A Comparison of Alternative Approaches to Economic Organization

Author(s): Oliver E. Williamson

Reviewed work(s):
Source: Journal of Institutional and Theoretical Economics (JITE) / Zeitschrift für die
gesamte Staatswissenschaft, Vol. 146, No. 1, The New Institutional Economics Different
Approaches to the Economics of Institutions (Mar. 1990), pp. 61-71
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 Journalof Institutional
and TheoreticalEconomics(JITE) 146(1990),61 71
Zeitschrift
fürdie gesamteStaatswissenschaft

A Comparisonof AlternativeApproaches to Economic

Organization

by
Oliver E. Williamson*

The SeventhInternational Seminaron theNew Institutional Economicsfea-

tured"DifferentApproaches to theEconomics of Institution."Real differences
amongthe approachesemployedby theconference papersnotwithstanding,
the new approachesmainlybear a complementary relationto one another.
Whether thesenewcontractualapproacheswilleventually be combinedto yield
a unifiedtheoryof firm,market,and hybridmodesoforganization remainsto
be seen.
The threedifferent approachesto thestudyof economicorganizationwith
whichtheconference papersare concernedare property rights,agencytheory/
mechanismdesign,and transactioncosts. Each of theseexamineseconomic
organizationincontractualterms,whenceall differfromtheneoclassicaltheo-
ryofthefirm- whichworksoutofa noncontractual (essentiallytechnological)
perspective.
Section1 setsouta generalschemafordescribing alternativetheoriesoffirm
and marketorganization.Comparisonsbetweenproperty rights,agency,and
transactioncostapproachesare thesubjectof Section2. Concludingremarks
follow.

/. A Schema

The schemasetout in Figure1 is concernedentirelywitheconomictheoriesof

firmand marketorganization and makesonlycrudedistinctions.Noneconom-
ic,especiallysociologicalapproaches,thusgo unmentioned.1 As betweennon-
contractual(technological)and contractual(organizational)economicap-
proaches,moreover, principalemphasisis placed on thelatter.2
* Thepaperwason outgrowth
oftheconference
discussion.
1 socialconstruc-
emphasizepower,embeddedness,
Sociologicalapproachestypically
tedness,and adventitiousness.
2 thatareimpoundedinthenode
Amongthemoreimportant noncontractualtheories
designated"other"in theschemaare evolutionary
economics,pathdependency,X-effi-
ciency,and managerialtheoriesof thefirm.
62 OliverE. Williamson dHÏÏTIE

j0 Neoclassical

Noncontractual y^v
(Technological)^/^ ^^^^
X^Other Public
^^
^* a Choice
^r
N. Public/^^

Contractual n. Environment^''^^^^^ Private

(Institutional) N. (Rulesi^^ >^
^v^^^ ^^^^ ^^ Property
•^ Rights

>v Agency
^^
Arrangements >^ ^^^0^^^^^ Theory
(Organizations) ^w^1^1^^ Complete
*'^ (Ex Ante)

Incomplete N.
(Ex Post) >v
>. Transaction
• Cost

Figure1
Economic of organization
theories

in theschemais whether
The firstcategoricaldistinction a theoryworksout
of a noncontractualsetupor approachesthestudyof economicorganization
froma contractual pointofviewinstead.The prevailing approach,untilabout
1960,was to viewthefirmin technological (mainlyproduction rather
function)
thanin contractual/organizationalterms.Comparativecontractual issueswere
ignoredbecause(1) theboundaryofthefirmwas takenas given(beingdefined
mainlybyeconomiesof scale and scope),(2) property rightswereassumedto
be well-defined,and (3) disputes,if any,wereassumedto be costlesslyand
decidedbythecourts.All contracts
efficaciously beingefficacious,theresimply
was no occasion to examinedifferences among them and ask whether these
differenceshad comparativeinstitutional (organizational)significance.
146/1(1990) A Comparison
of Alternative to EconomicOrganization63
Approaches

