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Paper Analysis Instructions:You are required to read some papers during the semester. These are the seminal papersabout important strategic theories and ideas. You need to read the paper and write yourunderstanding about it. In following, you will find some questions which you need todiscuss in your summary. What questions is the paper trying to answer?Are these important questions?What are the central points made by the paper?What conception of organizational strategy does the paper propose?What are the weak points of the paper?Is the logic of the paper internally consistent?Are the insights of the paper universally applicable?In what ways does the paper complement or contradict others from the course?What does the paper imply about the nature of organizations in general?What research questions does the paper suggest?What recommendations for strategy-makers does the paper suggest? Your summary should be no more than 1 page, single-spaced, Times New Roman font,and size 12 font. Margins should be 1 inch. If you find that you have too muchinformation, find a way to trim it down. Your summary SHOULD NOT be in list orbulleted form. You will write an essay in clear paragraph form.These summaries should be in your own words (i.e., extremely limited direct quotes). Iwill also look at the quality of your work in terms of misspellings, typos, and generalgrammar and punctuation. If you’re unsure that your writing skills are not up to snuff,there are writing centers available on campus. If you prefer a friend to read it (and Ihighly suggest you use this strategy), then be sure that friend is privy to the art of writingwell. The Economics of Organization:The TransactionCost Approach1Oliver E. WilliamsonUniversity of Pennsylvania The transaction cost approach to the study of economic organizationregards the transaction as the basic unit of analysis and holds thatan understanding of transaction cost economizing is central to thestudy of organizations. Applications of this approach require thattransactions be dimensionalized and that alternative governance structures be described. Economizing is accomplished by assigning transactions to governance structures in a discriminating way. The approach applies both to the determination of efficient boundaries, asbetween firms and markets, and to the organization of internal transactions, including the design of employment relations. The approachis compared and contrasted with selected parts of the organizationtheory literature.The proposition that the firm is a production function to which a profitmaximization objective has been assigned has been less illuminating fororganization theory purposes than for economics. Even within economics,however, there is a growing realization that the neoclassical theory of thefirm is self-limiting. A variety of economic approaches to the study oforganization have recently been proposed in which the importance ofinternal organization is acknowledged.Vhe one described here emphasizespaper has benefited from a number of discussions I have had with WilliamG. Ouchi, including those we had a t a Mini-Conference on Strategy, Marketing, andOrganization (held a t the Graduate School of Management, UCLA, during April 1980under the auspices of Booz, Allen, & Hamilton) and a t the recent Conference on theEconomics of Organization (held in Berlin in June 1980 under the auspices of theInternational Institute of Management). I t has also benefited from a year-long dialogue on these matters that Ouchi and I have had with Paul Kaestle and WilliamAllen. The paper also benefited greatly from remarks on an earlier version by BanriAsanuma and on a later revision by Herbert Simon. The assistance of AJS reviewersin reshaping the manuscript is also appreciated. Requests for reprints should be sentto Oliver E. Williamson, Department of Economics, University of Pennsylvania, Philadelphia, Pennsylvania 19104.2 These include the neoclassical theory of the firm-which,however is relatively sparsein its organizational implications-managerial discretion theory (Baumol 1959; Marris1964 ; Williamson 1964), team theory (Marschak and Radner 1972), agency theory(Alchian and Demsetz 1972; Jensen and Meckling 1976), and the transaction costapproach (Coase [I9371 1952; Williamson 1975). Although I was aware, when I was1 This O 1981 by The University of Chicago. All rights reserved 0002-9602/S2/S703-0002$01 .SO 548 AJS Volume 87 Number 3 Transaction Cost Approachtransaction costs and efforts to economize thereon. More than most economic approaches, it makes allowance for what Frank Knight (1965, p.2 7 0 ) has felicitously referred to as "human nature as we know it."3Economic approaches to the study of organization, transaction cost analysis included, generally focus on efficiency. T o be sure, not every interesting organizational issue can be usefully