Journal of Economics and Management Strategy, 15 (2), 255–78.
Grossman, Sanford J. and Oliver D. Hart (1986), ‘The costs and benefits of ownership: a
theory of vertical and lateral integration’, Journal of Political Economy, 94 (4), 691–719.
Joskow, Paul L. (1987), ‘Contract duration and relationship-specific investments: empirical
evidence from coal markets’, American Economic Review, 77 (1), 168–85.
Klein, Benjamin (1996), ‘Why holdups occur: the self-enforcing range of contractual rela-
tionships’, Economic Inquiry, 34 (3), 444–63.
Klein, Benjamin (2007), ‘The economic lessons of Fisher Body–General Motors’, International
Journal of the Economics of Business, 14 (1), 1–36.
Klein, Benjamin, Robert G. Crawford, and Armen A. Alchian (1978), ‘Vertical integra-
tion, appropriable rents and the competitive contracting process’, Journal of Law and
Economics, 21 (2), 297–326.
Segal, Ilya R. and Michael D. Whinston (2000), ‘Exclusive contracts and protection of
investments’, RAND Journal of Economics, 31 (4), 603–33.
Whinston, Michael D. (2001), ‘Assessing the property rights and transaction-cost theories of
firm scope’, American Economic Review, 91 (2), 184–8.
Williamson, Oliver E. (1983), ‘Credible commitments: using hostages to support exchange’,
Williamson, Oliver E. (1985), The Economic Institutions of Capitalism, New York: The Free
Press.
structured alternatives’, Administrative Science Quarterly, 36 (2), 269–96.
13 The transaction as the unit of analysis
Nicholas Argyres
Transaction cost economics (TCE) is so named because it analyzes the

costs of different kinds of ‘transactions’. Indeed, one of the important
departures TCE makes from neoclassical economics is to take the ‘trans-
action’ as its unit of analysis (Williamson, 1985). In this chapter, I discuss
how the transaction is a different unit of analysis than that of neoclassical
economics, and then discuss some of the advantages and limitations of
analyzing economic activity at the level of the transaction.
Neoclassical economics is primarily the study of economic choices by
individual consumers or firms. It is concerned, for example, with how
the price system guides consumer and firm choices about how much to
produce and consume of various goods, with the implications of these
choices for the allocation of resources in particular markets, and with
overall social welfare. In models of general equilibrium, consumers and
firms are assumed to enjoy many alternate trading opportunities for
inputs and outputs, and to act autonomously in choosing which of these
opportunities to pursue. Trade is generally treated as involving discrete,
well-defined goods (‘spot market’ trades), or promises of future delivery of
such goods (‘futures market’ trades).
This focus on the individual decision-making unit arguably led neo-
classical economics to neglect an important feature of economic activity;
namely, trading relationships between two economic actors, such as firms,
in which the terms of trade are not fully defined, and where the value of
continuing the relationship is high because both sides’ outside trading
options are much less profitable for them. These kinds of trading relation-
ships are pervasive in the economy, and even in the polity. They range
from long-term exchanges between firms to exchanges between employees
and their firm to exchanges of promises between legislators and or even
different branches of government (for example, Weingast and Marshall,
1988; Dixit, 1996). Whereas neoclassical economics offers little insight
into how these kinds of exchanges are arranged and efficiently governed,
TCE offers quite a bit of insight into these questions. (The most impor-
tant of these insights is that governance arrangements will reflect parties’
attempts to safeguard their transaction-specific investments, with vertical
integration being the last resort.) Indeed, this is what gives TCE its power:
it is able to shed light on the governance of a very wide range of exchange
127
relationships that neoclassical economics does not directly address. These

insights were made possible in large part because TCE takes the ‘transac-
tion’, rather than the individual firm or consumer, as its unit of analysis.
TCE and game theory

This focus on the transaction lends TCE a bilateral, rather than individual-
level, orientation: TCE is interested in explaining joint decision-making
between two transacting parties who, because they have some goals in
common, also have an interest in maintaining a cooperative relationship.
TCE also assumes, however, that the transacting partners have incen-
tives that can at some point conflict. In this way, TCE is similar to the
game-theoretic approaches that have become dominant in the industrial
organization literature. Game-theoretic approaches in economics usually
take the two-player game or duopoly as the unit of analysis. The players’
(for example, firms’) incentives in these games may coincide or conflict
(or some of both). The focus in these approaches is on determining each
player’s optimal choices when they depend sensitively on the other player’s
choices, and therefore to predict the outcome(s) of the game. This is a situ-
ation that of course does not arise in neoclassical economics because of its
assumption that markets are ‘thick’ with buyers and sellers. In this kind
of market, each actor’s optimal decision is independent of the decisions of
other individual actors.
Because the unit of analysis for game-theoretic approaches is similar
to that in TCE, it is not surprising that game-theoretic approaches have
succeeded in shedding light on how transactions are efficiently governed
(Baker et al., 2002; Gibbons, 2005). Still, David Kreps, a prominent game
theorist, has argued that there are fundamental limits on game theory’s
ability to formalize TCE’s main insights and to build on its foundation
(Kreps, 1996). This is because even if the unit of analysis is similar, the
behavioral assumptions are quite different. TCE assumes, following
Simon (1957), that the rationality of economic actors is bounded, whereas
for most game-theoretic models to be useful in making predictions, they
must assume quite a high degree of rationality. The recent explosion of
experimental research in behavioral economics is certainly more con-
sistent with the assumption of bounded rationality than with the high
degrees of rationality needed for many game-theoretic models, though
economic irrationality is a common finding (for example, Camerer,
2003).
Bounded rationality and foresight

TCE emphasizes that when seeking to understand why a transaction is
governed in a particular way, it is important to consider the transaction in
The transaction as the unit of analysis 129
its entirety. That is, it is important to recognize that while actors’ ration-
ality may be bounded, they are alert enough to take into account all the
elements of the ‘deal’, and are able to foresee at least the more obvious
threats to their interests in the transaction. Failure to account for the
entire transaction may cause the analyst to mistakenly view an efficiently
governed transaction as inefficiently governed.
Williamson’s (1985) example of the remote company town provides an
illustration. Historians and others long argued that such towns, in which
a single employer owns all of the housing as well as the only retail store,
exploit the workers in the town. They are therefore inefficient and should
be heavily regulated or banned. Williamson (1985) points out, however,
that housing and retail stores in remote locations are transaction-specific
investments that workers would be unwilling to make in the absence of a
strong safeguard, which is difficult to devise. Therefore, ownership of these
assets by the company may in fact be efficient. Moreover, before moving
to a company town, a ‘hard-headed’ worker will foresee that the company
will have the ability to charge monopoly prices for housing and other
goods, and will avoid being exploited by demanding a wage premium to
compensate, without which he or she will not move. That is, the worker
will recognize that the entire transaction involves not just payment of
a wage in exchange for work, but also payments for housing and other
goods. Now, Williamson (1985) acknowledges that there may be other
factors at work that make the company town an inefficient arrangement.
But here we can take Williamson’s point as purely a methodological one:
alert, far-sighted economic actors will take the entire transaction into
account when evaluating whether to participate in, and how to govern,
that transaction.
Governance inseparability
This issue of contracting in its entirety and the assumption of far-
sightedness brings us to some of the limitations of taking the transaction
as the unit of analysis. First, note that some economic actors may not be
so hard-headed, at least not all of the time. Once again, recent work in
behavioral economics has shown that experimental subjects often allow
their economic decisions to be influenced by impulsiveness, incorrect sta-
tistical inferences, altruistic feelings towards strangers, and other behav-
iors not accounted for in traditional economic analysis. The implication
for TCE is that some actors may not consider contracting in its entirety
for these or other reasons, and this may lead to systematically inefficient
governance arrangements that TCE alone cannot explain. Williamson
(1985, 1996) acknowledges considerations such as these, but suggests that
they are likely to be more relevant for transactions involving consumers or
individuals rather than firms with experience in business decision-making,

and with a more focused orientation toward efficiency. Moreover, TCE
assumes that firms that make systematic mistakes due to say, impulsive-
ness, will not long survive market competition, whereas there may be more
scope for less than economically rational behavior among consumers.
However, the Internet bubble of the 1990s, as well as the recent events in
which millions of home mortgages were overvalued by highly sophisti-
cated firms, suggests some caution in automatically assuming that firms
are always hard-headed and always engage in contracting in its entirety.
A second limitation to using the transaction as the unit of analysis is
more subtle. It emerges not from economically irrational behavior, but
from uncertainty in the environment that makes it difficult for actors to
foresee even major threats to the stability of their transactions. In these
cases, the actors in question may be quite hard-headed and may strive to
be far-sighted, but because some future events are essentially unforseeable,
they are unable to adequately safeguard transactions for those events.
When the environment is uncertain in this way, governance arrangements
may be observed that are (at least for some time) inefficient in ways that
TCE alone cannot explain.
For example, if a major unforseeable event occurs that reduces the bar-
gaining power of one party to an agreement struck in the past, the more
powerful party may be able to hold its contractual partner to the original
terms of that agreement, even if those terms are no longer efficient. Argyres
and Liebeskind (1999) described such situations as involving one kind of
‘governance inseparability’, because in such cases the governance arrange-
ments in the current agreement cannot be separated from those struck
in prior agreements. One example of this kind of phenomenon involved
General Motors (GM). During the mid 1990s, GM attempted to change
the way it governed transactions involving certain automobile compo-
nents; in particular, it attempted to move toward more outsourcing of
production. This led to a major strike by the United Automobile Workers
(UAW) union that cost GM approximately US$600 million. The union
sought to protect union jobs, wages and work rules, and invoked a prior
commitment GM had made to the union to limit outsourcing. The strike
was successful in derailing GM’s outsourcing plans. Governance insepa-
rability was manifested in this example in that GM failed to anticipate the
later bargaining strength of the union, as shown by the union’s ability to
carry out a damaging strike. Had it anticipated this future strength, GM
might have safeguarded its interests more by, for example, avoiding such a
sweeping commitment to limit outsourcing as part of its earlier agreement
with the union. Analysts agreed, however, that the increased bargain-
ing power for the union was a surprise to many in the industry, coming
The transaction as the unit of analysis 131
after a long period in which union power in the US had been declining
precipitously. Likely this change in bargaining power could not have
been anticipated. As a result of its inability to separate prior governance
arrangements from current arrangements, GM remained more vertically
integrated than efficiency considerations demanded.
A second form of governance inseparability links not so much sequen-
tial transactions, but concurrent transactions within an organization
(Argyres and Liebeskind, 1999). In these kinds of cases, transaction cost
considerations suggest that transactions carried out within the firm which
have very different characteristics will be governed differently. However,
bringing a transaction inside a firm has an important consequence; the
governance of that transaction becomes immediately dependent, to one
degree or other, on the way other transactions within the firm are gov-
erned. That is, it becomes subject to firm-wide policies that do not distin-
guish between transactions. The existence of such policies is almost the
definition of ‘bureaucracy’.
Under these conditions, it again becomes difficult to explain observed
governance arrangements using transaction cost analysis applied at the
level of the individual transaction. Argyres and Liebeskind (2002) provide
examples from the US biotechnology industry. One feature of this indus-
try is that despite years of attempts, large pharmaceutical firms have not
been able to match the research capabilities of small biotechnology firms,
either by developing such capabilities de novo, or by systematically acquir-
ing the smaller firms. A major reason is large firms have not been able to
match the incentive arrangements that small firms offer to their scientists.
Such arrangements typically include stock options, freedom to publish
and attend conferences, influence on choice of research projects, and so
on. Instead, large firms have maintained their same firm-wide policies that
involve restrictions on publishing, lowered-power incentives, and the like.
In part this may be because of influence activity by scientists in more tra-
ditional research areas who act (or threaten to act) out of envy or concern
for relative income and status. Whatever the precise underlying motiva-
tion, it becomes difficult for the large firm to treat its transactions with
the two groups of scientists (traditional and biotechnological) differently,
using separate governance arrangements.
Conclusions
To conclude, much of TCE’s success as a predictive theory is due to its
choice of the transaction as its unit of analysis. It appears that in many,
many cases, this choice helps explain arrangements that would be oth-
erwise difficult to explain using the tools of neoclassical economics. On
the other hand, there appear to be cases where the transaction is not the
appropriate unit, such as when behavioral considerations loom large,

or when the governance of linked transactions cannot be separated. An
important goal for future research, then, is to more clearly identify when
and where these kinds of circumstances are more or less likely to arise.
References
Argyres, N. and J. Liebeskind (1999), ‘Contractual commitments, bargaining power and
governance inseparability: Incorporating history into transaction cost theory’, Academy of
Management Review, 24 (1), 49–63.
Argyres, N. and J. Liebeskind (2002), ‘Governance inseparability and the evolution of the US
biotechnology industry’, Journal of Economic Behavior and Organization, 47 (2), 197–219.
Baker, G., R. Gibbons, and K. Murphy (2002), ‘Relational contracts and the theory of the
Camerer, Colin (2003), Behavioral Game Theory: Experiments in Social Interaction, Princeton,
NJ: Princeton University Press.
Dixit, A. (1996), Transaction Cost Politics, Cambridge, MA: MIT Press.
Gibbons, R. (2005), ‘Four formal(izable) theories of the firm’, Journal of Economic Behavior
and Organization, 58 (2), 202–47.
Kreps, D. (1996), ‘Markets, hierarchies and (mathematical) economic theory’, Industrial and
Corporate Change, 5 (2), 561–95.
Simon, Herbert (1957), Models of Man, New York: John Wiley and Sons.
Weingast, B. and W. Marshall (1988), ‘The industrial organization of Congress; or why
legislatures, like firms, are not organized as markets’, Journal of Political Economy, 96 (1),
132–64.
Press.
Williamson, Oliver E. (1996), The Mechanisms of Governance, New York: Oxford University
Press.
14 Bounded rationality and organizational
economics
Nicolai J. Foss
In very overall terms the existing research efforts on bounded rational-

ity may be understood as a very diverse set of attempts to elaborate and
examine the insights that: (1) the human capacity to process information
is limited (Simon, 1955); (2) humans try to economize on cognitive effort
by relying on short-cuts (‘heuristics’; Simon and Newell, 1972); and (3)
because of (1) and (2), as well as other factors, such as the influence of
emotions on cognition, human cognition and judgment is subject to a wide
range of biases and errors (Tversky and Kahneman, 1986; Rabin, 1998).
Economists’ thinking about the role of rationality (bounded as well as
full) has surprisingly often been done with reference to the business firm.
Thus, the issue has been highlighted in debates ranging from the descrip-
tive validity of profit maximization in the 1940s over Herbert Simon’s crit-
icism of oligopoly theory (Simon, 1979) to modern debates on incomplete
contracting and therefore issues that are central to new institutional eco-
nomics, such as efficient firm boundaries (for example, Williamson, 1985;
Hart, 1990; Tirole, 1999). The reason why economists have associated firm
organization and bounded rationality (BR) arguably lies in the inherent
complexity and uncertainty of decisions relating to competitive strategy,
investment decisions, the design of human resource management systems,
and so on. By comparison most consumption choices seem relatively
simple and more given to a treatment in terms of the standard maximiz-
ing model. Recently, BR has, under the banner of behavioural economics,
neuronomics, and so on, been generalized much beyond the theory of
the firm context, and appears prominently in finance, law and econom-
ics, and much else. However, the theory of the firm or, more broadly,
organizational economics remains an area where discussion of BR takes
place, and it is of course also a stronghold of new institutional econom-
ics (Williamson, 1985, 1996; Furubotn and Richter, 1997; Brousseau and
Glachant, 2003). For these reasons, most of this chapter makes reference
to organizational economics.
Instead of providing a comprehensive overview of work on BR and
its use in organizational economics, I shall argue that although many
organizational economists have agreed on the importance of BR, upon
133
closer inspection it turns out that BR itself is seldom explicitly modelled,

organizational economists do not seem to hold precise views of what BR is
and how it may be incorporated into models (if they do, they are likely to
stress different modelling approaches), and the main purpose of BR is to
provide intuition for contractual incompleteness.
BR and organizational economics

Organizational economists would likely agree that BR is important to the
study of economic organization (for example, Williamson, 1975, 1985,
1996; Milgrom and Roberts, 1992; Kreps, 1996; Furubotn and Richter,
1997). Indeed, some argue that it is indispensable, in the sense that BR
is a strictly necessary assumption in the theory of economic organization
(Williamson, 1996; MacLeod, 2000). Oliver Williamson is not only the flag
bearer of the modern literature, but also the most outspoken proponent
of the necessity to include BR in the economics of organization. ‘But for
bounded rationality’, he argues, ‘all issues of organization collapse in
favor of comprehensive contracting of either Arrow-Debreu or mecha-
nism design kinds’ (Williamson, 1996, p. 36). What Williamson calls ‘com-
prehensive contracting’ does not allow for ‘governance structures’ in the
sense of mechanisms that handle the coordination and incentive problems
produced by unanticipated change (Williamson, 1996, Chapter 4), simply
because the latter is ruled out under assumptions of ‘comprehensive’ or
complete contracting.
More generally, Williamson (1998) argues that taking more account
of the relevant psychological literature will improve the understanding
of organization ‘as an instrument for utilizing varying cognitive and
behavioral propensities to best advantage’ (Williamson, 1998, p. 12).
Many organizational economists would seem to concur. Following the
strong general increase in interest in building insights of cognitive science
into economics models, not only calls for drawing more strongly on the
relevant psychology research (for example, Lazear, 1991) but also actual
modelling efforts that incorporate some notion of BR are now relatively
common. To exemplify, Mookerji (1998) shows how ambiguity aversion
may be a source of contractual incompleteness; Anderlini and Felli (1999)
invoke costs associated with complexity to do the same, while Gifford’s
(1999) take on contractual incompleteness is to explain it as an outcome of
the trade-off between devoting scarce attention to managing existing con-
tracts and writing new ones. Hart (2006), who earlier was sceptical of the
use of BR in organizational economics (Hart, 1990), now argues that an
important source of the ex post haggling costs emphasized by Williamson
(1985) may lie in contractual parties holding different reference points.
Thus, a cursory glance at contemporary organizational economics may
Bounded rationality and organizational economics 135
easily convey the impression that Simon’s lessons have been absorbed, and
that organizational economists have realized the need to place BR truly
centre stage in their theorizing. However, this would clearly be an exag-
geration. The fact remains that very large parts of organizational econom-
ics have no use whatsoever for BR. In particular, the complete contracting
paradigm of agency theory (Holmström, 1979) rules out BR.
More generally, most contemporary organizational economics research
is entirely mainstream in character, and this also holds for most work on
incomplete contracts. Formal, mainstream economics typically assumes
that agents hold the same, correct model of the world and that model does
not change. Organizational economics is in general no exception to this.
More precisely, these assumptions are built into formal contract theory
through the assumption that pay-offs, strategies, and the like are common
knowledge, assumptions that are clearly at odds with BR. Indeed, the
game-theoretic models used in most theoretical research on the theory
of the firm ignore BR altogether. Fundamental notions and modelling
principles of mainstream economics, such as subjective expected utility,
common priors, rational expectations/dynamic programming, backward
induction, and so on, are not too easily aligned with fundamental findings
of cognitive psychology with a strong bearing on BR (such as gain–loss
asymmetries, role-biased expectations, and so on) (Camerer, 1998). The
result of the attempt to combine these notions with an attempt to make
room for BR is ‘hybrid models’ where BR is introduced in a highly selec-
tive manner as the spanner in the works of an otherwise entirely main-
stream machinery, so that agents are assumed to be boundedly rational
with respect to one variable and fully rational with respect to all other
variables (Furubotn and Richter, 1997; Foss, 2001).
‘Thin’ and ‘thick’ notions of BR

Many writers have observed that to the extent that BR enters contempo-
rary economics, it is in rather ‘thin’ forms (Schlicht, 1990; Akerlof, 1991;
Lindenberg, 1990; Furubotn and Richter, 1997; Macleod, 2000; Furubotn,
2001). This is also the case of organizational economics. The treatment of
BR in the literature at large is a far cry indeed from the rich, concrete
and ‘thick’ treatments of BR in the behavioural economics literature. For
example, Milgrom and Roberts (1992, p. 128) define BR as a matter of
‘[l]imited foresight, imprecise language, the costs of calculating solutions
and the costs of writing down a plan’. They then go on to develop at length
the implications of this in terms of imperfect contracts and subsequent
problems of imperfect commitment between contractual parties. However,
Milgrom and Roberts do not develop or truly explain their definition of
BR. In fact, it is quite arguable (see Foss, 2001, 2003) that the versions of
BR that are applied in organizational economics are thin versions, in the

sense that BR per se is not explicitly modelled, but simply asserted as a sort
of ‘background variable’ that functions to provide an intuitive foundation
for contractual incompleteness.
In spite of his insistence on the necessity of assuming boundedly
rational behaviour, Williamson is in actuality rather vague on BR. He
notes that ‘[e]conomizing on bounded rationality takes two forms. One
concerns decision processes and the other involves governance structures.
The use of heuristic problem-solving . . . is a decision process response’
(Williamson, 1985, p. 46). The latter ‘form’ is not central, however, in
transaction cost economics, which, Williamson argues, ‘is principally con-
cerned . . . with the economizing consequences of assigning transactions to
governance structures in a discriminating way’ (ibid.). Thus, Williamson
is interested in making use of BR for the purpose of explaining the exist-
ence and boundaries of firms and therefore the choice between alternative
governance structures rather than for the purpose of explaining ‘adminis-
trative behaviour’, as in Simon (1947). However, it is open to some debate
whether it makes much sense to separate BR as an important ingredient
in the understanding of governance structures from BR as the starting
point for the understanding of decision processes, as different governance
structures likely exhibit different decision process properties (March and
Simon, 1958). Clearly, from an organizational theory point of view, the
lack of concern with decision processes means that the important possibil-
ity that bounds on rationality may be endogenous to organization is not
inquired into (the exception being team theory: Marschak and Radner,
1972; Radner, 1996).
However, even the use of thin notions of BR is problematic from the
point of view of a number of scholars, particularly those with a formalist
bent (which means most modern research economists): as a minimum,
contractual incompleteness must be endogenously derived in a well speci-
fied model (as in, for example, Gifford, 1999) rather than being postulated
through a loose appeal to BR. Such a position indicts most of the largely
verbal TCE approach. More fundamentally, theorists have argued that
BR, in contrast to Williamson (1985), is in fact not necessary to organiza-
tional economics. Thus, what BR primarily does in the theory – namely,
rationalize contractual incompleteness and therefore the inefficient invest-
ment levels that are centre stage in much contract theory (Grossman and
Hart, 1986; Hart, 1995) – can be done more elegantly by asymmetric
information assumptions, particularly the assumption that investments in
a relation are unverifiable by a third party (for example, a judge) (for this
argument, see Hart, 1990). This raises the issue of the future of work on
BR in organizational economics.
Whither BR?
The role of BR in future organizational economics may be unchanged,
diminished or increased. If ‘unchanged’ this means that organizational
economics will continue to invoke BR as a catchy label for what makes
contracts incomplete in the context of otherwise entirely mainstream
models. For reasons given above, this is hardly a satisfactory scenario,
because this use of BR is flagrantly ad hoc. However, notions of BR
abound, and it is notoriously hard to formalize BR. This may lead to the
persistence of the ad hoc strategy of making use of BR.
On the other hand, the ad hoc use of BR and the difficulty of formal-
izing it in a general manner may lead theorists to abandon the concept.
A further reason why theorists may abandon the concept is they feel it
does not add anything. This is the case that has been forcefully argued
by Maskin and Tirole (1999). They essentially argue that BR, specifically
the inability to perfectly anticipate or describe all relevant contingencies,
does not constrain the set of feasible contracts relative to the complete
contracting benchmark. Of course, this implies that considerations of BR
are essentially irrelevant to the understanding of inefficient investment
patterns. Maskin and Tirole zoom in on the assumption in incomplete
contracts theory that although valuations are not verifiable, they may
still be observable by the parties, implying that trade may be conditioned
on message games between the parties. These games are designed ex ante
in such a way that they can effectively describe ex post all the trades that
were not described ex ante. Maskin and Tirole provide sufficient condi-
tions under which the indescribability of contingencies does not restrict
the pay-offs that can be achieved. Space does not allow us to go into the
subtle details of their argument, nor into the responses (for example, Hart
and Moore, 1999). Suffice it to be mentioned that the Maskin and Tirole
point is developed in the context of a specific modelling approach and that
it does not indict the use of BR in organizational economics in general.
The current general enthusiasm in economics for psychology may in
fact lead to a stronger incorporation of BR in organizational economics
models. A research strategy for this may proceed along these lines: (a)
consider the massive body of largely psychology-based research science
on biases to human cognition and judgement (summarized for economists
by Conlisk, 1996; Camerer, 1998; Rabin, 1998); (b) identify the regulari-
ties in how human decision-making systematically differs from the Savage
model; (c) treat these deviations as sources of transaction costs; and (d)
examine the implications for comparative contracting and the choice of
governance structures (Williamson, 1998, p. 18). Such a program may
be seen as primarily an invitation to explore mechanisms, that is, causal
connections that may or may not be triggered in specific situations, rather
than search for general regularities. To be more concrete, it is a call for

exploring how a specific manifestation of BR – such as, say, reference
level biases (Hart, 2006) – translates into transaction costs confronted by
agents in a specific setting, and how this influences the contract or govern-
ance structure chosen by these agents to regulate their trade. Thus, we can
imagine manifestations of BR such as context-dependent risk-preferences
and weakness-of-will problems complicating agency models, the endow-
ment effect complicating models that make use of assumptions of transfer-
able utility, the self-serving bias throwing light on ex post haggling costs,
and so on.
While this would seem to be a feasible research strategy, it is open to
debate whether it is also a desirable one. The fear is that the field may end
up with a mass of extremely partial models of strongly limited applicabil-
ity. The optimist may counter that insights of rather general applicability
may follow, because of the generality of many of the manifestations of
BR. For example, Babcock and Loewenstein (1998) argue that self-serving
biases are likely to be a very frequent determinant of a specific type of
transaction cost, namely bargaining impasse. Moreover, new insights may
be produced and old puzzles may be resolved. For example, in many work
situations, precise signals on output are available, yet monitoring still
takes place. Office workers may thus be supervised although it is trivial
to count the number of forms they have processed at the end of the day.
It seems unrealistic to argue that some random and unobservable factor
should intervene in the work process, shifting too much risk on to the
agent (Postrel and Rumelt, 1992). A more realistic explanation is lack of
self-discipline in the performance of a boring job (Rabin, 1998).
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15 Economizing and strategizing
Jackson A. Nickerson and James C. Yen
Research in business strategy explores how organizations create and

capture economic value. Two of the leading economic approaches that
inform this field are the economizing and strategizing perspectives. In this
chapter we define and explore the strengths and weaknesses of both per-
spectives. In particular, we explore the relationship between economizing
and strategizing perspectives and how they interact to inform each other.
Our exploration focuses on sunk costs as a central premise in both per-
spectives as they apply to business strategy. Finally, we assess the extent to
which these perspectives provide necessary and sufficient perspectives for
business strategy.
What is business strategy?

Successful firms are believed to have unique business strategies that create
value for customers by producing products and services at sufficiently low
outlays such that resulting profits exceed the cost of capital. A necessary
condition to maintain these profits appears to be that actual and potential
competitors find it difficult to imitate the strategy. Yet, business strat-
egy is a term that has many definitions in business and academic arenas
(Ghemawat et al., 2001, Chapter 1). For instance, scholars have defined
strategy as ‘a long-term plan’ (Chandler, 1962, p. 13), ‘actions of player’
(Camerer, 1991, p. 139), and ‘fit’ among internal activities (Porter, 1996, p.
70). Although managers and scholars have different definitions for strat-
egy, all can agree that ‘strategic decisions are concerned with the long-term
health of the enterprise’ (Chandler, 1962, p. 11).
A course on business strategy in the Masters in Business Administration
programs was first urged by the Ford Foundation and Carnegie
Corporation Reports on business education in the late 1950s (for an inter-
esting discussion see Arben, 1997). Harvard Business School was the first
business school to add a ‘Business Policy’ Course which ‘integrated what
the student had learned in the functional courses, serving as a capstone to
the core curriculum’ (Rumelt et al., 1994, p. 10). Business strategy then
grew from a capstone course of the 1960s into a field unto itself today.
Because of this history, the intellectual roots of strategic management
draw sustenance from many disciplines.
Research disciplines such as economics, organizational sociology,
140
Economizing and strategizing 141
political science, and psychology contributed to the development and

evolution of the strategy field (Rumelt et al., 1994). Yet, many view that
economics has been foundational to business strategy (Rumelt et al.,
1991). That said, economic contributions to the field of strategy are not
monolithic (Hesterly and Zenger, 1993) with various economics subdis-
ciplines separately and distinctly contributing to the field. Two of these
subdisciplines, namely strategizing and economizing, are elaborated below
and their theoretical relationship is explored in the context of the field of
business strategy.
What is the strategizing approach to business strategy?

There are many perspectives on the notion of strategy but they all agree
that strategy should contribute to the performance improvement of the
firms. For example, Porter (1980, 1985) emphasizes the importance of
strategic positions in the product markets and the competitive advantages
derived from the fit among the activity systems of the firms. Moreover,
the resource-based view (RBV) emphasizes the possession of valuable
resources and the capability-based view (CBV) focuses on the integration,
recombination and development of the resources to create value. This
chapter, however, focuses on the ‘strategizing’ perspective that explores
the effects of strategic interactions on the creating and capturing of value.
Teece et al. (1997, p. 509) define the strategizing approach as those
organizational actors ‘engaging in business conduct that keeps competi-
tors off balance, raises rival’s costs, and excludes new entrants’. More for-
mally, strategizing is associated with the methodology of game theory.
Mas-Colell et al. (1995) define strategy from a game-theoretic perspective
as a ‘complete contingent plan, or decision rule, that specifies how the
player will act in every possible circumstance in which she might be called
upon to move’ (Mas-Colell et al., 1995, p. 228, original emphasis).
Game theory offers a mathematical approach to the analysis of strategic
interaction between individuals who can contemplate what their counter-
parts think and can act on the basis of this contemplation (von Neumann
and Morgenstern, 1944). When applied to business, the game-theoretic
methodology largely is used to explore signaling, preemption and coordi-
nation among firms in concentrated industries (see Saloner, 1991; Shapiro,
1989; Tirole, 1988). The application of game-theoretic approaches has
been a growth area in economics since the 1980s with the development
of highly specific models with each model applicable to a precise set of
assumptions and conditions. Employing the set of firms as the unit of
analysis, common assumptions associated with game-theoretic models
of industrial organization typically involve a small number of firms with
expectations about their and others’ strategy set, self-interest and perfectly
rational decision making (for a discussion on the assumption of the degree

of rationality see Saloner, 1991). Tirole (1988), in his book The Theory of
Industrial Organization, offers an early and comprehensive compilation
of the topics in game-theoretic industrial organization.
Shapiro (1989) boldly summarizes the progress and contributions of
game-theoretic work in industrial organization and claims that this collec-
tion of specific models of business rivalry in concentrated markets is better
described as a general ‘theory of business strategy’ (Shapiro, 1989). The
central insight from this general theory of business strategy is the role that
‘commitment’ plays in analyzing the dynamics of strategic interactions
(Shapiro, 1989).
Strategic commitment
Strategic commitment is perhaps the most important key to a firm’s
long-term performance. Commitment creates sunk costs that can be a
credible signal (threat) to the competitors regarding the focal firm’s future
actions (for a comprehensive treatment on commitment see Ghemawat,
1991). These irreversible investments signal to others that there is no
profit should they proceed with a certain action because ‘it changes other
players’ expectations about your future responses’ (Dixit and Nalebuff,
1991, p. 120). Hence, the game-theory approach of business strategy
emphasizes the irrecoverability of strategic investments (Shapiro, 1989) as
means to shape competitor behavior and capture value. Generally speak-
ing, costlessly reversible actions do not constitute commitments and have
no strategic role.
Following this logic, the theory suggests that ‘firms may try to convert
recoverable costs into sunk costs for some strategic purpose’ (Shapiro,
1989, p. 128). Dixit (1980) provides a classic example of the role of an
irrevocable commitment of investment in entry-deterrence in altering
the ‘initial conditions of the post-entry game to the advantage of the
established firm, for any fixed rule under which that game is to be played’
(Dixit, 1980, p. 106). Therefore, strategizing is a means to create and
exploit market power.
Empirical evidence on strategizing

Despite the empirical studies that Shapiro (1989) has summarized and the
fact that game theory is a powerful apparatus to analyze the dynamics
of business interactions, it remains a puzzle that strategy scholars do not
widely apply this approach (Ghemawat, 1997). Peltzman’s (1991) critic on
the game-theoretical IO models may be relevant. He argues that research-
ers’ emphasis of the theoretical modeling without the obvious applications
to business practices cannot sustain the growth of the theory. Ghemawat
offers another reason which is that ‘game theoretic models have not lent
themselves to conventional large-sample tests’ (Ghemawat, 1997, p. 1) and
thus researchers suspect the utility of game-theoretic models. Ghemawat
responds to this puzzle and presents several detailed and persuasive case
studies to illustrate various strategizing behaviors in real business settings.
For instance, Ghemawat presents two different studies on capacity deci-
sions. One is capacity expansion in the titanium dioxide industry for the
purpose of pre-emption, and the other is capacity reduction in the declin-
ing chemical industry (Ghemawat, 1997).
What is the economizing approach to business strategy?

In contrast to Shapiro (1989), Williamson boldly argues that economizing
‘is the best strategy’ (1991a, p. 77). Economizing refers to designing govern-
ance arrangements to align with the transaction attributes in order to econo-
mize on transaction costs due to fundamental transformation (Williamson,
1985). The performance advantages of economizing behaviors can be exam-
ined in Williamson’s discriminating alignment hypothesis, which predicts
that managers who align organizational structures with exchange attributes
will achieve performance benefits, which can manifest higher profitability
and greater survivability (Williamson, 1993; Silverman et al., 1997).
Williamson (2005) summarizes the discriminating alignment hypothesis
in three steps. First, identify the exchange attributes of asset specificity,
uncertainty, and frequency that make some transactions simple and
others complex. Of these three attributes, asset specificity, defined as ‘a
specialized investment that cannot be redeployed to alternative users or by
alternative users except at a loss of productive value’ (Williamson, 1996, p.
377), is the main locomotive. Second, specify the costs and competencies of
alternative modes of governance such as the differences between market,
hybrid, and hierarchy. For example, in autonomous adaptations, market
mechanisms excel because price signals are the only necessary informa-
tion needed to complete the transactions. On the contrary, cooperative
adaptations are those for which coordinated responses are required and
for which hierarchies surpass markets. Moreover, the argument extends
to include hybrid forms that are located between markets and hierarchies,
such as long-term contracts, joint ventures and so on (Williamson, 1991a).
Third, the discriminating alignment hypothesis predicts that transactions
are aligned with governance structures so as to realize a transaction cost
economizing result (Williamson, 2005).
Empirical evidence on economizing

Despite three decades of empirical research and hundreds of empirical
transaction cost economics (TCE) studies (David and Han, 2004; Macher
and Richman, 2008; Masten, 1995; Shelanski and Klein, 1995), most
empirical studies on TCE are preoccupied with testing whether the dis-
criminating alignment hypothesis is supported, assuming that firms are
optimally organized given the transaction attributes. Consequently, the
number of empirical studies on economic performance at a transaction
level or on firm survival remains surprisingly small.
Armour and Teece (1978) provide one of the earliest empirical tests
on Williamson’s M-form hypothesis (1975, Chapter 8), a version of the
discriminating alignment hypothesis, which predicts the performance
advantages enjoyed by large corporations organized as a multidivisional
form (M-form) rather than organized as a centralized functional form
(U-form). Masten et al. (1991) provided the first estimates of economic
performance at a transaction level in shipbuilding components (pipefit-
ting). They found that overall organization costs in ship construction were
lower when transactions and organizational forms were aligned according
to the discriminating alignment hypothesis. Mayer and Nickerson (2005)
provided the first estimates of profitability at a transaction level based on
the discriminating alignment hypothesis. By examining the contracts of
an information technology company, Mayer and Nickerson estimated
that when the project’s governance structure is misaligned with project
attributes, the project’s profit margin drops by 20.8 percent and 200
percent for the expropriation concerns and 99.6 percent and 28.6 percent
for the measurement costs, depending on whether they predict outsourc-
ing or insourcing. This asymmetric impact on profits shows that for differ-
ent transaction attributes (expropriation concerns or measurement costs),
the relative costs of misaligned governance structures depend on the type
of misalignment.
Besides investigating profitability at the transaction level, research
has explored the extent to which transaction misalignment impacts firm
survival. In two papers, Nickerson and Silverman (Silverman et al., 1997;
Nickerson and Silverman, 2003) studied discriminating alignment of the
employment relation in the trucking industry following deregulation in
the US. Silverman et al.’s (1997) empirical analysis is among the first to
show increased mortality when firms do not adhere to operating policies
consistent with transaction cost minimization principles. Nickerson and
Silverman (2003) further found that poorly aligned firms (according to
transaction cost reasoning) realize lower profits than their better-aligned
counterparts, and that these firms will attempt to adapt so as to better
align their transactions. In another study on firm survival, Argyres and
Bigelow (2007) analyzed the early US auto industry (1917–33) to explore
the effects of discriminating alignment on firm survival during the pre-
shakeout stage and during the post-shakeout phase. They found that
aligning the engine transaction according to transaction cost economizing

principles had a significantly larger impact on increasing survival during
the shakeout stage than during the pre-shakeout stage, although align-
ment did not have a statistically significant impact over the entire period.
Argyres and Bigelow’s (2007) study indicates that transaction cost theory
needs to account for variation in selection pressures across the industry
life cycle.
What is the relationship between strategizing and economizing?

To explore the relationship between economizing and strategizing, we first
identify one common feature embedded in both approaches. This com-
monality is the notion of sunk costs. Sunk costs are the set of expenditures
that, once incurred, cannot be recovered. In the strategizing perspective,
sunk costs represent the commitment that sends a signal to shape com-
petitors’ behavior. For instance, in a review of sunk costs, Tirole (1988, p.
315) argues that the decision to buy equipment today may have strategic
consequences because competitors, while observing this action, will expect
the focal firm to ‘be around tomorrow if it cannot resell the equipment’.
Rivals will thus interpret the focal firm’s action of buying equipment as a
credible signal to stay in the business and ‘bad news’ for the profitability
of the product market, and they may decide to cooperate by reducing pro-
duction scale or to not enter the market at all.
Specific investments, a term associated with TCE, represent sunk costs
that emerge through the fundamental transformation. While sunk costs
may affect competitor behavior through strategizing, the focus in TCE is
on the ability of specialized investments to create value by lowering pro-
duction cost or enhancing quality. For instance, investments in specific
physical assets like machine dies or human asset specificity that arises in
learning by doing provide just two illustrations of specific investments that
can create value.
Sunk costs therefore are critical in both theoretical perspectives but for
different reasons. Strategic commitment allows a firm to capture from
competitors a greater portion of the profit pie because it sends a credible
signal to the opponents to foreclose entry and investment or to signal
cooperation and collusion. Investment in asset specificity, on the other
hand, generates value because it can create the benefits of specialization
in a transaction and enables the firm to capture value if its transactions
are better aligned than at least some competitors. Transaction cost econo-
mists therefore argue that these specialization benefits can be realized by
designing appropriate governance structures to mitigate potential oppor-
tunism. Although value is captured through differing mechanisms, sunk
costs are a common feature in both theories and provide an opportunity
to theoretically integrate strategizing and economizing approaches in the

business strategy literature, which we now explore.
When does economizing inform strategizing?

Foss (2003, p. 139), in a methodological essay, argues that TCE is ‘nec-
essary for adequately understanding the nature of strategizing, because
transaction costs are essential aspects of processes of creating, capturing
and protecting value’. That is, strategic moves involving some costs have
implications for governance choice, the cost of which may affect the choice
of strategic move. Nickerson and Vanden Bergh (1999) provide a specific
application of this perspective. In the context of competition between
Coca-Cola and Pepsi-Cola in the fountain channel, their research explores
the choice of asset-organization pair (a specific asset organized under
hierarchy or a generic asset organized through a market) in Cournot com-
petition. The model theoretically indicates that governance costs through
strategic interactions can influence which asset-organization pair is chosen
for each firm. Strategizing without consideration of economizing and its
attendant governance costs can lead to different equilibria because of dif-
ferences in cost functions. For instance, governance costs vary not only
by governance mode but also by institutional environment (Williamson
1991b). Without accounting for such differences game-theoretic analysis
not only can generate different equilibria but does little to inform organi-
zational choices.
More generally, the economizing perspective can inform the strategizing
perspective by identifying the set of feasible firm strategies and inform not
only the choice of sunk costs but also organizational and pricing choices.
These strategic alternatives then can be assessed employing game-theoretic
tools. For instance, recent approaches by Ghosh and John (1999),
Nickerson (1997) and Nickerson et al. (2001) identify alternative strategies
in various contexts by linking the economizing perspective with Porter’s
(1985, 1996) strategic positioning approach. Nickerson et al. (2001), for
instance, employ TCE to econometrically identify alternative strategic
positions within the international courier and small package industry,
identified by the nature of investment (co-specialized or re-deployable)
along an activity chain, the organization (make or buy) of each activity,
and the market position supported by these choices. This type of analysis
provides a full set of feasible strategies that can then be analyzed in a
strategizing context.
Boundary conditions of the strategizing perspective

Economizing can inform strategizing, but only within those boundary
conditions where game theory offers an appropriate methodology. Teece
et al. (1997, p. 513) argue that strategizing ‘is most relevant when competi-
tors are closely matched and the population of relevant competitors and
the identity of their strategic alternatives can be readily ascertained’. The
boundary condition of the game-theoretic approach is the number of com-
petitors within an industry. The relevance of game-theoretical predictions
decreases as the number of market participants increases because develop-
ing expectations of other firms’ alternatives and their effect on the focal
firm’s profitability becomes increasingly difficult and complex. The impact
of strategic interactions on firm decisions thus decreases as the market
approaches a traditional model of perfect competition.
When does strategizing inform economizing?

