Transaction Cost Economics: What Are the Questions?

Panel 1:

(Simple) Market Mediated Exchange
Interface
Coordinator
Supplier
Buyer

Coordinated

Adaptation

Coordinated

Adaptation

disputes

disputes

Goods and Services

Settling Up

Panel 2:

(Continuity Preserving) Hierarchy Mediated Exchange

Figure 2. Interface Mediation

Markets and hierarchies, so described, are polar opposites in incentive intensity, coordinated adaptation, and dispute settlement respects. The introduction of the interface coordinator for k > 0 transactions is truly consequential.

5.3.5 Burdens of bureaucracy

What are the burdens of bureaucracy and what do we do about them?

Bureaucracy is one of the most important but poorly understood conditions in the social sciences. One common mistake is to condemn bureaucracy because it falls short of a hypothetical ideal. Because, however, all feasible modes of organization are flawed, the burdens of bureaucracy need to be examined comparatively and evaluated with reference to a net gain criterion. TCE has addressed some of these issues, but in a piecemeal way.

Because the putative purposes of bureaucracy are usually commendable, because the downside of bureaucracy is amorphous and resides in the future, and because politicians often have a short horizons, the burdens of bureaucracy often become someone else’s problem by pushing them off to another day -- an example of which is Joe Nocera's visit to the recently organized Consumer Financial Protection Bureau, which he described to his mentor as an “inspiring day.” His mentor responded with the observation that “The beautiful thing about a new agency is that everyone is very driven to accomplish the mission”-- to which, however, he added “As they mature that's when people become more concerned with self protection, and maneuvering for the next promotion." Nocera’s response was “True enough, but a problem for another day“ (New York Times 2012).

This last has it exactly wrong. Predictable consequences should be factored in at the outset. Failure or refusal to do so shifts the bureaucratic burden to the successor generations – for which the task of correcting badly performing bureaus is not only costly but doubtful because such efforts face great resistance from those who have a stake. Indeed, terminating bloated bureaus is well-nigh impossible because the beneficiaries of termination are diffuse and difficult to organize in comparison with the bureaucrats and politicians and beneficiaries of the bureau who are fewer in number and individually have big stakes.

Note, however, that such arguments operate at a very high level of generality. Aside from the common concern that the burdens of bureaucracy build up over time and are sheltered by the difficulties of reversing regulatory decisions, what are the lessons? In the spirit of pluralism, this is surely a case where different lenses should be brought to bear in the hope that someone will “get it right.”

The TCE approach is to move beyond overarching critiques of bureaucracy to examine the particulars. A basic question that arises in this connection is this: How are the “transactions” for which regulatory solutions are proposed described? I suggest in this connection that administrative transactions (e.g., foreign policy) and regulatory transactions (e.g., pollution) are sufficiently different to warrant separate treatment.

My focus is on the regulatory arena. I conjecture in this connection that regulatory transactions are more variable than commercial transactions, as a consequence of which remedies for regulatory breakdowns are (probably) also more variable.

Regulatory breakdowns can take several forms, including capture (Bernstein, 1955), pre-capture (Stigler, 1971), being overmatched in relation to the expertise of the industry (e.g., the SEC in relation to financial industry), the propensity for over-reaching (which is common to all in variable degree), and the hazard of false confidence among members of the public who wrongly ignore hazards to which they are subject because they believe that they are safely protected by regulatory oversight and control.

The challenge is to uncover the particulars that are associated with each class of breakdown and ask the following questions of proposed regulatory initiatives: What implementation problems are in prospect? What are the ex ante regulatory design ramifications? And given best efforts to deal with these issues, does the proposed regulation satisfy the Remediableness Criterion? (Also, additional types of breakdown not described above should be included.³⁰)

5.4 Other Issues and Unmet Needs

5.4.1 Other Issues

What issues for which transaction cost economics has made provision are in a seriously underdeveloped state of analysis?

Several that I regard as important but are seriously underdeveloped are (1) the importance of atmosphere as it relates to textbook bromides, of which the advice never to leave any money on the table is an example, (2) the need to breathe operational content into the concept of power, (3) making provision for disequilibrium contracting, and (4) the putative benefits of pay-for-performance with respect to executive compensation.

