Transaction Cost Economics and Beyond: Toward a New Economics of the Firm

TRANSACTION COST ­ECONOMICS AND BEYOND Transaction cost economics has come to dominate discussions about the nature of the firm. In this critical analysis of the transaction cost paradigm, Michael Dietrich argues that whilst it offers some vital insights, the transaction cost approach is an inadequate basis for a general theory of the firm. Beginning with an overview of transaction costs, the book examines both the advantages and the disadvantages of the approaches of Oliver Williamson and that used to account for multinational development. Due to its comparative static methodology, transaction cost economics is least effective in explaining the dynamic aspects of firms’ behaviour. However, rather than rejecting the whole approach on these grounds, Michael Dietrich looks at ways in which the theory can be enlarged and its explanatory power increased. Considering such recent innovations in organisation design and management thinking as total quality control and just-in-time management, the book presents a vision of the firm in which decision making can be both hierarchical and creative. The implications of this for business and public policy are assessed. Michael Dietrich lectures in economics and business policy at Sheffield University Management School. He has published papers and articles in areas such as the organisation of the firm and corporate restructuring in Europe. He is joint editor (with Ash Amin) of Towards a new Europe?

TRANSACTION COST ECONOMICS AND BEYOND Towards a new economics of the firm

Michael Dietrich

London and New York

First published 1994 by Routledge 11 New Fetter Lane, London EC4P 4EE This edition published in the Taylor & Francis e-Library, 2008. “To purchase your own copy of this or any of Taylor & Francis or Routledge’s collection of thousands of eBooks please go to www.eBookstore.tandf.co.uk.” Simultaneously published in the USA and Canada by Routledge 29 West 35th Street, New York, NY 10001 © 1994 Michael Dietrich All rights reserved. No part of this book may be reprinted or reproduced or utilized in any form or by any electronic, mechanical, or other means, now known or hereafter invented, including photocopying and recording, or in any information storage or retrieval system, without permission in writing from the publishers. British Library Cataloguing in Publication Data A catalogue record for this book is available from the British Library Library of Congress Cataloging in Publication Data has been applied for ISBN 0-203-01599-1 Master e-book ISBN

ISBN 0-203-33398-5 (Adobe eReader Format) ISBN 0-415-07155-0 (hbk) ISBN 0-415-07156-9 (pbk)

To the memory of Jack Dietrich (1915–1988)

CONTENTS     List of Figures   Preface

   

viii

 

1

   

13

       

46

       

104

       

157

ix

  1  INTRODUCTION  

Part I  Beyond transaction costs: the background  

2  THE TRANSACTION COST PARADIGM 3  A GENERAL FRAMEWORK

27

 

Part II  Beyond transaction costs: the boundaries of the firm  

4  THE DEVELOPMENT OF THE FIRM 5  RELATED INTEGRATION AND THE FIRM 6  UNRELATED INTEGRATION AND THE FIRM 7  QUASI-INTEGRATION AND THE FIRM

60 74 88

 

Part III  A new economics of the firm  

8  THE FIRM AND ECONOMIC THEORY 9  THE FIRM AS A SYSTEM 10  ECONOMIC POLICY AND THE FIRM 11  CONCLUSIONS

119 135 151

    Notes   Bibliography   Author index   Subject index

166 181 185

FIGURES   2.1   The organisational failures framework

 

22

3.1   Model of the firm

 

28

3.2   Short-run contracting

 

29

3.3   Transaction cost curve

 

31

3.4

 

The fundamental theorem of transaction cost economics

 

3.5   Governance structure costs and benefits

 

31 35

3.6   Infeasible market governance

 

40

3.7   Firms-markets and ‘critical mass’ effects

 

41

3.8   Quasi-integration

 

41

5.1   The diversification decision

 

68

5.2   Diversification and in-house leasing

 

69

5.3   Diversification: further complexities

 

70

6.1   Vertical and horizontal internalisation

 

76

7.1   Quasi-integration

 

90

8.1   Profit maximisation: the objectives perspective

 

105

 

106

9.1   The dynamics of corporate change

 

126

10.1   The orthodox justification for the state

 

140

10.2   The state: dynamic failure and static advantage

 

141

10.3   The state: static failure and dynamic advantage

 

143

8.2

 

Profit maximisation: the survival of the fittest perspective

PREFACE ‘you can not step into the same river twice’ Heraclitus of Ephesus It is clear in retrospect that the evolutionary ‘big bang’ that led to the writing of this book occurred sometime during my doctoral research (on the economics of corporate planning East and West). While writing my thesis (in the first half of the 1980s) Oliver Williamson’s Markets and Hierarchies (1975) was making a significant impact on the economics of organisation. I spent many hours studying this work because of its potential in providing a conceptual framework for my own research. My response can best be described as ambiguous: on the one hand the transaction cost framework appeared a powerful analytical schema; on the other hand it was difficult to see what the framework could not explain—a characteristic I found worrying. Rather than confronting these uncertainties I played safe, a decision that was more subconscious or intuitive than deliberate. The transaction cost framework was reduced to a marginal acknowledgement in my thesis. In other words, I delayed consideration. Post-doctoral activity allowed me to dabble, for a few years, in transaction cost economics. I use the term ‘in’ here, rather than for example ‘with’, to convey the idea that the transaction cost framework appears to have theological overtones: there are believers and non-believers. The former group often appear fanatical in suggesting the all-explaining nature of the framework. Such support requires a leap of faith because the methodological (rather than analytical) principles of transaction cost reasoning have not, in general, been made clear—a matter I take up in this book. Non-believers might be grouped into ‘sceptics’ and ‘formalisers’, a taxonomy that depends as much on my experience of academic life rather than just knowledge of the literatures. The former (a group with which I eventually identified) suggest that the objectives of the transaction cost project are useful. Analysis of organisations and institutions is important, but the contracting approach has shortcomings—the perceived extent of these shortcomings determining the degree of scepticism involved. Formalisers take a different approach. Here theorists define economics as a method rather than an object of analysis. Hence the subject is viewed as a ‘hard’ science. Attitudes to the ‘softness’ of transaction cost reasoning appear at times to be equivalent to a patriarch who tolerates the wayward excesses of youth in the knowledge that given time, and adequate guidance, ‘normal’ behaviour will be resumed. It is revealing, in this regard, to note the support, in mainstream theoretical journals, of principal-agent approaches to organisation. These approaches necessarily involve an individual, rather than institutional, emphasis with fully specified functions that view ambiguity in terms of objective probabilities. This is not to argue against the use of formal methods, but rather they should be one among a number of approaches to a common subject. Being an optimist in these matters I am heartened by the extent to which game theory is beginning to acknowledge the importance of indeterminacy, human agency and organisation as a system rather than simply an agglomeration of individuals (see, for example, Kreps 1990a, Miller 1992, and the discussion in Hargreaves-Heap 1989).

  Preface In this work, I depart from the formalisers and to a lesser extent the sceptics. The former, in defining economics as a method, unnecessarily constrain the analysis of the firm. It is perhaps no accident that much of the critique of transaction cost reasoning to be developed here can be explained in terms of its (implicit) acceptance of a neo-classical method. It follows that my approach is inter-disciplinary. If economists cannot provide the necessary analytical building blocks, because of the constraints imposed by the dominant methodology, I have looked elsewhere. I identify with the sceptics because transaction cost economics has two shortcomings as a general theory of the firm: it is based on an organisational comparative static methodology, and it relies on a universal efficiency reasoning. These factors are, of course, self-reinforcing. So, for example, an attempt to introduce power, rather than just efficiency, considerations into the economics of the firm necessarily involves moving beyond organisational comparative statics. Within a static framework, power can be understood as bargaining over ex ante given aggregate rents, and with an a priori assumption that both parties wish to minimise bargaining costs organisational form (and any mention of power) is reduced to transaction cost efficiency. What this formulation misses is that the essence of power effects is not so much ex post distributional considerations but rather ex ante control over strategic developments. Heraclitus might have formulated this in terms of potential control over the unceasing motion of a river by changing its course or characteristics rather than bargaining over the use of a pre-existing sluice-gate. But the questioning of comparative statics and universal efficiency in this work is based on more than a, perhaps dogmatic, presumption that power in its own right is important in economics, rather it will be argued that orthodox transaction cost economics cannot explain the evolution of the firm in a dynamic context. Any attempt at universal explanation using organisational comparative statics involves ex post rationalisation rather than explanation. At this point in the story I depart from some of the sceptics. I have not changed my original view that transaction cost economics may have an important role to play in the economics of the firm. But in challenging the underlying principles of the framework it would, of course, be improper to simply juxtapose these principles with mutually exclusive alternatives. Rather a transaction cost logic must be mapped into a wider framework. Within this wider arena it will be seen that contracting reasoning still has a role to play, and arguably one that is methodologically more secure than usually presented, but the complexities of the mapping will transform this role, at times fairly significantly. I therefore hope that in some small way this book will move our understanding of the economics of the firm forward. The writing of this book can be described as a learning process, understanding and perceptions have shifted as arguments have been developed. It follows that it would be impossible to step into the same intellectual river again, the end result is a unique package of ideas, the characteristics of which are conditioned by two factors: the starting point, and ‘environment-learning interaction’ (if I may use such a phrase in this context). I have already given some idea of the starting point of this book, which is much earlier than either putting pen to paper (fingers to keyboard?) or the signing of contracts with Routledge. The rather pompous, or tongue in cheek (the reader can decide which), term ‘environmentlearning interaction’ refers to the fact that intellectual development is never undertaken in a vacuum. In this context I wish to acknowledge the encouragement, support, comments

Preface  xi (and criticisms) of friends and colleagues that have had a direct impact on the writing of this book (needless to say less direct influences range from my own educational history to the socio-economic context within which I exist). In particular I would like to thank Shaun Hargreaves-Heap, Geoff Hodgson and Christos Pitelis who have each read and offered critical comment on extended parts of this work. In addition, ex-colleagues at the University of Northumbria, most notably John Armitage and Arthur Walker, put up with my pestering and intellectual curiosities—their help and support will not be forgotten. More recently Sheffield University Management School has provided an environment that has allowed me to finish this book faster than might have otherwise been possible, and in particular Ian Baxter and Brian McCormick have read, responded to and improved, at short notice, Chapter 9. But my most important acknowledgement, and biggest thank you, must go to Siobhan, Liam and Asa. My debt to them is beyond description. In this regard I am unwilling to justify the writing of this book in ways that invoke long-run (potential) benefits—I am guided by Keynes’s dictum here that we are all dead in the long-run. Equally it would be hollow of me to suggest any cessation of academic activity—I hope I can call on their reserves in the future. But just as they have put up with my unavailability and tolerated my introspection I hope that I can reciprocate their care and support. Michael Dietrich

1 INTRODUCTION The title of this book indicates that its subject matter is concerned with the firm, one of the institutional cornerstones of economic theory. Over the last few decades our understanding of this entity has been increasingly taken over (more critical theorists might say ‘highjacked’) by transaction cost economics, which has achieved the position of somewhat of an orthodoxy in this area (for reasons which will soon become apparent). This dominant position is perhaps most obvious in the field of industrial organisation under the influence of work based on Oliver Williamson’s project to take institutions seriously. As he has pointed out ‘Transaction cost economics has helped to promote growing interest in the economics of organisation…. After a tentative beginning, research…has grown exponentially in the past fifteen years.’ (Williamson 1985:ix). A less obviously partisan, but no less forthright, statement is made by Thompson and Wright (1988:6) ‘The major figure in…developing a unified theory of organisations has been Oliver Williamson. His continuing contributions have had a major impact in shaping the efforts of other researchers.’ This book has similarly been shaped by Oliver Williamson’s contributions and is part of the exponential growth in the area.1 But the message contained in this work is somewhat different from that usually suggested. Attempts have been made to accommodate substantial criticisms of transaction cost theory that have been developed (see for example Francis et al. (1983), Hodgson (1988), Pitelis (1991), to name but a few). Unfortunately there has been a tendency to separate criticisms from the main body of transaction cost economics (although Pitelis is an exception here), this has allowed the latter school of thought to ignore their substantive content. Hence this work aims to fill this gap by accommodating the criticisms but at the same time building on the insights of transaction cost perspectives. It would be wrong, however, to suggest that this book has its roots only in the Williamsonian tradition, and its critical opponents because the study of the transnational corporation has involved its own, largely independent, transaction cost analysis. This, similarly, has achieved the status of an orthodoxy. For example, Pitelis and Sugden (1991:10) point out that ‘in the theory of the transnational, transaction cost analysis has arguably attained a dominance, and has done so fairly quickly’ (emphasis in original). The advantage of this ‘alternative’ transaction cost analysis is that its different history and subject matter mean that it is a useful complement to the better known Williamsonian tradition. This is recognised, particularly from Chapter 6 onwards in this book. TRANSACTION COST THEORY AND MICROECONOMICS The increasing influence of transaction cost perspectives in economics can be explained in terms of what might be called a theoretical comparative advantage. This advantage is based on the approach providing a necessary analysis of economic institutions, and specifically the firm, which is lacking in orthodox black-box analysis. Furthermore, the transaction cost

  Transaction cost economics and beyond framework is, in many respects, superior to what are usually considered the viable alternatives. These alternative approaches to the firm can be grouped under the general heading of ‘New Institutionalism’, the defining characteristic of which is that the methodologies involved are essentially consistent with orthodox microeconomic analysis, as discussed in more detail shortly. For example Williamson (1975:1) claims that ‘new institutional economists… regard what they are doing as complementary to, rather than a substitute for, conventional analysis’. This methodological consistency implies that mainstream economics finds it unproblematic to accept the perspectives offered by New Institutionalism, they can be mapped on to existing theory. In this way the choice between transaction costs and other New Institutional approaches is constrained to exclude non-orthodox positions, the characteristics of which will be considered later. In short, transaction cost economics is becoming an increasingly adopted approach within a constrained set of alternatives. The explanation presented here for the dominance of transaction cost economics suggests a number of important issues which will be examined in this first chapter. This discussion, besides being important in its own right, will provide a useful introduction to the arguments presented in this work. As has already been pointed out, Williamson (1975, 1985) explicitly locates his writing within a wider New Institutionalism. This is defined by Hodgson (1989) in terms of two important characteristics: the assumption of an abstract individual and the standard conception of rational economic agents. Key contributors are identified as Schotter’s (1981) game theoretic approach to institutional development, Hayek’s (1982) Austrianism, and of course Williamson.2 This conception of New Institutionalism is close to the meaning presented by Williamson (1985:26) ‘most’ of which he identifies with efficiency analysis in industrial organisation. He divides this efficiency reasoning into ‘incentive’ and transaction cost branches. The incentive branch is made up of property rights and agency perspectives on the firm.3 The important characteristic here is that once property rights (in the former perspective) or ex ante incentive alignment systems (in the latter perspective) are specified, efficient resource allocation will result. A clear problem, however, identified by Williamson is that given pervasive informational uncertainty and complexity ex ante alignment, created by either property rights or specifically designed systems, is in general not feasible. Rather, emphasis must be shifted to ex post bargaining chanelled by particular institutions. It is this change in emphasis that has provided transaction cost economics with its theoretical comparative advantage. But having isolated the difference between a transaction cost framework and other economic perspectives on the firm we should be clear that there are essential similarities between the approaches. Williamson (1985:29) acknowledges that ‘[i]n common with the property rights literature, transaction cost economics agrees that ownership matters’. In addition, the general agency problem is based on the idea that with asymmetrically distributed information the principal has an incentive problem in trying to ensure that an agent acts in its best interest. The solution to this problem is not costless but rather expenditures must be undertaken to structure, administer and enforce contracts (Smith 1989); such costs must be compared to the gains to be obtained from the different contractual and incentive arrangements. It is clear that these agency costs are the analogue of transaction costs, as discussed briefly in a moment and in more detail in Chapters 2 and 3. The important difference, however, between property rights/agency and transaction cost approaches is that the former involve an analysis of individual motivation whereas the latter situates the

Introduction   individual in a wider institutional framework which allows the firm to be analysed as an organisational entity. But while acknowledging this advantage of transaction cost economics we must also recognise its shortcomings. To understand the nature of these shortcomings, and correspondingly the rationale for this book, we must make a preliminary investigation into what transaction cost economics does and does not say. The basic approach of transaction cost economics can be stated in the following terms. Pre-given technologically separable units are posited (Williamson 1985). Exchange between these units must be organised and regulated. These activities involve real resource (transaction) costs, to a greater or lesser extent, in much the same way that friction exists in the physical world. It follows that if. we assume economising behaviour, economic institutions (or ‘governance structures’ in the transaction cost jargon) will evolve to minimise these costs of organising resource allocation. But, the evolution of institutional arrangements may involve other factors than just a minimisation of transaction costs. Equally institutions might evolve to facilitate changes in the units themselves. Using a geometric metaphor we can suggest that the sizes or shapes of units may change, the latter describing for a firm technological and/or product-market characteristics. These changes in unit characteristics can be called the benefits of resource allocation (Dietrich 1991a). Benefits of this sort are based on the use to which resources are put and introduce an important dynamic element into the analysis of the firm, or more generally economic institutions. This (superficially simple) shift in perspective has a number of radical implications that will be introduced here and developed in detail in later chapters. The first important point is that the exclusion of benefits from orthodox transaction cost analyses is not based on expositional convenience, it is an analytical necessity. As Dow (1987:18) points out: in comparing costs across governance structures, it is essential that the relevant transaction be specified independently of the governance structure which is superimposed on it. Otherwise, the claim that ‘transaction X is organised under governance structure Y’ would express not an empirical truth, but only a concealed tautology. If the attributes of a transaction do not remain invariant when one governance structure is replaced by another, the transaction costs involved are meaningless. To claim that the attributes of a transaction must not change when governance structures are compared is equivalent to saying that the benefits to be derived are unchanged—the units or economic agents involved must maintain their essential characteristics. In short, orthodox transaction cost economics must be based on ceteris paribus assumptions to rule out any changes in governance structure benefits. This necessary constraining of the analysis forecloses investigation of many important facets of the firm involving in particular idiosyncratic organisational capabilities and issues of economic power. An advantage of the approach developed in this book is that it is not necessary to make the gross assumption of invariance of benefits and therefore it opens up transaction cost economics to perspectives on organisational behaviour, suggested by critics, to which it would otherwise be blind. It is revealing to recognise that Arrow (1969), while investigating the implications of market failure arising from transaction costs, assumes that production costs will not vary with any change in the institutional environment, rather they depend on tastes and technology. In a general equilibrium setting it is clear that exogenous production costs implies exogenous demand for goods and services, i.e. unchanged governance structure benefits.

  Transaction cost economics and beyond A clear departure from this approach is developed in this work. It is argued that organisational and productive activities are non-separable. So, for example, if the management of a firm overcomes supplier quality deficiencies, this affects not only transaction costs, due to, for example, the monitoring activity involved, but also directly impinges on production because of price and/or productivity changes. These latter effects are governance structure benefits rather than costs. The only way to avoid benefit effects, apart from assuming their absence, is to posit a general institutional equilibrium where, by definition, there is no incentive to change or restructure organisational efforts. Equilibrium is defined here in the conventional sense of equality between ex ante and ex post conditions, which implies in this particular case before and after any contractual or organisational agreement. It is clear that institutional equilibrium requires full ex ante understanding of relevant issues and conditions, or a coincidental understanding that does not require changing in the light of actual events. Williamson has criticised agency and property rights perspectives for adopting this position, as discussed earlier. It is clear that transaction cost economics, when situated in a more general framework, suffers from the same shortcoming. It follows from this reasoning that in a dynamic setting governance structures may gain their rationale from benefit advantages, the attendant costs may or may not change. If transaction costs do change with different institutional arrangements they may increase to exploit potential benefits. This possibility of increasing transaction costs can, in principle, be accommodated in one of two ways. First, an orthodox inter-temporal approach could be adopted, in which case increasing transaction costs become an investment that must be viewed in present value terms. Such an approach with necessary ex ante fully specified functions is inconsistent with transaction cost reasoning for reasons that will become apparent in Chapter 2. The second approach is to recognise the limitations of static analysis and locate transaction costs in a dynamic framework that recognises change as evolutionary, that unfolds rather than being ex ante specified. An obvious implication of such a possibility is that general institutional equilibrium loses its significance. It follows that the evolution of governance structures need not just rely on transaction cost economising. It is therefore clear that orthodox transaction cost economics, based on the view that ‘institutions have the main purpose and effect of economizing on transaction costs’ (Williamson 1985:1), is comparative static and incapable, by itself, of explaining the dynamics of institutional change. A conclusion which is another aspect of the earlier mentioned methodological similarity between transaction cost reasoning and neo-classical microeconomic theory, which has facilitated the former’s acceptance. These comments set out the agenda to be followed in this work: the development of a dynamic analysis of the firm must be based on governance structure benefits as well as costs. But underlying this distinction between benefit and cost effects are more fundamental differences concerning the way the firm is conceptualised. It is clear from the above that transaction cost economics derives the basic rationale for the firm from exchange relationships. This procedure has two obvious shortcomings that can be mentioned here. First, it suggests that the essential nature of the firm is based on resource allocation. Secondly, and related to this first issue, it avoids any requirement to define what is meant by the firm, usually it is described as involving hierarchical relationships compared to the autonomy of markets. It is clear that the firm is not simply reducible to, or derivable from, resource allocation because the essential nature of the firm, stripped of any organisational

Introduction   significance, is as a production-distribution unit. We can therefore provide a general, and preliminary, definition of the firm as an economic unit that transforms inputs into outputs for use by other economic agents.4 Using this definition it is clear that the firm cannot be derived from exchange relationships. Neither can it be desolved into a nexus of contracts or individual agreements, which is common with New Institutional economics (for example Alchian and Demsetz 1972, Aoki et al. 1990), the logical consequence of which is to question whether the firm has any particular economic status at all (Cheung 1983). Rather it must exist in its own right. Furthermore, the origins and objectives of firms are non-separable (Pitelis 1991) being dependent on the aspirations of dominant organisational actors and production—distribution—exchange relationships. This conceptualisation of the firm as a production—distribution, and following from this an allocation, unit is necessary if governance structure benefits as well as costs are to be analysed, because as already mentioned benefit effects are based on the use to which resources are put rather than just efficient allocation with given technological and productmarket characteristics. But further issues are also involved. The procedure of deriving the origin and nature of firms from individual exchange is based on a methodological individualism in which the preferences and characteristics of economic agents are assumed exogenous and are basic theoretical building blocks (see Hodgson 1986). This is an assumption that may be more or less useful in particular circumstances.5 A principle suggested in this work is that organisations endogenise aspirations and define and channel individual decisions. In other words, theoretical explanation will not just run from individual to system, but a reverse causation (system to individual) is also needed to analyse many aspects of organisational behaviour. This perspective cannot be simply mapped on to an (implicitly) individualist framework that builds firms from individual behaviour. Methodological consistency implies that the nature of organisations must be re-conceptualised such that they do not derive their rationale simply from exchange. Once the nature of the firm is not simply derived from exchange relationships, a further step away from orthodox thinking is taken. This orthodoxy is embedded in the doctrine of classic liberalism which conceives of society mainly as a network of contractual relations and as a summation of contracts between individuals…. Within certain behavioural limits it is regarded that the devotion to self-interest will generally produce a result that is conducive to the harmony and development of society as a whole. It is clear that the works of the Property Rights School, and those of Williamson as well, fall within this same broad theoretical tradition. (Hodgson 1988:157) Once we move away from this tradition the historical and institutional nature of particular organisational forms become an issue in their own right. Their development and functioning need to be analysed rather than organisational relationships of dominant forms being assumed natural and necessarily harmonious.

  Transaction cost economics and beyond The analysis of this book is oriented towards capitalist firms that have characteristic authority and employment relationships. At a sufficiently abstract level we can follow Marx (1976:291–2) and suggest the following definition, ‘The [capitalist] labour process…exhibits two characteristic phenomena. First, the worker works under the control of the capitalist to whom his labour belongs…. Secondly, the product is the property of the capitalist and not that of the worker.’ Of course, once we introduce specific historical and institutional detail, this general definition is consistent with many detailed forms which have differing economic and organisational properties. These differences should be recognised if an adequate theory of the (capitalist) firm is to be developed. This is not to suggest that elements of the framework developed in this book are not relevant for understanding the nature of non-capitalist organisations e.g. one person firms, partnerships, producer co-operatives, even perhaps state enterprises, but these will not be the central focus of the analysis. These comments suggest clear differences between the way the firm is being viewed here and that usually adopted by transaction cost theorists. In particular rather than deriving institutions from exchange, both firms and markets must be separately identified. But the analogue of this different perspective suggests differences about the way markets are understood and defined. Kay (1992) points out that it is incorrect to identify exchange with the process of a good or service being ‘transferred across a technologicallyseparable interface’ (Williamson 1985:139). Transactions (technological separable transfers) can have a contractual or physical meaning. The former is characteristic of market relationships, but physical transfers occur with self organised or intra-firm activity. To conflate contractual and physical activity obscures the essential differences involved. To avoid these confusions we can define markets as involving (Moss 1981, Hodgson 1988):6 • the exchange of goods and services and the associated property and contractual commitments; • communication to inform potential customers that goods or services, with their associated prices, qualities and quantities, are available for sale; • informing suppliers that there is a demand for their products. It is clear from this discussion of the nature of firms and markets that we have moved a long way from orthodox transaction cost economics. There would appear to be two possible responses to this shift in emphasis. The first is to suggest that transaction cost economics is too constrained to offer a useful understanding of the nature of the firm. This appears to be the position adopted by, for example, Rutherford (1989) when he stresses the importance of Old Institutional Economics, and in particular the work of Veblen (1975) and Ayres (1962).7 This Old school questions two important principles of New Institutional Economics: methodological individualism and ‘invisible hand’ explanations of economic evolution. An even more forthright rejection of Williamsonian economics is suggested by writers emphasising the importance of ‘power’ in the understanding of institutions (see, for example, Willman 1983). Without questioning the content of these approaches, a major problem with suggesting alternative or substitute frameworks is that their substantive importance is marginalised because most economists view the world through the eyes of the dominant school of thought. In other words, scientific progress is not simply a matter of letting facts ‘speak for themselves’ because the questions we ask and interpretations of the facts offered are

Introduction   guided by the (theoeretical) frameworks we use. Witness the way that Williamson (1985) distances himself from the work of, for example, Marglin (1974): the analysis of hierarchy is consequently divided into separate efficiency and power explanations. To avoid this marginalising of important critiques, a different approach is adopted in this work. An attempt is made to develop transaction cost economics. This development involves, at its most general level, the obvious suggestion that the nature of economic units are not pre-given and exogenous to economic processes: rather, they can be transformed to further the objectives of economic agents. In short, governance structure benefits as well as costs will be considered. As already indicated this development of a dynamic, nonindividualist approach involves questioning key assumptions that are frequently implicit in orthodox writing. But in a methodological sense this is still just the relaxing of assumptions. Using the taxonomy introduced by Musgrave (1981) we are relaxing the domain assumptions of transaction cost theory, that define the arena within which its reasoning is appropriate, rather than negligibility or heuristic assumptions. Negligability assumptions have minimal impact on any analysis. Heuristic assumptions simplify analysis and are subsequently relaxed. It follows that this work is one of continuity as much as change, as is suggested by the title. The ‘bridge building’ between orthodoxy and important criticisms involved here will indicate that transaction cost reasoning is in a number of important respects a special case. Hopefully, having identified and acknowledged this ‘special case’ status, orthodox theorists will treat the criticisms with more respect than appears to be the case at present. AN OUTLINE OF THE BOOK To achieve the agenda set out in the previous section an inter-disciplinary approach is adopted in this book to inform, and develop, the economics of the firm. In particular, important inputs from business policy and organisation theory are used. This facilitates the development of the idea that dynamic competitive success, based on competition as a process rather than a structure, must exploit idiosyncratic organisational advantage. In addition the way that institutions embody differential power relations is central to the framework being developed. This importance of power is not an ‘optional extra’ but rather is central to the understanding of the dynamics of resource allocation. In Part I, the basic framework to be used is presented. Chapter 2 sets out the basic elements of transaction cost economics and introduces general criticisms. The antecendents of Oliver Williamson’s work are discussed. In particular the idea of the firm as a production—distribution unit is developed in detail. The concept of bounded rationality is introduced and it is argued that Williamson fails to incorporate the full implications involved because he appears to be reluctant to accept the critique of neo-classical thinking that this represents—another aspect of the orthodox nature of transaction cost economics, as argued earlier. These problems, concerning the ways that individual perception and cognition are understood, are used to present a critique of Williamson’s use of ‘opportunism’ which is a theoretical pillar of his transaction cost framework. In Chapter 3, these essentially negative comments are forged into a general framework that retains the insights of transaction cost economics but shifts the content to allow a richer analysis of microeconomic organisation.

  Transaction cost economics and beyond It is suggested that the distinguishing characteristic of the firm is that human and nonhuman inputs are organised to further production—distribution objectives. The recognition of such organisation allows a dynamic analysis of governance structures rather than the comparative statics of transaction cost theory. The rationale for governance structures based on differential benefit effects are explained in terms of idiosyncratic advantage and economic power. Part II of the book uses the general cost-benefit governance structure framework to examine what is commonly called the boundaries of the firm. Chapter 4 discusses the development of the firm. It is argued that the shift from putting-out system to factory, and in turn the development of the modern authority relationship, cannot be explained solely in terms of governance structure costs, rather benefit effects in terms of the ability to control economic processes and non-contractual motivation have been central. Particular attention is given to the recent development of just-in-time and total quality control systems, not only because the economics of these organisational innovations are worthy of discussion in their own right but also because their rationale is dominated by benefit factors, i.e. the importance of idiosyncratic knowledge, dynamic competitive advantage and non-contractual motivation. Chapters 5 and 6 shift attention to the integration of different activities within a single organisation. The first of these chapters concentrates on vertical integration and related (in terms of core production—distribution activity) diversification. Contrary to the claims of Williamson and Teece, it is argued that transaction costs cannot provide a uniquely dominant explanation of vertical integration and related diversification. The more general approach suggested here recognises the importance of idiosyncratic skill acquisition and the pervasive nature of power and dominance which appear to be consistent with empirical evidence in the areas. As in other chapters, a narrow emphasis on economising behaviour fails to recognise dynamic-strategic8 non-transaction cost factors which are important in the understanding of the boundaries of the firm. Chapter 6 shifts attention to unrelated diversification and multinational development. With regard to the first of these it is argued that the Williamsonian internal capital market explanation of conglomerate development is unconvincing; rather an explanation is presented based on institutional specificities and senior management behaviour. The transaction cost (internalisation) arguments developed in the ­ multinational company literature, while being overly static are an important alternative to the Williamsonian tradition, particularly with regard to the centrality and endemic nature of monopoly power. But, once again, the sole reliance on transaction cost reasoning constrains the insights generated. Chapter 7 develops the arguments presented in previous chapters to consider the nature of and rationale for quasi-integration, i.e. the development of long-term interactive relationships, based on networking, between legally separate economic units rather than arms-length contacts. Such relationships may take a number of forms, such as franchising, subcontracting, joint ventures and cartels, and are becoming increasingly important deriving their advantage from recent organisational—technological innovations. Different transaction cost explanations of these developments are discussed, but they all have the common drawback of having to assume given monopolistic or product-market characteristics. An alternative framework based on ‘competitive dynamics’ is suggested that endogenises governance structure benefits. Within this more general framework transaction costs become

Introduction   a sunk cost of relationship development inhibiting mobility into and out of networks. This non-contestability introduces the possibility of power asymmetries and dominance as central aspects of quasi-integration. Part III of the book shifts attention to the firm as a system in its own right, and develops in this context the principles developed in earlier chapters. Chapter 8 lays the groundwork by examining the view common in transaction cost economics that the firm as an organisation can be understood in profit maximising terms. The argument is developed in two stages. First it is suggested that transaction cost economics cannot consistently be based on profit maximising principles. Secondly, the implications of a more general framework, incorporating governance structure benefits and costs, are examined. The discussion is based on four possible defences of profit maximisation identified in the literature. Only one is found to be acceptable, but this introduces methodological problems for the analysis of firms in an organisational setting. The chapter concludes with the suggestion that the objectives of the firm, as a system, will reflect the objectives of those economic agents with effective control over resource allocation. For a capitalist firm this suggests a general objective of a desire to increase long-run profits. These ideas on the nature of the firm as a system are developed in Chapter 9. Existing approaches to this subject, based on behavioural and post-behavioural economics appear to have the common shortcoming of viewing intra-firm activity in terms of reacting to exogenous changes. An alternative perspective is suggested based on Penrose’s (1980) idea of a firm’s productive opportunity. This evolves endogenously in response to organisational learning activity which is an inevitable aspect of placing decision making within a bounded rationality framework. But the firm is still conceptualised as a single unit because individual and group decision making is endogenised by the strategic setting of the firm. This wider framework defines and guides individual aspirations. The idea of the firm as a strategic system is developed in detail by using recent work in the area of business policy, and in particular organisational culture. Particular emphasis is placed on the path dependent nature of decision making. Specific organisational trajectories are based on detailed organisational objectives derived from dominant coalitions and stakeholders. Recent developments in organisational thinking, in terms of a reaction to Taylorist principles, are introduced into this framework. Finally, individual decision making is re-set in this framework using an approach which is informed by cognitive psychology. Chapter 10 develops the policy implications of the framework developed in previous chapters. The general liberal tradition, in terms of the state being separate from the economy, that has informed transaction cost, and more generally New Institutional, economics is criticised. An alternative framework is suggested that builds on the idea that the state itself is a governance structure. Particular attention is placed on networked, rather than arms-length, relationships between the public and private sectors. In addition, the organisational complexities developed in Chapter 9 are introduced into a public sector setting which leads to the conclusion that the state is not neutral in terms of its dealings with the private sector. This overall framework is then applied to the particular area of industrial policy which is singled out because it is arguably the most controversial area of public sector influence on the activities of firms because of the weight of liberal ideas. Emphasis is placed on proactive industrial policy shifting the path dependent nature of private sector activities.

10  Transaction cost economics and beyond The final chapter of the book returns to the themes set out in this introduction and developed in intervening chapters. Specifically the issues of static—dynamic analyses and individual—social methodologies are explored in the context of possible explanations for the evolution of the firm given shifting organisational logics and changing competitive and socio-economic conditions. Hence transaction cost economics is linked to what are usually seen as completely separate literatures. In this global setting the ‘special case’ status of the transaction cost framework is illuminated. It cannot explain the overall dynamics of change which channel the particular ways that economic actors may exploit governance structure benefits, but given a particular global setting overall organisational parameters will be determined, in which case transaction costs may have some role to play.