More generally, neoclassicaltheoryregardedthefirmas beingof the"cate-

gory of the individual" ratherthanof the"categoryof markets."3The twin
pillarsof microeconomic theory- the theoryof the firmand the theoryof
consumer -
behavior displaystriking as a consequence.Thuswhere-
similarities
as thetheory ofconsumerbehaviordealswithconsumption possibilitysetsand
ascribesoptimality to an equalizationofthemarginalrateof substitution with
thecorresponding ratioof productprices,theneoclassicaltheoryof thefirm
employsproductionpossibility setsand ascribesoptimality to an equalization
of themarginalrateof transformation withthecorresponding ratioof input
prices.
The maindata withwhichtheneoclassicaltheoryof thefirmwas concerned
were pricesand output(Arrow [1971]). Althoughan impressiverange of
interestingeconomicphenomenafallwithintheambitofneoclassicaleconomic
analysis,theorthodoxtheoryofthefirmmakesonlylimitedheadwaywiththe
following puzzles:(1) whatfactorsare principally responsibleforthedecision
of a firmto produceto its own needsratherthanbuy a good or service,(2)
whereindo bureaucratic costsariseand why,(3) whatfactorsare responsible
forlimitations to firmsize,(4) whenis franchise biddingfornaturalmonopoly
effectiveand whennot,(5) do debtand equitydiffer in governancestructure
and
respects why,(6) what factorswarrant the use of a partnership (as against
the corporateformof organization),and (7) what factorsmost distinguish
capitalistand socialistenterprise? These and relatedissues are usefullyad-
dressedin comparativecontractualterms.
An earliergenerationof institutional economistshad beenconcernedwith
theadequacyof orthodoxyto addressmanyof thesematterspreviously. The
leadingnamesin theearliergeneration of U.S. institutionalistswereThorstein
Veblen,W.C. Mitchell,and JohnR. Commons.4Olderstyleinstitutional eco-
nomicsfellon hard times,however.Ratherthan advance a rival research
agenda,itbecameembroiledinsteadinmethodological criticismofneoclassical
economics(Stigler [1983,170]).Someconcluded,too harshlyI think,thatthe
workof Americaninstitutionalists "led to nothing...[since]withouta theory,
theyhad nothingto pass on" (Coase [1984,230]).
Real differences among themnotwithstanding,5 the older institutionalists
had an abidingrespectforinstitutions. Also, in the case of Commons,there
weretherudiments of a theory.Thus Commonssaw theproblemofeconomic
organizationas thatof dealingsimultaneously withconflict,mutualdepen-
dence, and order,whereupon the criterionfor the "ultimateunitof economic

3 The distinctionswerefirstcalledto myattentionby David Kreps [1984].

Thereis also a European,especiallyGerman,traditionin institutional
economics.
See T. W.Hutchison [1984].
5 For a discussionof the variousstrandsof the olderinstitutional
economics,see
Malcomb Rutherford[1983].
64 OliverE. Williamson dUTlïïE

