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Williamson and the Austrians

Mises Daily: Wednesday, October 14, 2009 by

Oliver E. Williamson
Nobel laureate Oliver E. Williamson

Oliver Williamson's Nobel Prize, shared with Elinor Ostrom, is great news for Austrians. Williamson's pathbreaking analysis of how alternative organizational forms — markets, hierarchies, and hybrids, as he calls them — emerge, perform, and adapt has defined the modern field of organizational economics.

Williamson is no Austrian, but he is sympathetic to Austrian themes (particularly the Hayekian understanding of tacit knowledge and market competition). His concept of asset specificity enhances and extends the Austrian theory of capital and his theory of firm boundaries has almost single-handedly displaced the benchmark model of perfect competition from important parts of industrial organization and antitrust economics.

He is also a pragmatic, careful, and practical economist who is concerned, first and foremost, with real-world economic phenomena, choosing clarity and relevance over formal mathematical elegance. For these and many other reasons, his work deserves careful study by Austrians.

Opening the Black Box

In economics textbooks, the firm is a production function or production possibilities set, a "black box" that transforms inputs into outputs. Given the existing state of technology, the prices of inputs, and a demand schedule, the firm maximizes money profits subject to the constraint that its production plans must be technologically feasible. The firm is modeled as a single actor, facing a series of uncomplicated decisions: what level of output to produce, how much of each factor to hire, and the like. These "decisions," of course, are not really decisions at all; they are trivial mathematical calculations, implicit in the underlying data. In short: the firm is a set of cost curves, and the "theory of the firm" is a calculus problem.

Williamson attacks this conception of the firm, which he calls the "firm-as-production-function" view. Building on Coase's (1937) transaction-cost or "contractual" approach, Williamson argues that the firm is best regarded as a "governance structure," a means of organizing a set of contractual relations among individual agents. The firm, then, consists of an entrepreneur-owner, the tangible assets he owns, and a set of employment relationships — a realistic and thoroughly Austrian view.

Williamson emphasizes asset specificity — the degree to which resources are specialized to particular trading partners — as the key determinant of the firm's boundaries, defined as the set of transactions that are internal to the firm (or, put differently, the set of assets owned by the entrepreneur). More generally, he holds that entrepreneurs will tend to choose the form of organization — a loose network of small firms, trading in the open market; a franchise network, alliance, or joint-venture; or a large, vertically integrated firm — that best fits the circumstances.

Some Austrians have argued, following Alchian and Demsetz (1972), that Coase and Williamson wrongly claim that firms are not part of the market, that entrepreneurs substitute coercion for voluntary consent, and that corporate hierarchies are somehow inconsistent with the free market (e.g., Minkler, 1993; Langlois, 1995; Cowen and Parker, 1997; Matthews, 1998Download PDF). I think this is a misreading of Coase and of Williamson. It is true that Coase speaks of firms "superseding" the market and entrepreneurs "suppressing" the price mechanism, while Williamson says firms emerge to overcome "market failure." But they do not mean that the firm is outside the market in some general sense, that the market system as a whole is inefficient relative to government planning, or anything of the sort.

Moreover, Williamson does not use the term market failure in the usual left-interventionist sense, but means simply that real-world markets are not "perfect" as in the perfectly competitive general-equilibrium model, which explains why firms exist. Indeed, Williamson's work on vertical integration can be read as a celebration of the market. Not only are firms part of the market, broadly conceived, but the variety of organizational forms we observe in markets — including large, vertically integrated enterprises — is a testament to the creativity of entrepreneurs in figuring out the best way to organize production.

What about Williamson's claim that markets, hierarchies, and hybrids are alternative forms of governance? Does he mean that firms and hybrid organizations are not part of the market? No. Coase and Williamson are talking about a completely different issue, namely the distinction between types of contracts or business relationships within the larger market context. The issue is simply whether the employment relationship is different from, say, a spot-market trade or a procurement arrangement with an independent supplier. Alchian and Demsetz (1972) famously argued that there is no essential difference between the two — both are voluntary contractual relationships, there is no coercion involved, no power, etc. Coase, Williamson, Herbert Simon,Download PDF Grossman and Hart (1986), myself, and most of the modern literature on the firm argues that there are important, qualitative differences.