Part I BEYOND ­TRANSACTION COSTS: THE ­BACKGROUND

2 THE TRANSACTION COST PARADIGM In this chapter, the basic elements of transaction cost economics will be outlined. In addition to the objective of introducing the reader to the literature the chapter will also develop a number of general problems that are evident with the approach. The explicit recognition of these problems will facilitate detailed discussions undertaken in later chapters. The material is organised as follows. Initially, Ronald Coase’s (1937) paper, ‘The nature of the firm’, will be examined. This work is separated from later contributions to the area for two reasons: first, Coase is generally acknowledged as the ‘founder’ of transaction cost economics (although he does not use this term in his 1937 paper), and for this reason his work is important in its own right; secondly, his analysis is, in many respects, more accessible as later contributors have built on his formulations (and at the same time compounded his shortcomings). Following this discussion of Coase, other antecedents of transaction cost economics will be examined. Finally, Oliver Williamson’s work will be critically outlined; the work of other transaction cost theorists will be introduced in later chapters. THE NATURE OF THE FIRM Coase opens his paper with the simple, but startling (for his time), observation that if the price mechanism can effectively allocate resources, why should resource allocation be planned/directed within firms.1 To unravel this apparent problem Coase suggests that ‘the main reason why it is profitable to establish a firm would seem to be that there is a cost of using the price mechanism’ (p. 390). This cost can be reduced to a number of factors: (a) the cost of discovering prices and (b) the cost of negotiating and concluding contracts. Thus, rather than construct an individual contract for each person employed specifying detailed responsibilities, obvious economies are available from using employment contracts that state limits to the power of an employer—detailed direction is undertaken within a firm. In addition, there is a further cost of the price mechanism with long-term contracts because forecasting, and consequently contract specification, problems inevitably exist. Therefore it is once again more efficient to use contracts that define general limits and responsibilities. In a later work, Coase (1960) returned to the definition of transaction costs as follows: In order to carry out a market transaction it is necessary to discover who it is that one deals with, to inform people that one wishes to deal and on what terms, to conduct negotiations leading up to a bargain, to draw up a contract, to undertake the inspection needed to make sure that the terms of the contract are being observed, and soon.

14  Transaction cost economics and beyond Much of the work developed in Chapter 3 will be based on this formulation of the issues. The above constitutes the central features of Coase’s analysis. Many of its insights will be carried forward and used in later chapters, but a number of problems must first be examined. Initially we can turn to two related shortcomings that have been recognised. First Alchian and Demsetz (1972) have claimed that Coase’s analysis is, in a sense, a tautology. To suggest that firms exist because of the relative costs of using the market must be an empty truth; it would be just as valid to turn the framework on its head and suggest that markets exist because of the relative costs of management. Similarly Fischer (1977) suggests that transaction costs have acquired a well-deserved bad name because almost any outcome could be explained by appeal to the framework. The central problem here is lack of a rigorous theoretical framework. A central theme of this book is that Fischer’s criticism is correct, and in addition, the development of an adequate framework involves moving outside a narrow transaction cost perspective. Let us now turn to what is perhaps a more fundamental problem with Coase’s analysis. He views the price mechanism and entrepreneurial control as alternative methods of organising production, i.e. the central problem is that of co-ordinating resource allocation. As discussed in Chapter 1 this implies that the nature of the firm can be derived from exchange relationships. In Coase’s (1937:388) words: Outside the firm, price movements direct production, which is co-ordinated through a series of exchange transactions on the market. Within a firm, these market transactions are eliminated and in place of the complicated market structure with exchange transactions is substituted the entrepreneur—co-ordinator, who directs production. It is clear that these are alternative methods of co-ordinating production. If this formulation is accepted literally it is inadequate because it is based on the view that production can somehow exist before or without its co-ordination. Coase appears to juxtapose two different microeconomic frameworks. As Penrose (1980) argues, the standard theory of the firm should not be confused with, what is called here, the economics of the firm: they serve different theoretical purposes. On the one hand, the theory of the firm is one element in a theory of price determination and markets, the central emphasis of which is the co-ordination of economic activity. On the other hand is a theory of the nature of the firm. As Fourie (1989) points out, in this regard, Coase fails to recognise that the central characteristic of a firm is the management of a production—distribution process; this is as true of a small firm as it is of General Motors. Markets cannot produce, they can only link production and consumption units. In short, it cannot be claimed ‘that the distinguishing mark of the firm is the supersession of the price mechanism’ (Coase 1937:389). To claim that firms take the place of markets assumes that markets can exist in the absence of firms. This is impossible because the non-existence of firms implies no production, which in turn implies that markets have no function, i.e. they will not exist. In short, Coase’s analysis is based on an inconsistency because of the view that firms and markets are alternative methods of co-ordinating pro-

The transaction cost paradigm  15 duction; any real development in the economics of the firm must remove this problem. This will be done in Chapter 3. It is possible to interpret the Coasian argument to exclude any explanation of one-person firms—he is, after all, attempting to understand the rationale for the hierarchical (for which read ‘capitalist’) organisation. But, besides side-stepping the issue of the rationale for nonemploying firms, such an interpretation does not remove the problems involved. With a one-person firm, production of a good/service is already being undertaken, or organised, in which case if it is brought within the boundaries of the firm integration will occur (transactions costs may account for this as is discussed in later chapters). But, if an individual, who was previously not a one-person firm, is employed, the change is from the absence of a market-based relationship to the instigation of an employment relationship (Fourie 1989). Consequently, when outside contracting of the services offered by an employee is not available, an alternative and prior market-based transaction will not exist. As a market transaction cannot be used, by definition there will be no cost of using the price mechanism, hence the employment decision cannot be explained within a Coasian framework. Rather ironically, therefore, the Coasian framework can account for integration of one-person firms but can have difficulty with the more usual argument of internal control of labour inputs into production. The discussion can now turn to a final, but related, problem with Coase’s (1937:392) analysis. He claims that: The entrepreneur has to carry out his function at less cost, taking into account the fact that he may get factors of production at a lower price than the market mechanism which he supersedes, because it is always possible to revert to the open market if he fails to do this. (emphasis added) The emphasised part of the above quotation is of central importance, because if the open market cannot be used as an alternative supply of inputs, internalisation cannot be explained in terms of the cost of using the price mechanism because market supply would be unavailable (this ignores the ‘supersession’ problem discussed above). An example of this was just given with regard to employment. More generally, however, it is by no means obvious that alternative sources of supply will always be available for all factors of production. Why this is so is an important matter and hence will be discussed in detail in later chapters. To round off this section it will be useful to examine Coase’s discussion of Knight’s (1921) work. Knight suggests that in a world of complete certainty, the management of firms will involve only routine co-ordination. Coase’s questioning of this (in terms of: why should it involve the supersession of the price mechanism?) has clear shortcomings, as earlier discussion has indicated. The characteristic of the ‘real-world’ however, according to Knight, is the existence of pervasive uncertainty, which is distinguished from risk where it is possible to allot probabilities to outcomes. Thus, according to Knight (1921:268), ‘With uncertainty present doing things, the actual execution of activity, becomes in a real sense a secondary part of life; the primary problem or function is deciding what to do and how to do it.’ Coase’s response to this view is to argue that better judgement or knowledge does not in itself explain firms because it is always possible to hire, or contract for, the use of advisers. But there are two problems with this response. First, consultancies produce outputs (of information and expertise) involving the co-ordination of inputs. It follows that eco-

16  Transaction cost economics and beyond nomically these production units are firms. Of course, a firm need not always have a legal identity—as might be the case with a university lecturer who sells expertise. But the legal position should not be confused with the economic substance of control and organisation of production-distribution activity. Secondly, Coase’s response ignores the complications analysed later by Arrow (1962) whereby information (in this case that supplied by advisers) cannot be bought and sold like other commodities because it has the characteristic that it is impossible, by definition, to know what is being bought until the information is acquired; but once the potential use of the information is known there is no need to purchase it. On this basis, separate consultancies would not exist in a Coasian world because of chronic market failure. The fact that they sell expertise, however, implies an idiosyncratic advantage in this respect. Such an advantage, based on ‘deciding what to do and how to do it’, cannot be reduced to transaction costs because of its production rather than exchange emphasis. Thus, to follow Knight, it appears that uncertainty and the economics of the firm are inextricably linked—this is one of the main themes running through this book. TRANSACTION COST ECONOMICS: THE ANTECEDENTS Before outlining and assessing Oliver Williamson’s work, it will facilitate later discussion if the economic antecedents that he has built upon are acknowledged independently.2 Perhaps the obvious place to start is Arrow (1969), the first author to use the term ‘transaction costs’. He claims that ‘market failure is not absolute; it is better to consider a broader category, that of transaction costs, which in general impede and in particular cases block the formation of markets’; such costs are the ‘costs of running the economic system’ (p. 48). Note that in Arrow’s formulation transaction costs, in particular circumstances, block the formation of markets. While this may be true, as analysed in the next chapter, and is therefore an improvement on the Coasian framework, the claim presents problems because if markets cannot exist, it is an analytical sleight-of-hand to impute costs of running them. Hence the framework is in need of development. The second building block for Williamsonian economics is (allegedly) Herbert Simon’s (1957, 1961) ‘bounded rationality’. This concept is based on two principles. (1) Individuals, or groups of individuals, have inevitable limits on their abilities to process or use information that is available. This limited computational capacity exists because of difficulties in understanding and manipulating the sense data involved in any but trivial situations. In short informational complexity exists. (2) It is equally implausible to suggest that all possible states of the world and all relevant cause—effect relationships can be identified, following which, probabilities can be calculated, presumably on the basis of previous occurrence. This implies that economic actors are inevitably faced with incomplete information, i.e. informational uncertainty exists.3 Thus, according to Simon (1957:xxiv) economic actors are ‘intendedly rational, but only limitedly so’. It is obvious that the Coasian framework is implicitly based on some idea of bounded rationality. Williamson claims to base his work on bounded rationality, but as will be argued below this is a one-sided use of the concept which is restricted to informational uncertainty. In the absence of complexity, all information that is available can be used, which implies unproblematic, if limited, understanding of reality. In such a situation disagreements are based on different information inputs

The transaction cost paradigm  17 and objectives or preferences, not different understanding. With informational complexity individuals must make sense of their world, hence differences of understanding, even with the same information, can exist. This one-sided use of bounded rationality is necessary if the arguments presented in Chapter 2, concerning the fundamental neo-classical basis of transaction cost economics, are accepted. If complexity is assumed not to exist, bounded rationality issues can be conceptualised in terms of minimising information costs, which is equivalent to economising on transaction costs. Such an approach is the dual of profit maximisation (Boland 1981). But with complexity present, an unproblematic cost minimisation/profit maximisation is not possible. This one-sided use of bounded rationality seems to be inconsistent with Williamson’s (1985) citing of Michael Polanyi’s (1967) work. Polanyi stresses that much knowledge is idiosyncratic and tacit, which occurs when it cannot be fully expressed and is therefore uncodified—Polanyi (1962) uses the example of being able to swim which can be acted upon but not effectively communicated. As discussed in later chapters, an important principle of organisation is that such knowledge may be shared to a significant degree by individuals who have a common experience. It is difficult to understand how the sharing of tacit information can be based on a common experience unless informational complexity exists. Note that other writers, not mentioned by Williamson, such as Penrose (1980) and Nelson and Winter (1982) suggest similar ideas about the nature of knowledge and skills. The importance of their contributions will be reflected in later chapters. Before going on to discuss Oliver Williamson’s work directly it will be useful to mention one more building block in the transaction cost structure: the economics of information. For some time the problems of asymmetrically distributed information have been recognised. It is usual to distinguish between ex ante and ex post asymmetries. Ex ante problems occur when one party to a transaction has less information about a potential purchase/ sale than the other, but this information disadvantage is eliminated after the transaction is completed. Such a situation is frequently called one of adverse selection, after the seminal work of Akerlof (1970). Ex post information asymmetries occur when one party to a transaction has less information than another even after the transaction has occurred. This was first recognised by Arrow (1962) in the context of insurance: an insurance company has no obvious way of knowing that a holder of an insurance policy is revealing all relevant information that is pertinent to a claim. In this context ex post information problems have been dubbed ‘moral hazard’. Clearly the problem extends beyond insurance. Williamson (1975) conflates ex ante and ex post information asymmetries into a more general category of information impactedness, upon which his centrally important assumption of opportunism is based (see below). The relevance of this assumption will be questioned in the next section. But the criticisms developed do not imply that information asymmetries are unimportant, on the contrary in the next chapter their existence will be linked to economic power differentials. Such power will be important in the framework developed in later chapters, a move away from the sole attention given to efficiency within transaction cost economics.

18  Transaction cost economics and beyond TRANSACTION COST ECONOMICS Let us now turn to an examination of Oliver Williamson’s work. This exposition and discussion will be based largely on his two contributions Markets and Hierarchies (1975) and The Economic Institutions of Capitalism (1985). While these two works have minor differences, some of which are pointed out below, the later work should be seen as a development of the earlier analysis. As discussed in Chapter 1 the basic principle underlying transaction cost economics is that economic institutions will develop to economise on transaction costs. Such institutions are usually dichotomised as atomistic markets, which involve anonymous, short-run relationships, and intra-firm hierarchies. In between, quasi-integration exists where long-term relationships between identifiable (rather than anonymous) economic actors are important. Williamson follows Arrow’s definition of transaction costs as the costs of running the economic system, and as such they are equivalent to ‘friction’ in the physical sciences. In more detail, ex ante transaction costs are the costs of drafting, negotiating, and safeguarding an agreement. Ex post transaction costs include: (1) the maladaption costs incurred when transactions drift out of alignment with requirements, (2) the haggling costs incurred if bilateral efforts are made to correct ex post misalignments, (3) the set up and running costs associated with the governance structures (often not the courts) to which the disputes are referred, and (4) the bonding costs of effecting secure commitments. Williamson argues that the existence of transaction costs depends on three factors: bounded rationality, opportunism, and asset specificity. Opportunism describes ‘self-interest seeking with guile’ (Williamson 1985: p. 47). Asset specificity refers to the degree to which durable human or physical assets are locked into a particular trading relationship, and hence the extent to which they have value in alternative activities. A high level of asset specificity implies the existence of a bilateral monopoly. In this regard an important distinction is made between before and after contract execution. Ex ante, many potential buyers or sellers may exist, but ex post this need not be the case if idiosyncratic investments are required. If bounded rationality, opportunism and asset specificity are not all present, transaction costs will not exist, according to Williamson. Consider the case of global rationality: in such a situation it would be possible to costlessly construct completely specified contracts at the outset, long-term contracting is possible. In the absence of opportunism, any gaps that exist in contracts, because of bounded rationality, will not pose execution hazards because neither party will attempt to gain advantage over the other: short-term, sequential contracting is possible. When asset specificity does not exist there is no need to have continuing economic relationships, hence markets will be fully contestable. These examples indicate the bounds of the orthodox analysis of markets. Outside of these bounds institutional arrangements to manage resource allocation are more complex. Given the existence of contracting problems (i.e. the existence of the above three factors), transaction cost economics claims to be able to specify the governance structures that can efficiently manage economic activity in any situation. Differing situations are defined in terms of different combinations of three factors: asset specificity, uncertainty, and frequency of use. Initially we can ignore the uncertainty dimension. With non-specific assets, markets can efficiently govern resource allocation no matter how frequent the transactions

The transaction cost paradigm  19 are. If any disputes arise this can be settled ultimately through court-ordered litigation. Such a settlement is likely to rupture the trading relationship but this is not important because of the non-specific nature of the assets. But as investments become more specific, safeguards are required to control the dangers of opportunism. If a particular transaction is undertaken regularly, specialised governance structures will develop: for highly specific assets this will involve organisation within a firm; for less idiosyncratic, but still specific, investments bilateral governance will develop. Bilateral governance, otherwise known as relational contracting, involves trading partners remaining independent but committing themselves to long-term relationships. In situations where a transaction is only undertaken occasionally, but idiosyncratic investment is required, it is not cost-effective to devote resources to the creation of specialised governance structures, hence trilateral governance structures will emerge. These involve resolution of disputes through third party assistance, e.g. arbitration, or the use of independent experts. When the uncertainty dimension is introduced into this schema the only real change is to increase the importance of protective, long-term governance structures when idiosyncratic investments are undertaken. The above constitutes the important characteristics of transaction cost economics, particular aspects of which will be discussed in more detail in later chapters. Before examining this framework it might be useful to point out that Williamson has changed his views about the relative importance of different governance structures. In his 1975 work he was of the opinion that economic institutions clustered at either end of the governance spectrum: hence the title Markets and Hierarchies. Intermediate structures were viewed as unstable. In his 1985 work he was ‘persuaded that transactions in the middle range [between market and hierarchy] are much more common’ (p. 83). What is not clear, however, is whether he believes the earlier work is mistaken or obsolete. As argued in Chapter 6, technological and organisational innovation have increased the importance of ‘middle range’ governance structures. TRANSACTION COST ECONOMICS: AN ASSESSMENT Let us now turn to an initial examination of this Williamsonian paradigm. The easiest place to start this is to refer back to the earlier discussion of Coase. Two errors have been carried forward. The first is that Williamson views different governance structures as alternative methods of organising production. Hence the theoretical possibility of no firms, is logically impossible because no firms implies no production. As with the Coasian framework, the introduction of single person firms displaces the issues but does not remove them. The language used here by Williamson has changed, but the problem still remains. In 1975 (p. 20) he asserts that ‘in the beginning there were markets’. By 1985 the ‘contract’ had replaced the market as the analytical benchmark: The proposed approach adopts a contracting orientation and maintains that any issue that can be formulated as a contracting problem can be investigated to advantage in transaction cost economizing terms. Every exchange relation qualifies. Many other

20  Transaction cost economics and beyond issues which at the outset appear to lack a contracting aspect turn out, upon scrutiny, to have an implicit contracting quality. (Williamson 1975:17) Alternatively, Williamson (1985:23) suggests the existence of ‘more complex forms of contracting (including nonmarket modes of organisation)’. The central shortcoming here is that identified in Chapter 1. This exchange-based methodology generates an inadequate specification of the particular nature of the firm. Rather, the characteristic of the firm involves the management of a production—distribution process. To remove this limitation we can follow the practice of Kay (1984) and Hennart (1991) and identify separately organisation and transaction costs. The former are costs of running firms rather than the costs of running markets. This approach will be adopted in the next chapter: having identified organisation costs it is possible to examine the factors underlying their existence. We can now turn to the second shortcoming that Williamson has carried forward from Coase. It is a logical necessity for transaction cost theorists to be able to posit the existence of market-based resource allocation. If it is not possible to use markets it is impossible to talk about transaction cost savings. In this regard Williamson’s (1985:22) comparative institutional approach may present problems: transaction costs are always assessed in a comparative institutional way, in which one mode of contracting is compared with another. Accordingly, it is the difference between rather than the absolute magnitude of transaction costs that matter. This approach is adopted because transaction costs are often difficult to quantify. This difficulty, in addition to echoing Fisher’s comment mentioned earlier, masks an implicit assumption that alternative governance structures are always feasible. The potential infeasibility of governance structures will be discussed in the next chapter. Let us now turn to a number of limitations with the Williamsonian framework that are not imported from Coase, in any obvious way. Such limitations can be grouped under two broad headings: those concerned with the assumption of opportunism; and those concerned with the links between contracting costs and production costs. These two areas will be discussed in turn. Opposition to the centrality of opportunism is based on three lines of argument. First, Williamson (1985:122) asserts that: ‘The hazards of trading are less severe in Japan than in the United States because of cultural and institutional checks on opportunism’. This statement implies that opportunism is an endogenous factor, rather than being an a priori assumption which is the usual Williamsonian formulation. But this is only part of a more fundamental problem. Earlier it was shown that, according to Williamson, if any of opportunism, bounded rationality or asset specificity did not exist transaction costs would not exist. Thus if cultural traits act as a background check on the existence of opportunism, as Williamson claims happens in Japan, the explanation for the existence of Japanese firms is undermined (Kay 1992). Why should markets, trilateral governance and relational contracting not be adequate to manage resource allocation? The way Williamson formulates his analysis makes it necessary to explain the existence of firms, rather than other forms of governance.

The transaction cost paradigm 21 The second problem with Williamson’s use of opportunism follows from the first. The claim that transaction costs would not exist in the absence of opportunism is perhaps problematic. Consider the following quotations from Williamson (1985): Consider…the situation where…opportunism is assumed to be absent, which implies that the word of an agent is as good as his bond. Although gaps will appear in these contracts, because of bounded rationality, they do not pose execution hazards if the parties take recourse to a self-enforcing general clause. Each party to the contract simply pledges at the outset to execute the contract efficiently (in a joint profit maximizing manner) and to seek only fair returns at contract renewal intervals. Strategic behavior is thereby denied, (p. 31) Plainly, were it not for opportunism, all behavior could be rule governed. This need not, moreover, require comprehensive preplanning. Unanticipated events could be dealt with by general rules, whereby the parties agree to be bound by actions of a joint profit-maximizing kind. Thus problems during contract execution could be avoided by ex ante insistence upon a general clause of the following kind: I agree candidly to disclose all relevant information and thereafter to propose and cooperate in joint profit-maximising courses of action, (p. 48) In the first quotation bounded rationality is explicitly recognised, but in the following sentence reference is made to joint profit maximising behaviour. But given bounded rationality, and in particular informational complexity, there is no reason to assume that individual perceptions and objectives will allow the definition of a unique maximising strategy. Similarly, it is claimed that only fair returns will be demanded. But how can objectively fair returns be defined when bounded rationality exists? In the second quotation the general clause refers to the disclosure of all relevant information and maximising behaviour. Once again: where is bounded rationality? The inconsistencies just highlighted lead to the third problem with Williamson’s use of opportunism. Consider the following statement opportunism refers to the incomplete or distorted disclosure of information, especially to calculated efforts to mislead, distort, disguise, obfuscate, or otherwise confuse. It is responsible for real or contrived conditions of information asymmetry, which vastly complicate problems of economic organization. (Williamson 1985:47–8) The first point to note is the change of definition. On the same page opportunism is defined as ‘self-interest seeking with guile’ and ‘incomplete or distorted disclosure of information’. The second of these definitions may be inappropriate because bounded rationality can lead to information disclosure problems without any malicious intent (a point taken up later). Related to this, it appears that bounded rationality and opportunism are confused. Opportunism does not cause information asymmetry, the latter exists because of bounded rationality. Given its existence, resource allocation problems can be aggravated by opportunistic behaviour.

22  Transaction cost economics and beyond This confusion between bounded rationality and opportunism is caused in Williamson’s work by his (1985) distinction between parametric and behavioural uncertainty. The former refers to exogenous disturbances, the latter is uncertainty of a strategic kind which is attributable to opportunism. In effect, two classes of information problems are therefore present: first, bounded rationality and parametric uncertainty, and secondly opportunism and behavioural uncertainty. Note that behavioural uncertainty is embedded in human action (i.e. opportunism) and hence is real uncertainty in the sense of not being able to specify probabilities for different possible outcomes. On the other hand it must be possible to separate parametric uncertainty from individual economic agents otherwise the confusions over bounded rationality and opportunism highlighted above will exist. Thus Williamson (1985:56) claims that ‘asset specificity only takes on importance in conjunction with bounded rationality/opportunism and in the presence of uncertainty’, i.e. bounded rationality and opportunism are paired as human characteristics and uncertainty is identified separately. In an earlier work, Williamson and Ouchi (1983:15) use the following diagram in Figure 2.1 to illustrate this point. This separate identification of uncertainty/complexity requires a definition independent of human behaviour, hence Williamson (1985) refers, on numerous occasions, to the ‘degree of parametric uncertainty’. But it is, of course, inadmissible to refer to degrees of

Figure 2.1 The organisational failures framework uncertainty—this is only possible in situations of risk where probabilities are calculable. It is revealing, in this context, to cite Williamson’s (1975:23) claim that ‘As long as either uncertainty or complexity is present in requisite degree, the bounded rationality problem arises’, and he notes that ‘I also point out in this connection that the distinction between risk and uncertainty is not one with which I will be concerned—if indeed it is a truly useful one to employ in any context whatsoever.’ By the time of his 1985 work, Williamson is calling upon the support of Ludwig von Mises (1949), Shackle (1961) and GeorgescuRoegen (1971), and their insistence on the importance of ‘novelty’ (as the latter authority calls it) and hence the greater relevance of uncertainty rather than risk. Williamson does not appear to recognise the methodological problems involved. Methodological consistency requires that real uncertainty cannot be identified independently of human behaviour. It is necessary to follow Hodgson’s (1988) practice, which is based on Keynes (1971), whereby uncertainty is only identifiable in terms of how confident an individual is about an event occurring. In short a further significant methodological problem exists in the Williamsonian framework: bounded rationality implies the existence of real uncertainty which is only identifiable in terms of individual perceptions. But such perceptions make it impossible to identify separately on the one hand bounded rationality and parametric uncertainty and on the other

The transaction cost paradigm 23 opportunism and behavioural uncertainty. This separation is of central importance to the Williamsonian framework because without it opportunism cannot be placed on a par with bounded rationality and asset specificity as the three fundamental factors that explain the existence of contracting problems. Thus the real problem is the central role given to opportunism, which rather ironically is not needed. Langlois (1984) makes an important step forward when he argues that the fundamental problem for an understanding of governance structures is not opportunism per se but rather uncertainty.4 For example, decisions to break contracts, or to dispute outcomes of contractual arrangements need not be manifestations of opportunistic behaviour, rather they might involve different perceptions of the world. As Hodgson (1988) argues, the breaking of contractual obligation may be based on altruistic motives if changing and divergent conceptions of cause-effect relationships, or final states of the world exist. The central point here is that made earlier while discussing bounded rationality. Individuals make sense of their uncertain, complex world by giving meaning to sense data. The significance of information depends on the perceptions of the individual. Hence conflicts can arise because of bounded rationality, and the consequential different views of the world, opportunism may be involved but this is a secondary consideration—see below. It is perhaps surprising that Williamson does not make these insights. For example, reference was made earlier in this chapter to his citing of Michael Polanyi’s work on the idiosyncratic nature of knowledge, and the way that such knowledge may be shared by individuals with a common experience. It follows that with differing experiences conflicts over the meaning of events may arise. In fact Williamson (1985:59 n. 19) comes very close to such a position, he recognises that Inasmuch as a great deal of the relevant information about trustworthiness or its absence that is generated during the course of bilateral trading is essentially private information—in that it cannot be fully communicated to and shared with others…knowledge about behavioural uncertainties is very uneven. The organization of economic activity is even more complicated as a result. Note that this comment is restricted to behavioural uncertainty. The following, however, does not appear to be (the relevance of earlier discussion is obvious here) ‘except as changes in states of the world are unambiguous, hard contracting between autonomous parties may well give rise to veridical disputes when state-contingent claims are made’ (p. 70). Williamson’s apparent reluctance to move beyond the recognition of these problems to a full accommodation of bounded rationality is perhaps because of his objective of trying to introduce contracting problems into orthodox, neo-classical economics as discussed in Chapter 1. This economic orthodoxy requires, among other things, an unproblematically specified reality that is common to all economic actors. It is fairly straightforward to remove these inconsistencies in transaction cost economics. All that is required is the removal of opportunism as one of its central pillars. A framework can then be developed that posits bounded rationality and examines the ways that different governance structures foster and constrain opportunism and trust. The importance of trust is emphasised by, for example Arrow (1974), Fox (1974) and Hodgson (1988). The development of opportunistic or trusting behaviour will be dependent, in part, on the extent to which governance structures generate convergent perceptions of the world. This is cen-

24  Transaction cost economics and beyond tral to understanding the nature of organisation and the firm, and is also an important factor underlying the development of quasi-integration strategies discussed in Chapter 7. Hence more detailed discussion of the development of trust, rather than antagonistic behaviour, is reserved for later chapters. To some extent the elements of such a framework are contained in Williamson’s work. In his 1975 book he stresses the importance of ‘atmosphere’: ‘Reference to atmosphere is intended to make allowance for attitudinal interactions and the systems consequences that are associated therewith’ (p. 37). By 1985 the concept of atmosphere had been dropped, in its place is the following, which can be usefully quoted at some length: Additional transaction-specific savings can accrue at the interface between supplier and buyer as contracts are successively adapted to unfolding events and as periodic contract renewal agreements are reached. Familiarity here permits communication economies to be realized: Specialized language develops as experience accumulates and nuances are signalled and received in a sensitive way. Both institutional and personal trust relations evolve. Thus the individuals who are responsible for adapting the interfaces have a personal as well as organizational stake in what transpires. Where personal integrity is believed to be operative, individuals located at the interface may refuse to be part of opportunistic efforts to take advantage of (rely on) the letter of the contract when the spirit of the exchange is emasculated. Such refusals can serve as a check upon organizational proclivities to behave opportunistically. Other things being equal, idiosyncratic exchange relations that feature personal trust will survive greater stress and will display greater adaptability. (Williamson 1985:62–3). This formulation comes very close to endogenising aspirations which is suggested in Part III of this work when the importance of organisational culture is stressed. Earlier, problems with the Williamsonian framework were grouped under two broad headings: those concerned with opportunism, and those concerned with links between contracting costs and production costs. The latter can now be examined. Williamson’s (1985:61) view can be briefly stated as follows More generally, the objective is not to economize on transaction costs but to economize in both transaction and neoclassical production cost respects. Whether transaction cost economies are realized at the expense of scale economies or scope economies thus needs to be assessed. The link between contracting and production costs is an important one, and will be developed in subsequent chapters, hence the end of this chapter will restrict itself to a few suggestive comments. It is not possible to just adopt the Williamsonian formulation because it is inconsistent to link transaction and neo-classical production costs, the former relies on bounded rationality, the latter ignores it. Such different methodological perspectives cannot be just thrown together. For example, Williamson (1985:11) quotes Michael Polanyi in the following way as an inspiration for his own work

The transaction cost paradigm 25 The attempt to analyze scientifically the established industrial arts has everywhere led to similar results. Indeed even in the modern industries the indefinable knowledge is still an essential part of technology. I have myself watched in Hungary a new, imported machine for blowing electric lamp bulbs, the exact counterpart of which was operating successfully in Germany, failing for a whole year to produce a single flawless bulb. (Polanyi 1962:52) Thus a non-neoclassical analysis of production is needed because contracting and organisation problems are inherently dynamic. The central problem here, for transaction cost reasoning, is that to ensure unchanged organisation characteristics (which is a requirement for transaction cost economics as discussed in Chapter 1) organisational and technological/ product-market factors must be separable. Any non-separabilities will result in governance structure changes causing changes in organisational characteristics. The Polanyi view just cited suggests that such non-separabilities are the rule rather than the exception. This complexity will be accommodated in the next chapter. For the purposes of the current discussion it is sufficient to draw attention to Williamson’s use of an economising perspective, that while meshing into a static production analysis, has an uneasy relationship with the inherent dynamism of organisations. Furthermore, as highlighted by McGuiness (1987), in concentrating on (neo-classical) economising behaviour, it is implicitly assumed that efficiency will be the driving force of change and innovation (see also Malcolmson 1984). Such a perspective relegates to insignificance questions of power between economic agents, thus ignoring insights made by, for example, Marglin (1974) and Putterman (1984). The central issue is that if the full implications of bounded rationality are adopted it is not possible to define an unproblematic efficient behaviour, a matter discussed in detail in later chapters. SUMMARY This chapter has outlined, and presented a general critique of, transaction cost economics. The main findings have been: 1 Transaction cost economics ignores the fundamental characteristic of a firm as a production—distribution unit, hence the existence of firms cannot be explained in transaction cost terms. 2 Transaction cost economics must always assume that market-based resource allocation is possible. This need not be the case. 3 The central role of opportunism introduces logical problems into transaction cost economics, 4 The link between contracting and production costs is important, but a neo-classical view of the latter is somewhat problematic. 5 A central role has been accorded to bounded rationality and the idiosyncratic nature of knowledge.