addressed, except perhaps in aminor way, in efficiency terms. A surprisingly large number can, however,especially if transaction cost aspects are emphasized. This is accomplishedby making the transaction-ratherthan commodities-the basic unit ofanalysis and by assessing governance structures, of which firms and marketsare the leading alternatives, in terms of their capacities to economize ontransaction costs.The transaction cost approach to the study of organizations has beenapplied at three levels of analysis. The first is the overall structure of theenterprise. This takes the scope of the enterprise as given and asks howthe operating parts should be related one to another. Unitary, holdingcompany, and multidivisional forms come under scrutiny when these issuesare a d d r e ~ s e d .The~ second or middle level focuses on the operating partsand asks which activities should be performed within the firm, which outside it, and why. This can be thought of as developing the criteria forand defining the "efficient boundariesn5 of an operating unit. The thirdlevel of analysis is concerned with the manner in which human assets areorganized. The object here is to match internal governance structures withthe attributes of work groups in a discriminating way.Only issues of the two latter kinds are addressed in this paper.G Thestudy of both of these issues turns critically on the dimensionalizing oftransactions. The antecedent literature from which the transaction costapproach derives is sketched in Section I. The rudiments of the approach,including the dimensionalizing of transactions, are then set out in Section11. Applications to the study of efficient boundaries are developed inSection 111.Employment relation issues are addressed in Section IV. Comworking on Markets and Hierarchies, that it had a number of applications outsideeconomics, the book was directed a t an economics audience. I was therefore gratifiedwhen organization theory specialists recognized merit in the approach. I a m especiallyindebted to William Ouchi for bringing the book to the attention of the organizationtheory audience (see Ouchi 1977).3 Knight’s remarks about the human attributes of economic agents have been widelydisregarded and attention has been focused narrowly on the risk-bearing aspects ofKnight’s classic work. 1 have discussed these issues a t length elsewhere (see Williamson 1970, chaps. 2 , 3,and 7 ; 1975, chaps. 8-9).5 The term "efficient boundaries" is borrowed from Ouchi ( 1 9 8 0 ~ ) . 6 F o r a discussion of the issues that arise a t the first level, see the references in n. 4. American Journal of Sociologyparisons with selected aspects of the organization theory literature andcontrasts with "power" approaches to the study of organizations are madein Section V. Concluding remarks follow.I. ANTECEDENTS The transaction cost approach to the study of organizations relates tothree relatively independent literatures. To be sure, there is considerableoverlapping among them and they have not proceeded heedless of oneanother. The extent to which they deal with common issues, however, israrely recognized.Considering that economizing is central to the transaction cost approach,it is not surprising that an economics literature is among the antecedents.Also, inasmuch as internal organizational issues are featured, the organization theory literature makes an expected appearance. The third literatureis less obvious: this is the contract law literature in which contract isaddressed as a governance issue.Each of these literatures is large, and my summary of the intellectualprogression in each is necessarily brief and omits important contributions.The 1930s witnessed significant advances in all three areas. My sketch ofthe antecedents begins there.The proposition that the transaction is the basic unit of economic analysis was advanced by John R. Commons in 1934. He recognized that therewere a variety of governance structures with which to mediate the exchange of goods or services between technologically separable entities.Assessing the capacities of different structures to harmonize relations between parties and recognizing that new structures arose in the service ofthese harmonizing purposes were central to the study of institutional economics as he conceived it.Ronald Coase posed the problem more sharply in his classic 1937 paper,"The Nature of the Firm." He, like others, observed that the productionof final goods and services involved a succession of early stage processingand assembly activities. But whereas others took the boundary of the firmas a parameter and examined the efficacy with which markets mediatedexchange in intermediate and final goods markets, Coase held that theboundary of the firm was a decision variable for which a n economic assessment was needed. What is it that determines when a firm decides tointegrate and when instead it relies on the