activity... [should] contain in itselfthe three principlesof conflict,mutuality

and order" (Commons [1925, 4]). The transaction,in his view, was responsive
to theseprinciplesand he proposed that the transactionbe made the basic unit
of analysis (Commons [1925, 4]; [1934, 4-8]).
Economics had long acknowledged thatconflictof interestwas a widespread
and natural condition. The definitionand enforcementof propertyrightsand
the use of marketsserved to harness conflict,produce order,and create value.
But Commons saw the need to push beyond and include other institutionsas
contributingto these very same purposes. What Lon Fuller subsequentlyre-
ferredto as "eunomics" is closer to Commons's vision, where eunomics is
definedas "the science, theoryor study of good order and workable arrange-
ments" (Fuller [1954, 477]). Both market and nonmarket institutionsare
implicated.
NeitherCommons nor his followersmade a systematiceffortto operational-
ize theseinsights,however. Instead, institutionaleconomics adopted the above
described posture of methodological hostilityand progressivelylost influence.
That the New InstitutionalEconomics has become "one of the liveliestareas
in our discipline" (Mathews [1986, 903]) is largely because it has shunned
methodological controversyin favor of operationalization. Not only does it
maintainthat institutionsmatter,6but it furthermaintainsthat institutionsare
susceptibleto analysis (Mathews [1986, 903]). This latteris what distinguishes
the new fromthe earlier approaches.
Albeit related, two branches of the New InstitutionalEconomics - institu-
tional environmentand institutionalarrangement- are usefullydistinguished.
Lance Davis and Douglass North [1971, 6-7; emphasis in original], in an
early and importantcontribution to the renewal of institutionaleconomics,
distinguishbetween these two as follows:
"The institutional
environment is thesetoffundamental political,socialand legalground
rulesthatestablishesthebasisforproduction, exchangeand distribution. Rulesgovern-
ingelections,property rights,and therightof contractare examples...
An institutional
arrangement is an arrangement betweeneconomicunitsthatgoverns
thewaysinwhichtheseunitscan cooperateand/orcompete.It.. . [can]providea structure
withinwhichitsmembers can cooperate.. .or[itcan]providea mechanism thatcan effect
a changein laws or property rights."
The firstnode alongthecontractualbranchof theschemareflectsthisdistinc-
tion betweenenvironment and arrangements.The institutional
environment
branchis concernedwithsettingup therulesof thegamein bothpublicand
privatesectors.The publicchoiceliterature
has developedin responseto the
ofthesewhiletheeconomicsofproperty
first rightsdealswiththesecond.Only
thesecondof thesewas dealtwithby theconference papersand is discussed
furtherin Section2, below.
6 Economicsonce
aspiredto workoutofan "institution
freecore."(The phraseis due
to VernonSmith.)
146/1(1990) A Comparison
of Alternative to EconomicOrganization65
Approaches

The institutionalarrangementsbranchis moreconcernedwiththedetailsof

organization. Bothex anteincentive
alignment (theagencytheorynode)and ex
post governance(the transactioncost node) are pertinent.
The firstof these
maintainsthatcontractsare comprehensive, whenceall of the relevantcon-
tractingactionis concentratedin theex anteagreement. Contractualincom-
pletenessis characteristic
oftransactioncosttheoriesofeconomicorganization
in whichex postgovernanceis featured.

2. Discussion

Transaction costeconomicsis an interdisciplinary undertaking thatjoins law,

economics,and organization. The approachis unabashedlyinterested in inter-
pretingorganizational varietyand unpackingpuzzles.Thus whereasphysical
"
(and someeconomists)ask What'sthelaw here?",transaction
scientists cost
is
economics preoccupied with "What's going on here?".7 It subscribesto the
following modest research "to
objective: organize our necessarilyincomplete
perceptionsabout the economy,to see connectionsthat the untutoredeye
would miss,to tellplausible... causal storieswiththe help of a fewcentral
principles,and to makeroughquantitative judgmentsabout theconsequences
of economicpolicyand otherexogenousevents"(Solow [1985,329]).
Interestingly, but forhis introductory remarks,R. C. O. Mathews [1986,
907] treats the "economics of institutionsand the economicsof transaction
costs[as]... a singleapproach".That is evidently becausethetransaction cost
economicsbranchhas developedso rapidlywithapplications"to manyareas:
industrialorganizationand corporategovernance;labor economics;public
choice;development; and economichistory"(Mathews [1986,907]).
Havingpreviouslyexaminedthedifferences betweentransactioncost and
neoclassicaleconomicsapproachesto thestudyofeconomicorganization, my
purposehereis to examinethewaysin whichthethreeapproachesfeatured by
theconference papers- property rights,
agencytheory, and transaction cost-
The pointof viewthatI adopt is this:whatare themainreasonsto go
differ.
beyonda property or agencytheorytreatment
rights to includetransaction cost
features?