3 A GENERAL FRAMEWORK In this chapter a general framework will be developed that overcomes the problems identified in Chapter 2. After a brief investigation into the nature of the firm the discussion will develop an abstract model of transaction cost economics. This model will be used to account for the existence of, and rationale for, firms.1 Following this the analysis will turn to more general questions about how the analysis of governance structures might be undertaken. The intention is to develop general principles, detailed development will be undertaken in later chapters. THE NATURE OF THE FIRM The general perspective on the firm to be developed in this chapter can be depicted as in Figure 3.1. The core of the firm is production and/or distribution activity. This core is real activity and is to be distinguished from the two outer circles that constitute economic control activities.2 The achievement of production—distribution objectives obviously requires the use of particular inputs; but inputs must be organised. Such organisation of human and non-human inputs, to further production—distribution objectives, is the characteristic of any firm. Particular types of firms can be understood in terms of particular organisational characteristics, e.g. capitalist organisations with a centralised authority system. This perspective, which will be developed in detail in later chapters, indicates the difference between a one-person firm and an employee. The output of the former is the result of the organised use of human and other inputs. The services of an employee, on the other hand, are not usable in the abstract but only in combination with other inputs organised within a firm. Note that in general it is incorrect to conflate internal intra-firm control and management as activities distinct from production—distribution. Except in very particular circumstances, to be examined in Chapter 4, it is inappropriate to posit that production— distribution labour is not, to some extent, self-organising. Analysis of internal organisation, within a bounded rationality framework, allows recognition of the fact that each firm is unique in terms of detailed bjectives and characteristics. More specifically, internal organisation adds a dynamic perspective to the firm, with explicit use of human agency. Such dynamics can be classed as either short-run (operating) or long-run (strategic) in nature. The first of these can perhaps be viewed as operating against a background of static equilibrium analysis and therefore involve allocative and technical aspects. Note there is no presumption here of optimal equilibrium, rather particular input combinations and technical efficiency levels are a function of organisational characteristics and their evolution over time. Strategic dynamics endogenise production and market parameters. An important feature of the framework developed below and in detail in later chapters, is that these dynamic aspects of the economics of the firm are a central explanation of the effectiveness of different governance structures. In terms of the

28  Transaction cost economics and beyond basic approach introduced in Chapter 1, these dynamics endogenise the characteristics of the units being organised. To stress the importance of internal organisation from another

Figure 3.1 Model of the firm point of view, it acts as a buffer between production—distribution and market-based contracting activity. Hence if its centrality is not recognised but rather just derived from market-based relationships, for reasons introduced in Chapter 1 and discussed in more detail below, we enter the organisational world of transaction cost economics with its comparative static emphasis. TRANSACTION COSTS: A REINTERPRETATION This section will recast transaction costs within a framework that overcomes the problems identified in the previous chapter. In so doing, it will significantly shift the analytical centre of gravity. To simplify, we can assume, for the purposes of this section, that economic organisation can take one of two forms, either market or intra-firm based, the resulting control of resource allocation leads to respectively transaction and organisation costs (Kay 1984, Hennart 1991). As detailed in the previous chapter, we can define transaction costs in terms of three factors: search and information costs, bargaining and decision costs, and policing and enforcement costs. If attention is restricted to firms, rather than final consumers, these factors can be recast in terms of the management costs associated with the construction and enforcement of contracts. This allows transaction costs to be viewed like production costs and analysed accordingly. In making this analogy between production and

A general framework 29 transaction costs it is important to stress that a mechanistic, black-box methodology is not being presumed. On the contrary, the cost analysis suggested below incorporates bounded rationality and an active role for human agency. To simplify we can assume the following, that transaction costs occur over two time periods. In the short-run the overall stock of managerial resources is given. Thus the only way to increase managerial input into any one activity is to divert resources away from other activities. These other activities can be either other managerial functions, such as negotiation of other contracts, management of production—distribution, and strategic planning, or activities aimed at the furtherance of personal utility, i.e. a reduction in managerial slack or intensification of effort. In the long-run, the overall stock of managerial and complementary resources can be increased.3 Using these assumptions it is possible to define a short-run relationship between management input per unit time into any one contracting activity determining contract output. The latter can be defined in terms of two ‘joint products’: responsibilities and prices. Thus greater management effort produces a more detailed specification and policing of responsibilities and/ or more advantageous prices (higher/lower for outputs/inputs). Obviously the nature of this contracting production function is complex, involving bounded rationality and human agency. Ignoring these complexities for the moment, it is possible to depict any one short-run contracting process as in Figure 3.2. The diminishing returns to contracting effort involved in Figure 3.2 would seem to be appropriate because of bounds on information collection and processing capabilities. It can be noted that if the simplicity of Figure 3.2 is to be maintained we have to assume that all contracting, internal organisation and other managerial activities are separable. If this is not the case, increased effort in any one area, that is achieved at the expense of effort in another, will have general systemic effects on managerial activity. Approximate separability will exist if managerial and other inputs are specialised and hence direct links between them are limited. While increased management time into any one activity is likely to have an effect as traced by Figure 3.2, its static nature should not be overemphasised. Increased (decreased) effort per unit time will shift the curve up (down). Note that this endogenisation of effort implies that the analysis suggested here is not embedded in any view of

Figure 3.2 Short-run contracting

30  Transaction cost economics and beyond necessary technical efficiency, rather effort levels are a function of, among other things, organisational relationships, as discussed in later chapters. In the long-run, when the stock of managerial assets can grow (or decline), a set of curves such as that in Figure 3.2 can be mapped out. Obviously the specific detail of such a mapping will depend on the nature of any contracting scale economies. Following Arrow (1974) we can presume that increasing returns are likely because of the centrality of information management to contracting processes. As important as returns to scale, however, are more subtle effects concerned with the relationship between the short and long-runs. The standard analysis of returns to scale assumes an unproblematic achievement of expost optimal equilibrium, thus rendering consistent plans and outcomes by assumption rather than analysis. Such a procedure is questionable for at least two reasons. First, within a bounded rationality framework it is clearly possible to over (under) estimate actual growth with the result that short- and long-run costs need not coincide. Secondly, standard analysis ignores the centrality of organisation to the firm. As emphasised by, for example, Penrose (1980) additions to a management team change organisational dynamics and thus have feedback effects on the nature of the team. A similar point is made by Nelson and Winter (1982) when they stress the importance of shifting organisational routines in response to new organisational members.4 Thus long-run expansion (or contraction) does not just involve returns to scale imposed on to an otherwise unchanged contracting production process. Shifting organisational dynamics can impede or facilitate any scale effects, and in addition can affect the trade-off between management input and bounds on information collection and processing. In short, long-run shifts in Figure 3.2 inevitably endogenise organisational parameters. Within an orthodox analysis such parameters would be taken to be the underlying state of organisational technology. Finally, more obvious technological change can affect Figure 3.2. For example, the exploitation of advances in information technology can enhance the information collection and processing abilities of an organisation, thus shifting the above curve upwards and perhaps to the left. Using standard microeconomic techniques it is straightforward to transform the shortrun relationship between inputs and outputs for any one contracting activity into the associated transaction costs. The main issue here is the valuation of input prices given that the overall stock of management is fixed in the short-run. The resource costs of extra management input into any one activity must be understood as the opportunity cost of the management in terms of lost control activity. Hence managerial input can be priced in terms of an increasing opportunity cost function. Thus Figure 3.3 can be defined, Cm being the transaction cost of a particular market-based activity. This diagram has an intuitive appeal because when more advantageous prices result from search activity or negotiation, and/or as a more precise negotiation or policing of responsibilities is undertaken, i.e. contracting output goes up, transaction costs concomitantly rise. It is obvious that Cm will shift in response to the factors discussed above, reflecting the dynamics of a firm’s development. The costs of internal organisation can be modelled in an analogous way to that just undertaken. Managerial input results in the specification or policing of intra-firm responsibilities involving not only production—distribution but also control within a managerial hierarchy. In addition, internal management may involve the determination of transfer prices. But such prices should not be given the same status as market prices (Kay 1992) for reasons equivalent to the inappropriateness of deriving firms from exchange relationships.

A general framework 31

Figure 3.3 Transaction cost curve

Figure 3.4 The fundamental theorem of transaction cost economics Negotiations over, and rules governing transfer pricing operate in the context of an organisational hierarchy. Hence internal management can be thought of only in terms of

32  Transaction cost economics and beyond organisational control which can be depicted in terms of a diagram equivalent to Figure 3.3 that would describe the organisation costs of one particular intra-firm activity. We are now in a position to restate what can be considered the fundamental theorem of transaction cost economics: it may be possible to economise on contracting costs by using partial contracts and managerial direction for labour inputs or internalisation within unified ownership for non-human inputs or outputs. This fundamental theorem can be depicted as in Figure 3.4. In this diagram the control costs incurred by the partial (for human inputs) or complete internalisation of one particular activity are described as Cf involving lower fixed costs or increased control efficiency levels than Cm, or C f involving long-run advantages that can only be exploited by intra-firm control over resource allocation. In short, the tangents to Cm and Cf or C f in Figure 3.4 indicate transaction cost savings for firm rather than market organisation. If a Williamsonian analysis is adopted, it follows that the extent of these cost savings will be a function of: asset specificity, frequency of use, and uncertainty; but note Williamson’s inappropriate use of the latter, as discussed in the previous chapter. From a different transaction cost tradition, that developed to understand internalisation of multinational companies, Hennart (1991) suggests that the extent of any differences between transaction and organisation costs will depend on the costs of monitoring performance within a hierarchy, cultural differences between superior and subordinate units, and managerial skills. Comparing Cm and C f, what may be involved is that an increase in the stock of management can lead to changes in the managerial division of labour. But such scale advantages can only be exploited with sufficiently frequent use of the managerial assets involved. In addition, these advantages may be more apparent for internal organisation rather than market-based exchange because the latter involves duplication of some assets in supplying and purchasing firms, such duplication inhibiting, to some extent, the managerial reorganisation upon which the scale advantages are based. Alternatively, comparing Cm and Cf, the advantages of internal organisation may be based on high degrees of asset specificity. When the latter is evident, being locked into a market-based relationship introduces potential problems of one party exploiting information asymmetries. Managerial confidence that this has not occurred will involve greater input for market-based organisation because intra-firm management builds up a greater degree of trust and will involve less haggling because of access to information. When transaction cost economics is presented as in Figure 3.4 an obvious shortcoming becomes clear, it is only potentially half a theory because any benefits from resource allocation are omitted from the analysis. When benefits are introduced a number of important advantages are evident. First, the appropriateness of one mode of organisation rather than another need not depend on transaction costs but rather on different benefits to be derived from market-based rather than intra-firm resource allocation. Transaction cost economics is blind to governance structures gaining their rationale from beneficial changes in the characteristics of organisational units. Secondly, if benefits are acknowledged it introduces the possibility that inefficient governance structures may exist (in the sense of costs being higher than feasible alternatives), and efficient structures need not exist. This leads on to the third advantage of introducing benefits of resource allocation. In the previous chapter it was shown that transaction cost economics has to be based on the existence of firms

A general framework 33 and markets otherwise transaction cost savings cannot be said to have occurred. But the existence of either mode of resource allocation need not be possible if costs of managing resource allocation are greater than any benefits derivable. THE EXISTENCE OF FIRMS Ignoring the important issue of benefits for different actors, their general nature can be understood by specifying the connections between production—distribution and economic governance. Turning first to distribution, within a contracting framework it is clearly not possible to base an analysis of pricing and turnover on abstract demand and supply functions because prices and volumes are (explicitly or implicitly) endogenous to contracting processes. Consequently, greater information searching, bargaining, and contract policing efforts by marketing management may result in higher output prices or greater sales volumes either from current or new customers. If attention is turned to the connections between economic control and production an equivalent observation to that just made is appropriate for input prices, but in addition the situation is more complex. Penrose’s (1980) and Leibenstein’s (1966) analyses can be used whereby output is produced by factor services which are derivable from factor inputs.5 But there is not a simple one-to-one mapping from inputs to services rather the connection between them is determined by contracting and organisational control activity. The issues involved can be illustrated as follows:

Link (1) is that relevant for contracting and organisational activity, and is therefore the arena within which transaction and organisation costs are determined. Link (2) concerns the technical activity of production—distribution. Transaction cost economics must assume that managerial and technical activities are separable to maintain the exogeneity of benefits. But this necessary assumption is arbitrary, and arguably it is misleading as bounded rationality is assumed to exist. If greater search and bargaining efforts are directed at contractually organised inputs into production, benefits can result from attenuating ex ante adverse selection problems involving a closer matching of perceived potential input characteristics with the intended responsibilities of that input. Benefits in terms of ameliorating ex post contract policing problems (i.e. moral hazard), can similarly be reduced by greater managerial efforts. Such benefits will be apparent as lower production costs because of reduced input prices or increased factor efficiency. The above comments covered possible connections between contracting effort and production—distribution, a similar analysis, in terms of ex ante and ex post decision making is appropriate for intra-firm organisational effort. As Williamson (for example 1975, 1981, 1985) argues, intra-firm organisation can facilitate adaptation to environmental change for the following reasons: opportunistic behaviour is less likely within a firm; disputes can be settled by top management; convergent expectations can facilitate planning; and access to relevant information will reduce haggling. While these factors will allow organisation cost

34  Transaction cost economics and beyond savings (link (1) above) by, for example, allowing responsibility specification and policing at lower cost, at the same time greater efforts in these areas will either lead to greater revenues or lower production costs because organisational and technical activities are nonseparable (link (2) above). The only way that such benefits can be ruled out is to make a global rationality assumption which is inconsistent with transaction cost analysis. It is now possible to specify the benefits derivable from different governance structures. Increased managerial activity will change production costs and revenues not just transaction—organisation costs. In Figure 3.5 Cm/f describes the transaction-organisation costs (assumed identical) for one particular activity. Bm describes the excess of sales revenues over all production, distribution and control costs other than those described by Cm, i.e. those control costs relevant to the contracting activity in question. Bf is defined equivalently for the same activity organised internally (note that Bm may be above Bf, a possibility discussed below). As we move around any benefit curve the increased managerial activity involved results in increased revenues and/or lower production costs. These benefits will occur at a diminishing rate. At low levels of managerial effort increased input into any one control activity will be at the expense of ‘small’ reductions elsewhere. But given the convexity of organisational effort, successive additions to managerial input into any one activity will be increasingly countered by efficiency reductions elsewhere. Using Figure 3.5 we can now specify the precise nature of the limited scope of transaction cost economics discussed in Chapter 1.Comparisons of governance structures based solely on transaction cost reasoning must assume unchanged production and productmarket characteristics (i.e. governance structure benefits) to avoid tautological reasoning. Unchanged benefits imply: 1 that the Bf and Bm curves coincide; and 2 that comparisons of governance structures must occur at a given level of management effort. If this changes governance structure benefits change with a movement around the relevant curve. 1 and 2 are the basis of the claim made in Chapter 1 that transaction cost economics is an organisational comparative static general equilibrium framework that can make no statement about short- and long-run dynamics. Hence for transaction cost economics to make statements about shifting governance structures, rather than ex post analyses, logical coherence requires a rather gross assumption of unchanged governance structure benefits. But such an approach is blind to a rich array of contributions, discussed in this and later chapters, that can explain the nature and development of firms. Another way of making the same point is that in general institutional equilibrium transaction costs can be assessed to include

A general framework 35

Figure 3.5 Governance structure costs and benefits or exclude production costs and revenues. Out of a general equilibrium, however, transaction costs must be specifically identified for the analysis to have any meaning. It follows that the earlier stated ‘fundamental theorem’ (Figure 3.4) is correspondingly of limited use. Any shift from one governance structure to another must involve changing managerial effort, even a managerial fixed cost advantage is likely to induce long-run substitution between organisational activities. It is clear from Figure 3.5 that although the external procurement of the good/service in question is feasible, as long as contract characteristics lie between M1 and M2, greater returns might be derivable from intra-firm resource allocation.6 This increased profitability is not the result of transaction cost savings but is due to increased benefits, as depicted by Bf. In general terms, these extra benefits will be a function of two factors7: skill idiosyncrasy and monopoly advantages, which will be discussed in turn. The first of these factors is related to the idiosyncratic nature of knowledge which, as argued in Chapter 1, is likely to accompany bounded rationality. Given such idiosyncrasies, effective use of assets does not just depend on an unproblematic use of information but rather the development and accumulation of skills. Following Nelson and Winter (1982) a

36  Transaction cost economics and beyond skill can be defined as an activity that, through continued practice or use, can be performed without conscious and explicit thought, as long as sufficiently stable conditions exist.8 In situations where skills and asset use are idiosyncratic and hence not readily transferable, generated revenue is higher, or production costs lower, from in-house activity. More generally, rents from asset use cannot be readily obtained by the direct sale of its services, therefore profitable exploitation must involve direct exploitation. It follows that shifting governance structures involves changed unit characteristics, in terms of profitability potential, that is unrelated to control costs. A few examples may illuminate these principles further. Consider, for example, a manufacturer of computer-aided engineering equipment, that can either contract out the fitting of equipment or use in-house employees. An advantage of in-house organisation is that higher quality standards can be achieved and maintained. If the fitting of the equipment is contracted out, the labour force used need not possess the specific skills required as the contractors may work for a number of companies. Higher quality has obvious market benefits in terms of extra turnover. Alternatively, benefits might exist in terms of promoting the company as a high quality supplier. This may have advantages in terms of effective product differentiation and a higher mark-up of price over cost. Thus the relatively greater profit of internal organisation results from extra revenues, control costs may, or may not, be different. Similar benefits might involve marketing efficiencies leading to in-house production and distribution rather than market-based alternatives. Such efficiencies might be based on a network of skilled sales representatives. Therefore promotional synergies because of marketing expertise in particular area(s) will lead to higher sales volumes and/or prices. Idiosyncratic skill acquisition is a significant sunk cost.9 The extent of this cost would appear to depend on the complexity of the skill(s) and the similarity with the current knowledge base of the individual(s) concerned. The ease of skill acquisition is, therefore, a function of the costs involved and competitive pressures that might limit the time available for their acquisition. Thus a decision concerning the relative profitabilities of market-based and internal management of a particular activity can be schematically described in the following way: first, the initial decision to use an asset,10 and secondly its subsequent recurrent use. The initial decision follows Richardson’s (1972) logic and involves consideration of relative profitabilities, given the knowledge base of an organisation and competitive conditions. In practice this decision seems not to be based on explicit fully specified analysis; rather an implicit or explicit mission statement, describing the perceived fundamental characteristic(s) of a firm’s production—distribution activity (see, for example, Johnson and Scholes 1989), guides decision processes. Note this does not imply that all decisions are correct, mistakes can easily be made if the possibility of fully specified cost-benefit calculation is rejected. In terms of Figure 3.5, with Bf being above Bm, internal control of asset use is more profitable. Once this initial decision is made, recurrent use of the asset will involve management (transaction and organisation) costs. The nature of these costs brings us back to the world of transaction cost economics. While this approach to incorporating both cost and benefit factors is suggestive it does not incorporate important complexities. Transaction-organisation costs assume unchanged organisational characteristics. On the other hand, as discussed in the next chapter and in more detail in Part III, skill idiosyncrasy implies at an organisational level dynamic advantages in terms of differential abilities to adjust to, exploit, and mould environmental devel-

A general framework 37 opments in ways based on shifting comparative advantages. In terms of Figure 3.5 a relative competitive advantage implies an increasing distance between Bf and Bm for any given level of management activity (greater than zero). It follows that a simultaneous use of static and dynamic factors involves use of differing perspectives. A consistent analysis might suggest that given a particular set of organisational idiosyncrasies, in other words a particular strategic orientation, a transaction cost analysis of governance structures becomes relevant. But, as the analysis of business policy emphasises, the management of organisational advantage is a continuous process. Hence current expenditures should always be undertaken to develop future capabilities. In such circumstances it is not obvious what (transaction) cost minimisation means—from a static perspective some current expenditures are discretionary but still essential given dynamic objectives (Dietrich 1990). It follows from this reasoning that when governance structure benefits, derivable from idiosyncratic advantage, are recognised, internal organisation might involve higher control costs than market-based alternatives, to exploit even greater benefits. But it does not follow that when firms emphasise static efficiencies at the expense of dynamic opportunities an orthodox transaction cost analysis is necessarily appropriate because governance structure benefits also involve monopoly power. To understand the ways in which monopoly power might influence governance structure formation we can distinguish between transaction cost reasoning that depends on asset specificity, as in the Williamsonian tradition, and that that depends on transactional non-specificities (Kay 1992). A particular advantage possessed by a firm that is non-specific can lead to appropriability problems because of diffusion to potential competitors, as argued by Casson (1987) with respect to multinational internalisation and Teece (1988) with respect to R&D. For the asset specificity school, monopoly power is identified separately and its importance is played down. The non-specificity school collapses monopoly power into transaction cost reasoning. We can introduce possible links between monopoly power and governance structure benefits by initially examining the reasoning underlying the approach adopted by the non-specificity school. The ability to collapse monopoly power into contracting efficiency is based on the (implicit) assumption of exogeneity of monopoly advantages. This means that a zero-sum world exists where transaction-organisation costs redistribute a given aggregate surplus. The analysis is therefore centred on bargaining and policing costs that are generated when a particular party attempts to appropriate quasi-rents, the appropriate organisational form being technically most efficient in terms of the bargaining and policing costs involved. It is usually argued that internal organisation possesses a secrecy advantage in this respect. What is not considered, however, is the possibility that different arrangements can endogenise monopoly advantages. In other words market imperfections need not be exogenous or natural (Yamin and Nixson 1988). It follows that in a non-zero sum world the organisational problem is not just the distribution of given profits but the creation of greater profit potential, which is a governance structure benefit for those with effective control over the transaction. To use the metaphor introduced in Chapter 1, shifting governance structures involve changes in the characteristics of the units under consideration. A simple example can be used to develop the implications of this perspective. A company uses homeworkers for a particular production process, but pilfering problems are evident. For the pilfering to be feasible, rather than just a oneoff theft, an ex post information asymmetry must exist to the advantage of homeworkers.

38  Transaction cost economics and beyond The owner(s)-manager(s) of the company would appear to have two possible solutions to this problem. First, to undertake closer monitoring of the homeworkers; or secondly to shift production in-house. Either of these strategies would involve a reduction in the information asymmetry that allows the pilfering. It is clear, however, that the first possibility involves transaction costs increasing rather than being lower. In terms of Figure 3.5 the extra monitoring involves a movement around Cm/f. With the in-house strategy organisational overheads will increase with the development of an organisational hierarchy. If the production activity is simply transferred in-house, with the same level of activity involved, unit control costs will rise. It will be rational to incur these costs only if they are less than any extra revenues from being able to use the previously stolen materials. The real gain, to the owners-managers, of reducing the information asymmetry is therefore a transfer from the homeworkers, who would clearly be worse off. The fact that homeworkers break contractual, or legal, obligations is irrelevant to this conclusion. In short, overcoming pilfering involves benefit not cost factors. Once the information impactedness problem that allows the pilfering to occur has been overcome transaction cost savings may be evident. For example, if we assume that the company undertakes closer monitoring of homeworkers, a shift in-house may involve lower transaction-organisation costs. This is a real gain because the same management output can be achieved with fewer resources. It follows that mutual financial advantage is possible. It is clear, therefore that transaction cost reasoning is only relevant to this latter situation when the pilfering problem has been removed. In effect, this limited relevance implies that all contract construction and policing problems have been successfully resolved which is only possible in a comparative static framework. If dynamic considerations are introduced, and shifts in governance structures analysed, (rather than given structures compared) bounded rationality renders this framework problematic, a point developed in more detail in the next chapter. As will become clear from the discussion in Chapter 4 of Marglin’s perspective on the development of capitalist organisation, the distinction made here between transfers between parties and real contracting-organisational gains is equivalent to the distinction between power11 and efficiency explanations of governance structures. The ability to transfer rents from productive activity to one party’s advantage was just seen to depend on information asymmetries. The use of non-specific assets requires secrecy, assuming the absence of any legal-institutional barriers to information diffusion such as patent or professional restrictions. With specific assets asymmetries are based on information impactedness and are likely to be more fundamental. In particular, with informational complexity, rather than simply uncertainty, for reasons discussed in Chapter 2 economic actors can have differing perceptions with the implication that a specific view may dominate over alternatives.This is an important issue for intra-firm resource allocation and organisation, as discussed in Chapter 9. But clearly power depends on more than access to uncertain and complex information. A more complete analysis requires dependency of one party on another: it must not be possible to move away from a relationship that is working to one’s relative disadvantage. It follows that the Williamsonian transaction cost tradition, with its emphasis on asset specificity, has, ironically, an important role to play in an economic analysis of power and its effects on governance structures. It is clear, therefore, that power effects are endemic, a

A general framework 39 point that is obscured if governance structure analysis is linked only to the costs of resource allocation in equilibrium. A similar point is made by Malcolmson (1984). He suggests that questions of power can only be ignored in perfect markets. This utopia requires: no barriers to entry, universal market clearing, and no transaction costs. The idiosyncratic and dynamic characteristics of firms, as discussed earlier, are sufficient reason to question the appropriateness of the first two factors; the relevance of the third is obvious. These comments are meant to be indicative of the general framework being suggested here, their detailed discussion and development will be undertaken in later chapters. It is clear from the above discussion that fruitful avenues of analysis are opened up when consideration is given to the benefits derivable from resource allocation. It is perhaps obvious that while idiosyncratic benefits and monopoly advantages have been examined separately they are likely to be linked in practice. Firm specific advantages are developed because of the monopoly advantages obtainable. From an intra-organisational perspective, control over a strategically important input can be the basis of a powerful organisational position. These benefit factors are major determinants of the evolution of governance structures and are central to the economics of the firm, as will be shown in later chapters. FIRMS, MARKETS AND QUASI-INTEGRATION The arguments presented in the previous section were developed in the context of Bf being above Bm in Figure 3.5, but this need not be the case. When Bm lies above Bf market-based control is relatively more profitable for reasons unrelated to transaction costs. In general terms this relative efficiency of market-based resource allocation is based on the same two factors identified above, i.e. idiosyncratic advantage and monopoly power. In terms of this chapter it is sufficient to give a number of examples to illustrate these factors. If the good—service being used is an input, its cost must be lower if controlled by markets rather than internally. This lower cost may occur for a number of reasons. Productive efficiency can be higher if an input is produced by an independent firm, as might be the case when skills necessary to produce an input are not readily transferable. Alternatively contracting-out may occur in response to the power of organised labour, perhaps in combination with monopsonistic power over supplying firms. Finally, market-based control of inputs may be more beneficial if prices are lower than the average cost of in-house production because of falling unit cost advantages available to a supplier that are not available to a buying company because of infrequency of use. More fundamentally what is involved here is whether skills are specialised and largely non-transferable. If skill transferability is possible it is difficult to understand what prevents a firm from diversifying into an activity and producing for in-house and external use, hence overcoming infrequency of use problems. Such diversification is inhibited when knowledge is non-transferable and consequently skill specialisation is important.

40  Transaction cost economics and beyond

Figure 3.6 Infeasible market governance The Bm curve might also be above Bf if the good—service being traded is an output. This is possible when output prices and/or volumes are higher. Two examples may be useful. First, a common decision is whether to undertake in-house distribution or franchising. While transaction cost considerations might be present here, involving particularly performance monitoring problems, an additional explanation is that a franchisee might offer equivalent benefits to a firm as those described for inputs. Alternatively, the decision to employ an outside advertising agency rather than inside resources may revolve around benefit rather than control cost considerations. The discussion can now turn to Figure 3.6 in which a market for the good—service in question is infeasible. Consequently there are no transaction costs of market-based resource allocation, i.e. they are zero. But internal organisation might shift the curves as shown by the arrows, with the result that intra-firm resource allocation is profitable. Obviously positive management costs are then incurred. Thus from a transaction cost economising perspective, internal organisation is either illogical or positive costs of organising markets are imputed. The latter is clearly problematic because real resource use is not involved, thus opportunity cost is zero. The relevance of Figure 3.6 is clear from Chapter 2. It was pointed out there that transaction cost economics is based on the assumption that this situation does not occur, i.e. that all governance structures are always feasible. In addition the way in which transaction cost economics cannot explain an employment decision, i.e. a shift from the absence of an employment relation to its introduction, will involve a diagram equivalent to that presented in Figure 3.6. The framework developed in this chapter is capable of supporting a more sophisticated analysis than that suggested up to now. Consider Figure 3.7 which for clarity ignores transaction (organisation) costs. Here a ‘critical mass’ of managerial output (M*) exists. Intra-firm organisation only yields greater benefits, compared to market-based control of an activity, beyond this critical level of effort, perhaps because of the existence of organisational economies.

A general framework 41

Figure 3.7 Firms-markets and ‘critical mass’ effects

Figure 3.8 Quasi-integration

42  Transaction Cost Economics and Beyond One interesting conclusion that may be derived is that the kink in the overall benefit frontier, described by Figure 3.7, can mean that both firms and markets are in principle as profitable as each other, a conclusion that obviously depends on the nature of transaction (organisation) costs. Therefore, the existence of market- (firm-) based resource allocation need not imply the unique superiority of this governance structure; an important point that will be developed in detail in Chapter 8. This conclusion is not dependent on Bf being above Bm initially with the reverse holding at higher levels of managerial output, the opposite could hold, i.e. a critical mass of managerial effort is required to yield greater benefits from market-based resource allocation, perhaps because of eventual organisational diseconomies. In addition, the same conclusion can be drawn if a kink is evident in the overall cost frontier, i.e. transaction and organisation cost curves intersect. Finally, in this section, the discussion can turn to an introductory consideration of quasiintegration. Consider Figure 3.8, intra-firm organisation is infeasible (Cf>Bf), perhaps because of highly specialised skills needed to produce an input. If the input is bought-in increased benefits will result (Bm>Bf) but transaction costs are excessive, perhaps because of small numbers trading and information asymmetries, therefore a market is also infeasible (Cm>Bm). But long-term relationships and the development of trust between (prospective) trading partners, i.e. quasi-integration, will shift Cm downwards towards Cf therefore rendering economic organisation feasible. Thus the existence of long-term relationships between legally separate bodies must be based on the benefits of economic organisation as well as transaction-organisation costs, a point that will be developed in more detail in Chapter 7. SUMMARY This chapter has developed a framework that overcomes the problems, identified in Chapters 1 and 2, associated with transaction cost economics. The main findings have been as follows: 1 The distinguishing characteristic of the firm is that human and non-human inputs are directed to further production-distribution objectives. 2 The recognition of such organisation allows a dynamic analysis of governance structures to be developed rather than the comparative statics of transaction cost theory. 3 Transaction and organisation costs can be understood as the costs of management and modelled accordingly. This approach facilitates recognition of the benefits derivable from resource allocation with different governance structures. 4 Governance structure benefits depend on skill and asset use idiosyncrasies and monopoly advantages. 5 Recognition of contracting and organisational benefits can facilitate the development of power, rather than just efficiency, perspectives on the firm.

Part II BEYOND ­TRANSACTION COSTS: THE ­BOUNDARIES OF THE FIRM

4 THE DEVELOPMENT OF THE FIRM The subject matter of this and the following three chapters will shift from the abstract theory of Part I to a detailed development and application of this framework to the determinants of the boundaries of the firm: in so doing, the intention is to develop an understanding of the firm’s nature and functioning. This chapter concentrates on the firm in general; the following two chapters shift attention to the integration decision; finally, Chapter 7 examines the counter forces of quasi- and disintegration. The structure of this chapter will trace the general evolution of the nature of the firm—market interface. Initially the shift from the putting-out system to the factory will be examined. This is not a comprehensive discussion, rather those aspects of the organisational changes that are significant for the economics of the firm will be initially outlined and then assessed more analytically. Following this, the rise and evolution of the firm as a cohesive unit will be explored. This discussion leads into that emphasising recent changes in management strategies, the significance and implications of which have yet to be adequately assimilated into the economics of the firm. The overall message is that transaction cost explanations, by themselves, are inadequate as an explanation of the determinants and nature of intra-firm resource allocation. A coherent analysis of the shifting firm—market interface must involve the relative benefits of market- and firm-based activity as well as the costs involved. It will be shown that, to some extent, analyses of such benefits already exist. FROM PUTTING-OUT SYSTEM TO FACTORY The putting-out system existed as an important means of organising production from the sixteenth to the eighteenth centuries.1 Its basic characteristic is domestic-based production that is co-ordinated by a central entrepreneur. The latter provides finance and raw materials, etc., and in turn has claim over output produced. The central advantage of the putting-out system, over handicraft production that preceded it, was the possible development of a division of labour. But disadvantages werealso evident. The behaviour of, and output produced by, home-based workers was difficult to control; as Landes (1969:59) puts it [The entrepreneur] had no way of compelling his workers to do a given number of hours of labour; the domestic weaver or craftsman was a master of his time, starting and stopping when he desired. And while the employer could raise the piece rates with a view to encouraging diligence, he usually found that this actually reduced output. In addition, as Salaman (1981:27) points out

The development of the firm 47 Wage cuts were equally ineffective [as a means of increasing production]. These simply resulted either in the workers leaving, or in their embezzling even more of the merchant’s raw material. For these reasons alternative means of organising production were developed, namely the factory system with its ‘characteristic definition of the functions and responsibilities of the different participants in the productive process’ (Landes 1969:2). This radical change in the nature of work organisation, involving far greater direct control and co-ordination of production by entrepreneurs, in turn facilitated technological changes that deepened the division of labour. But the removal of the ‘indisciplines’ of the putting-out system initially shifted, rather than eliminated, the organisational problems involved. Pollard (1965:160) emphasises the characteristic ‘aversion of workers to entering the new large enterprises with their unaccustomed rules and disciplines’. Thus, as Salaman (1981:31) argues The first priority with the new, factory work force was to encourage the employees to develop ‘appropriate’ and ‘responsible’ attitudes towards work regulation and discipline, and towards the new form of employment relationship based on the cash nexus. The widespread concern with sexual morals, drinking habits, religious attitudes, bad language and thrift was an attempt on the one hand to destroy pre-industrial habits and moralities, and on the other to inculcate attitudes of obedience towards the factory regulations, punctuality, responsibility with materials and so on. Pollard’s (1965:254) comment is apposite in this respect: men who were non-accumulative, non-acquisitive, accustomed to work for subsistence, not for maximisation of income, had to be made obedient to the cash stimulus, and obedient in such a way as to react precisely to the stimuli provided. It is against this background that Oliver Williamson (1980, 1985) claims that embezzlement, cheating and quality control problems were endemic to putting-out. In addition large inventories were required, which is linked to difficulties the system had absorbing and adapting to change; hence the factory possessed superior efficiency properties in terms of transaction costs.2 To analyse this claim we can refer back to the distinction, made in the previous chapter, between technical economies and pecuniary transfers. The latter only make one party better off at the expense of another. To this extent reductions in embezzlement and cheating represent respectively a fall and increase in revenues for the domestic workers and entrepreneurs. Furthermore, organisational overheads necessary for the detailed control to reduce embezzlement and cheating (the details of which will be discussed shortly), will increase with the shift from putting-out to factory. Hence, ceteris paribus, combined transaction and organisation costs will increase not fall, but this increase will be more than compensated for by extra revenues. But, of course, everything else is not equal: transaction cost savings will be evident with inventory and quality control economies. The same contracting and organisational activity can be achieved within a factory with lower managerial (and complementary) inputs. It is therefore possible to come to a preliminary conclusion that, in terms of the framework developed in Part I of this work, both the costs and benefits

48  Transaction cost economics and beyond of resource allocation will have increased with the shift from putting-out to factory, but the latter to a greater extent than the former. To understand the significance of the evident difficulties of absorbing and adapting to environmental changes with the putting-out system, as compared to the factory, involves somewhat different reasoning. It is clear from earlier discussion that the achievement of the relative organisational flexibility of the factory required more than just a simple restructuring of contractual relationships; considerable (moral and other) non-contractual motivation and sanction was involved. In addition this motivation was a prerequisite for contractuallybased incentives to be effective. Thus, it appears that the movement away from domestic labour, for organisational flexibility reasons, cannot be explained in terms of relative transaction-organisation costs because (to use Williamsonian terminology) the opportunism of workers, or behavioural uncertainty, was too extreme. The initial unresponsiveness to contracting and organisational incentives—penalties implies that if a simple restructuring of arrangements had occurred, with the basic characteristics of the transactions being otherwise unchanged, the factory-based system would have been infeasible because resource allocation costs would have exceeded any benefits obtainable (as described at the end of Chapter 3). Consequently the non-contractually based motivation evident at the time can be seen as a (successful) attempt to change the characteristics of the relationships and therefore shift the organisational benefit curve upwards. Once this shift in worker psychology and behaviour had been achieved the search, bargaining and policing cost advantages, vis-à-vis organisational flexibility, would become evident. The importance of this aspect of the evolution of the firm is not recognised within a narrowly conceived transaction cost perspective. For example, Williamson (1985:218) claims, while discussing various forms of work organisation, that with The employment relation…flexibility is featured as the employee stands ready to accept authority regarding work assignments provided only that the behaviour called for falls within the ‘zone of acceptance’ of the contract. In addition (p. 220) explicit and implicit understandings regarding the zone of acceptance of the employment relation…need to be reached. Once agreement has been reached…boss and worker essentially agree to ‘tell and be told’. There appears to be no recognition of the complexities involved in widening the ‘zone of acceptance’ to render employment—authority relations feasible, because, as indicated above, this would compromise the narrowly defined contracting analysis. In effect, imputing individual behaviour based on narrowly defined economic motives involves projecting historically specific conceptions of individual action into an inappropriate arena. Pollard’s (1965:269) comment is pertinent in this respect: the preoccupations with individual character seem to today’s observer to be both impertinent and irrelevant to the worker’s performance, but in fact it was critical, for unless the workmen wished to become