The missing concept with respect to bromides is not that such pronouncements are unhelpful for classroom teaching purposes but that they need to be put in perspective in conjunction with applications, lest students are persuaded by their teachers to take them literally.

Consider the bromide never to leave money on the table. This was contested by an investment banker who informed me that one of the most important negotiating lessons that he had learned was “always to leave money on the table." The problem with the maxim never to leave money on the table is that meticulous observance by one party invites responses in kind – with the result that what could have been a cooperative contractual relationship becomes much more adversarial as what could have been give-and-take results instead results in contentious ex ante bargaining and ex post disputes.

What distinguishes the advice to “leave no money on the table” and “always leave money on the table“ is not that the former is hardheaded and the latter is soft. Rather, in circumstances where cooperation during contract implementation is perceived to be important, the former is myopic and the latter is farsighted.³¹

Disequilibrium contracting is an issue that I briefly raise in conjunction with hybrids yet remains underdeveloped. Implicitly the standard TCE assumption is that choice among alternative modes of contract is done in an unhurried way. In the context of innovative startups or crises, however, the possibility that what would be regarded as efficient modes of governance under equilibrium conditions will often give way to the urgency of real time responsiveness (Williamson, 1991, pp. 292-293).

Similarly, the contention that “lack of strong pay-for-performance incentives for CEOs“ (Jensen and Murphy, 1990, p. 262) needs to be examined with respect to the ease with which boards of directors can be induced to approve the compensation recommendations of executives (Bebchuk and Fried, 2004, p. 73; Williamson, 2005a, pp. 31-33). This too awaits further study.

More generally, the hazards of making uninformed choices for failure to give prominent place to the attributes of human actors (in both bounded rationality and opportunism respects) are chronic concerns of public policy toward business.

5.4.2 Unmet needs

What are the unmet needs?

Unmet needs include full formalism, “implementation economics,” and a broader, deeper treatment of bureaucracy.

The full formalism of TCE has been a work-in-progress since the famous paper by Sanford Grossman and Oliver Hart (1986). Steven Tadelis and his collaborators have been especially important in moving the formal analysis of TCE ahead.³¹ This is outside my bailiwick but I raise again the possibility that a “new mathematics“ (to which Edward Prescott made reference) is needed.

The need for “implementation economics” was first called to my attention by a financial engineering colleague who suggested that a productive collaboration between financial engineering and TCE was possible. I objected and stated that most users of TCE lacked the technical background to design new financial instruments. My colleague agreed that financial engineers did not need assistance in designing financial instruments but observed that financial engineering was deficient in implementation respects.

Given the emphasis in TCE of ex post contract implementation, and considering the unforeseen problems with derivatives that contributed to the recent financial crisis, I could see where his concern with implementation was coming from. Given my efforts to understand the purpose served by non-standard contracting, moreover, I could see that the neglect of implementation by imaginative designers might well be the source of avoidable error.

The “problem” was and is that acquiring the requisite knowledge of the relevant microanalytics, which is where the TCE action is concentrated, is very demanding. Inasmuch, however, as the stakes are great, intensive efforts to uncover the prospective “unanticipated consequences” by TCE specialists could well be warranted. Ascertaining whether such is promising or not would benefit by a re-examination of the recent financial crisis -- with emphasis on the details, as viewed from the lens of contract/governance, and an assessment of the value added.

Finally, in addition to the burdens of bureaucracy discussed above, the study of bureaucracy is also relevant to an understanding of comparative economic systems. Albeit dated, I call attention to Oskar Lange's treatment of socialism (1938) as an example of what would become standard practice in economics for the next 50 years: concede that bureaucracy was important to an understanding of socialism, yet refuse to address bureaucratic consequences in a systematic way.

Thus Lange's influential treatment of socialism concedes that “the real danger of socialism is that of a bureaucratization of economic life, and not the impossibility of coping with the problem of allocation of resources” (1938, pp. 109-110; emphasis in original). Lange nevertheless declined to examine the importance of bureaucracy because such a discussion “belongs to the field of sociology rather than economic theory and must therefore be dispensed with here” (1938, p. 109). He furthermore stated that “the same, or even greater, danger” is posed by monopolistic capitalism (1938, p. 110) – although the basis for this is not revealed.

