Markets Hierarchies and the Modern Corporation an Unfolding Perspective

Journal of Economic Behavior and Organization 17 (1992) 335-352. North-Holland

Markets, hierarchies, and the modern corporation An unfolding perspective

Oliver E. Williamson*

University of California, Berkeley, CA, USA

Received October 1990, final version received January 1991

What is now referred to as the New Institutional Economics and/or the New Economics of Organization began to take hold about twenty years ago [Arrow (1969), Davis and North (1971), Williamson (1971), Coase (1972), Alchian and Demsetz (1972)]. Neil Kay focuses on one strand of that literature - transaction cost economics - and assesses its strengths and weaknesses as of 1985. Although I can relate to many of Kay’s concerns, others miss the mark and/or are mistaken. That he misses the mark is partly because, even as of his cutoff date of 1985,’ I read the record differently. But I would also emphasize that there have been developments in transaction cost economics since 1985 that are specifically responsive to and mitigate some of his key objections. Furthermore, I do not think that transaction cost economics is played out. Some of his objections can or will be dealt with during the decade of the 1990s.’ Finally, transaction cost economics does not purport to be an all-purpose theory of economic organization. My reading of the literature on economic organization is that we are at a pre-unified state of development and that several well-focused

Correspondence to: Oliver E. Williamson, University of California, Haas School of Business Administration, Berkeley, CA 94720, U.S.A.

*The author is Transamerica Professor of Business, Economics, and Law at the University of California, Berkeley.

‘Kay contends that The Economic Institutions of Capitalism (1985) ‘may be taken as the definitive and currenf statement of Williamson’s approach to economics’ (p. 3; emphasis added).

*Note that I trace the origins of the New Institutional Economics to the early 1970s. Being young, transaction cost economics has continued to unfold. Kay’s cutoff date of 1985 is arbitrary and inappropriate. Not only have there been numerous developments in the past live years, but more are in prospect. Interestingly, a conference on ‘The New Science of Organization’ has been organized for January 1991. I anticipate that the decade of the 1990s will be the period when the new science of organization comes of age.

0167-2681/92/$05.00 0 1992-Elsevier Science Publishers B.V. All rights reserved

336 O.E. Williamson, Markets, hierarchies, and the modern corporation

and internally consistent perspectives are needed. Some perspectives will inform one set of problems; some will inform another set; some will be bankrupt; and the more productive will lead to the variations on a theme of a kind to which Friedrich Hayek has made reference elsewhere: ‘whenever the capacity of recognizing an abstract rule which the arrangement of these attributes follows has been acquired in one field, the same master mould will apply when the signs for those abstract attributes are evoked by altogether different elements’ (1967, p. 50). The research record documents that many disparate phenomena turn out to be variations on a common underlying transaction cost economizing theme. 3 One way of looking at a purported weakness of transaction cost economics is that it is a research opportunity. If the subsequent application of transaction cost economics reasoning advances our understanding little or not at all, so be it. The possibility, however, that transaction cost economics can be responsive, but simply has not gotten around to it, should not be dismissed. As I have argued elsewhere, any problem that arises as or can be reformulated as a contracting problem can usefully be examined in transaction cost economizing terms. My response to Kay is subtitled as ‘an unfolding perspective’ - where unfolding is used in the sense of ‘moving toward full development’ - because transaction cost economics has been responsive to research opportunities in the past and, I anticipate, will be responsive in the future. For example, an early critique that was often made of transaction cost economics is that it dealt almost exclusively with markets and hierarchies while in fact a great deal of economic activity was organized by hybrid modes - long term contracting, franchising, reciprocal trading, regulation, and the like. To be sure, transaction cost economics did predominantly emphasize polar modes at the outset [Coase (1937), Williamson (1971, 1975)]. But the extension of transaction cost reasoning to deal with hybrid modes followed quickly thereafter [Williamson (1976, 1979, 1983, 1985), Goldberg (1976), Klein (1980), Klein and Murphy (1988), Joskow (1988), Masten and Cracker (1985)]. Or consider what I once thought was beyond the reach of transaction cost economics: the oligopoly problem. I originally approached the issue in market structure terms, primarily because that was the prevailing orientation. Upon reflection, however, it was obvious that the cartel problem pre-dated antitrust and that the cartel problem is fundamentally a contracting problem in which access to court-ordered enforcement is denied. Market structure is pertinent in that it affects the efficacy of tacit, privately enforced agreements. That leads into a reformulation of the oligopoly problem in

3Apparent differences notwithstanding, the following phenomena turn out to be variations on a theme: vertical integration, vertical market restraints, labor market organization, the discrimi- nating use of debt and equity, corporate governance, regulation, share cropping, and career marriages. Applications to business strategy, politics, and international relations have developed apace.