The development of the firm 49 ‘respectable’ in the current sense, none of the other incentives would bite. (emphasis in original) This comment is a stark reminder of the importance of non-contractual motivation in the development of the firm. But once this insight is made it becomes obvious that it is also relevant for modern economic organisation, as will be argued later in this chapter. It appears, therefore, that any transaction cost explanation of the demise of the dominance of the putting-out system is inevitably incomplete, and in addition Williamson’s (1985) claim of the irrelevance of power, rather than efficiency-based, explanations must also be questioned. For example, Marglin (1974) suggests that the shift from the puttingout to the factory system was based on the ability of capitalists to extract greater surpluses. These greater surpluses represent transfers from labour to capital because of the augmented power of the latter rather than because of technical efficiency gains. In a later work, Marglin (1982) suggests that this greater power is derived from differential control, or a monopoly over knowledge of production activities, similar to arguments advanced by Braverman (1974). In more technical language, the factory shifted the basis of the information asymmetry, and the control this implies, between workers and entrepreneurs-capitalists in favour of the latter thus facilitating the extraction of a latent surplus, i.e. greater benefits to capitalists. In addition, discussion earlier in this chapter implies that this shifting power relationship is not based solely on a simple restructuring of contractual relationships, rather the ability to define organisational functioning and to endogenise, and thereby shift, worker attitudes and behaviour is of central importance. Such issues will be taken up in detail in Chapter 9. THE RISE OF THE FIRM This and the next sections will chart the rise and evolution of the firm as a cohesive unit and in doing so will examine the relative costs and benefits of firm- and market-based resource allocation. Rather schematically the following stages can be identified: the system of inside contracting; the development of more characteristic authority relationships; and finally recent developments. The system of inside contracting presented a (temporary) solution to the problem of how to manage resource allocation in the emerging factories. It did not follow that entrepreneurs had the requisite technical and managerial skills necessary to organise production, hence direct management responsibilities were sub-contracted to agents within the firm. The resulting system has been described in the following way: Under the system of inside contracting, the management of a firm provided floor space and machinery, supplied raw material and working capital, and arranged for the sale of the final product. The gap between raw material and finished product, however, was filled not by paid employees arranged in [a] descending hierarchy…but by [inside] contractors, to whom the production job was delegated. They hired their own employees, supervised the work process, and received a [negotiated] piece rate from the company. [Buttrick (1952), cited in Williamson (1985:218)]

50  Transaction cost economics and beyond While the internal contracting system should be viewed as a transitional mode of organising intra-firm relationships, this does not imply that its existence was short-term: evidence indicates otherwise (Nelson 1975, Littler 1980). This non-transitory existence presents a problem for transaction cost economics. Williamson (1975, 1985) argues that internal contracting suffered inevitable difficulties. The contracting systems do not appear to have been of the contingent claims type (Francis 1983) where parties negotiate a long-term contract setting out obligations at the outset; Williamson would appear to be correct in arguing that such contracts face inevitable problems because of bounded rationality. The alternative system is sequential spot contracting, but this would encounter inevitable problems, according to Williamson (1975, 1985), because of two characteristics of the insider contracting system: bilateral monopoly between entrepreneur and agent, and information impactedness which inevitably existed because the rationale of the system was based on entrepreneurs being relatively ignorant and ill-informed. Consequently severe negotiation and policing problems existed (at least potentially) with the resulting high transaction costs. In such a situation it is difficult to understand why the insider contracting system existed at all. One answer is that ‘at the end of the eighteenth century managers were frequently chosen from within the entrepreneur’s family (in an effort to gain trustworthiness)’ (Salaman 1981:34–5). The recognition of this is important for two reasons. First is an issue that was introduced in Chapter 2: the existence of transaction costs, and therefore firms, is claimed by Williamson to be contingent upon the existence of bounded rationality, opportunism, and asset specificity—in the absence of any of these factors firms are not required. Clearly, the employment of family members places considerable bounds on opportunistic behaviour, this, after all was its objective. Hence, in such circumstances it is by no means obvious why intrafirm organisation should exist, from a transaction cost perspective. A rationale, based on benefit considerations, is clear however from the last section. The second implication of the frequent use of family members, or more generally trusted individuals, within the early firm involves Williamson’s (1985 ch. 9) numerous claims about the problems of needing to ‘bribe’ inside contractors to gain their compliance. This, once again, misses the importance of benefits derivable from non-contractual motivation and trust. The centrality of such motivation for the early factory cannot be over-emphasised (see Bendix 1963), as Salaman (1981:37–8) argues the traditional attitudes of labour that so infuriated the entrepreneur eager to take advantage of increased demand actually assisted the management of labour through sub-contract, because traditional ties and relationships between employers and employees persisted…[that were] coloured by traditional conceptions of the responsibility of the master for his hands. In short bribery, with its cost implications, was perhaps less important than traditional relationships, with their benefit implications. In terms of the motivation of sub-contractors, Personal relations can encourage personal arbitrariness and exploitation… Indeed, many contemporaries had occasion in the early stages of industrialisation to note and condemn the manner in which middlemen and contractors exploited their workers. (Salaman 1981:38)

The development of the firm 51 The demise of the inside contracting system can be explained by a number of factors that matured during the nineteenth century (see Salaman 1981). Productivity improvements came to rely more on an intensive, rather than extensive, use of labour. Original entrepreneurs were replaced by sons or agents who were not constrained by the previous traditionalism. Management as a profession, along with related specialist and technical training, was developing. This went hand-in-hand with the formalisation of rules and procedures, rather than ad hoc regulations, within the firm. In short a shift occurred from indirect to direct control. Williamson (1975:97) comes to a similar conclusion when he draws attention ‘to the conjunction of internal personnel changes in the late 1800’s with external “scientific management” developments in the early 1900’s’ as reasons for the demise of the inside contracting system. These developments would appear to have a number of implications for the economics of the firm. On the one hand, the development of formalised internal control systems and the maturing of contractually-based incentives are the very conditions appropriate to a transaction cost framework, a conclusion that will be qualified by discussion of recent developments later in this chapter. On the other hand, however, are two factors that reinforce benefit, rather than cost, aspects of internal organisation. The first of these factors is that the development of centralised control systems will shift, to the entrepreneur’s advantage, impacted information which will facilitate pecuniary transfers (rather than technical efficiency gains). As Francis (1983:109–10) points out craft workers did not wish to change from an inside contracting system to an employment relationship: 3

[The craft worker] loses his own opportunity to be opportunistic without the employer giving up his similar opportunity. All he gains is the time to engage in productive work that he otherwise spent in lengthy bargaining in his relation of bilateral monopoly with his employer…[In addition] many workers actually have a preference for leisure over work, even when the latter is paid and the former not. Of course the situation was different for unskilled workers because their weak labour market position meant that they had no control over entry to their occupations with the result that employers could impose employment contracts. In addition the developing philosophy of scientific management, or Taylorism, did not generate new knowledge but only reduced the impactedness of that already existing (see Rose 1978, Braverman 1974). The second factor with implications for benefit rather than cost aspects of internal organisation is that the development of specialist management and technical knowledge implies the reinforcing of idiosyncratic skills and assets with the resulting benefits of internal organisation, as discussed in the previous chapter. The detailed discussion of these issues will be the subject of the next section. THE MODERN FIRM Williamson (1985 ch. 9) undertakes a comparative analysis of different forms of intrafirm organisation, among which are putting-out, inside contracting, and the authority relation. The latter, which is defined in terms of capitalist ownership with its corresponding

52  Transaction cost economics and beyond employment relationship, is described as the most hierarchical in terms of contractual and decision-making characteristics. The conclusion drawn is that the authority relation is the most efficient form of organisation Although it is possible to argue that later modes displaced earlier modes because the ‘interests’ were determined to stamp out autonomy, an alternative hypothesis is that successor modes have superior efficiency properties to predecessor modes. The progression from Putting-Out to Inside Contracting to the Authority Relation is especially noteworthy in that respect. (Williamson 1985:231) To this extent we can follow Williamson’s logic and identify the modern firm in terms of the maturity and dominance of the (capitalist) authority relation. In this section the economics of the modern firm will be examined, and, similar to the last two sections, particular emphasis will be placed on analysing the suggestion that the ‘economic rationale for hierarchy is traced to transaction cost origins’ (Williamson 1985:206). Of course, many different forms of the hierarchical organisation have and do exist. Williamson (1985, ch. 10) suggests a simple taxonomy that can be used to structure the current discussion. Two dimensions of organisation are isolated: the degree of human asset specificity, and the extent to which work relations are separable. Using these two dimensions four organisational types, or internal governance structures, are identified. 1 Internal spot markets are efficient when there is low degrees of asset specificity and separable work relations. Neither workers nor firms have an efficiency interest in maintaining the association. Workers can move between employers without loss of productivity, and firms can secure replacements without incurring start-up costs. No special governance structure is thus devised to sustain the relation. Instead, the employment relation is terminated when dissatisfaction by either party occurs. (1985:245) 2 A primitive team is efficient with low degrees of asset specificity and non-separable work relations. This is the team organization to which Alchian and Demsetz refer (1972). Although the membership of such teams can be altered without loss of productivity, compensation cannot easily be determined on an individual basis. The simple brokerage role described [for internal spot markets] is thus extended to include supervision. (1985:246) 3 Obligational markets are appropriate when there is a considerable amount of firm specific learning but tasks are separable.

The development of the firm 53 Idiosyncratic technological experience…and idiosyncratic organizational experience…both contribute to asset specificity… [S]unk costs are incurred in qualifying a worker for productive employment in the firm. Both firm and workers have an interest in maintaining the continuity of such employment relations. (1985:246) 4 A relational team is efficient when human assets are specific and task non-separabilities are evident. The firm here will engage in considerable social conditioning to help assure that employees understand and are dedicated to the purposes of the firm, and employees will be provided with considerable job security, which gives them assurance against exploitation. (1985:247) To examine the subtleties of the modern firm indicated by this four way classification the underlying criteria, i.e. asset specificity and separability, can be discussed in detail. In the light of this discussion the Williamsonian taxonomy can be reconstructed using the framework developed in Part I. Turning first to human asset specificity, the issues involved can be disentangled by focusing on Williamson’s (1985) link between such specificity and trade union activity (see also Williamson, Wachter and Harris 1975). Efficiency requires the continuity of relationships when asset specificity exists, but in such situations bargaining economies will be evident with collective rather than individual negotiation. Hence Williamson (1985:256) suggests two ‘testable propositions’: (1) The incentive to organise workers increases with the degree of asset specificity, and (2) the degree to which an internal governance structure is elaborated will vary directly with the degree of human asset specificity. Marginson (1988) takes up this argument and points out that union organisation was a precondition for the ending of the casual labour system in certain industries in the UK (such as printing and the docks), and not the consequence of the evolution of a continuing employment relationship. The recognition of this fact does not, of course mean, that the efficiency reasoning has no substance, but it does imply that a shift away from internal spot markets within the four way classification introduced above is more complex than Williamson’s analysis suggests. One element of this greater complexity is to remove the arbitrary assumption, that runs through Williamson’s work, whereby workers are assumed to behave opportunistically whilst managers act in the interests of the organisation as a whole (see Dow 1987, Willman 1983).4 Given managerial opportunism, internal organisation and the employment relationship can be explained in terms of managerial pressure to raise effort to excessive levels (Pitelis 1991), as argued in earlier sections this is a benefit factor rather than a technical contracting efficiency gain. Fitzroy and Kraft (1985, 1987) point out that the possession of firm specific skills will impede labour market mobility and, via the increased dependency of workers on the firm, exacerbate this managerial opportunism problem. It follows that Williamson’s obligational market depends on more than just transaction cost factors.

54  Transaction cost economics and beyond The shift facilitated by the recognition of managerial, as well as worker, opportunism, and its role in internal organisation, is significant because it allows alternative perspectives to be developed on two further factors that are relevant in this section: the rationale for monitoring, and the central importance of motivation. These two factors can be incorporated into the analysis through discussion of the second criterion that underlies Williamson’s taxonomy of the modern firm, i.e. the existence of non-separabilities. The significance of non-separabilities is, of course, based on the work of Alchian and Demsetz (1972). They reason that with team production, individual productivity cannot be assessed by measuring output. An incentive to free-ride, or shirk, consequently exists which in turn requires a monitor to regulate inputs into work activity. Hence the existence of Williamson’s primitive team. The first point to recognise is that this use of a non-separability argument is a significant shift by Williamson. In his 1975 work (p. 50) he claimed5 The issue may be put operationally in the following way. Holding individual task technologies constant, up to but not including’ the physical transfer of a product from one stage to the next, is it commonly possible to sever the connections between successive workers by placing an intermediate product inventory between them? Many tasks, I submit, are separable in this sense… Internal organization thus arises less on account of nonseparabilities than as a means by which to economize on buffer inventories and mitigate costly haggling between technologically separable stages—in most instances because of transactional considerations. This earlier Williamsonian reasoning appears to be consistent with contemporary managerial philosophies. Sayer (1986) makes reference to just-in-case (JIC) systems of organisation, that are distinguished from just-in-time (JIT) methods (to be outlined shortly) that are becoming increasingly dominant. JIC systems are characterised by machinery and intrafirm organisation that are rigid and used to executing a single or narrow range of operations repeatedly. These organisational rigidities imply that large buffer stocks are an absolute requirement to avoid disruption—hence the just-in-case characterisation. The internal functioning of JIC systems is consistent with both the Alchian and Demsetz rationale for universal monitoring and the Williamsonian (1985:220–1) view that the authority relation is characterised by the ‘boss and worker essentially agreeing] to “tell and be told”’. But in practice a series of shortcomings have become evident with their use. These inefficiencies can be grouped under the following seven headings (see Oliver 1990, Sayer 1986, Wilkinson and Oliver 1989): 1 Organisational and technical inflexibilities imply that such systems are limited in the degree to which they can respond to market changes. 2 Intra-firm resource allocation requires expensive information and monitoring systems to avoid gluts and shortages, a problem that becomes more acute as the complexity of production increases. 3 Large buffer stocks are expensive. 4 Production and quality problems are concealed in buffer stocks which makes it difficult to solve problems at source.

The development of the firm 55 5 Quality testing is more expensive than building quality into production. A separate quality control department increases overheads without increasing value-added. 6 JIC systems require a rigid vertical hierarchy for co-ordination and control. This bureaucratisation is counter-productive in terms of control because of its infeasibility, and motivation because of resentment that heavy monitoring can cause. 7 Finally, 1–6 inhibit the development of dynamic economies and learning effects. On a more theoretical level, these inefficiencies have been recognised by, for example, Putterman (1984). He suggests, with regard to Alchian and Demsetz, that such an analysis is suspect in at least three areas: it ignores the psychic costs of monitoring; no reference is made to the inefficiencies of vertical relationships; and no comment is made about the improbability of detailed universal monitoring. Similarly, with regard to JIC-type management systems, Oliver (1990) points out that their relevance is restricted to situations of either limited complexity or high predictability, or using the terminology introduced in Part I: when bounded rationality does not impinge to any great extent on management activity. If management tasks are complex, the inefficiencies of JIC systems will become obvious. The only effective solution is to reduce the complexity of the processes by opting for JIT-type principles rather than universal monitoring. These principles are superficially consistent with Williamson’s relational team, but a detailed analysis indicates that such methods are not explicable in solely transaction cost terms. JIT principles are an umbrella term for a set of procedures that are becoming increasingly important for intra-firm resource allocation (Linge 1991).6 Narrowly conceived, JIT systems are based on the idea that buffer stocks are undesirable, for reasons outlined earlier, therefore their progressive reduction towards zero is desirable. Consequently, production is not organised round maximum volume in anticipation of demand, but rather work is done when needed. Output instructions are issued to the immediate upstream process detailing requirements that will be needed ‘just-in-time’. This process is repeated at successive stages of production, both inside and outside the firm. In short production is pulled rather than pushed through the firm. An important point, however, is that JIT procedures are impossible to implement in isolation from more general organisational factors because inventory reduction implies that errors and quality deficiencies become more visible. Hence JIT procedures are only effective if used in conjunction with total quality control (TQC) systems.7 The latter are based on the principle that quality is built into a product not inspected, or monitored, after production. Inspection deals with consequences not causes. The objective of building in quality, however, is contingent upon two related factors: (1) efficient worker—supervisor communication channels, and (2) self-motivated, co-operative and self-disciplined workers. These factors are necessary so that workers’ tacit knowledge is communicable up the hierarchy, with corresponding feedback so that scheduling and improvements are possible. In addition, a further necessary factor for TQC is that workers are trained to undertake regular preventative maintenance and immediate remedial action should problems arise. Relatedly, workers are trained in a wide range of activities to facilitate flexibility. An implication of TQC systems is that the ratio of indirect to direct labour will fall. For example (see Oliver 1990), in electro-mechanical components manufacture this ratio in

56  Transaction cost economics and beyond Japan is 1:2 compared with 3:2 in Britain; alternatively, the ratio of quality control inspectors to direct workers in the West is 15 per cent, in Japan the figure is 5 per cent. If we follow the later Williamsonian (1985) logic, based on Alchian and Demsetz (1972), these changes would be contingent upon a reduction in the importance of non-separabilities. Such a reduction would, in turn, shift organisational characteristics away from a relational team (which is the closest description of JIT/TQC forms of organisation) towards an obligational market. This shift is clearly not occurring; on the contrary the opposite appears to be the case, which appears to present a problem for Williamson’s analysis. An alternative transaction cost analysis of this area is suggested by Ouchi (1977, 1980). In the first of these works he argues that control systems must be based on observing and monitoring behaviour and/or output. Efficient behaviour control is contingent upon knowledge of the processes involved. On the other hand, with output control knowledge of the processes are not required, but reliable and valid measures of the outputs must be available. This availability, or otherwise, of reliable output measures suggests a further element of organisational analysis: performance ambiguity. This along with goal incongruence is used by Ouchi (1980) to develop the ‘clan’ form of organisation, which is equivalent to a relational team (Williamson 1985:246–7). A clan is more efficient than traditional bureaucratic structures because it not only facilitates goal congruence but also reduces the need for monitoring when performance ambiguity is high. The similarity between Ouchi’s clan and TQC/JIT systems is clear. The approaches suggested by Williamson and Ouchi are to some extent reconcilable by distinguishing between technological and organisational non-separabilities. Williamson’s (1975) comments, vis-à-vis the use of inventories, are only applicable for technological interdependence. Such was the case with JIC systems, with their attendant organisational inefficiencies. Thus, if non-separabilities, and performance ambiguity, are to contribute to an understanding of the nature of the firm it is perhaps at an organisational level that this is so. Inventories are clearly not appropriate as a means of disentangling organisational interdependence. Why this is so is clear from the very nature of organisation which exists because of complexity and uncertainty (Kay 1984). In such conditions, organisational relationships facilitate the development of a body of tacit knowledge that can only be effectively shared by common experience within a firm. Thus the existence of an organisation presupposes non-separability of its knowledge base. This perspective on the organisation will be examined in detail in Part III below, hence the current discussion will be restricted to a number of pertinent comments. Team activity and the nature of the firm in general, rather than a particular management style, are linked via the centrality of organisation, not a requirement to monitor performance and exert penalties. This statement, however, is not necessarily inconsistent with transaction cost reasoning. To identify the cost and benefit factors involved reference can be made to discussion in Chapter 3. One determinant of intra-firm benefits is the extent to which rents can be effectively derived from in-house asset use given that knowledge or skills can be idiosyncratic and hence non-transferable. It is generally acknowledged that the use of TQC/JIT systems improves intrafirm flexibility in terms of factor substitution and output mix but at the expense of making human assets more specific, and less standardised, hence making substitution from outside the firm more difficult. Hence, while

The development of the firm 57 contract-organisation cost problems may be ameliorated by in-house organisation, in ways analysed by Williamson, it is also clear that in addition extra benefits are involved. Idiosyncratic activity implies that in-house organisation changes the attributes of the economic agents which increases profit potential. It is perhaps instructive to note that Williamson (1985:214) removes the possibility of these increased benefits by assumption: The workers employed under each mode are a random sample of the technically qualified population of which they are a part… Thus although certain work modes may be competitively viable if they are staffed with workers with special attributes, that is foreclosed by… [this] stipulation wherein all modes are assessed with respect to a comon workforce. It is possible, to some extent, to gauge the relative importance of cost and benefit factors in this area by reference to business literature. For example, Prahalad and Hamel (1990) claim that corporate success depends on what they call ‘core competence’ which is the collective learning in the organization, especially how to coordinate diverse production skills and integrate multiple streams of technologies …[and] it is also about the organization of work and the delivery of value. (Prahalad and Hamel 1990:82) Similar views are expressed by authors stressing the importance of organisational culture as a recipe for success (see Peters and Waterman 1982, Clutterbuck and Goldsmith 1984, Johnson and Scholes 1989, and Whipp, Rosenfeld and Pettigrew 1989) and the importance of idiosyncratic organisational assets (Pettigrew and Whipp 1991). Clearly, the emphasis in these non transaction cost contributions lies in, what is called here, the benefits of internal organisation. Competitive advantage is generated by a body of idiosyncratic, and tacit, organisational knowledge. Such knowledge leads to internal organisation because any attempt to use market-based relationships will lead to a reduction in total profitability because of the rupturing of internal relationships. In principle contracting-organisation costs need or need not change, but the logic of investment in the development of organisational assets implies an increase in in-house control costs to exploit dynamic advantages—a central characteristic of the contributions just highlighted is that they stress the importance of strategic management rather than static efficiency. While the characteristics of the modern firm, and in particular TQC/JIT have static efficiency implications, as discussed earlier, their real superiority derives from dynamic benefits, i.e. from changing costs and revenues rather than their exogeneity. It follows that orthodox transaction cost reasoning, with its comparative static emphasis, has little to say about these organisational innovations. This relative unimportance of static efficiency advantages, and the corresponding relative importance of organisational benefit rather than cost factors explaining internal organisation, is reflected in a further characteristic of current business philosophy, the way in which non-contractual motivation is stressed. For example, Oliver (1990) makes the following comments about employee motivation and TQC systems:

58  Transaction cost economics and beyond if one is to avoid direct control which is both costly (and inadequate) then perhaps a sense of responsibility, obligation or commitment to make sure that a good quality product is produced can serve as a substitute mechanism…. Unlike the approach which typically assumes that a change in attitude must precede a change in behaviour, this view [of commitment] regards behaviour as governed largely by the social context within which people are operating. Changes in behaviour, under this model, stem from adjustments to the context rather than from adjustments to attitudes, (pp. 23–4) In addition: If the [TQC] arrangements…set up the conditions for social control and commitment then arguably it is systems of employee involvement which function to provide the direction of the commitment or legitimation of the standards and targets in use. (p. 28) Williamson precludes analysis of this area in two ways. First, use is made of exogenously given contractual limits or a ‘zone of acceptance’, as discussed above, that specify acceptable behaviour within a superior—subordinate employment relationship. But it is clear that if Oliver’s view is accepted such limits are endogenous to organisational processes. Leibenstein’s (1987) discussion of intra-firm behaviour is useful in this respect. Management—worker relationships are analysed in game theoretic terms with resulting co-operative and non-cooperative equilibria. The former, based on the development of trust rather than narrowly defined individual interest, is Leibenstein’s characterisation of the Japanese firm with its superior efficiency levels. Simon (1991) stresses an equivalent point when he argues that effective organisations must depend on initiative rather than simply obedience, but this is developed not simply by economic rewards but most importantly by organisational identification facilitating the growth of pride and loyalty. Hence the comparative advantage of intra-firm activity is a function of the benefits derivable from non-contractual employee motivation, and the resulting flexibility and efficiency, rather than economising on contracting costs with internal organisation. The second way that Williamson fails to incorporate analysis of non-contractual motivation is by reference to empirical evidence. Williamson (1985:269–70) criticises Blumberg’s claim (cited in Bowles and Gintis 1976:79–80) that ‘There is scarcely a study in the entire literature which fails to demonstrate that satisfaction is enhanced…or productivity increases from a genuine increase in workers’ decision making power…. The participative worker is an involved worker.’ But curiously Williamson goes on to cite ‘evidence relating job satisfaction to productivity [which] discloses little or no association between the two’ (p. 270, emphasis added). Clearly job satisfaction is not the same as employee involvement in decision making, which Blumberg (and Oliver) make reference to. More curiously still, Williamson cites Gallagher and Einhorn (1976:373): ‘We feel that job enlargement and enrichment can be useful tools of management. However, the important question that remains is not whether these programs work, but rather, under what conditions will they be most effective’ (emphasis added by Williamson). It is perhaps reasonable to suggest that job satisfaction schemes that are introduced into an otherwise bureaucratic hierarchy, what

The development of the firm 59 was called earlier the JIC model, will have little or no effect, but using TQC procedures employee participation, and job satisfaction, are central if Oliver’s views cited above are accepted.8 To some extent, investment in participatory management systems can be introduced into a transaction cost framework in ways suggested by Dow (1987). He accepts Williamson’s (1975) view that employee idiosyncratic knowledge introduces the possibility of opportunistic behaviour, but makes the point, as mentioned above, that opportunistic behaviour by senior management is possible. Hence participative management systems are useful to overcome a potential abuse of authority, with the search, bargaining and policing costs that will be involved. Dow’s observations are a step forward, however they do not change the overall picture with regard to the limitations of transaction cost reasoning, as already discussed. This rather negative discussion, has suggested a number of elements of a possible ‘new economics of the firm’ developed in Part III below. SUMMARY This chapter has discussed in detail the development of, and general rationale for the firm. The main findings have been: 1 The shift away from putting-out and the rise of the firm involved, in addition to transaction-organisation cost factors, pecuniary transfers and non-contractual motivation. 2 The differing organisational forms of the modern firm cannot be understood within the Williamsonian framework involving human asset specificity and task non-separabilities. 3 Emphasis was placed on organisational, rather than technological, non-separabilities as the basis of the modern firm. 4 The existence of modern organisations, involving just-in-time and total quality control systems, is dominated by benefit factors: the importance of idiosyncratic knowledge, dynamic competitive advantage, and non-contractual motivation.

5 RELATED INTEGRATION AND THE FIRM This and the next chapters will continue the overall theme of Part II of this work, analysis of the boundaries of the firm, but shift attention to the integration of different activities within a single organisation. More specifically, the first half of this chapter will examine vertical integration. Following this, the discussion turns to an examination of related diversification involving expansion into areas related to a core production and/or distribution activity. The arguments developed here are separated from the complementary discussion in the next chapter because the analysis of vertical integration and related diversification are based on similar principles. Such principles are somewhat different to those underlying conglomerate and multinational development which are examined in Chapter 6. Clearly the economic literature on integration, in its many forms, is voluminous but this chapter will be concerned with only a particular subset within which transaction cost economics dominates; as such, the various forms of integration to be discussed have common threads. This chapter is limited further by restricting attention to only market and intra-firm resource allocation, the important issue of quasi-integration will be discussed in Chapter 7. VERTICAL INTEGRATION This section will open with an examination of the transaction cost arguments that attempt to explain vertical integration. At the outset, however, it is important to guard against any simplistic analyses, for as Williamson (1985:103) argues The contention that transaction cost economizing is the main factor responsible for decisions to integrate does not preclude that there are other factors, several of which sometimes operate simultaneously. If, however, transaction cost economizing is really central, then the other factors are reduced to supporting roles. This is the basic argument. Broadly speaking, it will be shown here that the insights gained from applying the framework developed in Part I to the integration decision cast doubt on the dominance of this Williamsonian thesis. This is important because market failure reasoning would appear to be the dominant approach, within economics, to the analysis of vertical integration (Davies 1987). The basic transaction cost argument is, of course, an application of that outlined in Chapter 2: given bounded rationality, opportunism, and high degrees of asset specificity, contracting efficiency gains will be evident from intra-firm rather than market-based resource allocation for recurrent transactions. These efficiency gains will involve: reductions in opportunistic behaviour, dispute settlement by top management, the development of convergent expectations, and less haggling because of access to information (see

Related integration and the firm 61 Williamson 1981). It is claimed that this approach is superior to any argument based on technology. Efficiency gains from technological interdependence, for example thermal and transport economies from close location of steel production processes, can be exploited by close proximity without unified ownership if assets are non-specific. Not all forms of asset specificity lead to vertical integration (Williamson 1985:95–6). ‘Site’ specificity, where set up and/or relocation costs are great and thus parties to a transaction are locked into a relationship, would appear to be the transaction cost equivalent of the common technological interdependence argument. Similarly, ‘human’ asset specificity, that arises, for example, from learning by doing, would lead to common ownership of successive stages of a production process. On the other hand, lock-in problems with ‘physical’ specificity, involving for example specialised equipment, can be avoided by a buyer owning the assets which are then leased/rented to a user. Finally, ‘dedicated’ specificity (generalised investments that produce outputs for specific customers) leads to quasi rather than full integration.1 Perhaps the easiest way to examine this perspective on vertical integration is via empirical analyses developed by transaction cost theorists. Monteverde and Teece (1982a) collected data for 133 car components used by General Motors and Ford in 1976. For each component they estimated two variables, first the extent of engineering investment required for its development, and secondly the extent of vertical integration. They found a positive and strong significant correlation between the two variables and thus concluded that vertical integration occurred to avoid recontracting problems in the presence of a locked-in relationship. The Monteverde and Teece investigation appears to represent significant evidence in support of transaction cost reasoning, but contracting problems need not be the only explanation for the strong correlation they derived. It is clear that the first of their variables (the extent of engineering investment) reflects technological complexity and cost of component development. As such, using terminology introduced in Chapter 3, knowledge idiosyncrasies and the development and accumulation of skills would appear to be underlying explanatory factors. An alternative to the transaction cost hypothesis is, therefore, that in-house production of components can facilitate lower production costs and/or higher quality for reasons connected to individual and collective abilities and perceptions rather than contracting problems and opportunism, in short for benefit rather than organisational cost reasons. This alternative reasoning depends not only on skill complexity but also the similarity with the knowledge base of the core companies (General Motors and Ford), and competitive pressures that might limit time available for skill acquisition. In this regard it is perhaps pertinent to make reference to the nature of competition based on ongoing product (and process) innovation (Silver 1984). These comments do not imply a rejection of transaction cost reasoning rather that the evidence presented appears to be consistent with an alternative hypothesis, a conclusion that is generalisable to other transaction cost studies of vertical integration, for example Armour and Teece (1980) and Levy (1985). In short, vertical integration may be explained in different ways that cannot be separately identified using correlation analysis. A way out of this impasse is to follow Williamson’s procedure and make use of case material. Consider the following two examples, that are representative of much of Williamson’s (1985: ch. 5) evidence.

