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Oliver E. Williamson is Charles and William L. Day Professor of Economics and Social Science at the University of Pennsylvania and Director of the University's Center for Study of Organizational Innovation? A Guggenheim Fellow and former Special Economic Assistant to the Antitrust Division of the U.S. Department of Justice, he is author of The Economics of Discretionary Behavior and Corporate Control and Business Behavior.Excerpt. © Reprinted by permission. All rights reserved.:
Toward a New Institutional Economics
A broadly based interest among economists in what might be referred to as the "new institutional economics" has developed in recent years. Aspects of mainline microtheory, economic history, the economics of property rights, comparative systems, labor economics, and industrial organization have each had a bearing on this renaissance. The common threads that tie these various studies together are: (1) an evolving consensus that received microtheory, as useful and powerful as it is for many purposes, operates at too high a level of abstraction to permit many important microeconomic phenomena to be addressed in an uncontrived way; and (2) a sense that the study of "transactions," which concerned the institutionalists in the profession some forty years ago, is really a core matter and deserves renewed attention. Unlike the earlier institutionalists, however, the current group is inclined to be eclectic. The new institutional economists both draw on microtheory and, for the most part, regard what they are doing as complementary to, rather than a substitute for, conventional analysis.
The spirit in which this present book is written very much follows the thinking of these new institutionalists. I hope, by exploring microeconomic issues of markets and hierarchies in greater detail than conventional analysis commonly employs, to achieve a better understanding of the origins and functions of various firm and market structures -- stretching from elementary work groups to complex modern corporations. I focus on transactions and the costs that attend completing transactions by one institutional mode rather than another. While the relation of technology to organization remains important, it is scarcely determinative. I argue in this connection that, but for a few conspicuous exceptions, neither the indivisibilities nor technological nonseparabilities on which received theory relies to explain nonmarket organization are sufficient to explain any but very simple types of hierarchy. Rather I contend that transactional considerations, not technology, are typically decisive in determining which mode of organization will obtain in what circumstances and why.
Central to the analysis is what I refer to as the "organizational failures framework." Its distinction is that it expressly acknowledges the importance played by human factors in attempting to grapple with problems of economic organization. Such considerations usually operate, if at all, only in a vague, background way. Indeed, they are altogether suppressed in many of the conventional models of economic man that populate intermediate theory textbooks. Although references to "human nature as we know it" (Knight, 1965, p. 270) occasionally appear, these rarely occupy an active role in the analysis. I submit, however, that more self-conscious attention to rudimentary human attributes is essential if we are to accurately characterize and more adequately understand many of the problems of markets and hierarchies.
The remainder of this chapter is an overview of the mode of analysis and types of problems that this book is concerned with. Some of the antecedents to the proposed approach are examined in Section 1. A preliminary statement of the basic framework is set out in Section 2. The framework is then applied to three specific examples in Section 3. These applications reveal that a sensitivity to transaction costs is often essential. They also show that the language of studying markets and hierarchies proposed herein often permits microeconomic phenomena of quite diverse kinds to be understood in different and in some respects deeper ways than conventional analysis would otherwise afford.
1. Some Antecedents
The materials in this section are in no sense a survey. They merely indicate an early concern among some members of the profession of the types of institutional issues that I deal with in this treatise. With the exception of the market failure literature, which is examined briefly in Section 1.4, there is little reason to believe that there was a concerted effort among the successive authors whose work is cited to redefine economic problems in a complementary way. Each was, however, committed to the proposition that economics should expressly address and help assess the transactional properties of alternative modes of organization.
1.1 Commons on Institutional Economics
As Commons was aware, his treatment of institutional economics was a highly personal effort (1934, p. 1). lie was exploring new issues and inventing a quasijudicial language as he proceeded. Inasmuch as the transaction was held to be the ultimate unit of economic investigation (1934, pp. 4, 5, 8), he made transfers of legal control and the efficacy of contracting the focus of his studies.
He considered scarcity to be ubiquitous and conflict of interest, natural (1934, p. 6). He saw the central contribution of institutional economics to the study of economics to be the introduction and explication of the importance of collective action. The requisite degree of cooperation for efficiency to be realized arose not from a presupposed harmony of interests but from the invention of institutions that produced order out of conflict, where order was defined as "working rules of collective action, a special case of which is 'due process of law'" (1934, p. 6). To the extent that collective action was successful in mitigating conflict, a greater total yield -- hence, potentially, a more preferred result for all of the parties -- was thereby made feasible.
His treatment of "futurity" is of special significance, where "The concept of futurity is that of expected events, but the principle of futurity is the similarity of repetition, with variability, of transactions and their valuations, performed in the moving Present with reference to future events" (1934, p. 738). The emphasis, as I interpret it, is on (1) recurrent contracting, conducted under conditions of (2) uncertainty, and for which (3) successive adaptations are needed to bring the parties into efficient adjustment. As will be apparent, each of these plays an important role in the discussion of transactions in the sections and chapters that follow.
1.2 Coase on the Nature of the Firm
Coase has characterized his 1937 treatment of the firm as "much cited and little used" (1972, p. 63). The reason why it is so widely cited, I submit, is that there is a general appreciation among economists that conventional treatments of firms and markets are not really derived from first principles but are instead arbitrarily imposed. Coase's article makes this fact clear, which qualifies it as a natural in any survey of price theory. But the article is also rather tautological (Alchian and Demsetz, 1972, p. 783), a characteristic that explains why it is not more widely used. Transaction costs are appropriately made the center piece of the analysis, but these are not operationalized in a fashion that permits one to assess the efficacy of completing transactions as between firms and markets in a systematic way.