Coase and Simon emphasize fiat, by which they mean simply that employment contracts are, within limits, open-ended. The employer does not negotiate with the employee about performing task A, B, or C on a given day; he simply instructs him to do it. Of course, the employment contract itself is negotiated on the labor market, just as any contract is negotiated. But, once signed, it is qualitatively different from a contract that says "independent contractor X will perform task A on day 1." An employment relationship is characterized by the zone of authority (what Simon called the "area of acceptance"Download PDF). Williamson emphasizes the legal distinction, namely that disputes between employers and employees are settled differently from disputes between firms, between firms and customers, between firms and independent suppliers or distributors, etc.

Grossman and Hart, and my own work with Nicolai Foss, emphasize the distinction between asset owners and non-owners. If I hire you to work with my machine, I hold residual control and income rights to the use of the machine that you do not have, and thus your ability to use the machine as you see fit is limited. If you own your own machine, and I hire you to produce services with that machine, then you (in this case, an independent contractor) hold these residual income and control rights, and this affects many aspects of our relationship.

While Coase, Simon, Hart, etc. do not draw explicitly on the Austrians, this distinction can also be interpreted in terms of Menger's distinction between orders and organizations, or Hayek's cosmos and taxis. Coase and Williamson are simply saying that the firm is a taxis, the market a cosmos. This does not deny that there are "unplanned" or "spontaneous" aspects of the internal organization of firms, or that there is purpose, reason, the use of monetary calculation, etc. in the market.

Asset Specificity and Austrian Capital Theory

As noted above, the black-box approach to the firm that dominated neoclassical economics omits the critical organizational details of production. An equally serious omission is that production is typically treated as a one-stage process, in which factors are instantly converted into final goods, rather than a complex, multi-stage process unfolding through time and employing rounds of intermediate goods. Capital is treated as a homogeneous factor of production, the K that appears in the production function along with L for labor. Following Solow (1957) models of economic growth typically model capital as what Paul Samuelson called shmoo — an infinitely elastic, fully moldable factor that can be substituted costlessly from one production process to another.

In such a world, economic organization is relatively unimportant. All capital assets possess the same attributes, and thus the costs of inspecting, measuring, and monitoring the attributes of productive assets is trivial. Exchange markets for capital assets would be virtually devoid of transaction costs. A few basic contractual problems — in particular, principal-agent conflicts over the supply of labor services — may remain, though workers would all use identical capital assets, and this would greatly contribute to reducing the costs of measuring their productivity.

Williamson, by contrast, emphasizes that resources are heterogeneous, often specialized, and frequently costly to redeploy. What he calls asset specificity refers to "durable investments that are undertaken in support of particular transactions, the opportunity cost of which investments are much lower in best alternative uses or by alternative users should the original transaction be prematurely terminated" (Williamson 1985, p. 55). This could describe a variety of relationship-specific investments, including both specialized physical and human capital, along with intangibles such as R&D and firm-specific knowledge or capabilities. Like Klein, Crawford, and Alchian (1978), Williamson emphasizes the "holdup" problem that can follow such investments, and the role of contractual safeguards in securing the returns (what Klein, Crawford, and Alchian call quasi-rents) to those assets.

Austrian capital theory focuses on a different type of specificity, namely the extent to which resources are specialized to particular places in the time structure of production. Menger famously characterized goods in terms of orders: goods of lowest order are those consumed directly. Tools and machines used to produce those consumption goods are of a higher order, and the capital goods used to produce the tools and machines are of an even higher order. Building on his theory that the value of all goods is determined by their ability to satisfy consumer wants (i.e., their marginal utility), Menger showed that the value of the higher-order goods is given or "imputed" by the value of the lower-order goods they produce.

Moreover, because certain capital goods are themselves produced by other, higher-order capital goods, it follows that capital goods are not identical — at least by the time they are employed in the production process. The claim is not that there is no substitution among capital goods, but that the degree of substitution is limited. As Lachmann (1956)Download PDF put it, capital goods are characterized by multiple specificity. Some substitution is possible, but only at a cost.

