Theories of Economic Organization: The Case for Realism and Balance

Author(s): Peter Moran and Sumantra Ghoshal

Source: The Academy of Management Review, Vol. 21, No. 1 (Jan., 1996), pp. 58-72
Published by: Academy of Management
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c Academy of Management Review
1996, Vol. 21, No. 1, 58-72.

THEORIESOF ECONOMICORGANIZATION:THE
CASE FOR REALISMAND BALANCE
PETERMORAN
INSEAD,Fontainebleau, France
SUMANTRAGHOSHAL
London Business School

After reviewing Professor Williamson's response to our article, "Bad

for Practice: A Critique of Transaction Cost Theory,"our first reaction was
a sense of frustration because it was clear that we had failed to commu-
nicate to him the essence of the argument we had tried to make. That
feeling, in turn, suggested the need for a concise restatement of our ar-
gument in this reply to his response. On second thought, however, it
appeared unlikely that such a restatement would add any value because
we would continue to talk past one another. If this debate is to amount to
anything other than what a senior colleague once described as "the pure
joy of academic mud wrestling," it is necessary to focus our response on
the issues Professor Williamson has raised, so as to identify as clearly as
possible the gulf that separates his perspective from that of ours.
At the same time, we fear that a nuanced theoretical debate on the
admittedly important issues that Professor Williamson has raised may
obscure the broader and more important point we have made in our ar-
ticle: that markets and firms are very different kinds of institutions, with
very different internal logics; to be effective, each must implement its own
logic and not the other's. Theories that ignore this distinction, as trans-
action cost economics (TCE)does, are unsuitable for drawing normative
implications for corporate managers because managing an organization
based on the logic of markets prevents the development of what we have
described as "the organizational advantage." To be useful to managers,
a theory must be grounded in a deep understanding of the organizational
logic and "Bad for Practice" is an attempt to clarify the theoretical points
of departure that we believe are needed for researchers to begin work on
building such a theory.
Nothing in Professor Williamson's response contradicts this core ar-
gument. Indeed, there are two specific things he has said that rein-
force our critique of his version of TCE. First, he has confirmed that he
regards all forms of organization, including internal organization, as

The authors thankfully acknowledge the suggestions and comments they received from
YrjoKoskinen and Gerhard Holt.

58
1996 Moran and Ghoshal 59

"instruments." Second, he regards management as a "ceteris paribus con-

dition," and all that is required to acknowledge its role in companies is to
recognize that "good always does better than worse." In "Bad for Prac-
tice," we suggested that scholars who are interested in the issues of
strategy and management of firms are well advised to develop a different
theory, one more attuned to the logic of organizations, rather than adapt
theories like TCE that claim to inform organizational issues while being
rooted in the logic of markets. We now remind these scholars that "in-
struments" do not have or need strategies because they have no purpose
of their own and exist merely to serve the purposes of others; also, theo-
ries cannot yield any normative proposals with regard to factors that are
their ceteris paribus conditions.
In the concluding section of this article, we return to these broader
issues. However, having initiated this debate, we owe it to Professor
Williamson to first respond to the specific issues he has raised with re-
gard to (a) the nature of human beings, (b) the nature of organizations,
and (c) the nature of the empirical evidence.
The Nature of Human Beings
Drawing from Simon (1985: 303), Professor Williamson argues that
"Nothing is more fundamental in setting our research agenda and inform-
ing our research method than our view of the nature of the human beings
whose behavior we are studying" and that a "balanced and realistic"
view of human nature must inform both our research and the design of our
institutions. Presumably, Professor Williamson agrees with both Simon's
and Madison's notion of balance and realism (i.e., one that "requires a
certain degree of circumspection and distrust" and simultaneously "jus-
tifies a certain portion of esteem and confidence"). However, rather than
limit self-interestedness, as Simon does, to "frailties of motive and rea-
son" as the chief cause for concern, Professor Williamson adds the con-
cern of opportunism. We completely agree with the argument to this point
but are puzzled how he believes that either balance or realism is achieved
by augmenting self-interest with opportunism while at the same time
choosing to ignore those qualities that justify esteem and confidence! We
suggest that the view of human nature that stems from this approach is
neither balanced nor realistic.
Madison's and Simon's reminder that people behave in ways that
sometimes require "circumspection and distrust" and other times justify
"esteem and confidence" begs the question: What determines the form of
behavior individuals will choose? This question is not new and has been
at the heart of the dispositionalist versus situationalist debate that psy-
chology scholars have been embroiled in for decades (see Kendrick &
Funder, 1988,for a recent review). The dispositionalists have long argued
that human attitudes and behaviors are primarily determined by person-
ality characteristics or traits. According to the situationalists, the indi-
vidual's situation matters the most in shaping his or her attitudes and
60 Academy of Management Review January