O.E. Williamson, Markets, hierarchies, and the modern corporation 331

contracting terms [Williamson (1975, Ch. 12)]. The lesson is this: just because an issue has not yet been addressed in transaction cost economizing terms does not mean that the issue is beyond the reach of transaction cost economics reasoning. Often a comparative contractual reformulation of the issue turns out to be both possible and illuminating. But sometimes not. My rejoinder to Kay deals first with markets and hierarchies and then turns to the modern corporation.

1. Markets and hierarchies

While Kay grants that transaction cost economics has been instructive, he takes exception with my definition and contends that transaction cost economics overuses contractual imagery, does not make allowance for fiat, is underdeveloped in property rights respects, and does not deal with dynamic, evolutionary phenomena. Kay sows confusion in definitional respects. Moreover, I maintain that (as of this date) the contractual approach is under- rather than over-used. Also, fiat occupies a prominent place in the transaction cost scheme of things; and property rights can be and have been brought within the ambit. Transaction cost economics has been less responsive in dynamic, evolutionary respects.

I. 1. Defining transactions

Kay maintains that transactions can be described in both contractual and physical terms and believes that my treatment confuses the two. The contractual definition to which he refers is this: ‘Each feasible mode of conducting relations between technology-separable entities can be examined with respect to the ex ante costs of negotiating and writing, as well as the ex post costs of executing, policing, and, when disputes arise, remedying the (explicit or implicit) contract that joins them’ [Williamson (1986, p. 139)]. What he calls the physical definition is this: ‘A transaction may thus be said to occur when a good or service is transferred across a technologically separable interface’ [Williamson (1986, p. 139)].

Kay queries whether these are consistent by examining two examples. The first involves Robinson Crusoe (by himself and with Friday). The second involves three farmers. Both examples are confused. I focus on the latter.

Kay’s initial scenario involves three plots of land, each owned by a different individual. Each owner hires a separate manager to cultivate his plot. The three owners purchase and share one tractor among them. The tractor sharing contract is the source of repeated disputes.

Under the second scenario, one owner buys up the land of the other two and consolidates ownership of the tractor. Unified ownership of the land and the tractor thereby obtain, but each plot continues to be cultivated by a


separate manager. According to Kay, ‘The tractor is allocated to farms in much the same fashion as before’ (p. 320).

Kay concludes that the ‘net effect is therefore the elimination of the [tractor] transaction in the contractual sense and the preservation of the [tractor] transaction in the physical transference sense’ (p. 11, emphasis in original). I contend that the ownership and use of the tractor are usefully decribed in contractual terms for both scenarios.

Interestingly, although Kay avers that the tractor gets ‘allocated to farms in much the same fashion as before’, he never tells us how it was allocated before. By a fixed formula? On a first-come, first-served basis? Other? What exactly are we comparing? If the managers were having disputes previously, why not now? Has the common owner taken on an active tractor allocation function, which involvement explains the superiority of unified ownership over what was done previously? If so, then the tractor does not get allocated in much the same fashion as before. Also, what are the opportunity costs? And have the contracts with the managers been adjusted to reflect this more active ownership involvement? More generally, the fact that fiat is now used to avoid or settle disputes does not eliminate a contractual relation but merely transforms it. What had been a joint ownership condition with stipulated usage rights becomes a unified ownership relation with dis- cretionary usage rights. Kay and I evidently agree that fiat is empowered by unified ownership. His mistake is that he does not regard unified ownership as a meaningful contractual alternative (see 1.3, below).

1.2. On the merits of contractual imagery

Albeit instructive to characterize the firm as a production function to which a profit maximization purpose has been ascribed, that is also a restrictive perspective. A different view of the firm - that of a governance structure - has been promoted by formulating the issues in contracting terms4 Specifically, transaction cost economics differs from the more familiar neoclassical approach in the following significant respects: (1) marginal analysis gives way to discrete structural analysis; (2) within-firm analysis of efficient factor proportions gives way to comparative analysis of the adaptive efficacy of alternative governance structures; and (3) although the analysis of technologically nonseparable activities is interesting and important, the more interesting issue, for students of the modern corporation, is to understand how and why technologically separable stages of business

“As David Kreps remarks, ‘In textbook (neoclassical) economics the firm is of the category of the individual agent. Agents have utility functions - firms have the profit motive. Agents have consumption sets - firms have production possibility sets. But in the ‘transaction cost’ scheme of things, firms are more of the category of markets both [firm and market] are [governance structures] within which individuals can transact’ (1984, p. 8).


activity are linked. Contractual imagery is vital for these purposes. A large number of additional phenomena come within the ambit of economic analysis as a consequence.