62  Transaction cost economics and beyond 1 George Eastman developed, in the early 1880s, the first paper based Kodak photographic film. Distribution of this film was based on in-house activity for the following reasons: The wholesaler or jobber is a detriment to our business because a large proportion of it is sensitized goods which are perishable…. We have organized our distribution facilities so as to get the goods into the hands of the consumer as quickly as possible. Our sensitized goods carry an expiration date. Our own retail houses…have been educated to control their stocks very accurately so that the goods are kept moving. [Porter and Livesy (1971:178), emphasis added] 2 Alfred P.Sloan (1964:282) accounted for the use of franchises rather than own dealers in the following way: automobile manufacturers could not without great difficulty have undertaken to merchandise their own product. When the used car came into the picture in a big way in the 1920s as a trade-in on a new car, the merchandising of automobiles became more a trading proposition than an ordinary selling proposition. Organizing and supervising the necessary thousands of complex trading institutions would have been difficult for the manufacturer; trading is a knack not easily fit into the conventional type of a managerially controlled scheme of organization. So the retail automobile business grew up with the franchised-dealer type of organization. [Emphasis added] In these two cases the underlying rationale for the (non)occurrence of vertical integration is the development of organisational systems to ensure the production and realisation of rents from assets in circumstances where learned (in the first example) and idiosyncratic (in the second example) behaviour is important (matters discussed further in the next section). Neither case appears to constitute evidence for resource savings from contractually-based economies. It may appear that this line of argument implies a technological rationale for vertical integration being re-introduced through the back door. To some extent this is true if technology and skills are correlated. But it would be wrong to conclude that technologyskills are embedded in plant or a firm at the planning stage and hence have limited value as an explanation of integration processes, because, as was emphasised in Chapter 3, the skills base of an organisation inevitably evolves and transforms in response to internal and external conditions. Hence learned behaviour does not approach a static equilibrium. It would be grossly simplistic to jump from a conclusion based on examples to a more general one claiming that contracting efficiency gains have no role in explaining vertical integration. For example, Silver’s (1984) work suggests that a more qualified approach should be adopted. Among other arguments developed he shows that vertical integration can be explained in terms of innovation and quality problems. With regard to innovation, an example, based on the many cases cited by Silver, involves a potentially profitable new product which requires new inputs. An independent supplier may possess the technical expertise involved but may not have adequate market information about the final product to assess its commercial viability (note that this involves Williamson’s dedicated asset specificity). Because of this information asymmetry between the input supplier and user, the upstream firm may be unwilling to commit resources to production. In this situation,

Related integration and the firm 63 the downstream firm can pursue a number of strategies to reduce the significance of the uncertainty for the potential supplier: the writing of a detailed contract; the payment of a premium; the purchase or renting of the resources used by the supplier. Alternatively, vertical integration appears in practice to be a more efficient possibility. Note that the static nature of this analysis should not be over-emphasised. As diffusion of innovations takes place so the rationale for vertical integration will be less evident. But, in addition, integration will reoccur in the same or different industries because of new innovative activity. With regard to Silver’s second problem (input quality deficiency) a similar situation results. A downstream firm may adopt the following market-based policies: the introduction of penalty clauses into contracts; the purchasing of insurance; or the installation of inspectors in upstream factories. But vertical integration is likely to be the most effective option if: the supplier wishes to protect trade secrets; the failure of inputs is because of downstream misuse; or where upstream scale economies inhibit competition (see Davies 1987). The complexity of these various effects is alluded to by Williamson (1981:1549–50) when discussing vertical integration between producers and distributors: The normal presumption that exchange between producers of differentiated goods and distribution stages will be efficiently mediated by autonomous contracting is progressively weakened as demand externalities increase…. The externalities of concern are those that arise in conjunction with the unintended debasement of quality for a branded good or service, for instance when one retailer’s poor service in installation or repair injures a product’s reputation for performance and limits the sales of other retailers. When contractual safeguards are too costly transactions become internalized with a firm. (emphasis added) Clearly benefit as well as cost factors are involved in Williamson’s example. In addition, given the existence of the debasement of quality problem both greater contractual safeguards and internalisation will involve higher transaction-organisation costs, which presumably are more than countered by the increased benefits derivable. These complexities can only be ignored by assuming complete ex-ante recognition of all contracting-organisational contingencies, which as discussed in Chapter 1 is clearly inconsistent with a transaction cost approach. In short, the sole attention given to ex-post relative governance structure costs, as in the last sentence of the above quotation, is incomplete given the reasoning upon which it is based. It is clear from both the innovation and quality cases that while contracting aspects, and the potential for opportunistic behaviour, are present these are embedded in a more general framework that incorporates non-contracting problems. For example, lack of information and expertise, commercial secrecy and scale economies are all important. Such factors, in effect, may make the benefits of resource allocation less than the corresponding (transaction-organisation) costs. From this perspective contracting problems are not a uniquely dominant explanation of vertical integration. With regard to the effects of scale economies on vertical integration, Williamson’s (1985) analysis is instructive. Economy of scale and contracting effects are assumed separable and simply aggregated. Following the logic presented in Chapter 3, this separability of managerial and technical activities is necessary to ensure the exogeneity of governance

64  Transaction cost economics and beyond structure benefits. An implication is that increasing scale economies are seen to favour market rather than intra-firm organisation because an input supplier can aggregate various market demands rather than the demand of just one downstream firm. This analysis would appear to have at least two shortcomings. As mentioned in Chapter 3, within a transaction cost framework there is nothing stopping a downstream firm integrating backwards and producing for in-house and external use, hence exploiting scale economy benefits. But such a possibility is inhibited if the downstream firm lacks the requisite technical or market skills, which is clearly a non transaction cost factor. The second problem with Williamson’s treatment of scale economies is that just indicated when discussing quality problems and integration. The upstream scale economies exacerbate the contracting problems, i.e. the two sets of factors are not separable with the result that governance structure benefits are endogenous. This in turn indicates that it is inappropriate to claim a simple dominance of transaction cost reasoning. In short, economising on transaction costs cannot be the central explanation of vertical integration.2 VERTICAL INTEGRATION: ALTERNATIVE PERSPECTIVES A similar scepticism with regard to the power of transaction cost reasoning is displayed by Francis (1983). He points out that in the UK it is very rare to find a retailer that has integrated backwards into manufacturing, though it is not uncommon to find manufacturers who have integrated forward into retailing. This ‘striking asymmetry’ can be used as a framework to examine further perspectives on vertical integration. The retailing asymmetry may be explicable in transaction cost terms if from an upstream perspective manufacturerretailer relationships are characterised by high degrees of asset specificity, but from a down stream perspective the same relationships are characterised by low degrees of specificity, i.e. the manufacturers are locked-in but the retailers are not. No obvious locational economies would appear to exist, therefore we can discount ‘site’ specificity, thus we are left with human asset specificity as an explanation. But if, for example, learning-by-doing locks a manufacturer into a relationship with a retailer, it follows that the retailer is also lockedin because alternative suppliers are not readily available due to the learned behaviour. In short, lock-in is symmetrical (Williamson 1979:240, Silver 1984:ch. 9). This indicates a possible problem for transaction cost explanations of the retailing case. Two alternative suggestions are made by Francis (1983:112). 1 An explanation might involve ‘the high level of information retailers have about prices and quality of manufactured products and the fact that the relation between manufacturer and retailer rarely reduces to small-numbers exchange. Thus there is in the market relationship very little opportunity for opportunistic behaviour on the part of the manufacturers’. 2 The ‘primary reason for the manufacturers integrating forward into retailing often seems to be to create a situation of information impactedness on their side vis-à-vis the customer’.

Related integration and the firm 65 Turning to the first reason cited by Francis, one factor involved here would appear to be a transaction cost argument, i.e. the lack of small numbers exchange implying the relative efficiency of market-based exchange, but, as just argued, lock-in problems are symmetrical. One way of breaking this symmetry is to introduce monopoly power reasoning (see below, p. 74). But, in addition, alternative explanations are possible. Arrow (1975) has developed a model to account for vertical integration which is useful in this regard, because of the claimed high levels of information about prices and quality possessed by retailers. Arrow’s reasoning is based on downstream firms having limited information about the likely prices of inputs from upstream suppliers. In principle, however, equivalent reasoning would appear to be relevant for upstream firms having limited information about downstream conditions, a situation similar to that posited by Carlton (1979). This information asymmetry inhibits efficient production decisions, hence there is an incentive to integrate backwards (or forwards with equivalent reasoning) to make use of the more complete upstream information. Clearly, Arrow’s efficiency gains are based on production rather than contracting improvements—the latter have no place in the explanation. At the same time, however, it is difficult to understand, within Arrow’s framework, why vertical integration is necessary rather than a solution involving specialist firms selling information about supply conditions to buyers (or demand conditions to sellers). In short additional factors are required to explain the forward integration of manufacturers into retailing, and the lack of backward integration by retailers. The infeasibility of a market-based solution to Arrow’s problem may be based on one or more of three factors. First, is an argument consistent with transaction cost reasoning. Arrow (1962) points out the difficulties of trade in information because of ignorance of its content before its possession—information impactedness exists with resulting problems of opportunism. The second factor concerns the importance of corporate secrecy and information. Finally, information may be non separable from the skills base of a firm because of its tacit or idiosyncratic nature. It is clear that the second and third factors are related to benefit rather than cost considerations. Thus we can reiterate the conclusion drawn above that it is incorrect to claim a simple dominance of transaction cost reasoning when explaining vertical integration. Returning to the specific example used by Francis, it follows from the model suggested by Arrow that the integration characteristics of retailers and manufacturers may be explicable in terms of (in)adequacy of information, and production cost efficiencies, rather than transaction cost reasoning. But, in addition, Francis’ second reason, based on the development of monopoly with respect to final consumers, is relevant. In such circumstances intra-firm organisation facilitates pecuniary transfers, based on information impactedness, to the producer’s advantage, as discussed in Chapter 3. In addition, a similar, but more general, point is made by Francis. A firm that integrates backwards or forwards introduces the possibility of sole supply or use, with resulting monopoly gains, as is acknowledged by Williamson (1985) with his linking of vertical integration and the possibility of price discrimination. It is clear from discussion in previous chapters that such monopoly power cannot be described as a contracting efficiency gain with the implied mutual advantages. While Francis’ reasoning is valuable it is to some extent incomplete because it ignores insights from economic theory. Vernon and Graham (1971) show that a monopolistic incentive to integrate forward depends on the nature of production technology. With variable proportions technology it is possible for buying firms to substitute away from a monopo-

66  Transaction cost economics and beyond listically priced input, therefore (private) benefits, in terms of extra profits, will accrue if the monopolist integrates downstream. With fixed proportions technology such substitution possibilities do not exist. If the downstream industry is perfectly competitive profits are simply transferred upstream to the monopolist, with no advantage from integration. With a downstream monopoly final prices will fall with integration (Davies 1987, Waterson 1984). It follows that forward integration into retailing for market power reasons may be explained in terms of technical substitution possibilities by retailers as much as monopoly power in the final market. It is perhaps interesting to note that substitution will be inhibited with franchise dealing. More generally substitution possibilities will be a function of organisational characteristics. As discussed in the previous chapter the shift towards just-in-time and total quality management implies a reduction in substitution possibilities because of the development of firm specific skills. This may allow a concomitant shift away from integrated relationships that were previously required to realise rents from asset use. Franchising and contracting-out are elements of more general quasi-integration strategies, hence the issues involved here will be examined in detail in Chapter 7. To finish this discussion of vertical integration, reference can be made to the link between vertical integration and the creation or deepening of barriers to entry into a market (see Davies 1987) with potential monopolistic practices that this may introduce. A clear case in point is that of UK brewing companies and their use of ‘tied houses’. More generally, however, the link between vertical integration and entry barriers may be more subtle than just straightforward monopolistic behaviour. Richardson (1959, 1960) argues that entry barriers are one means of increasing the predictability of developments which is required if the future profitability of investments is to be assessed. This shifts the analysis of vertical integration away from a perspective that emphasises economising or optimising in current conditions and suggests that a more dynamic framework may be relevant. Richardson’s perspective can shed light on the retailing example which has been used to structure earlier discussion. Market relationships that are insulated, to some extent, from external shocks may not need the protection of entry barriers. Therefore relationships between retailers and suppliers that are locked-in may provide the necessary predictability to enable effective strategic planning. But potential contracting problems still exist, and it is in this context that the dominance of retailers is important. Thus monopoly power may have long-run (strategic) as well as short-run (profit) advantages. From an independent manufacturer’s perspective, predictability can be enhanced by product differentiation, but increasing competition, resulting in reduced dominance, would render vertical integration and/or franchising more effective options. These comments will be similarly taken up in more detail in Chapter 7 where quasi-integration is discussed. DIVERSIFICATION This section will examine the extension of the boundaries of the firm into new areas related to core production—distribution activities. The next chapter will examine unrelated, or conglomerate, development which is based on somewhat different transaction cost reasoning. The general theme will be as in the previous two sections: to examine, and then develop the influential contracting arguments.

Related integration and the firm 67 Related diversification involves developments that have supply-side and/ or demandside links to a firm’s current activities. As such, in theory and practice, there is much in common with the previous two sections’ discussions of vertical integration. Detailed repetition of an essentially similar argument will therefore be avoided. Transaction cost reasoning in this area is based on Teece’s (1980, 1982) work on the scope of the firm. This is a response to suggestions that multi-product activity can be explained in terms of economies of scope (Panzer and Willig 1975; Willig 1979). The latter argument is based on the view that intra-firm organisation evolves because the minimised cost of producing two or more outputs is less than the minimised cost of separate production. More formally, for two products q1, and q2: C(q1, q2)
68  Transaction cost economics and beyond It follows from the framework developed in Chapter 3 that a diversification decision, involving scope economies, can be described in the following way: first is the initial decision to use an asset in a new area, secondly is its subsequent recurrent use. The complexities of such a decision process are depicted in Figure 5.1. The notation used here is the same as that introduced in Chapter 3: Bm and Bf being respectively the benefits derivable from market and intra-firm resource allocation, Cm and Cf being the corresponding transaction and organisation costs. The initial decision involves consideration of the extent to which a scope economy can be best exploited directly or indirectly. Direct use of assets will occur with Bf>Bm, use of markets, simplified here to leasing, will be the preferred option with the inequality reversed. The relative sizes of Bf and Bm will be a function of two factors: first, the actual and prospective skills of a company and the extent to which these can support idiosyncratic advantage; and secondly, the ability to maintain control over production—distribution and hence extract monopoly rents. To be consistent with the principle of a potential scope economy only the first of these factors is strictly relevant. Inclusion of the second factor implies that the more general concept of a potential ‘synergy’ must be used. To simplify presentation examination of the second factor (extra revenues from internal organisation) will, apart from a few comments, be postponed to the next chapter.

Figure 5.1 The diversification decision Once the initial decision is made, management (transaction and organisation) costs will be incurred with recurrent asset use. Figure 5.1 indicates the possibilities involved. Starting with Bm>Bf, the precise management of the leasing will depend on the relative costs of managing resource allocation either in-house or using markets. With Cf>Cm the transaction cost advantages of markets reinforce the benefits involved, hence management of the leasing is contracted to a separate company. In this situation the firm, in effect, acts in a rentier capacity, which is likely to be the case when asset specificity and small numbers trading are not evident; a simple example might involve the management of surplus office accommodation being handed over to a specialist agency. With Cm>Cf, however, the leasing

Related integration and the firm 69 will be most effectively managed in-house, which implies that the company will become a conglomerate, assuming that the core activity is not already leasing. The reason for this can be explained in terms of Figure 5.2; but note that no suggestion is being made here of a generalised explanation of conglomerate development, which will be examined in its own right in the next chapter. The cost and benefit curves indicate that Bm>Bf and Cm>Cf.3 The option of in-house management of leasing allows a company to extract net benefits of Bm−Cf which are clearly larger than any other mode of organisation. An example of this reasoning might involve a company that does not possess the requisite skills to effectively exploit a scope economy directly, or no secrecy advantages exist, therefore Bm>Bf. In addition, a scale issue may also exist which can render in-house investment in assets unviable. The possible high unit costs reflect Adam Smith’s (1910) dictum that economies are limited by the size of a market, which we can ‘update’ to encompass either the early stages of a life-cycle or limited expansion in an existing market.4 An example is a firm that can make greater use of a developed technology by application in an area different to that already exploited, but relevant marketing and distribution skills and channels might not exist. An obvious means of profitable use of the e technology, however, is by leasing.5 But potential contracting problems might be

Figure 5.2 Diversification and in-house leasing apparent because of the ‘physical’ asset specificity involved (as described earlier in this chapter), i.e. Cm>Cf. Leasing arrangements based on a rentier relationship with an independent firm would involve inevitable information asymmetries and small numbers trading, with attendant negotiating and policing costs.Hence in-house management of leasing is more efficient and we return to the conclusion that effective exploitation of the scope economy involves the firm becoming a conglomerate. Organisational evolution might result in one of two possible developments occurring. First, recurrent use of leasing arrange-

70  Transaction cost economics and beyond ments may reinforce this governance structure not only for transaction cost reasons but also because of the development of a body of expertise in this area. Secondly, if high unit cost disadvantages underlie the in-house management of leasing an increase market presence might result in Bf becoming greater than Bm. A situation of this sort was described in Chapter 3 (Figure 3.7)—intersecting benefit curves imply a ‘critical mass’ of organisational activity to render in-house use the most preferred option. Returning to Figure 5.1 we can now trace the governance structures appropriate with Bf>Bm. With Cm>Cf, recurrent asset use will reinforce the initial decision, hence in-house related diversification will occur. This is the case emphasised by Teece (1980, 1982) when he links market failure and tacit organisational knowledge to explain diversification. The

Figure 5.3 Diversification: further complexities bargaining (transaction cost) problems arise because of inevitable small numbers relationships and haggling over prospective performance. Finally we can turn to the case of Bf>Bm and Cf>Cm. Here the analysis is more complex, with predictions being less clear cut, hence the question marks in Figure 5.1. Initially we can follow the same logic as for the conglomerate case just discussed except that the configuration of the curves will be as in Figure 5.3. Bf>Bm implies advantages of long-term, in-house relationships resulting from either skills and/or control benefits. On the other hand Cf>Cm implies contracting gains from short-term, market relationships because of limited bounded rationality problems, generalised assets and hence potentially large numbers trading, and infrequent use. Clearly in terms of skill or expertise factors the benefit and cost configurations are inconsistent. Hence governance structures relevant to Figure 5.3 might revolve around secrecy advantages of collusion. But sharing monopoly benefits of scope economies would appear to be an unlikely possibility

Related integration and the firm 71 because the small numbers necessary for collusive arrangements is inconsistent with the potentially large numbers available. It follows that analysis of an initial Bf>Bm with recurrent Cf>Cm must be based on the sign of the more complex expression: (Bf−Bm)−(Cf−Cm)

(5.1)

or equivalently: (Bf−Cf)−(Bm−Cm)

(5.2)

A rational choice for in-house activity requires that these expressions are greater than zero. This will occur when comparative benefit effects in 5.1, or net benefits of intra-firm organisation in 5.2, dominate, with the reverse being the case for less than zero. The positive result is perhaps the most interesting because it implies a governance structure opposite to that predicted by transaction cost reasoning. Rather than discuss this possibility here detailed consideration will be undertaken in the next chapter when discussing the specific case of multinational companies. Up to now in this section the logic of transaction cost explanations of related diversification have been examined. This discussion has been valuable, in particular in two respects: first, the ambiguity of market, rather than in-house, exploitation of scope economies, has been detailed; secondly, predictions opposite to those suggested by contracting logic have been derived. On the other hand, this discussion has not been informed by more applied investigations of diversification, a matter that will now be rectified in the final part of this section. The formal econometric evidence is clear on one point: that a significant positive relationship exists between diversification and research and development activity in US and UK manufacturing industry (Gort 1962, Amey 1964, Gorecki 1975, Grant 1977, Wolf 1977). While these results are consistent with earlier theoretical discussion this general correlation cannot be used to separate cost and benefit effects. The more detailed analysis of UK manufacturing industry undertaken by Gorecki (1975), however, may be useful in this respect. Dummy variables are included to divide the overall relationship between research intensity and diversification into separate consumer and non-consumer goods industry effects. The evidence suggests that the overall relationship is overwhelmingly dominated by research activity in consumer goods industries alone. In interpreting this result we should keep in mind that Gorecki’s study covers the UK, hence the results may be to some extent unique to this country. We will ignore the possibility that non-consumer goods manufacturing industries have an inherent propensity not to undertake research activity, and hence have limited scope economy opportunities. It follows that the differential propensity to diversify can be because of benefit and/or cost considerations, as just discussed. It is difficult to understand why transaction costs of exploiting scope economies are likely to be greater in consumer as compared to non-consumer industries. There are no a priori reasons to suggest consis

72  Transaction cost economics and beyond tently different degrees of asset specificity with resulting lock-in problems. Similarly, on the benefit side, there are no reasons to suggest a consistently differential impact of skill idiosyncrasy. We are thus left with the possibility of power or dominance as a benefit explanation. For equivalent reasons to those discussed earlier with regard to vertical integration, the importance of dominance is likely to be greater for consumer goods manufacturers because of information asymmetries. It is to be expected that such asymmetries will be less evident in non-consumer industries. In terms of Figure 5.1 this conclusion suggests that UK consumer goods manufacturers are channelled along Bf>Bm: Cm>Cf, whereas perhaps non-consumer industries tend to use Bm>Bf: Cm>Cf.6 Impressionistic support for this conclusion being, at least to some extent, applicable in the US as well as the UK is found in Rhoades (1973). This econometric analysis of US manufacturing industries in 1963 indicated a general positive relationship between diversification and industry price-cost margins, and in addition a statistically significant dummy indicating higher profitability in consumer rather than producer goods industries.7,8 Further evidence, consistent with this thesis, is presented by Prahalad and Hamel (1990). They compare the practices of leading Japanese and Western companies, analysing the comparative disadvantages of the latter in terms of differing perceptions of gaining and maintaining competitive dominance. Western companies are characteristically conceived as a portfolio of autonomous businesses which fails to exploit underlying ‘core competencies’, i.e. scope economies. Consequently, long-run advantage is impossible to maintain in the face of Japanese competition. Transaction cost economics, with its focus on economising behaviour, cannot accommodate these dynamics of corporate development and hence is an inadequate explanation of the diversification processes involved. This perspective offered by Prahalad and Hamel is consistent with other theorists who emphasise the supersession of ‘Fordist’ practices (based on exploiting scale economies and the use of rigid hierarchies) and the increasing dominance of competitive advantage based on developing scope economies.9 To some extent, however, these recent contributions from management, economic and other theorists do no more than echo earlier contributions, such as Penrose (1959), Ansoff (1965) and Thompson (1967), who suggest, in their different ways, that the successful shifting of organisational boundaries involves exploiting developed skills and competencies. Or in terms of the framework used in this chapter, explaining related diversification in terms of benefit rather than cost factors. SUMMARY This chapter has discussed vertical integration and related diversification and the extent to which transaction cost economics presents coherent analyses of these areas. It has been suggested that: 1 Transaction costs cannot provide a uniquely dominant explanation of vertical integration and related diversification. 2 Important elements in a more general theory are idiosyncratic skill acquisition and the centrality of economic power.

Related integration and the firm 73 3 Skills and power are not simple additions to transaction cost reasoning but transform the nature of contracting problems. 4 The narrow emphasis on economising behaviour fails to recognise important dynamic (strategic) non-transaction cost factors. 5 The empirical evidence presented is consistent with 1–4.

6 UNRELATED INTEGRATION AND THE FIRM This chapter will continue the analysis of integration but shift emphasis to unrelated diversification and multinational development. Transaction cost contributions in these areas are different from the subject matter discussed in Chapter 5, hence their separate development. The discussion is organised as follows. First Oliver Williamson’s arguments accounting for conglomerate development will be introduced and assessed. To anticipate this analysis it can be pointed out that the main conclusions drawn are critical of transaction cost reasoning in this area; alternative, non-contracting perspectives are stressed. Following this the chapter will turn to multinational development. The objectives here are twofold. First to introduce transaction cost formulations in this area, and secondly on the basis of this discussion to fill gaps left in earlier analysis, particularly that of the previous chapter. CONGLOMERATE DEVELOPMENT Oliver Williamson’s (1975, 1981) account of the development of conglomerate activity revolves around his discussion of the internal organisation of firms. This latter topic will be discussed in detail in Part III of this work, hence only a partial exposition is necessary here. The multidivisional (M-form) organisation was first introduced in the early part of this century (see Chandler 1962) with general diffusion occurring, at least in the AngloSaxon world post-1945. The central principle involved with the M-form is that a division of labour is developed between a company’s head office and semiautonomous divisions, usually organised around product or geography. Head office responsibilities should, according to Williamson (1985:284), be the following: (1) the identification of separable economic activities within the firm; (2) according quasi-autonomous standing (usually of a profit centre nature) to each; (3) monitoring the efficiency performance of each division; (4) awarding incentives; (5) allocating cash flows to high-yield uses; and (6) performing strategic planning (diversification, acquisition, divestiture, and related activities) in other respects. The link between the M-form company and conglomerate activity involves the establishment of an internal capital market. The allocation of finance to different specialised firms using an external capital market will involve inevitable transaction costs because of information search and performance monitoring activities. These costs will be non-trivial not least because of commercial secrecy. Consequently, argues Williamson, the allocation of financial resources to different activities (divisions) within a firm will have transaction cost advantages for the following reasons: 1 The quantity and quality of information available to the head office will be greater than for any external agent because of the internal availability of detailed reports and audits. 2 Problems of commercial secrecy will not be present.

Unrelated integration and the firm 75 3 Inter-divisional competition for investment funds allocated by the head office will improve allocative efficiency. 4 Middle management opportunism is reduced because of the separation between strategic and operational decisions. In short, internalisation within an M-form conglomerate, it is argued, is likely to have two advantages over market-based resource allocation: first, economising on transaction costs of capital markets; secondly, the minimising of managerial activity that detracts from shareholder wealth; both advantages are likely to occur with diminishing effect as firm size increases. This chapter will concentrate on the first of these claims, the second will be examined in detail in Part III below, particularly Chapter 9. This Williamsonian thesis may appear to gain empirical support from a number of studies into the relationship between the M-form structure and profitability. In the USA and UK, superior performance and the M-form appear to be related (Armour and Teece 1978; Teece 1981; Steer and Cable 1978; Thompson 1981; Hill 1985a, b). But this, in itself, is not a real test of the internal capital market hypothesis, or related to this, the profit maximising attributes of the M-form. Many studies point out the difference between a divisionalised firm and the M-form proper (for example, Williamson and Bhargava 1972; Hill 1985a, b). The M-form can be said to exist when the corporate centre undertakes the six functions mentioned above, on the other hand, a divisionalised firm has a central office that is either underdeveloped, or becomes over-involved in divisional matters. Either possibility implies that the firm does not operate simply as an internal capital market. Hill (1985a, b) and Hill and Pickering (1986a) argue that it is quite difficult to attain the necessary balance of central office responsibilities for the M-form to exist. Hill and Pickering’s (1986b) study of 12 UK conglomerates concludes that central office over- and under-involvement is as common as the M-form proper. Finally, we can cite the study of Scapens and Sale (1981) who found that in US and UK firms divisional capital expenditure depended less on simple financial return and more on projects nesting into central office objectives. Studies such as those just cited do not, of themselves, imply any necessity to question the Williamsonian internal capital market thesis. It is possible that corporate performance would have been enhanced if the M-form proper had been attained, rather than a corrupt alternative, with the incremental profitability being the result of transaction/organisation cost savings, as concluded by, for example Hill and Pickering (1986a) and Stephen and Thompson (1988). An alternative hypothesis, however, is that the Williamsonian analysis misspecifies the nature of the organisational problem. There may be positive reasons why central office over- or under-involvement is as common as the M-form. Organisational, rather than economic, analyses of (de)centralisation (for example Brooke and Remmers 1970, Lawrence and Lorsch 1967, Lorsch and Allen 1973, Mintzberg 1979, 1991, Woodward 1980) stress the way that appropriate corporate structuring responds to (1) environmental contingencies, and (2) organisational culture (of which more in Part III below). From such a perspective the M-form, rather than general divisionalisation, may be a unique solution to a unique set of circumstances. In which case the internal capital market may not be a general theory of conglomerate development. Investigation of these suggestions requires further discussion.

76  Transaction cost economics and beyond Kay (1992) questions the basis of the Williamsonian analysis of the conglomerate. He gives a simple example that can be explained in terms of nine specialised firms existing in three industries, as illustrated in Figure 6.1. The Williamsonian logic, as just described, is that transaction cost savings will result in the grouping of firms as shown by the lines. But Kay points out the arbitrary nature of this suggestion. Why should firms combine to form conglomerates rather than, for example, broadly specialised combinations, involving vertical rather than horizontal links? If the processes involved are stochastic, transaction cost economising is not a theory of conglomerate development per se, rather just of internalisation. But the processes involved need not be random because, as is clear from previous chapters specific advantages are likely to be evident from linking similar activities. Informational economies may exist or economies of scope may be evident. Hence while transaction cost savings, because of internal capital markets, may be generally available, specialisation or related diversification is likely to involve greater benefits of internal resource allocation (Kay 1988). Evidence that supports this line of argument, at least at a superficial level, is provided by Cable (1980). He used a 67 industry classification of UK manufacturing and found that more than half of all possible pairs of industries were not linked via any known M-form firm’s divisions; that over one-third were linked in this way by only one or two firms; the residual, less than 10 per cent of cases, linked industries by three or more separate M-form firms. In short, internal capital markets were found to be of limited significance

Figure 6.1 Vertical and horizontal internalisation for inter-industry allocation of capital. This line of argument takes us to Chandler’s (1977) view that the M-form developed because of organisational problems created by diversifying within a functional/U-form structure, i.e. the causation runs from strategy to structure (see Clegg 1990). From this perspective the diversification occurs because of, what are called here, the benefits of internal organisation with excessive organisational costs with the U-form acting as a block to their development. Internal capital markets have no obvious role in this explanation. An additional reason why transaction cost economising may not be a random process is because of government activity. It is common to examine the different experiences of the USA and UK in these terms. US anti-trust legislation is strict, in particular following the Celler—Kefauver Act of 1950. Consequently while vertical and horizontal mergers, which were most likely to be subject to anti-trust action, declined in importance throughout the post-1950 period, conglomerate mergers accounted for an increasing proportion of

Unrelated integration and the firm 77 the total. For 1948–53 and 1973–77 pure conglomerate mergers accounted for respectively 3.2 per cent and 49.2 per cent of large manufacturing and mining company assets acquired by merger in the US (Scherer 1980). It is hardly surprising, therefore that conglomerates are a characteristic feature of the US economy. In the UK, on the other hand, controls on horizontal or large mergers were only introduced with the 1965 Monopolies and Mergers Act and are much weaker than in the US. Consequently, for the period 1965–83 72 per cent of assets acquired by merger were horizontal, with 23 per cent being conglomerate (Clarke 1985). While the latter category became more important after 1970, this did not displace the overwhelming dominance of horizontal combinations. If the USA and UK economies are comparable in other respects (of which more will be said below), apart from anti-trust policy, it follows from the evidence just presented that significant conglomerate development has resulted from the effects of government activity rather than more narrowly defined economic processes. This conclusion does not question the underlying rationale of transaction cost economising and the development of internal capital markets, just any automatic and necessary link with conglomerate development. But it is possible to go one step further by questioning this underlying rationale. Cable (1988) highlights a series of qualifications and counterarguments to Williamson’s analysis of the M-form organisation. Of relevance here, rather than to later discussion, are the following. 1 It is possible to argue that the external capital market is in a better position to exert continuous, rather than discrete, corrective pressure. The exit of marginal shareholders can provide a straightforward signal, in terms of a reduction in share price. But for a corporate general office, exit is a drastic sanction. 2 Conglomerate development implies a transformation of autonomous companies into M-form divisions. An implication of this is that independent financial reporting is lost to the external market, and hence the investment scope of the market is reduced. It follows that analysis of internalisation is more complex than simply positing a shift of a transaction from external to internal capital markets, with no further elaboration of the secondary effects of such a shift. 3 The supposed superior transaction cost properties of the M-form are presented as improvements on what the external capital market can achieve. Hence the extent of conglomerate development is a function of the degree of external capital market failure. The first two points imply that internal and external resource allocation should not be rigidly dichotomised—a point developed below with regard to shareholder-company relationships and in particular in the next chapter in which quasi-integration is discussed. The implications of the third point can be developed by examining the problems of managing ‘cash cows’. Williamson’s (1985:288) comment is a useful introduction: The conglomerates in which M-form principles of organization are respected are usefully thought of as internal capital markets whereby cash flows from diverse sources are concentrated and directed to high-yield uses.

78  Transaction cost economics and beyond It follows that divisions that generate cash but have relatively low development costs because of the maturity of markets, frequently referred to as ‘cash cows’ in the management literature, should finance other divisions with high development costs and limited cash flow generation. But as Thompson (1988a) points out this is by no means a straightforward activity because of the motivation of management in cash cow divisions. It is therefore, perhaps, not surprising that Jensen (1987) argues, on the basis of US evidence, that much of the market for corporate control in the 1980s has concentrated on trade in cash flow generating activities. Similarly, management buyouts in the UK are concentrated in cash generating divisions (Thompson 1988b). Thompson (1988a: 83) concludes: This [ownership change] activity, which incurs all the costs associated with control changes, constitutes at least prima-facie evidence that M-forms find it difficult to devise suitable incentives for cash cow management. An implication of this conclusion is that the relative advantages of internal rather than external capital markets are likely to decline as the diversity of divisional net cash flow generation increases.1 This decline is due to managerial motivation problems, i.e. rising organisation costs, problems that are unlikely to exist with an external capital market. It follows that an internal capital market will function effectively if the variance of net cash flow generation across divisions is low because in such circumstances intra-divisional shifting of resources is relatively unimportant. This marginalises the appropriateness of the Williamsonian internal capital market hypothesis to those conditions that are economically relatively uninteresting. At its strongest it is perhaps possible to claim that the Williamsonian conglomerate can only avoid rising organisation costs by the central office not undertaking the internal capital market role that, in theory, is required. There is always the possibility, however, that conglomerate development is not based on transaction cost reasoning.2 CONGLOMERATE DEVELOPMENT: ALTERNATIVE ­PERSPECTIVES Various non-transaction cost accounts of conglomerate development exist in the economics literature that can be unified using the framework developed in Part I of this work. An obvious set of explanations follow from the analysis presented in Chapter 5. In addition to the example of in-house management of an externally used asset, there is the more general possibility that conglomerate development may be based on exploiting scope economies such as financial or portfolio management skills. But while this involves unrelated diversification if the benchmark is taken as production—distribution characteristics, the various parts of such a diversified company are related through the underlying skills. Somewhat different is an explanation of conglomerate development by Kay (1984). He suggests that unrelated diversification may be undertaken to minimise intra-firm linkages so as to isolate economic shocks in those parts of the firm directly affected and thus control the systemic implications of environmental change. From this perspective, there is no reason why profitability and conglomerate activity should be related, hence this hypothesis is consistent with the lack of any clear relationship between conglomerate mergers and improved performance, to be discussed shortly. More pertinently perhaps, the Kay thesis

Unrelated integration and the firm 79 can explain the earlier cited under-involvement of corporate head office activity, compared to a Williamsonian benchmark, because direct intra-firm resource allocation is not part of the rationale for diversification. A different strand in the conglomerate literature links diversification to more narrowly defined private interests. For example, Steiner (1975) stresses anti-trust implications in terms of reciprocity and the suppression of potential competition. It is clear that such practices represent monopolistic motives for internal organisation, the possibility of which was sketched out in Part I and Chapter 5.3 Reciprocity can cover two main practices: reciprocal dealing and spheres of influence. Reciprocal dealing involves firms agreeing to purchase their respective outputs, a practice that obviously has greater potential between conglomerates (Clarke 1985). Scherer (1980) shows that reciprocity is widespread in the US, and while not necessarily being evidence of monopolistic abuse, the potential is clearly present. The idea of spheres of influence (originating from Edwards (1955) and on an international scale Hymer (1960)) is that conglomerates will ‘respect’ the various product-market positions of potential competitors. Scherer (1980) gives examples in banking, the international merchant-marine industry, and the inter-war chemical industry; the latter involving Farben of Germany, ICI of England, and Du Pont of the US. The possibility of developing effective spheres of influence depends on limiting new firm entry, i.e. the suppression of potential competition. Obviously such activity is facilitated within diversified firms by the possibility of cross-subsidisation. Clarke (1985) cites the following UK examples: the British Match Company, the British Oxygen Company, and the cases of metal containers and electrical equipment for mechanically propelled land vehicles. It appears, therefore, that internal organisation, and in particular conglomerate development, may be based on benefits derivable from monopolistic power. At the same time, however, the ways in which conglomerate activity can facilitate new entry should be recognised. In particular, absorbing initial losses and raising capital will be easier (Clarke 1985). In addition, Williamson (1975) emphasises the way in which decentralised organisational practices can inhibit the central co-ordination necessary for any conglomerate to effectively exploit potential monopoly power. From a different perspective, it could be argued that the potential importance of power effects may be a factor explaining the findings, discussed earlier, that so-called over-involvement by central office in divisional affairs is not uncommon. A second strand of the conglomerate literature, emphasising a link with private interests, involves managerial motives for diversification. Of central importance here is the work of Harris (1964) along with Mueller (for example 1987) and Marris and Mueller (1980). It is argued that managers will pursue growth maximising strategies, for their own prestige, security, etc., including conglomerate acquisitions, at the expense of shareholders’ interests. A similar idea is suggested by Amihud and Lev (1981) and Marcus (1982) except in this case the emphasis is on managerial attitudes to risk. Evidence appears to be available in support of this managerial hypothesis. Amihud and Lev’s (1981) investigation of US industry covers the period 1961–70 and involves 309 conglomerate acquisitions. Their results indicate a statistically significant diminishing propensity to undertake conglomerate acquisitions from manager through to owner control. Evidence consistent with this conclusion is available for the UK. Meeks’ (1977) study of 233 large UK firms involved in more than 1,000 mergers during the period 1964–72 concluded

80  Transaction cost economics and beyond that, on average, merger activity resulted in modest declines in profitability, a conclusion consistent with that found by Cowling et al. (1980). In an extensive international study, Mueller (1980) concludes that European companies either experienced marginal declines in profitability following merger (France, Holland, Sweden), or slight increases (Belgium, FDR, UK), in the USA there was no significant change in profitability following merger. But, in addition, Belgian, FDR and UK companies did not experience any relative increase in sales following merger, which would have been expected if profitability increases had resulted from improved efficiency. Hence Mueller explains the improved performance in terms of market power effects. Finally, the study by Ravenscroft and Scherer (1986) can be cited. Their data covered the period 1950 to 1977 for approximately 6,000 lines of business. Among other things they conclude that acquired companies are more profitable than equivalent non-acquired firms, and that profitability declines post acquisition. This evidence is consistent with an explanation of diversification in terms of the dominance of managerial interests, and to a lesser extent monopoly power. To some extent this conclusion is useful in that it suggests it is inappropriate to invoke an a priori assumption of optimal, in some sense, corporate behaviour. We can thus criticise Williamson’s (1975) linking of the M-form to profit maximising activity, to be discussed in detail in Chapter 8. As introduced in earlier chapters, Williamson ignores the possibility of senior management opportunism. But this rejection of an abstract optimality begs the question how the behaviour involved is to be conceptualised, a brief discussion of which is warranted here. Senior management opportunism has been developed in terms of alternative theories of the firm that stress the dominance of managerial objectives (Baumol 1959; Williamson 1964; Marris 1964). But, a series of reasons cast doubt on the appropriateness of this approach. First, behaviour is still understood in maximising terms which is (for present purposes) inconsistent with bounded rationality. Secondly, analysing behaviour in terms of deviations from an abstract optimality is contingent upon the existence of financial and product market ‘inefficiencies’. An obvious development that is relevant here concerns the rise of institutional shareholders (pension funds, insurance companies, unit trusts and the like). In the early 1950s, such institutions owned 18 per cent of shares in the UK (Sawyer 1985); by 1990 this had risen to 80 per cent (CBI 1990). Concomitantly the importance of individual share holdings has declined. If the possibilities of senior management opportunism rely on relative shareholder powerlessness, the extra resources and information usable by institutions will result in the diminution of management power (Nyman and Silbertson 1978). In addition to the increased importance of institutional shareholders we must also recognise that organisational control can be based on a small proportion of total shares (1–2 per cent) depending on the dispersion of holdings (Cubbin and Leach 1983). In addition, senior management are themselves usually shareholders (Sawyer 1985). These comments imply that while a necessary assumption of organisational optimality is unwarranted it would also appear incorrect to suggest an analysis based on a dominance of (quasi) autonomous managerial motives. A useful way to proceed is to follow Aaranovitch and Sawyer (1975) and distinguish between ‘outsiders’ and ‘insiders’. The former seek no controlling activity, the latter are identified with internal control over strategic decisions. This distinction is useful because it facilitates the development of an institutional or organisational, rather than reified, perspective on owner-company relationships and in turn the analysis of diversification.