2.1. Property
Rights
The economicsof property
rightsis prominentlyassociatedwiththeworkof
ArmenAlchian [I960]. The generalview thatinformsthe propertyrights
approachis that"property
rightsdevelopto internalize whenthe
externalities

7 The distinctions
wereoffered
byRoy D'Andrade [1986]and Donald McCloskey
[1986].
66 OliverE. Williamson JJDTTIE

gains frominternalization become largerthan the costs of internalization"

(Demsetz[1967,350]).A similarconceptualschemahad beenadvancedearlier
byRonaldCoase in connectionwithhisstudyoftheFederalCommunications
Commission.He arguedthatthedefinition of propertyrightswas vitalto the
functioning of an enterprisesystem(Coase [1959,14]) and heldthat"One of
thepurposesof thelegalsystemis to establishthecleardelimitation of rights
on thebasis of whichthetransfer and recombination of rightscan takeplace
throughthemarket"(Coase [1959,25]).
Albeitilluminating,theproperty rightsapproachto economicorganization
pullsup short.Akinto theeconomictheoryof socialism,whichheldthatthe
centralexercisewas to "getthepricesright"(Lange [1938];Kornai [1986]),the
economicsof propertyrightsmaintainsthat the basic need is to "get the
property rightsstraight" - afterwhichmarketswillreliablyassignresourcesto
highvalued uses. Arguments of both kindstruncatethe studyof economic
organizationunnecessarily.
Coase's argumentthat the allocationof radio spectrumwas "merely"a
property rightsproblemis illustrative. ThusCoase arguedthatthe"realcause"
forthe"chaos" in radiobroadcasting in the1920s"was thatno property rights
werecreatedin... scarcefrequencies .... A privateenterprise systemcannot
function properly unlessproperty rights arecreatedinresources, and,whenthis
is done... [c]haosdisappears;and so does thegovernment exceptthata legal
system to define propertyrights and to arbitratedisputesis... necessary"
(Coase [1959,14]).
ThesesanguineviewsweresharedneitherbyChiefJusticeWilliamHoward
Taftin the 1920s nor by laterstudentsof spectrumallocationin the 1960s
(De Vany, et al. [1969]).Thus Taftis reportedto have said "I have always
dodgedthisradioquestion...and havetoldtheotherjusticesto avoid passing
on thismatteras longas possible,"hisreasonbeingthat"interpreting thelaw
on thissubjectis something liketrying to interpret
thelaw on theoccult.... I
wantto putit off...in thehope thatit becomesmoreunderstandable."8 Had
he been advisedthattheissue was merelyone of gettingthepropertyrights
straight,Taftwoulddoubtlessly have noddedassentand added "Elaborate."
Transactioncost economicsmaintainsthatwhetheror not property rights
can be (1) well-defined and, once defined,can be (2) understoodby and (3)
effectivelyenforcedbythecourtstheyare all problematic. Indeed,problematic
property rightsinvitetheappearanceofnonmarket modesoforganization that
havethepurposeand effect ofproviding contractual integrityfor transactions
thatare "deficient"in any or all of theseproperty rightsrespects.
This orientationis consonantwithKennethArrow'swork on economic
organization. Arrowwentbeyondthepropositionthatmarketfailuresinduce
redefinitions ofproperty rightsto arguethatnonmarket institutions
mightarise

8
Quotedin Coase [1959,40].
146/1(1990) A Comparison
of Alternative to EconomicOrganization67
Approaches

as wellor instead:"I proposeherethe view that,whenthe marketfailsto

achievean optimalstate,societywill,to someextentat least,recognizethegap,
and nonmarket willariseattempting
social institutions to bridgeit" (Arrow
[1963,947]). To be sure,the nonmarket institutions with whichArrowwas
concernedmainlytook theformof marketsupports(insurance;trust;licen-
sure)ratherthanmarketsubstitutes (suchas hierarchies). But thebreakwith
the reigningmarketsand propertyrightstraditionhad been made nonethe-
less. That marketsare a "marvel"is not disputed;9to argue,however,that
marketsare theonlymarvelis detrimental to thestudyof economicorganiza-
tion.
Transaction costeconomicsis specifically concernedwiththegovernanceof
contractualrelations(by markets,hierarchies, and hybridmodes)and rejects
theproposition thatthecourtscan administer justicein an informed, low cost,
and efficacious way. Ratherthanplace theprincipalburdenof contracten-
forcement on thecourts,it arguesinsteadthatcourtorderingoperatesin the
backgroundrole10and thatprivateordering11 by thepartiesis theprincipal
contractualarena. Thus whereasthe propertyrightsapproachto economic
organization finesses thestudyofexpostgovernance, transaction costeconom-
icsfocusesexpressly on thecomparative efficacy with which alternative
govern-
ance structures managetransactions duringcontractexecution.This latteris
whatprivateorderingis all about. The underlyinghypothesis out of which
transaction costeconomicsoperatesis this:aligntransactions (whichdifferin
theirattributes)withgovernancestructures (which differ in theircost and
competencies) in a transactioncosteconomizingway.12Repeatedapplication
of this hypothesis is responsiblefor much of the predictivecontentof the
transaction cost economicsagenda.