Be that as it may, rather than undertake a comparative study of bureaucracy, the study of comparative economic systems mainly set the burdens of bureaucracy aside, evidently in the conviction that “there is nothing wrong with the pure theory of socialism“ (Schumpeter, 1942, p. 172). (Subsequent theoretical work on activity analysis by Koopmans and Kantorovich would likewise ignore bureaucracy.)

Admitting to the burdens of bureaucracy would have to await the breakdown of the USSR, yet even now a comparative assessment of the burdens of bureaucracy as between capitalism and socialism (and variants within each) remains largely unexamined by economists.

7. Conclusions

((( to come )))


Footnotes

1. As David Kreps would observe, this could be viewed as a radical move in that previously “The firm is like individual agents in textbook economics. … Agents have utility functions; firms have a profit motive; agents have consumption sets; firms have production possibility sets. But in transaction cost economics, firms are more like markets – both are arenas within which individuals can transact“ (1990, p. 96). Treating firm and market as alternative modes of governance was a key TCE move.

2. For a discussion of research orientations in the sciences, see Roy D'Andrade (1986). Robert Solow takes the position that “there is a lot to be said in favor of staring at the piece of reality you are studying and asking, just what is going on here? Economists who are enamored of the physics style seem to bypass that stage“ (Solow, 1997, p. 57; emphasis added). The theoretical physicist John Bardeen in his work on the transistor nevertheless reports that they “did a lot of experiments to try to find out just what was going on here“ (Hoddeson and Daitch, 2002, p. 138; emphasis added), thereby to better inform their theoretical work. Evidently the difference between the two polar research traditions should not be overdone yet is nevertheless instructive.
3. As Stanley Fischer put it, “Transaction costs have a well-deserved bad name … [because] there is a suspicion that almost anything can be rationalized by invoking suitably specified transaction costs“ (1977, p. 322).

4. Of the 15 research faculty at GSIA when I arrived as a student in the PhD program in 1960, four would go on to receive the Nobel Memorial Prize in Economics for work that they did at GSIA– namely, Herbert Simon, Franco Modigliani, Merton Miller, and Robert Lucas (although Lucas did not arrive until 1963). Also, four graduate students in the GSIA program in the 1960s would also receive Nobel Prizes in Economics.

5. The next two paragraphs are based on Williamson (2010).

6. Even the Chicago School, which had grave reservations with overreaching externality arguments, was resistant to Coase's claims that externalities vanished under zero transaction cost conditions. For a discussion of Coase vs. Chicago, see Edmund Kitch (1983, pp. 220-221).

7. The next two paragraphs are from Williamson (1985, p. 10).

8. Note that it is the combination of both, rather than either by itself, that is needed. Absent bounded rationality, all complex contracts will be complete. Absent opportunism, contract as promise will suffice. Serious contracting problems await if, given both, a condition of bilateral dependency develops.

9. Donald Turner, who was the world's leading antitrust lawyer at the time, was the head of the Antitrust Division. Edwin Zimmerman, who was an extraordinary talent, was the Deputy Assistant Attorney General for Antitrust. Stephen Breyer was Turner's Special Legal Assistant. And Richard Posner was arguing antitrust cases before the Supreme Court as a lawyer on the staff of the Solicitor General.

10 Also note that the “habit of breaking down problems into smaller parts“ promotes discovery in the study of physics(Hoddeson and Daitch, 2002, p. 316) and

organization alike (Simon, 1962).

11. Getting it right in a logical sense does not imply that the theory is correct. As Friedman observes, "Science in general advances primarily by unsuccessful experiments that clear the ground” (in Snowdon and Vane, 1992,

p. 296). That is useful to bear in mind. Most would-be theories fail – which explains why Simon favors pluralism: perhaps someone will get it right (Simon, 1999, p. 22).