Unrelated integration and the firm 81 Rather schematically we can distinguish between ‘small’ and ‘large’ external owners. Small external owners are likely to have little knowledge and influence but because of the size of their holdings they can be traded with no effect on stock market conditions; in short there is minimal financial asset specificity. In addition, if more than a rentier relationship with a company is desired, co-operative influence is inhibited by excessive transaction costs of organising diverse small holdings. Large external owners, that we can identify with financial institutions, will have significant knowledge and influence, and because of the size of share holdings, significant asset specificity is likely to exist in the sense that short-term non-marginal buying and selling will influence market conditions. It follows from an orthodox transaction cost analysis that large external owners should develop close, long-term relationships with the companies concerned (Dimsdale 1991). The advantages involved are indicated by the experiences of Germany (Cable 1985; Cable and Dirrheimer 1983) and Japan (Cable and Yasuki 1985). In both these countries the banking system creates what has been called a ‘quasi-internal capital market’ (Cable 1988). As with any quasi-integration strategy, as discussed in the next chapter, financial institutions require long-term co-operation to facilitate the development of dynamic gains rather than shortterm economising (Kay, J. 1991). In the UK and US, however, the tradition is of a general non-involvement in company affairs by large external owners with a resulting short-term reactive focus (Dimsdale 1991, Porter 1992). Obviously the power of external owners depends on the extent to which firms rely on external capital markets (Stephen and Thompson 1988). In this regard it would appear to be important to distinguish between take-over activity and the raising of finance for capital investment. With regard to the latter, the Bank of England has estimated that in the UK at most 25 per cent of new capital expenditure is financed by new debt issues; other studies put the figure as low as 10 per cent (see Stephen and Thompson 1988). Thus the capital market would not seem to be able to constrain managerial discretion over investment decisions. On the other hand, however, as Williamson (1975) argues the M-form can intensify competition in terms of take-overs. But as Cable (1988) argues this could have the result of inducing short-term, risk averse managerial behaviour, which is perhaps only possible because of the autonomy of management in the field of fixed investment. Note that this behaviour need not involve conscious opportunism in the sense of trying to gain advantage over another party. The complexity of entrepreneurial and managerial activities implies that individual perceptions of appropriate behaviour will be determined, or channelled, by particular institutional conditions rather than fully specified cost-benefit analysis (see Demirag and Tylecote 1992). Hence large ‘outsiders’ will perceive their role in terms of financial asset management, which need not be the same perspective as that of ‘inside’ interests. It follows from this analysis that the M-form and the gains derivable from diversification, are institutionally specific. In addition, these different institutional arrangements will embody different incentive systems. It is because of this institutional specificity that there is no contradiction between suggesting differing short- and long-run perspectives (with the implication that the latter offers greater dynamic gains) and recognising the insights gained from the ‘efficient market hypothesis’. Institutional arrangements define local optima which determine the general nature of governance structure benefits, as discussed below in Part III. For the moment we can conclude this section by suggesting that the analysis of diversification is more complex than generalisations from institutionally specific analysis.

82  Transaction cost economics and beyond MULTINATIONAL DEVELOPMENT This section will complete the discussion of integration and the firm by examining the transaction cost literature developed to analyse multinational corporations (MNCs). It should be emphasised that this discussion is not of MNCs per se, but rather centres on the internalisation arguments, arguably the most dominant (Kay 1983), that have been developed somewhat independently of the Williamsonian tradition. These arguments complement and develop the general approach adopted in this work.4 Two general issues will be examined: first, internalisation, hierarchy and decentralisation; and secondly, the stress placed on proprietary knowledge, which in turn will lead into a series of related matters. This discussion will concentrate on the development of horizontal intra-firm links. Apart from the case of final markets and marketing, which is examined in this section, the treatment of vertical links within MNCs adds very little, conceptually, to the discussion presented in Chapter 5. Buckley (1983, 1988) draws a distinction between the application of transaction cost analysis in the study of MNCs (internalisation) and that developed by Williamson (markets and hierarchies). Internalisation need not imply hierarchy, particularly if foreign subsidiary managers have better knowledge of local conditions. This observation is useful, particularly in terms of an explanation of central office under-involvement in subsidiary affairs, compared to a Williamsonian internal capital market benchmark as discussed earlier. At the same time, however, breaking the link between internalisation and hierarchy presents a number of problems. Buckley suggests that organisation costs can be reduced by the use of a decentralised system of shadow prices. Subsidiary (profit centre) managers will respond to such prices to further central office objectives. Clearly, conceptualising internal organisation as a constrained optimisation problem in this way meshes into the economising approach characteristic of transaction cost economics. But, as Hennart (1991) points out measurement problems and interdependencies limit the use of internal prices as a control mechanism. Measurement problems are clearly just a manifestation of bounded rationality, without which transaction costs cannot exist. So suggesting that local managers have better knowledge of local conditions may prevent a shadow price system operating effectively. The existence of interdependencies implies that intra-firm resource allocation need not be characterised by gross substitutability,5 a necessary condition for decentralised allocation systems to operate (Heal 1973). If intra-firm, multinational operations build on the competitive advantage gained from idiosyncratic knowledge (see below), organisational interdependencies cannot be ruled out. In addition to these points which question the appropriateness of an internal market for intra-firm resource allocation we should also note the parallel between Buckley’s use of a shadow price system and the theory of economic planning (Hennart 1986). This parallel is of more than academic interest because of the latter’s analysis of the nature of decentralised systems (see Dietrich 1985). Ellman (1968) provides a three-way classification of planning systems: perfect centralisation, where all decisions are made at the centre; perfect indirect centralisation, where all decisions are made by individuals and firms but these decisions are those that would have been made by central authorities because the latter control

Unrelated integration and the firm 83 decision rules and parameters; perfect decentralisation, where all decisions are made by individuals and firms independently of what central authorities wish. It follows that Buckley’s system is not decentralised but rather indirectly centralised and therefore hierarchical. In addition, planning theory draws a distinction between decentralisation based on locus of authority and information structure (Heal 1973). Thus even though the generation and use of information may be decentralised the locus of authority need not be, and in the case of MNCs is not if effective strategic management is undertaken. Finally, the orthodox basis of Buckley’s intra-firm allocation can be highlighted. Being based on short-run optimising behaviour any notion of strategic change and dynamic advantage, of central importance to MNCs as is discussed shortly, cannot be incorporated. In short Buckley’s suggestion that internalisation need not involve hierarchy is useful as a counter to the Williamsonian tradition, but the formulation of the issues is somewhat problematic. We can now turn to the second general theme to be examined in this section: the importance of proprietary knowledge to internalisation arguments. This is a unifying characteristic of the application of transaction cost theory to MNCs (Buckley and Casson 1976; Casson 1979; Caves 1982; Magee 1977; Rugman 1981; Teece 1981), and is usually understood in a very broad sense to include technical, marketing and managerial know-how (Casson 1987). The emphasis placed on this one factor is based as much on an attempt to understand the stylised facts of MNC development (Casson 1987) as a priori reasoning which is characteristic of the Williamsonian tradition. The emphasis on such knowledge may be consistent with a general contracting framework based on bounded rationality, asset specificity, and opportunism, because as discussed in Chapter 2, information asymmetries exist in markets for knowledge which exacerbate contracting problems. On the other hand, the two approaches need not be consistent, as is discussed below, particularly with regard to the role of monopoly power and asset non-specificities (Kay 1992). A simple example involving proprietary knowledge might be a firm that has a competitive advantage based on technical know-how. This advantage can be exploited in nondomestic markets by either selling/renting its use to local firms (franchising, licensing) or by integrating horizontally overseas. The market-based solution6 will become progressively less profitable as search, negotiation and policing costs increase. According to Buckley and Casson (1976) and Casson (1979) the seller of the information will absorb the transaction costs because of the centrality of buyer uncertainty. To allay buyer suspicions about the quality of information being traded, a higher return on imported technology is demanded. This implies a lower price on the part of the seller, hence licensing becomes less profitable than foreign investment. While this transaction cost argument would appear to be correct in a logical sense, it is clear from the framework being used in this work that it is based on partial reasoning. Citing the importance of proprietary knowledge would seem to be equivalent to stressing the centrality of idiosyncratic skills. Hence benefit considerations, in terms of differential abilities to use resources profitably, cannot be ignored. This point is made by Cantwell (1991:47) the benefits of internalization tend to be greater where each participating affiliate begins with strong ownership advantages, owing to the potential for economies of scope, technological complementarities, and so forth… The need for ownership

84  Transaction cost economics and beyond advantages applies to both national firms and MNCs, although it is especially true of MNCs, since inefficient firms may be able to survive longer in their own domestic markets. In addition Cantwell (1991:49) claims Internalization thus offers a theory of the firm or the extent of the firm rather than its growth; except in as much as any static theory can be made dynamic by referring to changes in levels… Even when considering oligopolistic interdependence in the form of an exchange of threats, Casson (1987) assumes constant long-run market shares, or in other words fixed and exogenous ownership advantages. These views reflect the same criticisms of transaction cost economics being developed in this work. It is therefore, perhaps, hardly surprising that Cantwell (1991:54) suggests a broadening of the internalisation framework to accommodate an active role for managerial strategy rather than viewing the firm as a passive reactor to exogenous circumstances, the same point being made in Chapter 3 above. A second theme that is frequently stressed when discussing proprietary knowledge and MNC development is to link the discussion to different means of benefiting from resulting monopoly positions. Arguments based on monopoly power have a long tradition in the MNC literature, dating from Hymer (1960).7 This first contribution stressed multinational development as a vehicle through which collusion, and thus joint profit maximisation, can be organised. But as Casson (1985) points out, merger between firms existing in different national markets is only one means of suppressing competition, it is also possible for firms to organise a market-sharing agreement or to form a cartel. A cartel has transaction cost advantages over an arms-length agreement because the tangible organisation means that there is no need to renegotiate contracts as if new when conditions change. On the other hand, however, cartel members have an incentive to cheat or free-ride. Ignoring legal prohibition or restriction the policing of agreements will be more straightforward, and hence cartels stronger, in those industries characterised by, among other things, undifferentiated products, with slow growth and little technological change. In other circumstances, involving for example differentiated products and significant technological change, transaction cost minimisation implies in-house exploitation of proprietary knowledge. Thus it is claimed (Casson 1985; Hennart 1991) MNC development, rather than collusion, is reducible to transaction costs rather than monopoly power per se. There would appear to be two shortcomings with this attempt to locate monopoly benefits inside a transaction cost framework. First, it is possible to reverse the reasoning and claim that without the potential monopoly gain the differential transaction/organisation costs would be irrelevant. Thus to reiterate a point introduced in Chapter 3, analysis of economic organisation requires costs and benefits. Sole attention given to transaction costs is analytically meaningful only if governance structure benefits are assumed exogenous, which is not the case with regard to MNCs and monopoly power (Yamin and Nixson 1988). The second problem with this transaction cost comparison of cartels and internalisation is the same as the ‘pilfering home workers’ example discussed in Chapter 3. The possibility of cheating by cartel members is a transfer to the free-rider’s advantage. To counter this

Unrelated integration and the firm 85 cheating cartel members have an incentive to merge. The advantages of merger, however, can only be obtained at the differential cost of organising resource allocation internally rather than by cartel. It is by no means obvious why this cost difference should always be negative when the overhead and running costs of international intra-firm and cartel organisation are compared. In addition, if this organisation cost difference is assumed to be always negative, why is this given more importance than the non-transaction cost pecuniary advantages of avoiding cheating? This reasoning underlies the analysis of Figure 5.3 (p. 79) suggested in the previous chapter whereby the existence of monopoly benefits can lead to predictions concerning governance structures opposite to those drawn by transaction cost theorists. A consistent transaction cost explanation must assume complete ex-ante understanding of a cartel’s free-riding problems and the organisation costs involved in their removal. This reduction of the analysis to a comparative static choice effectively precludes the existence of bounded rationality, as well as the surprise existence of free-riding. These problems are carried forward into the analysis of potential monopoly gains from proprietary knowledge. Casson (1979) outlines the reasoning involved. A firm may have developed a new technology, monopoly returns to which are necessary to recover costs and hence allow future innovative activity. The central problem for the firm is that competition reduces rents because the marginal cost of using technology is lower than its development.8 One means of extracting the necessary surplus is to license the use of the technology in various national markets. This will only be effective, however, if transport costs are sufficiently high to segment the markets and/or if export restrictions are possible and legal, and if the innovation is easy to patent.9 In other circumstances foreign direct investment is necessary to exploit proprietary knowledge. It is clear that a dynamic analysis of this situation must go beyond orthodox transaction costs for the same reasons as those just discussed with respect to cartels. An interesting asymmetry may exist here in that while internalisation is explicable in terms of high organisational benefits because of monopoly power and secrecy, which require relatively high transaction/organisation costs to allow their exploitation, licensing is likely to exploit lower transaction/ organisation costs when monopoly (secrecy) benefits are relatively unimportant. This conclusion is consistent with that of Davidson and McFetridge (1982) in their study of 1,382 cases of technology transfer by 32 US MNCs. They found that licensing increased with: the age of the technology, the more peripheral the innovation to the core business, the smaller the R&D investment, and the greater the innovators experience in international licensing. The first three of these factors are consistent with the low monopoly benefit and transaction/organisation cost thesis. The final factor is consistent with the development of a body of idiosyncratic knowledge, and hence is an example of the diversification analysis undertaken in the previous chapter. Hennart (1991:87–8) discusses Davidson and McFetridge’s work and concludes that ‘the choice between licensing and FDI can be explained by the relative efficiency of the market for knowledge’. Efficiency is interpreted in terms of transaction costs—the partial nature of such a conclusion is clear. A similar, if not more extreme, telescoping of transaction cost analysis into an inappropriate arena is undertaken by Williamson (1985:294): [With MNC development a] more harmonious and efficient exchange relation…predictably results from the substitution of an internal governance relation for bilateral

86  Transaction cost economics and beyond trading under those recurrent trading circumstances where assets, of which complex technology transfer is an example, have a highly specific character. [emphasis added] As Kay (1988) points out, this explanation is flatly contradicted by empirical evidence which suggests the importance of appropriability problems. Such problems derive from the non-specificity of assets, and has been the basis of much MNC internalisation theory as just discussed. Two final matters can be discussed in this section that reinforce and complement the material of this and the previous chapter. The first concerns Casson’s (1985, 1987) introduction of marketing and final product markets into a transaction cost framework. In addition to being important in its own right this has implications for the intermediate product analysis characteristic of much transaction cost thinking. Ignoring the possibility of shifting transaction costs (in much the same way as with taxes), for customised products the buyer bears the transaction costs. For second-hand products brokers or agents bear such costs. But for mass produced products sellers normally incur the costs of resource allocation: The function of marketing is, quite generally, to reduce transaction costs. More precisely, in the absence of marketing activity, lack of information is a formidable obstacle to any kind of trade. (Casson 1987:149) According to Casson the central issue is that the quality of goods and services is variable which creates a potential information asymmetry to the disadvantage of consumers. This problem is particularly acute for novel and sophisticated products sold to first-time buyers, hence the importance of marketing in these areas. This centrality of marketing goes handin-hand with the development of goodwill, the latter in turn requires, among other things, the maintenance of quality. This framework allows Casson to draw two important conclusions. First that the degree of integration is determined by a trade-off between quality maintenance and diversity. Marketing benefits will accrue from integration as the quality of products, related both horizontally and vertically, can be guaranteed. This requires attendant costs of internal organisation which will be greater as the diversity of activities being managed increases. The more acute this diversity problem the greater is the incentive to use subcontractors, hence further and more detailed discussion of the issues involved will be undertaken in the next chapter. The second conclusion that Casson draws is that these marketing considerations imply that a trade-off exists ‘in which higher transaction costs in intermediate product markets generate lower transaction costs in final product markets, and vice versa’ (Casson 1987:140). Hence costs of managing resource allocation can be to some extent shifted within a firm to its advantage, as has happened with the development of total quality management as discussed in Chapter 4. These insights provided by Casson are useful, but the extreme position with sole reliance on transaction costs creates problems. It is clear from the economics of advertising literature that promotional activities, especially in oligopolistic markets, can reinforce market imperfections and hence accentuate monopoly power (see, for example, Comanor and Wilson 1974). Hence marketing cannot simply be reduced to a transaction

Unrelated integration and the firm 87 costefficiency gain because transfers from consumers to producers are also possible; as discussed in Chapter 3: given the existence of transaction costs power effects are endemic. It follows that Casson’s trade-off needs to be developed. The maintenance of quality involves higher transaction/organisation costs because of diversity and marketing, but the resulting market dominance allows increased benefits in terms of monopoly transfers to the advantage of the firm. Thus once again internalisation cannot be explained in terms of lower transaction-organisation costs. Furthermore, the shifting of transaction-organisation costs outside the organisation is not achieved in a literal sense but can be understood in much the same way as taxes can be shifted. The ability to shift a tax, i.e. the extent of any price rise, depends on demand and supply elasticities in an orthodox framework. These elasticities can be interpreted as summary measures of the extent of control over market conditions. Within an institutional setting a similar approach can be used—the ability to influence other economic agents depends on governance structure costs and benefits (information asymmetries, asset specificity etc.). It follows that transaction-organisation costs can be shifted, via higher governance structure benefits, the extent of which depends on relative dominance vis-à-vis trading partners. The final matter that can be mentioned here illuminates a point made in the last section. MNCs have an obvious problem of coping with cultural differences between home and host countries, which increases monitoring costs (Hennart 1991:107). More precisely a trade-off exists between extra monitoring costs and production/distribution costs. In more detail, the entering of a new market by acquisition implies that existing corporate culture must be moulded. This problem will be less severe with green-field entry, or less still with a joint venture. More generally, differing institutional arrangements must be recognised in an analysis of economic organisation because, to reiterate an earlier point, different cultures embody different incentive arrangements which endogenise management practice. SUMMARY The basic arguments presented in this chapter can be summarised as follows. 1 Williamson’s internal capital market thesis is an unconvincing explanation of conglomerate development both logically and in the light of evidence on management motivation and behaviour. 2 As an alternative, the institutionally specific nature of the conglomerate has been stressed and in particular an explanation based on senior management opportunism and arms-length contacts with financial institutions was found to be more convincing, at least in the UK and US. 3 The MNC literature on hierarchies and decentralisation, while being overly neo-classical, is a useful counter weight to the organisational rigidities of the Williamsonian M-form analysis. 4 The MNC transaction cost literature, and its emphasis on proprietary knowledge, contains important insights in terms of the centrality and endemic nature of monopoly power. But, sole reliance on a contracting perspective is analytically incomplete angenerates misleading conclusions. Thus transaction cost economics is inevitably not a complete theory of economic organisation.

7 QUASI-INTEGRATION AND THE FIRM The discussion of the boundaries of the firm in Chapters 4–6 has not extended beyond the traditional economic perspective that draws a clear distinction between markets and firms. The former are characterised by arms-length anonymous relationships with information flows based on volume and price; while the latter involve direct organisation and cooperation within an identifiable unit with flows of qualitative information. Arguably, however, this dichotomous framework is an oversimplification which cannot accommodate the complex array of economic institutions that involve long-run co-operative relationships between separate units. Transaction cost theorists have recognised the growing importance of these ‘anomalous’ relationships. Williamson (1985:83) claims he was earlier (1975) of the opinion that transactions would cluster at the extremes of market and hierarchy, intermediate forms being unstable, but he has become increasingly persuaded that transactions in the middle range are much more common.1 Similarly Casson (1987) argues, with respect to multinational companies, that alternatives to internalisation, such as franchising, subcontracting, joint ventures and cartels, are being used more frequently. These ‘alternative’ governance structures will be the concern of this chapter. Initially the discussion will concentrate on clarifying what is meant by quasi-integration, and related matters. Following this transaction cost explanations are considered. Perhaps inevitably, given the content of previous chapters, these analyses are found to have shortcomings: therefore, alternative perspectives are developed. THE NATURE OF QUASI-INTEGRATION Governance structures that combine features of firms and markets may concern any or all of a firm’s activities: research, production and/or marketing-distribution. Many terms have been suggested to describe the structures and processes involved: non-standard commercial market contracts (Williamson 1983); strategic alliances (Badaracco 1991); managed or organized markets (Butler and Carney 1983, Lundvall 1988); networking (Thorelli 1986); relational contracting or exchange (Dore 1983, Goldberg 1980, Williamson 1985); valueadded partnerships (Johnston and Lawrence 1988); quasi-integration (Blois 1972, Monteverde and Teece 1982b). To standardise the terminology to be used the following approach will be adopted here. Ignoring the role of the state (which will be incorporated in Chapter 10), resource allocation involves three principle governance structures: markets, hierarchies and networks (Thompson et al. 1991). Each of these governance structures, when considered in isolation, has its own characteristics. Networking involves mutual trust and co-operation with a longrun perspective and respected codes of behaviour. The development of these characteristics can be understood in terms of repeated playing of a prisoner’s dilemma game (Axelrod 1984). This game theoretic approach indicates two important points. First, the evolution of

Quasi-integration and the firm 89 networking requires that the parties are mutually dependent on the resources controlled by each other, which implies that there are gains to be had by pooling the resources involved (Powell 1990). Secondly, it indicates that trust and co-operation can coexist with self-seeking behaviour rather than being mutually exclusive characteristics.2 Hence, the Williamsonian ‘opportunism’ assumption, as discussed in Chapter 2 of this work, is inappropriate as a central principle with networking. Short-run self-seeking behaviour will be inappropriate because when disputes occur the mutual interdependence of the parties implies that ‘voice’ rather than ‘exit’ (Hirschman 1970) dominates strategies. A related point is that informal sanctioning mechanisms take on a more important role with the trust embedded in networking (Bradach and Eccles 1989) either linked to personal relationships or tied to formal structures (e.g. financial cross-holdings). While the previous paragraph describes the general characteristics of networking, particular forms will be determined by interactions with markets and hierarchies. This is hardly an original perspective because different market—firm characteristics, in terms of the forms of competition and the objectives and policies adopted by firms, are a standard aspect of microeconomics. In addition, the interface between firms and markets, either as structure or performance, is called integration—as discussed in the previous two chapters. Following this logic the interface between firms, markets and networks can be called quasiintegration. At this stage, three different forms of quasi-integration are worthy of note: joint ventures, the Marshallian industrial district, and sub-contracting/ franchising. The first may be characterised by oligopolistic partners. The second is an atomistic structure with strong external, or agglomeration, economies. Finally, sub-contracting/franchising involves suppliers/outlets located within the strategic arena of a central firm, hence hierarchical characteristics may be adopted. In short, it is inappropriate to generalise from one particular form of quasi-integration which depends on a particular set of circumstances.3 It may be useful to mention that the same point is more generally applicable. For example, markets can be structured in different ways. Hence particular forms of networking may lengthen (or shorten) the time horizons involved in market processes, a matter taken up in Chapter 10. Similarly, the presence or absense of trust and co-operation can affect the dynamics of intra-firm hierarchies. As discussed in Chapter 4, and further in Part III, the effective use of clan type organisation (Ouchi 1980) within hierarchies requires long-term relationships and trust, rather than short-run self-seeking behaviour with detailed monitoring. There would appear to be two ways of incorporating quasi-integration into the general framework outlined in Chapter 3. One way suggested earlier is to posit a third abstract governance structure (i.e. networks) with its attendant costs and benefits that can be compared to firms and markets. This has the advantage of implying that networking, and therefore, for example, structured (rather than abstract) market processes have always been important (yet largely unrecognised by economists). The disadvantage in this approach, however, is that it does not reflect the way that quasi-integration is usually presented as developing out of problems that are evident with firms and markets and combining features of both to overcome the shortcomings involved. Hence theoretical comment, and to some extent historical development imply that quasi-integration can be represented as introduced in Chapter 3 and reproduced here as Figure 7.1.

90  Transaction cost economics and beyond The important features of Figure 7.1 are Cm>Cf and Bm>Bf. Hence from a transaction cost perspective firms are more efficient, but when the benefits of resource allocation are considered markets are more profitable. As Figure 7.1 is drawn, intra-firm organisation for the transaction in question is infeasible (Cf>Bf at all levels of management activity).

Figure 7.1 Quasi-integration Reasons for this will be developed in detail below, but an obvious possibility may involve an input needing highly specialised skills that are not available to the firm. It follows that external procurement is more profitable as indicated by the configuration of the benefit curves. But market-based relationships have transaction cost implications which render external procurement infeasible (Cm>Bm at all levels of management activity). What might be involved here is small numbers trading with information asymmetries, which is possible given the skill characteristics just mentioned. But a quasi-integration strategy involving long-term relationships and the development of trust between trading partners will shift Cm downwards towards Cf (as denoted by the arrow) therefore rendering economic relationships feasible. One qualification needs to be made to this general analysis of quasi-integration. For expositional ease Figure 7.1 has been drawn such that both market and intra-firm organisation are infeasible, hence quasi-integration must occur if economic activity is to take place. But this oversimplifies the analysis to the extent that expertise, or competitive advantage upon which this is based, is not exogenous hence (inferior) more generic skills may be developed to render market-firm based (rather than networked) economic activity possible. This may be particularly important if long-term relationships and trust are difficult

Quasi-integration and the firm 91 to develop between separate units because of, for example, adversarial traditions. In economies that are organisationally more innovative, quasi-integration strategies with higher technical efficiency levels, because of more developed skills, may result from (long-run) profit seeking firms, as appears to have occurred in different ways in northern Italy and Japan (Best 1990; Johnston and Lawrence 1988). But given the successful organisational development, competitive pressures will shift the cost-benefit curves to the positions shown in Figure 7.1 for non-innovating firms, which will force either general organisational diffusion or the extinction of firms, in the relevant industries, based on discrete firms—markets. An interesting problem here concerns the economic policies that may be relevant to promote long-run innovative activity, an issue discussed in Chapter 10. Whether the simple or historically more accurate analysis is adopted, the implication for the analysis of governance structures is the same. The existence of quasi-integration must be based on the benefits of economic organisation as well as transaction-organisation costs. This point will be developed in detail in the rest of this chapter. QUASI-INTEGRATION AND TRANSACTION COSTS Williamson (1985) provides the most general transaction cost analysis of quasi-integration, hence this section will start with his work. It is grounded in his general approach to governance structures as outlined in Chapter 2. Given the existence of bounded rationality, asset specificity and opportunism transaction costs will exist. When asset specificity, uncertainty and transaction frequency are high, intra-firm organisation will reduce transaction costs. But firms rely on ‘low-powered’ (bureaucratic) incentives and cannot readily adopt the ‘high powered’ incentives of markets hence increasing efficiency loss of successive integration will be evident. It follows that high levels of asset specificity, with the attendant adaptiveness and security requirements of bureaucracy, can be combined with high-powered incentives if quasi-integration strategies are adopted. The central problem with this analysis is one that has been a recurring theme in this work: to avoid tautological reasoning transaction cost economics must assume that the characteristics (or benefits) of a transaction are unchanged when comparing governance structures. The introduction of high- and low-powered incentives implies that transaction characteristics change. Consider the following: by high-powered incentives I have reference to residual claim status whereby an agent, either by agreement or under the prevailing definition of property rights, appropriates a net revenue stream, the gross receipts and/or costs of which stream are influenced by the efforts expended by the economic agent. (Williamson 1985:132) In short, changes in gross receipts and/or costs (i.e. transaction benefits) are central to the analysis. In effect the Williamsonian analysis of quasi-integration is suggesting the same configuration of curves as depicted in Figure 7.1, i.e. Bm>Bf and Cm>Cf. This presents a major inconsistency in a framework that is reputedly based on transaction costs. A central concern of this chapter is to show that if the framework is developed to incorporate benefits

92  Transaction cost economics and beyond in a consistent and explicit way the analytical centre of gravity is significantly shifted. The inconsistency suggested here is found, in different ways, in all transaction costs discussions of various forms of quasi-integration. The rest of this section will examine this material by looking at, in turn: collusion, joint ventures, franchising and subcontracting. The transaction cost analysis of collusion, suggested by Casson (1985) was discussed in Chapter 6 and hence can be dealt with briefly here. In that chapter it was shown how the existence of cartels, rather than arms-length relationships or internalisation, can be (supposedly) reduced to transaction cost factors. The central limitation of the analysis, however, is an implicit, but necessary, assumption that monopoly advantages are exogenous. This means that bargaining and policing problems distribute given aggregate rents. Hence the efficiency gains are viewed in terms of minimising the bargaining and policing costs that would occur with different governance structures. In other words the analysis is static and based on organisational equilibrium, i.e. there is no incentive to reallocate managerial effort between tasks. In the short-run, if such a reallocation occurs there will be movement around cost and benefit curves implying that aggregate rents are not exogenous. In the longrun, production and/or product-market characteristics can be endogenised, more or less effectively depending on particular governance structures. These dynamic factors, whereby different arrangements endogenise competitive advantage, are of particular importance for the understanding of quasi-integration, as will be seen below. A similar analysis to that just outlined for collusion is developed to account for joint ventures. A transaction cost explanation is suggested by Hennart (1991). Suppose that the production of a particular good or service requires two types of knowledge, x and y, held by firms X and Y. If x is readily marketable without incurring high transaction costs, but not y, the two knowledge inputs will be combined by Y, with X licensing x to Y. The reverse will occur if y is readily marketable but not x. If, however, both inputs are not readily marketable, without incurring excessively high transaction costs, this provides a necessary condition for a joint venture to occur. Two failing know-how markets can provide a necessary condition for joint ventures, but equally the market failure could be accommodated by internalisation. N.M.Kay (1991) argues that from a supply-side, or transaction cost, perspective internalisation will always be the preferable strategy. Bargaining, negotiation and policing costs will be higher with a joint venture. In addition, a dual control system, one for each parent, will exist. Finally, the sharing of information with a joint venture introduces possibilities of appropriation by a venture partner. It follows that the development of joint ventures requires that the preferred internalisation strategy is blocked in some way. This blocking may occur in a number of ways. Governments may restrict merger-acquisition activity. A potential partner may not be readily purchasable. The know-how to be jointly used may be embedded in a wider collection of assets held by a potential partner, internalisation may therefore be locally rational but globally irrational from a company’s point of view. Alternatively internalisation may significantly increase management costs because of incompatible management cultures (Hennart 1991; Kay, N.M. 1991). Ignoring government restrictions it would seem that this analysis is consistent with the general framework outlined above and depicted in Figure 7.1, i.e. Cm>Cf and Bm>Bf. The first inequality accommodates Kay’s point that internalisation is always the preferable strategy, but benefit effects imply the opposite. In addition joint ventures can generate a dynamic of goodwill and trust (Casson 1987; Buckley 1988)

