Williamson (1979) - Transaction Cost Economics

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• This page is referenced in BPP Field Exam Papers

Reference(s)

Williamson, Oliver (1979), "Transaction-Cost Economics: The Governance of Contractual Relations", Journal of Law and Economics, Vol. 22, No. 2. (Oct.), pp. 233-261. pdf

@article{williamson1979transaction,
 title={Transaction-cost economics: the governance of contractual relations},
 author={Williamson, O.E.},
 journal={Journal of law and economics},
 volume={22},
 number={2},
 pages={233--261},
 year={1979},
 publisher={JSTOR}
}

Abstract

The new institutional economics is preoccupied with the origins, incidence, and ramifications of transaction costs. Indeed, if transaction costs are negligible, the organization of economic activity is irrelevant, since any advantages one mode of organization appears to hold over another will simply be eliminated by costless contracting. But despite the growing realization that transaction costs are central to the study of economics,1 skeptics remain. Stanley Fischer's complaint is typical: "Transaction costs have a well-deserved bad name as a theoretical device... [partly] because there is a suspicion that almost anything can be rationalized by invoking suitably specified transaction costs." Put differently, there are too many degrees of freedom; the concept wants for definition.

Vocabulary

"Opportunism is a variety of self-interest seeking but extends simple self-interest 
seeking to inlcude self-interest seeking with guile. It is not necessary that all
agents be regarded as opportunistic in identical degree. It suffices that those who
are less opportunistic that others are difficult to ascertain ex ante and that, even
among the less opportunistic, most have their price."
                                                 -Williamson, 1979, Footnote 3, p234

Opportunism - is what we would now call rational (selfish) utility or profit maximization.

Veridical - truthful (used in the context of differentiating between multiple truthful outcomes in Williamson)

General Concensus on Transaction Costs

The is agreement on:

1. Opportunism is a central concept in the study of transaction costs
2. Opportunism is especially important when there are transaction-specific investments in human or physical capital.
3. Efficient processing of information is important and related
4. The assessment of transaction costs is a comparative institional undertaking

The paper is primarily concerned with intermeditate-product market transactions, and deals with the market, hybrid and hierarchy modes of organization.

Three-way Classification of Contracts

Classical Contract Law

Classical contract law is concerned with enhancing discreteness and intensifying presentiation, where presentiation means "make or render present in place or time; to cause to be percieved or realized at present". It does this by:

• Considering the identities of the parties as irrelevant
• Carefully delimiting the nature of the agreement (and giving precedence to formal over informal terms)
• Narrowly prescribing remedies
• Discouraging third party participation
• Creating self-liquidating transactions

Neoclassical Contract Law

For long term contracts under uncertainty, presentiation is likely to be prohibitively costly or impossible. There are several types of problems that can arise:

1. Not all future contigencies can be anticipated
2. Appropriate adaptation may only be possible after the new circumstances have arisen
3. There may be veridical disputes when state-contigent claims are made (note that this is particularly problematic when parties are opportunistic).

The remedies include:

• Forgoing the contracts altogether
• Vertical intergration, so disputes can be internalized and solved by fiat
• A different contracting relationship that preserves trading and give additional governance might be devised.

In the last case, a (predesignated) third party has advantages over litigation. Specially an arbitrator can:

• Act quickly (relative to the courts)
• Use informal education from both parties (i.e. isn't contrained by the evidence and rules of proceedings)
• Enable continuity of the relationship (as opposed to termination of the contract by the courts)

Relational Contracting

Progressively increasing the duration and complexity of the contract leads to a need for a more transaction-specific governance structure. This is relational contracting. The relation:

• Is a minisociety of norms beyond those centered on the exchange
• Has the entire relationship as its reference point, rather than just the contract terms

Economizing

This is the criterion for organizing commercial transactions. It has two parts:

1. Economizing on production expense
2. Economizing on transaction costs

The object is to economize on the sum of the two parts.

"When transaction costs are negligble, buying rather than making 
 will normally be the most cost-effective means of procurement."
                                                -Willimson, 1979

When procurement expense is small relative to transaction costs, choosing the right governance structure is the first and most important part of the optimization. This is attraction of internal procurement of recurrent 'idiosyncratic' transactions, as market trading is "shot through with appropriable quasi-rent hazards" for these types of transactions.

Transactions

Generally one should assume the simple contract types will use use simple governance relationships, and complex ones complex governance relationships. Using a complex governance for simple contracts incurs unneeded costs, and simple governance for complex contracts invites strain.

We now turn to the types of contract, noting that uncertainty, frequency, and the extent to which durable transaction-specific investments are made. First though, we consider transaction specificity.

Transaction Specificity

To what degree are investments in transaction-specific expenses made?

Unspecialized investments pose few hazards: There are alternative sources of buyers and sellers. Problems arise when the specific identity of the parties has cost-bearing consequences. These are 'idiosyncratic' transactions. This might happen because:

• The identies are important from the outset - one party makes a specific investment to enter the contract and is then locked in.
• Human capital becomes specialized by training or learning by doing
• Something happens at the buyer-seller interface - i.e. communication is enabled by familarity/knowledge

Note that personal integrity and reputations can both serve as checks against opportunism,

The key features of transaction specific investments are:

• They occur over long terms
• The large numbers competition is transformed into bilateral monopoly
• Intertemporal efficiency requires adaptation. (many spot contract are not sufficient as they prevent investment).

