Transaction Costs Theory
The origin of transaction costs theory is Coase’s (1937) classic journal article on the nature of the firm. However, it took until the mid-1970s for transaction costs theory to become influential in both research and public policy following the works of Arrow (1974) and especially Williamson (1971, 1979). This chapter covers Arrow (1974), Coase (1988), and Williamson’s three transaction costs books (1975, 1985, 1996).
Arrow’s (1974) book on The Limits of Organization was originally given as the Fels Lecture for 1970-71 to the Fels Center of Government at the University of Pennsylvania. This lucidly written book focuses on at least four major themes: (1) the concept of rationality (individual and social); (2) information economics; (3) the agenda of organizations; and (4) the concepts of authority and responsibility. Throughout this work, Arrow (1974) considers the (often conflicting) demands of society and the needs of the individual and insists that some sense of balance is required.
Coase’s (1988) book on The Firm, the Market and the Law is a collection of his journal articles and economic writings. Coase (1988) argues that if we move from a regime of zero transaction costs to one of positive transaction costs, what becomes immediately clear is the crucial importance of the legal system. Coase (1988) maintains that it makes little sense for economists to discuss the process of exchange without specifying the institutional setting within which the trading takes place, since the institutional setting affects the economic incentives to
produce and the economics costs of transacting.
Williamson’s (1975) Markets and Hierarchies is a work of scholarship written for posterity. This research book combines ideas from Commons (1934), Coase (1937), Barnard (1938), Simon (1947), March and Simon (1958), Chandler (1962), and Arrow (1974), among others. In particular, Williamson (1975) emphasizes the fundamental importance of information (Arrow, 1974), organizational innovation (Chandler, 1962), transaction costs (Coase, 1937), and behavioral assumptions (Simon, 1947). Simultaneously, Williamson (1975) provides original ideas concerning vertical integration and the theory of the firm that have proven to be fruitful for the evolving science of organization.
Students of strategic management are well advised to study closely transaction costs theory. Transaction costs theory combines logical rigor with practical relevance to help describe, explain, and predict governance based on comparative efficiency criteria. In addition, the habits required of good scholarship can be learned from Williamson (1975):
• Describe others’ works fairly and accurately;
• Search extensively to find and develop plausible theory to help understand the phenomena at hand;
• Have an active mind;
• Work from a disciplinary base; and
• Have the courage to be interdisciplinary, if so inclined.
The organizational economics principles found in transaction costs theory are durable. Indeed, we are currently witnessing greater vertical de-integration (e.g., strategic outsourcing), arguably, as a result of fundamental transaction costs changes --- impacting input and output measurement costs and asset specificity (Mahoney, 1992c) --- that are due to dramatic changes in the development and diffusion of information technology (Shapiro and Varian, 1999). I believe this research area to be especially fruitful for students in the next generation of strategic management research.
Williamson (1985) documents well that empirical research testing transaction costs theory has been largely corroborative. Nevertheless, like all empirical research studies, students today will continue to be challenged by potential specification problems, measurement problems, and identification problems in econometric testing. Given the current state of the empirical research literature testing transaction costs theory (and even more so in other research areas of organizational economics), students in the next generation can arguably do better.
Williamson (1996) continues the agenda of joining law, economics, strategic management and organization theory. A systems perspective is employed to look at (incomplete) contracting in its entirety. Credible commitments are viewed as ways of safeguarding against contractual hazards inherent in incomplete
contracts.
Like Barnard (1938), and Simon (1947), Williamson’s (1975, 1985, 1996) transaction costs trilogy provides a conceptual framework simple enough to be used and complex enough to accommodate continuing insights into the workings of organization. Students of strategic management taking an organizational economics approach should take heart in achieving and pursuing the science of organization.
We begin this chapter with Arrow (1974). Arrow (1974) and Williamson (1971, 1975) were among the earliest economists to build upon Coase (1937, 1960).
