Transactional Cost Economics

In order to reflect upon Oliver Williamson’s framework of Transaction Cost Economics (TCE), it is important, if not essential, to consider Ronald Coase’s contribution to it. Coase argued that given absence of transaction costs, efficiency could be achieved under any number of ‘institutional arrangements. ‘ He says that the choice between each alternative institutional arrangement, including one between market and firm organization, gave birth to comparison of costs of transacting.

This essay identifies the limitations of Coase’s framework, and illustrates Williamson’s construction of it as a somewhat more predictive extension, highlighting its limitations. Coase’s claim that given markets, firms should not exist in the absence of inherent market failures related to transaction costs is highly acclaimed but widely criticized.

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These criticisms range from his failure to identify the precise factors determining institutional change to his treatment of different types of co-ordinations as a narrow economic problem, including his assumption that a competitive economy will incur the optimal mix of firm and market type coordination. We concern ourselves largely with his failure to sufficiently operationalise transaction cost arguments.

Although Coase’s arguments ‘firmly established the centrality of transaction costs in assessing merits of organizational alternatives, his original formulation of the theory lacked a basis for determining which institution was preferred’ (Masten). This led transaction cost reasoning to gain a ‘well-deserved bad name’ and caused economists to call Coase’s arguments merely tautological.

Williamson’s framework aims to rescue transaction cost reasoning, while elevating Coase’s insight, giving it a more predictive nature. In doing so, he acknowledged existence of various categories of transaction costs and organizational structures, where, “properties of the transaction determine what constitute the efficient governance structure”.

He argued that to incorporate an analysis of institutions and simultaneously operationalise the TCE framework, it was key to ‘(i) identify the behavioural traits responsible for the emergence of transactional frictions and (ii) relate the incidence of those frictions to institutional structures and observable attributes of transactions in a discriminating way, that is, in a way that would permit hypotheses about organizational form to be formulated and tested’ (Masten).

In trying to operationalise transaction cost reasoning, Williamson found that many conventional economic assumptions, such as high levels of rationality and effective enforcement of promises, were incompatible with the existence of organizational failures. Williamson argued that individuals are limited in their foresight and cognitive abilities and pursue self interest with guile: problems that arose due to market transactional frictions and would be resolved by the dominance of the institution. These conditions, encapsulated in the concepts of bounded rationality and opportunism, thus became the critical behavioural attributes to which all organizational arrangements must be responsive’ (Masten). Compared to conventional assumptions, Williamson is more cynical about human nature, portraying individuals as less competent optimizers, willing to skirt rules, exploit loopholes or capitalize on strategic advantages. He realizes not all individuals may act in such a manner but feels bounded rationality makes it difficult to distinguish between the ‘trustworthy and unscrupulous’.

He shows that efforts to control opportunism invariably puts increased demand on bounded rationality making the organization goal to ‘organize transactions so to as economize on bounded rationality while simultaneously safeguard them against the hazards of opportunism’ (Masten). In characterizing transaction costs he recognizes that even bounded rationality and opportunism pose organizational problems in the static world. Williamson emphasizes factors such as frequency of the transaction and the degree of uncertainty and asset specificity surrounding the transaction.

He suggests that due to recurring contracts needed to be drawn up with each transaction, if governed by markets, the co-ordination of highly frequent transactions are more efficient in vertically integrated structures. For him, the presence of change and uncertainty implicates the need for transactors to plan, monitor, and adapt to activities demanding cooperation and attention: this, in his view, poses the central problem of adaptability for economic organization. Williamson suggests that the higher the uncertainty surrounding the transaction, the more effective it is to coordinate it within a firm.

In examining the need to develop governance structures in transactions, Williamson refers to problems arising from asset specificity enabling opportunism. ‘Realization of cost economies or design-benefits often requires investment in relationship-specific assets that isolate transactors from market alternatives’ (Masten). These investments take place in various forms: (a) physical asset specificity; (b) site/location specificity; (c) human asset specificity; and (d) dedicated assets.

Despite their benefits, parties are often reluctant to invest without some safeguard to prevent trading partners from opportunistic behaviour. Safeguards could be in the form of long-term contracts, but even they increase demand on bounded rationality and only imperfectly limit opportunism. Therefore, when asset specificity and uncertainty are low, it would be more efficient to coordinate transactions through markets. On the other hand, high asset specificity and uncertainty lead to transactional difficulties which lead transactions to be internalised within the firm when transactions are frequent.