behaviors, and the idea of traits is unusable because either they do not
exist or they are not stable enough to be unaffected by most situations.
From the situationalist's perspective, the dispositionalist view is seen as
barren at best and more likely to be wrong and dangerous (Davis-Blake &
Pfeffer, 1989).Dispositionalists, in turn, reject the situationalist argument
on the grounds that "if behavior is completely determined by accultura-
tion, . . . then choice, purpose, and conscious adaptation are meaning-
less" (Jensen & Meckling, 1994: 11).
Interestingly, TCE is grounded in a schizophrenic view of human
nature that is simultaneously strongly dispositionalist and strongly situ-
ationalist. It is dispositionalist in the assumption that, with regard to
their attitudes, people are who they are and that their attitudes do not
change (independently from their behaviors). It is situationalist in the
assumption that, with regard to their behaviors, people are guided totally
by the incentives and disincentives that are present in the situation at
hand. The implication is not only that opportunism is arbitrarily selected
as the only disposition of relevance and the control of opportunistic be-
havior, then, naturally becomes the central function of organizations, but
also that all dispositions, including opportunism, can effectively be ig-
nored because they have no independent role in determining behavior or
in influencing governance. Hence, contrary to Professor Williamson's as-
sertions, TCE is actually locked out of candidly exploring the role of op-
portunism (or other dispositions) in any meaningful way.
Our argument in "Bad for Practice" is grounded in the assumption
that human behavior is shaped by both disposition ("priorconditioning")
and situation ("feelings for the entity"). We believe that in social organi-
zations, disposition and situation evolve interdependently in an iterative
manner, each influencing and being influenced by the other. Denial of
this interaction in any theory makes the theory ad hoc and incomplete; it
is ad hoc because, from a purely dispositionalist perspective, for example,
there is no basis other than the theorist's personal disposition-
essentially his or her personal values and ideology-for choosing the
focal traits among the many different and often contradictory elements of
human nature, and it is incomplete because a theory premised on either
a purely dispositionalist or a purely situationalist view tends to be static.
In strong-form dispositionalist theories, human beings change only
slowly if at all (i.e., their dispositions are relatively stable and unaffected
by the situation), whereas in strong-form situationalist theories, disposi-
tions can be safely ignored. By denying the interactions between human
volition and social context, both perspectives ignore the path-dependent
evolution that arises from this interaction.
Regarding Professor Williamson's specific comments on our paper,
he is wrong to suggest that we believe TCE to be preoccupied with ille-
gality and that we oppose a candid reference to opportunism on the
grounds that such candor invites bad practice. As the citations should
have made evident, our references to "embezzlers and bank robbers"
1996 Moran and Ghoshal 61