Strategizing can inform economizing on several fronts. Williamson argues
that contracting parties can foresee, although not with perfect foresight, the
potential for opportunistic behavior and then design appropriate govern-
ance structures to minimize transaction costs (Williamson, 1991a). This
anticipation and ex ante contract design is consistent with the game-theoretic
logic of a contingency action plan. Therefore, in order to design transaction
cost economizing contracts ex ante, firms should invest in foreseeing the
potential opportunistic behaviors of their trading partners and the potential
strategic moves of their competitors. This contemplation argues for consid-
erations of strategizing when choosing economizing governance structures.
Should strategizing models provide additional foresight then it should be
folded into the transaction cost economizing calculus for designing appro-
priate contracts as well as efficient governance arrangements.
A weakness of the economizing perspective is that it offers little insight
on which transactions a firm should pursue. Indeed, Williamson’s (1985)
conceptualization of TCE assumes that a firm already contains a core set
of transactions for which a ‘comparative assessment is unneeded’ and
therefore explores the organization of transactions that are added to the
core and ‘for which make-or-buy decisions can only be made after assess-
ing the transformation and transaction cost consequences of alternative
modes’ (Williamson, 1985, p. 96). Strategizing may inform economizing
by helping to identify which transactions to undertake as well as the desir-
able level of asset specificity. For instance, Nickerson and Vanden Bergh’s
(1999) Cournot model informs the level of asset specificity firms should
invest in; although, it does little to inform which transaction firms should
enter into.
Finally, the strategizing approach has been profitably employed to
explore behavior within bilateral relationships. Numerous models employ
a game-theoretic methodology to explore the vertical scope of a firm’s
activities (Grossman and Hart, 1986) and self-enforcing contract regimes
(Klein, 1996). While these strategizing approaches do inform the econo-

mizing approach, we do not consider this class of models further because
such analysis is between vertical trading partners as opposed to the
horizontal competition discussed in this chapter, and it rarely takes into
account potential strategic moves by horizontal competition (for a more
comprehensive treatment see Rey and Tirole, 2007).
Boundary conditions of the economizing perspective

While strategizing does and can inform economizing there nonetheless are
important boundary conditions. Most important is Williamson’s (1985)
assumption of bounded rationality where individuals are intendedly
rational but limitedly so. In contrast, the strategizing perspective often
and typically assumes perfect rationality. In relatively simple situations
where the bounds of rationality do not pose constraints, both perspectives
are compatible. This compatibility breaks down as cognitive limits are
reached and represents a boundary condition for a joint economizing–
strategizing perspective.
Bounded rationality imposes other boundary conditions as well.
Economizing usually is treated as if it were, in principle, a strategy equally
available to every firm all the time. However, not every firm may align
transactions according to the discriminating alignment hypothesis and
not all managers may have the capacity to recognize contracting hazards
and ways to mitigate them. Argyres and Liebeskind (1999) described how
prior contractual commitments that did not foresee new transactions may
constrain governance choices. In all of these contexts, bounded rational-
ity is sufficiently severe to limit the applicability both of economizing and
strategizing.
Are strategizing and economizing necessary and sufficient perspectives for

business strategy?
The large numbers of academic papers that consider investments in sunk
costs to signal to competitors and that explore the use of governance
structures to safeguard investments in asset specificity indicate that these
perspectives offer necessary insights to the field of business strategy. For
instance, Saloner (1991) reviews work on game-theoretic models and illus-
trates how game-theoretic modeling techniques are relevant to the studies
of strategic management and Williamson (1991a) does the same for TCE.
These perspectives assist managers and scholars alike in determining ways
to capture value either by holding competitors at bay or gaining coopera-
tion or by appropriating returns from investments in specific assets. The
economizing and strategizing perspectives undoubtedly provide necessary
insights to understanding how firms capture value.
A more challenging question involves the extent to which these per-

spectives are sufficient foundations for the field of business strategy. Both
approaches have a common weakness in that they only address one of the
fundamental strategy questions we mentioned in the outset of this chapter,
namely, value appropriation. Neither economizing nor strategizing has
much to say about value creation. For example, the strategizing literature
emphasizes the strategic moves to generate and exploit market power but
relies on the assumed existence of demand and marginal cost curves. The
literature on economizing, on the other hand, focuses largely on value
appropriation from economizing on transaction costs, assuming that the
transactions in which the firm is engaged are already chosen. Therefore,
these perspectives alone or in combination offer a necessary but not suf-
ficient foundation for the theory of business strategy because they fail to
provide insights into value creation.
By assuming that specific assets can create value to the transaction,
Williamson (1991a) can focus on the analysis of economizing on the costs
of opportunistic behaviors. In addition, Williamson emphasizes that hier-
archy is an effective mode of governance to deal with cooperative adapta-
tion. Although these adaptation benefits create value to the transaction
and firms, future research is required for the economizing perspective to
provide insight into value creation.
Conclusion
In this chapter we introduced the literature on economizing and strate-
gizing in the context of business strategy. The value of TCE rests on the
minimization of transaction costs with respect to potential opportunism
and the performance benefits the discriminating alignment hypothesis
engenders. On the other hand, the value of game theory rests on applying
its method to develop a contingency action plan based on considering the
strategic interactions among firms. Moreover, we described how investing
in sunk costs is a central decision premise in both theories as they apply
to business strategy, albeit enabling different mechanisms. Relying on this
central decision premise we introduced research that explores the intersec-
tion of strategizing and economizing of business strategy and their bound-
ary conditions. We concluded that while the economizing and strategizing
perspectives are necessary foundations to business strategy they neither
individually nor combined offer a sufficient theory of business strategy at
least because they do not inform value creation.
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16 Empirical methods in transaction cost
economics
Michael E. Sykuta
Transaction cost economics (TCE), and the New Institutional Economics

(NIE) more generally, places a strong emphasis on empirical research.
That research, in a number of applied fields, is described throughout this
volume. Empirical observation and analysis has played a central role in
the development of TCE, going back to Coase’s original inquiry into the
nature of the firm (Coase, 1937). Coase’s seminal work was motivated
by observations of incongruities between economic theory and the real
world, and a desire for a theory of the firm ‘where the assumptions may be
both manageable and realistic’ (Coase, 1937, p. 386). This approach has
led TCE researchers to crack open not only the black box of production
known as the firm, but also the market itself, examining the structures of
individual transactions and their implications for firm and market per-
formance. The result is a burgeoning field of empirical research on the
causes and consequences of different modes for governing the allocation
and coordination of resources in an economy.
Is the empirical evidence persuasive? Macher and Richman’s (2008)
review of the application of TCE across the range of social science dis-
ciplines finds ‘considerable support for the main propositions derived
from transaction cost economic theory’ (p. 138) but concludes there are
lingering challenges. Oliver Williamson (2000, pp. 605–7) is more bold,
calling TCE an ‘empirical success story’. But this view is by no means
universal (see, for example, Chapter 25 by Foss and Klein and Chapter 28
by Hodgson, in this volume). Some of TCE’s core concepts are difficult to
define, explanatory variables such as asset specificity and uncertainty are
difficult to measure, correlations between asset specificity and firm behav-
iour and organization are not necessarily causal relationships, moderating
influences are often omitted, and so on.
Williamson (2000, p. 610) characterizes the NIE (and hence TCE) as ‘a
boiling cauldron of ideas’. He continues on to state, ‘Not only are there
many institutional research programs in progress, but there are competing
ideas within most of them’ (p. 610). This bubbling mix of competing ideas
manifests itself as a wide range of questions and perspectives on economic
organization. Several reviews of these competing theories as well as of
152
Empirical methods in transaction cost economics 153
the empirical literatures they have spawned are available elsewhere. This
chapter reviews some of the empirical methods and techniques that are
most common in TCE research and reviews the empirical and theoretical
challenges facing scholars in this field. (Sykuta, 2008, provides further
details.)
Basic modeling frameworks

The most basic question in NIE research dates back to Ronald Coase’s
original (1937) inquiry: why use a firm (managerial control) instead of
the market (price mechanism) to coordinate the allocation of resources?
Coase addresses this general question in two steps. First, he considers the
question of ‘why a firm emerges at all in a specialised exchange economy’
(1937, p. 390). His proposed answer, as is now familiar to many econo-
mists, is that there are costs to using the price mechanism that may make
internal organization more efficient. However, this raises the second point
Coase considers, namely ‘why is not all production carried on by one big
firm?’ (ibid., p. 394). Employing the principles of marginal analysis, Coase
argues that the costs of managerial coordination increase as firm scale and
heterogeneity of transactions increase, to the point that the marginal cost
of internalizing another resource allocation decision (transaction) exceeds
the cost of using the price mechanism. Hence, the basic empirical question
resulting from Coase’s insights may be summarized as ‘what factors affect
the relative costs of internal coordination and market transactions that
determine whether a firm will internalize resource allocations or use the
price mechanism?’, that is, the make-or-buy decision.
Empirically, the make-or-buy decision would seem to present a straight-
forward econometric problem. Given the dichotomous nature of the deci-
sion, a simple dummy variable is sufficient to capture the distinction. The
econometric problem is to then estimate the probability that the activity
will be internalized based on a set of explanatory variables hypothesized
to affect the relative costs of managerial and market coordination. The
issue is how best to estimate the relationship between the discrete choice
of internalization and the set of explanatory variables, suggesting use of
probit or logit models (Hubbard and Weiner, 1991; Allen and Lueck,
1992, 1998; Geddes, 1997; Helland and Sykuta, 2004; James and Sykuta,
2006).
The make-or-buy decision is caricatured as the choice between two
extremes, (spot) market transactions and internalization. However,
between spot markets and hierarchy there is a wide range of contrac-
tual relations that exemplify characteristics of both spot (autonomous)
transactions and managerial coordination to varying degrees. This is the
gray range of organizational structure called ‘hybrids’ (Williamson, 1991;
Ménard, 2004). The addition of hybrids to the analysis simply adds one
more choice in organizational structure: market, hybrid, or hierarchy. Of
course, hybrids themselves may range from long-term contracts between
two otherwise autonomous parties to joint ventures and strategic alliances
that involve more mutual investment and governance to franchise agree-
ments with a quasi-managerial contractual control.
The first question to address with more than two discrete choices or
outcomes is whether the choices are inherently ordinal or simply repre-
sent multiple alternatives. For example, consider how the degree of asset
specificity affects governance structures. Williamson (1991) suggests that
as the degree of asset specificity increases, the optimal organizational
structure moves from market to hybrid to hierarchy. If one considers
market, hybrid, and hierarchy as degrees of hierarchical control, then a
discrete choice variable taking on values of 0, 1, and 2, respectively, makes
ordinal sense. Hierarchy (2) is more control than hybrid (1), which is more
control than market (0). As with the make-or-buy decision, however, the
richness of these differences is difficult to capture in discrete choice models,
although in principle increasingly fine categorizations of ‘hybrid’ could be
addressed by simply allowing more discrete values for the dependent vari-
able. When discrete choices have ordinal relevance, an ordered probit or
ordered logit model may be the most appropriate specification (Hubbard,
2001; James and Sykuta, 2005). For multiple discrete outcomes that do
not have an inherently ordinal relation, a multinomial logit model pro-
vides an appropriate mechanism (Crocker and Masten, 1991; Ménard and
Saussier, 2000).
The preceding models are well suited to studies of choices between two
or more discrete choices, such as choices among organizational forms,
whether to include or exclude a particular characteristic or contract
term, or choices reflecting varying degrees of an attribute. A different
set of research questions focuses on cardinal measures of organizational
and contractual characteristics, such as the number of terms included
in contracts, the number of business divisions or production lines in a
firm, or the number of members of corporate boards. Questions such as
these suggest use of a counting model such as a Poisson regression model
(Gompers and Lerner, 1996; Helland and Sykuta, 2004). Other problems
include censored data (for which Tobit models can be useful) and survi-
vorship bias (for which maximum likelihood estimation is preferred to
ordinary least squares). Dichotomous variables may also be needed for
cases in which firms simultaneously employ multiple governance modes
(the ‘make-and-buy’ decision) (Monteverde and Teece, 1982; Fan, 2000;
Lafontaine and Shaw, 2005).
Most of the empirical research on contracting and organization attempts
to explain some attributes of governance mechanisms based on, or given,

the characteristics of the transaction being studied. However, it is clearly
the case that in many instances transaction characteristics as well as gov-
ernance attributes are endogenously determined. For instance, the level of
specific investment and the nature of protections against post-contractual
hazards related to those investments may be simultaneously determined.
Indeed, the incomplete contracts theory of the firm (Grossman and Hart,
1986; Hart and Moore, 1990) implicitly recognizes this, as the ex ante
ownership arrangement is chosen based on its expected effect on the level
of specific investment. More generally, decision makers choose (self-select)
a governance mechanism with the objective of maximizing their payoff. To
deal with endogeneity researchers have typically used instrumental vari-
ables, seemingly unrelated regression (SUR), switching models, and other
techniques (Ackerberg and Botticini, 2002; Hamilton and Nickerson,
2003; Mayer and Nickerson, 2005). Identification is often particularly dif-
ficult in these studies, however.
A related issue is the endogeneity of terms within a contract and the
relationship between various contract terms. Sykuta and Parcell (2003)
argue that transactions have three fundamental characteristics: the alloca-
tion of value, the allocation of exposure to uncertainty, and the allocation
of decision rights. Terms affecting any one of these three allocations are
likely to have implications for allocations elsewhere in the contract. Thus,
it is important to consider the complete set of contract terms rather than
focusing on individual terms in isolation. Both Joskow (1987) and Crocker
and Masten (1991) examine the interaction between contract terms using
standard simultaneous equation techniques. In discussing this challenge,
Masten and Saussier (2002, p. 291) claim
[t]he binding constraint is not technique, but data availability. As the number of
provisions analyzed increases, the number of explanatory variables and the size
of the data set needed for statistical identification multiplies. Often, sufficient
numbers of observations to analyze more than two or three provisions at a time
will simply not exist.
Another issue relates to the performance effects of organization form

and the assumption of equilibrium contracting. As Williamson (1985, p.
22) states, ‘the question is whether organizational relations (contracting
practices; governance structures) line up with the attributes of transactions
as predicted by transaction cost reasoning or not’. The hypothesis test,
then, is based on the assumption that if we do not observe the expected
relation between transaction cost factors and (presumably efficient) organ-
izational design, the theory is not substantiated. The possibility of mis-
alignment and dynamic adjustment has not been well addressed. In short,
little work has been done directly examining the performance (or transac-
tion cost) implications of governance design and the dynamics of govern-
ance structures.
Although there have been attempts to measure the relation between
organizational design and performance (Armour and Teece, 1978;
Silverman et al., 1997; Poppo and Zenger, 1998), there is little conclusive
evidence. Masten (2002) explains the methodological and empirical chal-
lenges for establishing a causal relationship between organizational form
and performance. A major impediment concerns the ability to measure
performance at the unit of analysis: the resource allocation decision or
transaction. An important exception is Mayer and Nickerson (2005)
who actually examine transaction-level financial returns as a function of
organizational form. Using data on individual information technology
service agreements, Mayer and Nickerson find that service agreements
structured in ways consistent with transaction cost-based predictions
have higher financial returns, suggesting governance structure matters for
performance.
Although not direct tests of the link between organization and perform-
ance, recent studies do offer indirect evidence. Nickerson and Silverman
(2003) examine the dynamic implications of organizational misalignment
in the US interstate for-hire trucking industry and find that firms with
structures inconsistent with TCE predictions ‘realize lower profits than
their better-aligned counterparts, and that these firms will attempt to
adapt so as to better align their transactions’ (Nickerson and Silverman,
2003, p. 433). Argyres and Bigelow (2007) incorporate transaction cost
economizing in a life cycle model for the early US automotive industry
and find firms that were not organized in transaction cost economizing
ways were more likely to fail during the industry’s shakeout period in the
1920s.
The dynamics of contract structure – that is, how contracts evolve
and whether contracting parties learn from their experiences – have also
received little attention. This is a different question than the effect of repeat
dealing or reputation on contract design (Crocker and Reynolds, 1993).
Hill (2001) provides a legal production function explanation for the persist-
ence of poorly written contract documents, explaining how judicial insti-
tutions and the nature of legal work limit lawyers’ incentives to innovate
or improve upon previously sanctioned contract language. Argyres and
Mayer (2004) conduct an in-depth study of a series of contracts between
two parties to determine when and why contract terms change, and find
many changes that cannot be readily explained by changes in the assets at
risk. They also find a positive relation between inter-organizational trust
and contract length, if not contractual completeness.
Theoretical and conceptual challenges

Empirical research on contracting and organizations has generally been
successful, particularly the applications of Williamson’s (1985, 1996) TCE
theory. However, challenges still exist. Key terms and concepts in the
underlying theories are both poorly defined and difficult to measure. This
section briefly highlights these areas of potential concern not as a warning
sign against proceeding, but simply as a caution or perhaps as a call for
intentional focus to address these challenges. Measurement is a funda-
mental difficulty in empirical TCE research. While measurement problems
are often the result of imperfect data, several key measurement problems
result from theoretical concepts that are not well defined. It is difficult to
appropriately measure something that is not clearly defined. This section
highlights particular terms and concepts that hamper effective research on
contracting and organizational structure.
Vertical integration
From Coase’s original work in 1937, the make-or-buy decision has been a
focal point for empirical research. However, the concept of vertical inte-
gration is not well defined either in the NIE or in the traditional industrial
organization literature. The unanswered question regarding vertical inte-
gration is: what is the economic relevance of the concept? Without that
understanding, one cannot begin to determine the appropriate measure of
vertical integration.
Perhaps the most common understanding of vertical integration is
ownership of productive assets at consecutive stages of production. While
measuring ownership of assets at two stages of production is relatively
straightforward, such a measure ignores two important economic impli-
cations. First, such a measure does not address whether the volume of
production at one stage corresponds with the volume at the other stage,
what might be called the degree of vertical integration. A firm that verti-
cally integrates 10 percent of its input requirements is not the same as a
firm that integrates 100 percent of its needs. Fan (2000) and Fan and Lang
(2000) develop a measure of relatedness using input–output production
ratios to calculate the relative share of the vertically integrated resource.
Such a measure provides a better perspective of the economic relevance of
the integrated activity.
Second, defining vertical integration based on asset ownership at consec-
utive stages of production may miss the economic point. In Coase’s 1937
paper, the economic question is not: ‘why are assets commonly owned?’
It is: ‘why are resources allocated by managerial control rather than by
the price mechanism?’ Common ownership of assets is neither a neces-
sary nor sufficient condition for managerial (or non-price) coordination
or control of resources. It is not uncommon for commonly owned divi-

sions of a company to operate autonomously in the marketplace without
direct managerial intervention. Similarly, ownership is not required to
exert managerial control over assets. This is amply clear in US agriculture,
where production contracts in poultry and hogs, among other products,
stipulate many managerial practices and asset allocations – to the point
that such independent contracting arrangements are under scrutiny for
appearing too much like employment contracts.
An alternate definition of vertical integration would be based on control
of productive assets at adjoining stages of production. One might envision
a measure similar to Fan’s (2000) capturing the percentage of input needs
(distribution access) controlled. However, since assets can be controlled
by managerial discretion either through ownership or by contract, such
a definition of integration would fail to discriminate between the type of
governance mechanism used. Moreover, at least in the case of contractual
control, contractual incompleteness may give rise to circumstances in
which the residual rights of control do not correspond to the contractual
control rights, raising the question of which party actually ‘owns’ the
asset (the basis of the Grossman–Hart–Moore framework (Grossman and
Hart, 1986; Hart and Moore, 1990)).
Asset specificity
The concept of asset specificity plays a prominent role in Williamson’s
(1985, 1996) TCE and the incomplete-contracts approach as well. The
argument is that asset specificity creates a quasi-rent in the transaction
relationship that may induce one party or the other to engage in oppor-
tunistic behaviour and/or costly negotiations in an attempt to appropriate
the value of the quasi-rent. These quasi-rents are typically considered
the difference in the value of the specific asset in its current use versus its
next best use, net of any conversion, retooling, and redeployment costs.
Another way of thinking about the quasi-rent is as the difference between
the price currently being paid for the asset and the price required to keep
the asset employed in its current use (that is, its shutdown or reservation
price). The greater the quasi-rent, the greater the incentive for at least one
party to attempt to appropriate the value of the quasi-rent. Thus, the key
for arguments of asset specificity rests in the size of the quasi-rent.
Empirical research examining the role of asset specificity rarely uses
direct estimations of the size of the quasi-rent itself due to the difficult
nature of measuring opportunity costs. Rather, most research asserts a
positive correlation between certain characteristics and the size of the
quasi-rent, and attributes any incentives resulting from asset specificity to
the characteristics themselves. For instance, Fan (2000) uses geographic
proximity among petroleum refiners to proxy for specificity. Joskow (1987)

uses both the physical proximity of electric plants and coal mines and the
type of coal available from the mines as measures of geographic and tech-
nical specificities. Masten et al. (1991) use survey results from production
managers rating the degree of specificity and complexity of component
parts in shipbuilding. Saussier (2000) uses a dummy variable to indicate
whether suppliers deliver to facilities requiring specially-designed physical
assets. While the link between such measures of specificity and the exist-
ence of a quasi-rent are intuitively reasonable, the size of the appropriable
rent and hence the incentive for opportunistic behaviour are imperfectly
captured, at best.
A more appealing proxy for asset specificity may be the amount of
investment required in non-redeployable assets, such as Saussier’s (2000)
measure of site-specific investment. However, while quasi-rents may be
attributable to such sunk investments, a measure of redeployment costs
rather than initial deployment costs would be more accurate. Obviously,
quasi-rents are difficult to measure empirically and proxies such as those
described above may be the best alternative available to researchers.
Nonetheless, researchers should bear in mind the goal of measuring the
size of the appropriable quasi-rent itself rather than immediately relying
on characteristics of assets that may generate such rents.
A more fundamental question that researchers must address is ‘spe-
cific to what?’ The general premise in NIE theories of the firm is that
investments or assets that are relationship-specific give rise to potential
quasi-rents and associated behavioural ills. What is less clear is whether,
or when, assets that are firm-specific or industry-specific are necessarily
relationship-specific. For instance, Pirrong (1993) and Hubbard (2001)
use ‘thinness’ of the market to proxy for specificity of assets that, of them-
selves, are not necessarily specific to a particular transaction or trading
partner. Thinness in the market creates a potential temporal hazard like
unto that in Masten et al. (1991). However, in the former case, the tempo-
ral specificity derives from the sequential nature of a production process
rather than market structure characteristics. One may ask to what extent
the optimal governance response for such temporal specificities depends
on the source of the specificity, or the circumstances under which the
implications of the empirical results are more or less generalizable.
Conclusion
From the original seeds sown by Coase’s inquiry into why we observe firms
in a specialized market economy, TCE research has been characterized by
an interest in developing theories ‘where the assumptions may be both
manageable and realistic’ (Coase, 1937, p. 386). This intention to develop
models based in realism places a premium on quality empirical research

both to test alternative theories and to identify empirical phenomena
that might spur further innovations in our theoretical frameworks. The
tremendous variation in governance structures and transaction attributes
observed in the economy suggests numerous types of inquiries, each with
different statistical characteristics. Therefore the econometric toolkit for
researchers in the NIE must encompass a wide array of formulations and
researchers must be flexible in their abilities to adapt to new techniques as
are appropriate to their investigations.
Despite the large number of empirical studies to date and the general
consistency of empirical results with transaction cost-based theories of
economic organization, there is much work to be done. Theoretical con-
cepts must be refined to provide clearer insight into the nature of organi-
zational structure. Competing theories suggest opportunities to take what
is best from each to develop a more complete whole. New and better
sources of data on contract and organizational structures will provide fuel
for empirical research and facilitate more robust statistical analyses of the
causes and consequences of alternate governance forms. Though chal-
lenges exist, our understanding of how the economic system works will be
greatly enhanced as scholars continue their work.
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mation services’, Strategic Management Journal, 19 (9), 853–77.
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Électricité de France’, Journal of Economic Behavior and Organization, 42 (2), 189–206.
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tional alignment, and organizational mortality in the US trucking industry’, Strategic
Management Journal, 18 (S1), 31–52.
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and organization’, in E. Brousseau and J.-M. Glachant (eds), New Institutional Economics:
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Williamson, Oliver (2000), ‘The new institutional economics: taking stock, looking ahead’,
PART IV
APPLICATIONS
17 Vertical integration
Peter G. Klein
Vertical integration, or the ‘make-or-buy decision’, has been described as

the ‘paradigm problem’ of transaction cost economics (TCE) (Williamson,
1996b, p. 65). Indeed, while TCE can be regarded as a highly general
approach to economic organization – Williamson (1996b, p. 8) states
that ‘any problem that arises as or can be posed as a contracting problem
can be examined to advantage in transaction cost economics terms’ – the
theory was largely developed in the context of a particular application:
organizing the vertical stages of production. When Coase (1937, pp.
393–4) famously asks, ‘[w]hy does the entrepreneur not organise one less
transaction or one more?’, he is referring to transactions between the
entrepreneur and a factor of production (for example, labour) – a vertical
transaction.
Why, then, do some firms choose a vertically integrated structure, while
others specialize in one stage of production and outsource the remaining
stages to other firms? Why are some inputs procured on the spot market,
others through ongoing relationships with particular suppliers, yet others
through complex supplier networks or alliances? Should a manufacturing
firm use its own distributors, or should it contract with independent retail-
ers? Should investment projects be funded on the external capital markets,
or should the firm rely on internal finance?
Traditionally, economists viewed vertical integration or tight vertical
relationships as attempts by dominant firms to earn monopoly rents by
gaining control of input markets or distribution channels, to engage in
price discrimination, or to eliminate multiple markups along the supply
chain. Antitrust authorities, steeped in what Williamson (1985, p. 369)
calls the ‘inhospitality tradition’ toward vertical restrictions, generally
frowned upon vertical integration and long-term contracting. The trans-
action cost approach, by contrast, emphasizes that vertical coordination
can be an efficient means of protecting relationship-specific investments or
mitigating other potential conflicts under incomplete contracting.1
The theory of vertical boundaries

Coase was the first to explain that the boundaries of the organization
depend not only on the productive technology, but also on the costs of
transacting business. In the Coasian framework, the decision to organize
165
transactions within the firm as opposed to on the open market depends on

the relative costs of internal versus external exchange. The market mecha-
nism entails certain costs: discovering the relevant prices, negotiating and
enforcing contracts, and so on. Within the firm, the entrepreneur may be
able to reduce these ‘transaction costs’ by coordinating these activities
himself. However, internal organization brings other kinds of transac-
tion costs, namely problems of information flow, incentives, monitoring,
and performance evaluation. The boundary of the firm, then, is deter-
mined by the tradeoff, at the margin, between the relative transaction
costs of external and internal exchange. In this sense, the firm’s vertical
boundaries depend not only on technology, but also on organizational
considerations; that is, on the costs and benefits of various contracting
alternatives.
According to TCE, economic organization, both internal and external,
imposes costs because complex contracts are usually incomplete – they
provide remedies for only some possible future contingencies.2 This obvi-
ously applies to written contracts for all but the simplest forms of trade. It
also applies to relational contracts, agreements that describe shared goals
and a set of general principles that govern the relationship (Goldberg,
1980; Baker et al., 2002), and to implicit contracts, agreements that while
unstated are assumed to be understood by all sides. Moreover, contractual
incompleteness exposes the contracting parties to certain risks. Primarily,
if circumstances change unexpectedly, the original governing agreement
may no longer be effective. The need to adapt to unforeseen contingen-
cies constitutes an additional cost of contracting; failure to adapt imposes
what Williamson (1991a) calls ‘maladaptation costs’.3
The most often discussed example of maladaptation is the ‘holdup’
problem associated with relationship-specific investments.4 The holdup
problem figures prominently in Williamson’s (1975, 1985, 1996b), Klein
et al.’s (1978), and Grossman and Hart’s (1986) interpretations of the
transaction cost theory. Investment in such assets exposes agents to a
potential hazard: if circumstances change, their trading partners may
try to expropriate the rents accruing to the specific assets. Rents can be
safeguarded through vertical integration, where a merger eliminates any
adversarial interests. Less extreme options include long-term contracts,
partial ownership, and agreements for both parties to invest in offsetting
relationship-specific investments. Overall, several governance structures
may be employed. According to transaction cost theory, parties tend to
choose the governance structure that best controls the underinvestment
problem, given the particulars of the relationship.
In this sense, TCE may be considered the study of alternative institutions
of governance. Its working hypothesis, as expressed by Williamson (1991b,
Vertical integration 167
p. 79), is that economic organization is mainly an effort to ‘align transac-

tions, which differ in their attributes, with governance structures, which
differ in their costs and competencies, in a discriminating (mainly, transac-
tion cost economizing) way’. Simply put, the contractual approach tries to
explain how trading partners choose, from the set of feasible institutional
alternatives, the arrangement that best mitigates the relevant contractual
hazards at least cost.5
The theory is fleshed out by specifying which governance structures
go with which transactions. Transactions differ in the degree to which
relationship-specific assets are involved, the amount of uncertainty about
the future and about other parties’ actions, the frequency with which the
transaction occurs, and so on. Each matters for the preferred institu-
tion of governance, although the first – asset specificity – is particularly
important. Williamson (1985, p. 55) defines asset specificity as ‘durable
investments that are undertaken in support of particular transactions,
the opportunity cost of which investments is much lower in best alterna-
tive uses or by alternative users should the original transaction be prema-
turely terminated’.6 This could describe a variety of relationship-specific
investments, including both specialized physical and human capital,
along with intangibles such as R&D and firm-specific knowledge or
capabilities.
Governance structures include markets, hierarchies, and hybrids. The
pure anonymous spot market suffices for simple transactions such as basic
commodity sales. Market prices provide powerful incentives for exploit-
ing profit opportunities and market participants are quick to adapt to
changing circumstances as information is revealed through prices. When
relationship-specific assets are at stake, however, and when product or
input markets are thin, bilateral coordination of investment decisions
may be desirable and combined ownership of these assets may be efficient.
Ownership is completely combined in the fully integrated firm. The trans-
action cost approach maintains that such hierarchies offer greater protec-
tion for specific investments and provide relatively efficient mechanisms
for responding to change where coordinated adaptation is necessary.
Compared with decentralized structures, however, hierarchies provide
managers with weaker incentives to maximize profits and normally incur
additional bureaucratic costs.7
Alternatively, partial alignment may be achieved within intermediate or
hybrid forms such as long-term contracts, partial ownership agreements,
franchises, networks, alliances, and firms with highly decentralized assign-
ments of decision rights. Hybrids attempt to achieve some level of central
coordination and protection for specific investments while retaining the
high-powered incentives of market relations.
Empirical research on vertical boundaries

Most of the empirical work on the make-or-buy decision adopts the trans-
action cost framework and follows the same basic model. The efficient
form of organization for a given economic relationship – and, therefore,
the likelihood of observing a particular organizational form or governance
structure – is seen as a function of certain properties of the underlying
transaction or transactions: asset specificity, uncertainty, frequency, and
so on. Organizational form is the dependent variable, while asset spe-
cificity, uncertainty, complexity, and frequency are independent variables.
Specifically, the probability of observing a more integrated governance
structure depends positively on the amount or value of the relation-
ship-specific assets involved and, for significant levels of asset specificity,
on the degree of uncertainty about the future of the relationship, on the
complexity of the transaction, on the frequency of trade, and possibly on
some aspects of the institutional environment.
Detailed surveys of this literature are in Klein (2005), Macher and
Richman (2008), and elsewhere. Classic papers include Masten’s (1984)
study of aerospace component procurement, a series of papers by Joskow
(1985, 1987, 1988, 1990) on long-term contracting for coal, Crocker and
Masten’s (1991) study on natural gas contracts, research by Erin Anderson
and co-authors on marketing channels (Anderson and Schmittlein, 1984;
Anderson, 1985; Anderson and Coughlan, 1987) and several other indus-
try case studies. In most of these studies, organizational form is often
modelled as a discrete variable – ‘make’, ‘buy’, or ‘hybrid’, for example
– though it can sometimes be represented by a continuous variable. Of
the independent variables, asset specificity has received the most atten-
tion, presumably because of the central role it plays in the transaction cost
approach to vertical integration. Williamson (1991a) distinguishes among
six types of asset specificity. The first is site specificity, in which parties are
in a ‘cheek-by-jowl’ relationship to reduce transportation and inventory
costs and assets are highly immobile. The second, physical asset specifi-
city, refers to relationship-specific equipment and machinery. The third is
human asset specificity, describing transaction-specific knowledge or
human capital, achieved through specialized training or learning-by-doing.
The fourth is brand-name capital, reflected in intangible assets reflected in
consumer perceptions. The fifth is ‘dedicated assets’, referring to substan-
tial, general-purpose investments that would not have been made outside
a particular transaction, the commitment of which is necessary to serve
a large customer. The sixth is temporal specificity, describing assets that
must be used in a particular sequence.
Case studies comprise the bulk of the studies on the make-or-buy deci-
sion, primarily because the main variables of interest – asset specificity,
uncertainty, frequency – are difficult to measure consistently across firms

and industries. Of course, the classification of discrete variables like
‘make-or-buy’, for example, may require more discretion by the researcher
than economists are comfortable with. Also, of course, the evidence from
individual cases may not apply to other cases. Still, the cumulative evi-
dence from different studies and industries is remarkably consistent with
the basic transaction cost argument, though naturally there remain out-
standing puzzles, challenges, and controversies.
Identification, selection, unobserved heterogeneity

One problem with the empirical literature on vertical boundaries, common
to many areas of empirical social science research, concerns the thorny
issues of identification, selection, and unobserved heterogeneity. The
main problem is that we typically observe only the business arrangements
actually chosen, not the complete set of feasible arrangements. If these
arrangements are presumed to be efficient, then we can draw inferences
about the appropriate alignment between transactional characteristics
and organizational form simply by observing what firms do. Indeed, the
early empirical work on the transaction cost approach implicitly assumed
that market forces work to cause an ‘efficient sort’ between transactions
and governance structures. Williamson (1988, p. 174) acknowledges
this assumption, while recognizing that the process of transaction cost
economizing is not automatic, maintaining that TCE ‘relies in a general,
background way on the efficacy of competition to perform a sort between
more and less efficient modes and to shift resources in favor of the former’.
Concerning vertical integration, for example, Williamson (1985, pp.
119–20) writes that ‘backward integration that lacks a transaction cost
rationale or serves no strategic purposes will presumably be recognized
and will be undone’, adding that mistakes will be corrected more quickly
‘if the firm is confronted with an active rivalry’.
Within the last two decades, researchers have begun to examine this con-
jecture more closely, looking to see if appropriately organized firms – that
is, firms that match transactional characteristics to governance structures
as the theory says they should – really do outperform the feasible alterna-
tives. Several papers use a two-step procedure in which organizational
form (in particular, the relationship between transactional characteristics
and governance structure) is endogenously chosen in the first stage, then
used to explain performance in the second stage. By endogenizing both
organizational form and performance this approach also mitigates the
selection bias associated with OLS regressions of performance on firm
characteristics.8
This evolutionary approach sheds considerable light on the processes
by which organizations adapt and change, along with the costs of mis-
alignment or maladaptation. However, reliance on evolutionary models
introduces additional problems. In many cases, survival may not be the
best measure of performance, compared with profitability or market
value. Poorly performing firms may survive due to inefficient competitors,
regulatory protection, or legal barriers to exit such antitakeover amend-
ments or an overprotective bankruptcy code. In short, efficient alignment
between transactions and governance should be expected only if the selec-
tion environment is strong. Moreover, when market conditions change
rapidly and unexpectedly, ex post survival may not be a good measure of
ex ante efficiency; a particular organizational form may be right for the
times, but the times change.9
More generally, most of the applied studies on vertical boundaries
establish correlations, not causal relations, between asset specificity and
internal governance. These studies typically test a reduced form model
where the probability of observing a more hierarchical form of governance
increases with the degree of relationship-specific investments. Plausibly,
if the presence of such investments reduces the costs of internal organi-
zation, then asset specificity could lead to integration, independent of
the holdup problem or other maladaptation costs. Masten et al. (1991)
attempt to distinguish these two effects in the context of human capital.
They find that specific human capital investments appear to reduce inter-
nal governance costs more than they increase market governance costs.
Further studies of this type would be valuable in assessing the implications
of the evidence for the reduced form version of the basic theory. However,
we do not yet have a general theory of how relationship-specific assets
might reduce the costs of internal organization. By contrast, the underin-
vestment problem associated with specific assets and market governance is
fairly well understood.
Make, buy, or hybrid?

Another issue relates to the place of hybrids in the transaction cost story.
As described elsewhere in this volume by Ménard (Chapter 18), Michael
(Chapter 19), and Raynaud (Chapter 20), there is a healthy literature
on the characteristics of hybrid forms. However, the choice between
hybrids and alternative organizational structures is less well understood.
Perhaps surprisingly, most of the make-or-buy studies examine the
binary choice between market procurement and some, more hierarchi-
cal, alternative, either vertical integration or a hybrid arrangement. The
choice between one hierarchical agreement and another – between long-
term contracting and vertical integration, for example – has received less
attention.
An exception is the continuing controversy surrounding the purchase

of Fisher Body by General Motors (GM) in 1926. Klein et al. (1978)
and Klein (1988) cite the case as a classic example of vertical integration
designed to mitigate holdup in the presence of asset specificity. Fisher
refused to locate its plants near GM assembly plants and to change its
production technology in the face of an unanticipated increase in the
demand for car bodies, leading GM to terminate its existing ten-year
supply contract with Fisher and acquire full ownership. Coase (2000),
revisiting the original documents, argues instead that the contract per-
formed well, and was gradually replaced with full ownership only to
get Fisher’s top managers (the Fisher brothers) more closely involved in
GM’s other operation.
Coase (2000) reveals that the original ten-year supply contract included
provisions that GM would acquire 60 per cent of Fisher’s stock and
that three of the five members of Fisher’s finance committee would be
appointed by GM. Moreover, in 1921 one of the Fisher brothers became
a director of GM, with two other brothers joining him in 1924, one of
whom became president of GM’s Cadillac division. A fourth brother was
added to the board in 1926 when GM acquired the remainder of Fisher’s
stock. As Coase points out, the interests of the two companies were suf-
ficiently aligned during the period covered by the original contract that
it is unlikely that Fisher would have used the contract to extract rents
from GM. Also, contrary to the conventional understanding of the case,
Fisher did in fact build eight new body plants between 1922 and 1925 that
were close to GM facilities and had incentives to use the most efficient
technology available. In short, GM did not acquire the remaining 40 per
cent of Fisher’s stock in response to an inappropriate alignment between
transactional attributes and an existing governance structure. Rather, the
long-term contract signed in 1919 was adequate for mitigating holdup in
the face of asset specificity and uncertainty, and was replaced by vertical
integration for secondary reasons.10 Klein (2000, 2007) vigorously disputes
Coase’s revisionist account, holding that the newest evidence confirms his
earlier claim that GM’s acquisition of Fisher in 1926 was a response to
opportunistic behaviour by Fisher.11
Conclusion
Despite these and other challenges, the transaction cost theory of the firm
has had remarkable success in explaining the vertical structure of the enter-
prise. Indeed, the empirical literature on the make-or-buy decision is gen-
erally considered one of the best-developed parts of the new institutional
economics. As noted in the chapters below by Foss and Klein (Chapter 25)
and Hodgson (Chapter 28), not all critics agree with Williamson (1996a,
p. 55) that TCE is ‘an empirical success story’. But even the negative atten-
tion TCE sometimes draws is a testament to its influence in the theory and
practice of vertical boundaries.
Notes
1. Recent surveys of the theoretical and empirical literatures on the transaction-cost
and agency-theoretic approaches to vertical integration include Joskow (2005), Klein
(2005), Lafontaine and Slade (2007), and Macher and Richman (2008).
2. This contrasts with the agency-theoretic literature (for example, on franchise contracts),
which generally works within a complete-contracting perspective.
3. Williamson (1975, 1985, 1996b) attributes incompleteness to bounded rationality (see
Chapter 14 by Foss in this volume for a detailed discussion). Klein (1996) frames the
problem instead in terms of drafting costs, while the modern incomplete-contracting
literature (Grossman and Hart, 1986; Hart, 1995) simply assumes that certain variables
are non-contractible, either because they are unobservable or because they cannot be
verified to third parties (for example, courts).
4. More generally, contractual difficulties can arise from several sources: ‘(1) bilateral
dependence; (2) weak property rights; (3) measurement difficulties and/or oversearch-
ing; (4) intertemporal issues that can take the form of disequilibrium contracting,
real time responsiveness, long latency and strategic abuse; and (5) weaknesses in the
institutional environment’ (Williamson, 1996b, p. 14). Each of these has the potential
to impose maladaptation costs. Foreseeing this possibility, agents seek to reduce the
potential costs of maladaptation by matching the appropriate governance structure
with the particular characteristics of the transaction.
5. Most of the literature assumes that, for each transaction or class of transactions, there
exists a uniquely optimal governance structure. Sometimes, however, we observe bi-
sourcing, the simultaneous use of in-house and outsourced production for the same
components by the same firm. Du et al. (2006) use bargaining theory to show how
simultaneously making and buying can mitigate the holdup problem associated with
exclusive reliance on an external supplier. He and Nickerson (2006) tell a more nuanced
story in which ‘the interaction of efficiency, appropriability, and competition concerns’
explains simultaneous bi-sourcing.
6. Klein et al.’s (1978) definition is similar, though they omit the qualifier ‘much’.
Essentially they define a relationship-specific asset (‘specialized asset’) as any asset that
generates appropriable quasi-rents; that is, any asset whose value to its current renter
exceeds its value to another renter.
7. Williamson (1975, 1991b, 1996b), unlike Klein et al. (1978) and Grossman and Hart
(1986), places particular emphasis on adaptation as a characteristic of organizational
forms, leading Gibbons (2005) to call Williamson’s approach (in at least one variant)
the ‘adaptation theory’ of the firm, as distinct from the ‘rent-seeking’ approach. For
more on adaptation see Mayer and Argyres (2004), Argyres and Mayer (2007), and
Costinot et al. (2009).
8. Papers using a two-stage approach (such as Heckman’s selection model) in this fashion
include Masten et al. (1991), Poppo and Zenger (1998), Saussier (2000), Macher (2006),
Nickerson et al. (2001), Sampson (2004), and Yvrande-Billon (2004).
9. In this sense experimentation – even the reversal or ‘undoing’ of previous actions – can
be consistent with efficient behaviour (Mosakowski, 1997; Boot et al., 1999; Matsusaka,
2001; Foss and Foss, 2002; Klein and Klein, 2002).
10. Coase (2006) reviews the evidence on Fisher and GM and traces the development and
evolution of the canonical account. His explanation for the widespread acceptance of
the Fisher Body ‘myth’ is complex. First, Coase doubts the overall value of the basic
asset specificity-holdup-opportunism story of TCE, and thinks researchers have exag-
gerated the importance of this case because it supports what would otherwise be a
suspect theory. Coase has a broader purpose in mind, however. He uses this episode to
criticize economists for overreliance on deductive methods, for failing to investigate the
‘facts on the ground’, and for general sloppiness in empirical work:
If it is believed that their theory tells us how people would behave in different cir-
cumstances, it will appear unnecessary to many to make a detailed study of how they
did in fact act. This leads to a very casual attitude toward checking the facts. If it is
believed that certain contractual arrangements will lead to opportunistic behavior, it
is not surprising that economists misinterpret the evidence and find what they expect
to find. (Coase, 2006, p. 275)
11. See Chapter 12 by Klein in this volume for further details on this case.
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de France’, Journal of Economic Behavior and Organization, 42 (2), 189–206.
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pp. 174–86.
18 Hybrid organizations
Claude Ménard
There are many ways to organize transactions in a modern market

economy. Beside the polar cases of spot markets on the one hand, in
which trading activities are coordinated through the price mechanism,
and integrated firms on the other hand, in which the allocation of
resources and the coordination of decisions depend in the last resort
on a hierarchical structure, many different types of arrangements have
developed, from long-term bilateral contracts to franchise systems and
networks of tightly interwoven firms. These non-standard forms likely
represent the usual way of doing business, although they deviate from the
usual representation of microeconomic textbooks in which there are firms,
that is, ‘producers’ processing goods and services through a production
function, and ‘markets’, that is, places in which producers and consumers
proceed to exchanges.
In what follows I concentrate on forms that involve multiple partners
pooling some strategic decision rights and even some property rights while
keeping distinct ownership over key assets, so that they require specific
governance to monitor and discipline their interactions. I identify these
arrangements as ‘hybrid organizations’, in line with the terminology
proposed by Oliver Williamson (1991).1 In the next section I go farther
in identifying and delineating these arrangements. I will then discuss the
forces at work that may explain why parties accept to share strategic rights
in the next section. The following section exhibits different mechanisms of
coordination that may play distinctly or in combination. The next section
suggests a typology of hybrid organizations based on the prevalence of
each different mechanism. The final section concludes by emphasizing
problems raised by the very existence of hybrids, particularly with respect
to competition policies.
What are hybrids?