2.2. AgencyTheory

Bothagencytheoryand transaction cost economicstaketheproperty rights,

whateverthesemaybe, as givenand examinehow thepartiescontractwithin
therules(institutional
environment) of thegame.Agencytheoryassumesthat
the partiesconcentrateall of the relevantcontractingactionin the ex ante

9 The term"marvel"to describethemarketis due to FriedrichHayek [1945,527],

lv/As Karl Llewellyn
[1VJ1,/3/j,puts it, courtsare reservedior purposesoi
"ultimateappeal" whenprivateordering effortscease effectively Contract
to function.
and thecourtsplayan important rolein delimitingthreatpositions.
11 For an elaboration,see Marc Galanter [1981]and Williamson[1985,20-21;
164-66].
Economizingon thesumof productioncostsand
To be sure,thisoversimplifies.
transactioncostsis a moregeneralstatementof thehypothesis (Riordan and William-
son [1985]).
68 OliverE. Williamson JJDTTIE

incentiveagreement.The usual agency theorysetup also assumes that agents

are more risk averse than principals. Accordingly,agency theoryworks offof
the tradeoffbetween incentiveintensityand efficientrisk bearing.13
Transaction cost economics maintains that all complex contracts are un-
avoidably incomplete (by reason of bounded rationality).14Accordingly,it is
impossible to address and resolve all of the relevant contracting issues in
advance - best effortsat ex ante incentivealignmentnotwithstanding.Instead,
much of the relevantcontractingaction spills over into the contractexecution
intervaland must be resolved ex post by whatevergovernance apparatus has
been provided. Agency theoryand transactioncost economics are thus distin-
guished by the factthat the ex ante incentivealignmentemphasis of the former
gives way to an ex post governance structureemphasis by the latter.(In fact,
of course, both are needed.)
Transaction cost economics also describes the main tradeoffdifferently.
Rather than examine the relation betweenincentiveintensityand efficientrisk
bearing, the focus instead is on the relation between incentiveintensityand
bilateral adaptability. (Risk neutralityis typicallyassumed, whereupon issues
of efficientriskbearingevaporate.) As hithertoremarked,the object is to align
transactionswith governance structuresin a discriminatingway.
Specifically,if some transactionsbenefitespecially fromincentiveintensity
while others have greaterneeds for adaptability,if adaptability and incentive
intensitynormallystand in a tradeoffrelationto one another,and ifgovernance
structuresdiffersystematicallyin the mannerin which thistradeoffis resolved,
then the manner in which transactionsand governance structuresare aligned
will have economizing consequences. Roughly speaking, transactioncost eco-
nomics predicts that there will be a shift out of markets (which have the
strongerincentiveintensityproperties) into hierarchies(which featureadapt-
ability) as the condition of asset specificitybuilds up.15 Hybrid modes of
organization (joint ventures, franchising,regulation, various forms of long
termcontracting)are interpretedas governance structuresforwhich an incen-
tiveintensity/adaptability compromisehas been reached. Agency theorymakes
no such distinctions.