were quotations from Professor Williamson's writings-it is he who

referred to such behaviors as illustrations of opportunism. Also, our ob-
jection to his theory is not because of its candor but (a) because of its
incomplete focus on only one of several important elements of human
disposition and (b) because of his incomplete analysis that is restricted to
the potential hazards of opportunism while taking its source for granted.
More specifically, we argued that once the situational sources of oppor-
tunism are factored in, his prescriptions for mitigating the hazards of
opportunism within organizations are likely to enhance it.
The issue is not whether opportunism exists and should, therefore, be
candidly considered. Of course, it exists and must be addressed, but this
should be done with balance and realism. Simon's and Madison's re-
minder of the positive side of human nature also must be taken into
account. The critical issue, as we see it, is whether the assumption of
opportunism-as an irremediable attribute of human nature-is a useful
starting point for understanding and developing theory to explain and
guide organizational design. To what extent does taking this assumption
of opportunism as a starting point, without considering its sources, actu-
ally preordain the outcome of the three principles of conflict, mutuality,
and order that Commons insists must be addressed and TCEpurportedly
captures?
We suggest that a normative use of the TCE framework within orga-
nizations only serves to heighten the potential conflict, reduce the poten-
tial for mutual gains, and limit the means by which order can be accom-
plished. This is the crux of our argument why TCEis bad for practice, and
we supported our analysis with a large body of theoretical and empirical
literature, much of it quite recent. Therefore, we are surprised that Pro-
fessor Williamson totally rejects our critique without addressing this ar-
gument in any way.
Professor Williamson writes, "Ialso agree that the design of political
(and, I would add, economic) institutions is influenced by the choice of
behavioral assumptions." This is precisely why a more moderate view of
human nature, one which is more "balanced and realistic," would inval-
idate his design principles. Douglass Northshowed the vital role of social
context in creating market efficiency: "efficient markets require a govern-
ment that not only specifies and enforces a set of property rights but
lowers the costs of transacting, toward the Coasian ideal, as well; and
that operates within a framework of attitudes toward honesty, integrity,
fairness and justice that makes possible low costs of transacting per unit
of exchange" (1986:236). This "frameworkof attitudes" defines the broader
social context that influences human behavior and that Professor
Williamson's analysis essentially ignores. In "Badfor Practice" we make
the same point that North has made but at the level of the individual
organization. Unless Professor Williamson can argue why (a) attitudes
such as honesty, integrity, and trust matter any less than that of oppor-
tunism and (b) why and how attitudes remain substantively unaffected by
62 Academy of Management Review January

the context, his reiteration of why opportunism matters will not invalidate
either North's critique of his theory at the societal level or our critique at
the level of the individual organization and its management.
This difference between Professor Williamson's perspective on hu-
man nature and our own is critical because it influences practically all
that follows in theory development. In particular, as we show in the fol-
lowing section, TCE's narrowly defined role of organizations, as instru-
ments assigned the task of constraining behavior, follows directly from
Professor Williamson's view of human nature. In contrast, a more bal-
anced and realistic view of human nature also suggests a much more
expanded role of organizations as institutions capable of efficiently tap-
ping the vast and largely unexploited reserves of human knowledge and
aspiration.
The Nature of Organizations
"The economic problem of society," according to Friedrich Hayek, "is
a problem of the utilization of knowledge not given to anyone in its total-
ity" (1945:520). He argued persuasively that "the peculiar character of the
problem of a rational economic order is determined precisely by the fact
that the knowledge of the circumstances of which we must make use
never exists in concentrated or integrated form, but solely as the dis-
persed bits of incomplete and frequently contradictory knowledge which
all the separate individuals possess. The economic problem of society is
thus not merely a problem of how to allocate 'given' resources.... 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 these
individuals know" (1945:519-520).
The same argument that Hayek made for society as a whole applies
equally to firms, particularly large ones. "Theproblem is precisely how to
extend the span of our utilization of resources beyond the span of the
control of any one mind; and, therefore, how to dispense with the need of
conscious control and how to provide inducements which will make the
individuals do the desirable things without anyone having to tell them
what to do" (1945:527).
The challenge, however, is that although the dispersion of knowl-
edge makes decentralized decision making more attractive, it also in-
creases the transaction costs associated with accessing and using this
knowledge. Indeed, this was the original contribution of Coase (1991,
1992):the identification of transaction costs as a major reason, if not the
reason, for the existence of organizations. Translated at the level of a
single focal organization, this problem poses a dilemma: how to reduce
transaction costs within the organization while at the same time main-
taining the ability to exploit local knowledge of organizational members
that is so vital for effective adaptation.
By focusing on only one of the twin horns of this dilemma (viz., trans-
action cost economizing), Professor Williamson sacrifices realism and
1996 Moran and Ghoshal 63

