Transaction cost economics and its uses in marketing

Abstract

Scholarship at the intersection of transaction cost economics (TCE) and marketing has enjoyed an impressive record of growth over the past three decades, and the future promises more of the same. Following Erin Anderson’s perceptive uses of TCE in her 1982 dissertation, the field of marketing has made many constructive uses of and contributions to TCE, where the latter include broadening the reach of TCE, posing important challenges, and identifying opportunities still to be addressed. Given this history, we advance the proposition that the relation between TCE and marketing has been and should be a two-way street. In considering the scope for future research, we give special attention to issues of asymmetric costs, the dynamics of governance, and disequilibrium contracting. We also discuss the four precepts of pragmatic methodology, with special emphasis on prediction and empirical testing. The Appendix provides added perspective on the evolving “science of organization” of which TCE is a part.

Appendix

This Appendix was prepared by Oliver Williamson at the suggestion of the Editor of the Journal of the Academy of Marketing Science.

Transaction cost economics: background and successive developments

With the benefit of hindsight, transaction cost economics had its origins in “four forces.” The first was Ronald Coase’s classic article on “The Nature of the Firm” (1937).¹⁶ The second was the 3 years from 1960 to 63 that I spent as a student in the PhD program at the Graduate School of Industrial Administration, Carnegie Mellon University.¹⁷ The third was the demonstration by Coase (1960) and Arrow (1969) that pushing the logic of zero transaction costs to completion revealed that there would never be an occasion for government intervention to correct for externalities or successive stages of production (vertical integration)—because costless contracting would everywhere be efficient.¹⁸ And the fourth was my experience as Special Economic Assistant to the Head of the Antitrust Division in the United States Department of Justice, 1966–67.¹⁹(Williamson 2003)

Individually and collectively, these four factors persuaded me that the field of Industrial Organization erred by focusing almost entirely on market structure to the neglect of internal organization, a practice that led frequently to wrong-headed public policy—of which the “inhospitality tradition” is an example. (Stanley Robinson, 1968)²⁰ But where to start?

Early beginnings

My paper “The Vertical Integration of Production: Market Failure Considerations” (1971) re-examined vertical integration in comparative contractual terms, with emphasis on the details of alternative modes of governance (markets and hierarchies) in relation to the attributes of transactions, to include express provision for plausible behavioral attributes of human actors.²¹ Economists did not flock to it, and I initially thought of it as a stand-alone paper. In the process of addressing other puzzles with my students, however, I discovered that many contractual phenomena could be interpreted as variations on a theme. Also, what appear to be non-contractual phenomena can often be reformulated in contractual terms.²² Vertical integration would turn out to be a paradigm problem!

Markets and Hierarchies (1975) was an effort to build out from the vertical integration problem to examine the employment relation, the limits of firm size, divisionalization and the modern corporation, and applications to public policy. Chapter 1 observes that a “New Institutional Economics” is in progress, which is the first mention of this new field of study.

Chapter 2 of Markets and Hierarchies sets out the “Organizational Failures Framework” with reference to (1) bounded rationality and uncertainty/complexity, (2) opportunism and small numbers, (3) information impactedness, and (4) atmosphere (informal organization). I also observe that the assumption of two-way common knowledge needs to be extended to three-way common knowledge if the courts are called upon to settle disputes, information is impacted, and opportunism is operative. Three- way common knowledge is a much more demanding condition and undermines the purported efficacy of two-way common knowledge in the study of complex contracts.

My paper on “Franchise Bidding for Natural Monopoly—In General and With Respect to CATV” (1976) had its origins in views advanced by the Chicago School that franchise bidding was a general purpose solution to the problem of natural monopoly (Demsetz 1968), as illustrated by its applications to CATV (Posner 1972). Relying, as Demsetz did, on a very simple example (automobile license plates), I was skeptical of its general relevance. I also questioned its efficacy for CATV in the early 1970s. Not only would the non-redeployability of specific assets pose problems at the contract renewal interval, but a focused case study of “bidding competition” in Oakland, California, that I undertook as well as earlier experience that I had with CATV in New York City (Williamson 1970) revealed that politics posed a lurking hazard . Here as elsewhere, the action was in the microanalytics of transactions and governance structures, as examined through the focused lens of contract/governance.

TCE’s codification

The article, however, that broke the ice was my 1979 paper “Transaction Cost Economics: The Governance of Contractual Relations.”²³ What this article accomplished was to breathe operational content into transaction cost economics in a more concerted and transparent way than had been done previously. The critical dimensions with respect to which the transaction (the unit of analysis) varied were expressly named. Similarly, the internally consistent syndromes of attributes that define alternative modes of governance were set out. Upon taking economizing on transaction costs to be the main purpose of organization, a predictive theory of economic organization was at hand. This was the hitherto missing piece to which young scholars in business (including marketing) and the social sciences were quick to pick up on.

My paper “Credible Commitments: Using Hostages to Support Exchange” (1983) can be thought of as a precursor to my interpretation of the “Commons Triple,” as expressed by John R. Commons: “The ultimate unit of activity … must contain in itself the three principles of conflict, mutuality, and order. This unit is a transaction” (1932, p. 4). Inasmuch as I was already treating the transaction as the basic unit of analysis, I was pleased that Commons concurred. But while I was intrigued by the triple of conflict, mutuality, and order, I was unsure what to make of it. My work on credible commitments led me to interpret governance as the means by which to infuse order, thereby to mitigate conflict and realize mutual gains—which is a constructive way by which to think about contracting.