Although there is an abundant empirical literature describing the many
different forms that the organization of transactions can take, from strate-
gic alliances involving several partners to networks of firms tightly coordi-
nated to franchise systems, the terminology fluctuates, making it difficult
to capture exactly what is at stake. These variations in the vocabulary
reflect the richness of arrangements to be considered as well as the lack of
176
Hybrid organizations 177
a unifying theory that could properly identify the nature of these arrange-
ments and the logic underlying their diversity.
To fix ideas about what can be assembled under the term ‘hybrid organi-
zations’, let me start with a stylized fact.2 In the late 1970s, French millers
were confronted by a sharp decline in the consumption of bread, par-
ticularly the famous ‘baguette’, and this decline exacerbated competition
among them. A group of millers decided to react by establishing a niche
of high quality products. To do so, they created a brand name to signal
these products, with a strict list of requirements regarding the quality of
flour to be used, the conditions under which it should be transformed and
commercialized, and so on. Marketing the product also required contract-
ing with thousands of bakers who would commit to follow strict rules (for
example, using only the high quality flour delivered by these millers, never
selling products that have been frozen, and so on). The millers established
a joint entity, with each miller represented on the board of directors, to
define the requirements, to develop new products (for example, mixing
different cereals), to market the brand, and to control quality and prevent
free-riding. However, disciplining parties remained a major issue. To make
control more efficient, the millers implemented a private court, delegating
to three of them the power to investigate cases in which one party or the
other would have cheated and to penalize the free-riders, up to the point
where one could be excluded from the network. So we have an arrange-
ment in which parties were sharing some major decision rights and some
property rights (for example, over the brand name, over the investments
required by the joint venture), while remaining legally and economically
autonomous. Indeed, the millers were also competitors: for example, eight
of them were competing to attract well-located bakers for selling their
products in metropolitan Paris.
Of course this is not a unique example, although it has its own specifi-
city. Strategic alliances in the airline industry, groups of producers com-
mitting to deliver high-quality products in the agri-food industry, partners
creating joint ventures for R&D projects in high-tech industries, and so
on, are confronted with similar problems and find solutions in implement-
ing modes of governance that differ markedly from those implemented in
integrated firms while not primarily relying on market prices.
We can generalize the underlying logic of these ‘facts’ as follows.
Assume three players, A, B, and C. Let SA, SB, and SC be vectors of the
respective specific assets they hold, let dA, dB, and dC be the vectors of their
respective decision rights, and let πA, πB, and πC be the payoffs associated
with their respective property rights. Now, assume these parties pool
specific investments ShA, SiB, and SjC and decision rights dhA, diB, and djC,
these joint activities generating a joint payoff π9A,B,C, the allocation of
which is not fully contractible ex ante. Forms of governance must then be

implemented to monitor joint decisions and sharing rules, with rights that
are pooled and uncertainties in the allocation of payoffs determining the
choice of means of coordination and control that shape these forms.
There is indeed a large variety of possible combinations of the three
dimensions identified above. Empirically, it is the presence or absence of
a specific coordinating entity – call it a ‘strategic centre’ – and the exten-
sion of its authority when it exists that seems to differentiate arrange-
ments on the wide spectrum of hybrid modes of organization (I come
back to what determines these choices below). To illustrate, subcontract-
ing or supplier parks usually depend on a leading firm that operates
as a ‘buyer’ imposing specification on goods or services, although the
‘leader’ may also hold some decision rights and even property rights on
its partners. Franchise systems or joint ventures markedly differ in that
they unambiguously rely on a coordinating centre, whether this centre
gets its decision rights through delegation (joint ventures) or imposes
its rules on participating partners (franchise). There are also the various
forms taken by strategic alliances, supply chain systems networks, and so
on, which may restrict coordination to identifiable persons in charge of
monitoring the agreement or may create bureaus or autonomous entities
to control parties to the arrangement more or less tightly, as illustrated
by the millers’ case.
Notwithstanding their diversity, these forms qualify as hybrids in that
they differ markedly from markets as well as from hierarchies. To simplify,
using the notation above in the context of two parties, if we identify SE
as a strategic entity that coordinates partners, we can characterize ‘ideal
types’ (in a Weberian sense) as follows:
MARKET HYBRID FIRM
STRATEGIC ENTITY STRATEGIC ENTITY STRATEGIC ENTITY

= = =
Ø {SA1, SB2, dB1, dB2, ␲'} {SA, SB, dA, dB, ␲A, ␲B}
FIRM A FIRM B FIRM B FIRM B Division A Division B

SA SB SA1, SB2, SA1, SB2,
dA dA Ø Ø
␲A ␲B dB1, dB2 dB1, dB2
␲A ␲B
Figure 18.1 Hybrids contrasted

Why do parties delegate or even abandon part of their rights?

Given the above characterization, why do holders of property and deci-
sion rights who could transact through markets renounce significant rights
in deciding to pool resources? From a certain point of view, this question
has similarities with that of why employees transfer their decision rights to
employers (Coase, 1937; Cheung, 1983). However, there is an important
difference: in hybrid arrangements legally distinct entities also share some
specific assets and property rights. Why do they engage in activities that
seriously weaken their residual rights (so much so that finding an adequate
sharing rule is a key issue, and often a source of instability in hybrids)?
Three leading factors seem to be at work.
First, parties may accept to share rights in order to face complexity.3
Complexity has two dimensions. It may result from the need to coordi-
nate multiple interwoven transactions; or it may be due to a changing
environment. In both cases, cooperation that involves the abandonment
or delegation of some rights may prevail in order to overcome the result-
ing uncertainties or to develop an adequate buffer. For example, the tight
networks developed by general contractors and their subcontractors in the
construction industry are determined by the specificity of each project and
the highly variable demand, both dimensions generating uncertainties that
make adaptability among parties a key issue. More generally, unstable or
unpredictable demand; technological changes; potential variations in the
quality of inputs; risks of opportunistic behaviour; and unsecured insti-
tutional environments are all factors that might push partners to choose
hybrid forms, mitigating uncertainty through buffer strategies, shared
knowledge, common standards, and joint governance.
Second, parties may view mutual dependence as a source of value, not-
withstanding the fact that they often remain competitors, as strategic alli-
ances in the airline industry illustrates. Several factors can motivate firms
to endorse mutual dependence in holding pooled assets. The size of invest-
ments required may exceed their individual capacity, and/or economies of
scale may be expected, as in many R&D projects. Complementarity may
offer strategic responses to resource dependence, securing access to exist-
ing resources or facilitating access to new ones. Learning effects might also
be anticipated, each firm becoming a portfolio of skills that networking
allows to transfer and recombine more efficiently. Also, joint investments
may help in building a reputation with an expected snowball effect on
revenues.
Third, payoff expected from interaction among parties may not be con-
tractible ex ante, with specific contributions difficult to assess, so that part-
ners look for organizational solutions that facilitate ex post negotiations
to share rents with the lowest possible transaction costs. Indeed, because
standard incentive contracts would perform poorly and measurement

problems may be at stake, defining rules that allow a satisfactory split of
the gains is not trivial. Some hybrid forms seem to have found relatively
standardized solutions to the implementation of adequate sharing rules, as
in franchise systems. However, many other forms rely on ex post negotia-
tions and on non-contractible rules such as fairness or ‘perceived equity’.
Unfortunately and notwithstanding recent developments in experimental
economics, we still know little about how such rules work effectively.
Governance mechanisms
What is clear, though, is that hybrid arrangements need monitoring. This
is so because of high risks of opportunistic behaviour and free riding,
which is the dark side of the forces pushing towards cooperation. Hence
selecting the right partners, building trust through relational ties, and
developing a credible threat in case of misbehaviour might impose specific
mechanisms of governance. Indeed, there is a continuing tension between
the search for stability and the pressure coming from opportunistic temp-
tations. In that respect, different devices can be implemented, with varying
degree of authority over partners who can always exit.
At the loose end of the authority spectrum, information systems such
as integrated logistics, joint buying procedures, shared transportation
facilities, and so on offer the possibility to reduce information asym-
metries among partners, reducing risks of opportunism and facilitating
mutual control. They also provide means for shaping the interface with the
environment through the implementation of shared routines, standards
facilitating communication, devices allowing conversion, and transla-
tion of protocols at low cost. Although information technologies play
an important role in that respect, numerous studies also show the signifi-
cance of informal relationships such as social ties in building and sharing
appropriate information that contributes to organizing and consolidating
hybrid arrangements.4
The existence of formal contracts represents a step forward in tighten-
ing coordination. As emphasized by Macaulay (1963), contracts mainly
provide a framework, a blueprint facilitating decisions and orienting joint
actions. In doing so, contracts help delineate a stable environment within
which partners can plan collaboration, set reciprocal expectations, and
reduce misunderstandings and costly missteps. At the same time, contracts
suffer the limitations of blueprints, leaving most decisions on tasks and
process aside and often opening the way to adjustments through legally
unenforceable clauses (for example, arbitration provisions waiving rights
to bring disputes before the courts).5
However, most hybrids are not composed solely of independent
entrepreneurs operating an outside structure governed solely by formal

contracts. Other devices complement and interfere. One is the possibility
of exogenous regulators initiating, implementing and eventually moni-
toring coordination among partners. In many cases, public authorities
provide the backbone to hybrid arrangements, either directly through
bureaus or agencies, as illustrated by Galileo, a global satellite navigation
system designed to compete with the GPS system, developed by a network
of firms at the initiative of the European Commission; or indirectly, as
when public authorities provide subsidies and other incentives conditional
on cooperation among the benefactors (for example, the so-called tech-
nology parks). However, such exogenous monitoring often mixes public
and private interests. A good example is provided by the French certify-
ing organizations, in which representatives of the government, producers,
consumers, and distributors define standards and allocate rights associ-
ated with the identification of networks delivering high-quality products
(the successful ‘red label’ system).
Last, but not least, hybrids often coordinate through a formal body that
operates as a depository of authority for monitoring their joint actions.
The simplest case is that of joint ventures, in which parent companies
monitor their ‘child’ through a Board of Administration that they control.
More complex forms also develop in which a strategic centre might
operate along rules that exceed the power of individual partners to control
joint activities, as illustrated by the example of the millers. A governing
body with rules of its own can be implemented in charge of defining collec-
tive actions and joint strategies, designing enforcement mechanisms and
implementing rules. Such entities can take different forms, for example,
co-owners assemblies (as in the condominium model), delegates compos-
ing an autonomous board, or a specific permanent entity. All of these
arrangements involve centralization of key decisions, a non-negligible
level of formal rules, and partial control over property rights.
A typology of hybrid arrangements

These different mechanisms of governance suggest a trade-off among
hybrid arrangements, from forms that involve loose coordination, with
separation of decision rights and property rights among partners, to forms
that impose very tight control, with strictly monitored shared rights. The
variety of franchise systems illustrates this spectrum well.
On the one hand, the richness of observable arrangements may suggest
a continuum of hybrid forms spread between spot markets and the
command-and-control hierarchical firm. At the same time, forms such as
strategic alliances differ from franchises and joint ventures. To capture
this intuition, one possibility is to hypothesize the existence of discrete
structural forms that could relate to the characteristics identified so far.

The underlying model could be synthesised as in Figure 18.2.
Explanatory variables Costs of governance Types of hybrids
Forces pushing Four coordinating

towards hybrid arrangements devices
Figure 18.2 Discrete structural forms
More explicitly, the degree of transfer of property rights and decision

rights should translate into the need for coordinating devices that imply
different costs of governance, determining different types of hybrids.
Specifically: (1) the more concentrated property rights are over relationship-
specific assets, the easier it is to coordinate, although at higher costs of gov-
ernance; (2) the more concentrated joint decision rights are, the tighter the
coordination involved, but also the more costly the associated governance
mechanism; and (3) the more centralized control is over residual gains, the
easier it is to coordinate, but this also pushes costs upwards.
Using a deeply revised version of a representation provided by
Williamson (1991), I would then suggest that hybrid forms tend to crys-
tallize around four typical arrangements, determined by their dominant
governance mechanism (which does not preclude the presence of elements
of the other mechanisms). Figure 18.3 illustrates these arrangements.
Costs of
governance
Hybrids
Markets
Integration
Formal
authority
Monitoring centre
leadership
Relational-
Informational based
networks agreements
Benefits of coordination/control
Figure 18.3 Hybrids and governance costs

If we assume that partners to hybrid arrangements target the maximi-
zation of the expected value of their joint activities while minimizing the
associated costs of governance, then they will want to make a trade-off

that will keep them on the inferior frontier of the cost curve associated
with the different governance mechanisms they can select.
Problems raised by hybrid arrangements

In all modern market economies, hybrid modes of organization proliferate
because the advantages of cooperation and coordination often overcome
the gains associated to market competition, while the capacity for partners
to maintain their autonomy of decision and their control over the core of
their residual rights provides more flexibility and better incentives than can
be expected from an integrated structure. However, the very nature of these
arrangements blurs the frontiers of the firm as well as challenges the standard
representation of markets. Unfortunately theories encompassing the nature
and variety of these arrangements remain remarkably poor. Moreover, we
still miss adequate data for estimating precisely the weight and dynamics of
these forms, even for a form as well defined and extensively studied as fran-
chising. We also need to understand better why in so many sectors hybrids
co-exist with integrated firms, apparently without one prevailing over the
other even in the long run. Another issue has to do with the role institutional
environments, for example, rules governing property rights, may play in that
co-existence as well as in the comparative degree of development of hybrid
arrangements and of specific forms of hybrids. Last, but not least, hybrids
almost always involve vertical as well as horizontal restrictions, which seri-
ously challenge standard competition policies still largely built around the
trade-off between markets and hierarchies. In-depth revision of these poli-
cies is therefore likely to be needed in the near future.
Notes
1. This terminology is convenient in that it embeds hybrid types of organizational arrange-
ments in a well-defined framework, as argued below. It also has its drawbacks in sug-
gesting that these forms could be interpreted as a simple mixture of ingredients coming
from the pure forms that are markets and hierarchies, although the biological connota-
tion of the term should clearly indicate that specific processes and forms are at stake in
hybrids.
2. This case is extensively described in Raynaud (1997).
3. This was the argument already developed by Simon (1951) to explain the employment
contract.
4. Greif (1993) provides a nice example of how a network can depend on informal informa-
tion channels in a particularly challenging institutional environment.
5. Ryall and Sampson (2006) illustrate this aspect well.
References
Cheung, S. (1983), ‘The contractual nature of the firm’, Journal of Law and Economics, 26
(1), 1–22.
Coase, R.H. (1937), ‘The nature of the firm’, Economica, 2 (1), 386–405.
Greif, A. (1993), ‘Contract enforceability and economic institutions in early trade: the
Maghribi traders’, American Economic Review, 83 (3), 525–47.
Macaulay, S. (1963), ‘Non-contractual relations in business. A preliminary study’, American
Sociological Review, 28 (1), 55–67.
Ménard, Claude (2004), ‘The economics of hybrid organizations’, Journal of Institutional and
Raynaud, E. (1997), Propriété et exploitation partagée d’une marque commerciale: aléas con-
tractuels et ordre privé, PhD dissertation, Université de Paris (Panthéon-Sorbonne).
Ryall, M.D. and R.C. Sampson (2006), ‘Do prior alliances influence contract structure?
Evidence from technology alliance contracts’, in A. Arino and J. Reuer (eds), Strategic
Alliances: Governance and Contracts, London: Palgrave Macmillan, pp. 206–16.
Simon, H.A. (1951), ‘A formal theory of the employment relationship’, Econometrica, 19
(3), 293–305.
19 Franchising
Steven C. Michael
Franchising, in which independent businesses operate under a shared

trademark using a common production process, is used primarily by
service businesses. It is an enduring and pervasive organizational form.
As an organizational form, franchising has a large and visible presence in
consumer industries such as restaurants, lodging, auto repair, real estate,
hair styling, and specialty retailing, where it has captured typically 30
to 40 per cent of sales. Business services in which franchising is promi-
nent include temporary employment, commercial cleaning, printing and
copying, tax preparation, and accounting services. Recent areas of growth
include home health care, business signage, and child development and
education.
Historically, franchising was introduced in the US in the early twentieth
century by manufacturers in order to secure local distribution of their
product (Dicke, 1992). Franchise chains formed at that time still dominate
automobile and gasoline retailing, and soft drink and beer distribution.
This type of franchising is called product franchising. A second type,
business format franchising, was initiated in the 1950s by entrepreneurs
in service industries, and is the subject of this chapter. When sales from
product franchises such as gas stations and soda bottlers are combined with
business format franchises such as restaurants and dry cleaners, franchise
chains account for over 40 per cent of retail sales in the US (International
Franchise Association, 2004). Further, franchising has become a key
mode of expansion for US and European firms in foreign markets; there
are over one million franchisees worldwide (Michael, 2003).
The mechanics of business format franchising are as follows. A fran-
chise is a legal contract between the owner of a production process and a
trademark (the franchisor, such as McDonald’s) and a local businessper-
son (franchisee) to sell products or services under the franchisor’s trade-
mark employing a production process developed by the franchisor. When
a franchise contract is signed, the franchisee pays a lump sum, a franchise
fee. After signing the contract, the franchisor gives the franchisee services
needed to open the unit, including training and blueprints for the produc-
tion process, and in some cases support for site selection or construction
management. The franchisee typically makes all necessary investments in
land, building, and equipment to open the particular site.
185
After opening, the franchisor provides periodic inspection of the

franchise (to ensure operating standards are being followed), access to
trademarks and marketing services (such as advertising and new product
development). In return for these services, the franchisee pays a royalty
on sales (typically ranging between 1 and 10 per cent) and a royalty for
marketing expenses (from 0 to 6 per cent), commonly called the adver-
tising fee. Generally franchisees do not sell products of the franchisor
(although important exceptions exist); the franchisor is compensated for
the trademark and its management (Michael, 2000c). The franchise chain
is composed of units franchised to local operators and units owned by the
franchisor. Both types operate the same production process and sell under
the same trademark, but most franchise chains are primarily composed of
franchised units.
Research contribution
Franchising has two characteristics that distinguish it from other interor-
ganizational forms such as equity joint ventures and strategic alliances.
First, franchising typically occurs in businesses where there is a notable
service component that must be performed near customers. The result is
that service-providing outlets must be replicated and dispersed geographi-
cally. The second key characteristic is that franchise contracts typically
reflect a unique allocation of responsibilities, decision rights, and profits
between a centralized principal (the franchisor) and decentralized agents
(franchisees). Franchising furnishes a visible contract embodying much
of this allocation that facilitates testing important organizational hypoth-
eses. And franchise chains exist in numbers large enough for statistical
analysis.
Franchising has been a subject of interest for students of the econom-
ics of organizations for many years. Initial and still-insightful works are
Caves and Murphy (1976) and Rubin (1978). Lafontaine and Slade (1997)
reviewed much of the empirical literature from economics and highlighted
agency theory as a motivation for franchising; further amplification and
analysis can be found in Blair and Lafontaine (2005). A perspective com-
bining economics and organization theory can be found in the review by
Combs et al. (2004).
Most relevant to this collection, Williamson has discussed franchising
inter alia in several of his works (see Williamson, 1985, 1996). Franchising
has not been analysed explicitly but it has instead been cited as an example
of hybrid governance. Here is a typical reference:
The distribution of branded product from retail outlets by market, hierarchy,

and hybrid, where franchising is an example of this last, illustrates the argument
Franchising 187
. . . Forward integration out of manufacturing into distribution would be

implied by hierarchy. That would sacrifice incentive intensity but would (better)
assure that the parts do not operate at cross-purposes with one another. The
market solution would be to sell the good or service outright. Incentive inten-
sity is thereby harnessed, but suboptimization (free riding on promotional
efforts, dissipation of the brand name, etc.) may also result. Franchising awards
greater autonomy than hierarchy but places franchisees under added rules and
surveillance as compared with markets. Costs control and local adaptations
are stronger under franchising than hierarchy, and suboptimization is reduced
under franchising as compared with the market. The added autonomy (as com-
pared with hierarchy) and the added restraints (as compared with the market)
under which franchisees operate nevertheless come at a cost. If, for example,
quality assurance is realized by constraining the franchisee to use materials
supplied by the franchisor, and if exceptions to that practice are not permitted
because of the potential for abuse that would result, then local opportunities to
make ‘apparently’ cost-effective procurements will be prohibited. Similarly, the
added local autonomy enjoyed by franchisees may get in the way of some global
adjustments (Williamson, 1996, p. 107).1
Broadly speaking, these insights have been demonstrated to be correct.

The purpose of this chapter is to briefly review empirical and theoreti-
cal amplifications. It is important to note, however, that the insight that
franchising gives a larger share of high-powered incentives (relative to
corporate ownership) is redolent of the key arguments of agency theory,
and indeed the language of agency has been more commonly employed
than that of transaction cost economics (for example, residual claims and
ownership rather than ‘high-powered’ incentives). Similarly, the problem
of ‘suboptimization’ that Williamson describes has usually been described
as ‘free-riding’. Nonetheless, the analysis is the same.
Franchising yields higher incentives and effort

Strategically, franchising is an organizational form chosen by entrepre-
neurs in order to compete in certain industries. Services entrepreneurs
choose franchising in order to solve the incentive problem. When oper-
ating a chain of dispersed service outlets, each outlet typically requires
intensive on-site supervision. Franchising makes the local supervisor
the owner of the local business, granting to the supervisor-franchisee
the profits after all expenses have been paid. Requiring site managers to
invest their own capital and giving them profits after costs induces the
franchisee-manager to put forth more effort in supervision than would
a corporate employee-manager (Rubin, 1978). Franchisees do not shirk
(that is, reduce effort) because their income is tied to their effort. Through
franchising, higher-powered incentives are offered (compared to corpo-
rate ownership), greater operational efficiency is obtained, and the agency
problem is mitigated.
In franchising, however, the potential for shirking is two-sided (a

double-sided moral hazard). The franchisor can fail to invest in the trade-
mark or inadequately screen prospective franchisees, for example. Given
that both parties can shirk, one stream of research has focused on how
franchise contracts divide tasks and residual claims to create incentives
that promote efficiency and minimize shirking. Lafontaine (1992) ana-
lysed royalties and franchise fees and observed that the division of revenue
between franchisee and franchisor reflects the effort required of each.
Klein (1995) argued that chains’ brand name reputations create pricing
power that allows franchisors to pay franchisees quasi-rents – amounts
greater than the franchisee’s opportunity cost in alternative employment.
Hence franchisees suffer if they leave the franchise chain. By paying quasi-
rents, coupled with ongoing monitoring and the threat of contract termi-
nation, the franchisor motivates the franchisee. Michael and Moore (1995)
compared franchisees’ total returns to an estimated return on franchisee
labour plus return on invested capital and found that franchisees earn con-
siderably more than either independent entrepreneurs in similar businesses
or employee-managers in company-owned outlets.
Franchising yields more free-riding

As theory predicts, free-riding is indeed a significant problem in the hybrid
organizational form of franchising. Because all outlets operate under a
shared trademark and customers transfer goodwill associated with one
outlet to others with the same trademark, certain investments franchisees
make have spillover benefits to other franchisees. For example, the clean-
liness of one outlet affects customers’ perception of all outlets under the
trademark. Because the benefits are shared, franchisees prefer to free-ride
on others rather than to invest their own effort. These individual actions
potentially can lead to chain-wide underinvestment. This argument applies
to all local investments that strengthen the brand and that cannot be con-
tractually specified by the franchisor. For example, franchisee local adver-
tising spills over by reaching distant customers who purchase in nearby
markets and by reaching local customers who purchase further afield.
Franchisees who benefit from national advertising by the franchisor and
spillover advertising by nearby franchisees might therefore under-invest in
advertising. Franchisors attempt to limit free-riding through monitoring
(Brickley et al., 1991), with practices such as periodic inspections, mystery
shoppers, and advertising audits.
Free-riding has been shown to occur in franchising. Using chain-level
hotel and restaurant data, Michael (1999) found that chains that rely
heavily on franchising advertise less (as a percentage of sales). In addi-
tion, Michael (2000a) found that franchised chains offered lower quality
Franchising 189
in both the restaurant and hotel industries. These two studies uniquely
compared franchised chains and chains that do not franchise. In addi-
tion, Lafontaine (1999) showed that prices are higher at franchised outlets
than company-owned outlets in restaurant chains. Thus, while franchis-
ing appears to solve shirking, the consequences of using franchising also
include higher prices, lower quality, and less advertising. This suggests
that gains from the control of shirking may be offset by costs of free-
riding.
The possibility that ‘local autonomy’ can hamper ‘global adjustment’
has also been demonstrated. Research has shown that franchisors also
appear less able than firm-owned chains to coordinate elements of the
marketing mix of price, quality, and advertising. Michael (2002) observed
that price and quality were positively related and price and advertis-
ing were negatively related (presumably the chain is advertising lower
prices) among firm-owned chains as recommended by marketing prac-
tice. Among franchised chains, however, price and quality were inversely
related, and price and advertising had no relation, suggesting an inability
to coordinate the marketing mix. Thus a further conclusion from this line
of research is that franchise chains are less able to present a consistent
product positioning with their marketing mix of price, quality, and adver-
tising to customers.
Thus, franchising is truly a hybrid organizational form; high-powered
incentives do yield predictable results of superior operating efficiency –
an improvement over hierarchy – but inferior investment in chain-wide
public goods such as quality and advertising – a disadvantage versus
hierarchy.
Identical transactions are sometimes treated differently

Franchising is a hybrid organizational form in a second sense: it con-
tains units that are hierarchy (company-owned units) and units that are
closer to the market (franchises) within the same system. Explaining this
observed fraction (proportion of outlets franchised or per cent franchised)
has also been a focus of research. In general, variation in transaction
conditions affecting the cost of monitoring has driven the outcome. Firms
use more franchising when the cost of monitoring outlets through direct
observation and inspection increases. Specifically, rural (Norton, 1988),
distant (Brickley and Dark, 1987), and foreign (Fladmoe-Lindquist and
Jacque, 1995) outlets are more frequently franchised because of the costs
of frequent travel by monitoring personnel (Carney and Gedajlovic, 1991)
and the difficulty of assessing managers’ efforts in unfamiliar markets
(Minkler, 1990). Norton (1988), for example, observed that the Waffle
House relied more on franchising in the southwestern US than near its
headquarters in the southeast. Franchising is also used more often when

outlet managers’ local market expertise is an important competitive input
(Combs and Ketchen, 2003); the need for such expertise makes central-
ized monitoring difficult and costly (Minkler, 1990). Finally, larger outlets
are less frequently franchised (Combs and Ketchen, 2003); large outlets
give the firm greater economies of scale in monitoring (Lafontaine, 1992).
These results collectively support the idea that franchising is a solution to
agency. Firms substitute strong incentives via franchising when outlets are
costly to monitor.
A challenge to this explanation is that some firms frequently maintain
both franchised and firm-owned outlets in close proximity to one another.
This practice is called either dual distribution (Gallini and Lutz, 1992) or
the plural form (Bradach, 1997). Having two identical outlets in the same
market with different ownership implies that differences in monitoring
costs are not exclusively driving franchising decisions.
The puzzle can be explained through application of the Williamsonian
analysis of neoclassical contract law (Michael, 2000b). The contract law
that enables and underpins franchising is characterized as ‘neoclassical’
contract law (Williamson, 1991). Neoclassical contract law is generally
more elastic than classical contract law. Rather than specifying explicit
and formal terms for all conditions, the neoclassical contract creates an
‘adaptive range’, a framework and a set of boundaries, within which con-
flicts are resolved through negotiation between the parties. Negotiation
within the adaptive range rather than literal adherence to contract terms
facilitates adaptation to change and the preservation of the relationship.
Such a negotiation is always carried out in the shadow of the law; when
the parties cannot agree within the adaptive range, they resort to the
courts.
Thus the franchisor has incentive to increase bargaining power. In the
context of the ongoing negotiation between franchisee and franchisor,
ownership of some units suggests to the franchisee that the franchisor
has the information and the willingness to operate those units if quality
declines, thus strengthening the bargaining power of the franchisor. In
support of this hypothesis, research found that franchisors resorted to
litigation less when they owned units (Michael, 2000b).
An important extension of transaction costs is added here. Given the
frequency and similarity of franchising transactions, it is possible that the
opportunity for strategic interaction affects the choice of whether to own
or franchise. Hence action taken with regard to one franchisee can signal
behaviour to other franchisees. Identical transactions are governed differ-
ently, and the set of transactions becomes worthy of analysis.
Franchising 191
Within chains, incentives do appear to be aligned

The general logic of the economics of organizations suggests that inef-
ficient organizational forms are eliminated through market competition.
To succeed, interorganizational forms such as franchising must align
incentives of participants. Nonetheless, empirical tests of this proposition
have been rare.
Investigating the alignment of incentives through contract terms was
a useful by-product of a study of franchisee failure. Michael and Combs
(2008) examine how terms of the franchise contract affected franchisee
failure. They found that franchisor policies designed to limit adverse
selection and moral hazard reduce failure by franchisees. The results
are consistent with the argument of Williamson (1983) who notes that
franchisees should desire many restrictive policies to be imposed by the
franchisor because such policies strengthen the brand that all franchisees
rely upon.
To examine the efficiency premise of organizational economics, Michael
and Combs’s (2008) analysis also compared the effect of contractual terms
on franchisee survival in their paper and on franchisor survival elsewhere
in the literature (Combs and Ketchen, 1999; Shane, 1998, 2001; Shane
and Foo, 1999). Such provisions as requiring industry experience, requir-
ing active ownership, length of training, exclusive territories, and brand
investments enhance survival of both franchisees and franchisors. In addi-
tion, Michael and Combs (2008) found that franchisor performance (here
return on assets) positively and significantly affects franchisee survival.
Thus, a strong commonality of interest exists between franchisor and fran-
chisee, and the organizational form seems to be efficient.
Conclusion
Franchising research has largely supported the research program of the
incipient science of organization. Moreover, the use of a different theo-
retical language (though not a different theoretical reasoning) should not
obscure the observation that franchising has provided valuable service
(albeit indirectly) to transaction cost economics. In particular, franchis-
ing has amplified and elaborated what a hybrid form requires, and has
introduced the possibility of strategic effects that one (seemingly identical)
transaction can have on another.
Important tasks remain. It is certainly desirable to learn more of the
dynamics of hybrid organizations, and how such organizations success-
fully innovate (or do not). The management of such hybrid organizations
remains a challenge for study by business and management scholars, if not
economists (directly). More generally, franchising can and should con-
tinue to be a valuable subject for transaction cost economics research.
Note
1. Williamson also uses the term franchise in another sense: the allocation by government
of the right to engage in an (exclusive) business. See, for example, Williamson (1985),
Chapter 13. This chapter does not examine this alternative usage.
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Franchising 193
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Press.
20 The structure of franchise contracts
Emmanuel Raynaud
The word franchise comes from an old French word meaning ‘privilege’
or ‘freedom’. In the Middle Ages a franchise was a privilege or a right. In
those days, the local sovereign or lord would, for instance, grant the right
to hold markets or fairs. Eventually, the king could grant a franchise for
many commercial activities such as building roads and the brewing of ale.
The modern use of the term, as business franchising, is in the same spirit.
Franchising may be defined as a contractual agreement in which one firm,
the franchisee, buys from another firm, the franchisor, the right to operate
under a particular trademark and follow a set of guidelines.1 In 2001, fran-
chised businesses operated in the US 764 483 outlets and accounted for 7.4
per cent of all private-sector jobs.2
This chapter adopts a ‘contractual’ approach to the study of franchis-
ing. It explains the role of franchising as an efficient governance structure –
that is, as an attempt to mitigate various contractual hazards (Williamson,
1996; Blair and Lafontaine, 2005). It omits the industrial-organization
literature that explains governance choices as strategic tools to miti-
gate actual or potential competition (see Lafontaine and Slade, 2005).
Franchising is an interesting ‘contractual laboratory’ for at least two
reasons: first, data on organizational design in franchising are available
that allow empirical analysis. Insights gleaned from studies on franchised
chains allow researchers to understand better how firms organize their
activities across business units and markets much more generally. Second,
franchising agreements include several contractual provisions, sometimes
called vertical restraints (for example, selective or exclusive distribution),
that can be used to analyse the rationale behind contractual design.
To study the organization of franchised chains, the overall governance
question will be broken down into a two-step, sequential decision: first, get
the allocation of ownership right (the ‘make-or-buy’ decision), and second,
get the contractual design right. An extension of step 1 will focus on an
interesting stylized fact, the coexistence of both company-owned and fran-
chised units within the same chain. While this sequence might not corre-
spond to the real decision-making process, it is a useful expository device.
Moreover, if a chain decides to rely partly on franchising as an alterna-
tive to vertical integration, it must still decide what the (formal) contract
should look like (see James, 2000, for a distinction similar in spirit).
194
The structure of franchise contracts 195
Building on the contractual approach, most of the literature reviewed here

adopts an economizing logic to explain franchising. The decision to make-
or-buy (or make-and-buy) and the choice of contractual provisions turn on
the comparative costs of the various alternatives, and the organizational
modes selected should be the ones that economize on coordination costs.
Choosing the right governance structure

One of the most important empirical regularities in franchising is the
existence of both franchised and company-owned units in most chains.
So it is hardly surprising that much of the literature studies the determi-
nants of vertical integration in chains, that is, the ‘make-or-buy’ problem.
Moreover, a recent wave of papers also attempts to understand govern-
ance of chains as a way to ‘make-and-buy’.
Franchising vs company ownership

Initial explanations for franchising focused on mitigating capital and
managerial constraints (Caves and Murphy, 1976; Norton, 1988). If fran-
chisors do not have enough capital to open their own stores, franchisees
can reduce this constraint by providing their own capital. Despite its pop-
ularity among practitioners, this approach has been widely criticized for
being inconsistent. Rubin (1978) argues convincingly that if franchising is
a way for the franchisor to alleviate a capital constraint, there is a more
efficient (that is, cheaper for the franchisor) alternative in terms of risk
allocation. At the same time, empirical work does not support the main
proposition deduced from the capital-constraint argument. If chains are
successful, the capital constraint should be reduced over time. Lafontaine
and Shaw (2005) show, however, that the extent of company-owned units
is stable over time.
Moreover, it is not unusual for a franchisor to provide franchisees
with funding, which appears to contradict the capital-constraint explana-
tion. The previous argument may be further extended to another form of
capital scarcity, namely managerial human capital scarcity (Shane, 1996).
The empirical propositions derived from this approach are partly similar
to the previous one. If selection and human-resource scarcities decrease
with chain’s maturity, there should be less reliance on franchising. As
pointed out earlier, this is not backed up by empirical analysis, suggesting
that chains probably use other means to mitigate this problem.3
Building on the modern theory of the firm, an alternative body of
research emerged to explain franchising. The larger part of this literature
emphasizes moral hazard and free-riding (see Lafontaine and Slade, 2001,
2007, for summaries).4 A few papers also emphasize the holdup problem
as a motive for the extent of vertical integration in franchising.
Asset specificity and the holdup problem feature prominently in the

empirical transaction cost economics (TCE) literature on governance
structure in industrial procurement (see Klein, 2005, and Chapter 12 in this
volume by Benjamin Klein). However, asset specificity and holdup play a
smaller role in the literature in retail contracting in general and franchising
in particular (see Lafontaine and Slade, 2001, 2007). Some authors even
doubt the relevance of specific investment as the driver of organizational
choice in franchising (Lafontaine and Slade, 2001). On the one hand, the
chain’s brand name may be considered a specific asset (Williamson, 1991).
The managers of outlets have an incentive to expropriate quasi-rents
generated by the value of the brand (Bercovitz, 2004; Minkler and Park,
1994). However, this approach is similar to the previous free-riding story:
the more valuable the brand, the larger the extent of vertical integration
expected in chains. On the other hand, some empirical evidence suggests
that the value of franchisees’ investments is not significantly lower outside
of the relationship (even if the value of the investments can be quite sig-
nificant) (Kaufman and Lafontaine, 1994). Despite this lack of enthusiasm
for the holdup problem in franchising, the literature has begun to pay
more attention to the consequences of contractual incompleteness as a
motive for vertical integration. For instance, Lutz (1995), Maness (1996),
and Hennessy (2003) all rely on incomplete contracts models to shed light
on the vertical integration decision.
Dual distribution as make and buy

What if, instead of trying to solve the make-or-buy problem for each
individual outlet, franchisors make-and-buy at the chain level at the same
time? This phenomenon is called dual distribution or plural form. The point
is to assess the governance benefits of simultaneous making and buying.
The first explanations for dual distribution suggest a transitory phenom-
enon, but more recent works explain that dual distribution can be an effi-
cient governance structure.
If franchising is more profitable than company ownership, a franchisor
may initially operate several units either to demonstrate the quality of
its business plan to potential franchisees (Gallini and Lutz, 1992) or to
commit credibly to protecting the value of its brand name (Scott, 1995).
The extent of company ownership is thus likely to decrease with chain
maturity and brand name reputation (franchising redirection). Other
authors suggest that the rationale for franchising should instead disap-
pear with chain maturity. As previously seen, franchising yields access
to certain scarce resources, either capital (Caves and Murphy, 1976),
managerial talent (Norton, 1988), or local information (Minkler and Park,
1994), all of which facilitate expansion. As firms become established, they
should reduce their reliance upon franchising (ownership redirection).

These two extreme franchising evolution patterns (franchising redirec-
tion and ownership redirection) are not seen in the data, however. For
instance, Lafontaine and Shaw (2005) have shown stability in the franchise
mix as chains become mature. This suggests that dual distribution may be
an efficient and persistent organizational form.
As noted by Williamson (1985, 1991), different economic circumstances
require different organizational solutions. The overall governance of the
chain – that is, the extent of dual distribution – is simply the aggregation
of governance decisions made at the store level. Most studies explain dual
distribution in terms of heterogeneous outlet characteristics such as dis-
tance to headquarters (Brickley and Dark, 1987), percentage of repeated
business (Brickley, 1999), or risk (Norton 1988). This implies that if all
units are similar, the chain should be either wholly franchised, or company
owned. This raises the question of whether different characteristics are
needed for dual distribution to emerge, or whether dual distribution arises
for other (maybe complementary) reasons. Recent papers have shown
that dual distribution may emerge in situations with identical units. In
Gallini and Lutz (1992), all units are identical and dual distribution is an
efficient response to ex ante asymmetric information about the value of the
chain. Similarly, Bai and Tao (2000) model local managers (franchisees or
employees) as responsible for both local sales effort and goodwill provi-
sion. Chains have company-owned units because this directs the produc-
tion of goodwill. The chain offers some unit managers a balanced contract
to induce goodwill effort and a more high-powered incentive contract on
sales for the remainder. Dual distribution emerges as an optimal means
for providing incentive for both tasks. A related explanation is provided
by Scott (1995), who emphasizes the importance of franchisor effort for
the profitability of individual outlets. However, the franchisor also needs
an incentive to make these efforts. One possibility is setting a high royalty
rate but this reduces the incentives for franchisees. An alternative is for the
franchisor to have a stake in the business and own some units.
More recently, the literature suggests that dual distribution should be
studied at a more ‘systemic’ or ‘chain’ level. Bradach (1997) emphasizes
the complementarities between the two governance structures to maintain
quality and homogeneity of the business concept across the units while
also promoting innovation. Combining both governance modes creates
‘synergy benefits’. It is important, however, to explore the sources of
these gains in more detail. For instance, Bergen et al. (1995) identify two
main benefits, the first relating to asymmetric information, the second to
credible commitment. Exclusive reliance on market governance can be
plagued with information problems. Firms may be limited in their ability
to evaluate ex ante, and monitor ex post, the performance of franchisees.