balance in his analysis of organizations, just as he does in his analysis of

human nature by focusing on opportunism alone while ignoring the more
positive traits. The consequence is that autonomous adaptation of the
Hayekian kind is largely precluded within the boundaries of the firm.
A more realistic and balanced view of organizations requires re-
searchers to recognize that, just like societies, organizations also need to
develop and exploit local knowledge internally; to do so, these organiza-
tions also must adapt to evolving internal social pressures. Such internal
forces are always different and often contradictory to market forces (oth-
erwise, they would be better served outside the organization). Although
organizations are instruments, as Professor Williamson suggests, they
also are much more. They are social institutions. Just as markets provide
much of the institutional context in which organizations and individuals
interact, organizations provide unique institutional contexts in which
their members interact. The contribution that organizations make to the
economy is not so much in doing what markets do, only better and more
efficiently (although, undeniably, they do play this role). Rather, organi-
zations' real contribution to economic progress is in their unique ability to
create their own distinct context-not an instrumental one that mirrors
the market or responds to market failures (although this role, too, is
played by many)-but a coherent institutional context, which enables the
organization and its members to actually defy (albeit, and importantly,
for only a limited time) the relentless gale of market forces, in order to
create a social environment with a combination of its own unique mix of
incentives and muted market incentives that encourages the assimilat-
ing, sharing, and combining of local knowledge in ways that are difficult
to do under the alternative institutional contexts of the market or of other
organizations. In short, organizations exist to do things that would be
inefficient and, therefore, not rational if attempted in other institutions or
markets.
As North argued, "Institutions alter the price paid for one's convic-
tions and hence play a critical role in the extent to which nonwealth-
maximizing motivations influence choices" (1990:26). Effective organiza-
tions do not search markets for transactions to internalize based on their
asset specificity only to transform themselves anew, like chameleons
each time a new transaction set is internalized, in order to efficiently
govern each set. Rather, they search for, and are themselves sought out
by, certain people: people who are differentially stimulated, challenged,
and liberated to pursue those convictions that the organization's unique
environment enables them to pursue at a cost that is perceived by the
individual as lower than the cost for him or her to behave similarly in any
other institutional environment.
Professor Williamson sees the combination of transaction, environ-
ment, and human factors as responsible for what he calls the fundamen-
tal transformation, which turns a large numbers supply condition into
bilateral dependencies. Once so transformed, transactions are ripe for
64 Academy of Management Review January

exploitation and, therefore, in need of safeguards to keep protective (mon-

itoring, enforcement, etc.) costs from getting out of control. Organizations
that offer appropriate safeguards are essentially efficient instruments for
providing damage control.
We, in contrast, view the organization as creating the environment
that fosters a sense of mutual dependency on and between its members in
the sense that they are attracted to its unique incentive context. The
organization effectively transforms the market context, which favors cer-
tain activities over others, into an alternative context that (explicitly or
implicitly) favors economic activities that are disfavored by the market
and other institutions and that would be unproductive and inefficient if
carried out in those institutions.
It is this mutual dependency, on this subsidiary institutional context,
among the organization's members that allows them to behave in a co-
herent fashion that would not be practical or even possible (i.e., such
behavior would be inefficient or irrational) outside of this subsidiary con-
text. Rather than damage control, organizations and the interdependen-
cies they foster create unique opportunities for both the organization and
its members. Yet the piper must ultimately be paid; that is, local knowl-
edge must be sufficiently accessed and mined for opportunities to be
productively exploited and lead to efficient (i.e., market-acceptable) be-
havior either in the production of goods or services that ultimately con-
form to the market's evolving rules or that change the rules. In the pro-
cess, however, the organization's path also influences the evolution of
market adaptation. Although the nature and extent of such influence are
almost certainly uncertain, the organization's participation may influence
the process more in its favor than would otherwise occur. This ability to offer
respite from market forces and the resulting potential to ultimately alter
these forces is the essence of the organization's (and the economy's) ability
to direct in a purposeful way (which ProfessorWilliamson refers to as reme-
diability), not only its own future and that of its members, but also that of
society. Even though, far from the nearly omniscient remediability of "third-
degree" path dependency to which Liebowitz and Margolis (1995)referred,
remediability, however imperfect, is still possible through organizations. In
imperfect but atomistic markets of autonomous actors, it is far less so.
Professor Williamson chides us for not having a defensible definition
of inefficiency. This is probably true. However, to demand a definition of
inefficiency as a precondition for challenging Professor Williamson's as-
sertion that "economizing is all" is to make that challenge a prisoner of
his framework. Despite the altar on which it has been placed, the concept
of efficiency, as used by Professor Williamson, is a weak one. It rests on
an act of faith that inefficient organizational forms will be selected out
over time by more efficient ones. Once again, our arguments can be better
understood from the perspective of Douglass North, who showed that a
defensible concept of efficiency (in comparing different institutional
structures) may be impossible. "As long as transaction costs are positive
1996 Moran and Ghoshal 65