market?Friedrich Hayek’s 1945 article, "The Use of Knowledge in Society,"shed further insight. He observed that the economic problem is relativelyuninteresting except when economic events are changing and sequentialadaptations to these changes are needed. What distinguishes a high per- Transaction Cost Approachformance economy is its capacity to adapt efficiently to uncertainty. Although he did not state the issues in transaction-cost-economizing terms,such terms are implicit in much of the argument.The postwar market failure literature helped better to define some ofthe "failures" with markets that common ownership (the firm) served toovercome. I t was not until 1969, however, that the underlying difficultieswith markets were unambiguously traced to transaction cost origins. AsKenneth Arrow put it: "Market failure is not absolute; it is better toconsider a broader category, that of transaction costs, which in generalimpede and in particular cases completely block the formation of markets"(1969, p. 48).The appearance of Chester Barnard’s book T h e Functions of the Executive in 1938 and of Herbert Simon’s explication of the Barnard thesis inAdministrative Behavior in 1947 are widely recognized as significant eventsin the organization theory field. Purposive organization was emphasized,but the limits of human actors in bounded rationality respects and theimportance of informal organization were prominently featured.This stream of research was further developed b y the "Carnegie School"(March and Simon 1958; Cyert and March 1963). Hierarchical organization and associated controls are traced to the limited capacities of humanactors to cope with the complexity and uncertainty with which they areconfronted. The organization is essentially viewed as a "problem-facingand problem-solving" entity (Thompson 1967, p. 9 ) . But organizationalefforts are often myopic, and demands for control can and often do giverise to dysfunctional outcomes.Although Alfred Chandler’s remarkable book, Strategy and Structure(1962)) had its origins in business history rather than organization theory,in many respects this historical account of the origins, diffusion, nature,and importance of the multidivisional form of organization ran ahead ofcontemporary economic and organization theory. The mistaken notion thateconomic efficiency was substantially independent of internal organizational structure was no longer tenable after this book appeared.James Thompson built on all of the foregoing in fashioning his classicstatement of the organizational problem in 1967. Both uncertainty andbounded rationality were featured. Moreover, implicitly, and sometimesexplicitly7 attention was fixed on efforts to economize on transaction costs.Core technologies, domains (or boundaries) of organized action, and thepowers and limits of market and hierarchical modes are all recognized.The legal literature to which I refer is concerned with contractingespecially the distinction between "hard contracting" (or black-letter law)For example, Thompson’s proposition that "under norms of rationality, organizationsgroup positions to minimize coordination costs" (1967, pp. 64-65) is in this spirit. 7 American Journal of Sociologyand "soft contracting" in which the contract serves mainly as framework.Karl Llewellyn’s 1931 essay addressed these issues. H e observed that transactions come in a variety of forms and that a highly legalistic approachcan sometimes get in the way of the parties instead of contributing to theirpurposes. This is especially true where continuity of the exchange relationbetween the parties is highly valued.Others who adopted and refined this theme include Steward Macaulay(1963)) Lon Fuller (1964)) Clyde Summers (1969)) David Feller (1973))and Ian Macneil (1974). As Macneil puts it, the discrete transaction"sharp in by clear agreement; sharp out by clear performance” (1974,p. 738)-is very rare in both law and economics, and we deceive ourselvesby treating it otherwise. What he refers to as "relational" forms of contracting-whichmay involve arbitration, collective bargaining, and othertypes of obligational market exchange-are becoming more important andneed to be recognized.A deepening awareness of transaction cost issues marks the progressionof each of the literatures. Among other things, by the early 1970s it wasbecoming clear that the study of organizations was a comparative institutional undertaking in which alternative governance structures-both withinand between firms and markets-requiredexplicit attention. Inasmuch,moreover, as the transactions of interest were not all of a kind, differencesamong them would evidently have to be recognized. What were the distinguishing attributes? Finally, although transaction cost economizing isan important and greatly neglected topic, such economizing cannot proceedregardless of the production cost ramifications. Put differently, transactioncost economizing needs to be located within a larger economizing framework and the relevant trade-offs need to be recognized. 