In-house operations allow firms to mitigate these problems. By owning
some outlets, the chain is better able to assess the costs and difficulties of
the task and can use this information to design a better performance evalu-
ation and monitoring system. The other benefit relates to ex post govern-
ance issues. Terminating a partnership with an opportunistic distributor is
an efficient sanction when assets are non-specific. If the chain has invested
in specific assets in its transaction with a distributor, premature termina-
tion is a less credible sanction because part of the quasi-rents will be lost
by the firm. An in-house operation restores part of the incentive effects of
a threat of termination. If the firm terminates its relation with the supplier,
it can use the internal agent as an alternative.
Choosing the right contractual design: aligning incentives in chains

Vertical integration is not the only mechanism for mitigating contractual
hazards. Franchising basically involves franchisors granting franchisees
the right to operate under their trademarks and use their business proce-
dures. But as these intangible assets remain the property of the franchisor,
the granting of these rights results in incentive problems. Two main types
of incentive mechanisms to mitigate these problems have been highlighted
in the literature: the granting of residual claimancy rights through mon-
etary provisions (see Mathewson and Winter, 1985) and the reliance on
self-enforcement (Klein and Saft, 1985; Klein, 1995). Other non-monetary
dimensions of franchise contracts have also been recently explored.
Franchising as incentive contract: monetary provisions

Most literature on franchise contracts and incentives focuses on mon-
etary provisions, namely establishing the ‘right’ royalty rates and initial
franchise fees. When franchisee effort is not observable, and thus cannot
be contracted on directly, the best option for the franchisor is to sell the
outlet to the franchisee for a fixed price. This outright sale makes fran-
chisees full residual claimants, giving them incentives to put forth optimal
effort (Mathewson and Winter, 1985). However, in practice, the typical
franchise contract involves sharing, which prevents the first-best outcome,
as the franchisee has an incentive to reduce his or her effort. The literature
suggests two amendments to the model to account for sharing arrange-
ments. The first, and most traditional, is to assume the franchisee is risk
averse. Sharing in this model then becomes a means of shifting risk from
risk-averse franchisees to risk-neutral franchisors. The second amendment
to the model relies, instead, on the assumption that the franchisor brings
some valuable input to the production process and that his or her behav-
iour, like that of the franchisee, is difficult to monitor. In this double-sided
moral-hazard model, sharing arises from the need to provide incentives

to both franchisees and franchisor (Rubin, 1978; Bhattacharyya and
Lafontaine, 1995).
Three main testable implications arise from this principal–agent model.
The share parameter will be higher: (a) the lower the importance of
franchisee effort; (b) the higher the level of risk involved (assuming the
franchisee is more risk averse than the franchisor); and (c) the greater
the importance of franchisor effort (assuming this is not observable).
Empirical studies have found support for the first and third, but not the
second, implication (see Lafontaine and Slade, 2007, for a survey).
Self-enforcement in contracting
Parties to a contract can also be given effort incentives by making sure
they derive benefits from the relationship that are at risk if the relationship
ends. The capitalized value of these benefits acts as a hostage (Williamson,
1985). Incentives embedded in franchise contracts stem from the com-
bined effect of three elements: (a) an ongoing stream of rents that the
franchisee earns within the relationship, but forgoes if he or she ‘leaves’
the franchised chain; (b) franchisee monitoring by the franchisor; and (c)
the franchisor’s ability to terminate the franchise contract. Because the
ease or cost of termination is largely determined by the legal system, the
franchisor is left with the tasks of choosing the level of ongoing rent to
be left with franchisees and selecting the frequency of monitoring so as to
minimize the ex post costs of enforcing the desired effort level.5
In this literature, a franchise contract is said to be self-enforced if, in
every period, the present value of the ongoing rent the franchisee earns
from the partnership exceeds the (expected) franchisee benefit from devi-
ating from the franchisor’s requested behaviour. For the contract to be
continuously self-enforcing, the franchisee must earn a minimum amount
of rent each period. For that reason, given that the expected rent over the
remainder of the contract decreases as the franchise gets closer to expira-
tion, the value of ‘cooperative behaviour’ must include not only this rent,
but also rent associated with future additional outlets, and with the prob-
ability of contract renewal.6
In this context, specific contract terms play different roles (Klein, 1995).
Some terms specify certain franchisee obligations, for example, manda-
tory input purchases from the franchisor. These contract terms limit the
gains from cheating as they make it easier for the franchisor to detect
non-performance and to intervene quickly. They also make it less costly
for the franchisor to rely on third parties, or court enforcement, as they
provide more objective bases for establishing non-performance. Other
contract terms ensure the stream of ongoing rent, the potential loss of
which gives incentives to the franchisee. Clauses such as exclusive territo-

ries limit intra-brand competition, and thus contribute to the franchisee’s
profitability (Lafontaine and Raynaud, 2002). At the same time, there is
a maximum amount of rent to which the franchisor can credibly commit.
If the franchisor prefers franchising to company-managed stores, it is pre-
sumably because vertical integration is less profitable than franchising. So
the franchisor’s promise of rent to the franchisee is credible if the present
value of the rent is less than the discounted profit difference between
franchising and vertical integration, in every period. If this condition is
continuously met, then it is in the best interests of the franchisor to pay
the rent. Otherwise, it is more profitable for the franchisor to vertically
integrate and appropriate the rent.
Empirically, Kaufmann and Lafontaine (1994) show, through a detailed
analysis of US McDonald’s restaurants, that rent is indeed left down-
stream in that chain. Using a similar method, Michael and Moore (1995)
confirm the existence of rents in a number of other franchised chains.
More on non-monetary contractual provisions

So far, most of the papers on franchise contracts focus on monetary
terms, namely royalty rates and franchise fees. This is not surprising, given
that incentive contracts are the cornerstone of formal contract theory.
Data limitations also play a role. Information on non-monetary terms
is extremely limited. Nevertheless, despite such scarcity, studies on non-
monetary contractual terms are slowly appearing.
Arruñada et al. (2001) study the alignment between the allocation of
decision rights and incentive mechanisms in Spanish automobile distribu-
tion. The (incomplete) contract is unable to specify ex ante all the relevant
decisions to be taken. However, the contract does specify an allocation of
decision rights among the parties. They reveal that this allocation is rather
unbalanced; franchisors own many more decision rights than franchisees
(a point already noted in Hadfield, 1990). This degree of asymmetric allo-
cation is explained by the extent of franchisee moral hazard. The more
severe the likelihood for franchisee moral hazard, the more the contract
allocates decisions and enforcement rights to the franchisor.7
In a similar vein, several other papers focus on more narrowly defined
contractual provisions. Brickley (1999) links the occurrence of contractual
restrictions (such as exclusive territories) to the likelihood of free-riding
among franchisees. Contractual provisions can mitigate this problem
by increasing investment benefits or by committing franchisees to make
minimum contractible efforts on specific tasks.8 Consistent with this
proposition, Brickley (1999) shows that the occurrence of contractual
restrictions increases with the level of horizontal externalities (proxied
here by repeated customers).9 Similar papers explain contract duration

in franchising (see, for instance, Brickley et al., 2006). Finally, Bercovitz
(2003) studies the use of multi-unit ownership as a way of supporting
self-enforcement. By increasing the potential of ex ante and ex post rents,
multi-ownership should mitigate franchisee opportunistic behaviour.
Empirical results support the idea that litigation and termination rates are
negatively related to multi-unit ownership. More generally, the multi-unit
ownership is interesting because it shows that chains have greater margins
for organizing than have been initially presumed. Chains not only choose
the kind of contract and the extent of vertical integration but also the
concentration of ownership among franchisees, the spatial distribution of
unit ownership among franchisees, and more. All of these can be studied in
terms of their efficiency effects (Kalnins and Lafontaine, 2004).
Conclusion
This chapter has highlighted numerous issues for which the contractual
perspective appears to be fruitful. It shows that chains have different
margins for efficiently governing their contractual relations with indi-
vidual outlets. First, the chain decides on the extent of vertical integration.
Second, the chain designs the contractual provisions of franchise agree-
ments. Monetary as well as non-monetary provisions respond to incen-
tives and coordination issues. More generally, these margins are largely
explained by expected contractual hazards, either vertical (between fran-
chisees and franchisor) or horizontal (among franchisees). Issues such as
the difficulties of monitoring outlets, the relative importance of outlet and
chain effort levels, and free-riding, are also important.
Empirical findings provide a set of stylized facts and generally support
most of the efficiency explanations on franchising. This empirical support
is particularly important. Most work in contract theory is based on theo-
retical models that provide important insights into the determinants of
contractual and organizational choice, but for which empirical evidence
is missing. Franchising is a case for which lots of data are available.
Furthermore, empirical regularities found in franchising are also relevant
for other contractual issues.
The new institutional economics (NIE) is typically motivated by real-
world contracting problems and should play a role in controversies about
real contracting practices. One controversial area in franchising is the
chain’s ability to terminate the contract prematurely. Some authors, mostly
lawyers and practitioners, argue that termination provisions are imposed
by the franchisor when negotiating the agreement, because of unbalanced
bargaining power. Others, mostly economists, see these provisions as essen-
tial parts of the enforcement mechanism needed to mitigate opportunistic
behaviour by franchisees (see Raynaud, 2008). Empirical results suggest

that the cost of termination does affect franchisors’ decisions to franchise
or vertically integrate, as well as the terms of their contracts, supporting the
idea that franchisors rely on rent and termination provisions in their deal-
ings with their franchisees. It also shows that chains react to mandatory
requirements by modifying the pricing of franchise contracts.
Another controversial issue is antitrust (Lafontaine and Slade, 2001).
A ‘bad’ application of competition law can distort the costs and benefits
of alternative governance structures and restrict firms’ abilities to provide
appropriate incentives. Thanks to contributions within the NIE field, the
antitrust attitude toward the motivations behind vertical restrictions in
distribution contracts has considerably evolved over the years. This is true
both in the US and Europe (OECD, 1994). We have shifted from a regime of
open hostility to a new regime where the benefits of vertical restraints in pro-
moting efficient coordination are more explicitly recognized and accepted.
Notes
1. See the FTC document, ‘Disclosure Requirements and Prohibitions Concerning
Franchising and Business Opportunity Ventures’ (16 CFR § 436.1 et seq.) (FTC,
1986), and European Union rule (4087/88) for legal definition of franchising (EC,
1999).
2. These statistics count both outlets owned by franchisees and establishments owned by
franchisors. See ‘The Economic Impact of Franchised Businesses’ by the International
Franchise Association (2008).
3. For instance, Bradach (1997) shows that new franchisees are quite often previous
employees of company-owned units. This reduces the asymmetric information problem
regarding their talent and motivation, and decreases the time they need to efficiently run
the outlet.
4. See Michael, Chapter 19 in this volume, for details.
5. For self-enforcement to work, the franchisor must be able to evaluate, ex post, whether
or not the franchisee’s performance is satisfactory, even if the desired effort is too
complex to specify in the contract.
6. Indeed, only high performance franchisees can expect renewal and additional outlets
within the same chain. These decisions therefore involve rent that gives further incentives
to franchisees.
7. According to Arruñada et al., the potential for franchisors to display opportunistic
behaviour is limited by his reputation vis-à-vis actual and potential franchisees.
8. If part of the returns of local marketing investments accrues to other units, an individual
franchisee will underinvest. By granting him or her an exclusive territory, or by requir-
ing a mandatory (and verifiable) minimum level of expenditure on local promotions, the
incentive to invest is restored.
9. Brickley (1999) also tested the impact of externalities on the extent of vertical integration
and found a non-significant result. It seems that the favoured margin by which chains
adjust to free-riding hazards risks is contractual design.
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Press.
21 Strategy and transaction costs
Laura Poppo
Strategy is a complex domain, and while I do not intend to trivialize alter-

native definitions and approaches to strategic management, in this chapter
strategy is fundamentally about achieving competitive advantage through
resources, capabilities, and/or competences: the resource-based view of
the firm. According to Williamson (1999), this realization of ‘strategy’
occurs by economizing through optimal governance: choosing the optimal
form of governance. For rent-generating assets, firm ownership offers
the greatest ability to coordinate, adapt, and protect because potential
conflict ‘threatens to undo or upset opportunities to realize mutual gains’
(Williamson, 1999, p. 1090). Bounded rationality, opportunism, and the
characteristics of the transaction remain central conditions that constrain
this boundary decision. Through a comparative governance choice assess-
ment, managers assess how should they organize an activity given its
‘pre-existing strengths and weaknesses (core competences and disabilities)’
(Williamson, 1999, p. 1103). Firms thus generate advantage by minimizing
the misappropriation of rent, adaptation delays, and coordination prob-
lems (transaction costs).
Some strategists, however, do not necessarily agree that the transac-
tion cost framework ultimately informs strategic analysis. Some dismiss
its applicability outright because opportunism can be mitigated through
informal mechanisms, such as trust (Madhok, 1995; Adler, 2001). Others
offer alternative views of the firm (Conner and Prahalad, 1996; Foss,
1996) or of the dynamic nature of resources (Langlois, 1992; Teece and
Pisano, 1994) that necessitate a broader domain or set of logics than that
offered by the transaction cost logic alone. For example, resources may
generate profit for the firm not simply from avoiding transaction costs,
but through realizing performance gains that occur through specialization
(Conner and Prahalad, 1996; Poppo and Zenger, 1998). This conversation
on whether strategy, namely the resource-based view of the firm and its
extension to knowledge and dynamic capabilities, and the transaction cost
logic converge, diverge, or coexist is dated, but it is by no means resolved
(Williamson, 1999; Carter and Hodgson, 2006).
Rather than review the entire spectrum of this conversation, in this
chapter I will first present some general comments on whether empirical
analysis confirms the viability of using the transaction cost framework to
205
inform strategy research. Next, I focus more narrowly on a set of strategy

research that continues to challenge the applicability of the transaction
cost logic for more complex forms of transactions that commonly occur in
markets: the viability of hybrids, in particular alliances, to produce com-
petitive advantage.
Is the transaction cost framework an empirical success story?

Hybrids, as an institutional governance form, are commonly used in
business practice and generally share both ‘market’ features, such as high-
powered incentives, and hierarchical features, such as rules and directives
(for example, formal contracts) (Hennart, 1993; Hodgson, 2002; Ménard,
2004). While hybrids were initially believed to undermine the integrity of
the transaction cost framework, Williamson (1991) aptly responded to
these criticisms by extending the framework to consider hybrid govern-
ance choices. While Williamson (1999) maintains that the transaction cost
framework is an empirical success story, others offer a more fine-grained
analysis and interpretation of its success. The underlying motive for
these more fine-grained reviews is to inquire whether the transaction cost
framework is a viable framework and whether it needs to be ‘broadened’
in order to meaningfully inform strategy research. Related, unresolved is
whether the empirical examination of hybrids supports the transaction
cost prediction (Madhok, 1995; Carter and Hodgson, 2006).
Criticizing some of the earlier reviews because they lacked a system-
atic selection and evaluation criteria, David and Han (2004) diligently
analyzed empirical transaction cost papers for their consistency in both
measurement and findings (for example, actual vs predicted relationships).
Consistent with Williamson’s (1999) success story, the most important
relationship proposed by the transaction cost logic receives the great-
est level of empirical confirmation: asset specificity is associated with
an increased likelihood of vertical integration. Yet, as David and Han
(2004) note, systematic measurement of variables, namely uncertainty
and its multiple dimensions, is lacking across empirical transaction cost
economics (TCE) works. Moreover, studies do not generally test all of
the relationships predicted by the framework. For example, few studies
include frequency or measure the interaction of uncertainty and asset spe-
cificity. Fewer studies have outcome measures (for example, performance
or transaction costs), which are an integral aspect of a comparative choice
analysis. Thus, in their view, success has yet to be fully established regard-
ing the predictive validity of the framework.
More recently, Carter and Hodgson (2006) try to diminish the value
of the transaction cost framework as a definitive strategic framework by
showing that for some empirical studies, results support a resource-based
Strategy and transaction costs 207
logic as well as a transaction cost logic. In particular, asset specificity,

especially human-intensive asset specificity, measures both specific assets
and a potentially productive capability or routine. This conceptual
overlap implies that a transaction cost prediction and empirical finding
of internalization is also consistent with that of a competence or resource
logic. While not reviewed by Carter and Hodgson (2006), work shows
that these two logics can be meaningfully separated in terms of analytics
(Poppo and Zenger, 1998). Nonetheless, Carter and Hodgson’s (2006)
review does highlight the need to consider and test transaction cost and
resource-based theories simultaneously. That is, TCE is not the only per-
spective that meaningfully informs strategic outcomes.
A focus on alliance research

Strategic alliances between firms are a common vehicle for exchanging,
sharing, or developing various products, services, and technologies. While
there are different forms of hybrid organizations, I deliberately choose
alliances because the sizable number of empirical works enables a more
cogent focus on whether or how transaction cost analysis informs strategic
analysis. In addition, some of this research questions not only the original
resource-based logic that competitive advantage stems from the internali-
zation (for example, ownership) of the resources and capabilities, but also
the comparative governance prediction that ownership is necessary to
minimize transaction costs that arise due to uncertainty and self-interest.
Alliances and value creation

Early research found that most alliances are short lived and a variety
of factors may account for termination, and thus the alliance failure
(Harrigan, 1988; Kogut and Singh, 1988). This work, however, fell short
of capturing the intended duration of the alliance, a likely determinate of
termination. It also did not explore the performance or potential sources
of value created through alliance activity: that is, the strategic value of
alliances. In the last ten years, this focus, the positive performance of alli-
ances, is a focal point of theoretical development and empirical work. In
particular, some strategists extend the resource-based logic to consider
that a firm’s exchange partners are important sources of value-creation:
that is, alliances may offer important sources of new ideas and information
(Dyer and Singh, 1998; Inkpen, 2000). Related, the relationship between
two trading entities may constitute ‘a unique and productive resource for
value creation’ (Madhok and Tallman, 1998, p. 327; McEvily and Marcus,
2005).
This literature generally posits that social mechanisms enable firms to
extract value from alliances: cooperative, trusting relationships can both
effectively govern complex market exchanges and produce synergistic

gains. Underlying value creation are relational routines, such as informa-
tion sharing, collaborative norms, and reciprocity (MacNeil, 1978; Kale
et al., 2002), which are supported by trust (McEvily et al., 2003). These
relationship-specific investments ease coordination and enhance bilateral
cooperation, thereby minimizing transaction costs. Moreover, when both
parties undertake specific human, yet relationship-specific activities that
promote collaboration, synergistic outcomes are possible (Madhok and
Tallman, 1998). For example, partners may ‘invest’ in knowledge-sharing
routines by committing specific individuals to frequent interactions, meet-
ings, and problem-solving activities (Kale et al., 2002). If these interactions
permit not only the transfer of tacit and explicit knowledge, but also its
recombination and extension to current and future projects, then the alli-
ance may create value for both alliance partners.
The focus on trust and cooperation as mechanisms to minimize oppor-
tunism in market exchanges is not incidental: it directly challenges the
transaction cost assumption that market exchanges are atomistic, under
socialized relationships (Williamson, 1996). Social theorists offer an
alternative conceptualization: market exchanges are embedded in a social
context and trust is a natural byproduct of social and business interaction
(Granovetter, 1985). This characterization of business practice is also
contrary to the transaction cost position that social interaction between
transactors is limited to clarifying contractual intent. Williamson (1996)
further counters the social theorist’s position by arguing that in eco-
nomic exchanges trust is inherently calculative; the personal form of trust
advanced by social theorists does not characterize market exchanges, and
thus cannot effectively govern them. Consistent with this calculative logic,
recent empirical work shows that the presence of trust depends critically
on ‘a shadow of the future’: prior history supports trust only through its
effect on expectations of future exchanges (Poppo et al., 2008a).
Still, this controversy over ‘trust’ has generated a large research stream
on trust, governance, and economic exchange. For social theorists, when
trust exists, parties to both organizations hold a collective trust-orientation
toward each organization (Zaheer et al., 1998), and thus display a willing-
ness to rely on and to be vulnerable to the other organization (Rousseau
et al., 1998). Consistent with this governance objective, studies show
that trust and its related normative conventions decrease transaction
costs (Larson, 1992; Artz and Brush, 2000), improve satisfaction with
exchange performance (Zaheer et al., 1998; Poppo and Zenger, 2002), and
improve knowledge transfer (Szulanski et al., 2004). Recent work further
shows that knowledge sharing between a focal firm and its broader sup-
plier network does not appear to ‘leak’ to the suppliers’ exchanges with
other buyers, demonstrating the network can be a source of capability-

development (Dyer and Hatch, 2006).
Research further argues that prior experience triggers the capture and
extension of value. Because managing an alliance poses numerous chal-
lenges, including adverse selection, moral hazard, and uncertain and
complex transactions, firms that learn and develop skills and capabilities
that facilitate coordination realize greater alliance performance (Kale et
al., 2002). Prior experience in a related technological area may further
increase the focal firm’s absorptive capacity, providing an additional
source of value-creation in the focal alliance. Consistent with this, empiri-
cal works show that prior alliance experience improves the performance of
the focal alliance (Zollo et al., 2002; Sampson, 2005). They further show
that firms with a dedicated alliance function are associated with greater
abnormal stock gains following an alliance announcement because the
firm is more able to effectively manage, share, and disseminate know-how
gained from prior experience (Kale et al., 2002; Kale and Singh, 2007).
Trust: a complement of or substitute for formal contracts

A second focus of this research is examining the relationship between
prior alliance experience and formal contracts. Initially, some proposed
that one benefit of trust is reduced transaction costs, such as less stringent
contracts. These theorists offered this proposal because as alliance part-
ners learn over time what to expect from one another, they form a basis of
trust and cooperation. Parties, thus, no longer need to craft such complex
contracts (Gulati, 1995; Dyer and Singh, 1998). Dyer and Singh (1998)
pointedly argue that relational advantage is best achieved through an
effective governance system that employs informal rather than third party
or formal enforcement mechanisms. Thus, trust as a governance form may
effectively substitute for formal governance.
Subsequent empirical work, however, does not fully support this logic:
the combined use of trust and its related normative conventions is associ-
ated with greater performance than any one governance mechanism alone
(Poppo and Zenger, 2002). Works further show that managers learn to
craft better contracts over time as they learn better methods for fostering
adaptation (Mayer and Argyres, 2004). In fact, contrary to the substitu-
tion logic, prior experience (Reuer and Arino, 2007) or trust (Dyer and
Chu, 2003) does not lead managers to drop enforcement provisions (such
as arbitration clauses, confidentiality provisions, restrictions on propri-
etary information). Thus, at this time it does not appear that trust neces-
sarily substitutes for formal governance.
The behavioral mechanisms of information sharing, cooperation, and
collaboration may also explain why trust and contracts appear to operate
as complements in fostering alliance performance (Poppo and Zenger,

2002). When well-specified contracts exist, parties are more likely to
understand the boundaries for acceptable behavior and punishments for
non-compliance. Because expectations and consequences are known, the
contract provides rules of the game which can then encourage coopera-
tion and ultimately enhance alliance performance. It also provides general
guidelines that may ease conflict and uncertainty as parties adapt the
exchange given exogenous change. The complementarity of trust and con-
tracts in enhancing alliance performance may also work in reverse. Trust
may guide cooperative action for situations in which the contract is incom-
plete. It may also shield alliance performance from losses that arise when
contracts are imperfect mechanisms for fostering adaptation. Trust, for
example, hinges critically on perceptions of equity and justice; a bilateral
orientation, whose absence not only is likely to undermine cooperation
but may derail the alliance agreement (Arino and Torre, 1998; Husted and
Folger, 2004).
The potential dark side to long-standing ties

While most of the literature focuses on the benefits that accrue from
embedded, long-standing ties, more recent work suggests that they may
actually undermine alliance performance. For example, the lack of hierar-
chical oversight may cause managers to fail to systematically evaluate and
restructure alliances when needed. As parties become complacent with the
existing partner, they fail to adequately search for new partners and capa-
bilities, even when newness is desirable (Uzzi, 1997; Gulati and Gargiulo,
1999; Anderson and Jap, 2005). Empirical studies examining this dark
side of embedded ties remain nascent, though Goerzen (2007) finds that
repeated partnerships are associated with lower firm performance and
Poppo et al. (2008b) similarly find that the performance benefits associ-
ated with relational governance decline when parties rely on repeated
partnerships. Sampson (2005) also finds that the performance benefits
from experience decline over time presumably because the knowledge, and
thus its value, depreciates over time.
Conclusions
According to Williamson (1999), the transaction cost framework guides
strategy research that focuses on competitive advantage through resources.
The transaction cost question ‘What is the best generic mode (market,
hybrid, firm or bureau) to organize X?’ is rephrased to ‘How should firm A
– which has pre-existing strengths and weaknesses (core competences and
disabilities) – organize X?’ (Williamson, 1999, p. 1103). As shown in the
above review, the alliance research has focused on the viability of hybrids
as a governance form and as a potential vehicle for rent-generation. It has

also focused on a discriminating alignment hypothesis regarding the use
of contracts and trust, and shown that the transaction cost logic does not
wholly account for how firms generate advantage through resources.
One unresolved issue, however, is to more fully understand the bounda-
ries of the firm, given the strategic search and development of resources
and advantage. For example, there are some theorists that speculate that
alliances, if properly managed, may substitute for firm ownership. For
example, Madhok (1995, p. 117) argues that a ‘trust-centered logic is
largely consistent with approaches that emphasize the issue of ownership’
and that ‘a shift in focus from ownership to relational dynamics is encour-
aged’. Most empirical work on alliances has focused on equity ownership,
and demonstrates support for the transaction cost logic that transactions
that are associated with more risk are governed through more hierarchi-
cal contracts (see, for example, Oxley, 1997; Sampson; 2005; Gulati, 1995;
and Reuer and Arino, 2007). These empirical works, however, have yet to
fully incorporate relationship dynamics into empirical models as well as to
compare the governance choice of a trust-based hybrid to that of vertical
integration.
Relatedly, Hill (1990, p. 509) argues that the case for vertical integra-
tion may be overstated: ‘among a population of actors who are engaged in
repeated transactions that require investments in specialized assets, behav-
iors that stress cooperation, trust, and forgiveness of isolated opportun-
ism by others have an economic value’. This logic implies that over time
cooperative rather than opportunistic actors will dominate a population
and raises serious questions about the transaction cost logic for vertical
integration. Hill foresaw the idea that social networks may constitute
another kind of hybrid that competes with or may complement vertical
integration. Consistent with this logic, Dyer’s (1996, p. 649) research
on the Japanese keiretsu argues that ‘hybrids/alliances as employed by
Japanese automakers realize virtually all of the advantages of hierarchy
(e.g., asset co-specialization) without the disadvantages (e.g., loss of
market discipline; loss of flexibility, higher labor costs)’. This hybrid form
has numerous safeguards that include financial hostages, reputation,
formal contracts and trust. Thus, a query for future research is whether or
more precisely when network governance may supplant or substitute for
vertical integration and the more ‘atomistic’ ties that characterize simple
forms of market governance.
In sum, left unanswered in these research probes is the comparative
analysis of governance choices, namely ownership versus hybrids, and
their outcomes. While research on alliances has expanded our understand-
ing of their social context and their likely impacts on governance and
value-creation, future work is still needed to explore their comparative

governance.
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22 Labour economics and human resource
management
Bruce A. Rayton
It has become fashionable among modern labour economists to treat labour

economics and industrial relations as distinct and separable subjects, allowing
economists to concentrate on the operation of labour markets, while the influ-
ence of ‘institutional’ factors is delegated (or relegated) to industrial relations
experts. Kaufman (2005, p. 409)
Kaufman (2005) suggests that the practice of labour economics and indus-
trial relations are largely separate enterprises, but recent developments in
labour economics emphasizing the significance of contracting problems and
examining employment relationships as organizational responses to con-
tracting failures suggest that fashions are changing. Transaction cost eco-
nomics (TCE) is well placed to inform these new developments in the field.
In what ways can TCE inform the study of labour economics and by
extension the study of personnel economics and human resource manage-
ment? This chapter offers some answers to this question by first enumer-
ating the characteristics of labour market decisions that have meant that
the study of these phenomena has generated a unique field of economic
inquiry. Next, the chapter delineates the basic features of the neoclassical
approach to labour economics in order to make explicit the areas in which
the recognition of transaction costs can improve our understanding of
labour market phenomena.
What makes labour markets special?

Defined in the most general terms, labour economics is the study of the
allocation of a scarce resource across unlimited wants, where the resource
is time and the unlimited demands on this time include leisure, employ-
ment, self-employment, home production, and any other uses of time. This
definition of labour economics is certainly comprehensive, but it raises an
interesting question: why should we regard the study of labour markets
as a separate field within economics? After all, there are not separate sub-
fields in microeconomics for every market. There is no field called ‘wheat
economics’, nor are there fields for the analysis of computer software,
airframes, or breakfast cereals. What is it about the labour–leisure choice
that makes it special?
215
The most obvious thing to say is that the majority of adults in developed
countries participate in labour markets, and a detailed understanding of
the systems, processes, and motivations at work in these markets appears
crucial to understanding how such economies work. Second, and perhaps
more compelling, we note that labour market decisions are the logical
inverse of decisions in goods markets. Households supply their time
through labour markets to earn the income that allows them to purchase
goods and services from other markets. Thus the supply decision in labour
markets is based on utility maximization rather than on profit maximiza-
tion, while the converse is true for labour demands. Labour demands are
built as derived demands. In other words, the demand for employees is
not based on some intrinsic valuation of the degree to which employing
workers enhances employers’ utility, but it is instead based on a calcula-
tion of the additional profits made possible through the employment of
workers. Similarly, workers are presumed to work (at least in part) in
order to earn the income required to purchase utility-enhancing products
in goods markets. This perspective is captured in the name for payments to
labour in national income accounts: employee compensation.
According to Jacobsen and Skillman (2004, p. 9), there have been
three eras of labour economics. The emergence of labour economics as a
distinct field within economics began with a largely descriptive and case
study-based stream of work which was based on institutionally informed
neoclassical economics (Kerr, 1988, p. 14). This was followed by human
capital theory which relied on modified principles of supply and demand,
and focused on labour market outcomes rather than industrial institutions
and practices. Mincer (1958), Schultz (1963), and Becker (1964) represent
the departure points in this area, and this work was substantially extended
and modified by Sherwin Rosen (1972) and Richard Freeman (1971). The
contributions of human capital theory continue to be felt today, but these
are augmented by a third phase of labour economics that reinstates the
importance of contracting difficulties and the organizational responses to
these difficulties. It is this recent strand of labour economics which is most
informed by transaction cost approaches.
Contributions of TCE to labour economics

Neoclassical analysis of labour markets forms the foundation of modern
labour economics. Consistent with neoclassical models of other markets,
this foundation is based on several key assumptions that are detailed in
Part I of this book. As in other markets, these assumptions combine to
allow the generation of supply and demand curves that interact via some
invisible hand to determine a market-clearing equilibrium price (wage)
and quantity (hours worked). As in other markets, there are also a range
Labour economics and human resource management 217
of standard transaction cost critiques of these assumptions, and readers

interested in these details are encouraged to examine Part III of this book.
In the following subsections we highlight some of the specific ways in which
a transaction costs approach enhances the study of labour markets.
Transaction costs and the labour–leisure choice

The most basic choice analysed in labour economics is the choice of whether
or not workers offer their time to firms through labour markets (labour
force participation). This choice is often modelled as a choice between
home production (or self-employment) and labour market participation.
Individuals compare the utility they gain from market employment with
the utility they gain from non-participation, where the gains from market
employment are an increasing function of the wage rate. Thus we see the
standard result that generates the labour supply curve: that increases in
the wage rate increase the quantity of labour supplied to the market. We
can also see that the value of non-market options is equally important in
determining the choices individuals make. Local institutional settings may
contribute heavily to the relative values of these non-market options, and
there is substantial evidence of differences in labour market participa-
tion rates and the importance of the informal sector across countries (for
example, Johnson et al., 1997).
The assumptions of the neoclassical model of labour markets include
homogeneous labour inputs and perfect information about the actions
undertaken and outcomes generated by these labour inputs. Neither of
these assumptions is, unsurprisingly, strictly true in most settings, and the
violation of such assumptions has implications for the costs of the process
by which workers find and ultimately contract with potential employers
for the time they offer through labour markets. In particular, worker het-
erogeneity, coupled with difficulties associated with observing or credibly
communicating these heterogeneous qualities, generates substantial costs
for potential employers and employees as they search for a good match
(for example, Rogerson et al., 2005).
Labour contract form and transaction costs

Transaction costs feature in various models of the choice between formal
employment relationships and market contracts for specific labour serv-
ices. In essence the choice can be likened to a particular application of the
decision to ‘make’ or ‘buy’ inputs to the production process, where this
decision depends on the attendant transaction costs associated with trans-
action frequency, uncertainty and specificity (Williamson, 1979, p. 245).
Transaction frequency reflects the number of hours of work required
in the production process. Greater scale enhances the likelihood of
employment because it allows for more intensive use of human capital.

For example, very small firms are unlikely to hire a lawyer on a full-time
basis, and instead are likely to purchase legal services from individuals
who serve a range of clients.
Uncertainty about the tasks required of workers enhances the desir-
ability of formal employment because in the presence of uncertainty the
costs of constant recontracting with an external agent may be high relative
to the costs of signing a long-term contract with an employee in which the
employee agrees to carry out the commands of the employer (Coase, 1937:
391; Simon, 1951). Uncertainty in the demand for a firm’s output may also
raise transaction costs, as the volatility of firm output will, on the assump-
tion that workers are relatively risk averse in comparison with firms, raise
the expected value of long-term contracts in the eyes of employees, while
raising the expected value of short-term relationships in the eyes of firms.
This increased divergence of opinion about the desired labour relationship
has the potential to increase the costs of negotiations surrounding any
individual relationship, while the demand volatility itself will increase the
likelihood that any individual relationship will face renegotiation.
Transaction costs related to specificity can arise either through the
nature of the output produced through work or through the nature of
the human capital required to generate output. Like other investments
in specific assets, previous investments in job-specific, career-specific and
firm-specific human capital represent sunk costs. These generate quasi-
rents that induce costs associated with market transactions (Williamson,
1985). Thus jobs with nontrivial job-specific and task-specific skills give
rise to serious costs associated with market-based labour transactions that
lead to greater formalization of employment relationships and the crea-
tion of internal labour markets on efficiency grounds (Williamson et al.,
1975).
Dealing with transaction costs arising from human capital is compli-
cated by the inability to use one of the standard solutions to bargaining
problems as the outright sale and purchase of human capital (slavery)
is prohibited. What results is a decision between the use of ‘contrac-
tors’ or ‘employees’, where contractors retain the rights to all surplus
generated from their human capital, and where the inability to purchase
human capital creates a range of unrelieved hazards in the employment
relationship.
Employment relationships can be thought of as rental agreements in
which the employer exercises control over the job done and the methods
used to achieve it, and may also invest in training that builds the value of
human capital. Any returns generated by an individual’s human capital
within the terms of the rental agreement accrue to the employer, but any
improvements in the value of human capital and any returns to this capital
that are generated outside the rental agreement (either after its termina-
tion or out of normal hours) are the property of the employee. Investments
in training in general human capital are thus exposed to ex post external
appropriation while investments in specific human capital may require
credible commitments in order to facilitate employee participation.
TCE argues that such difficulties can be minimized by careful choice
of institutional arrangement. For example, Simon (1951) illustrates that
greater uncertainty about the value of a specific employee action generates
costs of contracting, thus creating incentives for the use of formal employ-
ment contracts. Hashimoto (1979, 1981) and Hashimoto and Yu (1980)
argue that investments in specific human capital create an environment
in which employer and employee have an incentive to sever their relation-
ship even though they have a collective interest in the continuation of the
employment relationship. Hashimoto describes a sharing arrangement in
which the parties attempt to minimize the loss associated with separation
by sharing the gains from the specific investment. This sharing comes in the
form of pre-specifying wages in an employment contract, and Hashimoto
shows that costs associated with measuring and agreeing on worker pro-
ductivity levels (ex post negotiation) increase the attractiveness of such
sharing arrangements. Hashimoto effectively suggests that employer and
employee tie their hands with a contract to avoid ex post opportunism,
though the result is inefficient to the extent that self-interested contracting
parties consider only their share of the return rather than reflecting the full
value of the relationship. Carmichael (1983) suggests that a third party is
required in order to achieve the best solution in this environment, and that
seniority-based promotion systems can fill this role, as ex post opportunism
by the firm is mitigated by the fact that firing a worker simply raises another
worker one rung up the seniority ladder (Carmichael, 1983, p. 252).
The work of both Hashimoto and Carmichael illustrates the role that
institutional arrangements can play in influencing the transaction costs
associated with employment relationships. In the absence of specific
investments, for instance, the selection of these institutional arrangements
would be suboptimal as they impose non-trivial governance costs on the
relationship, but as the character of the economic relationship changes
the institutional arrangements best-suited to managing this relationship
change as well.
Contractual variety is possible even within the employment relation-
ship. For example, the pay mechanism may be altered to reflect the needs
of a particular environment. Several authors show that deferred compen-
sation (for example, pensions) can provide worker motivation (Lazear,
1979; Medoff and Abraham, 1980). Others show that relative performance
can provide motivation in promotion hierarchies (for example, Lazear and

Rosen, 1981), and there is also ample research on the effects of piece-rate
pay systems on quality and quantity (for example, Freeman and Kleiner,
2005). Oyer and Schaffer (2005) present an investigation of the value of
granting stock options to employees throughout a company hierarchy.
Like stock options, linking the pay of employees to company profits
(profit sharing) ties pay to firm performance (for example, FitzRoy and
Kraft, 1986; Kruse, 1993). Holmström (1982) presents a model of profit
sharing in which the efficient outcome can be approximated through the
introduction of discontinuities in the mechanisms used to share company
profits with employees. Employees in Holmström’s model are presented
with only two potential outcomes: one option generates the efficient
outcome, and the other option provides employees with a level of utility
below the utility value attainable if employees elect to shirk. This suggests
that employers should limit their discretion in making pay awards in order
to solve the problem of suboptimal employee effort. This is another way
of saying that employers should raise the costs of making anything other
than the two payment options mentioned earlier.
Milgrom (1988) presents a model that similarly argues that firms may
have an interest in restricting their ability to undertake particular actions.
Milgrom argues that employment contracts usually fail to compensate
workers for the effects of events that occur after the formation of these
contracts when employees are faced with costs associated with job change.
This situation leads to an environment in which employees may spend
valuable time and energy attempting to influence the decisions of manag-
ers with authority to make discretionary decisions. This means that firms
may choose to tie the hands of managers (limit discretion), particularly
for decisions that have largely distributional (rather than efficiency)
effects, thus eliminating the incentive for employees to waste their time
and energy. As in Holmström (1982), Milgrom (1988) describes a world in
which firms impose limits on discretion in order to avoid waste.
Transaction costs and wage rigidities

Kahn (1997, p. 993) documents three important features of nominal wage
dynamics in the US:
1. A significant proportion of workers remaining in the same job over a

year receive the same nominal wage/salary in adjacent years.
2. When a given real wage change requires a small nominal wage/salary
change it is less likely to occur than when it requires a larger nominal
change.
3. There is evidence of downward nominal wage stickiness.
This evidence of transaction costs in US labour markets is complemented

by more recent work by Dickens et al. (2006) that identifies both real and
nominal wage rigidities in their investigation of 31 million wage changes
from 16 countries.
The existence of nominal wage rigidities is important because these rigidi-
ties have featured heavily in theories of the macroeconomic effects of labour
market phenomena. Early theories often explained the existence of nominal
rigidities with reference to phenomena like money illusion, where individuals
systematically mistake nominal values for real values when making deci-
sions, but such assumptions do not sit well with economic assumptions of
rationality, and other answers have been sought. These sorts of wage dynam-
ics can be better understood with reference to specific transaction costs.
Menu costs are an example of a transaction cost that generates nominal
wage rigidities. Introduced in Akerlof and Yellen (1985), menu costs are
the costs associated with changing prices (for example, selecting new
prices and reprinting menus, and so on). In the context of labour markets,
it is useful to think of menu costs in terms of activities like performance
appraisal and wage negotiations as well as wholesale systemic changes in
the reward system. Examples of such changes might include the introduc-
tion of profit sharing systems or the implementation of structured job
grading and evaluation systems (e.g. Hay-style systems) designed to map
roles across the organization and facilitate banding.
Contract structure is not the only source of rigidity. For example,
Wachter (1986) suggests that union wage rigidities are influenced not only
by the nature of the labour contract (especially contract renegotiation
lags), but also by the regulations surrounding the union–management
relationship. US labour law dictates who firms must negotiate with and
stipulates many of the precedents and customs within which negotiations
take place. It also dictates the process through which disputes may be
resolved, as well as limiting the tactical options available to each side. US
labour law is seen through this lens as imposing a particular set of transac-
tion costs on labour markets, and we can see other ways in which broader
institutional environments influence transaction costs.
Links between institutional arrangements and organizational performance

Williamson refers to the role of institutional arrangements in the organi-
zation of firm activities, and suggests that such arrangements could be
well-adapted to their institutional environment or ‘maladapted’, where
maladaptation is thought to damage the performance of the organization.
Much energy is spent in the transaction cost literature to understand the cir-
cumstances under which particular activities are best performed in the firm
and which are best performed through markets or hybrid organizational
forms. Understandably, this question features heavily in analyses of labour

issues. The ‘make-or-buy’ question typically appears in the analysis of the
decision to employ workers on a part time vs full time basis (for example,
Davis-Blake and Uzzi, 1993); or the decision to employ workers rather than
hire consultants or other external specialists (for example, Masten, 1988;
Masters and Miles, 2002). Jensen and Meckling (1992) argue that such deci-
sions about organizational structure are influenced by the desirability and
extent of specific and general knowledge transfer between agents.
Freeman and Kleiner (2005) use a case study environment to examine
the financial performance of a shoe company in its move from a piece-
rate to a simple hourly wage system. They identify meaningful declines in
worker productivity as a result of the change, but they also identify sub-
stantial improvements in firm performance which they attribute to savings
made on monitoring workers under the (much simpler) wage system. This
work is consistent with earlier work by Nalbantian and Schotter (1997, p.
314), who find that, ‘monitoring can elicit high effort from workers, but
the probability of monitoring must be high and, therefore, costly’.
The focus in the existing new institutional economics (NIE) literature
is on the relative costs of internal organization vs market procurement
under different circumstances. Relatively little research has been devoted
to building our understanding of how various institutional arrangements
affect the costs of internal governance. This issue, in the context of labour
issues, has been considered extensively in research in human resource
management (HRM). The next section characterizes the nature of current
debate on the link between HRM and firm performance, and discusses the
ways in which TCE can inform this debate.
Contributions of TCE to human resource management