The Economic Institutions of Capitalism (1985) is my most cited book. It draws upon and integrates published papers on TCE between 1975 and 1984, including public policy ramifications for antitrust, regulation, and corporate governance. It also includes a chapter dealing expressly with the incentive and bureaucratic limits of hierarchy, which was then and remains today an underdeveloped area of study. It being my ambition to breathe operational content into Ronald Coase’s concept of transaction cost, I was understandably pleased when Coase opined that “In a real sense, transaction cost economics, through his writing and teaching, is his [Williamson’s] creation” (1993, p. 98).²⁴

Extensions

Although I viewed my 1983 paper on “Credible Commitments” as having made provision for hybrid contracting, locating it between the polar extremes of simple market exchange on the one hand and unified ownership (hierarchy) on the other, that view did not register with many students of organization outside of the economics community. It was mainly for that reason that I submitted my paper on “Comparative Economic Organization” to the Administrative Science Quarterly (1991). Not only does this paper describe the hybrid mode of organization more fully and carefully than earlier efforts, but it also makes the case that each generic mode of organization is supported by a distinctive form of contract law—where (1) contract as legal rules applies to simple market exchange, (2) contract as framework is a more flexible form of contract law and applies to the hybrid mode, and (3) forbearance contract, wherein the firm is its own court of ultimate appeal, applies to hierarchy. I also briefly discuss problems of disequilibrium contracting.

The Mechanisms of Governance (1986) concentrates on developments in transaction cost economics between 1985 and 1995, of which the treatment of hybrids (1991) and trust (1993) are two. A precautionary chapter on applied welfare economics makes the case for the Remediableness Criterion. Inasmuch as all feasible modes of organization, public and private alike, are flawed in relation to a hypothetical ideal, the normative public policy practice of “supposing that … policy was made by an omnipotent, omniscient, and benevolent dictator” (Dixit 1996, p. 8) plainly biases public policy in favor of intervention. The Remediableness Criterion is proposed as a means by which to relieve this bias; specifically, an extant mode for which no superior feasible alternative can be described and implemented with expected net gains is presumed to be efficient. To be sure, this is a rebuttable presumption. Applied welfare economics is moved to much more solid ground by eschewing the fanciful constructions upon which normative pubic policy was based.

The strategy field and literature have grown rapidly over the past 20 years. Transaction cost economics relates but differs (Williamson 1999). It relates in that the governance of contractual relations has strategic ramifications for the viability of a firm—as revealed by governance errors both past (the undervaluation of outsourcing at the River Rouge plant of Ford Motor Company (Williamson 1985, pp. 119–120)) and recent (the excesses of outsourcing at Boeing Aircraft with the Dreamliner (Tadelis 2010)), the lesson of which is to introduce TCE reasoning when making outsourcing decisions in the future. Viewing debt and equity as modes of governance (as well as modes of finance) also has strategic lessons. More generally, since TCE has ramifications for any issue that arises as or can be reformulated in contractual terms and since many of these lessons are consequential, the strategic uses of TCE are endless.

Strategy nevertheless raises broader issues, of which the concept of core competence is one. The problem here is that the concept of core competence, like that of transaction cost in its earlier years, has not been operationalized—with the result that ex post rationalization is a chronic concern. If core competence is to strategy as governance is to TCE, then a promising place to start would be to name the attributes with respect to which clusters of core competence are described. Devising an overall strategic plan for the cost effective development of a firm’s core competences would be unarguably important.

The “New Institutional Economics” (NIE) program to which I referred in Markets and Hierarchies (1975) has flourished in the years since. As I discuss in “The New Institutional Economics: Taking Stock, Looking Ahead” (2000), the NIE divides into two main parts: the institutional environment (the rules of the game) and the institutions of governance (the play of the game). TCE relates mainly to the play of the game, but both the informal rules (e.g., customs, norms, traditions, religion) and the formal rules (e.g., property and contract laws and their enforcement as well as the organization of the polity) of the game are also important to the choice of governance structure for managing transactions within and, especially, between nation states (Henisz and Macher 2004). The institutional environment also has a significant influence on innovation, especially leading edge innovation. Considerations of hierarchy (especially public bureaucracy) are important to this last point—which is an important area for future research. Note in this connection that the features of public bureaus to which TCE calls attention are precisely those that describe governance structures more generally: incentive intensity, administrative control, and the applicable law of contract—where, typically, low powered incentives, extensive controls (internal rules, regulations, and administrative apparatus), and weak (forgiving) enforcement mechanisms are associated with public sector bureaucracy. As the recent financial crisis reveals, these features ought to figure more prominently in whether to expand and how to design public sector oversight and administrative agencies.

Coda

My papers, “The Economics of Governance” (2005) and “Transaction Cost Economics, The Natural Progression” (2010) both reflect upon the foundations of TCE and discuss research needs for the future. Full formalization is one. Entrepreneurship (in general and as between nation states) is another. Uncovering and explicating prospective implementation problems that await actual or proposed organizational innovations in the public and private sectors (with emphasis on finance, banking, and health care) are vitally important but much neglected—possibly because such problems reside in the details and will entail combining TCE concepts with deep knowledge of the particulars. More generally, although calculativeness can be pushed to dysfunctional extremes, hard-headed analysis that is mindful of calculative excesses is what applied social science greatly needs. Endless applications of the lens of contract/governance in theoretical, empirical, and public policy respects await—if and as the torch is taken up by a new generation of young scholars.