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of Economic Behavior & Organization &O@&tiOIJ
Vol. 31 (1996) 149-155

Transaction cost economics and the

Carnegie connection’
Oliver E. Williamson
ffassSchool of Business, University of Catifomia, 350 Barrows Hall. Berkelqy CA 94720, USA

Revised 3 October 1994

Abstract

This paper tracks my remarks at the September 1993 conference honoring Richard M. Cyert. It
begins with some recollections of my years as a graduate student at GSIA in the early 1960s. I then
shift to transaction cost economics and how this project relates to what I learned from Dick Cyert
and others at Carnegie.

XL classification: D2; L2; B3

Keywords: Production and organizations; Firm objectives; Organization and behavior

1. Carnegie in the 1960s

Dick Cyert deserves great credit for many things. One of those things is to help open up
the world of economics to organization theory.
Thus, while the other social sciences - political science, organization theory, aspects of
sociology and social psychology, parts of the law - have regularly availed themselves of
economics, economics was always special: it was self-contained; it was the queen of the
social sciences; it played hardball.
Dick Cyert did not think that any of the social sciences - economics included - were
self-contained; and he and others at Carnegie were determined to correct this
misconception. The Cyert and March (1963) book, The Behavioral Theory of the Finn

‘The author is Edgar F. Kaiser Professor of Business Administration, Professor of Economics, and Professor
of Law, University of California, Berkeley. My remarks are based in part on an autobiographical essay,
“Transaction Cost Economics and the Evolving Science of Organization,” to appear in Arnold Heertje, Ed.,
Makers of Modem Economics II (1995).

0167-2681/96/$15.00 0 1996 Elsevier Science B.V. All rights reserved

PII SO167-2681(96)00898-O
150 O.E. Williamson/J. of Economic Behavior & Org. 31 (1996) 149-155

joined economics and organization theory to pry open what had been a black box,
thereupon to examine the business firm in more operationally engaging ways.
Those who witnessed the 1960s will recall that the world of economics was not
overjoyed with these intrusions. But a beach-head was established from which further
excursions could be launched.
To be sure, the idea that firms are production functions to which an assumption of
profit maximization is appropriately ascribed, is still useful for many purposes. But there
are many other purposes for which a richer conception of the firm and market
organization - in the spirit of the behavioral theory, or of evolutionary theory, or of
transaction cost economics, or of still other variants - is needed. Dick Cyert, Jim March,
Herbert Simon, and others at Carnegie opened the door to these developments.
Carnegie has always been an incredible place at which to be a student. That was
obvious to me in the 1960s and has become even more evident to me since. The faculty at
GSIA was small but extraordinarily able, highly motivated, mainly accessible, and very
serious about research. It was an infectious place.
The astonishing thing about Carnegie is that it joined two very fundamental and
seemingly incompatible strands of research. The one dealt with bounded rationality,
organization theory, and behavioral economics. The leading members of that group were
Herbert Simon, Richard Cyert, and James March. The second strand dealt with rational
expectations and efficient markets. Members of that group include Franc0 Modigliani
(who, unfortunately, left Carnegie just as I arrived), John Muth, Merton Miller, and Allan
Meltzer - to be joined later by Robert Lucas (who arrived as I was graduating), Thomas
Sargent (who had been my first research assistant), and Edward Prescott.
I worked mainly with the behavioral economics group at Carnegie. Bounded rationality
- which Simon (1957) defined as behavior that was intendedly rational but only limitedly
so - seemed to me, then and since, as a useful way to go. March’s course in organization
theory disclosed that one did not need to think about organizations in classical (machine
model) or fanciful (hyperrationality 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 the horse’s mouth - Richard Cyert - in 1961 when the famous
Cyert and March book of that title was in late stages of completion. I co-taught the BTOF
course with Dick during my last semester at Carnegie, by which time Cyert had become
Dean.
My dissertation had its origins in Jim March’s class - when he playfully remarked that
managers maximize slack, and lightbulbs began to blink and beckon. I shortly thereafter
set about to examine managerial discretion issues in terms of constrained utility
maximization (in which several measures of slack as well as profits were entered into the
managerial utility function). That was only partly in the behavioral theory tradition, Thus,
although the objective function of the firm was reformulated in favor of realism in
motivation, I worked out of a maximization rather than a satisficing setup. The
dissertation therefore reflected some of the tensions between behavioral economics and
orthodoxy to which I referred earlier.
Allan Meltzer was on my dissertation committee and was comfortable with the
maximizing setup. Also, I discussed the issues with Jack Muth, who emphasized the
importance of thinking problems through in their entirety. Although I did not grasp all of
 O.E. Williamson/J. of Economic Behavior & Org. 31 (1996) 149-155 151

the ramifications (Jack, in my experience, is always one step ahead of everyone else), I
was persuaded of the need to avoid myopic formulations.
As Carnegie was a permissive place - the test being not methodological rectitude but
whether a formulation deepens our understanding of complex issues - I was comfortable
operating between the two extremes of behavioral economics on the one hand and
rational expectations on the other.
In a nutshell, the research approach as I learned it at Carnegie was this: have an active
mind; be disciplined; be interdisciplinary - to which there was an additional lesson,
which I also associate with Arrow (1969, 1974) : research problems that do not fit into
orthodox boxes should be addressed on their own terms. It would have been unthinkable,
for example, at Carnegie to declare that bureaucratization was a more serious problem for
economic organization than was resource allocation, yet to restrict attention to the latter
because bureaucracy, as Oskar Lange (1938, p.109; emphasis added) put it, “belongs to
the field of sociology rather than to economic theory and must therefore be dispensed
with here.” Such discipline-based property rights were alien to Carnegie. That I have
found the joinder of law, economics, and organization so productive is partly because, as
a student of Carnegie, it could hardly be otherwise.