and large, we have no way by which to define an efficient solution with

any real meaning, because we have no way of specifying what an effi-
cient 'government' underlying the economic structure of property rights
is.... At this point, we really don't know what makes for efficient mar-
kets" (1986:236). As would be obvious, once this ambiguity in the defini-
tion of efficiency is acknowledged, Professor Williamson's scheme for
determining "which transactions go where and why" becomes indetermi-
nate and less useful.
If we acknowledge the institutional nature of organizations, it is not
necessary to have a precise definition of inefficiency to make the case that
the logic of static efficiency is not enough to understand the process of
adaptation. Let us revert again to Douglass North: "Incremental change
comes from the perceptions of the entrepreneurs in political and economic
organizations that they could do better by altering the existing institu-
tional framework at some margin" (1990: 8). Note, these entrepreneurs
could alternatively assemble a bundle of contracts in the market to
achieve their goals without altering the institutional framework. How-
ever, the subsidiary institutional framework provided by an organization
gives its members an organizational context and structure from which
they can collectively challenge and overcome, by altering, the forces of
the market in which they must interact. They do this directly by purpose-
fully replacing (i.e., ignoring or suppressing some and enhancing other)
incentives that are "efficient" in the market (within its given institutional
framework) with alternative incentives which are "inefficient"(within the
same framework). Even though it is true that this asymmetry in incentives
cannot (and should not) persist indefinitely (i.e., the organization ulti-
mately must respond to market forces that define evolving current period
efficiency), by providing a subsidiary institutional framework for its mem-
bers, the organization buys time and sets forces in motion to pursue a
path that could not be (efficiently) pursued under the institutional context
of the market alone or even of other organizations.
What Professor Williamson misses because of his conceptualization
of organizations as instruments and the resulting focus on efficiency is
the key role of learning in the evolution of organizations as institutions.
Nowhere is this more evident than in his claim that "provided that oppor-
tunism is examined in the context of farsighted contracting, the lesson is
to look ahead, perceive possible hazards, and take hazard mitigating
actions." This is the main justification for what he calls "the case for
candor." The problem of such candor-of such care in hazard mitiga-
tion-is that it tends to eliminate the opportunity for discovery and learn-
ing among transaction partners (both internal and external) and for them
to benefit from their evolving local knowledge. It locks organizations into
predetermined paths and, thereby, sacrifices the flexibility of responding
to unfolding uncertainty and of using evolving knowledge. Our objection
to his "economizing-is-all" principle rests not on a justification of ineffi-
ciency, per se, but on the ground that flexibility and learning require a
66 Academy of Management Review January

minimum level of trust and some sacrifice. Candor, in the sense the term
is used by Professor Williamson, befits the omniscient-one who knows
and knows best. For those, like managers of most companies, who do not
know (who, because of uncertainty, do not have the foresight that Profes-
sor Williamson's theory demands), it is not the elimination of hazards but
the ability to learn and to use the learning of others that is the prerequi-
site for "healthy progress." For them, the role of efficiency acts more as a
constraint than as the objective or driving force of progress that Professor
Williamson views it to be.
In reflecting on the progress made in TCE since his critical insight
over 50 years ago, Coase recently remarked, "the interrelationships
which govern the mix of market and hierarchy, to use Williamson's terms,
are extremely complex, and in our present state of ignorance it will not be
easy to discover what these factors are. What we need is more empirical
work" (1992:718). Notwithstanding this remark, Professor Williamson re-
fers to TCE as "an empirical success story." We turn now to examine the
state of the empirical evidence that is often cited to support this claim and
to assess the implications that this literature has on our critique of TCE.
We argue that the state of this body of empirical research is such that
even though it may be "broadly corroborative"(i.e., not disconfirming) of
TCE'spredictions, it also does not disconfirm either our criticisms of TCE
or the alternative logic we propose.
The Nature of the Empirical Evidence
Before comparing our competing arguments against the weight of the
empirical evidence, it is helpful to first consider some points (a) on which
these two arguments differ and (b) that might suggest some testable prop-
ositions for distinguishing between them. As we stated in "Bad for Prac-
tice" and reiterated in this article, we agree with Professor Williamson
that opportunism exists, that it drives opportunistic behavior, and that
such behavior can be one (but in our view, not the only) major factor
contributing to transaction costs. We also agree that (a) transaction char-
acteristics, such as asset specificity, uncertainty, and so on, broaden the
scope for opportunistic behavior; (b) that the scope for such behavior, in
turn, moderates the relationship between opportunism and opportunistic
behavior (i.e., the greater the scope for opportunistic behavior the more
likely opportunism will manifest into such behavior); and (c) that organi-
zations play an instrumental role in lowering transaction costs. But
whereas TCEtheory confines the role of organizations to one of restricting
the scope for opportunism, our view of organizations as social institutions
gives them a much more expansive role.
Indeed, it is this institutional role of organizations that we have ar-
gued allows managers to lower the cost and to increase the effectiveness
of economic activity, not by controlling pathological behavior, but by
creating and sustaining a context in which collaborative entrepreneurial
behavior can flourish. We believe that effective organizations are more
1996 Moran and Ghoshal 67