Among the issues that are illuminated by adopting a contractual perspective, but that are beyong the reach of the usual production function setup, are the limits of firms and the requisites for fiat. The first of these is briefly considered here. The second is discussed in 1.3, below.

As I have discussed elsewhere, one of the chronic puzzles of economic organization was ‘Why can’t a large lirm do everything that a collection of smaller firms do and more?’ That troublesome issue has been around since the 1920s. Efforts to deal with it all suffered from a serious defect: they did not pose the issue in a genuinely comparative way.

There were two problems with the usual ‘proof’ of limitations to firm size. First, merely to show that internal organization experiences bureaucratic costs is neither here nor there (as a comparative institutional matter) if those bureaucratic costs would merely be spread out - but, in the aggregate, would be unchanged - were the same transaction to remain in the market. Differential transaction costs needed to be but were not displayed. Second, the hierarchical structure within which internal transactions were to be organized was arbitrarily constrained: implicitly, if not explicitly, internal transactions were managed in a centralized way. That precludes use of a more interesting and, as it turns out, more illuminating option: employ selective intervention.

Selective intervention is really the key. The idea is to replicate the market mode within the firm in all respects save those where intervention is the source of expected net gains. If hierarchical control is reserved for the latter and if the firm replicates the market in all other respects, then the firm never does worse than the market (by replication) and sometimes does better (through selective intervention). Accordingly, the firm will everywhere do as well as and will sometimes do better than the market.

This formulation disclosed that prior explanations for limitations to firm size [as in Williamson (1967)] relied on arbitrary constraints. The core condition that needed to be explained is wherein does selective intervention break down [Williamson (1985, Ch. 6, 1988a)]. Suffice it to observe here that the main sources of breakdown - asset dissipation, the unavoidable loss of incentive intensity, and added latitude for politicking - are ascertained by examining firm and market organization in comparative contractual terms.

1.3. Fiat

Kay characterizes my hierarchies as ‘false’, at least partly because I do not make allowances for fiat. That, however, is mistaken. I expressly identify fiat as one of the distinguishing features of hierarchies, as compared with


markets, in my very first article on transaction costs (1971, p. 114). Moreover, I expressely take exception with Armen Alchian and Harold Demesetz’s contention (1972, p. 777) that firms and markets have identical access to fiat [Williamson (1975, pp. 67-70, 101)].5 Differences between firms and markets in adaptive, sequential decision-making respects are largely explained by differential access to fiat [Williamson (1981, p. 1549)]. The zone of acceptance in the employment relation is crucial in this connection [Williamson (1985, p. 249)].

One could nevertheless argue that the differential access to fiat within firms, as compared with between firms, warrants further explication. I not only agree but have recently argued that contract law differences between firms and markets contribute significantly to the differential efficacy of fiat in these two organizational forms. The basic hypothesis is this: each generic form of governance - market, hybrid, hierarchy, bureau - is supported by a distinctive form of contract law [Williamson (1990, 1991)]. Whereas market governance is supported by classical contract law [Macneil (1974)], the (implicit) contract law of hierarchy is that of forbearance: technical disputes that arise within firms are exempted from court-ordered enforcement. The efficacy of fiat turns critically on the fact that hierarchy is its own court of ultimate appeal.

One could complain that there is more to fiat than this. I do not disagree. I submit, however, that the efficacy of fiat needs to be established comparati- vely. Kay nowhere indicates that a comparative institutional approach is needed to assess fiat, much less does he identify the crucial comparative features on which the differential efficiency of fiat rests. Rival explanations for fiat to which transaction cost economics can be compared are nowhere mentioned (or even hinted at) by Kay.

Perhaps that is because fiat differences are obvious and hence can be taken as given. As Chester Barnard remarked, ‘Either as a superior or as a subordinate,. . . I know nothing more “real” than authority’ (1962, p. 170. n. 5). Appearances, however, can be deceiving - which presumably explains why Alchian and Demsetz asserted that firm and market were indistinguish- able in fiat respects. My position is that all significant differences between alternative forms of organization need to be explicated. An examination of alternative forms of governance in comparative contractual respects has been instructive for these purposes.