11. SOME RUDIMENTS A transaction occurs when a good or service is transferred across a technologically separable interface. One stage of activity terminates and another begins. With a well-working interface, as with a well-working machine, these transfers occur smoothly. In mechanical systems we look forfrictions: do the gears mesh, are the parts lubricated, is there needlessslippage or other loss of energy? The economic counterpart of frictionis transaction cost: do the parties to the exchange operate harmoniously,or are there frequent misunderstandings and conflicts that lead to delays,breakdowns, and other malfunctions? Transaction cost analysis supplantsthe usual preoccupation with technology and steady-state production (ordistribution) expenses with an examination of the comparative costs of Transaction Cost Approachplanning, adapting, and monitoring task completion under alternative governance structures.Some transactions are simple and easy to mediate. Others are difficultand require a good deal more attention. Can we identify the factors thatpermit transactions to be classified as one kind or another? Can we identifythe alternative governance structures within which transactions can beorganized? And can we match governance structures with transactions ina discriminating (transaction-cost-economizing) way? These are the neglected issues with which organizational design needs to come to grips.These are the issues for which transaction cost analysis promises to offernew insights.Behavioral AssumptionsI t is widely recognized-by economists, lawyers, and others who have aninterest in contracting-thatcomplex contracts are costly to write andenforce. There is a tendency, however, to accept this fact as given ratherthan inquire into the reasons for it. As a result, some of the consequencesof and remedies for costly contracting are less well understood than wouldotherwise be the case.What is needed, I submit, is more self-conscious attention to "humannature as we know it." The two behavioral assumptions on which transaction cost analysis relies that both add realism and distinguish this approach from neoclassical economics are ( 1 ) the recognition that humanagents are subject to bounded rationality and ( 2 ) the assumption that a tleast some agents are given to opportunism.Bounded rationality needs to be distinguished from both hyperrationalityand irrationality (Simon 1978). Unlike "economic man," to whom hyperrationality is often attributed, "organization man" is endowed with lesspowerful analytical and data-processing apparatus. Such limited competence does not, however, imply irrationality. Instead, although boundedlyrational agents experience limits in formulating and solving complex problems and in processing (receiving, storing, retrieving, transmitting) information (Simon 1957), they otherwise remain "intendedly rational."But for bounded rationality, all economic exchange could be efficientlyorganized by contract. (The economic theory of comprehensive contractingfor unboundedly rational agents has been elegantly worked out.8) Givenbounded rationality, however, it is impossible to deal with complexity in8 T h e comprehensive contracting model is widely referred to as the Arrow-Debreumodel. For a discussion and an interesting contribution to this literature, see Radner(1968). American Journal of Sociologyall contractually relevant respects. As a consequence, incomplete contracting is the best that can be achieved.Ubiquitous, albeit incomplete, contracting would nevertheless be feasible.if human agents were not given to opportunism. Thus, if agents, thoughboundedly rational, were fully trustworthy, comprehensive contractingwould still be feasible (and presumably would be observed). Principalswould simply extract promises from agents that they would behave in themanner of steward when unanticipated events occurred, while agents wouldreciprocally ask principals to behave in good faith. Such devices will notwork, however, if some economic actors (either principals or agents) aredishonest (or, more generally, disguise attributes or preferences, distortdata, obfuscate issues, and otherwise confuse transactions), and it is verycostly to distinguish opportunistic from nonopportunistic types ex ante.A different way of putting this is to say that while organizational manis computationally less competent than economic man, he is motivationallymore complex. Thus, whereas economic man engages in simple self-interestseeking? opportunism makes provision for self-interest seeking with guile.Problems of contracting are greatly complicated by economic agents whomake "false or empty, that is, self-disbelieved threats or promises" (Goffman 1969, p. 105), cut corners for undisclosed personal advantage, coverup