13 As theconference
paperbyHolmström and Milgromindicates, agencytheoryhas
begunto considerothertradeoffs, ofwhichincentive intensityversustaskvarietyis one.
This is a verynewand promising direction.
Also,contractas promiseis assumedto fail,thereasonbeingthatcontracts unsup-
portedbycrediblecommitments willbe undonebyopportunism. For an elaboration,see
Williamson[1985,64-66].
can take severalforms- of whichsitespecificity,
Assetspecificity physicalasset
humanassetspecificity,
specificity, and dedicatedassetsare themainvarieties.Each has
somewhat different
contractingramifications.For a relatedbutdifferenttreatmentofthe
relevanttradeoff,see Sanford Grossmanand Oliver Hart [1986].
146/1(1990) A Comparison
of Alternative to EconomicOrganization69
Approaches

3. ConcludingRemarks

Significantdifferencesamongthefourcontractual nodes- publicchoice,prop-

ertyrights,agencytheory,and transactioncost economics- of the schema
notwithstanding, thesefourprogramscan be viewedas complements. Indeed,
a cumulative contractualresearchprogramis inprogress.Thejoinderoftheory
withinstitutionshas crosseda thresholdfromwhichthereis no returning.
The nextdecadewillwitnesscontinuing developmentsand refinements ofthe
contractual approach- in conceptual,theoretical,
empirical,and publicpolicy
respects.The elusive"scienceoforganization"to whichChesterBarnardmade
reference fiftyyearsago (Barnard [1938,290]) mayeventually takeshape.16
Such a new science,if it materializes,
will,I conjecture,cross disciplinary
boundaries.The mainaxis willbe economicsand organizationtheory,where
theformer providesan economizingorientation and thelattersuppliesadded
behavioraland organizationalcontent,to whichthelaw (especiallycontract
and property law) providesadded support.Workof thiskindis in progress.17

Summary

Earliernoncontractual treatmentsof firmand marketorganizationare con-

trastedwithmorerecentcontractual approachesto theseissues.Publicchoice,
propertyrights,agencytheory, and transactioncost approachesare distin-
guishedamong the latter.
Whereas propertyrightsemphasizesex anteinstitu-
tionalarrangements, agencytheory focuseson ex ante incentivealignments,
and transactioncosteconomicsemphasizesex postgovernance.All are perti-
nentto theincipientscienceof organization.

Zusammenfassung

AnalysenderOrganisationsformen
Älterenichtvertragstheoretische Unterneh-
mungundMarktwerdenneuerenvertragstheoretischen Ansätzenvergleichend
Bei den neuerenAnsätzensinddie Theorieder kollektiven
gegenübergestellt.
Wahlhandlungen, TheoriederVerfügungsrechte,
die die ökonomische Theorie
undderTransaktionskostenansatz
derStellvertretung Wäh-
zu unterscheiden.

16 For a discussionof Barnardand recent

progresstowardan incipientscienceor
organization,see Williamson[1990].
17 As Arrowremarks,"the New Institutional Economicsmovement...[does] not
consistprimarily of givingnew answersto the traditionalquestionsof economics-
Ratherit consistsof answering
resourceallocationand degreeof utilization. newques-
tions,whyeconomicinstitutions have emergedtheway theydid and not otherwise;it
mergesintoeconomichistory, butbringssharpernanoeconomic...('nano' is an extreme
versionof 'micro')reasoningto bearthanhas beencustomary"(Arrow [1987,734]).
70 OliverE. Williamson ¿IITOTE

renddie Theorieder Verfügungsrechte vorwiegend auf eine ex ante Analyse

institutioneller
Arrangements abstellt,setztdie ökonomische TheoriederStell-
vertretungeinenSchwerpunkt bei derGestaltungvon Anreizenex ante.Dem-
gegenüber betontderTransaktionskostenansatz die Bedeutungderorganisato-
rischenGestaltungex post, d.h. in der Phase der Vertragsabwicklung. Alle
Ansätzesindfürdie nochjungeWissenschaft derwirtschaftlichen Organisation
relevant.

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OliverE. Williamson
TransamericaProfessor
ofBusiness,Economics,and Law
Departmentof Economics
Berkeley
of California,
University
250 BarrowsHall
Berkeley,CA 94 720
U.S.A.