likely to replace hierarchy with institutional forms of governance that

foster a framework of attitudes that moves people away from opportunism
and closer toward attitudes that induce the esteem and encourage the
confidence that is necessary for effective collaboration among its mem-
bers (North, 1990).To elicit desirable extra-role behavior from their mem-
bers, institutions that are able to achieve such a context are likely to
expand, not restrict, discretionary behavior. Hence, although some orga-
nizations undoubtedly will attempt to offset the greater behavioral dis-
cretion associated with certain transaction characteristics (as TCE pre-
dicts), other organizations with a coherent institutional context will
tolerate, indeed encourage, greater discretion and will benefit from doing
so (this TCE denies).
Unfortunately, the state of the empirical evidence available to com-
pare these competing arguments is still too crude to rule out either TCE's
logic or ours. However, advances in methodological sophistication are
beginning to expose some of the weaknesses that we have suggested
exist in TCE'slogic. Moreover, as some of the empirical evidence that has
historically been cited in support of TCEcontinues to be scrutinized, it is,
increasingly, being reinterpreted to support arguments that pose anom-
alies for TCE but are largely consistent with our view.
Despite the large body of empirical work that has been conducted to
test TCE, most, if not all, of its findings are equivocal in their ability to
confirm the underlying logical links on which the theory depends. For
example, even though most studies confirm an association between
transaction characteristics and governance form (i.e., market or hierar-
chy), they are unable to explain the nature of this association. Does hi-
erarchy arise as a response to the increased hazards of market contract-
ing? (as TCE unequivocally argues), or does internalization of those
transactions lower their costs beyond what market governance can
achieve, even without the threat of opportunism? (as we and others like
Holmstrom & Milgrom, 1991, 1994;Masten, Meehan, & Snyder, 1991;and
Monteverde, 1995,have argued). The correlational evidence assembled to
date cannot rule out either of these two alternative causal explanations.
Testing TCE's hypotheses with the necessary rigor to rule out com-
peting views is a daunting task. That any progress has been made-and
a great deal has-is a tribute to the time, skill, and innovativeness of the
many scholars who have applied themselves to this effort. (See, for ex-
ample, Masten, 1994, for an enlightening review of some of the thorny
conceptual and practical hurdles encountered and overcome by these
researchers, as well as their remaining challenges.) As progress contin-
ues, some methodological weaknesses responsible for this equivocalness
have been identified and are beginning to be addressed. For example,
noting that empirical tests of TCE theory have "concentrated on factors
aggravating market exchange" and, by contrast, have treated the limita-
tions of internal organization "as a barrier to be overcome before integra-
tion would occur," Masten, Meehan, and Snyder (1991: 1) argued that
68 Academy of Management Review January