‘Also, whereas Kay emphasizes that my treatement of hierarchy is mainly contractual [referring specifically to Williamson (1985, p. 221)], note that my use of the term contractual hierarchy refers to the degree to which one or a few agents are responsible for negotiating the full set of contracts when contract renewal comes due, or if instead each agent contracts directly with others. That is to be distinguished from the decision-making hierarchy, which has reference to the use of or access to fiat during the operating interval. As between the two, I specifically remark that ‘the more critical hierarchy for performance purposes is the decision-making hierarchy’ [Williamson (1985, p. 222)].


1.4. Property rights

Kay contends that transaction cost economics is underdeveloped in property rights respects and that ‘non-specificity of assets may frequently create property right problems’ (pp. 16-17). I concur with the first of these. I would restate the latter argument as follows: asset specificity may be used strategically as a way by which to protect investments in a weak property rights regime.

(a) Property rights, general It has been argued that the economic institutions of capitalism with which

I have been predominantly concerned are those of advanced Western capitalist economies and that other forms of capitalism exist and warrant explication [Hamilton and Biggert (1988)]. I agree.

One way of doing this is to distinguish between the institutional environment on the one hand and the institutions of governance on the other. Lance Davis and Douglass North describe the institutional economics enterprise as follows (1971, pp. 67; emphasis in original):

The institutional environment is the set of fundamental political, social and legal ground rules that establishes the basis for production, exchange and distribution. Rules governing elections, property rights, and the right of contract are examples.. . An institutional arrangement is an arrangement between economic units that governs the ways in which these units can cooperate and/or compete. It . . . [can] provide a structure within which its members can cooperate . . or [it can] provide a mechanism that can effect a change in laws or property rights.

Thus, setting feedback effects aside, the institutions of governance (firms, markets, hybrids, bureaus) are embedded in the institutional environment (rules of the game) of which property rights are a part. Changes in the institutional environment can thus be treated as shift parameters. If these give rise to differential transaction cost consequences in one form of organization as compared with another, and if these changes apply at the margin, then changes in the organization of economic activity can be predicted [Williamson (1991)].

Not only can property rights differences be used to predict and interpret organizational differences within (longitudinal) and between (cross-sectional) economic systems, but the efficacy of, for example, communal property rights will vary systematically with the governance structure employed [Williamson (1985, pp. 217-218, 227-228)J and with the nature of the transactions to be organized [Hansmann (1989)]. What has become apparent only more


recently, however, are that organization form and assets relate to property rights in a strategic way.6

(b) Appropriability The proposition that investments in transactions specific assets may be

induced by contractual hazards has long been featured in the transaction cost economics literature. Benjamin Klein and Keith Leffler (1981) make the argument in conjunction with brand-name capital. Klein elaborates in his treatments of franchising (1980) and vertical market restraints [Klein and Murphy (1988)]. I likewise argue that the reciprocal exposure of specialized assets may be used as a devise by which to infuse credible commitment in what would otherwise be a hazardous trading regime [Williamson (1983, pp. 53&537)].

David Teece (1986b) has since extended the argument to deal with the lack of patent or other legal protection for intellectual property rights. The argument is that innovators may be induced to integrate into related stages (backward, forward, lateral) if such integration serves to mitigate contractual hazards under ‘weak regimes of appropriability’. If contracting with related stages runs the risk that valued knowhow will leak out, and if firms operating in related stages possess specialized assets, then effective control over innovations may inadvertently pass into the hands of others.

To be sure, integration into related stages can operate in the service of trade secrecy whether the newly integrated assets are specific or not. The denial of knowhow to specialized stages is especially important, however, where assets specificity has cost reducing effects. If de facto control of the innovation accrues to those who combine knowhow with asset specificity, then the leakage of knowhow will be deterred by integrating into co- specialized stages of production and distribution [Teece (1986)].

A related, but different, argument has been advanced by Jan Heide and George John (1988) who are concerned with intertemporal hazards that sometimes arise in distributing a good or service. They consider a manufacturer that has developed a new product and needs specialized distribution to get it to market. The manufacturer could make these investments himself or could employ manufacturers’ agents, who already know the market and can service it more cheaply. These agents will be leery, however, of deepening their investments if the success of their marketing efforts invites the manufacturer to bypass the agents and sell directly.