Quasi-integration and the firm 93 which may allow Cm to shift down towards Cf. Or to put the same point in another way: mutual hostage positions will develop, because of joint expenditure on asset development, that will lead to an improved alignment of incentives (Kogut 1988). Two comments can be made about this perspective on joint ventures. First, for the analysis to be based on transaction costs it must be static, for the same reasons as those just discussed for collusion. This presents a problem because joint ventures are frequently used to develop competitive—monopoly advantages and profit potential, as discussed below. Secondly, while the introduction of goodwill and trust between partners is a useful development this represents a form of investment in human assets. Such investment implies that decision making is temporally non-separable which presents a problem for a framework based on short-run comparative static optimisation, as is transaction cost economics. Once a long-run perspective is adopted it becomes obvious that joint ventures have advantages in terms of developing the knowledge base of companies and therefore developing (rather than assuming exogenous) production and/or product-market capabilities. The tension between using quasi-integration to create advantages rather than having its rationale based on organising given capabilities also exists in discussions of franchising and sub-contracting. With regard to the former, Wright’s (1988) survey of the transaction cost literature appears to be consistent with the general approach adopted by Williamson which stresses a trade-off between low-powered and high-powered incentives. Franchising will be a viable alternative to internalisation in certain circumstances. First, clear and complete specification of the franchise contract must be possible. Secondly, contracts must give the franchisee the incentive to perform, which is facilitated by residual claim status, and when repeat business is high to avoid free-riding on quality factors. Finally, inefficient risk-bearing must be avoided, hence low risk investment may be more appropriate for franchising. The first point that can be made about this perspective on franchising is that the introduction of a ‘residual claim status’ argument implies that Bm>Bf for reasons developed earlier. The other conditions imply that monitoring costs may be lower with franchising rather than internalisation, particularly when outlets are dispersed, which increases the costs of hierarchy, i.e. Cf>Cm. Given these two inequalities arms-length market-based relationships will dominate organisational choices. Hence it is either inappropriate to classify franchising as a form of quasi-integration, or the transaction cost analysis is unconvincing because there is nothing to distinguish it from arms-length distribution. The latter possibility is arguably more likely because as Wright (1988) points out franchising can be described as an ‘intermediate transactional relationship’. An alternative framework to understand the rationale for franchising can be derived from other perspectives that are available which overcome the inconsistencies just mentioned. Bonanno and Vickers (1988) analyse the relative profitabilities of forward integration and franchising in oligopolistic markets. If manufacturers produce substitute products, and when prices are strategic variables, vertical separation induces ‘friendly’ behaviour from rival firms. If one manufacturer increases wholesale prices the final product prices of competitive goods are likely also to increase with franchised relationships because commitment is highly observable and harder to reverse than with internal organisation. Consequently the higher prices, and profits, are in the individual and general interests of manufacturers.4 Hence, using this framework, organisational form affects monopoly advantages rather than

94  Transaction cost economics and beyond just allocating pre-given rents. Of course, an implicit assumption is that a franchise contract can be written so that manufacturers can extract maximum profits from franchisees, which involves transaction cost considerations. Such a contract, or arrangement, would be easier to achieve with internal organisation rather than non-dependent market-based outlets hence Cm>Cf, which is a requirement for quasi-integration rather than arms-length distribution. How franchisees become locked into relationships, resulting in transaction costs becoming closer to those appropriate for firms rather than markets (Cm shifting down towards Cf) will be discussed later in this chapter. Vernon and Graham (1971) also suggest an analysis which is relevant here. As discussed in Chapter 5 they show that a monopolistic incentive to integrate forward depends on the nature of production technology. With variable proportions it is possible for downstream firms to substitute away from monopolistically priced inputs, therefore (private) benefits will accrue if a monopolist integrates downstream. With fixed proportions technology the substitution possibilities, and hence internalisation benefits, do not exist. With a downstream monopoly final prices will fall with integration (Davies 1987; Waterson 1984). It is clear that substitution by distributors—retailers will be inhibited with franchise dealing, and that negotiation and policing costs of inhibiting substitution with arms-length relationships would be excessive. It follows that a strategy of minimising substitution by distributors—retailers will result in Cm>Cf (and Bm>Bf with downstream monopoly power). Consequently, combining the Vernon and Graham and Bonanno and Vickers frameworks provides a monopolistic motive for franchising rather than internalisation or arms-length distribution. This conclusion is based on an equilibrium framework, important dynamic aspects of the analysis will be introduced below. The discussion can now turn to consider subcontracting. Casson’s (1987) analysis is useful in this respect. He stresses the problems of quality maintenance and monitoring, and the leaking of trade secrets which are involved with subcontracting. He concludes that because of these problems subcontracting is likely to become more prevalent as product life cycles mature. Similar life cycle considerations will increase the number of potential suppliers as markets become more competitive, reinforcing the avoidance of subcontracting early in a cycle to avoid bilateral monopoly problems. An additional feature of subcontracting relationships, however, is that their recurring nature provides the basis for trust, routinization and mutual adjustment (Butler and Carney 1983) which reduce transaction costs, i.e. shift Cm down to approach Cf. But as was discussed earlier in this chapter, while the emphasis on trust and co-operation is useful, its long-run emphasis compromises a narrow short-run economising framework (Dore 1983). The development of just-in-time purchasing systems and total quality control, as discussed in Chapter 4, would appear to reinforce this conclusion because they are a means of using supplier—buyer relationships to gain dynamic advantage, involving strategic co-operation to endogenise production and/ or product/ market characteristics, as much as static organisational efficiency gains. A particular form of sub-contracting is discussed by Monteverde and Teece (1982b). They concentrate on the ‘ownership by a downstream firm of the specialized tools, dies, jigs and patterns used in the fabrication of components for larger systems’ (p. 321). The explanation is based on ‘postcontractual opportunistic behavior’ which is possible when parties are locked-in by transaction specific investment. If bargaining power is asymmetrically distributed, short-term quasi rents may be appropriated by violating agreed-upon terms of trade, a problem that can be overcome by quasi-integration. This hypothesis is examined

Quasi-integration and the firm 95 econometrically with significant but limited results. The conclusion is that ‘while appropriable quasi rents are, indeed, one important consideration in the integration decision concerning tooling, these rents may not be the only driving force’ (p. 328). One possible reason why the Monteverde and Teece framework is only a partial explanation is provided by Semlinger (1991). He takes up the point that risks associated with lock-in can be reduced if a downstream firm owns specific assets, and points out that this may constitute a threat as much as a relief to a supplier because it is easier for the buying firm to transfer future orders to another supplier. For a supplier ‘to take the risk of investing in specific assets, serves to reduce the longer-term risk as it creates mutual dependence’ (Semlinger 1991:101). Once again we see a difference between a short-run equilibrium analysis and a long-run perspective that is consistent with the arguments already presented in this section. QUASI-INTEGRATION AND COMPETITIVE DYNAMICS A recurring theme in the previous section has been one equivalent to that repeatedly stressed in this work that transaction cost explanations of quasi-integration are only relevant with given competitive—monopolistic characteristics. This suggests that the framework is not relevant, in the ways it is usually presented, as a means of understanding long-run dynamics of economic activity. This is a significant shortcoming because such dynamics underlie quasi-integration strategies in that they involve attempts to mould or endogenise environmental developments. But we must be careful here not to throw the baby out with the bath water. This questioning of the transaction cost framework does not mean that it has no relevance, rather it must be situated in a more general framework. Central to an account of quasi-integration based on long-run advantage is the nature and use of technological and product-market knowledge. Broadly speaking quasi-integration strategies can be understood in defensive and offensive ways depending on whether knowledge is respectively communicable or tacit.5 This distinction, first introduced in Part I of this work, is to some extent artificial because in practice a continuum is likely to exist. But for analytical purposes we can assume a simple dichotomy and discuss the different implications involved. For the purposes of understanding quasi-integration, knowledge will be communicable when four conditions hold (Badaracco 1991). First, it must be clearly articulated. Second, a person/ group must be capable of understanding the knowledge. Third, the person/ group must have sufficient incentives to do so. Finally, no barriers must inhibit communication. Clearly a necessary condition involved here is minimal sunk cost of knowledge acquisition. Consequently communicable knowledge implies that its use is ‘contestable’, the possibility of which depends on general diffusion of ideas which is likely to occur as product and technological life-cycles mature. In response, firms may resort to quasi-integration strategies, rather than integration or arms-length relationships for the following reasons (Badaracco 1991; Semlinger 1991): cost and risk reduction; accelerating speed to market; increasing flexibility; to monitor and neutralise competitors; and to guide the migration of knowledge. Therefore a preliminary conclusion is that competitive dynamics will result in organisational form evolving because of the benefits (rather than costs) of governance structures.

96  Transaction cost economics and beyond Of course co-operation requires (at least) two parties. But this long-run perspective on quasi-integration complicates the analysis in that short-run losses may be traded against perceived long-run gains. With regard to small, or follower, firms three reasons may be evident here (Semlinger 1991). Agreement may be made in the hope of later improvement. Being linked to an established firm may improve a firm’s reputation. Finally, a firm may be locked-in to current strategic trajectories because of organisational and/or technological path dependencies (which are discussed in detail in Chapter 9 below). For larger firms, or strategic leaders, the rationale for developing enduring links, when communicable knowledge is evident, are the same as those outlined above. But this introduces a potential longrun conflict: In some ways, they are pacts with the devil. In exchange for a product today, a company helps to strengthen a competitor, providing it with distribution, technology, scale and experience economies, profits for further investment, and confidence that its products can sell successfully in its partner’s markets. (Badaracco 1991:76–7) In short, quasi-integration strategies based on communicable knowledge cannot be understood in a single transaction, short-run optimisation framework. But this longer run perspective on quasi-integration, based on communicable knowledge, suggests that its rationale is essentially defensive because it offers little opportunity of strengthening long-run competitive position, which requires investment in tacit knowledge. This can offer a further set of explanations for quasi-integration. As discussed in Part I of this work, tacit knowledge will exist when it cannot be fully expressed and is therefore uncodified. With an intraorganisational division of labour such knowledge will be based on formal and informal social relationships. It follows that the knowledge involved may be shared to a significant degree by individuals who have a common experience. The link between this idiosyncratic experience and quasi-integration can be developed using ideas suggested by Richardson (1972). As discussed in Chapter 3, he argues that the characteristic of a firm is based on a set of core skills or expertise. Activities that lie within this core will be grouped within the firm, necessary activities that lie outside the core will be bought in. But the uncertainty this can engender leads to quasi-integration strategies. When tacit knowledge, or idiosyncratic expertise, exists competition is based on capabilities with the result that strategic change is central. Differential capabilities will condition the extent to which firms can respond to and mould environmental developments. When developments are deemed necessary that require skills outside the exisiting core of a company, quasi-integration strategies have a comparative advantage over arms-length contracts or internalisation, because they facilitate the central objective of learning and creating new knowledge (Badaracco 1991, Kogut 1988). Internalisation can involve a clash of cultures, which is particularly likely because the existing and new tacit knowledge will be based on different social relationships. In addition, an autarkic strategy is likely to be slow and limiting which can present a competitive problem. Arms-length relationships are also unsuitable for two possible reasons. First, their shortrun, anonymous characteristics may present problems because shared idiosyncratic skills

Quasi-integration and the firm 97 are likely to deteriorate if not used frequently (Nelson and Winter 1982). Secondly they are likely to be adversarial. Hence, quasi-integration strategies, being based on an enduring not single period perspective, are central to dynamic advantage (Dore 1983). The mutual dependence involved will facilitate trust development and reduce the risk of one party exploiting revealed information. In addition, the increased sharing of information will result in a greater ability to cope with diversity, complexity and change. This sharing may occur informally as well as formally. Von Hippel (1987) points out that ‘informal know-how trading’ is based on a gift relationship, inclusion in a network requires both ‘give’ and ‘take’. Therefore the threat of being excluded from a network, with the implication of no access to ongoing shared information, will encourage co-operative behaviour (Baumol 1992). In general, therefore, the increasing importance of quasi-integration strategies can be understood in terms of the possibilities offered by technological changes (Walsh 1991). But technological potential is not exogenous rather it is a function of the organisational framework. In this regard it will be argued in Chapter 10 below, where the policy implications of, among other things, this discussion of quasi-integration will be developed, that the forging of vertical, rather than horizontal, relationships is central if competitive advantage is to be developed and maintained. An important reason for this is developed by Porter (1985). He points out that strategic capability depends not only on any one company’s resources, but also on outside resources which are a linked part of a complete process from product-service design, through production and marketing to end use. Hence he refers to a ‘value chain’ that recognises these important links. Long-run competitive success depends on strategic consistency throughout the chain. This implies that strategic co-operation, is central if consistency is to be achieved. The relevant question, however, is not that co-operation is neccesary but how it is best achieved. Johnston and Lawrence (1988) argue that internalisation has its weaknesses. Echoing earlier discussion they point out that a strong culture, while being necessary for organisational cohesion, results in difficulties in performing diverse tasks. Hence separate companies along a value chain can facilitate focusing on particular aspects of a global process. This focus also implies low managerial overheads with the dynamic advantage of less bureaucratic suppression of creativity. At the same time ‘value adding partnerships’ have some of the advantages of vertical integration in terms of strategic co-operation and the benefits of economies of scale by sharing activities. Recent organisational innovations are relevant in this respect. As discussed in Chapter 4, the development of total quality management and just-in-time systems increases, or more acurately recognises, the importance of tacit knowledge in production. Hence using the arguments just presented such changes increase the comparative advantage of quasi-integration rather than discrete firms—markets. In addition, these advantages reduce flexibility less than full internalisation because, in the extreme, break up (or exit) costs are likely to be lower with quasi-integration than for selling an integrated subsidiary (Geroski 1992). In short, vertical quasi-integration strategies have obvious advantages. At the same time the implications involved should be recognised. The organisational innovations just referred to change the cost structure of a firm. As argued in Chapter 4 the intra-firm flexibility resulting from total quality and just-in-time systems implies limited extra-organisational substitution. Hence, the intangible organisational assets involved are fixed rather than variable (Dietrich 1990). Consequently organisational capacity use must be high to guarantee

98  Transaction cost economics and beyond low unit organisational cost. It follows that any uncertainties that compromise the logic of a high use strategy will be removed from the core of the organisation. The result is the ‘flexible firm’ (see Pollert 1988) in which the primary, or core, group of employees is organised on the basis of self motivation towards corporate goals. Competitive advantage is based on the use and development of tacit knowledge. Co-existant is the peripheral sector, based on, for example, short-term contracts and subcontracting. Here competitive advantage is based on communicable knowledge with its short-run focus. The externalisation advantage, to the core firm, is that it is more able to absorb uncertainties because traditional hierarchical management principles do not have the cost implications just discussed. Hence we should recognise that quasi-integration strategies based on attempts by core firms to increase static efficiency, will result in peripheral organisations. This begs a number of important questions not least why peripheral firms are locked-in to these relationships—a matter taken up later in this chapter. QUASI-INTEGRATION: A GENERAL FRAMEWORK The previous section dealt with explanations of quasi-integration based on competitive dynamics. While the dynamic emphasis is in many respects superior to transaction cost explanations it would be wrong to conclude that the two approaches are mutually exclusive. To see the issues involved here what is needed is a similar analysis to that used in previous chapters that distinguishes between ex-ante (dynamic) and ex-post (static) effects. The former endogenises transaction characteristics. This initial decision involves the perceived profitability potential of a project, and its particular form of organisation. For reasons that do not need repeating here, knowledge considerations can result in Bm>Bf. Ex-post, i.e. when transaction characteristics are given, the developed organisational and technological assets will be subject to recurrent use and hence their management will involve transaction and organisation costs: it would unnecessarily lengthen the discussion to repeat the arguments presented earlier in this chapter concerning the issues involved here. It follows that when change is incremental, involving no strategic reorientation, quasiintegration strategies can be explained in transaction cost terms. But we should not conclude from this special case that organisational development is necessarily globally optimal (whatever this may mean). For reasons to be developed in Part III of this work, path dependent behaviour is likely to exist. But if the discussion presented in this chapter is accepted, quasi-integration strategies are irrelevant in, what amounts to, a steady state equilibrium. The traditional firm-markets framework captures the necessary features involved. Hence orthodox transaction cost analyses of quasi-integration are inadequate. But this does not mean they are irrelevant, a reformulation, however, is necessary. If the basis of quasi-integration strategies is strategic change the distinction between exante and ex-post effects, as it has been presented above, is somewhat misleading because change is continuous rather than discrete. In such circumstances transaction-organisation costs become an entry and exit barrier into and out of markets (Thorelli 1986). The central insight of contestable markets theory is, once again, appropriate here: the only (relevant) costs of entry are those that are sunk which become exit barriers. The ex-ante—ex-post distinction may now be interpreted in a slightly different way. While long-run survival

Quasi-integration and the firm 99 may force firms into quasi-integration strategies, ex-ante they are free to enter or not any particular quasi-integration relationship. All that is required is that a minimum of ‘domain consensus’ (Thorelli 1986) must exist among potential participants. But this basic requirement may define more than one potential network each with a particular strategic orientation. Ex-post, however, i.e. when a firm has entered a particular network, the organisational efforts of relationship development become a sunk cost. Repositioning transaction costs in this way has a number of important implications. As Richardson (1959) has argued, barriers to perfect mobility are necessary to facilitate a sufficient degree of predictability to make strategic decision making feasible. Organisational sunk costs provide a basis for this predictability. As discussed earlier in this chapter the mutual dependence will reduce the significance of opportunistic behaviour and provides an explanation for dominant-subordinant relationships (in ways discussed shortly) that facilitates the orientation of strategic developments. A second implication is that if strategic reorientation is at the heart of quasi-integration strategies it follows that networks are not spontaneous relationships but are based on conscious co-ordinative effort, in the absence of this effort they would disintegrate (Thorelli 1986). But as with intra-firm activity, discussed in Chapter 3 of this work, networked relationships, and the particular strategic orientation resulting from the co-ordinative efforts involved, are not static but are endogenous to network evolution. As Penrose (1980) argues organisational advantages will shift overtime in response to external and internal developments—discussion of which will be taken up in Chapter 9. The significance of these comments depends on the particular form of quasi-integration relationship. On the one hand are those where co-ordinative effort revolves around a dominant strategic partner, as with subcontracting and franchising. On the other hand are relationships where co-ordinative effort and strategic orientation are shared, as with joint ventures. In this second case the evolution of network dynamics will result in payoffs to participants changing over time. This is the case with a number of Japanese companies that have entered into and benefited from strategic alliances with Western counterparts (Prahalad and Hamel 1990). If cumulative, monopoly advantage will lead to either network disintegration, or a conscious reorientation of strategic effort. The latter is descriptive of Japanese corporate groupings (Aoki 1988). Where quasi-integration revolves around a dominant strategic partner the organisational exit barriers for participants implies that subordination to the strategic centre is rational as long as payoffs exceed the opportunity costs of organising alternative trading partners. Specification of these payoffs, in a dynamic context, involves different attitudes to risk taking—a higher perceived risk will increase the opportunity cost of an exit strategy. Important factors involved here are: asset specifity, the availability of strategic management capabilities, and subjective perceptions. The first of these factors implies mutual lock-in; hence, it is rational for central firms to concern themselves with the strategies of related companies to enhance co-ordination (and therefore reduce the transaction-organisation costs of strategic reorientation) and to facilitate technical or organisational improvements as occurs in Germany and Japan (Eltis et al. 1992). With regard to strategic management capabilities, small firms are likely to be at a disadvantage here. Similarly the dominance of a founder (owner-manager) is likely to generate greater organisation lock-in for small rather than large companies. A possible implication of this lock-in was discussed earlier in

100  Transaction Cost Economics and Beyond this chapter—the ability of core firms to shift transaction-organisation costs on to peripheral firms. This, perhaps, raises important questions about appropriate industrial policies, detailed discussion of which will involve matters raised in Chapters 8 and 9, hence further analysis is inappropriate at this stage. As in previous chapters, a reformulation of transaction cost economics therefore leads to the issue of differing abilities to control resource allocation, i.e. differential economic power. Once again we can draw the conclusion that monopoly power is an inevitable aspect of dynamic competitive advantage. This exists not only in the orthodox sense of pecuniary advantage because of control over prices, but also control over strategic developments which is arguably of more significance in the long-run. An implication of this long-run emphasis is that a difference is evident between legal and economic conceptions of the firm. The former may be characterised in terms of unified ownership, but the latter can be understood as a locus of strategic control (Dietrich 1990; Amin and Dietrich 1991a). Given the existence of exit barriers it is rational to subordinate decisions to a strategic centre. Hence quasi-integration may shift the economic boundaries of the firm beyond their legal equivalents in much the same way that in orthodox economic theory a cartel is analysed in terms of joint profit maximisation. This conclusion applies to horizontal as well as vertical relationships if the strategies of (legally defined) firms are subject to direct influence because of network membership. Indirect influence will of course always exist if differential monopoly advantages are evident. In Chapter 9 these comments will be developed in more detail and an economic, rather than legal, definition of the boundaries of the firm will be presented in terms of the existence of a strategic framework. SUMMARY The basic arguments presented in this chapter can be summarised as follows. 1 Quasi-integration can be understood as the interface between firms, markets and networks and will develop when Cm>Cf and Bm>Bf. 2 Central to networking is that parties are mutually dependent on each other’s resources with the result that trust and co-operation tend to develop. 3 Transaction cost explanations of quasi-integration must assume unchanged transaction characteristics which is inconsistent with the emphasis placed on ‘low-’ and ‘high-’ powered incentives. 4 Competitive dynamics (that endogenise transaction characteristics) provide a more satisfactory explanation of quasi-integration, which involves an important distinction between communicable and tacit knowledge. 5 A general dynamic framework can be developed that involves viewing transactionorganisation efforts as sunk costs inhibiting mobility into and out of networks.

Part III A NEW ECONOMICS OF THE FIRM

8 THE FIRM AND ECONOMIC THEORY This and the following two chapters shift attention away from the boundaries of the firm and concentrate on the firm as a system in its own right, and develops in this context the general framework outlined in Chapters 2 and 3. Chapter 8 lays the ground work by examining the view, evident in for example Williamson (1975) and Casson (1987), that the firm as an organisational form can be conceived in profit maximising terms. This leads into the discussion of Chapter 9 where the firm is viewed as a complex system of strategic control, interacting in a dynamic way with its environment. A necessary feature here is that active human agency must be given a central role. Finally in Chapter 10 microeconomic policy implications of the discussion will be developed. TRANSACTION COSTS AND PROFIT MAXIMISATION Transaction cost economics is based on economising behaviour. It is clear from standard microeconomics that such behaviour is the dual of maximisation. When this optimisation is specifically defined it is formulated in terms of profits, being understood as a static maximisation problem, involving equality between marginal cost and marginal revenue. There appears to be two different justifications for linking transaction cost analyses with this view of the firm, the ‘objectives’ and the ‘survival of the fittest’ perspectives. Using the framework developed in Part I we can examine the implicit assumptions involved here and furthermore show that in general, transaction cost economics cannot consistently be based on profit maximising principles. The ‘objectives’ justification is evident in Williamson (1975:150): ‘The organization and operation of the large enterprise along the lines of the M-form favors goal pursuit and least-cost behavior more nearly associated with the neoclassical profit maximization hypothesis than does the U-form organizational alternative’. Casson (1987) implicitly adopts this ‘objectives’ view when he uses standard marginal revenue-cost analysis to examine organisational form and monopoly power. Figure 8.1 can be used to show the problems with this approach. Bm and Cm are the benefits and costs of, for example, external procurement of a particular input, with governance structure benefits assumed unchanged for intra-firm activity. It is clear from the tangents to Cm and Bm that M* is the profit maximising level of contracting activity with external procurement. But if transaction cost savings exist, as indicated by Cf
The firm and economic theory  105 lows that if a profit maximising view of the firm is adopted, a transaction cost comparison of governance structures will in general involve changed governance structure benefits

Figure 8.1 Profit maximisation: the objectives perspective (because of reorganised managerial activity). Central to the arguments presented in Parts I and II of this work is that transaction cost economics must assume transaction characteristics unchanged when governance structures are being compared, if tautological reasoning is to be avoided. In short an ‘objectives’ view of profit maximising behaviour is inconsistent with a general transaction cost analysis. The ‘survival of the fittest’ view of profit maximisation is present in North (1981:7): ‘competition in the face of ubiquitous scarcity dictates that the more efficient institutions… will survive and the inefficient ones perish’. Similarly Williamson (1985:394) argues that ‘viable modes of economic organization…ordinarily possess an efficiency advantage’. Williamson (1988) changes this argument marginally and suggests that survival of the fittest is a weak or imperfect process rather than a strong one. While, in one sense, this qualification is useful in recognising (at least implicitly) complexities to be discussed later in this chapter; in another sense the qualification is inadequate because there is no real analysis of the complexities involved, simply an assertion—‘survival of the fittest’ is still adopted as a central tenet of the transaction cost framework. A graphical presentation of what might be involved here is set out in Figure 8.2. Competition has reduced governance structure benefits to such an extent that the only feasible level of managerial activity is the profit maximising M*. Hence given the configuration of the curves the activity in question will be internalised. It is clear, therefore, that this evolutionary view is based on a comparative static, long-run equilibrium analysis. Any position

106  Transaction cost economics and beyond that is not a long-run equilibrium will result in a change in governance structure benefits as managerial activity is reorganised. It therefore might seem that while this ‘survival of the fittest’ view is restrictive it is perhaps more relevant (for transaction cost economics) than the ‘objectives’ view just discussed. But the restrictions that are necessarily placed on the analysis present problems. The long-run equilibrium implies no monopoly profit which must be based on perfectly contestable markets. The latter, in turn, require no asset specificity. It follows that the ‘survival of the fittest’ view logically implies no firms as organisational units (from a transaction cost perspective) which is clearly irrational; as in all non-institutional neo-classical economics, firms (for market contestability theorists) simply exist as black-box production functions. It follows that transaction cost analysis must be presented in a rather restrictive

Figure 8.2 Profit maximisation: the survival of the fittest perspective way that the significance of any transaction—organisation cost savings must be more important than the sunk costs due to specific assets. If this is not the case, in Figure 8.2, the monopoly power derivable from imperfect contestability will allow the Bm/f curve to shift up above (in part) the Cm curve. In addition, once the logical impossibility of perfect contestability (for a transaction cost framework) is acknowledged a further problem is introduced. As discussed in Chapter 3 governance structure costs and benefits embody organisational relationships which preclude any analysis based on necessary technical efficiency. It follows that firms may adopt organisational postures that are less efficient than for a profit maximising framework. Such notional inefficiencies, which reflect organisational relationships, can exist in the short-run because of imperfect contestability. In the

The firm and economic theory  107 long-run the analysis becomes more complex, in ways suggested below, but there is no necessary efficiency, in the sense of Figure 8.2 because it is possible to cross-subsidise between organisational activities, particularly over time in dynamic circumstances as discussed later. It follows that any suggestion of optimisation for survival reasons is based on circular reasoning because configurations of curves such as those depicted in Figure 8.2 can always be constructed given appropriate organisational relationships with corresponding governance structure costs and benefits. Furthermore this ignores the additional problem that the benefit curve(s) must be stable and exogenous in the long-run. This only occurs if costs and revenues are exogenous which among other things implies no organisational or technical innovation or dynamic competitive advantage. In short, transaction cost economics cannot explain the evolution of governance structures if it adopts an economising (profit maximising) perspective. Among other things the framework must acknowledge the inevitability of changing governance structure benefits. But once this is done a whole series of problems are encountered which compromise a profit maximisation assumption. It was for this reason that no specific objective(s) was posited in Parts I and II of this work. To unearth the issues involved here the rest of this chapter will discuss possible defences of profit maximisation. Four such defences can be identified in the economics literature: the nature of modern management; plausibility of the assumptions; survival of the fittest; and the purpose of the theory. It will be argued that only the last of these is acceptable, but this acceptance introduces methodological problems for the analysis of the firm in an organisational setting. DEFENCE 1: THE NATURE OF MODERN MANAGEMENT This defence of profit maximisation can be traced back to Earley (1955, 1956). He examined a sample of 110 ‘excellently managed’ companies in the USA and concluded that modern accounting and management methods provide marginal cost and marginal revenue information which is used by well organised firms. A more recent version of the same argument is developed by Williamson (1975). As introduced in Chapter 6 of this work, the M-form organisational structure allows a hierarchical division of labour such that strategies are centralised and operations are decentralised. This division of labour facilitates the development of appropriate global, rather than ‘partisan’, senior management behaviour. The conclusion, as quoted earlier in this chapter, is that profit maximisation becomes a relevant organisational objective. Goold and Campbell’s (1987) work can be used to examine the implicit assumptions underlying both the Earley and Williamson arguments. Goold and Campbell divide the British companies they study into three groups: manageable businesses (using financial control), diverse businesses (using strategic control), and core businesses (using strategic planning). The first of these groups appears to correspond to the Williamsonian hierarchical division of labour: financial control implies that the (small) central office sanctions expenditure, agrees targets, monitors performance against these targets and takes appropriate reorganising action given poor performance. The primary focus is annual financial performance. This characterisation implies that businesses within a financially controlled company should have few linkages with each other, should be in relatively stable

108  Transaction cost economics and beyond competitive environments, and should not involve large or long-term investment decisions (Goold and Campbell 1987:46). The short-run pressures on divisional and lower level management implies that inter-unit long-term co-operation to foster product and process developments will be inhibited. Consequently, long-term corporate profitability is likely to involve continuing acquisition and divestment activity, as is the case, in the UK, with Hanson Trust and BTR, that Goold and Campbell highlight as examples of financial control companies. While financial control companies correspond to the Williamsonian norm the Goold and Campbell strategic control and strategic planning cases involve increasing divergence. Strategic control companies are like their financial counterparts to the extent that tight financial control is exercised, but an important difference is that performance is measured against financial and strategic objectives. Hence although business units tend to be profit centres the centre focuses on establishing planning procedures and reviewing business unit proposals, which tends to be the case in UK companies such as ICI, Plessey and Vickers. Strategic planning companies have even greater headquarters involvement in lower unit decisions in that a prime responsibility is to participate in and influence the development of business unit strategies by establishing planning decisions and making substantive contributions to strategic orientation. An implication here is that these activities downgrade the importance of corporate control because performance targets are flexible and reviewed in the light of developments. Correspondingly, payoffs are considered long-term, with inevitable short-term problems that will develop in building core business strength. BOC, BP and Cadbury Schweppes are examples of strategic planning companies identified by Goold and Campbell. There would appear to be two possible responses to the Goold and Campbell framework. The first is that common among transaction cost theorists, as discussed in Chapter 6, and suggests that central office over-involvement characteristic of non-financial control is sub optimal. To some extent Goold and Campbell agree with this position in that they warn of (a) unwarranted central office interference into divisional affairs and (b) a weakening of control and motivation systems because of flexibility of targets and that divisional management can use interference as a scapegoat for failure. But they diverge from transaction cost theorists in that their work is not based on an a priori assumption of the rationality of short-run optimisation. This therefore implies a second response to the Goold and Campbell framework. Non-financial control is central to establishing and maintaining long-term competitive advantage that is inconsistent with short-run profit maximisation. In Chapter 4 reference was made to the work of, for example, Prahalad and Hamel (1990) and Pettigrew and Whipp (1991) who respectively suggest that the ‘core competence’ and ‘intangible assets’ of a company must be developed over time, which is the essence of non-financial control and the basis of idiosyncratic advantage underlying governance structure benefits. In the light of this discussion it is evident that a shortcoming of the ‘modern management’ defence of profit maximisation is a lack of clarity with regard to the maximand being suggested. If short-run profit is being maximised this presents a problem for companies that emphasise the importance of strategic change, rather than efficient exploitation of given product-market circumstances. As Williamson himself argues strategic, rather than static, advantage is the basis of the M-form’s superior performance. But when strategic change is considered some costs are ‘optional’ in the short-run, in the sense that they detract

The firm and economic theory  109 from static efficiency, but they may be essential for long-run objectives. This is clearly the case with training, R&D and marketing expenditures. In short, when strategic change is important it is inappropriate to maximise short-run profits. In the light of this conclusion it is clear why Williamson and Ouchi (1983) find it difficult to identify a transaction cost rationale for the matrix structure. Appropriate use of such a structure can help overcome co-ordination problems that may be evident with the multidivisional form. The strength of matrix organisation lies not in furthering static efficiency gains, but rather in facilitating proactive strategic developments (Knight 1976; Johnson and Scholes 1989; Mintzberg 1979). It is therefore no accident that Goold and Campbell’s (1987) core business is identified with a matrix form. At root here is a standard problem with the orthodox theory of the firm. The static MC=MR rule is only appropriate when temporal separability of decisions exists (Koutsoyiannis 1979). If time periods are not independent profit maximisation must accommodate temporal spillovers. Hence rather than maximisation being achieved on a short-run, period by period, basis long-run profits become the maximand. In principle this long-run perspective can be introduced by invoking fully specified functions with firms maximising the net present value of future profit streams. But long-run maximisation is only necessary because of temporal non-separabilities deriving from strategic change, which precludes steady state growth. It follows that full specification of functions must involve knowledge of all relevant future states of the world with appropriate probability distributions, so that expected values can be evaluated and appropriate insurance protection organised. The setting out of the problem in this way reveals an obvious shortcoming. Fully specified systems describe programming problems which, while being useful for some purposes, preclude human agency which is creative and the basis of long-run competitive advantage. Hence, long-run maximisation cannot be incorporated into an analysis of the firm as a dynamic organisation because of mutually inconsistent frameworks (as discussed later in this chapter). Two implications follow from this: static optimality is removed as a central theoretical issue and decision making is irreversible which complicates matters in ways discussed in the next chapter. In summary, the claim that modern management techniques and systems allow short-run profit maximisation is tenable only in a world where strategic change does not exist, because this allows the temporal independence of decision making. DEFENCE 2: PLAUSIBILITY OF THE ASSUMPTIONS The writers suggesting this defence of profit maximisation are Machlup (1946, 1967) and to a lesser extent Friedman (1953). The central point is that actual knowledge of marginal costs and revenues are irrelevant to the usefulness of the theory because they can be known in an intuitive way and to this extent the standard assumptions of profit maximising theory are plausible. The argument is developed by analogy: for example, Friedman asserts that a good billiard player uses, but need not know, the laws of mathematics and physics describing velocity, acceleration, friction, angular momentum and distance, etc. Similarly, economic actors use, but need not know, the (maximisation) laws of economics when decision making is based on entrepreneurial intuition or idiosyncratic product-market knowledge. In

110  Transaction cost economics and beyond short, profit maximising theory is still valid as a scientific, rather than descriptive, approach to decision making within the firm. The first point that may be made about this argument is that nobody is born with highly developed billiard skills, they are developed by years of practice. The result is that the skill becomes second nature and hence performable without conscious and explicit thought (Nelson and Winter 1982). Furthermore such skills are developed in highly stable, and therefore predictable, conditions. It follows that this second defence of profit maximisation is misplaced with companies that base competitive strength on strategic advantage because, as already argued, this strength lies in proactive change. As argued in Dietrich (1990), the correct use of the billiard analogy in such circumstances would involve emphasising competitive advantage based on changing the rules of the game, rather than developing skills using given (i.e. exogenous) rules. For example, billiard clubs or individuals might change the type of cloth or the way it is brushed, or even more radically use octagonal tables—the possibilities are endless as dynamic market leaders realise. The analogy breaks down here because any such innovating club or individual would find it impossible to get competitors (or more accurately co-operators) trained under the old conditions; but this is the very advantage, to any one company, of economic competition. To generalise the argument just presented, when it is possible to build up a stock of appropriate knowledge subjective assessments may be made of cost and revenue conditions which are adequate for profit maximisation theory. So, for example, in static conditions cost-plus pricing is perfectly consistent with profit maximising behaviour—a profit markup over variable costs can be estimated using the price elasticity of demand (or an intuitive knowledge of market conditions) that can be shown to be profit maximising (Koutsoyiannis 1979). It may even be possible to argue that when change is incremental the knowledge base of a firm evolves because of idiosyncratic learning processes (Malerba 1992), with the same conclusions being relevant. But strategic management, with competitive advantage based on changing technological and product-market characteristics, implies that past knowledge is no longer a useful predictor of future activity. This is not just the direct effects of any one firm’s decisions but results from the added complexity of competitive interaction and market evolution. In such circumstances Machlup suggests that long-run profit maximisation can be understood in terms of expected costs and revenues. But as Koutsoyiannis (1979:269) points out, this treatment of expectations (which implies ‘doctored’ demand and cost curves)… reduces marginalism to a tautology, since any observed behaviour can be compatible with profit maximisation, with appropriately constructed cost and demand curves in which future uncertainty is ex ante eliminated. In short, we can draw a similar conclusion to that in the previous section: the assumptions of orthodox theory cease to be plausible when they are mapped on to a dynamic analysis of the firm that stresses proactive behaviour.