TCE lies very much within the realm of economics, and the relationship
between research in economics and in human resource management has
been fairly tumultuous. This is typified by a critique of economic models
of human behaviour by O’Reilly and Pfeffer (2000, p. 16):
[T]here is a presumption that people are unlikely to expend effort unless they
are paid to do so or are supervised closely. A second common belief is that
people . . . will often misrepresent their true preferences and engage in guile
and deceit. A third widespread assumption is that . . . employees and managers
want different outcomes at work . . . Although each of these assumptions may
be valid in a specific situation, or for a particular individual, none is likely to be
right in most settings with normal human beings.
Economists would not disagree that many people are motivated for
a range of interesting reasons, nor that they receive some intrinsic value
from undertaking certain activities, but economists typically abstract from

these issues by restricting their analysis to behaviour at the margin. The
fact that individuals might choose to volunteer to work for a charity in the
absence of financial compensation is not at odds with economic models of
behaviour, as these models are designed to be accurate for marginal deci-
sions. Thus if tax laws change the way they treat the donation of services
to charitable organizations an economic model of human behaviour can
make predictions about the extent to which the amount of volunteered
hours will change, under the assumption that there have not been changes
to the intrinsic value of the work done by the charity or to the ethics of
the volunteer, but instead there has been a change in the relative price of
making such a donation of time. TCE, like other branches of economics,
is focused on behaviour at the margin.
This difference of approach between HRM and economics has pre-
sented several interesting opportunities for research informed by eco-
nomics and, more specifically, TCE. One notable area in which this has
occurred is personnel economics, which sits directly between economics
and HRM. According to Lazear (2000, p. 611), personnel economics is,
‘the application of microeconomic principles to human resources issues
that are of concern to most businesses’. Coalescing in the early 1980s,
personnel economics was based on a conscious attempt to use the tools of
labour economics in a way that would be of greater interest and relevance
to business decision makers and students. Lazear (2000) argues that this
move was facilitated by advances in economic theory which included early
developments in agency theory (for example, Johnson, 1950; Cheung,
1969; and Ross, 1973), contract theory (Baily, 1977; Azaridis, 1975; and
Gordon, 1974), and the role of monitoring in the presence of team produc-
tion (Alchian and Demsetz, 1972).
Personnel economics takes the ideas of labour economics into a more
practical realm, and this makes its connections with TCE even more appar-
ent. While the focus of labour economics tends to be on labour supply and
demand at the market level, personnel economics tends to focus more
on the within-labour-market activity of individuals: in particular on the
selection of effort levels by employees. There is a large literature that has
developed, in part because the advent of the personal computer has greatly
lowered the costs to researchers of making sense of company data. Baker
et al. (1994a, 1994b) provide detailed analysis of 20 years of personnel data
from one particular firm in order to investigate several hypotheses about
the operation of internal labour markets. Prendergast (1999) and Lazear
(2000) both provide useful surveys of the literature on employee incentives
in firms, with the former focusing more on tests of agency theory and the
latter focusing more specifically on research in personnel economics.
TCE has the prospect of further informing debates in HRM research

outside of personnel economics. For example, there has been a great deal
of work in HRM over the past decade which has attempted to link HRM
to business performance, but the results have been widely questioned.
Within this literature, there has been a tendency to focus on identifica-
tion of statistical associations between stated HR policies and financial
performance, with little attention to how these policies are implemented
through the organization (HR practices). There has been a particular
lack of research trying to uncover the causal chains driving these associa-
tions, and this appears to be the result of a narrow focus on HR policies
to the exclusion of wider factors which impact on employee attitudes and
behaviour.
A few studies have used the term ‘people management’ in preference
to HRM (Paul and Anantharaman, 2003; Purcell et al., 2003; Michie and
West, 2004) to indicate a broader conception of the area of study. This
broader focus allows for the development of a deeper causal model linking
policy to performance via employees, and it also allows the inclusion of
factors such as organizational values, operational strategies, and the role
of line managers together with HR policies in their effect on work climate,
job experience, and employee attitudes and behaviours. This is impor-
tant because an influence of HRM on financial performance can only be
expected to exist if HRM changes employee behaviours. This may come
in the form of easier recruitment, better retention, increased work effort,
enhanced team working, expanded beyond-role effort (organizational citi-
zenship behaviour), or any of a wide range of other employee behaviours
that may influence the bottom line.
This literature resonates with the TCE perspective because the features
of the people management environment that are suggested by recent devel-
opments in HRM research appear to satisfy the definitions of institutions
and institutional arrangements described in this book, and as such could
be usefully investigated from a transaction cost perspective. Williamson
(1996, p. 378) defines an institutional arrangement as, ‘the contractual
relationship or governance structure between economic entities that
defines the way in which they cooperate and/or compete’. HR policies on
recruitment, retention, training, job design, performance evaluation, and
promotion surely fit within this definition, but they are only a part of a
much larger set of institutions that influence behaviour and performance
in firms.
North (1990, p. 3) refers to institutions as; ‘the rules of the game in a
society, or more formally, the humanly devised constraints that shape
human interaction’. Aoki (2001, p. 2) suggests a complementary defini-
tion that defines institutions as a set of ‘relevant characteristics’ of an
equilibrium, particularly in instances where the institutions are concep-

tualized as being endogenously generated. These characteristics might
be regarded as effort levels, cooperation, organizational commitment,
or elements of organizational culture. This is clearly alluded to in Aoki’s
(1995) work on A-type vs J-type equilibria, where he explains how differ-
ent organizational structures might represent optimal structure given the
institutional background in which each firm operates.
Many of the broader set of HR issues included within ‘people man-
agement’ fall within definitions of institutions and institutional arrange-
ments. In discussing these issues, it is helpful to draw upon North’s (1990)
distinctions between types of institution: North notes that institutions
can be formal or informal; and can also be constructed or emergent.
In the context of HRM, HR policies can be thought of as constructed
institutions and HR practices can be thought of as emergent institutions.
Policies may differ in their levels of formality but there are still important
differences between the intentions of these policies and the way they are
implemented (Kinnie et al., 2005).
Adopting the perspective of ‘people management’ suggests the treat-
ment of HR policies and practices as part of a wider institutional structure.
This approach allows a deeper understanding of the effects of human
resource management on firms, and allows us to think of HR policies and
practices both as a cause of firm performance and a response to the extant
institutional environment in which the firm operates. The focus of ‘people
management’ is the whole range of policies, practices, and processes which
are hypothesized to influence organizational outcomes by stimulating
employees’ behaviours, whether positively or negatively. The approach
starts from the premise that while the application of HR polices to, on or
for employees is the central interest it can never be sufficient to cover the
various ways in which employees are managed and which are likely to influ-
ence their performance. Included in this wider focus are such attributes as
organizational values and culture as articulated by senior management, the
work climate of the organization as experienced by employees, the nature
and experience of doing the jobs allotted to employees, the influence and
role of line managers in enacting HR policies, and operational manage-
ment strategies concerning technology and task integration. In seeking to
evaluate how these ‘clusters’ of activities together with HR policies impact
on organizational performance the critical focus is placed on employee
attitudes and behaviours since it is asserted that it is the employees’ experi-
ence of being managed, of working in the organization and doing the job
which is likely to influence their work related attitudes and behaviour. It is
these people management behaviours which impact performance in asso-
ciation with a wide range of non-human resources, such as technology.
The focus on organizational culture, leadership and work related atti-

tudes and behaviour also appears in recent work in economic sociology.
Akerlof and Kranton (2005) open their article by describing the US Army
approach to recruitment, selection, and training to illustrate both the
importance of organizational norms and the mutability of individual pref-
erences. Through this lens, Army training can be seen as a period in which
the pre-existing preferences of individuals are replaced with preferences
more suited to the Army. Such change is less costly to achieve for individu-
als who arrive with preferences that are already near those desired, and
this has implications for recruitment and selection.
Cultural factors matter in many organizations. Some of these factors
are national or regional in nature, but others are specific to the organi-
zation or workplace. Purcell et al. (2003, 2004) suggest that companies
perform better when they have a clear sense of mission underpinned by
values and a culture expressing what the firm is and its relationship with
customers and employees. Clarity of this ‘big idea’ makes the basis for
decision making clearer for those who are distant from the strategic deci-
sion makers of the organization. This allows better exercise of discretion
on the job, thus facilitating greater delegation of authority in the organiza-
tion, all else equal. Building a sense of group cohesion may also enhance
trusting and trustworthy behaviour (Goette et al., 2006), thus allowing
greater capture of the benefits of cooperation in the prisoners’ dilemma
environment that characterizes the firm (Miller, 1993).
Conclusion
Industrial relations and labour economics have been separate subjects
for many years, but recent advances in labour economics have closed this
gap substantially. Institutional features of labour markets previously of
primary interest in industrial relations have become important features
of labour economic models. Of particular note are recent developments
emphasizing the significance of contracting problems and examining
employment relationships as organizational responses to contracting
failures, and TCE is well placed to inform these new developments in the
field.
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23 The Chicago school, transaction cost
economics, and antitrust
Joshua D. Wright
John Roberts’ reign at the US Supreme Court is only in its nascent stages.
Already, however, its antitrust activity level has exceeded the Court’s
single case average prior to the 2003–04 Term by a significant margin.
This flurry of antitrust activity, combined with an apparent willingness to
reconsider long-established precedents that conflict with modern antitrust
theory, suggests that the Supreme Court will play a relatively significant
role in shaping antitrust doctrine for years to come.
In the four decades prior to the Roberts Court’s first Term, antitrust
jurisprudence could be summarily, but accurately, described as slowly but
surely absorbing the insights of the Chicago school and the transaction
cost approach: per se prohibitions against vertical restraints gave way to
rule-of-reason analysis, the per se rule against tying was softened, hostility
to vertical integration and predatory pricing all but disappeared, and the
law incorporated a more sophisticated understanding of the procompeti-
tive uses of exclusive dealing contracts. As courts increasingly incorporated
the lessons of the Chicago school and transaction cost contributions of the
1960s, 1970s, and 1980s, the hostility toward various business practices
was relaxed in favour of a rule-of-reason approach that placed evidentiary
burdens on plaintiffs to demonstrate these practices would generate anti-
competitive effects (Wright, 2007a).
Identifying the economic influences underlying a series of court decisions
is a difficult task. But that task is rendered impossible without some guide-
lines as to what the author intends when he claims that a particular set of
decisions is influenced by the Chicago school, transaction cost economics
(TCE), or new institutional economics (NIE). In that spirit, some defini-
tions and disclaimers are in order. First, the Chicago school’s history and
its influence on antitrust is well documented and will not be recounted here
(Bork, 1978; Posner, 1979; Kitch, 1983; Page, 1989; Meese, 1997; Kovacic
and Shapiro, 2000). Jonathan Baker and Timothy Bresnahan (2006, pp.
23–6) usefully decompose the Chicago school’s influence on antitrust
into two separate components. The first component, ‘the Chicago school
of industrial organization economics’, consists of the work in industrial
organization economics that aimed, and succeeded, at debunking the
230
The Chicago school, transaction cost economics, and antitrust 231
structure-performance-conduct paradigm and its hypothesized relation-

ship between market concentration and price or profitability (see, for
example, Goldschmid et al., 1974; Brozen, 1982).1 The second component,
‘the Chicago school of antitrust analysis’, primarily (but not exclusively)
contributed empirical work in the form of case studies demonstrating that
various business practices previously considered manifestly anticompeti-
tive could be explained as efficient and procompetitive. The second com-
ponent’s basic features are generally attributable to the work of Aaron
Director (see Newman, 1998, pp. 227–33 and pp. 601–5; Peltzman, 2005, p.
313) and others from 1950 to the mid 1970s (see, for example, Bork, 1954;
Director and Levi, 1956; Bowman, 1957; McGee, 1958; Tesler, 1960). A
group of eminent antitrust scholars, such as Richard Posner, Robert Bork,
and Frank Easterbrook, followed in Director’s footsteps, building on
these studies and economic analyses and advocating bright-line presump-
tions, including, but not limited to, per se legality. Antitrust liability rules,
Chicago school scholars argued, should reflect the competitive reality and
economic consensus that the marketplace produced many contracts, but
few that would systematically produce anticompetitive effects.
This is not to say that the Chicago school’s contributions to antitrust eco-
nomics were completed by the 1970s, or to imply inappropriately that they
were limited to the ultimate rejection of the structure-conduct-performance
paradigm. For example, ‘Chicago school’ industrial organization econo-
mists have continued to contribute to our economic understanding of
various business practices, despite the fact that developments in industrial
organization economics for the past 20 years have relied primarily on
game-theoretic modelling techniques. Recent Chicagoan contributions
to antitrust economics include work on exclusive dealing (Marvel, 1982;
Klein and Lerner, 2007), slotting contracts (Wright, 2006; Klein and
Wright, 2007; Wright, 2007b) and vertical restraints theory (Klein and
Murphy, 1988).
The influence of the Chicago school

The Chicago school’s influence on antitrust law and policy has been sub-
stantial, particularly in the Supreme Court. Supreme Court decisions such
as Continental T.V. v. GTE Sylvania (1977), State Oil Co. v. Khan (1997),
Verizon Communications Inc. v. Law Offices of Curtis V. Trinko (2004)
and Brooke Group Ltd. v. Brown & Williamson Tobacco Corp. (1993) were
influenced by Chicago school thinking, not to mention the development
of the 1982 Horizontal Merger Guidelines by Assistant Attorney General
William Baxter. Indeed, the 1970s and 1980s were marked by a dramatic
shift in antitrust policies, a significant reduction in agency enforcement
activity levels, and calls from Chicago school commentators for the use of
bright line presumptions (for example, Easterbrook, 1984), per se legality

of vertical restraints (Posner, 1981), and even repeal of the antitrust laws
altogether (for example, Armentano, 1986).
Richard Posner (1979, p. 928) has described the key distinguishing
feature of Chicago school antitrust analysis as its unique view of anti-
trust policy ‘through the lens of price theory’. While there is no doubt
that neoclassical price theory is a fundamental building block of Chicago
school antitrust analysts, it should also be noted that the Chicago school
approach has not been limited to applying the model of perfect competi-
tion.2 Chicagoans have also incorporated the insights of NIE and its focus
on comparative institutional analysis and transaction costs.
On the distinction between the Chicago school, TCE, and NIE applica-
tions, a few more words of clarification are in order. Classification is a
difficult problem in an area of industrial organization economics that has
more similarities than differences. For example, Benjamin Klein is gener-
ally classified as a Chicagoan working in the tradition of integrating the
insights of TCE to explain a number of contractual arrangements such as
resale price maintenance, tying, block booking, exclusive dealing, and slot-
ting contracts (Klein, 1980, 1999; Klein and Kenney, 1983; Klein and Saft,
1985; Klein and Murphy, 1988, 1997, 2008; Klein and Lerner, 2007; Klein
and Wright, 2007).3 But that tradition is not uniquely Chicagoan. TCE,
as Joskow (2002, p. 97) notes, ‘has always had a policy dimension as well,
especially applications to antitrust and competition policies’. The most
prominent non-Chicagoan contributor to TCE has been the recent Nobel
Laureate Oliver Williamson, beginning with his seminal work, Markets
and Hierarchies: Analysis and Antitrust Implications (1975), and in later
work (Williamson, 1975, 1985, 1996). One could just as easily and without
loss of analytical coherence introduce a UCLA school including Armen
Alchian, Harold Demsetz, and Benjamin Klein which has had its own
impact on antitrust separate from the contributions of prior Chicagoans
or the TCE school more generally.
For the purposes of this chapter, it is most important to recognize the
similarities between these approaches and their collective influence on
antitrust jurisprudence, including that of the Roberts Court. For example,
both the Chicago school and TCE emphasize that a robust conception of
the competitive process, to be of any use for policy analysis, must deviate
from the model of perfect competition. Both schools of economic thought
are therefore inherently less suspicious of the ‘non-standard’ contractual
arrangements that would become the core focus of antitrust enforcement.
There are also some important general differences between the Chicago
school and TCE contributions to antitrust analysis, with the latter focus-
ing its efforts almost exclusively on how transacting parties mitigate ex
ante contracting costs associated with the potential for holdup with verti-
cal integration and other non-standard arrangements (Joskow, 2002).
These insights have been critical in relaxing some of the hostility antitrust
regulators and courts demonstrated toward vertical integration, franchis-
ing, and other vertical restraints through the 1960s.
One example of key but subtle differences between the Chicago school
and TCE approaches to contractual arrangements can be seen in the
competing but complementary understandings of the theory of the firm.
The ‘rent-seeking’ and ‘adaptation’ theories of the firm developed by
Williamson (1971, 1985), Klein et al. (1978), Klein and Murphy (1988,
1997), Klein (1996, 2000), and Klein and Lerner (2007) emphasize the role
of integration in preventing socially destructive ‘haggling’ over ‘appropri-
able quasi-rents’. While these simplifying labels come with some risk of
obfuscating important and subtle differences between theories, they are
useful for highlighting some of the critical features of the theories. For
example, the ‘rent-seeking’ label correctly captures the fact that a holdup
involves attempts to redistribute wealth between parties, and that the
resources parties expend in attempts to obtain and prevent these transfers
also have allocative effects. Of course, the view that the TCE approach
focuses exclusively on ex post contracting costs is overstated, as Klein
(1996) and others have also emphasized ex ante contracting costs, where
transactors engage in a wasteful search for informational advantage over
transacting partners during the negotiation process. Nonetheless, while
these subtle differences between Chicago school and TCE approaches
to understanding various contractual arrangements generate important
economic questions, the similarities between the Chicago school and
TCE analysts have produced a modern antitrust policy that no longer
reflexively condemns non-standard contractual arrangements and novel
business practices.
The post-Chicago approach

However, a growing post-Chicago school (PCS) movement in the eco-
nomic literature and the antitrust community more broadly has become a
strong force that would restore, with more rigorous economics and model-
ling, at least some of the hostility towards vertical arrangements observed
in the 1960s. Joskow (2002, p. 97) describes the tension in the TCE and
PCS literatures:
At the present time TCE and [PCS] and are like ships passing in the night. The
development of sound antitrust legal rules and remedies would benefit from
integrating these approaches and realizing that they are complements rather
than substitutes. Otherwise [PCS] runs the risk of returning us to the 1960s
antitrust treatment of nonstandard vertical arrangements.
The quote could accurately describe the interaction between PCS econom-
ics and both the Chicago school and TCE literatures. Indeed, it is the
powerful combination of both Chicago school and TCE insights that have
been the driving force behind what I describe here as the ‘Chicago school/
TCE’ revolution in antitrust.
Conventional wisdom predicted that the PCS economics movement,
which is favoured in most economics departments around the country (and
in top economic journals), would soon result in a paradigm shift in antitrust.
The PCS is the leading alternative to the Chicago school approach (see
Baker, 2002). The PCS challenged the conditions under which well-known
Chicago school results, such as the single-monopoly-profit theorem, held.
Indeed, authors in the PCS movement produced a series of models in which
a monopolist in one market has the incentive to monopolize an adjacent
product market (see, for example, Whinston, 1990). PCS economists also
created a literature focusing on possible vertical foreclosure. This raising
rivals’ costs strand of literature has become the most influential PCS contri-
bution, and has provided a theoretical framework for a number of theories
exploring the possibility of anticompetitive effects of various exclusionary
business practices (Krattenmaker and Salop, 1986). For example, such the-
orems have been produced to demonstrate that it is possible for tying (see,
for example, Whinston, 1990; Carlton and Waldman, 2002; Kobayashi,
2005), exclusive dealing (Rasmusen et al., 1991; Bernheim and Whinston,
1998; Simpson and Wickelgren, 2007), and predatory pricing (Bolton et
al., 2000)4 to generate anticompetitive effects under certain conditions,
including an assumed absence of any procompetitive justifications for the
conduct examined (Kobayashi, 1997; Evans and Padilla, 2005).
It momentarily appeared that the PCS movement would indeed claim
its victory in 1992 when the Supreme Court issued its decision in Eastman
Kodak Co. v. Image Technical Services, Inc. (1992).5 Kodak allowed an
aftermarket tying claim to survive summary judgment based largely on the
PCS theory that competition in the equipment market would not be suf-
ficient to protect consumers who did not have complete information in the
aftermarket. However, Kodak failed to start a PCS revolution in antitrust
jurisprudence and was not more than a hiccup in the Chicago school march.
Further, the Supreme Court’s most recent tying decision in Illinois Tool
Works, Inc. v Independent Ink, Inc. (2006), which unanimously rejected the
presumption that a patent warranted a presumption of antitrust market
power in tying cases, failed to cite Kodak or even mention it in passing.
The Roberts Court

So what would be the economic underpinnings of the Roberts Court’s
antitrust jurisprudence? Would the Roberts Court be influenced by the
newer, game-theoretic PCS scholarship and trigger the regime change that
had been anticipated? After all, the country’s top economics departments
were producing industrial organization theorists who developed PCS
models. The somewhat surprising answer, in my view, is that the Supreme
Court’s antitrust jurisprudence has clung tightly to and been heavily influ-
enced by the Chicago school and TCE approaches to antitrust analysis.6
This development is surprising for several reasons. First, the Supreme
Court’s jurisprudence, as discussed, has been historically linked to
advances in mainstream economics with some time lag. Because recent
advances leading up to the Roberts Court’s first term had consisted pri-
marily of the PCS variety, it is somewhat of a surprising development
that the Court so strongly embraced Chicago school economics and TCE.
Further, despite the fact that Chief Justice Roberts and Justice Alito were
presumed to be conservative antitrust thinkers, there was little evidence
from their prior judicial output or litigation experience that either would
exercise any distinctively ‘Chicagoan’ or TCE influence on the Court’s
jurisprudence.7 Finally, PCS theoretical contributions had been becoming
increasingly popular in the increasingly international antitrust commu-
nity, and had caught the eye of foreign regulators, especially in Europe.
Despite the convergence of these forces in favour of a ‘post-Chicago
revolution’, the Supreme Court’s antitrust output for the 2006–07 Term
strongly demonstrates the Chicago and TCE influence in the Court’s ana-
lytical approach.8
Consider first the Supreme Court’s most controversial decision, at
least if controversy is measured by vote count, in Leegin Creative Leather
Products, Inc. v. PSKS, Inc. (2007). Leegin is a typical resale price main-
tenance (RPM) case involving a terminated dealer. The plaintiff, PSKS,
operated a women’s apparel store in Texas. The defendant, Leegin, manu-
factures and distributes a number of leather goods and accessories includ-
ing handbags, shoes, and jewellery under the ‘Brighton’ brand name. In
1997, Leegin introduced its RPM program, the ‘Brighton Retail Pricing
and Promotion Policy’, a marketing initiative under which it would sell
its products exclusively to those retailers who complied with the sug-
gested retail prices. When Leegin learned that PSKS was discounting the
Brighton product line below the suggested retail prices, Leegin terminated
PSKS and PSKS, in turn, filed suit alleging that Leegin’s new marketing
and promotion program violated the Sherman Act. The trial court found
Leegin’s policy per se illegal under the standard set forth in the Supreme
Court’s Dr. Miles Med. Co. v. John D. Park & Sons Co. (1911) decision.
The jury awarded a US$1.2 million verdict that was upheld by the United
States Court of Appeals for the Fifth Circuit.
Justice Kennedy authored the Supreme Court’s majority opinion,
reversing the Fifth Circuit. He was joined by Justices Scalia, Thomas,

Roberts, and Alito. Justice Kennedy’s analysis largely adopted the argu-
ment offered by both the antitrust agencies and a group of economists in
amicus briefs filed in support of Leegin and in favour of overturning Dr.
Miles and evaluating minimum RPM under a rule of reason standard.
Justice Kennedy’s majority opinion offers four central points: (1) per se
analysis is reserved for restraints that, echoing the language of Continental
T.V. v. GTE Sylvania (1977), ‘always, or almost always, reduce consumer
welfare by limiting competition and output’; (2) economic theory strongly
suggests that RPM does not meet that stringent standard; (3) empirical
evidence comports with economic theory on RPM; and (4) stare decisis
rationales for continuation of a per se rule and adhering to Dr. Miles are
unpersuasive.
The majority launched their attack on Dr. Miles with a reminder that
the rule of reason, and not per se analysis, is the appropriate default rule
for antitrust analysis of any economic restraint, and deviation from this
default is warranted only when the restraint is known to be ‘manifestly
anticompetitive’ and ‘would always or almost always tend to restrict
competition and decrease output’. Measured against this standard, and
after a review of the theoretical justifications for RPM and the empiri-
cal evidence concerning its competitive effects, Justice Kennedy found
the case for continued application of the per se rule profoundly lacking.
Importantly, from an economic perspective, the majority did not limit
its discussion of justifications for RPM to the conventional discount
dealer free-riding story. Instead, it finds the literature ‘replete with pro-
competitive justifications’ and notes the consensus on this point amongst
economists.
Significantly, the majority also recognizes that RPM might be used to
encourage retailer services even where inter-dealer free-riding is not possi-
ble.9 While recognizing the potential for RPM to produce anticompetitive
effects by facilitating collusion, the majority finds that the empirical litera-
ture suggests that efficient uses of RPM are not ‘infrequent or hypotheti-
cal’, and, therefore, the standard for applying the per se rule has not been
satisfied. Leegin at least temporarily symbolizes the end of the era of hos-
tility towards vertical restraints and relies extensively on a Chicago school/
TCE approach, as well as a more general sensitivity to the social welfare
consequences of antitrust false positives. However, the per se rule lives on
through state antitrust regulation, and federal legislation is pending that
would revive Dr. Miles.
In Bell Atlantic Corp. v. Twombly (2007), the Roberts Court took the
opportunity to clarify the pleading requirements under Section 1 of the
Sherman Act. The plaintiff class alleged that four major local exchange
carriers – Bell Atlantic, Bell South, Qwest Communications International,

and SBC (known as Incumbent Local Exchange Carriers or ILECs) –
colluded to block competitive entry by Competitive Local Exchange
Carriers (CLECs) pursuant to the framework established by the 1996
Telecommunications Act, which required the incumbent carriers to sell
local telephone services at wholesale rates, lease unbundled network serv-
ices, and permit interconnection. The allegations themselves consisted of
claims that the defendants agreed not to enter each other’s territories as
CLECs and to jointly prevent CLEC entry altogether.
The district court found that these allegations amounted simply to
assertions of parallel conduct and, as such, were vulnerable to dismissal,
pursuant to the defendants’ Federal Rule of Civil Procedure 12(b)(6)
motions, without allegations of additional ‘plus factors’, such as those
required at the summary judgment stage. The Second Circuit reversed
unanimously, despite some hesitation and concern regarding the ‘some-
times colossal expense’ of discovery in complex antitrust cases, and held
that Federal Rule of Civil Procedure 8(a) did not require allegations of the
‘plus factors’ required to survive summary judgment.
Justice Souter authored the 7–2 majority opinion holding that ‘stating [a
Section 1 claim] requires a complaint with enough factual matter (taken as
true) to suggest that an agreement was made . . . [This requirement] simply
calls for enough fact to raise a reasonable expectation that discovery will
reveal evidence of illegal agreement’. The majority clarifies that allegations
of parallel conduct alone are not sufficient to survive the pleading stage,
‘retiring’ and rejecting the ‘no set of facts’ formulation favoured by Conley
v. Gibson (1957), despite the conventional rule disfavouring motions to
dismiss in antitrust cases. The Court’s rationale for increasing a plaintiff’s
pleading burden in antitrust conspiracy cases is explicitly motivated by the
desire to avoid the extraordinary costs of discovery unless there is good
reason to believe that an agreement will be unearthed. Applying the new
plausibility standard to plaintiffs’ claims was relatively straightforward
as the allegations consisted of parallel conduct alone and no independent
allegation of an actual agreement among the ILECs. While Twombly’s
full implications are yet to be realized, concerns with false positives in
Section 1 cases and the massive social costs of discovery motivated the
Court to increase an antitrust plaintiff’s pleading burden. Twombly reflects
the Roberts Court’s implicit, and correct, view that there were a host of
procompetitive reasons why the ILECS would stay out of each other’s ter-
ritories that had nothing to do with anticompetitive collusion.
In Weyerhaeuser Co. v. Ross-Simmons Hardwood Lumber Co. (2007),10 the
Court tackled the issue of identifying the appropriate standard for ‘preda-
tory buying’ claims under Section 2 of the Sherman Act. Ross-Simmons, a
saw mill in the Pacific Northwest, alleged that Weyerhaeuser overpaid for
alder saw logs in a scheme designed to drive its rivals out of business. The
district court instructed the jury that Ross-Simmons was required to prove
that Weyerhaeuser engaged in ‘conduct that has the effect of wrongly pre-
venting or excluding competition or frustrating or impairing the efforts
of the firms to compete for customers within the relevant market’. With
respect to the ‘predatory buying’ allegation specifically, the district court
instructed the jury that finding Weyerhaeuser ‘purchased more logs than it
needed or paid a higher price for logs than necessary, in order to prevent
Ross-Simmons from obtaining the logs [it] needed at a fair price’ was suffi-
cient to conclude that an anticompetitive act had occurred (Weyerhaeuser,
2007, p. 1073).
The jury found in favour of Ross-Simmons and awarded US$78.7
million. The United States Court of Appeals for the Ninth Circuit
affirmed the judgment, despite Weyerhaeuser’s contention that the district
court erred by not including both the pricing and ‘recoupment’ prongs
of the conventional Brooke Group standard in the jury instruction. The
Department of Justice and the Federal Trade Commission petitioned the
Supreme Court for certiorari and submitted joint amicus briefs recom-
mending that the Court apply the Brooke Group standard to predatory
buying.
Justice Thomas authored the unanimous decision on behalf of the
Supreme Court, agreeing with the position the enforcement agencies
advocated and reflecting much of the insight of the Chicago school/TCE
learning with respect to predatory pricing. Justice Thomas wrote that in
predatory buying cases, plaintiffs must demonstrate both that the buyer’s
conduct led to below-cost pricing of the buyer’s outputs and that the buyer
‘has a dangerous probability of recouping the losses incurred in bidding up
input prices through the exercise of monopsony power’. (Weyerhaeuser,
2007) Because Ross-Simmons conceded that it had not satisfied the
Brooke Group standard, the Court vacated the Ninth Circuit’s judgment
and remanded the case.
The Supreme Court’s endorsement of the Brooke Group standard
appears to rest on three principles that suggest the Court adopted the
Chicago school/TCE learning on predatory pricing. First, the Court drew
attention to the fact that ‘predatory-pricing and predatory-bidding claims
are analytically similar’ as a matter of economic theory, suggesting that
similar legal standards are appropriate. Second, the Court espouses a view
that the probability of successful predatory buying, like predatory pricing,
is very low, in part because of the myriad of explanations for ‘bidding up’
input prices in an effort to increase market share and output or to hedge
against price volatility, or as a result of a simple miscalculation. Finally,
the Court notes that, like low output prices, higher input prices may result
in increased consumer welfare as firms increase output. While the Supreme
Court does not take the lower court to task for allowing this jury instruc-
tion, there is little, if any, doubt that the Supreme Court was correct to
reverse the Ninth Circuit’s affirmation of a disastrous jury instruction that
would require a determination as to whether a firm purchased more inputs
than it ‘needed’ or paid more than ‘necessary’. Rather, the Supreme Court
focused almost exclusively on the theoretical similarities between preda-
tory pricing and buying, the attributes of the Brooke Group standard,
and why the economic similarity should translate into symmetrical legal
treatment.
Conclusion
These cases, taken together, embody an approach to antitrust analysis that
is consistent with the lessons of the Chicago school and TCE approaches.
First, the cases clearly favour price theory and NIE over the formal game-
theoretic contributions of the PCS literature. Second, the Roberts Court
decisions embrace the principle of institutional modesty for antitrust.
Each of the three decisions is motivated, at least in part, by the possibility
of chilling procompetitive conduct by erroneously assigning liability to
efficient conduct. A corollary is that the Court, again in each of the cases
but especially Leegin, is sensitive to what is known and unknown about
the competitive effects of RPM and other contractual arrangements. The
combined affinity for price theory and TCE, emphasis on empiricism and
knowledge, and institutional modesty in light of the potential for sig-
nificant error costs follow directly from Chicago school/TCE analytical
principles.
The economic rationalization of antitrust is one of the great success
stories of the law and economics movement and was motivated, in large
part, by the contributions of the Chicago school and TCE. Perhaps the
overwhelming analytical and explanatory power of the Chicago school
and TCE approaches, in combination with the fact the PCS model has
been heavily criticized for its failure to produce testable implications, is
responsible for the Supreme Court’s somewhat surprising adherence to
these principles in the face of strong forces to abandon them in favour
of the PCS model. Nonetheless, antitrust jurisprudence stands at an
interesting crossroad as antitrust economics, especially in top econom-
ics departments and journals, becomes more mathematically formal and
less accessible to generalist judges. These trends might give one reason to
believe that the once solid Chicago school and TCE foundations of anti-
trust analysis might finally be starting to crack. However, the Supreme
Court’s antitrust jurisprudence, combined with the relative youth of its
recent additions, suggests a significant amount of scepticism is appropriate

concerning any prediction of the demise of the Chicago school or TCE in
antitrust in the coming years.
Notes
1. Especially influential in the dismantling of the structure-conduct-performance hypoth-
eses was UCLA economist Harold Demsetz (1974), whose work was central to exposing
the misspecification of this relationship in previous work by Joe Bain and followers, as
well as offering efficiency justifications for the observed correlation, which is that firms
with large market shares could earn high profits as a result of obtaining efficiencies,
exploiting economies of scale, or creating a superior product. The contributions of
Demsetz and other participants in the famous Airlie House Conference are discussed
by Timothy J. Muris (1997).
2. Chicagoans themselves were among the first to criticize reliance on the model of perfect
competition as a useful benchmark for antitrust analysis (Demsetz, 1991).
3. On Klein’s contributions to law and economics more generally, see Wright (2009).
4. These arguments were endorsed by the Department of Justice in United States v. AMR
Corp. See Brief for the Appellant United States of America, United States v. AMR
Corp. (2003).
5. In aftermarket ‘lock-in’ cases most closely resembling the post-Chicago theories in
Kodak, lower courts have ‘bent over backwards to construe Kodak as narrowly as pos-
sible’ (Hovenkamp, 2002, p. 8; Klein, 1996).
6. Wright (2007a) elaborates and provides support for this claim. Some disagree. For
example, Elhauge (2007) argues that the Roberts Court’s antitrust jurisprudence
reflects a distinctively Harvard school approach.
7. In a law review article, Justice Roberts (1994, p. 112) had praised the Supreme Court
for ‘regain[ing] its equilibrium after the dizzying Kodak decision of two Terms ago’ with
the three decisions in the 1992–93 Term where the Court ‘returned to a regime in which
the objective economic realities of the marketplace take precedence over fuzzy economic
theorizing or the conspiracy theories of plaintiffs’ lawyers’. This is bad news for profes-
sors and lawyers, good news for business.
8. I will discuss three of the four antitrust decisions the Court decided in the 2006–07
Term. I omit Credit Suisse Securities (USA) LLC v. Billing (2007), which involved the
Court’s implied preemption of antitrust in favour of securities regulation in the context
of allegations involving conspiracy and manipulation of the IPO underwriting process.
Wright (2007a) discusses Credit Suisse in greater detail.
9. This argument has long been accepted in the economics literature, first introduced in
Klein and Murphy (1988), and later formalized in Mathewson and Winter (1998). Until
Leegin, antitrust analysis had focused primarily on Telser’s (1960) pathbreaking but
narrow ‘discount dealer’ free-riding analysis which did not explain many uses of RPM
observed in practice.
10. The author participated in this case as a signatory to the Law Professors’ Amicus Brief
in Support of Petitioner (filed 24 Aug. 2006).
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24 Financial-market contracting
Dean V. Williamson
Should a firm finance a project with non-recourse debt – that is, with debt
that affords creditors recourse to nothing more than the project-specific
assets in the event of default? Alternatively, should the firm finance a
project with corporate-level debt – that is, with debt that affords credi-
tors recourse to other assets in the firm? Should the firm even finance the
project with infusions from equity investors? Finally, should the firm
adopt a ‘financial structure’ that features a combination of debt and equity
financing?
These questions suggest that the firm might perceive tradeoffs in adopt-
ing one financial structure over another. While it may be easy enough to
pose tradeoffs, characterizing optimal structures is a rich and interesting
problem. To begin, the irrelevance theorems of Modigliani and Miller
(1958) indicated that one can identify environments in which no particu-
lar structure dominates in equilibrium. The results motivated prodigious
streams of research about how different structures can dominate, yet, forty
years on Hart and Moore (1998, p. 1) could still observe that ‘economists
do not yet have a fully satisfactory theory of debt finance (or of the differ-
ences between debt and equity)’.
To fix ideas, consider the decision of one entity (the ‘firm’, say) to
finance a discrete project with a financial contract called ‘debt’ by which
the firm yields to another party (the ‘investor’) a non-contingent stream
of payments and a right to foreclose – that is, with the right to march in
and demand the redeployment of assets in the event of default. Alternative
financial contracts might feature state-contingent streams of payments
and other control rights in addition to (or in place of) the foreclosure right.
The firm might also, at some cost, assemble governance mechanisms such
as auditing schemes or accounting schemes to allow investors to monitor
streams of payments.
Three things (among many) that a fuller theory might yet do in such a
context are: (1) characterize the bundling of types of payment streams with
particular control rights; (2) characterize the alignment of these bundles
with supporting governance mechanisms; and (3) the financial structure
question: characterize the selection of debt financing, equity financing, or
some combination of financing for a given project. First consider control
rights. We traditionally understand ‘debt’ as a contract that bundles a
244
Financial-market contracting 245
non-contingent stream of payments with a foreclosure right. Yet, as Hart

and Moore (1998) observe, it is not obvious that such a foreclosure right
should necessarily be bundled with non-contingent payments schemes.
Why not bundle them with state-contingent schemes or dispense with
them entirely?
Now consider governance mechanisms. Williamson (1996, Chapter 4)
suggests that parties to exchange select contracts and support govern-
ance mechanisms simultaneously. Financial contracts are no exception
(Williamson, 1988). For example, problems of asymmetric information
can complicate the implementation of state-contingent payment schemes,
because informed parties within the firm might be able to underreport pro-
ceeds and cheat investors. Accordingly, the firm might find itself having
to assemble costly mechanisms such as auditing schemes so that equity
investors may monitor the state-contingent payment streams that attend
equity. An advantage of debt is that non-contingent streams require less
monitoring; creditors need not know all the details about all streams
flowing into the firm. In turn, the firm might choose to dispense with
certain costly mechanisms and secure debt financing.
Finally consider the selection of debt or equity. If debt requires fewer
costly support mechanisms than equity, then why should not debt domi-
nate? Williamson (1988, pp. 579–81) poses an hypothesis by which the
selection of debt or equity is driven by asset-specificity – the degree to
which the redeployment of assets dedicated to a project would induce the
dissipation of surplus. In a stick-figure version of the argument, the debt-
versus-equity question amounts to a ‘rules-versus-discretion’ tradeoff by
which debt corresponds to a more rigid, rules-oriented mode of financing
and equity constitutes a more flexible, discretion-oriented mode of financ-
ing. In the event of default, control of the underlying assets reverts to the
creditor, in which case the creditor may exercise his option to demand
redeployment. The creditor may yet exercise some discretion and allow the
debtor to ‘work things out’, but the advantage of an equity-based regime
is that it features administrative processes that are specifically designed
to facilitate ‘working things out’.1 While there would be little demand to
work things out in cases involving highly redeployable assets, demands
increase as redeployability diminishes. In cases featuring highly specialized
assets, equity-based schemes dominate.
Note what is going on. Hart and Moore (1998) go some way toward
endogenizing the bundling of control rights with payment streams.
Williamson (1988) takes such bundles as given but goes some way toward
endogenizing the matching of these bundles to supporting governance
mechanisms. Along the way Williamson (1988) provides a contract selec-
tion hypothesis. In this chapter I describe two empirical exercises in which
I exploit the contract selection hypothesis of Williamson (1988). One of

the exercises is similar to that of Hart and Moore (1998) in one respect:
it goes some way toward endogenizing the bundling of particular control
rights with either debt or equity financing. A difference is that these par-
ticular control rights are indicated in contracts distinct from the financial
contracts. Specifically, I examine an environment in which contracting
parties commit to (possibly) long-term exchange. They have to line up
project-specific financing, and they indicate terms of exchange in separate,
long-term contracts. I characterize interactions between types of financing
and the structure of the long-term contracts.
In both empirical exercises I also do something which is much the
converse of the governance hypothesis featured in Williamson (1988).
Williamson (1988) suggests that parties actively assemble governance
mechanisms to support different types of financial contracts. That is,
parties meet demand for governance by actively supplying governance.
I examine problems in which parties may sometimes be less equipped to
assemble governance mechanisms but rather must exploit features of the
institutional environment to govern their relationships. They thus end up
adapting demands for governance (by adapting contracts) to the existing
supply of governance mechanisms.
Note that the idea that parties may sometimes adapt demands for govern-
ance to supply of governance instead of adapting supply to meet demand
suggests a fourth consideration that a fuller theory of financial structure
might accommodate: how do the design of contracts, the design of sup-
porting governance structures, and the selection of contracts interact with
the institutional environment? There is some related work on this count.
Levy and Spiller (1994) explore how the design of regulatory regimes varies
across political environments. Oxley (1999) explores how parties to collabo-
rative R&D adapt governance structures to differences across environments
in intellectual property protection. Silva and Azevedo (2007) characterize
how parties adapt franchising contracts across legal regimes.
All of the discussion in the next three parts of the chapter focuses on
the financing of discrete projects with debt or equity-like financing. In the
first part I characterize the design of electricity marketing contracts. These
contracts are interesting, because they are designed to support the financ-
ing of electricity generation projects. In the second part I characterize the
financing of overseas trade ventures in the Eastern Mediterranean in the
years 1190–1220 and 1300–1400. The financing of trade also posed a debt-
versus-equity problem. It also constitutes an example of how financial
structure could vary with differences across institutional environments.
The medieval traders may have had less capacity to actively design mecha-
nisms to support financing, but in some environments they could exploit
features of the environment to support equity-like schemes. Other envi-

ronments featured less in the way of institutional supports, and medieval
traders found themselves having to resort to debt financing. The last part
of the chapter concludes.
The financial structure of electricity marketing contracts