In effect, there are three scenarios to be evaluated: (1) the manufacturer sells directly from the outset, its disadvantages in this respect notwithstanding; (2) the manufacturer initially uses an agent to sell to the market and

6Actually, the strategic importance of asset specificity as a barrier to entry was recongized much earlier [Williamson (1975, 1976), Caves and Porter (1977), Dixit (1980)]. Appropriability issues of the kinds discussed below have come up more recently.


subsequently enters if the agent’s efforts are successful but not otherwise;7 and (3) the manufacturers uses an agent but is deterred from subsequent entry by the use of linking investments made by the agent. Farsighted agents under the last scenario recognize that their market development efforts will be expropirated by the manufacturer unless they are able to develop ties to the customers that preclude the second scenario from materializing. Which scenario is the most cost effective will vary with the circumstances. As Heide and John argue, linking investments are often the most effective way to go.

Thus, although Kay may believe that property rights weakenesses are beyond the reach of transaction cost economics reasoning, that is incorrect. To be sure, table 1-l (at page 31 of The Economic Institutions of Capitalism) should carry the proviso that strong property rights are assumed. If, however, contractual problems can be shown to appear in a strong property rights regime, then contractual problems can be expected where the appropriability regime is weak, a fortiori. Since the authors of each of the foregoing articles found that transaction cost reasoning was the natural way to think through and interpret the weak property rights phenomena in question, the real puzzle is this: Why does Kay resist doing the obvious?

1.5. Intertemporal

Kay refers to the desirability of addressing ‘dynamic, evolutionary phenomena’ in an internally consistent way. I not only concede merit in this, but I have previously indicated that transaction cost economics is limited in this respect [Williamson (1988b)].

It nevertheless bears remark that transaction cost economics has been concerned with intertemporal issues from the outset - as witness the key role played by the Fundamental Transformation [Williamson (1971, 1985, pp. 61- 63)] and other process transformations [Williamson (1988a)]. Also, the R&D process has been described in an intertemporal way [Williamson (1975, pp. 196207)], Schumpeterian ‘handing on’ has been expressly discussed (1985, p. 129), life cycle features have been discussed in conjunction with vertical integration and investment [Williamson (1985, pp. 127, 152)], and timing is important in dominant firm (1975, Chapter 11) and in entry deterring respects (1985, pp. 373-384).

Be that as it may, the need to be alert to a wider array of ‘dynamic, evolutionary phenomena’ is real. Although some of that can be introduced through more self-conscious treatment of the institutional environment (see

‘There are two variants of the second scenario: The manufacturer could offer to compensate the agent for any specialized investments should the manufacturer decide to integrate, or the manufacturer could refuse to compensate. I assume the latter, there being many problems in establishing value for the former [for a discussion, see Williamson (1985, Ch. 13)].


above), that does not exhaust the possibilities. Transaction cost economics stands to benefit from the further development of evolutionary economics.

2. The modern corporation

Early analyses of the make-or-buy decision (in its various forms) work out of gross distinctions between markets and hierarchies. But polar distinctions between markets and hierarchies merely begin the inquiry. Not only are there a variety of market modes - which is to say that the study of hybrids is pertinent - but there are a variety of ways to organize hierarchies. Contrary to the technolo~cal tradition, transaction cost economics insists that organization form matters and attempts to ascertain and explicate the reasons why. The latter part of Kay’s paper is concerned with the modern corporation - with special emphasis on conglomerates, the multinational enterprise, and evolutionary economics. I discuss aspects of each.

2. f . The c~~g~orn~ra~e

Kay evidently sees merit in characterizing the multidivisional firm as an internal capital market.* But he poses the following challenge: ‘Williamson does not explain why the conglomerate should evolve in preference to [horizontal or vertical mergers]’ (p. 22). There are three responses, two of which are historical.’

The first (and nonhistorica~ response) relates to the ~om~rison of vertical and conglomerate mergers. There are certainly some vertical acquisitions to which I would attach economizing value. Vertical relations, however, that involve negligible degrees of bilateral dependency should not be integrated (for transaction cost economizing reasons). The rule is try markets, try hybrids, and revert to vertical integration only for compelling cause - the reason being that to integrate into related stages where dependency is negligible incurs costs without benefits [Williamson (1985, Ch. 6)]. Leakage considerations (of the kind referred to in 1.3(b) above) aside, vertical integration is the governance structure of last resort.