The article is nevertheless an uncommonly insightful treatment of a fundamental problem at an early point in time and can scarcely be faulted because it did not go further. Of special importance for my purposes are its following attributes:
1. Transactions, and the costs associated therewith, not technology, are the central object of the analysis (1937, pp. 336, 338, 341,350).
2. Uncertainty and, implicitly, bounded rationality are key features of the argument (1937, pp. 336-337).
Coase contends that the firm serves to economize on transaction costs in two respects. First, reliance on the price mechanism requires that the relevant prices be discovered (1937, p. 336). The firm becomes a sole source supplier to itself for those transactions that are shifted out of the market and into the firm; relevant prices are known or, in any event, bids are presumably solicited less frequently as a result. Second, the firm substitutes a single incomplete contract (an employment agreement) for many complete ones. Such incomplete contracts purportedly economize on the "cost of negotiating and concluding" separate contracts (1937, p. 336). They also facilitate adaptation to changing market circumstances, because the requisite services to be provided are described in the employment agreement in only general terms -- the details are to be elaborated at a later date (1937, p. 337).
The underlying factors that explain how and why these economies are realized are not worked out, however, and Coase's discussion of why internal organization does not fully displace the market is even less complete. Though its discussion here would be premature, I submit that a more complete theory of firms and markets than Coase was able to forge in this seminal study awaits more self-conscious attention to the ramifications of the elementary attributes of human decision makers -- of which opportunism is one, and bounded rationality is another.
1.3 Hayek on Information
Hayek's discussion of the rational economic order is of interest in several respects. For one thing, he was especially anxious to dispel the notion that central planning is a realistic alternative to competitive market systems (1945, p. 521). Although I shall not be concerned with this issue here, the transactional approach developed herein and the firm or market issues that I address in the chapters that follow have an obvious bearing on the plan or market controversies that have occupied the attention of the profession for many years. More germane to the purposes of this book, however, are Hayek's observations of the following general kind:
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 (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" (1945, pp. 521-522).
3. The economic problem is relatively uninteresting except where economic events are changing and sequential adaptations to changing market circumstances are called for (1945, pp. 523-524).
4. The "marvel" of the economic system is that prices serve as sufficient statistics, thereby economizing on bounded rationality (1945, pp. 525-528).
Although each of these observations is important to the argument of this book, I use them 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. Also, unlike Hayek, the alternative organizational modes examined here are strictly firm and market; central planning boards never expressly enter the picture.
1.4 Market Failure
The postwar market failure literature is also an important antecedent literature that poses many of the same types of issues that arise in the markets and hierarchies discussion. As will be apparent, the insurance problem, as described by Arrow (1971, pp. 134-43) and examined in Section 3.1, below, is really a paradigm for studying the employment relation, vertical integration, and competition in the capital market, all of which are developed in the chapters that follow. Similarly, public goods issues (Samuelson, 1954; Hurwicz, 1972), including option demand discussions (Weisbrod, 1964; Cicchetti and Freeman, 1971), are variants of the price discrimination problem (see section 3.2, below). The extensive literature on externalities has long been linked with the question of vertical integration (Davis and Whinston, 1962). Akerlof's (1970) and Arrow's (1969) treatments of the effects of information asymmetries on market exchange are intimately connected with what I refer to as the information impactedness problem.
I draw, directly and indirectly, on this literature throughout the book. At the same time I find it instructive to apply the microanalytic contracting approach herein proposed to reinterpret aspects of the market failure literature. Commonalities among types of failures that are not otherwise apparent are thereby disclosed.
1.5 A Summing Up
My debts to Commons are principally that he defined the economic problem in a spirit that is very much akin to my own. I do not borrow more in detail from what he did because his is a highly personalized analysis and there have been significant developments in the economics and organization theory literatures of the past forty years that are more apposite. Coase's remarkable article on the nature of the firm is instructive in that he both posed the firm and market issues in a direct way and identified transaction costs and contractual relations as the critical factors to be investigated. Hayek's examination of the rational economic order, though directed toward central planning rather than firm and market issues, is very much concerned with problems similar to those found in this book. An appreciation for bounded rationality and idiosyncratic knowledge is essential if the study of markets and hierarchies is to proceed in an operationally engaging way. Finally, the market failure literature raises many of the same types of issues that are of interest here. The context and details differ, but the underlying phenomena are very much the same.
1.6 Some Differences
Despite my considerable reliance on prior literature, this book differs from earlier treatments of markets and hierarchies in significant respects. Even more striking are the differences between my approach to industrial organization issues and the familiar structure-conduct-performance paradigm. Some of the main dissimilarities are indicated here.
The markets and hierarchies approach is interdisciplinary in that it draws extensively on contributions from both economics and organization theory. In addition to the literature referred to above, the contingent claims contracting (Arrow, 1971, pp. 121-134; Meade, 1971, pp. 147-188) and recent organizational design (Hurwicz, 1972) literatures supply the requisite economic background. The administrative man (Simon, 1957) and strategic behavior (Goffman, 1969; Schelling, 1960) literatures are the main organization theory inputs.
The principal differences between the earlier literature and the approach taken here are that: (1) I am much more concerned than are prior treatments with tracing out the ramifications of bounded rationality; (2) I expressly introduce the notion of opportunism and am interested in the ways that opportunistic behavior is influenced by economic organization; and (3) I emphasize that it is not uncertainty or small numbers, individually or together, that occasion market failure but it is rather the joining of these factors with bounded...
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