Firms that develop generation facilities (‘generators’) tell a compelling
but incomplete story about how they organize the financing of electric-
ity generation facilities. They line up long-term contracts with electricity
‘marketers’. Contracts generally run as long as the expected life of the gen-
erating assets; the parties often specify contract duration longer than 20
years, although there is much variation in contract terms. Marketers trade
electricity on wholesale electricity markets, and they often secure ‘dispatch
rights’ from generators – rights to make real-time demands for electricity
generation as well as demands to cease generation.2 In return, marketers
often compensate generators according to two-part schemes. The variable
part of the scheme compensates generators for their operating costs, and
generators extract profits through the fixed part of the scheme. Marketers
end up bearing risk for generators, and generators turn around and appeal
to prospective creditors (‘the bank’) for loans in the order of $100 million
to finance the construction or acquisition of electricity generation capac-
ity. Indeed, generators report that they need to line up two-part compen-
sation in order to motivate creditors to finance investment in generation
capacity that can support timely dispatch demands.3
One reason the story is incomplete is that it does not indicate why assign-
ing the marketing risk to the marketer makes it easier for the generator to
secure debt financing. Another reason is that the story does not indicate
why debt financing should dominate. Finally, the story does not explain
one other common feature of electricity marketing contracts: contracts
that include two-part compensation and long terms often feature provi-
sions that allow the marketer to effectively veto the proposals of the gen-
erator to add, tune-up, or withdraw generation capacity over the course
of long-term exchange. In a project titled ‘Adaptation and Renegotiation
in Long-term Exchange Relations: Evidence from Electricity Marketing
Contracts’ (Williamson, 2007), I provide both theory and evidence from a
dataset of 101 electricity marketing contracts about how generators mar-
keters use four instruments – contract duration, compensation schemes,
financial structure, and veto provisions – to support the financing of
project-specific assets and to address demands for contract adjustments
over the course of long-term exchange.
The project joins two types of hypotheses drawn from transaction cost
economics (TCE). One is that adapting relationships over the course of
long-term exchange is an important economic problem. It is economic,

because there can be tradeoffs between the ways contracting parties might
address demands to adapt the terms of exchange. That leads to an ‘effi-
cient adaptation’ hypothesis in the spirit of those developed in such classic
studies as Masten and Crocker (1985), Crocker and Masten (1988), and
Crocker and Reynolds (1993). The second exploits the selection hypoth-
esis of Williamson (1988). If one accepts that generation assets are highly
redeployable outside of any relationship between a specific generator and
specific marketer, then debt financing should dominate.
I operationalize the efficient adaptation hypothesis and the selection
hypothesis in a reduced form model. That in itself is not interesting. What
is interesting is that the modeling exercise suggests a simple narrative
about how electricity marketing contracts work, and it provides stark
predictions about patterns that should emerge in the contract data. Even
more interesting is the fact that these patterns actually obtain. First, con-
sider the narrative: suppose a generator and marketer commit to a 20-year
contract by which the marketer secures dispatch rights in exchange for
a two-part stream of payments to the generator. Having effectively sold
off its generation capacity for a fixed fee, the generator may perceive a
private benefit to expanding capacity on site or at a nearby site and selling
off that capacity under another contract with a different marketer. A dif-
ficulty with expanding capacity is that it could frustrate the ability of the
marketer to commercialize the capacity that is already under contract.
One way to accommodate this problem is to give the marketer the right to
impose renegotiation over the terms of the contract – or at least over the
fixed fee in the two-part compensation scheme – whenever the generator
proposes to add, withdraw or tune-up capacity. One way to enable the
marketer to impose renegotiation is to give it the right to exit the relation-
ship in response to any proposal by the generator. An alternative is to
assign to the marketer the right to veto proposals.
The key point about veto provisions is not that parties exercise them
out of hand but rather that they use them to impose renegotiation. So,
for example, if a proposal to add capacity would diminish the vertical
rent that the parties collectively perceive, then the marketer should be
expected to exercise its veto. In contrast, it is reasonable to expect that
over time the parties would collectively perceive opportunities to increase
the vertical rent by increasing capacity. In such cases the threat of the
veto allows the marketer to impose adjustment of the fixed fee in order
to secure its participation. Thus, the veto allows the parties to achieve
efficient (rent-increasing) adaptations in capacity and to avoid inefficient
(rent-diminishing) changes in capacity.
Note that there may be alternatives to veto provisions. If parties can
anticipate expanding capacity after a short term, then they could replace
a long-term contract with a sequence of short term contracts. A problem
with short-term contracting, however, is that it amounts to programming
a sequence of (possibly) costly renegotiations. Alternatively, parties might
choose to dispense with two-part compensation and impose some of the
market risk on the generator. Sometimes parties commit to ‘linear’ com-
pensation by which the marketer pays the generator a fee per unit output
(kilowatt hour). Linear compensation induces the generator to internalize
some of the effects of changing capacity, and the parties may be able to
dispense with veto provisions. A difficulty is that linear compensation may
complicate the effort to line up debt financing.
The question of why linear compensation may complicate debt financ-
ing is nontrivial. I pose a monitoring hypothesis in the spirit of ‘delegated
monitoring’ (Diamond, 1984) by which contracting parties effectively
exploit monitoring mechanisms situated elsewhere in the institutional
environment. A marketer may have its hand in a broad portfolio of
projects with any number of generators. Pooling streams from different
projects amounts to pooling risks, but pooling risks may make it more
difficult for outside investors to disentangle and monitor streams, thus cre-
ating demands for costly auditing schemes. The generator, however, may
separately incorporate each of its production projects. In the language of
Hansmann and Kraakman (2000), the generator may be able to ‘partition
assets’ across separately incorporated entities so that outside investors
may forgo the costs of disentangling any one project’s streams from those
of other projects. But risky streams still require monitoring, because gen-
erators might cheat investors by misrepresenting their payoffs. However,
imposing two-part compensation relieves the generator of project-specific
risk and, in turn, relieves outside investors of having to bear incremental
monitoring and auditing costs (D. Williamson, 2005). Thus, imposing
the residual claims on the marketer still enables risk pooling, but it also
enables parties to economize on auditing and monitoring costs; investors
need only concentrate the lens of costly auditing and monitoring on the
marketer.
Taken all together, the discussion suggests that contract duration,
financial structure (debt or equity), compensation (two-part or linear),
and veto provisions are simultaneously determined. The reduced form
model captures interactions between these four instruments and yields
two types of results. First, the model yields dominance results. One result
is that contracts should not feature both linear compensation and veto
provisions. Second, the model yields patterns of complementarity and
substitution between the four instruments. Three patterns that are robust
over all degrees of redeployability are: (1) contract duration and veto
Table 24.1 Dominance results
Veto provision No veto Total

Marketer bears risk 21 45 66
Parties share risk – 29 29
Total 21 74 95
provisions are complements; (2) veto provisions and two-part compensa-

tion are complements; (3) two-part compensation and debt financing are
complements.4
The dominance result is immediate. Of the 95 contracts in the dataset
that exclude wind-driven generation, 21 feature veto provisions and 29
feature linear compensation, but none feature the combination of linear
compensation and veto provisions.5 (See Table 24.1.) The complementa-
rity results require more preparation. The first step toward operational-
izing analysis was to pose the hypothesis that one can understand the
contracting problem as a system composed of a continuous choice (con-
tract duration) and three binary choices (debt or equity, two-part or linear
compensation, veto or no veto). The simultaneity of these choices implies
a problem of simultaneous discrete choice – a hard econometric problem.
I finesse the problem by appealing to various ‘full information’ and ‘single-
equation’ methods, each of which has its advantages and drawbacks.
First, I impose the ‘linear probability model’ on the discrete choices – that
is, I treat each binary choice as a continuous variable. I then apply three-
stage least squares (3SLS) to the system. I first estimate a system of three
equations that features a ‘duration equation’, a ‘compensation equation’,
and a ‘veto equation’. I exclude a fourth ‘debt equation’, because all of the
generation projects were financed with debt.
The system I estimated corresponded to a linearized version of the
model:
LogTermi 5 aT 1 bTsTwoParti 1 bTvVetoi 1 gTWTi 1 eTi

TwoParti 5 as 1 bsTLogTermi 1 bsvVetoi 1 gsWsi 1 esi
Vetoi 5 av 1 bvTLogTermi 1 bvsTwoParti 1 gvWvi 1 evi
where i = 1, . . ., 101, WTi and Wvi are vectors of variables that reflect
demands for adaptation, Wsi includes variables that reflect the feasibility
of timely dispatch, and the error terms eTi, esi, and evi indicate potentially
non-normal processes. I then demonstrate that the complementarity of
contract duration (Term) and veto provisions (Veto) implies bTv . 0 and
bvT . 0 in the linearized model. The complementarity of veto provisions

(Veto) and two-part compensation (TwoPart) implies bsv . 0 and bvs . 0.
Applying the linear probability model may induce heteroskedastic
residuals. Bootstrap methods can be applied to 3SLS (Freedman and
Peters, 1984; MacKinnon, 2002), and boostrapping data directly (‘pairs’
bootstrap), in contrast to bootstrapping residuals from the original esti-
mation, constitutes a method of generating standard errors and confidence
intervals that are robust to heteroskedasticity (MacKinnon, 2006, p. S7;
Johnston and Dinardo, 1997, p. 369). Nevitt and Hancock (2001) further
observe that the bootstrap provides an alternative and often superior
means of generating standard errors with small datasets featuring data
that may be non-normal.
As a robustness check, I also apply single-equation methods such as
two-stage least squares (with and without bootstrapped standard errors)
and the two-stage conditional maximum likelihood method (2SCML) of
Rivers and Vuong (1988).6 As Petrin and Train (2003) observe, 2SCML
constitutes an application of the ‘control function’ approach to probit
models. (For accessible discussions, see Alvarez and Glasgow, 1999 and
Wooldridge, 2002, p. 474.) It is a single equation method that accommo-
dates continuous endogenous explanatory variables and provides simple
Hausman-like ‘endogeneity tests’ (Hausman, 1978) of both continuous
and discrete explanatory variables (Rivers and Vuong, 1998, p. 358;
Wooldridge, 2002, p. 474).7
All of the methods I applied yielded affirmative and statistically sig-
nificant complementarity results. The results indicate that longer-term
contracts tend to feature veto provisions, and veto provisions tend to
accompany two-part compensation. These complementarity results and
the dominance results are consistent with the larger hypothesis that ‘effi-
cient adaptation’ drives the design of contracts and choice of financial
structure.
The financial structure of long-distance trade

Histories of trade in the Mediterranean in the late Middle Ages assign a
pivotal role to equity-like principal–agent contracts known generically
as commenda. Commenda would join investors (‘merchants’) and trading
agents in seasonal trade ventures. An investor would advance capital in
specie or in kind. The agent would often commit to following an itinerary
in and around the Mediterranean, trading at ports along the way as he
would see fit. Sometimes the investor yielded to the agent complete control
over the itinerary. All contracts indicated a term, almost never longer than
a year, and usually limited to three months or six months. At termination
the agent would be called to account for transactions executed over the
course of the contract term, and parties would share proceeds according to
a compensation scheme. Almost universally, the investor would agree to
bear losses from physical losses (for example, shipwreck or piracy) when-
ever such losses could be ‘clearly proven’.8
The one feature of commenda contracts that continues to be the focus of
attention is the equity-like schemes by which the contracting parties would
share proceeds from transactions the agent would have executed over the
term of the contract. Parties typically shared proceeds in proportions half/
half, two-thirds/one-third, and three-quarters/one-quarter with the larger
portion going to the investor. According to the traditional historical nar-
rative, the function of these schemes was to allow parties to share risks;
risk-sharing helped mobilize investment in overseas trade; overseas trade
drove economic growth; equity-like schemes financed trade at the frontiers
of the Mediterranean trade economy.
While risk-sharing may have been an important consideration, the tra-
ditional narrative as well as any other studies that focus on commenda con-
tracts suffer one great limitation: they fail to recognize a larger contract
selection problem. Evidence from contracts between investors and trading
agents operating out of Venice from 1190–1220 and out of Venetian Crete
from 1300–1400 indicates that more often parties financed trade ventures
with simple debt contracts rather than with commenda. Of the 1567
contracts I have reviewed, over 52 percent were loans by which agents
assumed the residual claim; investors loaned capital to trading agents thus
effectively selling to agents for a fixed fee the right to conduct a particular
venture.9 Another debt-versus-equity question obtains.
I pose a contract selection hypothesis according to which contracting
parties match contingent and non-contingent compensation schemes
(commenda and debt contracts, respectively) to features of the institu-
tional environment. While characterizing the selection of compensation
schemes is hardly a novel problem,10 it constitutes but one dimension of a
much larger problem. Specifically, the investor’s and agent’s contracting
problem involved at least three simultaneous, interacting processes: (1) a
matching of investors to agents; (2) the selection of ventures; and (3) the
selection of compensation schemes. The matching problem involved a
complicated ‘many-to-many’ match in that any one party might conduct
a venture for some number of investors and could turn around and invest
in ventures conducted by other agents. The matching problem likely inter-
acted with the sorting of agents and investors across candidate ventures.
At the same time, the selection of ventures likely interacted with the selec-
tion of compensation schemes. Finally, insofar as risk-preferences varied
across investors and agents, the selection of compensation schemes may
have interacted with the matching of investors and agents.
While there exist many theoretical and empirical studies on matching

problems and no fewer studies on the selection of compensation schemes,
few studies simultaneously characterize matching and contract selection.11
My focus here is on the contract selection problem. I suggest that one can
understand it as a problem of ex post hidden information: both parties to
contract would contribute complementary inputs (capital and labour) to
the production of a venture; output may have been uncertain, but only
one party (the trading agent) could observe output. Thus, there was some
prospect that the agent could cheat the investor after the resolution of
uncertainty by underreporting output and expropriating the unreported
returns. If one poses output as the agent’s ‘type’, then one can understand
the contracting problem as one of having to commit to a (possibly) type-
contingent compensation scheme before the agent learns his type – hence,
ex post rather than the usual ex ante hidden information. By this interpre-
tation, the commenda contract corresponded to type-contingent compen-
sation whereas debt corresponded to compensation that was invariant to
the agent’s type.
The standard approach to problems of hidden information is to craft
contracts that join (potentially) type-contingent compensation schemes
with at least one other type-contingent instrument. In contexts involving
problems of ex ante hidden information, the contract designers might be
able to post a type-contingent menu of contracts that induces agents to
reveal their types by self-selecting into different contracts; the contract
design problem may feature a well-defined ‘sorting condition’. In contexts
involving ex post hidden information, the designer has the appearance of
being restricted to posting only a single contract, but interactions between
type-contingent compensation and other type-contingent instruments may
yet induce agents to sort themselves in a way that reveals their underly-
ing types. So, for example, in the literature on ‘costly state falsification’
inspired by Townsend (1979), auditing schemes constitute the other instru-
ment: contracting parties are endowed with a costly auditing technology,
and a contracts map agents’ reports of their types into levels of compensa-
tion and into some probability of agents’ reports being subjected to audit.
Contracting parties might be able to commit to a schedule of compensa-
tion and probablisitic auditing that induces the agent to reveal his type.
As a matter of theory, it is easy to come up with mathematically isomor-
phic instruments that contracting parties might exploit to induce truthful
reporting. Faure-Grimaud and Mariotti (1999) observe, for example, that
expanding a principal–agent problem featuring one-shot interactions to
one that permits follow-on exchange between the contracting parties may
allow the parties to operationalize a broad range of other instruments.
Crocker and Morgan (1998) indicate a less obvious class of instruments in
an environment featuring one-shot exchange. Agents might be endowed

with costly falsification technologies: an agent might bear some cost in
order to misrepresent his type. Insofar as the costs of falsification vary
across types, then the parties might want to induce self-selection and
support type-contingent compensation schemes.
Faure-Grimaud and Mariotti (1999) observe that, as a matter of theory,
contracts that feature non-contingent compensation – that is, contracts
that look like debt – are not very general given that contracting parties
might be able to operationalize any one of a broad range of mathematically
isomorphic ‘other’ instruments. Debt-like contracts may yet correspond to
optimal contracts even when parties have access to other instruments,
but a separate conclusion is that non-contingent compensation obtains in
environments in which parties are unable to operationalize other instru-
ments. It is this conclusion I exploit here: in some environments contract-
ing parties could tap into streams of information relevant to an agent’s
reported transactions. In these environments, the parties could detect
cheating and could, in turn, operationalize other instruments. I am agnos-
tic on what those other instruments are, but reputation mechanisms or
probablisitic reward/punishment schemes could support type-contingent
compensation. In other environments, contracting parties were denied
access to transaction-relevant information and could not operationalize
auditing schemes. They were thus denied access to other instruments. In
these environments, non-contingent compensation prevailed.
Note that the decision of contracting parties to operate in one environ-
ment or the other amounts to resolving the venture selection problem.
A difficulty is that the contract data alone does not provide a means of
subjecting the venture selection problem to econometric analysis. I put
that problem aside and note that it does not preclude all analysis of the
contract selection problem. I pose a contract selection hypothesis that
is conditional on the selection of types of ventures: one can partition the
contract data into two sets. One set corresponds to ventures parties con-
ducted in conjunction with regular convoys and trade fairs organized by
the state, the Republic of Venice. The other set is composed of all other
contracts. State-sponsored convoys traveled between major trade hubs
in and around the Eastern Mediterranean. Traveling with a convoy to
trade in major hubs amounted to choosing to trade in an information-rich
environment – the kind of environment in which one could detect (if not
verify) cheating. In such environments, parties had the option of choosing
equity-like financing. Deviating from trade along established routes served
by regular convoys amounted to choosing to trade in environments that
featured little in the way of transaction-relevant information parties could
use to police cheating. In such environments, debt contracting prevailed.
The Republic of Venice managed to assemble a combination of regular

convoys and trade fairs in Venice from 1190–1220. The convoys included
convoys dedicated to supporting a trade with Egypt that the Republic had
already maintained for some centuries. The trade with Egypt focused on
agricultural commodities such as pepper. Contrast the experience from
1291 to 1370. In these years the Republic only managed to sporadically
organize convoys, if not corresponding trade fairs, to Egypt. In the 1330s
and 1340s, Italy suffered severe famines, and then plague (the Black Death)
invaded the Mediterranean in 1347. Plague broke out again in the 1360s.
The few convoys to Egypt that were organized in these years focused on
the acquisition of grain. Post-1370 the convoys to Egypt that the Republic
did assemble had become overshadowed by a new convoy route linking
Venice to the Levant via Beirut (Ashtor, 1975).
The data specific to convoy traffic and to trade with Egypt enable three
simple quasi-experiments. The data from 1190–1220 feature ventures
organized around regular, state-sponsored convoys and all other ventures.
The prediction is that ventures specific to convoys and the Venetian trade
fairs could support commenda contracts and that all other ventures would
be less likely to support commenda. These same data indicate the family
relationships (if any) of the contracting parties. One might speculate
that family bonds could support commenda contracts. What one finds,
however, is that while related parties tended to select commenda, they
also tended to select convoy-specific ventures. Thus, it is not obvious at
all that contracting parties appealed to family bonds as a way of policing
cheating. Family bonds served other purposes. Finally, the data support
a comparison of trade between Venice and Egypt from 1190–1220 – trade
that was convoy-specific – to trade between Venetian Crete and Egypt
from 1300–1400. The latter trade was less likely to be organized around
trade fairs and regular, state-sponsored convoys. The prediction is that
parties could support commenda contracts in the convoy-specific trade but
that debt should dominate the other trade with Egypt.
The results are plain for each experiment. Consider the alignment of
contracts with regular, state-sponsored convoys. Table 24.2 indicates the
cross-tabulation of a binary variable ‘Convoy’ with type of contract (com-
menda or debt) for the 56 extant contracts from 1190–1220. Of 33 con-
tracts that parties aligned with a convoy, 32 were commenda and only one
was debt. Of the 23 contracts not aligned with a convoy 12 were commenda
and 11 were debt. How contracting parties supported these 12 unaligned
commenda is unknown, but the data are consistent with the hypothesis
that parties could exploit features of the institutional environment (the
state-sponsored convoys) to support contracts featuring contingent
compensation schemes.
Table 24.2 The financial structure of contracts organized around the

convoys, 1190–1220
Convoy No convoy Total

Commenda 32 12 44
Debt 1 11 12
Total 33 23 56
Table 24.3 The financial structure of contracts organized around kinship

relations, 1190–1220
Family relation No relation Total

Commenda 14 30 44
Debt – 12 12
Total 14 42 56
Table 24.4 The distribution of kinship relations and convoys, 1190–1220
Family relation No relation Total

Convoy 10 23 33
No convoy 4 19 23
Total 14 42 56
Now consider the role of family relations. At first sight, one would be
tempted to conclude that contracting parties exploited kinship relations to
support contingent compensation schemes. Table 24.3 features the cross-
tabulation of a binary variable ‘Family relation’ with type of contract. All
of the 14 contracts that featured a kinship relation between the contracting
parties were commenda contracts. Contracting parties selected the 12 debt
contracts only in cases featuring no documented family relationship. If
one ‘controls’ for the selection of ventures – specifically, if one controls for
the selection of convoys – then a different interpretation emerges. Table
24.4 indicates that of the 14 contracts featuring kinship relations, ten were
assigned to convoy-specific ventures and only four were not aligned with
convoys. One interpretation consistent with these results is that contracting
parties exploited trade coordinated around convoy traffic as a way of train-
ing younger family members and as a way of allowing younger members
to begin building up some capital of their own for future investments.12
Contracting parties did not rely on kinship relations to police cheating.
Table 24.5 The trade with Egypt
1190–1220 1303–1400
Commenda 15 6
Debt 3 100
Total 18 106
Finally, consider differences in the trade with Egypt between 1190–1220

and 1300–1400. Table 24.5 indicates the distribution of contract types over
these two intervals. Of the 18 contracts dedicated to trade between Egypt
and Venice from 1190–1220, 15 were commenda. In contrast, of the 106
contracts dedicated to trade with Egypt from 1300–1400, 100 were debt
contracts and only six were commenda.
Conclusion
I have suggested that a complete theory of financial structure would simul-
taneously accommodate the design of contracts, the design of supporting
governance structures, and the selection of contracts – a demanding order.
On top of that, I have suggested that a complete theory would accom-
modate interactions between these three factors and the institutional envi-
ronment. While no one theoretical or empirical study may accommodate
all four factors, different studies have taken up at least two factors at a
time. In this chapter I have outlined a study on the financing of electric-
ity marketing projects that takes up aspects (albeit not all aspects) of all
four factors. The study takes as given the bundling of foreclosure rights
with non-contingent payment streams in financial contracts we recognize
as ‘debt’. Yet, the study indicates the alignment of debt and equity with
control rights indicated in long-term contracts. The study goes on to indi-
cate how contracting parties use these control rights (veto provisions) and
other dimensions of contract to manage demands for adaptation over the
course of long-term exchange.
I have also outlined a second study on the financing of overseas trade
in the late Middle Ages. That study features a contract selection hypoth-
esis that lends itself to an interpretation of medieval contracting practices
that runs counter to the traditional historical narrative. The traditional
narrative focuses on the role of equity-like schemes in mobilizing invest-
ment in overseas trade. The narrative suggests that equity financed trade
at the frontiers of the trade economy, yet that same narrative fails to
characterize, much less recognize, a role for debt financing. An alternative
interpretation presented here is that merchants and their trading agents
could support equity-like financing in environments that featured external
supports. At the frontiers, however, contracting parties did not have

access to such supports and thus had to appeal to modes of financing that
would not require supports. Debt financing required little in the way of
institutional supports, and it was thus debt, not equity, that financed trade
at the frontiers of the trade economy.
Notes
1. A fuller account, rather than a ‘stick-figure’ account, would address the prospect of the
creditor exercising discretion. Williamson’s approach is to appeal to what amounts to
a theorem of transaction cost economics, ‘the impossibility of selective intervention’.
Williamson observes that ‘to combine rules with discretion will never realize the hypo-
thetical ideal but will always entail compromise’. (See Williamson, 1988, pp. 581–2.)
‘Put differently, the admonition to “follow the rules with discretion” is too facile.’
2. Certain types of generation capacity (for example, nuclear or coal-fired capacity) are
not suited to meeting time-sensitive dispatch demands. The optimal program is to
let them continuously pour electrons into the transmission grid to serve ‘baseload’
demands. In contrast, gas-fired generation capacity is better suited to meeting time-
sensitive demands at the margin. One can understand gas-fired generators as jet engines
bolted to the ground, and, indeed, they are manufactured by firms like General Electric
that also manufacture jet engines.
3. Contracting parties can get away with a ‘linear’ (one-part) fee per unit output ( kilowatt
hour) with baseload capacity. Wind-driven generation is a hybrid case. It depends on
the wind and thus cannot be counted on to serve marginal demands; contracting parties
use it to serve baseload demands and assign linear compensation to it.
4. These complementarity results derive from the value function implied by the model. It
turns out, however, that the value function is not supermodular in the four instruments,
so it was not possible to conduct analysis by appealing to monotone comparative
statics.
5. Wind-driven generation is a hybrid case that, strictly speaking, lies outside the scope of
the model. The dataset does include six contracts that feature wind-driven generation.
All six contracts feature linear compensation, and two feature veto provisions. The
model does not provide guidance on why contracts pertaining to wind-driven gen-
eration might feature veto provisions. One can speculate that the parties include veto
provisions to accommodate the fact that wind-driven generation is more dependent
on a regime of subsidies, and contracting parties might be sensitive to the prospect of
subsidies being withdrawn.
6. 2SCML involves including three new generated variables, ‘LogTerm Residuals’,
‘TwoPart Residuals’, and ‘Veto Residuals’ to single-equation estimation of the contract
duration equation and to estimation of probits for TwoPart and Veto. The residuals
derive from ordinary least squares regression of reduced-form equations – that is, from
separately regressing LogTerm, TwoPart and Veto on all of the exogenous variables
featured in the system. Applying 2SCML to the duration equation yields the same coef-
ficient estimates that one would obtain from two-stage least squares and yields virtually
the same standard errors (Davidson and MacKinnon, 1993, p. 240).
7. The tests amount to tests of the significance of the coefficients assigned to the generated
variables LogTerm Residuals, TwoPart Residuals, and Veto Residuals.
8. Example: in Candia (now Heraklion), Crete on 25 May 1335 Gregorio Langadhioti
advanced to Giorgio de Raynaldo capital composed of 483 ‘measures’ of bottled wine
valued at 22.5 Cretan hyperpers per 100 measures (almost 109 Cretan hyperpers in
all). The agent committed to conducting a round trip from Candia to Rhodes. Rhodes
constituted an important commercial hub through which trade from the Eastern
Mediterranean and the Aegean flowed. The parties committed to evenly sharing
proceeds from transactions Giorgio would conduct in Rhodes. As usual, the investor
committed to bearing physical losses. The contract is recorded in the logbook of the
notary Giovanni Gerardo in the notarial series Notai in Candia maintained at the State
Archives of Venice.
9. The data from 1300–1400 (1511 contracts) derive from the logbooks (‘cartularies’) of
25 notaries maintained at the State Archives of Venice. All of these data pertain to
trade ventures that merchants operating out of Crete had organized. The records of
only two notaries, Angelo de Cartura and Donato Fontanella, have been published
(See Stahl, 2000). One can find all of the records in the archival series Notai in Candia
maintained at the State Archives of Venice. The remaining data (56 contracts) from the
years 1190–1220 derive from the archival series the Cancelleria Inferiore maintained
at the State Archives of Venice. These data do not derive from notaries’ cartularies
but derive from contracts that individuals had maintained in family archives. Most of
the contracts pertain to trade ventures originating in Venice, although a few ventures
originated in other sites such as Constantinople. These contracts have been published in
Morozzo della Rocca and Lombardo (1940) and Lombardo and Morozzo della Rocca
(1953).
10. See, for example, the introduction of Allen and Lueck (1999) with respect to agricul-
tural tenancy contracts. Sharecropping alone has constituted an important and surpris-
ingly rich context for exploring the design of compensation schemes in principal-agent
contracts.
11. Ackerberg and Botticini (2002) is an exception. They examine a one-to-one matching
problem involving the matching of tenant farmers to land owners. They suggest that
insofar as risk-preferences vary across farmers and land owners, then matching may be
important and may interact with the selection of compensation schemes.
12. For example, in September 1217 Bartolomeo Bembo advanced to his son-in-law
Domenico Gradonico 200 Venetian lira with which Domenico would conduct transac-
tions in Puglia (the heel of Italy). Bembo would assume three-quarters of the proceeds
and would also assume physical losses. The venture was coordinated around the Easter-
season convoy. The agent was free to travel on whatever vessel he saw fit. See Morozzo
della Rocca and Lombardo (1940, pp. 112–13).
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Cambridge: MIT Press.
PART V
ALTERNATIVES AND
CRITIQUES
25 Critiques of transaction cost economics:
an overview
Ever since its emergence in the early 1970s (for example, Williamson
1971; Alchian and Demsetz, 1972; Furubotn and Pejovich, 1972; Arrow,
1974; Jensen and Meckling, 1976), the new institutional economics
(NIE) has been the subject of intense debate. As the most important
constituent body of thought in the NIE, transaction cost economics
(TCE) is no exception. Much of the debate on TCE has been ‘inter-
nal’, in the sense that it has been conducted between scholars generally
sympathetic to the approach (for example, Hart, 1995; Kreps, 1996;
Furubotn, 2002; MacLeod, 2002). However, there also is a large set of
‘external’ critiques, arising from sociologists, heterodox economists,
and management scholars. For instance, early critics argued that TCE
ignored the role of differential capabilities in structuring economic
organization (Richardson, 1972); neglected power relations (Perrow,
1986), trust, and other forms of social embeddedness (Granovetter,
1985); and overlooked evolutionary considerations, including Knightian
uncertainty and market processes (Langlois, 1984). Such critiques have
been echoed and refined in numerous more contemporary contribu-
tions, and criticizing TCE remains a thriving industry. The incumbents
are mainly sociologists (Freeland, 2002; Buskens, et al., 2003) and
non-mainstream economists (Hodgson, 1998; Loasby, 1999; Dosi and
Marengo, 2000), but new entrants are increasingly recruited from the
ranks of management scholars (Kogut and Zander, 1992; Conner and
Prahalad, 1996; Ghoshal and Moran, 1996). This chapter offers a brief
review and assessment of this critical literature. By no means do we
claim to be comprehensive; unavoidably many authors, papers, and
insights must be left out. However, we aim to capture what we see as the
fundamental critiques.
Basic characteristics of TCE
Coase and Williamson

The foundations of TCE were laid by Coase (1937, 1960). The starting
point for a transaction cost approach to governance and organizational
263
issues is Coase’s (1960) insight that if it were not for transaction costs,
all gains to trade would be exhausted and this could take place under
any organizational arrangement. This connects to Coase’s earlier paper
(Coase, 1937), for the argument in that paper is that the assessment of the
net benefits of organizational and governance alternatives must proceed
in terms of a comparative analysis of the costs of transacting under the
relevant alternatives (Barzel and Kochin, 1992).
In a string of influential contributions, Williamson (notably, 1975,
1985, 1996) has built a theory that while built on Coasian foundations
also incorporates ideas from psychology and contract law. The behav-
ioural starting points in Williamson’s theorizing are bounded rationality
and opportunism. Simon’s (1951) notion of bounded rationality implies
the presence of contractual incompleteness and, consequently, a need for
adaptive, sequential decision-making. Opportunism is defined as ‘self-
interest seeking with guile’ (Williamson, 1975, p. 255), and its implica-
tion is that contracts will often need various types of safeguards, such as
‘hostages’ (for example, the posting of a bond with the other party). The
unit of analysis in Williamson’s work is the multi-dimensional trans-
action. In addition to uncertainty (which is ‘frozen’), the dimensions
of transactions that are primarily determinative of the costs of those
transactions are frequency and asset specificity. The latter has increas-
ingly become the central independent variable in TCE analysis. Specific
assets open the door to opportunism. If contracts are incomplete due to
bounded rationality, they must be renegotiated as uncertainty unfolds,
and if a party to the contract (say, a supplier firm) has incurred sunk
costs in developing specific assets (including human capital), that other
party can opportunistically appropriate an undue part of the invest-
ment’s pay-off (‘quasi-rents’) by threatening to withdraw from the
relationship. This situation leads to an inefficient outcome. Efficiency
dictates the internalization within a firm of transactions that involve
highly specific assets. More generally, Williamson (1985, p. 68) argues
that variety in contracts and governance structures ‘is mainly explained
by underlying differences in the attributes of transactions’. The general
design principle of discriminating alignment dictates aligning trans-
actions that differ in the dimensions of uncertainty, frequency, and
asset specificity with governance structures which differ in the capaci-
ties to handle different transactions (compare the earlier discussion of
governance structures and governance mechanisms) in a transaction
cost economizing way. Thus, specific constellations of (values for) the
uncertainty, frequency, and asset specificity variables map directly into
specific governance structures. This is the main predictive content of
Williamsonian TCE.
Critiques of transaction cost economics 265
Fundamental characteristics of TCE

Here we briefly outline a number of fundamental characteristics of TCE.
Other characteristics may be identified; however, the characteristics below
are those that the critics have focused on.
Cognition Bounded rationality is usually invoked as a necessary part of

TCE. ‘But for bounded rationality’, Williamson argues (1996, p. 36), ‘all
issues of organization collapse in favor of comprehensive contracting of
either Arrow-Debreu or mechanism design kinds’. What Williamson calls
‘comprehensive contracting’ does not allow for ‘governance structures’ in
the sense of mechanisms that handle the coordination and incentive prob-
lems produced by unanticipated change (Williamson, 1996, Chapter 4).
Motivation Motivation is assumed to be extrinsic (Frey, 1997). Hence,

stronger monetary incentives call forth more effort (in at least one
dimension).
Explaining economic organization Problems of economic organization

are explained generically in terms of minimizing transaction costs related
to incentive conflicts, usually involving the holdup problem. TCE gener-
ally disregards coordination type problems; the problem is to align incen-
tives rather than to coordinate actions. Production costs play no direct
role in the explanation.
Everything is given The choice of efficient economic organization is por-

trayed as a standard maximization problem in the case of contract design
or as a choice between given ‘discrete, structural alternatives’ (Williamson,
1996) in the case of the choice of governance structure. At least in the
canonical Williamsonian versions of TCE, learning and innovation are
mostly excluded from consideration because of the complexities they
raise (Williamson 1985, pp. 141–4). There may be reference to processes
(other than the fundamental transformation), but this has the character of
pointing to evolutionary processes that are assumed to perform a sorting
between organizational forms in favour of the efficient ones (Williamson,
1985).
Criticizing TCE
Most of the above characteristics are not particular to TCE, but are gen-
erally present in game-theoretical microeconomics. Thus, critics of TCE
may appear to be really criticizing modern microeconomics. However,
while this may indeed be the case for some critics, the reason that TCE
has drawn particular fire may lie in its main explanandum, that is, the firm.
Thus, while some critics may balk at methodological individualism and

assumptions of full, instrumental rationality in general, they are likely to
find such assumptions particularly objectionable when they are applied to
the theory of the firm. Thus, in much of the literature that is critical of the
modern theory of the firm, firms are often portrayed in rosy terms as ‘mini-
societies’ (Freeland, 2002) that provide ‘identity’ (Kogut and Zander,
1996), ‘higher-order organizing principles’ (Kogut and Zander, 1992), trust
relations (Ghoshal and Moran, 1996), and collective learning (Hodgson,
1998) that, purportedly, ‘atomistic’ markets cannot provide. While we are
sceptical of such arguments, we acknowledge that they may point to unre-
solved issues and weak spots in TCE. In the following sections, we discuss
and assess a number of critiques of TCE in greater detail.
Cognition and motivation

While often invoked, the role of bounded rationality in Williamson’s work
is mainly to provide a reason why contracts are incomplete. The theory is
taken up with comparative institutional exercises, focusing on transaction
cost economizing, and hence has no room for the process aspects intro-
duced by more substantive notions of bounded rationality (for example,
Furubotn, 2002). However, Dow (1987) argues that it is inconsistent to
invoke bounded rationality as a necessary assumption in the analysis of
contracts and governance structures, and then assume that substantively
rational choices can be made with respect to the contracts and governance
structures (that are imperfect because of bounded rationality). In contrast,
bounded rationality has long been a central assumption in organization
theory (for example, March and Simon, 1958). In fact, recent critics of the
theory of the firm have drawn explicitly on these older sources to develop
alternative, evolutionary views emphasizing the role of bounded rational-
ity in problem-solving, and the role of firms as cognitive structures around
such problem-solving efforts (for example, Dosi and Marengo, 1994).
Other critics, also echoing behaviourist organization theory, argue that a
key characteristic of firms is that they tend to shape employee cognition
(Kogut and Zander, 1996; Hodgson, 1998).
While the role of bounded rationality in the theory of the firm has
given rise to a fair amount of debate, it is nothing compared to the enor-
mous amount of critical writings on the motivational assumptions in the
theory. In particular, opportunism has been a favourite bête-noire. The
critique of opportunism takes various forms. Empirically, the relevance
of opportunism is dismissed by pointing to the low frequency with which
opportunistic action can be observed, for example, in industrial networks
or in long-term associations between firms and their suppliers (see, for
example, Håkansson and Snehota, 1990). The obvious problem with such
arguments is that they are based on a misunderstanding of the counterfac-

tual nature of reasoning in the theory of the firm: opportunistic behaviour
is seldom observed because governance structures are chosen to mitigate
opportunism. Another argument asserts that opportunism is not a neces-
sary assumption in the theory of the firm (for example, Kogut and Zander,
1992), but this line of reasoning fails to provide convincing alternative
accounts.
According to a more recent and more sophisticated set of arguments, the
primary problem with the treatment of motivation in the theory of the firm
is not opportunism per se, but rather the assumption that all motivation
is of the ‘extrinsic’ type (Ghoshal and Moran, 1996; Osterloh and Frey,
2000). In other words, all behaviour is understood in terms of encourage-
ment from an external force, such as the expectance of a monetary reward.
(In contrast, when ‘intrinsically’ motivated, individuals wish to undertake
a task for its own sake). These arguments do not necessarily deny the
reality of opportunism, moral hazard, and so on, but assert that there are
other, more appropriate ways to handle these problems than providing
monetary incentives, sanctions, and monitoring. The arguments are often
based on social psychological research (notably Deci and Ryan, 1985) and
on experimental economics (for example, Fehr and Gächter, 2000).
Few transaction cost scholars have reacted to accommodate these
critiques. With respect to the bounded rationality point, we suspect this
is partly because taking these critiques seriously means questioning fun-
damental tenets of mainstream economic modelling. For example, taking
bounded rationality seriously opens up a Pandora’s box because bounded
rationality challenges the game-theoretic foundations underlying the
formal literature on the theory of the firm (that is, subjective expected
utility theory, the independence of payoff utilities, the irrelevance of label-
ling, and common prior beliefs (Camerer, 1998)). In our opinion, working
with alternative motivational assumptions may be a more fruitful way
forward. It is easier to doctor utility functions than cognitive assumptions.
There is established social psychology work, the insights of which may be
fed relatively directly into modelling efforts. Moreover, the implications
for economic organization may also seem more immediate (see Lazear,
1991, and Fehr and Gächter, 2000 for examples).
Firm heterogeneity, capabilities, and production costs

Many writers within heterodox economics (particularly evolutionary
economics) and strategic management embrace ‘capabilities’, ‘dynamic
capabilities’, or ‘competence’ approaches (for example, Langlois, 1992;
Kogut and Zander, 1992; Dosi and Marengo, 1994; Winter, 1991). These
writers have often been fiercely critical of TCE. The critique concerns the
reliance on opportunism and the neglect of differential capabilities (that is,

firm heterogeneity) and dynamics (for example, Winter, 1991; Langlois,
1992; Kogut and Zander, 1992) in TCE. Knowledge-based writers often
argue that differential capabilities give rise to different production costs,
and that such cost differentials may crucially influence the make or buy
decision. Thus, firms may internalize activities because they can carry out
these activities at lower production costs (not transactions costs) than
other firms. Some writers argue that the firms themselves can be explained
in knowledge-based terms, without reference to opportunism (Demsetz,
1988; Kogut and Zander, 1992; Hodgson, 2004). They argue that firms
can build capabilities and engage in learning efforts that markets cannot.
However, this is postulated rather than shown. Moreover a firm’s ability
to cultivate capabilities may depend on transaction cost considerations.
Capabilities are firm-specific assets that give rise to an appropriable quasi-
rent, and, hence, should be organized under unified governance.
While we are sceptical of the specific knowledge-based explanations
for economic organization, we acknowledge that the view does point to
some weak points in the theory of the firm. For example, differential capa-
bilities probably do play a role in determining the boundaries of the firm
(Walker and Weber, 1984; Monteverde, 1995; Argyres, 1996). However,
there are two major problems in this area that may hinder progress. The
first is that the nature of the central construct (that is, capabilities) itself is
highly unclear. It is not clear how capabilities are conceptualized, dimen-
sionalized, and measured, and it is not clear how capabilities emerge and
are changed by individual action (Abell et al., 2008). The second problem
partly follows from the first: the mechanisms that link capabilities and
economic organization are unclear (Foss, 2005).
Process issues
The claim that the theory of the firm, because of its emphasis on efficiency
at a point of time and on cross-sectional variation, is ahistorical and
neglects process has often been made by economists and management
scholars within both the knowledge-based and the evolutionary perspec-
tive (for example, Winter, 1991, p. 192).
One way to interpret this critique is that the theory of the firm seeks to
explain the governance of individual transactions (Williamson, 1996), or
clusters of attributes (Holmström and Milgrom, 1994), without identify-
ing how the governance of a particular transaction may depend on how
previous transactions were governed. Argyres and Liebeskind (1999) term
this historical dependency ‘governance inseparability’. Where governance
inseparability is present, firms may rely on governance structures that
appear inefficient at a particular time, but which make sense as part of a
longer-term process. Changes in governance structure affect not only the

transaction in question, but the entire temporal sequence of transactions.
This may make organizational form appear more ‘sticky’ than it really
is. This criticism will sound familiar to Austrian and evolutionary econo-
mists, who have long argued for a ‘process’ view of economic activity that
takes time seriously (Hayek, 1948; Kirzner, 1973).
Williamson (1996), recognizing the need to incorporate history into
TCE, has introduced the notion of remediableness as a welfare criterion.
The outcome of a path-dependent process is suboptimal, he argues, only if
it is remediable – that is, an alternative outcome can be implemented with
net gains. Merely pointing to a hypothetical superior outcome, if it is not
attainable, does not establish suboptimality. Thus, a governance structure
or contractual arrangement ‘for which no superior feasible alternative can
be described and implemented with expected net gains is presumed to be
efficient’ (Williamson, 1996, p. 7, original emphasis).
The explanation of economic organization in terms of efficiency has
been one of the most frequently criticized characteristics of the theory of
the firm: assuming that agents can figure out the efficient organizational
arrangements seems to collide with the assumption of bounded rationality
(Dow, 1987; Furubotn, 2002). Presumably in response to this problem,
early work in the theory of the firm often explicitly assumed that market
forces work to cause an ‘efficient sort’ between transactions and govern-
ance structures, an assumption that is not in general tenable. The problem
is that the efficiency assumption has always been taken as an essential, but
untested, background assumption.
However, one approach is to see if ‘appropriately’ organized firms –
that is, firms organized along the lines recommended by the theory of the
firm – outperform the feasible alternatives. Several papers in the empirical
TCE literature use a two-step procedure in which organizational form
(in particular, the relationship between transactional characteristics and
governance structure) is endogenously chosen in the first stage, then
used to explain performance in the second stage. By endogenizing both
organizational form and performance this approach also mitigates the
selection bias associated with OLS regressions of performance on firm
characteristics.
Conclusion
Two decades ago Paul Milgrom and John D. Roberts (1988, p. 450)
argued that the ‘incentive-based transaction costs theory has been made
to carry too much of the weight of explanation in the theory of organiza-
tions’, and predicted that ‘competing and complementary theories’ would
emerge, ‘theories that are founded on economizing on bounded rationality
and that pay more attention to changing technology and to evolutionary

considerations’. However, no serious competitors have emerged. One
possible reason is that TCE is sufficiently successful, theoretically and
empirically, that competitors have a hard time gaining a foothold. Still,
as we have stressed throughout this chapter, many of the critiques do in
fact point to weaknesses that should ideally be remedied. A further reason
is that the critics tend to focus on phenomena that are difficult to model.
Innovation, entrepreneurship, bounded rationality, learning, evolutionary
processes, and differential capabilities are examples of such phenomena.
Finally, the various critiques are not separate but overlapping or comple-
mentary. For example, the claim that TCE neglects bounded rationality is
very close to the claim that it ignores differential capabilities, learning, and
path dependence. In other words, the critiques come in a package, so that
embracing one critique may be taken as embracing the rest – which would
mean abandoning TCE as we know it.
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26 Subjectivism, understanding, and
transaction costs
Fu-Lai Tony Yu
Since Ronald Coase’s ‘The Nature of the Firm’ (1937), the concept of
transaction costs has been applied to a wide range of economic and man-
agement issues. The transaction cost paradigm, though widely accepted
and increasingly integrated into the mainstream neoclassical analysis, does
not lack criticisms. A major drawback of the transaction cost paradigm is
that the role of the entrepreneur is missing. Foss and Klein (2008, p. 428)
rightly point out that:
modern theories of the firm portray decision situations as always unambigu-

ous and ‘given’. The choice of efficient economic organization is portrayed as
a standard maximization problem . . . There is no learning, no need for entre-
preneurial creation or discovery, and explicit room for the emergence of new
contractual or organizational forms . . . [T]he strategy spaces are fully specified
ex ante.
The transaction cost theory of institutional change, as presented by