"recognition that variations in internal organization costs may also play

a role in the decision to integrate exposes an inherent weakness in the
nature of these tests." Much of the equivocalness in the evidence neces-
sarily stems from the "reduced-form"nature of the hypotheses on which
analysts have had to rely in order to compare the differential efficiencies
of organizational alternatives for which transaction costs could not be
measured, or even observed (Masten, 1994;Masten et al., 1991).
However, as Masten pointed out, "such tests do not permit identifi-
cation of the structural relations that underlie those hypotheses. The hy-
pothesis that asset specificity favors integration, for example, is based on
propositions (i) that investments in relationship-specific assets increase
the scope for opportunism, and (ii) that internal organization attenuates
opportunism relative to market exchange.... A finding that asset spec-
ificity increased the likelihood of integration could result even if asset
specificity had no effect on the hazards of market exchange . . . if, for
some reason, investment in relationship-specific assets reduced internal
organization costs" (1994: 10).
In fact, this is just what Masten and his colleagues (1991)found in
probably the only study that has attempted to estimate the underlying
structure of transaction costs: "the correlation between human capital
specificity and the likelihood of integration . . . is a consequence of a
decrease in internal organization costs rather than the increase in the
costs of market exchange that the [TCE]theory predicts" (1991:19, empha-
sis added). They also found that "complexity has an unexpected non-
monotonic affect on both internal organization costs and the probability of
integration, initially increasing and then decreasing the costs of organiz-
ing within the firm, with opposite effects on the likelihood that a trans-
action will be integrated. Fully satisfactory explanations for these find-
ings are elusive" (1991:21, emphasis added). It is important to note that,
as Masten (1994)pointed out, even though the "reduced-form"results sup-
port all TCEpredictions, the structural-equation estimations support only
some of the underlying hypotheses and call into question the causal
mechanisms implied in TCE theory. For example, if opportunism were
driving integration, as TCE predicts, added complexity would increase
the cost of coordination both inside and outside firms and integration
would be favored only by a widening differential in market costs over
internal costs and not because integration costs are lower!
In noting these striking results, Monteverde suggested, "Ironically,
although the authors title their article 'The Costs of Organization,' their
findings might perhaps be more appropriately labeled the 'Benefits of
Organization.' Their principal finding suggests that transactions involv-
ing a high degree of human capital specificity are vertically integrated
not necessarily because of fears of using the marketplace, but because it
is somehow beneficial having such transactions executed within organi-
zations" (1995:6).
Importantly, scholars are beginning to marshal together the
1996 Moran and Ghoshal 69

theoretical explanations that might explain this finding, and, in the pro-
cess, they are beginning to reinterpret past empirical work that was ini-
tially argued to be supportive of TCE. For example, Holmstrom and Mil-
grom (1991, 1994) applied the argument that organizations are better able
to ensure the combined performance of certain multitask activities (that
vary in importance and performance measurability) by muting market
incentives, to reinterpret the findings from Anderson and Schmittlein's
(1984) investigation of the integration of industrial sales forces. Holm-
strom and Milgrom argued that internalization of sales personnel is more
likely when "the cost of measuring sales performance is high . .. or when
hard-to-measure nonselling activities are important" (1994: 974). Con-
versely, the use of independent representatives is more likely "when per-
formance is easy to measure or when nonselling activities are unimpor-
tant" (1994: 974). Comparing their interpretation with TCE, they add that
"notably, variables meant to reflect Williamson's (1985) version of trans-
action-cost theory, emphasizing asset specificity, uncertainty, and the
interactions between the two, all proved much less significant" (1994: 974).
Kirk Monteverde (1995), one of the first scholars to find empirical sup-
port for TCE theory (Monteverde & Teece, 1982), provided a more salient
interpretation of his earlier findings and those of other empirical studies.
He gives us yet another possible explanation for the cost-reducing bene-
fits of internalization without the need to invoke opportunism. Rather than
assume the "consequent fear of quasi-rent appropriation," as he did ini-
tially, Monteverde now argues that "it may be the case that components
produced internally by the auto companies are those whose efficient de-
sign and production requires dialog between engineers who, if they work
within the same organization, have come to use the same firm-specific
communication codes" (1995: 5). Neither of these interpretations relies on
opportunism in any way. Moreover, both accommodate the view that in-
ternalization is a way to actually lower transaction costs, per se (and not
just stem market cost increases).
Taken separately, findings like those considered in the preceding
paragraphs represent stubborn anomalies to TCE's core predictions but
are only suggestive of the reasonableness of our argument. Taken to-
gether, this set of anomalies begins to form a pattern that weakens TCE's
core argument and begs the familiar question that Professor Williamson
himself is fond of asking, "What's going on here?" Moreover, when this
research is joined with the vast and growing body of empirical research
that exists outside the TCE paradigm (of which we reviewed only a small
sample in "Bad for Practice" and that Professor Williamson has chosen
not to acknowledge), any conclusion that TCE is an "empirical success
story" appears to be premature.
The Case for Realism and Balance
In his Presidential Address to the members of the Academy of Man-
agement in 1993, Donald Hambrick (1994: 13, 15) issued a call to relevance
70 Academy of Management Review January