2. Transaction cost economics

In addition to being an interdisciplinary joinder of law, economics, and organization, I

would describe transaction cost economics as (1) relentlessly comparative (organization
forms are always examined in relation to alternative feasible forms), (2) microanalytic
(the action resides in the details), (3) discrete structural (alternative forms of governance
differ in kind - on which account it is impossible to replicate markets by hierarchies, or
the reverse), and (4) preoccupied with economizing, principally with reference to
organization rather than technology. Moreover, as between the question “What’s going
on here?” and the imperative, “This is the law here,” the enterprise is inspired mainly by
the former.
By contrast with the firm-as-production function approach, which treats technology -
economies of scale; nonseparabilities - as the main determinants of the natural
boundaries of the firm, transaction cost economics approaches firm and market
organization from an efficient contracting/comparative organizational perspective. As
Ronald Coase (1937) so perceptively observed, firms and markets are alternative forms of
organization for managing the very same transactions. Whether a firm makes or buys -
that is, produces to its own needs or procures a good or service from an outside supplier -
turns largely on the transaction costs of managing the transaction in the firm as compared
with mediating the transaction through the market. Which transactions go where depends
on the attributes of transactions on the one hand and the costs and competence of
alternative modes of governance on the other.
The production function or the pre-contractual view of vertical integration was that,
minus special physical or technical aspects - the standard example being that of a blast
furnace and rolling mill, where integration purportedly avoided the need to reheat ingots
and hence realized thermal economies - vertical integration was deeply problematic and
1.52 O.E. Williamson/J. of Economic Behavior & Org. 31 (1996) 149-155

probably anticompetitive. In fact, however, the thermal economies to which Joe Bain
(1968, p.381) referred supply a physical/technical rationale for vertical integration, did
not withstand comparative institutional scrutiny. Those thermal economies could be
realized merely by locating blast furnace and rolling mill together. Co-located assets do
not, without more, imply unified ownership. One option would be for each stage to
remain independent, the relation between them to be mediated by contract. Another
possibility is that both stages could be placed under common ownership and the interface
mediated by hierarchy (administration). Holding technology, including location, constant,
the unrecognized need was to assess the comparative efJicacy of alternative modes of
governance.
To be sure, technology does matter - in that if the transportation expenses of locating at
a distance are negligible, if reheating expenses are trivial, and if the economies of scale in
blast furnaces are not great, then rolling mills can procure ingots from large numbers of
parity suppliers. Markets - both presently and prospectively - can then be presumed to
work well. The really interesting problems of managing transactions across successive
stages of production show up when bilateral dependency conditions appear.
Since pre-existing bilateral monopoly is a rare event, bilateral dependency was held to
be a very special and unusual condition. Bilateral dependency need not, however, have
pre-existing (technological) origins. And there is the rub: bilateral dependency can also
have intertemporal, contractual origins. That is because what begins as a large numbers
supply condition frequently gets transformed into a small numbers exchange relation
during contract execution and at contract renewal intervals. This had been missed because
the prevailing thinking scanted organization in favor of technology, was a myopic
construction, and led to public policy mistakes.
Examining the issues of economic organization from a comparative contractual point
of view requires that the behavioral attributes of human actors and the microanalytic
attributes of transactions and of organization be described. Of special importance are the
behavioral assumptions - since interesting problems of comparative economic
organization vanish if either hyperrationality or unfailing stewardship are ascribed to
economic actors. Transaction cost economics supplants the assumption of hyperration-
ality by that of bounded rationality - heretofore defined as behavior that is intendedly
rational but only limitedly so. And the assumptions of stewardship or even simple self-
interest seeking are supplanted by the assumptions of opportunism - which is a more
subtle form of self-interest seeking to include self-interest seeking with guile.
To be sure, opportunism is a relatively unflattering behavior assumption. There is,
however, no need to assume that most economic agents are opportunistic most of the
time. What is important is to be alert to potential contractual hazards and, if and as these
arise, to make provision for cost-effective safeguards. As Robert Michels (1962, p.370)
observed in the context of oligarchy, “nothing but a serene and frank examination of the
oligarchical dangers of democracy will enable us to minimize these dangers.” The lesson
applies more generally.
Transaction cost economics adopts John R. Commons’ (1934) proposal that the
transaction be made the unit of analysis and moves the argument forward by asking what
are the critical dimensions with respect to which transactions differ. As it turns out, the
condition of asset specificity, which refers to the redeployability of assets and is
 O.E. Williamson/J. of Economic Behavior & Org. 31 (1996) 149-155 153