Mises and Hayek used this concept of specificity to develop their theory of the business cycle. Williamson's asset specificity focuses on specialization not to a particular production process but to a particular set of trading partners. His aim is to explain the business relationship between these partners (arms-length transaction, formal contract, vertical integration, etc.). The Austrians, in other words, focus on assets that are specific to particular uses, while Williamson focuses on assets that are specific to particular users. But there are obvious parallels, and opportunities for gains from trade.

Austrian business-cycle theory can be enhanced by considering how vertical integration and long-term supply relations can mitigate, or exacerbate, the effects of credit expansion on the economy's structure of production. Likewise, transaction cost economics can benefit from considering not only the time-structure of production, but also Kirzner's (1966) refinement that defines capital assets in terms of subjective, individual production plans — plans that are formulated and continually revised by profit-seeking entrepreneurs (and Edith Penrose's concept of the firm's subjective opportunity set).

Vertical Integration, Strategizing, and Economizing

The general thrust of Williamson's teaching on vertical integration is not that markets somehow "fail," but that they succeed, in rich, complex, and often unpredictable ways. A basic conclusion of transaction-cost economics is that vertical mergers, even when there are no obvious technological synergies, may enhance efficiency by reducing governance costs. Hence Williamson (1985, p. 19) takes issue with what he calls the "inhospitality tradition" in antitrust — namely, that firms engaged in nonstandard business practices like vertical integration, customer and territorial restrictions, tie-ins, franchising, and so on, must be seeking monopoly gains. Indeed, antitrust authorities have become more lenient in evaluating such practices, evaluating them on a case-by-case basis rather than imposing per se restrictions on particular forms of conduct.

While this change may reflect sensitivity to Chicago-school claims that vertical integration and restraints need not reduce competition, rather than to claims that such arrangements provide contractual safeguards (Joskow 1991, pp. 79–80), the Chicago position on vertical restraints relies largely (though not explicitly) on transaction-cost reasoning (Meese 1997). In this sense, Williamson's work can be construed as a frontal attack on the perfectly competitive model, particularly when used as a benchmark case for antitrust and regulatory policy.

Likewise, Williamson argues that for managers, "economizing" is the best form of "strategizing." The literature on business strategy, following Porter (1980), has tended to emphasize "market-power" as the source of firm-level competitive advantage. Building directly on the old structure-conduct-performance model of industrial organization, Porter and his followers argued that firms should seek to limit rivalry by enacting entry barriers, forming coalitions, limiting the bargaining power of buyers and suppliers, etc.

Williamson challenges this strategic-positioning approach in an influential 1991 article, "Strategizing, Economizing, and Economic Organization," where he claims that managers should focus on increasing economic efficiency, by choosing appropriate governance structures, rather than increasing their market power. Here again, moves by firms to integrate, cooperate with upstream and downstream partners, form alliances, and such are not only profitable for the firms, but for consumers as well. Deviations from perfect competition are, in this sense, part of the market process of allocating resources to their highest-valued uses, all to the benefit (as Mises emphasized) of the consumer.


Includes Hayek's shocking Nobel acceptance speech, "The Pretense of Knowledge"

On a personal level, Williamson is friendly and sympathetic to Austrians and to Austrian concerns. He encourages students to read the Austrians (particularly Hayek, whom he cites often). Williamson chaired my PhD dissertation committee, and one of my first published papers, "Economic Calculation and the Limits of Organization,"Download PDF was originally presented in Williamson's Institutional Analysis Workshop at Berkeley. Williamson did not buy my argument about the distinction between calculation and incentive problems — he maintained (and continues to maintain) that agency costs, not Mises's calculation argument, explain the failure of central planning — but his reactions helped me shape my argument and refined my understanding of the core Misesian and Hayekian literatures. (Also, the great Sovietologist Alec Nove, visiting Berkeley that semester, happened to be in the audience that day, and gave me a number of references and counterarguments.)

Williamson, knowing my interest in the Austrians, once suggested that I write a dissertation on the Ordo School, the influence of Hayek on Eucken and Röpke, and the role of ideas in shaping economic policy. He cautioned me that writing on such a topic would not be an advantage on the job market, but urged me to follow my passions, not to follow the crowd. I ended up writing on more prosaic topics (1, 2, 3) but never forgot that advice, and have passed it along to my own students.