12. Solow maintains that plausible simple models of complex phenomena are expected to “make sense for 'reasonable' or 'plausible' values of the important parameters” (Solow 2001, p. 112). The plausibility precept challenges users of fanciful constructions to explain “What is going on here?"

13. Personal communication from Milton Friedman to the author, Feb. 6, 2006.

14. I discussed similar difficulties with Edward Prescott (who was also in the PhD program at Carnegie in the 1960s). On both occasions Ed advanced the view that the economics profession was in need of a “new mathematics” to better address governance issues. Be that as it may, it is noteworthy that full formalism efforts that originated with Sanford Grossman and Oliver Hart (1986) and are works-in-progress to this day (see Section 4 of Tadelis and Williamson, 2012).

15. For a more extensive version of the Peguy quote, see Williamson (1996, p. 13).

16. This article was instrumental in promoting empirical analysis across a wide range of fields in economics, business, and the contiguous social sciences. (It was reprinted 16 times.) Although credible commitments are sometimes thought of as a user-friendly way to contract, credibility is actually hardheaded in that it is used in cost effective degree to support those transactions where asset specificity and contractual hazards are at issue. Such supports are without economizing purpose for transactions where generic technologies are employed.

17. TCE addresses the issue of scaling up in Williamson (1985, pp. 96-98). The text here is based on Tadelis and Williamson (2012).

18. Michael Jensen and William Meckling expressly recognized the importance of scaling up from a single owner-manager to a multitude of owners in a modern corporation and stated that this was an issue that they planned to deal with it in a later paper (1976, p. 356). That paper never materialized, presumably because of the difficulties. (Their 1976 paper has nonetheless been influential.)

19. The Institutional Environment branch of Institutional Economics is crucial. The work of Douglass North and his colleagues is especially important in this connection.

20. International Herald Tribune (1990; italics added).

21. As reported in Williamson (1976, p. 91, n. 11).

22. As reported in Williamson (1976, pp. 92-101).

23. See Williamson (1985, p. 199) for more such “reinterpretable”statements.

24. For citation counts of each, see Williamson (2005b).

25. George John and Torger Reeve especially emphasize the 1979 article which “spurred empirical work“ in marketing by dimensionalizing the attributes of transactions and governance structures and advancing “refutable conjectures“ (2010, p. 249).
26. Such tautological reasoning gave transaction cost a bad name in its early years, which critique also applies to many users of the term “power“—which is a word of many meanings, as witness that it takes up over an entire column in Webster's Third New International Dictionary. If, therefore, power is used by social scientists, the delimited purpose intended ought to be disclosed.

Although some social scientists contend that while power is “tricky to define … it is not that difficult to recognize“ (Pfeffer, 1981, p. 3), which repeats the confusion that are associated with the word trust. As James March puts it, power is a “disappointing concept. It tends to become a tautological label for the unexplained variance“(1988, p.4).

Transaction cost economics concurs (1985, pp. 238-239).

27. See p. 49 of the text.

28. The diagrams and comparisons track Tadelis and Williamson (2012).

29. This oversimplifies but is broadly congruent with the spirit of simple market exchange. Courts, for example, sometimes award other relief, such as specific performance. But “classical contract law“ (Macneil, 1978, pp. 862-864), which applies to the polar transaction of k = 0, is basically a money damages transaction.

30. My suggestion is that such a research program would benefit by working through the voluminous bureaucracy literature in the classroom. This is most certainly a case where “teaching is learning.”

31. The distinction that TCE makes between perfunctory and consummate cooperation in the context of ongoing contractual relationships is also relevant in this respect (Williamson 1975, pp. 38-39, 55-56) and stands in need of further development.