Washington School economists including Steven Cheung, Douglass
North, and Yoram Barzel, has also been charged with circular reasoning.
Sven-Erik Sjöstrand (1995, p. 34) notes:
in this paradigm, the institutional setting represents the individuals’ incentive

to act. At the same time, the institutions provide the standards for eliminating
‘failing’ attempts. We then ask what explains the possible motive for an indi-
vidual to do something new, something that is not part of the incentives built
into the existing institutions. To put differently, how is it possible to develop
new paths and institutions, when institutions themselves (as constraints) define
both incentives and outcomes?
Therefore, given a level of transaction costs, the transaction cost theory at

best indicates the direction of institutional change, but fails to explain the
origin of the change. This shortcoming is partly attributed to the fact that
scholars in the new institutional economics (NIE), like their neoclassical
economist counterparts, do not in general put human agency at the centre
of analysis. The roles of creative and proactive entrepreneurs in the forma-
tion of institutions are largely ignored.
This chapter outlines an alternative approach based on methodological
273
individualism, subjectivism, time, and process, particularly as those ele-

ments have been developed by the Austrian school of economics. The sub-
jectivist approach has important implications for the analysis of property
rights, transaction costs, and the firm.
A subjectivist approach to social cost, externalities, and transaction

costs
In 1960 Ronald Coase published ‘The Problem of Social Cost’. The term
‘social cost’ can make readers think that cost can be aggregated as the
concept of ‘social product’ in the Pigouvian paradigm. Corresponding
to James Buchanan (1969), cost can be viewed in both an objective and
a subjective dimension. Objectively, cost is measured directly in terms
of resource outlays. It is the market value of the alternative product that
might be produced by rational allocation of resources. Cost in this dimen-
sion is given and can be objectively identifiable. It is defined in the mecha-
nistic model of pure economic man or woman. The man or woman inside
this model does not choose, but behaves predictably in response to objec-
tively measurable changes in their environment (Buchanan, 1969, p. 42).
This cost concept is backward-looking in the sense that it can be calculated
by a third party such as an accountant, economist, or policy-maker.
Viewed subjectively, cost is defined as the perceived benefit lost by the
actor upon sacrificing a rejected alternative. This cost can only be per-
ceived and borne exclusively by the decision-maker and it is impossible
for the individual to shift cost to others (Buchanan, 1969, p. 49). Cost
exists only in the mind of the decision-maker and cannot be measured by
someone else. In this sense, ‘social cost’ and ‘social benefit’ can hardly exist
and be calculated by a third party. Because benefit is subjectively felt, it
is quite possible that benefits forsaken will be wrongly perceived, leading
to ex post regret. Thus, unlike what economics textbooks claim, ‘sunk
costs’ can influence decision-making. If an entrepreneur realizes he or she
has made a wrong decision, though he or she knows the decision cannot
be reversed, this wrongdoing experience will influence his or her future
outlook and choices.
An alternative way to deal with problems of social cost or externalities
is the subjectivist approach, or ‘first-person’ perspective (Addleson, 1995),
associated with the Austrian school of economics. Subjectivism as an
economic method does not deny the existence of objective facts. However,
all objective facts must go through the conscious mind of human agency
for interpretation or classification when formulating a plan or making a
choice. The ‘first-person’ approach in tackling the problems of externalities
becomes the issue of why the individual does not internalize the external
effects. It is the individual who assesses the problem situation and perceives
Subjectivism, understanding, and transaction costs 275
the cost associated with an action to internalize the external effect. The
subjectivist research program stresses difficulties and constraints encoun-
tered by the actor in dealing with negative externalities. Solving externali-
ties is thus a matter of experimentation and learning involving contractual
negotiations and arrangements. This process includes defining property
rights that have not yet been established. In the case of positive externali-
ties, many individuals simply never think of asking for compensation, for
example for maintaining a beautiful front yard.
Similar considerations apply to the analysis of transaction costs. In the
modern theory of the firm, transaction costs are objectively given and
computable. The economist’s job is to explain, given the nature and size
of the relevant transaction costs, the appropriate organization form or
institutional choice. In other words, economists attempt to understand,
ex post, why one form of contract or organization supersedes another
form. In the human-agency perspective, transaction costs are not treated
as static and given. Instead, they too are subjective in the sense that they
must be perceived and discovered by the entrepreneur. In the real world,
the entrepreneur perceives the level of transaction costs associated with a
new form of organization or contractual arrangement. Hence, transaction
costs can be defined as the subjective benefit forgone or utility lost by an
individual from sacrificing a rejected contractual arrangement or organi-
zational option. These costs include persuasion. Often, the entrepreneur
initially has a very vague concept about the new form of contract he or she
imagines. The entrepreneur experiments and evaluates different kinds of
imagined organizations in terms of perceived transaction costs. In doing
so, human agents create institutions that have not existed before.
A subjectivist approach can also be a good complement to the NIE in
understanding economic change. Max Weber and Alfred Schutz argue
that an action has a meaning attached to it as human agents make sense of
their everyday life. Making sense of the external world requires interpreta-
tion. Coordination involves understanding of actions and interpretation
of the meaning of other actors. Human agents interact with other people
in their everyday life; as they communicate with each other, they share
meaningful constructs with others in the social world. Hence, action is
intersubjective. Experiences from everyday life are accumulated into a
stock of knowledge that can be used to interpret incoming events and to
anticipate things to come (Schutz, 1970, p. 74). Whenever we encounter a
problem, we utilize our stock of knowledge or interpretive framework to
classify the situation and formulate a plan to deal with the problem. This
stock of knowledge grows with experience and is by no means homogene-
ous. Each stock has ‘a particular history’ (Schutz, 1970, p. 74). Due to
diverse experiences, human agents will respond differently to the same
objectively defined stimulus. In short, the interpretation framework allows

actors to make sense of the world and to solve problems. Without such
a framework, economic understanding, problem-solving, and strategic
management would be impossible.
The interpretation framework, originating from the actor’s lived experi-
ences, is a device of receiving external information and organizing it into
patterns. As soon as actors perceive an event, they can follow the estab-
lished interpretative channel and access all knowledge (meaning) about
that event. If incoming events are repeated and familiar, human agents
can utilize rules of thumb to solve problems. Economic activities are
then coordinated. However, if incoming events are novel, the established
interpretative framework may fail to give an adequate account of the
new environment – in other words, the stock of knowledge in the agent’s
mind is inapplicable to the new event. The agent then enters into a state
of conflicting experience. Given this situation, the agent may devise new
methods to solve the new problem. Agents learn to adopt new methods by
trial and error. Encountering uncertainty, they cope with their knowledge-
deficiency by creating temporary expectations that serve as knowledge
surrogates (White, 1977, p. 80). Schutz (1970) refers to this process as
projected action in the future perfect tense. In other words, the indi-
vidual projects and plans as if his or her action were already completed.
This knowledge surrogate will be tried out in the market. If it works, the
method will be adopted and routinized as a rule of thumb. The new stock
of knowledge can once again serve as an interpretative framework for the
agent to anticipate things to come and to coordinate economic activities.
Applications of subjectivism to firm structure, strategy, and institutional

change
The subjectivist, first-person approach outlined here has several implica-
tions for theoretical and applied research in transaction cost economics
(TCE) and related approaches to the firm and firm strategy.
Vertical integration
Building on the concept of dynamic transaction costs (Langlois and
Robertson, 1995, p. 35), the subjectivist perspective provides a useful
argument for vertical integration in the case of Schumpeterian innovation.
Given radical innovation, the stocks of knowledge of market participants
are unable to tackle new problems. Knowledge taken for granted becomes
problematic. The success of a radical innovation requires combination and
adaptation of complementary activities. In an economy in which people
interpret external events in routine manners, it is difficult for innovators to
make suppliers understand novel and idiosyncratic ideas. Accordingly, it
is costly to inform and persuade contracting parties to invest in specialized

assets. In many cases, suppliers may refuse to comply with the innova-
tor’s vision, and market coordination fails. Hence the entrepreneur may
need to integrate the cospecialized activities and employ those parties with
relevant skills rather than contracting them out (Langlois and Robertson,
1995). Within the integrated firm, the entrepreneur provides a set of rules,
which generally lay down clear lines of authority and communication with
the intention of ensuring that the entrepreneurial goal may be attained
(Silverman, 1970, p. 14). By asking its members to subordinate their own
motives to the officially defined goals, the firm ‘attempts de facto to sub-
stitute an objective context of meaning for the subjective configuration
in which the individual actor discovers the meaning of his or her action’
(Jehenson, 1973, p. 227). The world taken for granted inside the firm is
thus composed of individuals following typical courses of action prompted
by a set of common motives. Consequently, members of the firm are able
to catch the meanings associated with the actions of other people and
form a self-view based on the responses of others (Jehenson, 1973, p. 229).
In essence, they conform to a set of shared values, which is central to the
existence of a firm (Silverman, 1970, p. 131). In this regard, the firm is a
common environment for facilitating communication (Schutz, 1970).
Management of innovation
The human-agency perspective also sheds light on innovation policy, espe-
cially regarding consumer–producer interaction. Innovation strategies can
be explained in terms of knowledge creation and exploitation. Knowledge
can be classified as tacit or articulable (Cohen and Levinthal, 1990).
Tacit knowledge is personal, not easily formalized and communicable,
and rooted in a specific context. Articulable knowledge is explicit, codifi-
able, and transmittable with a formal or systematic language. Knowledge
creation is a social process that transforms tacit into articulable knowl-
edge (Cohen and Levinthal, 1990). This process requires direct and con-
tinual dialogues between people who are grounded in the same situation
(Nonaka, 1994). From the Schutzian perspective, knowledge arises from
the social construction of shared understandings, within a context of
previously constructed understandings. In other words, transmission of
an innovative idea will be facilitated if the parties share the same social
construction. Moreover, the world of knowledge is incoherent, only par-
tially clear, and not free from contradiction (Schutz, 1970, pp. 80–81).
One difficulty in the innovative process is that customers may not be able
to articulate their needs clearly and those needs may change as they learn
to use the product. This implies that the product’s attributes cannot be
easily specified and can change over time (Dougherty, 1992, p. 78). At the
same time, the product or technology may be new, meaning that techni-
cal problems may appear unexpectedly. This explains why entrepreneurs
must experiment with sets of attributes, work closely with customers, and
pursue multiple paths as they craft the comprehensive package of market
and technological characteristics into a viable product. Often, producers
have to imagine the product in use and develop a subjective sense for the
problem the product will solve for customers. They also examine how
customers perceive value, appreciate customers’ preferences and decision-
making processes, and try to understand how to specify customer needs
(Dougherty, 1992, pp. 78–81). Producers in this case are just like explorers.
They are engaged in an expedition with the aim of transferring tacit knowl-
edge into articulated knowledge. In doing so, they immerse themselves in
the community of their potential customers. They often use fieldwork to
help conceive the ways they can create value for potential customers by
synthesizing the firm’s technologies and capabilities into a variety of per-
formance possibilities or other product features. Face-to-face interaction
(Schutz, 1970, p. 189) with customers is an effective way of visualizing the
product (Dougherty, 1992, p. 82).
Advertising and persuasion

The most significant feature of advertising in modern society is its persua-
sive power. In neoclassical economics, advertising is explained as informa-
tion provision that can be bought and sold. In this paradigm, the (optimal)
amount of information can be calculated and delivered by the advertising
industry in response to consumers’ desires. Neoclassical economists con-
clude that extensive advertising to persuade potential customers under
rivalrous conditions is duplicative and wasteful. This argument ignores the
subjective evaluation of a commodity by consumers and fails to explain
the persuasive role of advertising.
While mental activity at the knowledge stage is mainly cognitive (or
knowing), the main type of thinking at the persuasion stage is affective
(or feeling) (Rogers, 1983, p. 170). Until consumers know about the new
product or idea, they cannot form an attitude towards it. In developing an
attitude towards the innovation, individuals may apply the new idea men-
tally to their present or anticipated future situations before deciding whether
to try it. In Rogers’ words (1983, p. 170), ‘the ability to think hypothetically
and counter-factually and to project into the future is an important mental
capacity at the persuasion stage where forward planning is involved’. The
function of an innovating firm is not only to present consumers with a
particular buying opportunity, but to present it to them so that they cannot
fail to ‘notice’ its availability. In other words, the supplier must get con-
sumers to notice and absorb that information. In this regard, it is therefore
unsurprising to find that a piece of information is repeated in top-rated TV

shows. More importantly, through persuasive promotion, consumers’ tastes
are altered. Advertising has the power to change the knowledge consumers
believe and possess concerning the factual state of the world. As mentioned,
human agents often take their experiences for granted (Schutz, 1970). Very
often, consumers’ perceptions of the external world are ‘locked in’ by their
experiences and therefore consumers show no interest in new consump-
tion opportunities even though they know of their existence. Advertising
helps consumers unlock their preoccupied knowledge and perceptions. It
is a process of unlearning. Furthermore, many products can be furnished
with new images through the use of famous celebrities. To consumers, the
product that has been promoted by a superstar is different from the product
that has not been so promoted. The former becomes another product with a
new perception and value. Advertising, when explained from the subjectiv-
ist perspective, is not a waste.
Institutional change
Institutions emerge as a result of human agents attempting to reduce
uncertainty. In the case of adaptive responses, institutions gradually
evolve as human agents modify their plans to coordinate economic activi-
ties better. Thus, most of the time, institutions are fairly stable and can
serve the function of coordination. However, institutions can change dras-
tically. The instability of institutions is attributable to creative responses
exerted by transformative entrepreneurs. Human agents on one hand
attempt to mitigate uncertainty. On the other hand, they also create
uncertainty by venturing into uncharted frontiers. Using their imagina-
tive powers, entrepreneurs initiate a disturbing impact on institutions and
create uncertainty in the market, which in turn alters the transaction costs
of economic activities and requires new property-rights systems. Facing
this situation, market participants will find that their stocks of knowledge
are inadequate to interpret the novel events. The existing institutional
frameworks are incapable of coordinating economic activities because
the meanings attached to them have changed significantly. The creative
response creates confusion in the market. Thus, new institutions are
needed for coordination.
Before new institutions emerge, gaps appear between the technical and
economic structure of the market and the institutions’ need for coordi-
nating new activities. This implies profit opportunities (Cheah, 1994). It
follows that if market participants can devise new methods to improve
coordination, they can reap rewards. Before this happens, opportunities
in the market remain unexploited. Given new technologies, new relative
prices and tastes, adaptive entrepreneurs soon identify and capitalize upon
these new opportunities by refining production methods, modifying and

improving models. In short, adaptive response follows creative response.
At the beginning, entrepreneurs are experimenting with various methods
to deal with the new situations. By trial and error, through learning, some
methods are found superior to others and therefore rewarded with profits.
Once an idea originally grasped by pioneering entrepreneurs has been
tested and found successful, it can be safely employed as a means to success
by imitative entrepreneurs. Imitators flock in as long as profit opportuni-
ties remain. Under keen competition, imitators modify their production or
transaction methods with the aim of improving profit margins. Gradually,
successful plans crystallize into new institutions and once again serve as
social coordinators.
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Unpublished Senior Honours Thesis, Harvard College, 31 March.
27 Austrian economics and the theory of the
firm
As the transaction cost theory of the firm was taking shape in the 1970s,
another important movement in economics was emerging: a revival of the
‘Austrian’ tradition in economic theory associated with such economists
as Ludwig von Mises and F.A. Hayek (Dolan, 1976; Spadaro, 1978). As
Oliver Williamson has pointed out, Austrian economics is among the
diverse sources for transaction cost economics (TCE) (Klein, 2010, pp.
187–193). In particular, Williamson frequently cites Hayek (for example,
Williamson, 1985, p. 8; 1991, p. 162), particularly Hayek’s emphasis
on adaptation as a key problem of economic organization (Hayek,
1945). Following Williamson’s lead, a reference to Hayek’s ‘The Use of
Knowledge in Society’ (Hayek, 1945) has become almost mandatory in
discussions of economic organization (for example, Ricketts, 1987, p. 59;
Milgrom and Roberts, 1992, p. 56; Douma and Schreuder, 1991, p. 9).
However, there are many other potential links between Austrian econom-
ics and TCE that have not been explored closely and exploited.
This chapter argues that characteristically Austrian ideas about prop-
erty, entrepreneurship, economic calculation, tacit knowledge, and the
temporal structure of capital have important implications for theories of
economic organization, TCE in particular. Austrian economists have not,
however, devoted substantial attention to the theory of the firm, preferring
to focus on business-cycle theory, welfare economics, political economy,
comparative economic systems, and other areas. Until the 1990s the theory
of the firm was an almost completely neglected area in Austrian econom-
ics, but since then, a small Austrian literature on the firm has emerged.1
While these works cover a wide variety of theoretical and applied topics,
their authors share the view that Austrian insights have something to offer
students of firm organization.
The Austrian school of economics

The Austrian school was born with the publication of Viennese Professor
Carl Menger’s Grundsätze der Volkwirtschaftslehre (Menger, 1871), making
the Austrian school one of the three great ‘marginalist’ traditions (along
with the approaches of William Stanley Jevons and Léon Walras). Menger
281
offered a unique account of the pricing process, the structure of capital,

and the causes of economic fluctuations, along with an emphasis on
explaining institutions, that differed substantially from the Marshallian,
Walrasian, and Keynesian approaches that came to dominate the econom-
ics profession. Like Jevons and Walras, Menger emphasized subjectively
held consumer wants as the source of economic value (as opposed to the
classical view that production costs determined value). Unlike the neoclas-
sical approach, however, Menger’s approach to economics was causal and
realistic, seeking to explain real-world prices and institutions in terms of
the subjective values, plans, and actions of market participants.
The Austrian school rose to prominence in the late nineteenth and early
twentieth centuries in Europe and the US under the influence of Menger,
Eugen von Böhm-Bawerk, Frank A. Fetter, Herbert J. Davenport, Philip
Wicksteed, Mises, Lionel Robbins, and Hayek, but fell into obscurity by
the end of the 1930s. Important contributions to the Austrian tradition
were added later by Mises (1949), Rothbard (1956, 1962, 1963a, 1963b),
Kirzner (1966, 1973), and Lachmann (1956), but at least publicly, the
Austrian tradition lay dormant. When the 1974 Nobel Prize in economics
went to Hayek, interest in the Austrian school was suddenly and unexpect-
edly revived. Already that year an ‘Austrian revival’ was underway, led by
students and followers of Rothbard and Kirzner (Dolan, 1976; Vaughn,
1994; Salerno, 2002). Since then, the modern Austrian school has become
an important ‘heterodox’ tradition within the milieu of contemporary eco-
nomics, now featuring its own academic journals, professional societies,
graduate programs, and sponsoring organizations.
Throughout its history, the Austrian school has developed many of its
key ideas as alternatives to other, more dominant perspectives. Menger’s
subjectivist, marginalist approach challenged the classical theory of value,
and Menger later engaged the German Historical School in a lengthy
debate on the proper scope and method of economics. Mises refined his
views on monetary calculation during the socialist calculation debate, and
Hayek developed and extended his and Mises’s theory of business cycles
in the course of several encounters with Keynes. Similarly, the Austrian
literature on the firm challenges important aspects of other, more popular
perspectives on economic organization, entrepreneurship, and strategic
management.
The Austrians as precursors to TCE

While the Austrians until recently had little to say about the theory of
the firm per se, problems of economic organization and its institutional
embodiment have always occupied centre stage within the Austrian tradi-
tion. This includes, most obviously, issues in comparative systems such as
Austrian economics and the theory of the firm 283
the socialist calculation debate (for example, Mises, 1920, 1936; Hayek,
1935, 1945; Lavoie, 1985). Indeed, it is surprising that the Austrians had
so many necessary ingredients for a theory of the firm and yet it was left
to non-Austrian Ronald Coase to frame and analyse the problem of the
existence, boundaries, and internal organization of the firm.
Kinds of orders
Perhaps the most pertinent overall distinctions to be made in a discussion
of economic organization are the ones between ‘pragmatic’ and ‘organic’
institutions (Menger, 1883) or ‘planned’ and ‘spontaneous orders’ (Hayek,
1973). While pragmatic institutions are the results of ‘socially teleologi-
cal causes’, organic institutions are ‘the unintended result of innumer-
able efforts of economic subjects pursuing individual interests’ (Menger,
1883, p. 158). Menger’s discussion aims primarily to explain the different
ways institutions arise, not how they are preserved, or their principles of
operation once established. Hayek’s (1973) distinction between planned
and spontaneous orders supplements Menger’s discussion in this regard,
because his distinction is based on the different organizing rules these
orders comprise. The rules supporting spontaneous order are abstract,
purpose-independent, and general, while the rules (or commands) sup-
porting a planned order are designed and specific in nature. Although
Hayek tends to distinguish sharply not only between spontaneous and
planned orders, but also between the relevant rules that direct them –
nomos and thesis, respectively – precise distinctions are difficult to draw:
spontaneous orders may be more or less general, planned orders may com-
prise elements of spontaneous orders, and so on. Obviously, the overall
distinction between planned and spontaneous orders closely parallels that
between ‘markets and hierarchies’ (Williamson, 1975), or ‘spontaneous’
and ‘intentional governance’ (Williamson, 1991).
The socialist calculation debate

Of course, the interwar debate on the economic efficiency of socialism is
a prime example of contrasting ‘spontaneous’ and ‘intentional’ modes of
governance, albeit on an economy-wide level. However, the debate yielded
numerous insights that have been important to later developments in the
theory of economic organization, including TCE, such as: (1) the insight
that welfare assessments of institutions and outcomes should not be based
on a ‘Nirvana approach’ (Demsetz, 1969); (2) the importance of change to
economic organization; (3) the understanding that an economic organi-
zation should be sensitive to the knowledge and rationality that agents
possess; and (4) an understanding of the principal–agent relationship
and the importance of incentives more generally (see Foss, 1994). Thus,
it is apparent already from Mises’s (1920) opening salvo in the debate

that what really irritated the Austrians was their socialist opponents’
use of unrealistic and unattainable standards of comparison. Naturally,
on such standards, capitalism would appear inefficient and wasteful. To
the Austrians, socialist economists (including the proponents of market
socialism) neglected the role of incentives (Mises, 1936; Hayek, 1940);
made unrealistic assumptions about the amounts of knowledge that agents
can possess (particularly the planning authorities); and formulated their
reasoning within static models that obscured all significant economic
problems. Mises, on the other hand, insisted that ‘the problem of economic
calculation is of economic dynamics; it is no problem of economic statics’
(Mises, 1936, p. 121), and Hayek later added that ‘economic problems
arise always and only in consequence of change’ (Hayek, 1945, p. 82). In
Salerno’s (1994, p. 121) words, Mises ‘makes it crystal clear that the static
prices mathematically imputed from perfect knowledge of the economic
data would not lead to a dynamically efficient allocation of resources. The
latter can only be achieved by the entrepreneurially appraised prices that
are generated by the historical market process’.
One way to interpret this Austrian insight is that absent change there
are no transaction and information costs; that is, in the absence of the
knowledge and appraisement problems introduced by economic change
there would be no costs of identifying contractual partners, drafting and
executing contracts, monitoring production, constructing contractual safe-
guards, judging quality, and so on. In the absence of transaction costs the
choice between price-mediated market transactions and firm hierarchies is
indeterminate. This indicates a link between Austrian insights in the calcu-
lation debate and Coasian insights in economic organization, though these
links were not recognized either by the Austrians or by Coase, probably
because they were focusing on different institutions: when Hayek (1945)
praised ‘the marvel’ of the price system, Coase had eight years earlier
established that the reason firms existed was that the ‘telecommunications
system’ of prices did not perform costlessly. Indeed, some commentators
have seen the analysis of Coase and that of Hayek as strongly opposed.
Instead, however, it is only in the kind of dynamic economic reality visual-
ized by the Austrians that Coase’s argument acquires its full force.
Incentives and property rights

One of the rapidly expanding areas in the theory of economic organization
is principal–agent theory. The Austrians made several arguments that in
important ways anticipate this theory. They pointed to agency problems
under socialism such as risk allocation (for example, Hayek, 1940). Under
socialism, they noted, managers would be either inefficiently risk averse or
risk loving, in the face of career concerns and the presence of an institu-
tion (the planning authorities) that could act as an insurance institution
and take over the moral hazard of individual managers (Mises, 1936, p.
122; Hayek, 1940, pp. 141–2). Moreover, the Austrians pointed out that
socialist economic organization would encourage rent seeking (Mises,
1936, 1944, 1949).
A primary virtue of a market system organized on the basis of private
ownership, as Mises saw it, is the strong mitigation of potential principal–
agent problems:
In the capitalist economy, the operation of the market [does] not stop at the
doors of a big business concern . . . [It] permeate[s] all its departments and
branches . . . It joins together utmost centralisation of the whole concern with
almost complete autonomy of the parts, it brings into agreement full responsi-
bility of the central management with a high degree of interest and incentive of
the subordinate managers (Mises, 1944, p. 47).
Breaking the corporation into separate profit centres is the way that top
management monitors subordinate managers. Anticipating Fama (1980),
Mises (1944, pp. 42–7) points to career concerns as important forces miti-
gating manager shirking. To be sure, both principal–agent theory and the
specific Austrian incentive arguments in the calculation debate rest on
more general property-rights reasoning. For example, it is fundamentally
because agents usually do not have property rights to residual income
streams from the productive activities they engage in that they may shirk
their duties.
While Austrian thinking about the economic function of property
rights begins with Menger (for example, 1871, p. 97, p. 100), the most
advanced Austrian thinking on the matter is represented by Mises’s work.
For example, Mises (1936, p. 182) clearly explains that property rights are
composite rights, and he argues that well-defined residual-income rights
are crucial to the efficient working of the economy. A central reason why
the ‘artificial market’ of market socialists will not work is precisely because
the transfer of goods between socialist managers is not equivalent to the
transfer of goods in a capitalist economy: under socialism it is not full
property rights that are transferred; prices and incentives are accordingly
perverse. Where Mises perhaps most explicitly anticipates modern devel-
opments, specifically work on the market for corporate control, is where
he describes the critical role of capital markets for the efficient functioning
of the economy. Securities markets facilitate the most important kind of
economic calculation in a dynamic economy through ‘dissolving, extend-
ing, transforming, and limiting existing undertakings, and establishing
new undertakings’ (Mises, 1936, p. 215).2
Capital theory and business-cycle theory

Capital and business-cycle theory seem less-closely connected to the
theory of economic organization. However, they supply the last compo-
nent in the set of concepts needed to make a coherent statement about
economic organization in general and the firm in particular. The relevant
component is the intertemporal structure of production highlighted in
Austrian capital and business-cycle theory (for example, Hayek, 1931,
1941; Lachmann, 1956). To the Austrians, the economy’s production
process represents a series of stages of production, each of which bears a
temporal relationship to final consumption (Menger, 1871; Hayek, 1931,
1941; Lachmann, 1956). In other words, there are important complementa-
rities among production processes. Moreover, credit expansion introduces
maladjustments in the structure of production that have to be worked out
over time (Hayek, 1931), which means that some resources or activities
are specific to each other and to particular production processes (see also
Lachmann, 1956). These relationships can only be understood fully in a
framework that emphasizes the time structure of production, like Austrian
capital and business-cycle theory (ibid.); they are obscured in the usual
production-function view of economic activity in which capital is homoge-
neous and production is timeless. Vertical integration is also much easier
to portray and comprehend in a sequential framework than the atemporal
framework of neoclassical microeconomics. As recent work in the theory
of the firm has demonstrated, notions of complementarity and specificity
are needed to tell a coherent story about the firm (Hart, 1995; Williamson,
1996).
Austrian economics and the contractual perspective on the firm

There is some debate within the Austrian literature about the basic Coasian
approach and its compatibility with the Austrian perspective. O’Driscoll
and Rizzo (1985, p. 124), while acknowledging Coase’s approach as an
‘excellent static conceptualization of the problem’, argue that a more
evolutionary framework is needed to understand how firms respond
to change. Some Austrian economists have suggested that the Coasian
framework may be too narrow, too squarely in the general-equilibrium
tradition to deal adequately with Austrian concerns (Boudreaux and
Holcombe, 1989; Langlois, 1994). However, as Foss (1993) has pointed
out, there are ‘two Coasian traditions’. One tradition, the moral-hazard
or agency-theoretic branch associated with Alchian and Demsetz (1972),
studies the design of ex ante mechanisms to limit shirking when supervi-
sion is costly. Here the emphasis is on monitoring and incentives in an
(exogenously determined) agency relationship. The above criticisms may
apply to this branch of the modern literature, but they do not apply to the
other tradition, the governance or asset-specificity branch, especially in

Williamson’s more heterodox formulation. Williamson’s transaction cost
framework incorporates non-maximizing behaviour (bounded rational-
ity); true, ‘structural’ uncertainty or genuine surprise (complete contracts
are held not to be feasible, meaning that all ex post contingencies cannot
be contracted upon ex ante); and process or adaptation over time (trading
relationships develop over time, typically undergoing a ‘fundamental
transformation’ that changes the terms of trade). In short, ‘at least some
modern theories of the firm do not at all presuppose the “closed” economic
universe – with all relevant inputs and outputs being given, human action
conceptualized as maximization, etc. – that [some critics] claim are under-
neath the contemporary theory of the firm’ (Foss, 1993, p. 274). Stated
differently, one can adopt an essentially Coasian perspective without
abandoning the Misesian view of the entrepreneur as an uncertainty-
bearing, innovating decision-maker.3
Economic calculation and the limits to the firm

One approach to developing a uniquely ‘Austrian’ approach to the firm is
to start with the basic contractual approach, and the Coasian explananda
of the firm’s existence, boundaries, and internal organization, and add
concepts of entrepreneurship, economic calculation, the time-structure of
production, and other elements of the Austrian tradition. For example,
the limits to firm size can be understood as a special case of the arguments
offered by Mises (1920) and Hayek (1937, 1945) about the impossibility of
rational economic planning under socialism (Klein, 1996). Kirzner (1992,
p. 162) adopts this approach in interpreting the costs of internal organiza-
tion in terms of Hayek’s knowledge problem:
In a free market, any advantages that may be derived from ‘central planning’
. . . are purchased at the price of an enhanced knowledge problem. We may
expect firms to spontaneously expand to the point where additional advantages
of ‘central’ planning are just offset by the incremental knowledge difficulties
that stem from dispersed information.
What, precisely, drives this knowledge problem? The mainstream lit-

erature on the firm focuses mostly on the costs of market exchange, and
much less on the costs of governing internal exchange. The new research
has yet to produce a fully satisfactory explanation of the limits to firm
size (Williamson, 1985, Chapter 6). Existing contractual explanations
rely on problems of authority and responsibility (Arrow, 1974); incentive
distortions caused by residual ownership rights (Grossman and Hart,
1986; Holmström and Tirole, 1989; Hart and Moore, 1990); and the
costs of attempting to reproduce market governance features within the
firm (Williamson, 1985, Chapter 6). Rothbard (1962, pp. 544–50) offers
an explanation for the firm’s vertical boundaries based on Mises’s claim
that economic calculation under socialism is impossible. Rothbard argues
that the need for monetary calculation in terms of actual prices not only
explains the failures of central planning under socialism, but places an
upper bound on firm size.
Rothbard’s account begins with the recognition that Mises’s position on
socialist economic calculation, as noted above, is not about socialism per
se, but the role of prices for capital goods. Entrepreneurs allocate resources
based on their expectations about future prices, and the information con-
tained in present prices. To make profits, they need information about all
prices, not only the prices of consumer goods but the prices of factors of
production. Without markets for capital goods, these goods can have no
prices, and hence entrepreneurs cannot make judgments about the relative
scarcities of these factors. In any environment, then – socialist or not –
where a factor of production has no market price, a potential user of that
factor will be unable to make rational decisions about its use. Stated this
way, Mises’s claim is simply that efficient resource allocation in a market
economy requires well-functioning asset markets. To have such markets,
factors of production must be privately owned.
Rothbard’s contribution is to generalize Mises’s analysis of this
problem under socialism to the context of vertical integration and the
size of the organization. Rothbard writes in Man, Economy, and State
(1962) that up to a point, the size of the firm is determined by costs, as in
the textbook model. However, ‘the ultimate limits are set on the relative
size of the firm by the necessity for markets to exist in every factor, in
order to make it possible for the firm to calculate its profits and losses’
(Rothbard, 1962, p. 536, original emphasis). This argument hinges on
the notion of ‘implicit costs’. The market value of opportunity costs for
factor services – what Rothbard calls ‘estimates of implicit incomes’ –
can be determined only if there are external markets for those factors
(Rothbard, 1962, pp. 542–4). For example, if an entrepreneur hires
himself or herself to manage the business, the opportunity cost of his or
her labour must be included in the firm’s costs. Yet without an actual
market for the entrepreneur’s managerial services, he or she cannot know
his or her opportunity cost; his or her balance sheets will therefore be less
accurate than they would if he or she could measure his or her oppor-
tunity cost.
The same problem affects a firm owning multiple stages of production.
A large, integrated firm is typically organized into semi-autonomous profit
centres, each specializing in a particular final or intermediate product. The
central management of the firm uses the implicit incomes of the business
units, as reflected in statements of divisional profit and loss, to allocate

physical and financial capital across the divisions. To compute divisional
profits and losses, the firm needs an economically meaningful transfer
price for all internally transferred goods and services. If there is an exter-
nal market for the component, the firm can use that market price as the
transfer price. Without a market price, however, the transfer price must be
estimated, either on a cost-plus basis or by bargaining between the buying
and selling divisions; such estimated transfer prices contain less informa-
tion than actual market prices.
The use of internally traded intermediate goods for which no exter-
nal market reference is available thus introduces distortions that reduce
organizational efficiency. This gives us the element missing from con-
temporary theories of economic organization, an upper bound: the firm
is constrained by the need for external markets for all internally traded
goods. In other words, no firm can become so large that it is both the
unique producer and user of an intermediate product; for then no market-
based transfer prices will be available, and the firm will be unable to cal-
culate divisional profit and loss and therefore unable to allocate resources
correctly between divisions.4 Of course, internal organization does avoid
the holdup problem, which the firm would face if there were a unique
outside supplier; conceivably, this benefit could outweigh the increase in
‘incalculability’ (Rothbard, 1962, p. 548).
Like Kirzner (1992), Rothbard viewed his contribution as consistent
with the basic Coasian framework. In a later elaboration of this argument,
Rothbard states that his own treatment of the limits of the firm:
serves to extend the notable analysis of Professor Coase on the market determi-
nants of the size of the firm, or the relative extent of corporate planning within
the firm as against the use of exchange and the price mechanism. Coase pointed
out that there are diminishing benefits and increasing costs to each of these
two alternatives, resulting, as he put it, in an ‘“optimum” amount of planning’
in the free market system. Our thesis adds that the costs of internal corporate
planning become prohibitive as soon as markets for capital goods begin to dis-
appear, so that the free-market optimum will always stop well short not only of
One Big Firm throughout the world market but also of any disappearance of
specific markets and hence of economic calculation in that product or resource
(Rothbard, 1976, p. 76).
‘Central planning’ within the firm, then, is possible only when the firm
exists within a larger market setting. Ironically, the only reason the Soviet
Union and the communist nations of Eastern Europe could exist at all
is that they never fully succeeded in establishing socialism worldwide,
so they could use world market prices to establish implicit prices for the
goods they bought and sold internally (Rothbard, 1991, pp. 73–4).
Entrepreneurship and Austrian capital theory