Because conglomerate acquisition involve a negligible amount of intratirm trade, the likelihood of intra~rm cost excesses of these same kinds is mitigated. Assuming, therefore, that the firm to be acquired is either a generic supplier or is a business with which the acquiring firm has no current or prospective trading association, the acquisition of the latter could easily be the less disadvantageous.

sOthers who viewed the M-form in a somewhat similar way include Heflebower (1960), Alchian (1969), Drucker (1970), and Bower (1971).

‘Kay’s discussion is context-free. That may be because he believes that a timeless rationale for the conglomerate is needed. I am persuaded that context matters.


That is a rather extreme hypothetical, however. More important to an understanding of the conglomerate are historical changes that have ocurred in antitrust enforcement and in competition in the capital market during the past 25 years, Although Kay mentions neither, context matters.

There have been massive changes in antitrust enforcement since 1965. The 1960s and early 1970s was an era during which mergers with even very small degrees of horizontal and vertical overlap were routinely challenged by the antitrust enforcement agencies, which challenges were invariabily sustained by the courts. (As Justice Stewart put it, in a dissenting 1966 opinion, the ‘sole consistency that I can find is that in [merger] litigation under Section 7, the Government always wins.‘)” That has changed. Antitrust has become progressively more sensitive to possible efficiency gains in horizontal and vertical mergers - especially since 1980.”

Also, competition in the capital market has undergone substantial change since the 1960s. Challenges to incumbent managements principally took the form of proxy contests before the conglomerate movement in the late 1960s. The proxy contest was a beauty contest and incumbents were rarely defeated. Lacking credibility, claims by challengers that they would somehow do better were discounted. Merger is an alternative corporate control device [Manne (1965)] with superior credibility properties. Rather than rely on mere promises to add value, the shareholders of acquired firms could examine the terms under which the merger would be made.

To be sure, horizontal or vertical mergers could sometimes yield added value (in market power, scale economy, and/or transaction cost economizing respects) over and above the corporate control benefits of the con~omerate merger. But that is operationaily irrelevant if antitrust enforcement blocked mergers of both horizontal and vertical kinds. If the conglomerate merger was the only game in town, and if the alternative corporate control instrument was the proxy contest, then conglomerate acquisitions in the late 1960s and early 1970s - at least those of the M-form kind, which excludes conglomerates of the Go-Go variety12 - had redeeming qualities.

As it turns out, that was a transitional condition. Not only did antitrust enforcement change, but new corporate control instruments took shape. Challenges to incumbent managements that took the form of tender offers - paying a permium for shares - relieved the need for mergers as a managerial

“United States t’. Van’s Grocery Co., 384 U.S. 270, 301 (1966) (Stewart, J., dissenting). “The March 1983 issue of the Ca&rnia Law Rsuiew traces the key changes in the Merger

Guidelines up through 1982. There have been subsequent relaxations in the Guidelines since. “Some early congtomerate acquisitions might have been mistaken. As I have repeatedly

emphasized, the conglomerate form to which I ascribe potential benefits is organized as an M- form enterprise. The so-called Go-Go conglomerates do not display M-form features and should not be expected to function as miniature capital markets. Many critics of conglomerates do not make organization form distinctions but treat them as being all of a kind (usually of the Go-Go kind).


displacement device. Recourse to takeover by tender offer supported by new or perfected forms of finance - leveraged buy-outs, bust-up takeovers, junk bonds - progressively took shape during the 1970s and 1980s.

Indeed, a further consequence of the relaxation of antitrust endorcement against horizontal and vertical mergers is that earlier conglomerate acquisitions could be (and some were) sold off and reconfigured into what were arguably higher-valued horizontal and vertical relations. I do not, therefore, wholly disagree with Kay’s argument that ‘Williamson’s own transaction cost tool-kit provides arguments for specialization rather than conglomerates’ (p. 22). I would only urge that (1) the issues need to be examined in context and (2), subject to size and variety limits, the M-form conglomerate possesses affirmative features. Those who argue that history matters should be mindful of that advice.

2.2. Multinationals

Kay observes that my treatment of multinationals is brief and incomplete. I agree. The fact, however, that my treatment of multinationals is limited does not imply that transaction cost economics cannot be made to apply more generally. Not only have others found that transaction cost economics usefully informs the study of multinationals,‘3 but I anticipate that further applications can and will be made. I would note in this connection that all of the puzzling multinational practices to which Kay refers in his article are ones to which transaction cost economics can be brought to bear.