Despite being highly acclaimed in the study of New Institutional Economics, Williamson’s framework is frequently criticised. “I assume, for expositional convenience, that ‘in the beginning there were markets’. (Williamson) The foundation of Williamson’s framework is based on this singular assumption through which, with exercises in comparative statics, he places markets and firms as alternatives for completing transactions. He suggests that the emergence of firms is the result of market failure.

Ankarloo and Palermo argue that the ‘system of pure markets is defined in a context of zero-transactional cost’, and that in such a context, although failures are possible, they are not recognized in Williamson’s framework. Williamson’s focus remains only on failures caused by transaction costs, ignoring other types of market failures. In this context, Williamson fails to recognize that Path Dependency is sufficient to produce insufficient outcomes. Williamson’s initial assumption was made for ‘expositional convenience and should be deemed irrelevant from the viewpoint of analytical results.

Williamson illustrates the institutions of capitalism as a result of an evolutionary process saying the explanatory-key to this process is Pareto-efficiency. He explains the emergence of hierarchies by saying that ‘only Pareto-efficient institutions emerge and survive. ‘ He adds that institutional evolution towards higher efficiency will continue so long as ‘individual interactions take place spontaneously, without coercion’ (Williamson). However, critics argue that spontaneity in action is not sufficient to prove Pareto-efficient social interaction.

Moreover, his use of comparative statics for historical analysis further reflects that ‘the efficiency of capital institutions is not argued historically but deduced from the assumption that in the initial conditions ‘natural endowments’ are distributed heterogeneously’ (Ankarloo & Palermo). In assuming the existence of a singular ‘primordial institution in capitalism’ (markets), Williamson fails to provide a sound explanation for it and goes further to make it universal, inevitably falling ‘into a sterile idealisation of this institution (Ankarloo & Palermo).

Ankarloo & Palermo also point out that any other assumption would have made the project self-contradictory, not sufficiently explaining some capitalist institutions. Williamson’s assumption of the market as the natural institution is criticized for idealizing the market without any coherent justification. Williamson is also criticized for assuming heterogeneity of individual natural endowments which, critics feel, was taken for granted and not sufficiently justified. His discussion fails to show that no other elements other than these endowments cause the emergence of firms.

Further, Williamson’s model has been accused of being driven by predictive power rather than historical accuracy. His selection of historical events seems ad hoc, sometimes simply assumed to fit his theory. Since historically organizations of production preceded markets, Williamson’s notion of ‘selecting, voluntarily through conscious choice’ on the basis of efficiency, seems flawed. ‘If markets are assumed to exist prior to selection, nobody could have chosen them for their efficiency’ (Ankarloo & Palermo). However, if markets are ‘consciously chosen’, they fail to be a ‘spontaneous’ result of evolution.

According to the Marxian approach: ‘Production may occur without exchange… but exchange (of products)… cannot occur without production’ (Engels). Thus, logically ‘production presupposes exchange’ and renders the NIE assumption of markets as an original institution inconsistent and problematic. However, Hodgson pointed out that Williamson’s definition of firms exclude individual production and are based on work-contracts. Even so, his framework fails to recognise a major aspect of the firm as a production unit and fails to analyze some production units that it has already presupposed.

Williamson’s concept of transactions and opportunism are also criticised. He viewed transactions as the unit of analysis but his definition of the same is often deemed ambiguous leading to various doubts on what actually constituted a transaction (Martin). Another problem relates to his account of power relations and the problems associated with power imbalances. The main themes behind this are contracts and opportunism, for where greater power exists, maximum self interest is attained.

He suggests people should safeguard themselves from transactions, however, people need to be aware of the interests of the parties carrying out the transaction as problems are a result of differences in interest and power resources (Martin). To conclude, we find that Williamson’s framework of TCE, in attempt to operationalize Coase’s framework, remains one of the most comprehensive, well-acclaimed theories in New Institutional Economics despite its limitations, because of his widespread contributions to NIE and the opportunities provided for research into the field using alternative approaches.