The close relationship between the Misesian concept of entrepreneurship
as action under uncertainty and the ownership and control of resources
suggests a bridge between entrepreneurship and the mundane activities of
establishing and maintaining a business enterprise. Foss and Klein (2005)
and Foss et al. (2007b) offer an entrepreneurial theory of the economic
organization that combines the Knight–Mises concept of entrepreneur-
ship as ‘judgment’ and the Austrian approach to capital heterogeneity. In
Knight’s formulation, entrepreneurship represents judgment under ‘true’
uncertainty that cannot be assessed in terms of its marginal product and
which cannot, accordingly, be paid a wage (Knight, 1921, p. 311). In other
words, there is no market for the judgment that entrepreneurs rely on, and
therefore exercising judgment requires the person with judgment to start
a firm. As Mises (1949, p. 585) puts it, ‘the real entrepreneur is a specula-
tor, a man eager to utilize his opinion about the future structure of the
market for business operations promising profits. This specific anticipative
understanding of the conditions of the uncertain future defies any rules
and systematization’.
Of course, judgmental decision-makers can hire consultants, forecast-
ers, technical experts, and so on. However, in doing so they are exercising
their own entrepreneurial judgment. Judgment thus implies asset owner-
ship, for judgmental decision-making is ultimately decision-making about
the employment of resources. The entrepreneur’s role, then, is to arrange
or organize the capital goods he or she owns. As Lachmann (1956, p. 16)
puts it: ‘We are living in a world of unexpected change; hence capital com-
binations . . . will be ever changing, will be dissolved and reformed. In this
activity, we find the real function of the entrepreneur’.
Austrian capital theory provides a unique foundation for an entrepre-
neurial theory of economic organization. Neoclassical production theory,
with its notion of capital as a permanent, homogeneous fund of value,
rather than a discrete stock of heterogeneous capital goods, is of little help
here. Transaction cost, resource-based, and property-rights approaches
to the firm do incorporate notions of heterogeneous assets, but they
tend to invoke the needed specificities in an ad hoc fashion to rationalize
particular trading problems – for TCE, asset specificity; for capabilities
theories, tacit knowledge; and so on. The Austrian approach, starting with
Menger’s (1871) concepts of higher- and lower-order goods and extending
through Böhm-Bawerk’s (1889) notion of roundaboutness, Lachmann’s
(1956) theory of multiple specificities, and Kirzner’s (1966) formulation of
capital structure in terms of subjective entrepreneurial plans, offers a solid
foundation for a judgment-based theory of entrepreneurial action.
One way to operationalize the Austrian notion of heterogeneity is to
incorporate Barzel’s (1997) idea that capital goods are distinguished by

their attributes. Attributes are characteristics, functions, or possible uses
of assets, as perceived by an entrepreneur. Assets are heterogeneous to the
extent that they have different, and different levels of, valued attributes.
Attributes may also vary over time, even for a particular asset. Given
Knightian uncertainty, attributes do not exist objectively, but subjectively,
in the minds of profit-seeking entrepreneurs who put these assets to use in
various lines of production. Consequently, attributes are manifested in
production decisions and realized only ex post, after profits and losses
materialize.
Entrepreneurs who seek to create or discover new attributes of capital
assets will want ownership titles to the relevant assets, both for specula-
tive reasons and for reasons of economizing on transaction costs. These
arguments provide room for entrepreneurship that goes beyond deploying
a superior combination of capital assets with ‘given’ attributes, acquiring
the relevant assets, and deploying these to producing for a market: entre-
preneurship may also be a matter of experimenting with capital assets in
an attempt to discover new valued attributes.
Such experimental activity may take place in the context of trying out
new combinations through the acquisition of or merger with another firm,
or in the form of trying out new combinations of assets already under the
control of the entrepreneur. The entrepreneur’s success in experimenting
with assets in this manner depends not only on his or her ability to antici-
pate future prices and market conditions, but also on internal and external
transaction costs, the entrepreneur’s control over the relevant assets, how
much of the expected return from experimental activity he or she can hope
to appropriate, and so on. Moreover, these latter factors are key deter-
minants of economic organization in modern theories of the firm, which
suggests that there may be fruitful complementarities between the theory
of economic organization and Austrian theories of capital heterogeneity
and entrepreneurship.
Foss et al. (2007b) show how this approach provides new insights into
the emergence, boundaries, and internal organization of the firm. Firms
exist not only to economize on transaction costs, but also as a means for
the exercise of entrepreneurial judgment, and as a low-cost mechanism for
entrepreneurs to experiment with various combinations of heterogeneous
capital goods. Changes in firm boundaries can likewise be understood as
the result of processes of entrepreneurial experimentation. And internal
organization can be interpreted as the means by which the entrepreneur
delegates particular decision rights to subordinates who exercise a form of
‘derived’ judgment on his behalf (Foss et al., 2007a).
Witt (1998, 1999) offers another approach to combining an Austrian
concept of entrepreneurship with the theory of the firm. Entrepreneurs

require complementary factors of production, he argues, which are coor-
dinated within the firm. For the firm to be successful, the entrepreneur
must establish a tacit, shared framework of goals – what Casson (2000)
calls a ‘mental model’ of reality – which governs the relationships among
members of the entrepreneur’s team. As Langlois (1998) points out, it is
often easier (less costly) for individuals to commit to a specific individual,
the leader, rather than an abstract set of complex rules governing the
firm’s operations. The appropriate exercise of charismatic authority, then,
facilitates coordination within organizations (Witt, 2003). This approach
combines insights from economics, psychology, and sociology, and leans
heavily on Max Weber. Leaders coordinate through effective communica-
tion, not only of explicit information, but also tacit knowledge – plans,
rules, visions, and the like. The successful entrepreneur excels at commu-
nicating such models.
Here, as in Coase (1937), the employment relationship is central to the
theory of the firm. The entrepreneur’s primary task is to coordinate the
human resources that make up the firm. Foss et al. (2007b), by contrast,
focus on alienable assets, as in Knight (1921). They define the firm as the
entrepreneur plus the alienable resources the entrepreneur owns and thus
controls. Each approach has strengths and weaknesses. The cognitive
approach explains the dynamics among team members but not necessar-
ily their contractual relationships. Must the charismatic leader necessarily
own physical capital, or can he or she be an employee or independent con-
tractor? Formulating a business plan, communicating a corporate culture,
and the like are clearly important dimensions of business leadership. But
are they attributes of the successful manager or the successful entrepre-
neur? Even if top-level managerial skill were the same as entrepreneurship,
it is unclear why charismatic leadership should be regarded as more ‘entre-
preneurial’ than other, comparatively mundane managerial tasks such as
structuring incentives, limiting opportunism, administering rewards, and
so on. On the other hand, the judgment approach does not generalize
easily from the one-person firm to the multi-person firm.
Conclusion
TCE, while firmly rooted in the neoclassical economics tradition, has
always drawn upon a broad range of sources in law, organization theory,
economic sociology, political science, history, as well as a diverse set of
economists from behavioural, ‘old’ institutional, and other ‘heterodox’
traditions. The Austrian school, while providing some direct influence
mainly through Hayek, has not had as much influence as one might
imagine, given the Austrians’ rich heritage in the areas of property rights,
knowledge, incentives, and institutions. This chapter highlights some pos-

sible bridges between the Austrian and new institutional literatures and
points to the emerging Austrian literature on the theory of the firm. We
expect this to be a growth area in the years to come.
Notes
1. Examples include Langlois (1992, 1995, 2002); Minkler (1993a, 1993b); Foss (1994, 1997,
1999, 2001); Klein (1996, 1999, 2008); Young et al. (1996); Lewin (1998); Dulbecco and
Garrouste (1999); Ionnanides (1999); Witt (1999); Yu (1999); Sautet (2000); Foss
and Foss (2002a, 2002b); Lewin and Phelan (2000); Foss and Christensen (2001); Klein
and Klein (2001); Foss and Klein (2002); Foss et al. (2002); Adelstein (2005); Ng (2005);
Foss et al. (2007a); Pongracic (2009); and Walsh (2009).
2. See also Klein (1999).
3. Foss and Foss (2000) argue, more generally, that contractual and knowledge-based theo-
ries of the firm are fundamentally complements, not rivals. For more on the Misesian
theory of the entrepreneur see Foss et al. (2007b), Klein (2008), and Salerno (2008).
4. Note that in general, Rothbard is making a claim only about the upper bound of the
firm, not the incremental cost of expanding the firm’s activities (as long as external
market references are available). As soon as the firm expands to the point where at
least one external market has disappeared, however, the calculation problem exists.
The difficulties become worse as more and more external markets disappear, as ‘islands
of noncalculable chaos swell to the proportions of masses and continents. As the area
of incalculability increases, the degrees of irrationality, misallocation, loss, impoverish-
ment, etc., become greater’ (Rothbard, 1962, p. 548).
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28 Limits of transaction cost analysis
Geoffrey M. Hodgson
Transaction cost economics (TCE) is one of the most influential approaches

in the social sciences today. In reality, transaction costs exist. Yet they
were neglected in economic theory until Ronald Coase (1937) and Oliver
Williamson (1975) explored their implications.
Nevertheless, there are many unanswered questions of a conceptual,
theoretical and empirical nature. Even the term ‘transaction cost’ awaits
an adequately precise definition. As Williamson (1995, p. 33) himself
notes: ‘There is nonetheless a grave problem with broad, elastic and
plausible concepts – of which “transaction costs” is one and “power” is
another – in that they lend themselves to ex post rationalization. Concepts
that explain everything explain nothing’.
The critical literature on TCE is almost as large as the TCE literature
itself. This chapter examines some of the issues requiring attention. The
following section looks at claims concerning the empirical evidence.
The two remaining sections look at some central theoretical problems.
The argument is not that TCE has to be junked, but that it has to be signif-
icantly extended to deal with some of the major problems and omissions.
Evidence and alternatives

Williamson has been hugely instrumental in the rise to prominence of
TCE. His operationalization of TCE avoids direct measurement of
transaction costs themselves, to focus instead on other variables, such as
uncertainty and asset specificity. Reviewing empirical work in the area,
Williamson (1985, p. 130; 1999, p. 1092; 2000, pp. 605–7) upholds that
the ‘cumulative evidence’ for TCE is ‘broadly corroborative’ and it is ‘an
empirical success story’.
If valid, these important claims would suggest that transaction cost
approaches have triumphed over rival explanations of the nature of the
firm, particularly over competence-based approaches.1 In fact, the evi-
dence is more equivocal. A systematic evaluation by Robert David and
Shin-Kap Han (2004) of 304 statistical tests of Williamson’s TCE frame-
work, found in 63 journal articles, reaches the conclusion that the results
are ‘mixed’.2
Richard Carter and Geoffrey Hodgson (2006) adopt a different meth-
odology and focus on a smaller number of the most influential and highly
297
cited studies. They considered prominent empirical studies of both vertical

integration and hybrid relationships. Regarding vertical integration, they
found no more than a partial and qualified consistency with Williamson’s
analysis. The hybrid relationship studies provide even less support, with
the majority being inclusive in their tests of Williamson’s TCE. This
concurs with the ‘mixed’ verdict of David and Han. Carter and Hodgson
further argue that the results of tests of the role of asset specificity, which
seem to be among the more successful for TCE in empirical terms, are also
consistent with the competence-based approach.
In dealing with the empirical evidence it is important to be clear about
what is being tested, whether the broad and viable claim that transaction
costs are important (Macher and Richman, 2008) or the more specific
claims of particular approaches to TCE.
Williamson’s (1979, p. 245) particular analytical approach focuses on:
‘(1) uncertainty, (2) the frequency with which transactions recur, and (3)
the degree to which durable transaction-specific investments are incurred’.
Williamson’s framework predicts that: (a) trilateral governance mecha-
nisms (or ‘neoclassical’ contracting) will be efficient for transactions that
are occasional, have intermediate levels of uncertainty and have either
idiosyncratic or mixed investment characteristics, and (b) bilateral govern-
ance mechanisms (or obligational contracting) will be efficient for transac-
tions that are recurrent, have intermediate levels of uncertainty and have
mixed investment characteristics.
In practice, testing this form of TCE has faced several major problems.
As Scott Masten et al. (1991, p. 17) argue: ‘Because of difficulties in observ-
ing and measuring transaction costs, analysts have had to rely on estima-
tions of reduced-form relationships between observed characteristics and
organizational forms’. But, ‘such indirect tests are unable to distinguish
whether observed patterns of organization resulted from systematic, but
as yet unexplored, variations in the costs incurred organizing production
internally’ (ibid.). More than one type of theoretical explanation could
be consistent with the data. In particular, and especially in the absence of
direct measures of transaction costs, a non-transaction cost explanation
might be viable (Masten, 1996).
Kirk Monteverde reinterprets TCE empirical studies from a resource-
based perspective, arguing that the human asset-specificity construct
should be reinterpreted as a set of firm-specific communication codes
(or competences). Monteverde (1995) constructs his empirical model to
account for the openness of the human asset-specificity concept to alter-
native interpretations and finds empirical support for his resource-based
hypotheses. Monteverde argues that the findings of Monteverde and Teece
(1982), Masten et al. (1991), and Anderson and Schmittlein (1984) can all
Limits of transaction cost analysis 299
be reinterpreted in this way. Of the 12 vertical integration studies assessed

in Carter and Hodgson (2006), 11 employed Williamson’s reduced form
model and nine of those studies found support for a separate human asset-
specificity variable. Hence no less than nine of these 12 most highly cited
studies could be reinterpreted as being consistent with a competence or
resource-based perspective.
Masten (1996, pp. 51–2) noted that ‘reduced-form estimates do not dis-
close the magnitude of transaction costs’ and consequently that ‘without
additional information, the magnitude of transaction cost differentials and
the effects of organizational form on performance cannot be inferred from
standard empirical tests of transaction cost hypotheses’. In simple terms,
even if empirical results are consistent with the predictions of Williamson’s
model, this does not in itself demonstrate that transaction costs are
being minimized. This concern has been raised by a number of empirical
researchers (Heide and John, 1990, 1992; Noordewier et al., 1990; and
Osbourn and Baughn, 1990). Indeed Heide and John (1990) take the issue
further by arguing that the observed governance form could have been
chosen for strategic as opposed to transaction cost economizing reasons.
Given the plausibility of alternative interpretations of even the positive
results in favour of Williamson’s TCE, there is an obvious need for tests
that can discriminate between these rival (or possibly complementary)
interpretations.
Although there are several hundred empirical studies of TCE, many of
which claim to be corroborative, only four conjoint tests of competence-
based and Williamsonian approaches have come to my notice. All four
point to the viability of a hybrid explanation for the existence of the firm,
involving both competences and transaction costs, and are broadly con-
sistent with the argument here (Argyres, 1996; Poppo and Zenger, 1998;
Combs and Ketchen, 1999; Jacobides and Hitt, 2005). Another empirical
study compares the transaction cost approach with property rights theory,
with inconclusive results (Whinston, 2003).
A prominent conclusion is that an integration of TCE and competence-
based explanations represents perhaps the most productive area for devel-
opment. Instead of premature declarations of scientific victory, innovative
theoretical development, and careful conceptual refinement, leading to
more thorough joint testing, is the best approach for the future.
Back to basics
While TCE has been criticized for inadequate definitions of key terms and
‘catch-all’ concepts, similar accusations can be made against rival theories.
Throughout the TCE literature and that of its rivals there is still lacking a
consensus on basic definitions such as the firm. When the defining features
of this basic entity are beyond agreement, derivative issues such as the
boundaries of the firm, the nature of ‘hybrids’ and the ‘make-or-buy’
decision become hopelessly clouded by terminological confusion. Further
theoretical and conceptual work is required, as well as the more inclusive
approach to empirical testing highlighted in the preceding section.
In many ways it is useful to return to Ronald Coase’s (1937) seminal
thought experiment. Following Coase it is useful to distinguish between
just two governance forms, the firm and the market. This heuristic simpli-
fication precedes later complications of the picture.
The Coasean thought experiment compares the costs of using the
price mechanism in a market-like relationship with the costs of grouping
together transactions under the single organizational umbrella of the firm.
When costs of organizational arrangements within the firm are less than
the cost of using the price mechanism in a market arrangement, then the
existence of the firm is viable. The boundary of the firm is where the mar-
ginal costs of the firm or market mode are equivalent. This is an extremely
powerful framework that has inspired TCE throughout its existence.
But the thought experiment involves some challengeable assumptions.
First, in the comparison of the two modes, technology and production
routines are assumed to be constant. This implies a separability of produc-
tion and technology from governance structures or transaction costs. Paul
Milgrom and John Roberts (1992, pp. 33–4) highlight some of the theoret-
ical problems involved in trying to separate production and governance,
and their corresponding costs. The transaction costs argument assumes
that production costs are given and do not differ across governance or
transaction modes. However, technologies are often linked to transaction
modes and structures of governance.
Second, the methodology adopted by Coase, and likewise adopted and
acknowledged by Williamson (1985, pp. 143–4), is one of comparative
statics. As a number of authors have pointed out, this downplays the
vital issues of learning, innovation, and dynamic change (Langlois, 1992;
Nooteboom, 1992, 2004; Pagano, 1992).
Third, the analysis assumes that individual productive capabilities and
amenabilities of individuals are unchanged by any transition from one
mode to another. As Mary Douglas (1990, p. 102) put it, Williamson
‘believes firms vary, but not individuals. He has the same representative
rational individual marching into one kind of contract or refusing to
renew it and entering another kind for the same set of reasons, namely, the
cost of transactions in a given economic environment’. This omission leads
to a neglect of context-specific processes of individual transformation,
development and learning, as well as an overly narrow focus on presumed
invariant human attributes such as opportunism.3
All three of these limitations are highlighted in a simple heuristic model

devised by Geoffrey Hodgson and Thorbjørn Knudsen (2007). Harold
Demsetz (1988, p. 144) has pointed out that ‘writings on the theory of the
firm sometimes use transaction costs to refer indiscriminately to organi-
zational costs and whether these arise from within the firm or across the
market’. Accordingly, Hodgson and Knudsen (2007) separate two types
of cost that have been gathered under the ‘catch-all’ transaction cost label.
On the one hand, there are costs associated with the definition, nego-
tiation, monitoring or enforcement of the employment contract. They
include the costs involved in hiring, organizing, monitoring or managing
the human resources within the firm. On the other hand, there are costs of
defining, negotiating, monitoring or enforcing contracts for other services
and goods, in the sphere of markets or exchange.
Hodgson and Knudsen (2007) use the term ‘transaction costs’ to refer
exclusively to the costs of defining, negotiating, monitoring or enforcing
contracts for goods and services, in the sphere of markets or exchange. The
costs of monitoring and managing workers within the firm are referred to
as ‘monitoring costs’.
What happens if ‘transaction costs’ are lower than ‘monitoring costs’?
A simple Coasean model would predict that the firm would not exist,
because there would be no advantage in cost terms. But this argument
overlooks another significant possibility.
The key point is that the firm can provide an organizational environ-
ment, consisting of routines, images, artefacts, and information, which
can enhance the capabilities of workers. Some routines, images, and
stored information depend on the existence of the organization per se,
and hence may not be found in a market context. The market has differ-
ent attributes and benefits. Accordingly, even if knowledge is regarded as
an individual phenomenon, existing solely in the memory traces of indi-
viduals, the organization provides a structured environment consisting of
interactions and routinized practices that can augment individual skills.
The organizational whole is more than the sum of its individual parts.
Consequently, through individual relations and interactions, the organiza-
tion can enhance overall productivity, more than the total productivity of
workers performing in isolation.4
This point underlines that individual interactions and their outcomes
are context specific. The average productivity of individuals can be
enhanced in specific organizational and cultural environments (Hodgson,
1998). Some organizational environments can enhance individual produc-
tivity through learning, additional to the incentive effects and contracting
economies that are at the centre of the transaction cost explanation.
It is possible (but neither universal nor inevitable) that interactions
between one set of workers in one context will yield higher productivity than
the interaction of the same set of workers in another. Pursuing this possibil-
ity, Hodgson and Knudsen (2007) demonstrate in their simple model that
the firm can be more profitable than the ‘market’ mode of organization,
even if ‘monitoring costs’ are positive and ‘transaction costs’ are zero.
Hodgson and Knudsen (2007) develop their model and bring in the
dynamic feature of learning. This strengthens the result. The firm can
become viable in the future even if it is not so at present. The boundary of
viability between the firm and the market shifts through time.
In some circumstances, markets have the capacity to create learning
effects that may counterbalance the learning effects within firms. There are
good reasons why markets exist. The Hodgson and Knudsen (2007) model
depends on possible rather than universal effects. In reality, comparisons
of the net benefits of firms and markets have to take into account the
learning effects of both market and firm institutions, as well as transaction
costs.
The model assumes firm-specific productivity effects. It is asserted that if
such effects exist, then they may be sufficient to explain the existence of the
firm. Admittedly, if such effects are small, then the burden of the explana-
tion for the existence of the firm may shift back to transaction costs. The
onus is on supporters of the argument that all firms are always explained
by transaction costs alone to show that firm-specific effects are generally
insignificant. No basis is evident for such a general statement.
Another response may be simply to deny the existence of any firm-
specific productivity effects. Or it may be argued that if there were such
productivity advantages, then they could be replicated in the ‘market’
mode, by the free bargaining of independent producers. But a market is
not a firm. Hence these responses are another way of saying that any such
productivity advantages are not firm-specific, and thereby denying the
assumption. This denial goes against immense evidence to the contrary in
organization studies and elsewhere.
Other critics might acknowledge the existence of these firm-specific
effects but insist that they are generally less important than transaction
costs. This question cannot be decided on a priori grounds because it is an
empirical issue. It requires a comparison between measures that directly
capture learning effects and transaction costs. This is an important agenda
for future research.
Context, evolution, and causal explanation

The preceding section considered a simple Coasean world with two ways
of organizing production – the firm and the ‘market’. It was pointed out
that the Coasean thought experiment paid insufficient attention to the
ways in which structured relations between individuals may affect their

capabilities or dispositions. Context matters.
Williamson’s theoretical structure is more complex, with several alter-
native governance modes. He makes major advances in searching for
explanations of different organizational forms, including different kinds
of hierarchy and the viability of cooperative versus more hierarchical
firms.
The issue of context is also important with Williamson’s theory. The
literature on institutional complementarities is relevant here (Amable,
2000; Aoki, 2001; Boyer, 2005). This theoretical and empirical literature
addresses the possibility that the performance of one institution may
depend on the nature of other institutions to which it relates. Accordingly,
Japanese firms may perform well in the context of Japanese-style state
or financial institutions, but less well in other institutional contexts
(Gagliardi, 2009).
The performance of cooperative firms, for example, may be dependent
on the type of banking system that prevails, thus helping to explain why
cooperatives are more numerous in some countries rather than others.
Consequently, and contrary to Williamson (1985), one cannot infer
that cooperatives are a universally inferior form of organization. Their
efficiency may depend on their institutional context.
A further limitation of the Coase–Williamson approach is that com-
parative statics detract attention from the mechanisms that lead to differ-
ent possible outcomes. If governance forms tend to minimize transaction
costs, it is not clear how this occurs. Are managers to some extent aware
of these costs and do they consciously reduce them? Or are costs reduced
through some process of competitive evolutionary selection of the less
costly over the costlier firms? With his emphasis on information problems
and bounded rationality, Williamson does not suggest that managers have
sufficient information. Instead Williamson (1975) hints at an evolutionary
process of selection, but never develops this argument. If he did, he would
have to address the well-established theoretical limitations to an (near)
optimal evolutionary process of selection, including frequency effects and
other context-dependent outcomes (Winter, 1964; Hodgson, 1996). Also
in evolution, context matters.
To make further progress we do not need to dispense with the achieve-
ments of TCE. Instead we have to overcome the limitations of the com-
parative statics approach and develop a more dynamic theory. Even in the
statics case, contextual effects have been under-appreciated. In a dynamic
theory they also must play a major part. Prominent items on the theoretical
agenda for TCE include the development of evolutionary approaches and
the exploration of possible syntheses with competence-based theories.
Notes
1. Including competence, capabilities, knowledge-based, resource-based and evolution-
ary approaches (Penrose, 1959; Nelson and Winter, 1982; Rumelt, 1984; Foss, 1993;
Montgomery, 1995; Foss and Knudsen, 1996; Nooteboom, 2004).
2. Other TCE empirical review studies are cited and analysed in Carter and Hodgson
(2006). For an extensive but unprobing review see Macher and Richman (2008), which
covers several different forms of transaction cost analysis.
3. Opportunism is a central concept in Williamson’s but not Coase’s analysis. In a critique
of Williamson, Hodgson (2004) does not deny the existence and importance of oppor-
tunism but argues that there are additional important reasons why contracts may not be
fulfilled and monitoring may be required. Hence an explanatory emphasis on opportun-
ism is both theoretically and strategically misleading.
4. Alchian (1991, p. 233) has argued that ‘cooperative activity with a “firm” yields an
output greater than could otherwise be achieved and . . . the underlying factor in that
source of gain in the firm is “teamwork’’’. See also Argyris and Schön (1996) and other
works on organization theory.
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Index
Ackerberg, D. 259 Bai, C.E. 197

active mind (Carnegie Triple) 17–18 Baker, G.P. 223
adaptation 14, 79–80 Barnard, C. 14, 20, 58–65
advertising 278–9 Barzel, Y. 44, 94, 95, 97, 108, 291
Aggarwal, R. 30 Beard, C.A. 68
Akerlof, G.A. 221, 226 Beard, M.R. 68
Alchian, A.A. 3, 17, 41, 82, 94, 94–5, behavioral assumptions and
96, 97–8 transaction cost analysis 53
Allen, D. 259 Behavioral Theory of the Firm 52, 53
Allen, D.W. 30 Bell Atlantic Corp. v. Twombly 236–7
Allen, W.R. 94–5 Bercovitz, J. 201
alliances 207–12 Bergen, M. 197
Anderlini, L. 134 Big Mac Index 114
Anderson, E. 168 Bigelow, L. 144–5, 156
Andrews, K.R. 58 biotechnology industry 131
antitrust Blair, R.D. 186
and Chicago school 230–40 Bolton, P. 79
and franchising 202 Botticini, M. 259
Aoki, M. 224–5 boundary conditions
Argyres, N.S. 130, 131, 144–5, 148, economizing perspective 148
156, 268 strategizing perspective 146–7
Armour, H.O. 144 bounded rationality 42, 49, 59, 128–9,
Arrow, K.J. 108 264, 265
Arruñada, B. 200 criticism of 266, 267
asset ownership 98–100 of individuals 59
transfer costs 111 and organizational economics 133–8
vertical integration 157–8 Bradach, J. 197, 202
asset specificity 80–81, 143, 167, 264 Brickley, J.A. 200, 202
empirical challenges 158–9 Brousseau, E. 3
and franchising 196 Buchanan, J. 9
and governance structures 154 Burt, R. 90
and hold-ups 120–25 business cycle theory and Austrian
types 168 school 286
attributes of capital goods 291 business format franchising 185–92
Augier, M. 85 business strategy 140–41, 145–9
Austrian school 281–93 economizing approach 143–9
and entrepreneurship 290–92 strategizing approach 141–3, 145–9
history 281–2
and transaction cost economics 282–6 Camerer, C.F. 140
autonomous adaptation 14 capital theory, Austrian school 286
Azevedo, P. 246 entrepreneurship 290–92
Carmichael, L. 219
Babcock, L. 138 Carnegie Institute of Technology 8, 50
Bach, G.L. 50 Carnegie school 49–56
307
Carnegie triple 8–9, 10–18 Corporate Control and Business

Carrington, P.D. 71 Behavior 55
Carter, R. 206–7, 297–8, 299 cosmos 77
Casson, M. 292 cost, social, subjectivist approach
Caves, R.E. 186 274–6
Chandler, A.D. 140 costly state falsification 253
Chicago school and antitrust law costs, definitions 107–9
230–40 costs of exchange 107–15
Coase, R.H. 3, 6, 18, 21, 28, 29, cross-country variations 109–10,
30–31, 32–3, 39–47, 93–4, 97, 98, 111–12
124, 152, 153, 157, 159, 165, 171, definition 108–9
172–3, 263–4, 274, 300 reasons for variations 109–10
Hayek’s influence on 77–8 variations across individuals 110,
Coase theorem 97 112–13
cognition 265, 266–7 variations in money prices 113–14
Combs, J.G. 186, 191 Crocker, K.J. 155, 168, 253–4
commenda contracts 251–7 cultural factors and human resource
Committee on Social Thought, management 226
University of Chicago 75 Cyert, R. 49–53
Commons, J.R. 9, 66–7
communication, Barnard’s D’Andrade, R. 17
organizational theory 60 David, R.J. 206, 297
company towns 129 Davis, L.E. 29
Conduct of Economics, The 45 Dawes, R.M. 88
consent theory of authority 60–61 debt versus equity financing
context, effect on productivity 301–3 244–58
contract law 16–17 electricity generation 247–51
and franchising 190 trade, Middle Ages 251–7
and University of Wisconsin deception and holdups 124
66–70 decision-making, Barnard’s
contract selection hypothesis 245, 246, organizational theory 61
248 Demsetz, H. 3, 17, 29, 41, 82, 94, 95,
long-distance trade, Middle Ages 97, 98, 240, 301
252–7 Dickens, W.T. 221
Contracting and Organizations Director, A. 231
Research Institute (CORI) 4 discipline 10–13
contracts discrete structural analysis 54
ex post problems 122–4 discriminating alignment 143–5
franchises 194–202 Dixit, A.K. 142
hybrid arrangements 180 Djankov, S. 112, 116
incompleteness 166 docility 87–90
solutions to potential holdups 121 Documentary History of American
structure Industrial Society 67
dynamics 156 Doherty, R. 50
franchises 194–202 Douglas, M.T. 300
termination, franchises 201–2 Dow, G.K. 266
terms 155 Dr Miles Med. Co. v. John D. Park &
effect on franchise survival 191 Sons Co. 235–6
cooperation 59 Dreze, J. 21
coordinated adaptation 14, 79–80 Du, J. 172
Index 309
dual distribution 196–8 firm size limits 287–9

Dyer, J.H. 209, 211 firm strategy and subjectivism
dynamics of contract structure 156 276–80
firm theory see theory of the firm
Eastman Kodak Co. v. Image Technical Fischer, S. 18
Services, Inc. 234 Fisher Body, acquisition by General
Economic Institutions: Spontaneous and Motors 45–6, 120–24, 171
Intentional Governance 79–80 Ford Foundation 50–51, 52
Economic Institutions of Capitalism, foresight 128–9
The 3, 74 formal organization 59–60
Economic Institutions of Strategy 5–6 Foss, K. 100
Economics and Knowledge 76 Foss, N.J. 47, 100, 146, 273, 286, 290,
economizing 9–10 291, 292
economizing approach to business Fowler, R. 44
strategy 143–9 franchising 185–92
efficiency of organizations 269 franchise contracts 194–202
efficient adaptation hypothesis 248 and free-riding 188–9
Eggertsson, T. 108, 115 incentives 187–8, 191, 198–201
Eigen-Zucchi, C. 115 Frankfurter, F. 68
Eisenberg, T. 33 free-riding and franchising 188–9
electricity marketing contracts free will, Barnard’s organizational
247–51 theory 60
Elster, J. 10 Freeman, R.B. 222
Ely, R. 66–7 frequency see transaction frequency
embedded ties, disadvantages 210 Friedman, M. 11, 12–13
empirical research, TCE 19–20, Functions of the Executive, The 58
152–6 Fundamental Transformation 15
employment relationships as rental funding, franchises 195
agreements 218–19 Furubotn, E.G. 97, 108
entrepreneurship
and Austrian capital theory 290–92 Gallini, N.T. 197
missing from TCE 273 game theory
Ernst, D.R. 68 and business strategy 141–3
ex post contractual problems 122–4 and transaction cost economics
exchange costs see costs of exchange 10–11, 128
108–9 Garrison, L. 68
General Motors
Fan, J.P.H. 157, 158 acquisition of Fisher Body 45–6,
Farrell, J. 79 120–24, 171
Fatal Conceit, The 75 governance inseparability 130–31
Faure-Grimaud, A. 253, 254 Georgescu-Roegen, N. 12
Federal Communications Commission Geyskens, I. 19
43 Ghemawat, P. 142–3
Felli, L. 134 Ghosh, M. 146
Ferguson, A. 77 Gibbons, R. 20
financial-market contracting 244–58 Gifford, S. 134
financial structures Gilson, R.J. 72
electricity marketing contracts Glachant, J.-M. 3
247–51 Goerzen, A. 210
long-distance trade 251–7 Goldberg, V. 47
governance 9 IKEA, cross-country price comparison

and trust 209–10 114
governance inseparability 129–31 Illinois Tool Works, Inc. v. Independent
governance mechanisms 245 Ink, Inc. 234
hybrid arrangements 180–81 incentives
governance structures 166–7 and Austrian school 284–5
franchising 195–8 and franchising 187–8, 191, 198–201
Graduate School of Industrial inducement-contributions balance
Administration, Carnegie Institute 61–2
8, 50 informal organization 60
Greif, A. 33, 183 innovation policy, subjectivist
Grossman, S. 31, 79 perspective 277–8
Guetzkow, H. 51 institutional arrangements 29–30
and employment transaction costs
Han, S. 206, 297 219
Hancock, G. 251 and organizational performance
Handbook of Organizational Economics 221–2
20 institutional change, subjectivist
Hansmann, H. 249 perspective 279–80
Harris, R. 71 institutional economics 28, 67
Hart, O. 5, 31, 96, 100, 134, 244, 245 institutional environment 29–30
Hashimoto, M. 219 and costs of contracting 43
Haskel, J. 114 institutions 27–8, 224–5
Hayek, F.A. 14, 28, 74–82, 281, 283, intelligent altruism 87–90
284 interdisciplinary approach 13–17
He, D. 172 intertemporal regularities 14–16
Heide, J.B. 299
Hennessy, D. 196 Jacobsen, J.P. 216
Hill, C.A. 156 Jensen, M.C. 42, 222
Hill, C.W.L. 88, 211 John, G. 146, 299
History of Labor in the United States Joskow, P.L. 155, 159, 168, 233
67
Hodgson, G.M. 206–7, 297–8, 299, Kahn, S. 220
301, 302 Kaufman, B.E. 215
holdups 120–25, 166 Kaufmann, P.J. 200
contractual solutions 121 Kennedy, A.M. (Justice) 235–6
franchising 196 Keynes, J.M. 75
reasons for 124–5 King, B.G. 72
Hubbard, R.G. 159 King, E. 71
human actors 13–14 Kirzner, I.M. 78, 287
human resource management and TCE Klein, B. 3, 45, 47, 125, 171, 172, 188,
222–6 232
Hurst, J.W. 67–9, 71 Klein, P.G. 3–4, 27, 47, 273, 290
hybrid organizations 153–4, 167, 170, Kleiner, M.M. 222
176–83 Knight, F.H. 9–10, 290
definitions 176–8 Knudsen, T. 88, 301, 302
governance mechanisms 180–81 Kochin, L. 44
reasons for 179–80 Kraakman, R. 249
and transaction cost framework 206 Kranton, R.E. 226
typology 181–3 Kreps, D. 21, 128
Index 311
La Porta, R. 33 Maskin, E. 137

labour economics and TCE 216–22 Masten, S.E. 144, 155, 156, 159, 168,
labour markets 215–16 170, 298, 299
Lachmann, L.M. 81, 290 Mayer, K.J. 144, 156
Lafontaine, F. 186, 188, 189, 197, 200 McMillan, J. 17–18
Lang, L. 157 Mechanisms of Governance, The 3, 46,
Lange, O. 15 49
Langlois, R.N. 292 Meckling, W.H. 42, 222
law Ménard, C. 3
legal processes to open new Menger, C. 81, 281–2, 283
businesses 112 menu costs 221
and new institutional economics 31 Michael, S.C. 188, 189, 191, 200
and ownership 98–9 Milgrom, P.J. 135, 220, 269–70, 300
see also antitrust; contract law; Miller, G.P. 33
property rights Miller, M. 18, 244
Law and the Conditions of Freedom 69 Mises, L. von 74, 284, 285, 290
Lazear, E.P. 223 Missouri, University of 4
leadership, Barnard’s organizational Modigliani, F. 18, 244
theory 62–4 monetary incentives, franchising
Leegin Creative Leather Products, Inc. 198–9
v. PSKS, Inc. 235–6 money price variations 113–14
Legal Realists 67, 68 Monteverde, K. 298
Levitt, S. 5 Mookerji, S. 134
Levy, B. 246 Moore, H.J. 188, 200
Liebeskind, J.P. 130, 131, 148, 268 Moore, J. 31, 244, 245
linear compensation 249 moral commitment 63–4
Llewellyn, K.L. 16 Morgan, J. 253–4
Loewenstein, G. 138 motivation 265, 266–7
London School of Economics and employees 219–20
Political Science 75 multi-unit ownership, franchises 201
long-distance trade, Middle Ages, Murphy, W.F. 186
financial structure 251–7 Muth, J. 21
long-standing ties, disadvantages of
210 Nalbantian, H.R. 222
Lueck, D. 259 Nalebuff, B.J. 142
Lutz, N. 196, 197 Nature of the Firm, The 18, 39
neoclassical contract law 190
M-form hypothesis 144 neoclassical economics 127
Macaulay, S. 69–70, 71–2, 180 network governance 211
Macher, J.T. 152 Nevitt, J. 251
Macneil, I.R. 66, 70, 72 new institutional economics 27–32
Madhok, A. 207, 211 Newell, A. 12
make-or-buy decision 153–4, 165–72 Nickerson, J.A. 144, 146, 156, 172
see also vertical integration Nobel Prizes 3–4
maladaptation costs 166 nominal wage dynamics 220–21
Maness, R. 196 Non-Contractual Relations in Business:
March, J.G. 49–54, 56, 85 A Preliminary Study 70
Mariotti, T. 253, 254 North, D.C. 27, 28, 29, 32, 87, 95–6,
Markets and Hierarchies 3, 78 115, 224, 225
Mas-Colell, A. 141 Norton, S.W. 190
O’Driscoll, G.P. 286 process analysis 53–4

O’Reilly, C.A. 222 productivity, effect of context 301–3
Occam’s Razor 85 property rights 93–6
operationalization 18–20 and Austrian school 284–5
opportunism 14, 86–7, 264, 266–7 and institutional economics 31
orders 81, 283 and transaction costs 96–8
organization theory 8–9, 13–16 property rights economics 92–101
inventory of 51 and transaction cost economics
organizational adaptation 54 97–8
organizational design, effect on public authorities and hybrid
performance 155–6 arrangements 181
organizational economics and bounded Pure Theory of Capital, The 75
rationality 133–8
organizational performance see quasi-rents 158–9
performance
organizational theory 58–64 Ramsey, J. 69
Organizations 49, 51, 53 Raushenbush, E.B. 71
Ostrom, E. 4 relationship-specific investments 207–8
ownership see asset ownership remediableness 12, 269
Oxley, J. 246 remote company towns 129
Oyer, P. 220 rental agreements, employment
relationships as 218–19
Parcell, J. 155 Richman, B.D. 152
path dependencies 15–16 Richter, R. 108
Pejovich, S. 97 Rise of American Civilization 68
people management224–5 Rivers, D. 251
per se rule 236 Rizzo, M.J. 286
performance Roberts, J. 20
and institutional arrangements Roberts, J. (Justice) 230, 234–9, 240
221–2 Roberts, J.D. 135, 269–70, 300
and organization form 155–6 Roberts Court 230, 234–9
Perrow, C. 58 Robertson, D.H. 77
personnel economics 223 Rogers, E.M. 278
persuasion 278–9 Rothbard, M.N. 82, 288–9
Petrin, A. 251 Rubin, P.H. 186, 195
Pfeffer, J. 222
Pirrong, S.C. 159 Sachs, J.D. 116
planned orders 283 Salerno, J.T. 284
Plant, A. 39 Saloner, G. 148
plausibility 12 Saussier, S. 42–3, 155, 159
plural form, franchising 196–8 Schaffer, S. 220
Poppo, L. 210 Schotter, A. 88–9, 222
Porter, M.E. 140, 141 Schutz, A. 275, 276
Posner, R.A. 232 Scott, F.A. 197
post-Chicago school (PCS) 233–4 Scott, W.R. 59
predatory pricing 238–9 Segal, I.R. 125
Prendergast, C. 223 self-enforcement, franchise contracts
principle-agent theory 284–5 199–200
private ordering 11, 66–70 self-interest 14
Problem of Social Cost, The 43–4 Selznick, P. 14, 15, 58
Index 313
Shapiro, C. 142 theory of the firm 39–44, 233

Shaw, K.L. 197 and Austrian school 281–93
Shirley, M. 3 Chicago School and TCE
Silva, V. 246 approaches 233
Silverman, B.S. 144, 156 critiques of 265–9
Simon, H.A. 10, 49, 51–2, 56, 58, thin and thick notions of bounded
85–90, 183, 219, 264 rationality 135–6
simple contractual schema 24–6 Thomas, C. (Justice) 238
simplicity 11 Tirole, J. 137, 142, 145
Singh, H. 209 Townsend, R. 253
Sjöstrand, S.-E. 273 Train, K. 251
Skillman, G.L. 216 transaction as unit of analysis 127–32
Slade, M.E. 186 limitations 129–31
Smith, A. 86, 88 transaction cost economics
Smith, D.G. 72 characteristics 263–5
social cost, subjectivist approach criticisms of 265–9, 273, 297–302
274–6 empirical analysis 152–60, 206–7,
socialist economics and Austrian 297–9
school 283–4 and human resource management
Solow, R. 11–12, 17 222–6
Souter, D.H. (Justice) 237 and labour economics 216–22
specific investments 145 limitations 129–31, 297–303
specificity 80–82 and new institutional economics
and transaction costs, labour 30–31
contracts 218 transaction costs
see also asset specificity definition 107–8
Spiller, P. 246 and institutional economics 30–31
spontaneous orders 79, 283 and labour contracts 217–20
Stigler, G. 44 and property rights 96–8
Stiglitz, J.E. 79 see also costs of exchange
strategic alliances 207–10 transaction frequency 42, 264
strategic commitment 142 labour contracts 217–18
strategizing approach to business trust 209–10, 208
strategy 141–3, 145–9 two-stage conditional maximum
strategy and transaction costs 205–12 likelihood method (2SCML) 251,
Strauss, S. 21 258
subjectivism 273–80
sunk costs 145 uncertainty 42–3, 264
Sykuta, M.E. 3–4, 155 and labour contracts 218
union wage rigidities 221
tacit knowledge 76 Use of Knowledge in Society, The 76
Tallman, S.B. 207
Tao, Z. 197 value creation and alliances 207–9
taxis 77 Vanden Bergh, R. 146
Teece, D.J. 141, 144, 146–7 Veblen, T. 67
termination franchise contracts 201–2 vertical integration 19, 165–72
Thaler, R.H. 88 empirical challenges 157–8
Theory of Industrial Organization, The preventing holdups 123–4
142 and social networks 211
Theory of Moral Sentiments, The 86–7 subjectivist perspective 276–7
Vertical Integration, Appropriable Williamson, D.V. 247

Rents, and the Competitive Williamson, O.E. 3, 4, 5, 28, 29, 31,
Contracting Practice 45 41, 43, 44, 46, 49, 50–51, 54–6, 64,
Vertical Integration of Production, The 66, 70, 74, 85, 87, 96, 124, 125,
55 129, 134, 136, 143, 147, 148, 149,
veto provision 248 152, 154, 155, 166–7, 168, 169,
Vuong, Q. 251 172, 186–7, 191, 197, 205, 206,
208, 210, 221, 224, 232, 245, 264,
Wachter, M.L. 221 265, 269, 281, 287, 297, 298, 303
wage rigidities 220–21 influence of Hayek 78–81
Wallis, J.J. 115 Wisconsin, University of 66–70
Warner, A.M. 116 Witt, U. 291–2
Wealth of Nations, The 86 Wolf, R. 114
Weber, M. 275 Wolf, W.B. 61
Weyerhaeuser Co. v. Ross-Simmons
Hardwood Lumber Co. 237–9 Yellen, J.L. 221
Whinston, M.D. 125, 126 Yu, B.T. 219

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THE ELGAR COMPANION TO

TRANSACTION COST ECONOMICS

All rights reserved. No part of this publication may be reproduced, stored

Edward Elgar Publishing, Inc.

A catalogue record for this book

Library of Congress Control Number: 2009941001

ISBN 978 1 84542 766 5

Printed and bound by MPG Books Group, UK

List of contributors vii

PART II PRECURSORS AND INFLUENCES

PART III FUNDAMENTAL CONCEPTS

11 The costs of exchange 107

14 Bounded rationality and organizational economics 133

17 Vertical integration 165

PART V ALTERNATIVES AND CRITIQUES

25 Critiques of transaction cost economics: an overview 263

Nicholas Argyres is Vernon W. and Marion K. Piper Professor of Strategy

Strategy at the Olin Business School, Washington University, St Louis,

University, St Louis, where he wrote his PhD dissertation on the effects of

Levitt’s comments allude to the fact that the field of organizational

volume explore the applications of TCE to various topics in strategy and

This overview of transaction cost economics (TCE) differs from prior

The Carnegie Triple

discussion is found in its relation to social policy, assumed to be directed

Of the various forms that economizing can take, TCE is predominantly

for contractual incompleteness as the limits on rationality become binding

Getting it right ‘includes translating economic concepts into accurate

attempting rationally to cope. For TCE purposes, the key ramification of

Coordinated adaptation Adaptation is taken to be the main problem of

Intertemporal regularities As Philip Selznick has observed, organization,

regularities have a significant impact on the organization of economic

as unfair or anticompetitive from an orthodox perspective, TCE interprets

another law of contract, the contract law of internal organization, applies.

Have an active mind

Those who have an abiding interest in economic organization are thus

transaction cost reasoning were unsatisfactory. What to do? The unmet

1. Rather than proceed in a fully general way, TCE focuses on specific

question that TCE is more influential because of the empirical work

The simple contractual schema

Figure 2.1 Simple contractual schema

further that the component can be supplied by either a general purpose

best bilateral efforts to craft safeguards at Node C, the transaction may be

The concept of transaction costs is central to the modern economic analysis

an interdisciplinary enterprise combining economics, law, organization theory,

Institutions and the economics of institutions

This definition places institutional analysis squarely within the ‘rational’

The relevant question, Coase (1964, p. 195) explains, is whether a feasible

structures with transactional characteristics, occur more slowly. Changes

The role of transaction costs and property rights

Questions about the new institutional economics

of ‘neoclassical economics’ broadly defined (today’s ‘old institutional’

believed that certain contractual arrangements will lead to opportunistic behavior, it

Encyclopedia of Law and Economics, Cheltenham, UK and Northampton, MA, USA:

As a student at the London School of Economics (LSE), Ronald Coase

The basic question

The ‘simple’ answer

In a slightly more positive assessment, Oliver Williamson (1975, p. 3)

Beyond the simple answer

Uncertainty and contractual incompleteness

more difficult, expensive, and risky it will be to establish a contract that

The institutional environment

Beyond the ‘nature of the firm’

Coase and transaction cost economics