32. For a recent discussion of and contribution to full formalism, see Tadelis and Williamson (2012).

References
Anderson, Erin M. 1982. “Contracting the Selling Function: The Salesperson as Outside Agent or Employee,” Unpublished Ph.D. Dissertation, University of California, Los Angeles, United States.
Arrow, Kenneth J. 1969. "The Organization of Economic Activity: Issues Pertinent to the Choice of Market Versus Nonmarket Allocation." In The Analysis and Evaluation of Public Expenditure: The PPB System. Vol. 1, U.S. Joint Economic Committee, 91st Congress, 1st Session, 59-73. Washington, DC: U.S. Government Printing Office.
Augier, Mie, and James March. 2011. The Roots, Rituals and Rhetorics of Change: North American Business Schools After the Second World War. Stanford: Stanford University Press.
Barnard, Chester. 1938. The Functions of the Executive. Cambridge: Harvard University Press (fifteenth printing, 1962).
Bebchuk, Lucian Arye and Jesse Fried. 2004. Pay without Performance : The Unfulfilled Promise of Executive Compensation. Cambridge, MA: Harvard University Press.
Ben-Porath, Yoram. 1980. "The F Connection: Families, Friends, and Firms and the Organization of Exchange," Population and Development Review, 6 (March): 1-30.
Bernstein, Marver. 1955. Regulating Business by Independent Regulatory Commissions Princeton: Princeton University Press.
Buchanan, James. 1975. "A Contractarian Paradigm for Applying Economic Theory," in Microeconomic Theory: Conflict and Contract: Papers and Proceedings, American Economic Review, 65 (May): 225-230.
____________. 2001. “Game Theory, Mathematics, and Economics.” Journal of Economic Methodology, 8 (March): 27-32.
Coleman, James. 1990. The Foundations of Social Theory. Cambridge, MA: Harvard University Press.
Coase, Ronald. 1937. “The Nature of the Firm,” Economica., 4(16): 386-405. Reprinted in The Nature of the Firm: Origins, Evolution, Development, 1991, ed. Oliver E. Williamson and Sidney Winter, 18-33. New York: Oxford University Press.
____________. 1960. “The Problem of Social Cost,” Journal of Law and Economics, 3(1): 1-44.
____________. 1964. "The Regulated Industries: Discussion," American Economic Review, 54 (May): 194-197.
____________. 1983. Comments in Edmund W. Kitch, ed., "The Fire of Truth: A Remembrance of Law and Economics at Chicago, 1932-1970," Journal of Law and Economics, 26 (April): 163-234.
____________. 1988. "The Nature of the Firm: Influence," Journal of Law, Economics, and Organization, 4 (Spring): 33-47.
____________. 1992. "The Institutional Structure of Production," American Economic Review, 82 (September): 713-719.
Commons, John R. 1934. Institutional Economics. Madison: University of Wisconsin Press.
D'Andrade, Roy. 1986. "Three Scientific World Views and the Covering Law Model," in Donald W. Fiske and Richard A. Schweder, eds., Metatheory in Social Science: Pluralisms and Subjectivities. Chicago: University of Chicago Press.
Demsetz, Harold. 1968. "Why Regulate Utilities?" Journal of Law and Economics, 11: 55-66.
Dixit, Avinash. 1979. "A Model of Duopoly Suggesting a Theory of Entry Barriers," Bell Journal of Economics, 10 (Spring): 20-32.
____________. 1982. "Recent Developments in Oligopoly Theory," American Economic Review, 72 (May): 12-17.
____________. 1996. The Making of Economic Policy: A Transaction Cost Politics Perspective. Cambridge, MA: MIT Press.
Doeringer, P., and M. Piore. 1971. Internal Labor Markets and Manpower Analysis. Lexington, MA: D. C. Heath.
Duesenberry, James. 1960. "An Economic Analysis of Fertility: Comment," in Demographic and Economic Change in Developed Countries, National Bureau of Economic Research. Princeton, NJ: Princeton University Press.
Eaton, C., and R. G. Lipsey. 1980. "Exit Barriers Are Entry Barriers: The Durability of Capital," Bell Journal of Economics, 1 (Autumn): 721-729.
Elster, Jon. 1994. "Arguing and Bargaining in Two Constituent Assemblies," unpublished manuscript, remarks given at the University of California, Berkeley.
Fischer, Stanley. 1977. "Long-Term Contracting, Sticky Prices, and Monetary Policy: Comment," Journal of Monetary Economics, 3: 317-324.
Friedman, Milton. 1953. Essays in Positive Economics. Chicago: University of Chicago Press.