tracks, and the like.That economic agents are simultaneously subject to bounded rationalityand ( a t least some) are given to opportunism does not by itself, however,vitiate autonomous trading. On the contrary, when effective ex ante andex post competition can both be presumed,1° autonomous contracting willbe efficacious. Of these two, effective ex ante competition is a much easiercondition to satisfy: it merely requires that there be large numbers ofqualified bidders at the outset. The subsequent transformation of an exchange relation involving large numbers to one involving small numbersduring contract execution is what causes problems. Whether ex post competition is equally efficacious or breaks down as a result of contract execution depends on the characteristics of the transactions in question, whichbrings us to the matter of dimensionalizing.As Peter Diamond has put it, standard "economic models . . . [treat] individualsas playing a game with fixed rules which they obey. They do not buy more than theycan pay for, they do not embezzle funds, and they do not rob banks" (1971, p. 31).Only recently has this standard presumption come under scrutiny, often by makingallowance for what insurance specialists refer to as "moral hazard," which is a particular form of opportunism.1oAlthough large numbers of qualified bidders are frequently on a parity a t the outset, winning a bid and executing a contract often introduces a disparity between thequalifications of winners and those of nonwinners, with the result that bidding competition involving large numbers is not equally effective at the contract renewal interval. For a discussion, see Williamson (1971; 1975, pp. 27-36; 19796) ; and Klein,Crawford, and Alchian (1978).9 Transaction Cost ApproachDimensionalizingAs set out elsewhere (Williamson 19796), the critical dimensions for describing transactions are ( 1) uncertainty, ( 2 ) the frequency with whichtransactions recur, and (3) the degree to which durable, transactionspecific investments are required to realize least cost supply. Only recurrenttransactions are of interest for the purposes of this paper;ll hence attention will hereafter be focused on uncertainty and asset specificity, especially the latter.Asset specificity is both the most important dimension for describingtransactions and the most neglected attribute in prior studies of organization. The issue is less whether there are large fixed investments, thoughthis is important, than whether such investments are specialized to a particular transaction. Items that are unspecialized among users pose fewhazards, since buyers in these circumstances can easily turn to alternativesources and suppliers can sell output intended for one buyer to other buyers without difficulty. Nonmarketability problems arise when the specificidentity of the parties has important cost-bearing consequences. Transactions of this kind may be referred to as idiosyncratic.12Asset specificity can arise in any of three ways: site specificity, as whensuccessive stations are located in cheek-by-jowl relation to each other soas to economize on inventory and transportation expenses; physical assetspecificity, as where specialized dies are required to produce a component;and human asset specificity that arises from learning by doing. The reasonasset specificity is critical is that, once an investment has been made, buyerand seller are effectively operating in a bilateral (or at least quasi-bilateral)exchange relation for a considerable period thereafter. Inasmuch as thevalue of specific capital in other uses is, by definition, much smaller thanthe specialized use for which it has been intended, the supplier is effectively "locked into" the transaction to a significant degree. This is symmetrical, moreover, in that the buyer cannot turn to alternative sourcesof supply and obtain the item on favorable terms, since the cost of supplyfrom unspecialized capital is presumably great.13 The buyer is thus committed to the transaction as well. Accordingly, where asset specificity isgreat, buyer and seller will make special efforts to design an exchangethat has good continuity properties.The site-specific assets referred to here appear to correspond with those11 For a discussion of the organizational consequences of occasional, rather than recurrent, contracting, see Williamson (1979b, pp. 246-54). Also see n. 32 below.12For earlier treatments of the economies of idiosyncrasy, see Williamson (1975, pp.9-10, 27-33, 68-74; 19796, pp. 238-45). Others who are persuaded that idiosyncraticinvestments are crucial to the understanding of the economics of organization includeKlein et al. ( 1 9 7 8 ) , Klein ( 1 9 8 0 ) , and Teece ( 1 9 8 0 ) .13 For a somewhat related discussion of symmetry, see Thompson (1967, pp. 32-35). American Journal of SociologyThompson describes…

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