Note in this connection that the discussion of weak appropriability (in section 1.3, above) is pertinent to an assessment of the licensing puzzle to which Kay refers. Thus Kay observes that ‘there is evidence that specificity of transactional relationships may encourage the licensing (market exchange) option in some circumstances’ (p. 29) and quotes Farok Contractor’s finding that ‘The disadvantages of licensing arising from licensee independence are often removed if the licensee is kept dependent for trademarks, required components, foreign market access, technical improvements, etc.’ [Contractor (1981, p. 78)]. Kay regards this as a contradiction of transaction cost reasoning.

As hitherto remarked, however, the contractual hazards that arise in a strong property rights regime need to be distinguished from those that arise under weak property rights. Licensing in a strong property rights regime works well if assets are nonspecific. That is the standard argument. If, however, licensing poses leakage hazards (because property rights are weak),

“Applications of transaction cost economics to the study of multinational enterprise include Richard Caves (1982), J.F. Hennart (1982), Wilfred Ethier (1986), Alan Rugman (1986), David Teece (1986b). Eirik Furubotn (1989) and Saul Klein, Gary Frazier and Victor Roth (1990). See also John McManus (1971) and the book by Mark Casson and Peter Buckley (1985).


then efforts to seal leaks are indicated. One possibility is to forego licensing in favor of direct foreign investment. Another is to license only if the licensee is dependent on the licenser in the ways described by Contractor. Note, however, that the dependencies described by Carpenter do not entail investments in specialized assets (of a cost saving kind) by the licensee. Indeed, trading under a weak property rights regime with licensees who invest in co-specialized assets invites precisely the loss of control condition referred to by Teece (1986).

It is relevant in this connection to ‘distinguish between the licensing problem and the franchising problem. Both pose leakage hazards, but whereas the franchisee can be deterred from dissipating quality by (1) requiring him to make nonredeployable investments in the franchise and (2) imposing a termination-at-will clause [Klein (19X0)], this same strategy will not work for licensing. That is because termination is of no concern to the licensee, once he has acquired the relevant knowhow. Accordingly, the licensing agreement needs to be embedded in a larger contractual relation in which penalities other-than-termination have integrity infusing properties. Absent the ability to effect deterrence - by the credible threat of enforcing trademarks more vigorously, using politics to limit foreign market access, restricting access to proprietary technical improvements, etc. - and assuming that direct foreign investment is prohibitively expensive, licensing will predictably take the form of a one-time, lump sum fee rather than a royalty agreement. i4

2.3. Evolution of the M-form

Kay splices a 1971 quotation of mine together with his interpretation of a 1985 statement of mine and expresses dissatisfaction with the result. Kay’s argument reads as follows (p. 26):

. . .it is important to identify exactly what Williamson is saying: expan- sion of the U-form leads to crisis and collapse and the development of the M-form to solve these problems ‘eventually the U-form structure defeats itself and results in the M-form structure to solve these problems’ [Williamson (1971, p. 350)]. The evolution of the M-form is regarded as an evolutionary process operating according to natural selection criteria [Williamson (1985, p. 296)].

Readers who are advised by Kay that he wants to establish exactly what I am saying have reason to expect that he is representing me correctly and preserving the context. Surely readers have reason to believe that the passage appearing in quotes - ‘eventually the U-form structure defeats itself and

14This last is a ‘node B’ transaction cost argument [Williamson (1985, pp. 32-35)].

J.E B.O. B


results in the M-form structure to solve these problems’ - is mine. What I actually wrote, at the cited page, is this [Williamson (1971b, p. 350)]:

Functional organization . . . was and is the natural way to decompose simple tasks. Preserving the functional form as the firm is gradually expanded is also to be expected. Eventually, however, the U-form structure defeats itself. This will obtain even if the U-form enterprise undergoes a simple radial amplification in size without concurrent diversification. If accomplished through diversification, coordination within the functional form can be expected to present even more severe problems. The organizational innovation that was devised as a reponse to these conditions involved substituting quasi-autonomous operating divisions (organized mainly along product, brand, or geographic lines) for the functional divisions of the U-form structure as the principal basis for achieving compartmentalization.

I stand by these remarks with one modification: the second paragraph should being with the article ‘An’ rather than ‘The’.