 A clause along the lines of:
 
"I agree to behave responsibly rather than seek individual advantage when an occasion to adapt arises"
 
 Would suffice in the absense of opportunism. But humans make false and misleading statements!

Idiosyncratic goods are those where tranaction specific investments in human or physical capital are made. A governance structure to attenuate opportunism is needed here.

Examples in practice include:

• The purhase of a specialized component
  • Assume that the specialized version is needed, and the alternative in its next best use is lower
  • Assume that scale economies require a significant investment be made
  • Assume that alterative buyers are sparse
• The proximate location of plant
  • So that transport and flow-process efficiencies arise
  • Long life and a unique location are needed
• Human capital that involves tacit knowledge
  • Established character and trust may mitigate this problem - see Babage's example on p243/4.

Crucially, parties must remain in a continuing relationship - for these parties a court room is a detrimental to the relationship.

Characterizing Transactions

Assume that uncertainty exists to some intermediate degree, that supplier intend to be in business on a continuing basis, that potential suppliers are numerous, and that investment refers to investment by suppliers, then the following is the classification:

Frequency:

• one-time (not important and so not analyzed further)
• occasional
• frequent

Investments:

• Non-specific
• Mixed
• Idiosyncratic

Governance structures:

• Non-transaction-specific
• Semi-specific
• Highly specific

The market is the classic nonspecific governance structure within which 
     "faceless buyers and sellers meet for an instant to exchange 
              standardized goods at equilibrium prices."
                                       -Williamson '79, citing Lowry '76
                                       

Identity matters in in specific transactions.

Market Governance

Markets:

• Are the main governance for non-specific transactions
• Use the traders own experience and prices
• As investments become more specific reputation and formal ratings matter
• Is the medium of 'sale' rather than 'contract'
• Identity of parties is of negligible importance
• Formal terms of the contract apply
• Litigation is for settling claims, not to sustain the relationship

Trilateral Governance

This mode is needed for occasional transactions with mixed and highly idiosyncratic investments. Here:

• There are strong incentives to see the contract through
• As the specificity increases, so do the incentives to sustain the relationship
• Setup costs often can not be recovered
• The cost of bilateral governance is prohibitive
• Uses third party assistance - an arbitrator

Bilateral Governance

This mode applies to reoccuring transactions with mixed and highly idiosyncratic investments. Here:

• Nonstandard nature makes markets hazardous
• Reoccuring nature justifies the costs of the additional governance over trilateral governance

It is important to differentiate between when autonomy is maintained and the parties are integrated (and subject to fiat). Highly idiosyncratic investments do not have scale economies and therefore integration is best. With mixed investments outside procurement might be favoured by scale economies. Outside procurement is also good for cost control, but poor for adaptation.

In the case of outside procurement, some the degree of allowable adjustments should be restricted. Price adjustments are more problematic than quantity (because of the strategic nature and direct gains). Excalator clauses, related to economic conditions, are one option. But price adjustments, in particular, must be able to be shown to result from exogenous circumstances. Validitation is important.

With vertical integration, adaptions can be made without the need to change (or even consult) agreements. The paper refers to vertically integrated bilateral governance as unified governance

The Match of Governance Structures

The following table lays out the match:

                          Investment Characteristics
                   ------------------------------------------- 
                   |NonSpecific  |   Mixed   | Idiosyncratic |
                   -------------------------------------------
                   |             |                           |
        Occasional |   Market    |      Trilateral           | 
                   |             |                           |
Frequency          -------------------------------------------
                   |             |           |               |
        Reccurent  |   Market    | Bilateral |    Unified    |
                   |             |           |               |
                   -------------------------------------------
                   

Uncertainty

Different governance structures may affect the time required to reach an equilibrium when there is uncertainty in the relationship, but otherwise any will do.

In market governance if the uncertainty increases:

• The need for adaptations will increase
• The time to deal with each adaptation decreases
• Adaptations become more important
• If adaptation can be sacrificed for standardization, then markets are good
• Otherwise as adaptations increase the need for a more specialized governance structure increases.

Other Applications

Labor

Non-specific transactions : Migrant farm labourers for example. Market governance applies.

Mixed-transaction: Large numbers of workers acquire an intermediate amount of firm-specific skill.

Here:

• Firms should redesign jobs to standardize them, but this may (will) sacrifice least-cost production.
• Collective bargaining puts limits on claims and curbs small-numbers opportunism.
  • Ed's claim: It also provides a single bargaining problem (which may reduce transaction costs - this should be traded off against bargaining power)
• Promotion ladders should be long and thin and based on merit (not seniority)

Highly Idiosyncratic transactions: Workers whose great firm-specific experience accrue great benefits. "Merger" is prevented by laws against indenture. Nonvested, long term reward schemes and severe punishment if either party seeks unilateral termination should be used.

Natural Monopoly

Williamson recommends rate of return regulation, providing there are transaction-specific investments (there aren't in trucking for example, according to Williamson).

Family Law

Should adjudication be expanded to help govern family relationships? Clearly the relationships should be ongoing and relations are idiosyncratic. Therefore, no, not according to Williamson, as it would discourage investment.

Capital Market Transactions

"Ease of verification" should be substituted for "degree of transaction specific investment".