for the field of management studies. "We must recognize," he said, "that
our responsibility is not to ourselves but to the institutions around the
world that are in dire need of improved management, as well as to those
individuals who seek to be the most effective managers they possibly can
be.... Right now, we have a minute role in most major debates regard-
ing business and management. Why is that?"
There are, no doubt, many reasons for the general indifference that
most management practitioners apparently have for the work of their
academic counterparts. However, we believe that a major source of the
growing gulf between theory and practice lies in the lack of realism and
balance in most theories. Although the demand for parsimony requires a
certain degree of abstraction from reality, for any theory to be useful, the
theory's "use in practice" must be considered, and this is rarely done. In
their collective desire to enhance the rigor of their theorizing, manage-
ment scholars have increasingly turned a blind eye to the extreme styl-
ization and sweeping assumptions in the ideas they have imported from
different disciplines to analyze organizational and managerial issues.
Whereas these abstractions, stylizations, and restrictive assumptions
have enhanced our understanding of certain isolated situations, they are
not yet sufficiently general to apply to practice in any meaningful way.
It is not just that the ideas we have borrowed are partial; they are also
biased. In response, perhaps, to the earlier overemphasis on functional-
ism, theories of today are dominated by a profoundly pessimistic view of
organizations, concerned far more about the unintended consequences of
organizing than about organizing for their intended purpose, and by an
even more skeptical view of individual-organization interactions,
grounded in the assumption that the human role in organizations is
largely passive and frequently pathological. TCE is only one example of
this bias; the pessimism is just as strong in the strong assumptions of
inertia in population ecology (Hannan & Freeman, 1977), in the faith in
isomorphism that has virtually replaced the role of leadership in institu-
tional theory (contrast, e.g., DiMaggio &Powell, 1983,and Selznick, 1957),
in the denial of any role of organizational purpose and direction in the
behavioral theory of the firm (Cyert & March, 1963), and in the all-
pervasive concern for shirking, opportunism, and inertia in organization-
al economics (Alchian & Demsetz, 1972;Jensen & Meckling, 1994;Milgrom
& Roberts, 1992).The issues these theories highlight are not wrong, and,
indeed, these issues have considerably enriched our research agenda.
However, collectively, they also have shaped a field of enquiry that is
neither realistic nor balanced in its fundamental premises.
Hambrick's call to relevance does not require a return to the old days
of management studies when theory was viewed to be antithetical to
practice. Rather, it requires the development of new positive theories that
are grounded in realistic and balanced assumptions about people and
organizations (drawing on, wherever possible, the insights of different
disciplines but informed by, at the same time, the realities and
1996 Moran and Ghoshal 71

constraints of practice). We know that there are many in our field who
believe that the search for such theories is like the search for an oxymo-
ron. We believe, however, that only by developing such theories can
management studies not only meet the obligations that Hambrick drew
attention to, but also earn its right to exist as a legitimate and distinct
field of inquiry and not just as a minor subfield of other academic disci-
plines.

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Peter Moran is a doctoral candidate in strategic management at INSEAD.His re-

search focuses on the influence of organizational context and structureon individual
and group behavior and on organizational performance.
Sumantra Ghoshal received a Ph.D. in international management from MIT'sSloan
School of Management and a DBA in business policy from the Harvard Business
School. He holds the RobertP. Bauman Chair in Strategic Leadership at the London
Business School and is on leave of absence fromINSEADin Fontainebleau, France.
His current research focuses on the roles and tasks of managers in large corpora-
tions.