It is also pertinent to examine the passage upon which Kay relies for his statement that ‘The evolution of the M-form is regarded as an evolutionary process operating according to natural selection criteria.’ The relevant passage (on the page referred to by Kay) reads as follows: ‘Investors will presumably be prepared to supply capital on superior terms . . . to a large, diversified M-form corporation than they would be to an equivalent H-form firm. In the degree to which the M-form is in fact jitter, natural selection, which includes competition in the capital market, favors this result [Williamson (1985, p. 296; emphasis added)]. I have no reason to modify this statement. Note, however, the reference here is to the H-form (not the U- form). Also, my contention that cost savings favor selection, ceteris paribus, is a very general weak-form selection argument. If Kay objects to the preposition that cost savings favor selection, he should elaborate.

Kay subsequently argues that a ‘genuine natural selection argument would see the M-form innovation generating crisis and collapse in the (inferior) U- form, rather than the U-form collapse generating the M-form innovation’ (p. 26). That is because genuine natural selection ‘selects from among present competitors’ (p. 26). Such an argument seems to me to be needlessly deferential to biological reasoning. If economic actors behave intentionally - which, within limits, they do - then why eschew intentionality in the study of organizational innovation?

Specifically, one interpretation of the M-form innovation is that it was an intenationally crafted response to the severe problems of organization that U-form and H-form firms experienced as they grew in size and variety. How did such firms infer that they had problems? One possibility is that their


managements reflected upon previous experience (when the firm was smaller and simpler). Another was to consult the marketplace. Still another would be to work through the logic of organization. ’ 5 If Donaldson Brown (1924) and Alfred P. Sloan (1964) are to be believed, General Motors devised and implemented the M-form innovation in a very ‘conscious, deliberate, purposeful’ fashion.i6

But I do not insist on an intentional explanation. It could be that the M- form was one of many spontaneous organizational innovations that occurred at about the same time. Conceivably, some of these (undescribed) organizational innovations might have been objectively superior to the M-form. That the M-form won in the resulting competitive contest was not because it possessed intrinsic merit but because it was favored by chance and/or mindless imitation by others.

The problem with reasoning of this kind is that anything goes. As I have argued elsewhere, if a compelling evolutionary argument for or against an efficiency outcome cannot be made, then ‘plausible efticiency arguments must be assessed differently. Abstract selection logic gives way to an examination of refutable implications’ [Williamson (1988c, p. 177)]. I therefore propose that the data bearing on the M-form hypothesis be examined in relation to Kay’s rival hypothesis. The M-form hypothesis is this (1971, p. 367; emphasis in original):

the organization and operation of the large enterprise along the lines of the M-form favors goal-pursuit and least-cost behavior more nearly associa- ted with the neo-classical profits-maximization hypothesis than does the U- form organizational alternative.

Kay’s rival hypothesis is.. . ???

3. Concluding remarks

Transaction cost economics needs to be refined and extended. It needs to be qualified and focused. It needs to be tested empirically. Criticism can help in all of these respects.

Kay’s paper contributes to the dialogue. But much of his argument is confused and/or confusing. Not only are many of his arguments mistaken (as, for example, the ‘false hierarchies’ claim), but many of the purported

15To be sure, the logic [Ashby (1960) Simon (1962)] of the ultrastable system had not yet been worked out. Brilliant managers (of which Alfred P. Sloan, Jr. was one) nonetheless appear to have intuited the benefits of near-decomposability.

r6The words ‘conscious, deliberate, purposeful’ are borrowed from Chester Barnard’s charac- terization of cooperation in the business firm (1938, p. 4).


shortcomings of transaction cost economics already have been or can dealt with by an extension or refinement of transaction cost reasoning.

Kay advises that we re-read Coase. I always find that instructive. He also suggests that insights can be gleaned from the property rights literature. I concur and hope that the foregoing indicates that this not only can be done but has been going on.

More generally, transaction cost economics has displayed the capacity for growth. To be sure, transaction cost economics may play out as the better parts are incorporated within and refined by orthodoxy. Indeed, that too has been going 0n.l’ But transaction cost economics has also been an unfolding perspective in both deepening (older applications) and widening (new applications) respects. Since I regard the past as the best predictor of the future, I project continuing vitality - at least over the next decade.”

“‘The new orthodoxy to which I have reference works out of an incomplete contrasting setup [the key article here being that of Sanford Grossman and Oliver Hart (1986)]. Interestingly, some of the language and many of the concepts of transaction cost economics - bounded rationality, opportunism, information impactedness (including the distinction [Williamson (1975, pp, 31-37)] between observability and verifiability), asset specificity, incomplete contracting, hostages, governance, and the like - now appear routinely in the formal modelling literature. David Krep’s examination of transaction cost economics in his recent microeconomic theory text is illuminating (1990, Chapter 20).

“See note 2, supra.

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