implicated in the aforementioned bilateral (or, sometimes, multilateral) dependency

condition, is the most important of these.
Adaptation is taken to be the central problem of economic organization, of which two
types are distinguished: autonomous or Hayekian adaptation (where markets enjoy the
advantage) and cooperative or Barnardian adaptation (where the advantage accrues to
hierarchy). More generally, the discriminating alignment hypothesis holds that
transactions, which differ in their attributes, align with governance structures, which
differ in their cost and competence, in a discriminating - mainly, transaction cost
economizing - way.
What is distinctive about the study of governance is that it makes provision for both
spontaneous and intentional forms of organization - the Hayekian markets and the
Barnardian hierarchies to which I just referred. More generally, the study of incomplete
contracting in its entirety implicates both ex ante incentive alignment and ex post
administration (which is what governance is all about).
Of special relevance in this connection is the concept of credible commitment. Recall
that Machiavelli (1952, p.92) advised his prince to breach contracts with impunity -
“when by doing so would be against his interest, and when the reasons which made him
bind himself no longer exist.” This myopic approach to contract is to be contrasted with a
more farsighted (but nonetheless incomplete) approach to contract according to which the
prince is advised to mitigate ex post opportunism by crafting ex ante safeguards. Rather
than reply to opportunism in kind, the wise prince is one who seeks to both give and
receive credible commitments (Williamson, 1983). Partly that entails incentive
realignment, but mainly the need is to craft governance structures with superior adaptive
properties.
While the Behavioral Theory of the Firm has been described as the intersection of
economics and organization theory, transaction cost economics works from the
intersection of law, economics, and organization. Contract law plays an integral role in
the exercise, the argument being that each generic mode of governance - market, hybrid,
and hierarchy - is supported by a distinctive form of contract law. Following Ian Macneil
(1974, 1978), the market mode is supported by an exacting application of legal rules
(classical contract law), while hybrid modes are supported by more elastic contracting
relations (neoclassical contract law). But while prior treatments describe the contract law
of internal organization as that of the employment relation, transaction cost economics
maintains that the implicit contract law of hierarchy is that offorbearance (Williamson,
1991). Thus while courts will routinely hear disputes over prices, delivery, quality, etc. in
transactions between firms, these same courts will refuse to be drawn into identical
disputes between divisions within a single firm. In effect, hierarchy becomes its own
court of ultimate appeal. It is largely because of the forbearance law that firms are able to
exercise fiat, while markets cannot, to manage transactions. This has pervasive
comparative institutional ramifications.
As it turns out, any issue that can be posed directly or indirectly as a contracting
problem can be examined to advantage in transaction cost economizing terms. A huge
number of phenomena - including vertical integration, vertical market restrictions,
franchising, regulation and deregulation, labor market organization, the organization of
work, corporate finance and corporate governance, family firms, multinational firms, and
154 O.E. Williamson/J. of Economic Behavior & Org. 31 (1996) 149-155

the economics of trust - qualifies. That key regularities keep recurring is responsive to
Milton Friedman’s (1953, p.33) remarks that fruitful hypotheses give rise to variations on
a theme. It also invites empirical testing.
Although some appear to hold otherwise, my reading of the literature is that transaction
cost economics is an empirical success story - there being in the neighborhood of 200
published empirical studies, and more are in progress. Empirical work is always
demanding and those who have pioneered in this area deserve enormous credit. Unable to
work off of census reports and data tapes - because these do not record the relevant
observations and/or are too aggregative - empirical transaction cost economics has had to
develop primary, microanalytical data. That cost is more than repaid by the analytical
benefits. As Thomas Kuhn (1970) remarks, a new science collects its own, rather than
work off of extant, data.
To be sure, transaction cost economics (as everything else) needs more and better
empirical research. I concur, however, with (Paul Joskow, 1991, p.81), that “this
empirical work is in much better shape than much of the empirical work in industrial
organization generally.” Empirical transaction cost economics is a success story that we
should celebrate.
I have not spoken of the public policy applications, but transaction cost economics has
numerous ramifications for, and has even had some influence on, antitrust and regulation.
Also, as James Robinson (1993) is in the process of developing, it helps to engage the
relevant institutional issues that are pertinent to the study of health care. Relatedly and
more generally, transaction cost economics is pertinent to a comparative assessment of
public, nonprofit, and private bureaus in both developed and reform economies. It
furthermore has a bearing on the ideas of core competence and corporate capabilities,
which David Teece (1988) and others are addressing. Finally, transaction cost economics
has helped to promote an interdisciplinary dialogue between law, economics, and
organization that is richer and more respectful of what each has to offer than was the case
10 and 20 years ago.

3. Conclusions

This last brings me back to my opening remarks. Maybe a productive dialogue would
have gotten under way without Carnegie, but it is clear that Carnegie took the lead and
made it respectable for others to follow. The participation of economists in this exercise
was vital, and someone needed to make the first move. Dick Cyert is the Carnegie
economist who took the lead, for which those of us who were his students and are his
followers are forever grateful.

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