The firm and economic theory  111 DEFENCE 3: SURVIVAL OF THE FITTEST The third defence of profit maximisation is based on the work of Alchian (1950) and Friedman (1953), although the argument is frequently invoked in an ad hoc way in economics, as was illustrated earlier in this chapter with regard to Williamson (1985). The so-called Darwinian principle of the survival of the fittest is invoked such that firms have to profit maximise to survive in the long-run, hence economic natural selection will eliminate weaker firms, where weakness is defined as non-profit maximising. As already discussed, transaction cost theorists cannot logically adopt this defence of profit maximisation, but reasons for a more general (un)acceptability have not been examined. Following Hodgson (1990) we must recognise that the Alchian and Friedman views are based on different reasoning. For Friedman the behaviour of firms can be (not necessarily is) random, and hence competition, it is claimed will result in only the most efficient surviving. The major problem here is that there is no discussion of evolutionary mechanisms that are meant to select out inefficient firms, it is just asserted that this will be the case. Recent work in this area, to be discussed shortly, shows that in general selection mechanisms are unlikely to be efficient in the way that Friedman claims. The link between evolution and efficiency in Alchian’s work is based on a different mechanism: less efficient firms will imitate the more efficient. But as Hodgson (1990) points out imitation is a non-trivial problem. For example, what characteristics of the most efficient should be copied and how should this be done? Discussion of these issues will be taken up later in this section. The evolutionary metaphor in economics is usually used in conditions of homogeneous markets that are perfect either in the competitive or contestable senses—the situation depicted in Figure 8.2. In this world selection processes are, by assumption, largely irrelevant. But evolution implies diversity rather than homogeneity because there must always be a variety of forms from which to select (Hodgson 1991). In addition evolution implies a dynamic disequilibrium framework rather than a static analysis. We can therefore examine the evolutionary metaphor in more detail by examining, in turn, diversity and disequilibrium. Diversity can be understood in two senses: first, each firm will face environmental diversity; secondly, firms themselves will be different. The first perspective is examined by Seal (1990). He points out that the different environments any one firm faces will, in general, require different survival traits. At the simplest level four markets will be relevant: the product market, the labour market, the capital market, and the market for control. If markets are assumed perfect (whatever this may mean) the homogeneity involved will preclude any conflicts or difficulties, but if the firm is viewed as a governance structure then, by definition, markets are impure, hence Problems may arise because the contractual/organisational forms that ensure success in one market may not be appropriate for success in other markets…the selection environment confronts the firm with a variety of conflicting pressures which may require ‘contradictory practices’. (Seal 1990:270)

112  Transaction cost economics and beyond Of course what must be involved here is an explanation of why a firm cannot combine different practices within a single organisation to mirror environmental diversity. In Chapter 9 it will be argued that organisational culture and the differential power of organisational stakeholders and coalitions constrain practices in this way. In addition, as Seal (1990) points out, to avoid tautological reasoning, markets must be ranked. If this is not done, any organisational form could be explained in terms of being efficient in at least one market. This ranking implies that some environmental pressures are more significant than others which has significant analytical and policy implications to be discussed in later chapters. For example, short-term pressures from financial markets in the UK may dominate business decisions, even at the expense of long-term developments. In short, Seal’s insight implies that fitness is a multi-dimensional variable with mutually exclusive aspects. Hence evolutionary processes will be skewed in particular directions depending on particular organisation-environment interactions. In addition to environmental diversity (or perhaps because of it) firms are likely to have diverse product-market characteristics. This diversity has two aspects: in any market products can be differentiated and in any one firm more than one good or service can be produced. The combination of these two aspects with an ability to innovate implies that there is no necessary link between survival and efficiency in the long-run. Furthermore the latter term loses its economic meaning because continuous change precludes an equilibrium where only normal profits are made. This brings us to the issue of disequilibrium dynamics which is the second aspect of the evolutionary metaphor to be examined here. Langlois (1986) develops the idea of what he calls a flexibility—efficiency trade-off: One implication of this tradeoff is, in effect, that efficiency is not an absolute concept: it can’t be defined independently of the organization’s environment. A firm in a very rapidly changing environment may have very bad transaction-cost properties but be far more efficient—far better able to survive—than a relatively less flexible organizational structure with good transaction-cost properties in equilibrium. (Langlois 1986:20) The implication of this trade-off is far reaching. We can follow Langlois and distinguish, rather schematically, between two classes of firms: those that are good at economising in a static sense and those that are more able to exploit disequilibrium dynamics involving proactive behaviour. Following arguments presented earlier in this chapter, the development of effective strategic management systems will put firms into the second group even though this involves investment in human and other assets that from a static viewpoint is irrational. Hence the efficient firms in the first group will not survive out of equilibrium with the consequence that because of competitive dynamics we will end up with a set of statically inefficient firms that are more capable of surviving. A complementary point to that made by Langlois is that natural selection always favours greater fecundity (Hodgson 1991), or in economic terms the birth of new firms. In this case the introduction of new firms into a market will change the environment, and by implication competitive conditions. If separable time periods are evident this changed competition may be viewed as progressive in an economic sense because relatively inefficient firms will be eliminated. But the inefficiency may be based on temporal non-separabilities, as

The firm and economic theory  113 discussed earlier in this chapter—investment expenditures that, if not undertaken, will inhibit long-run survival. Hence we can end up with a ‘hit and run’ problem in contestable markets (Baumol 1982). Once again natural selection need not promote survival when strategic change is evident. To link natural selection and survival, the dynamics of the analysis can be developed in ways suggested by, for example, Downie (1958). He posits the existence of a ‘transfer mechanism’ whereby, because of firm specific advantages, more efficient firms gain at the expense of the less efficient. The specific advantages involved protect firms from the entry problems just discussed. One implication of Downie’s ‘transfer mechanism’ is that markets will tend to monopolise over time,1 which itself presents a problem for survival of the fittest arguments. To prevent this Downie introduces an ‘innovation mechanism’ whereby the less efficient firms will have the greatest incentive to introduce new innovations and hence reverse the ‘transfer mechanism’. But the existence of temporal non-separabilities with innovation, implies that the currently inefficient firms will not have a profit base to finance investment, which returns us to the Langlois analysis. On the basis of the Langlois—Hodgson insights we can divide economic evolutionary processes into two broad types. First, where trivial investment in competitive advantage is required, statically efficient firms will tend to survive because of potential and actual competition. Secondly, where non-trivial investment in competitive advantage is required, market processes will tend to be cumulative, static efficiency not being a sufficient condition for survival. But the distinction between these two groups can only be defined with a given environmental context. To illustrate this latter point we can posit the existence of two firms, a non-investor with low gearing and low technical efficiency and an investor with high gearing and high technical efficiency. In boom conditions, with low interest rates, investors will survive; in slump conditions, with high interest rates, non-investors will survive. Hence the very idea of the survival of the fittest in an abstract universal sense may have little concrete meaning. An idea that is closely related to disequilibrium dynamics is that of path dependency. Fisher (1983) shows that the final equilibrium of a system is not exogenous but rather is endogenous to disequilibrium dynamics. Hence, long-run outcomes depend on initial conditions and process disturbances. More recently, Arthur (1988, 1989) links path dependency to the dynamics of resource allocation. If choice between technologies follows a random walk, one technology will inevitably become locked-in if falling unit costs with use and co-ordination benefits are evident. In addition, the chosen technology will not necessarily be the most efficient because use will be locked-in by externalities. Hence, ex ante multiple equilibria, with indeterminate outcomes, can exist. Evolutionary paths become dependent on ‘chance’ events, as is the case with the QWERTY keyboard (David 1985). But, as discussed in detail in the next chapter, lock-in may be organisationally as well as technologically based. The basis of organisation, as discussed in Parts I and II of this work, can be located in bounded rationality and tacit knowledge which produce learning effects and co-ordination advantages from information externalities (Arrow 1974)—as in Arthur’s lock-in. Arguably this is relevant for an analysis of governance structures that recognises the benefits involved as well as the costs. In short, governance structures will generate path dependencies (North 1990).

114  Transaction cost economics and beyond Ignoring the disequilibrium issues discussed above, the central problem of lock-in is that a difference can exist between local and global optimality. In short the problem is of ‘multiple adaptive peaks’ (Hodgson 1991) with selection processes generating a local rather than a necessarily global optimum. In addition the more competitive are economic conditions, the more significant will ‘valleys’ between intervening ‘peaks’ become because of the temporal non-separabilities involved with shifting from ‘peak’ to ‘peak’. In terms of governance structure analysis it follows that any claim of superior efficiency must be made not only in a ‘comparative institutional’ way, as is done by Williamson (1985), which ignoring all other issues discussed in this chapter, may generate a local peak, but also in what may be called a ‘trans-institutional’ way because existence need not imply global optimality. The complexities introduced by path dependency are more involved than suggested by the conclusion just drawn because the surface defining optima can, of course, change (Hodgson 1991). As will be discussed in the next chapter change of this sort is endogenous to strategic decisions as well as being dependent on exogenous environmental developments. Hence, even if global efficiency is attained in one time period the economic surface may change with the result that existing configurations may be rendered inefficient, compared to that globally attainable, but locked-in with their own organisational-technological logic. If this dynamic behaviour is linked to the disequilibrium analysis developed earlier it is clear that existence need not imply efficiency (Ullmann-Margalit 1978) which undermines a universal, rather than a specifically argued, survival of the fittest argument. If the above critique undermines simplistic evolutionary economics a second line of argument buries this third defence of profit maximisation. The analogy between Darwinian natural selection and economic competition is incorrect because there is nothing equivalent to a gene that transmits efficient behaviour (Penrose 1952; Nelson and Winter 1982). Winter (1964) has argued that the Friedman version of the ‘survival of the fittest’ argument is flawed in this respect because if the behaviour of firms is viewed as random there is nothing to ensure that maximisers this period will continue to be maximisers next period. In this respect N.M.Kay’s (1991) criticisms of the Williamsonian natural selection account of the transition from the U-form to M-form structures appear pertinent. He points out that for natural selection it is the appearance of the superior form which causes problems for the inferior, not problems in the inferior form stimulating the adoption of a superior form. In Darwinian theory evolution occurs via a gene which is durable, i.e. it lasts from generation to generation, and transmits hereditable traits. As Hodgson (1990:7) argues ‘[w]hat is required [in economics] is a degree of inertia in…structures and routines to restrict change so that selection can operate effectively’. Nelson and Winter (1982) suggest that ‘routines’ act as the economic equivalent of the gene. They act as stores of organisational practices so that skills and knowledge can be transmitted over time. Routines are obviously not static but are transformed in response to organisational dynamics, with implications for the survival of a firm, as will be examined in the next chapter.2 From a more managerial or organisational tradition we can refer to ‘core competence’ (Prahalad and Hamel 1990), ‘intangible assets’ (Pettigrew and Whipp 1991), or ‘organisation culture’ (Whipp et al. 1989) that act in a similar way to Nelson and Winter’s routines. These different perspectives are similar to the extent that each firm is, in detail, unique in terms of its underlying organisational practices. It follows that Alchian’s (1950) link

The firm and economic theory  115 between evolution and efficiency based on imitation is problematic because it is not obvious how detailed practices (rather than general ideas) can be effectively copied if all firms are unique. In short, competition cannot force an abstract optimal behaviour. This conclusion, combined with others drawn in this section, implies that there is no necessary link between economic evolution and progress. This is not of course to argue that market processes involve no economic selection but rather that there should be no a priori view of optimality. It will be argued in Chapter 10 that this introduces a significant role for government policy which is not usually recognised within economics. DEFENCE 4: PURPOSE OF THE THEORY This final defence of profit maximisation has been suggested by, among other people, Penrose (1980). She argues that the firm, qua the theory of the firm, should not be confused with an organisational firm because the former is one element in a theory of markets and price determination. It follows that the profit maximising firm can only be criticised within these terms of reference. This defence of profit maximisation is the only one of the four presented in this chapter that is considered acceptable. But this acceptance introduces a series of further matters that must be discussed. To claim that the profit maximising firm is a universal theoretical benchmark implies either that the only matters of relevance in economics are prices and markets,3 which dismisses the possibility of any wider institutional analysis, or that the profit maximising firm is useful in all circumstances which can of course be argued but not assumed. Discussion earlier in this chapter clearly signalled that the firm as a governance structure or organisation is not the same theoretical entity as a profit maximising firm, and furthermore the two are not comparable in any obvious way. Conventional analyses of price determination are based on demand and supply interaction given particular market structures. Within a more contractual or organisational framework prices can be viewed as one of the outputs of managerial activity. Any attempt to map one perspective on to the other, by for example following the Williamsonian method discussed above, is not valid unless the theoretical issues involved with this mapping are taken into account. The sorts of confusions that can be introduced if the particular theoretical status of the firm is not explicitly recognised have been indicated in this chapter. The firm as a governance structure has strategic advantages that cannot be readily mapped on to profit maximising theory. Any attempt to conflate these two views of the firm will confuse rather than clarify our understanding. It follows from this defence of profit maximisation that no particular view of the firm should be given an a priori status above another. Among other things this implies that the theory of the firm cannot be criticised as unrealistic because, by definition, this applies to all theory which simplifies reality to facilitate understanding. Of course it is true to say that the analysis of the firm as an organisation, or more generally governance structures, is based on, among other things, informational complexity and uncertainty. In such a world the future, and to a lesser extent the present, is unknown. It follows that marginal costs and revenues are unknown. But this does not imply that profit maximisation is unrealistic rather it suggests that the two theoretical frameworks are mutually inconsistent. To avoid any misunderstanding we can make the additional point that although black-box principles imply

116  Transaction cost economics and beyond a maximising methodology the analysis of the firm as an organisation does not necessarily imply a non-maximising approach. Principal-agent frameworks, as discussed in Chapter 1, are a case in point. In addition, Radner (1986) provides a useful discussion of the internal economy of large firms using an individual maximising perspective. His approach necessarily involves exogenous, and fully specified, technology and preferences. These assumptions are clearly not appropriate for strategic decisions which are aimed at endogenising and developing technology and preferences (as discussed in the next chapter). It is hardly surprising, therefore, that Radner excludes the matrix structure from his analysis, for equivalent reasons to those discussed earlier with respect to Williamson. The position presented in this section involves a rejection of Friedman’s (1953) view that assumptions do not matter. He argues that a theory should only be judged on the basis of its predictions. He claims, without providing any conclusive proof (Koutsoyiannis 1979; Hodgson 1988), that the traditional theory has produced reasonably good predictions, and on this basis it should be judged as satisfactory. But it is by no means obvious why one universal methodology should provide good predictions in all circumstances because (frequently implicit) particular questions are posed by the nature and use of assumptions. More generally the internal workings of theories, not just predictions, are important to develop understanding. It follows that assumptions can be described as more or less useful in different circumstances, given the objectives of the analysis being conducted. THE FIRM AS A GOVERNANCE STRUCTURE In this final section the elements of the discussion in this chapter will be brought together. The intention here is to come to preliminary conclusions about how the objectives of the firm can be conceptualised which will lead into the discussion in the next chapter. It has been argued that when the firm is viewed as a governance structure it is not acceptable to posit a profit maximisation objective. This presents a problem for transaction cost economics. The necessary assumption of unchanged transaction, or technological and product market, characteristics implies that the (production) cost and revenue characteristics of any transaction are given. It follows that maximisation must be assumed because if this is not the case possible changes in governance structure benefits cannot be ruled out by, for example, ‘X’ inefficiencies being introduced. Hence a maximising methodology (the dual of economising behaviour) is a logical necessity to avoid the circular reasoning introduced when transaction characteristics change as governance structure are compared. An additional effect of this maximising methodology, and exogenous governance structure benefits, is that senior management decisions are viewed as universally rational (Williamson 1975, 1985) rather than being subject to their own opportunism, which constrains the analysis of human agency and organisational relationships. This is the basis of the profit maximising view of the firm in transaction cost economics. If the analysis could be stopped at this stage it would be reasonable to assume that a discussion of governance structures could be mapped on to an orthodox discussion of markets to complete economics. But such a procedure is not acceptable. It will be recalled from discussion at the start of this chapter that transaction cost reasoning is not consistent with a profit maximising objective for the firm, even though, as we have just seen, maximisation

The firm and economic theory  117 is an analytical requirement. The introduction of governance structure benefits only displaces the issues involved here rather than solving the problems. It is clear from discussion of the first three defences of profit maximisation in this chapter that the development of such behaviour cannot be guaranteed because the endogenisation of governance structure benefits implies strategic change and dynamic competitive advantage. It may be argued that while profit maximisation is not an appropriate assumption, organisational actors can be assumed to maximise utility. To discuss this line of argument we can initially examine the possible specification of utility functions. Following managerial theories of the firm we might suggest utility being a function of sales revenue (Baumol 1959), staff, discretionary profit and emoluments (Williamson 1964) or growth (Marris 1964). All these maximands appear to involve either directly, or indirectly, the benefits of resource allocation. Hence it might seem appropriate to suggest formulating organisational objectives in terms of maximum benefits. While superficially plausible this approach will not be adopted here for a number of reasons.4 The maximand is still based on short-run comparative statics with all the limitations discussed earlier, in particular ignoring microeconomic dynamics. As important, however, is that such an approach does not reflect the rise of institutional shareholders, as discussed in Chapter 6. If the possibility of utility/benefit rather than profit maximisation relies on relative shareholder powerlessness, the extra resources and information usable by institutions will result in the constraining of non-profit objectives. In the light of these problems it seems appropriate to reject the use of any maximisation approach to the specification of organisational objectives (for current purposes) and, as an alternative, suggest that general business policies will reflect the objectives of those with effective power to control resource allocation in an organisation.5 In a capitalist firm (as defined in Chapter 1) the furtherance of these objectives necessitates increasing profit levels. The rationale behind this is threefold: first, the possible presence of dominant owners, most notably financial institutions; secondly, profits being a means to further senior management objectives the end results of which may differ from those of the owners; finally, long-run attempts to increase profits are rendered necessary by the dynamics of competition and rivalry. Rivalry, in this sense occurs not only between organisations but also within them (Pitelis 1991). Organisational relationships endogenise costs and revenues in ways that should be clear from Parts I and II of this work. This implies a two-way relationship between profit and intra-organisational rivalry. On the one hand, increased profits are required to control and channel conflict. On the other hand, profit changes are the result of effort, resource distribution and strategic orientation matters which introduce the possibility of intra-organisational conflict and rivalry. On the basis of these three justifications we can follow Penrose (1980:29) and suggest ‘that in general the financial and investment decisions of firms are controlled by a desire to increase total long-run profits’. We therefore have ended up with a dynamic conception of organisational objectives more appropriate for the firm as an organisation than profit maximisation, not least because it can accommodate proactive human agency. But where does this leave transaction cost economics with its economising perspective? With a given strategic orientation locally efficient governance structures become relevant. Any necessary claim to global efficiency is inappropriate because of strategic lock-in. When competition is based on strategic change, however, current expenditures will be undertaken to develop future capabilities, and in this

118  Transaction Cost Economics and Beyond respect it is not obvious what (transaction) cost minimisation means. For example it may be rational to adopt organisational configurations involving higher governance structure costs because of the benefits involved—as examined in previous chapters. The particular strategic orientation adopted by a company will be constrained by the configuration of organisational power. One way of conceptualising this is to posit multiple organisational solutions, each with their own power-efficiency characteristics (Dietrich 1992). In static terms this collapses into an organisational equivalent of orthodox distribution-efficiency welfare analysis. But dynamically, particular governance structures will embody developmental paths that are not reducible to a uni-dimensional efficiency reasoning because of organisational benefits, which implies that the evolution of governance structures is not neutral or inevitable. This characterises the material to be discussed in the next two chapters where respectively theoretical and policy aspects of the firm are examined. SUMMARY This chapter has suggested the following. 1 Transaction cost reasoning is based on a contradictory position with regard to a profit maximising view of the firm. On the one hand economising behaviour is the dual of maximisation, but on the other hand it is inconsistent with such an objective if governance structures are analysed in benefit as well as cost terms. 2 In the economics literature four defences of profit maximisation can be identified. The first two (‘the nature of modern management’ and ‘plausibility of the assumptions’) cannot accommodate the complexities involved with strategic change. The ‘survival of the fittest’ argument is inappropriate because it fails to specify the dynamics of economic evolution. This leaves ‘purpose of the theory’ as the only valid defence of profit maximisation; but the profit maximising firm from this perspective is an aspect of price theory rather than an institutional or organisational unit. 3 Rather than assuming any maximising methodology it is suggested that capitalist firms will have the general objective of increasing long-run profits.

9 THE FIRM AS A SYSTEM In Chapter 8 it was suggested that organisational objectives can be understood in terms of the structure of organisational power, and that in a capitalist firm this leads to a general long-run attempt to increase profitability. This idea will be developed in this chapter and in particular the nature and dynamics of intra-firm activity will be discussed. As the title suggests, this involves examining the firm as a system. In response to existing approaches in this area, which as argued in the next section tend to view intra-firm activity in terms of reactions to exogenous changes, this chapter will stress the proactive or creative nature of decision making. This implies that the way organisational power is structured endogenises opportunities and defines, or enables, what is possible. In other words, it will be concluded, the firm should be treated as a locus of strategic control. THE FIRM AS A SYSTEM: EXISTING APPROACHES In this section existing approaches to conceptualising intra-firm activity will be discussed. It will be argued that these approaches are unsatisfactory because they are based on shortrun reactive decision making which cannot accommodate the dynamics of intra- and inter-firm activity. Ignoring the contributions of pre-twentieth century writers,1 the first generally acknowledged attempt within economics to analyse the firm as an administrative unit rather than a black-box is that of behavioural theorists (perhaps most notably Simon 1955, March and Simon 1958, and Cyert and March 1963). Their basic approach is that firms are populated by individuals and coalitions. Hence organisational goals should not be reified but rather are derived from (continuous) intra-firm bargaining processes. These goals should not be understood in an optimising sense, which is rendered inappropriate because of bounded rationality,2 but rather are either non-operationalised or expressed as aspiration levels. Objectives will change endogenously as aspiration levels adjust to actual achievement. In other words, goals respond to exogenous environmental changes which prevent the achievement of aspiration levels. In this respect there are a number of characteristic features of the behavioural theory. Adaptation to environmental change and negotiation over differing goals is made possible by the inevitable existence of ‘organisational slack’ which absorbs intra-organisational conflict. In addition reactions to problems are channelled by established behavioural norms known as ‘standard operating procedures’ which are subject to long-run organisation specific evolution. Finally, the development of solutions to problems involves sequential, not simultaneous, search activity. The first alternative that enables the relevant aspiration levels to be achieved is adopted. Behaviour is therefore not maximising but ‘satisficing’ which is a rational response to the complexities of decision making. A recent contribution in this tradition, by March (1988), develops this idea into a

120  Transaction cost economics and beyond ‘garbage can’ model of choice in which solutions are linked to problems because they just happen to be present simultaneously. While the behavioural theory’s approach to decision making is useful in a number of respects the short-run emphasis is a major shortcoming (Devine 1985, Kay 1979). Aspiration levels and operating procedures are essentially exogenous and respond to immediate problems. Senior management are one party to the ongoing bargaining process but with the advantage of control over ‘side payments’. What is not incorporated is a strategic perspective that firstly facilitates the endogenisation of aspiration levels and operating procedures and secondly defines the way that an organisation interacts with its environment, rather than just accepting the ‘buffeting’ of outside forces. As Baumol and Stewart (1971:119) point out ‘behavioural analysis…has, up to this point, provided no theory of the determination of the rules of thumb themselves. It has not suggested how these rules will vary with changes in the values of exogenous economic variables’. A starting point to a more proactive perspective on the firm is to recognise that change need not be stimulated just by the external environment but also may respond to an evolving productive opportunity (Penrose 1980) which reflects the potential uses and opportunity costs of a firm’s resources. Furthermore, as Penrose argues, it is a ‘subjective’ productive opportunity (based on particular perspectives and expectations) that determines behaviour. This, of course, must be consistent with an ‘objective’ productive opportunity, as defined by environmental conditions: but the relevant environment is not an objective fact discoverable before the event; economists cannot predict it unless they can predict the ways in which a firm’s actions will themselves ‘change’ the relevant environment in the future…. Firms not only alter the environmental conditions necessary for the success of their actions, but, even more important, they know that they can alter them and that the environment is not independent of their own activities. (Penrose 1980:41–2) In other words change can be internally generated as well as being a response to exogenous changes. But this shift in perspective cannot simply be grafted on to the behavioural theory because differing decision making processes are involved. As Bianchi (1990) points out, what is missing from behavioural theory is any idea of decision making being a learning process. The assumed separability of aspirations from search procedures implicitly assumes that the parameters of a problem can be specified ex ante. If this is not the case search processes will involve learning, i.e. discovery and development of aspects of the problem(s) being solved. This more complete specification of the issues being investigated can endogenise aspirations to the extent that goals shift along with knowledge and understanding. As Argyris and Schon (1978) argue, learning is instigated when mental models are in error. A discrepancy between expected and actual outcomes will lead to revision of models i.e. learning. In a group setting the same logic exists. Thompson (1982:237) points out that when senior management reconcile different views ‘[a]ny action towards an “end” or objective will itself change what those ends are conceived to be’. In short, the behavioural theory’s treatment of decision making responding to exogenous change ironically

The firm as a system  121 has to assume that bounded rationality does not exist. If the parameters of a problem cannot be specified ex ante, learning processes will endogenise change. There are perhaps two responses that can be made to these comments. One possibility is to suggest that bounded rationality is still rooted in an orthodox rational decision making methodology (Thompson 1982; Hodgson 1988). The former writer (p. 242) suggests that satisficing is ‘specified in an overtly psychologistic fashion’ based on the subjectively determined wishes of management. In line with this view Bianchi (1990) suggests that treating decision making as a learning process involves a shift from a psychological to a logical perspective. Aspiration levels are no longer needed rather there is continuing problem solving implying solutions to evolving problems. But arguably this perspective renders decision making and problem solving, what may be called, a ‘self enclosed’ activity that is undertaken for its own sake. For example, Thompson (1982:242) suggests that the ‘firm largely constructs the agents and sub-agencies operating within it and the pattern of practices and procedures that they operate there’ (emphasis in original). What this perspective appears to involve is a reification of the firm. An alternative view is that the overriding purpose of decision making is to manage environmental and intra-firm interaction. This suggests a second response to the above critique of behavioural theory: that learning processes do not remove individual aspirations rather they are endogenised within a wider strategic framework. This implies that particular human aspirations, i.e. those with effective control over strategic developments, guide or channel decision making processes. In terms of the fundamental characteristics of decision making, the shift in perspective suggested here has an analogue in the way rationality is conceptualised. Hargreaves-Heap (1989) discusses the differences between instrumental, procedural and expressive rationality. Instrumental rationality is that dominant in economics involving adherence to a means—end choice framework. Behavioural theory, with its emphasis on norms and rules of thumb uses procedural rationality. Expressive rationality is embedded in the idea that decision making concerns itself with the choice of ends, rather than either given ends or an emphasis on procedures. Furthermore, this choice of ends involves genuine uncertainty and conflict between alternatives. In short, expressive rationality encompasses creative or proactive decision making, rather than reactive or programmed behaviour. This shift in perspective introduces a series of organisational complexities that are the subject matter of this chapter. An important implication of this placing of bounded rationality within a more dynamic and proactive setting is that the strategic framework defines the boundaries of an organisation. Consequently the firm as a system can have an economic identity rather than being just a group of individuals making decisions or undertaking learning processes within a legally identified unit. This view is consistent with recent work by Gillies and Ietto-Gillies (1991) on the use of probability in economics. They suggest that probabilities can be defined not only in an individual or subjective way, but in addition inter-subjective probabilities can be applied to social groups. For the latter to be possible two important conditions are: first that members of the group be linked by a common purpose; and secondly, that there must be a flow of information between members of a group, no matter how this flow is organised. It follows that a relevant strategic framework that channels aspiration levels can be defined in terms of the existence of inter-subjective probabilities. It should be emphasised, however, that Gillies and Ietto-Gillies define probabilities in an

122  Transaction cost economics and beyond epistemological rather than objective sense. This means that they are not properties of the external world but are based on a degree of knowledge or belief. This distinction is important because it implies that constraints on decisions do not render individual and group learning processes deterministic. The fundamentals of human agency are unchanged and involve choice and creativity that are bounded by and interact with constraints (Hodgson 1988). While these comments have been based on problems that are evident with the way that the behavioural theory analyses the firm as a system, similar problems are evident with the post-behavioural Nelson and Winter (1982) evolutionary perspective on the firm.3 Stress is placed on the importance of organisational routines that act as stores of collective knowledge which is frequently tacit rather than being readily codifiable. As discussed in Chapter 8 routines can be interpreted as the equivalent of a firm’s genetic code. This perspective is useful in that stress is placed on the way that organisational dynamics evolve via ‘mutating’ routines and this constrains responses to environmental changes, and in this respect the insights will be used later in this chapter. In addition, it recognises the diversity of organisational processes, as emphasised in the next section. Hence the evolutionary perspective on the firm involves a shift away from the means—ends logic of neo-classical theory. But, on the negative side the emphasis on routinized activity restricts attention to a procedural rationality. To this extent the approach has much in common with behavioural theory— change is still constructed in terms of responses to exogenous factors (Bianchi 1990). The complexities of expressive rationality, with its proactive decision making, require more than a (probabilistic) chance of innovative behaviour. Rather, learning processes must be embedded in organisational practices, as is suggested later in this chapter. Endogenous change in an organisational setting requires a strategic framework within which routines function, and an analysis of the characteristics of strategic decision making. THE FIRM AS A STRATEGIC SYSTEM This and the next sections will build on the comments just presented and suggest that if the firm is to be conceptualised as a unit, rather than simply a collection of interacting individuals involved in decision making, emphasis must be placed on its strategic framework. This is important for at least two reasons. First, as discussed in this section, much recent work on strategic management has stressed the importance of organisational culture as a filter for decision making which has obvious relevance given the earlier discussion of the endogenisation of aspirations and organisational routines. Following this, the next section takes up the second point that the strategic framework revolves around dominant organisational actors. In brief, the rest of this chapter will link the earlier comments on individual decision making to the systemic problem of organisational decision making. To understand the firm as a strategic system we have to recognise a distinction, which is common in the business policy literature, between economic and socio-political—cultural aspects of the processes involved. Economic aspects of business policy refer to the management procedures involved in the deliberate allocation of resources to different activities and the development of material incentive systems. In the language of behavioural theorists, what is involved here is senior management allocation of side payments, given current operating procedures, to guide lower level units in directions compatible with higher level

The firm as a system  123 intentions. It is clear from discussion in Chapter 6 that divisionally organised companies, with decentralised resource allocation procedures, are more efficient (in the sense of being more profitable) for large firms. There would appear to be two reasons for this greater efficiency. First decentralisation limits over-involvement by central office which compromises the logic of the managerial division of labour upon which hierarchies are based. Secondly, competition between divisions is an incentive mechanism. But while these economic aspects of intra-firm resource allocation are important, a number of shortcomings are evident (Strong and Waterson 1987). Accounting-based earnings figures may be manipulated. Divisional managers may be reluctant to undertake investment projects that are viewed as risky at divisional level, despite much of the risk of these projects being diversified away at the corporate level. Finally, resource allocation based on profitability might induce a narrow focus on the short-term with long-term developments suffering as a result. A central characteristic of these problems is that the underlying perspective constrains managerial relationships within a narrowly economic or mechanistic framework whereby input: output relationships are understood in a deterministic manner. It is important to recognise that individuals are not only guided by economic (dis)advantages but preferences can be moulded and developed to induce people to behave in particular ways. For example Channon (1979:69) stresses the importance of (strategic) planning as a behavioural and political process within the organisation. The understanding of this is vital for successful planning. There must therefore be a full commitment to a direct involvement in the process by the top management of the corporation, and great care must be taken to ensure full participation by line executives…. For planning to be of value the whole corporation must be committed and educated to what is expected of them and how it should be done. This line of thinking brings us to socio-political and cultural aspects of strategic management.4 These features create the assumptions and beliefs shared within an organisation. They define the corporate identity and the rituals and routines that make this up, the language used, and the symbols that support status, incentives, etc. The beliefs and assumptions of an organisation reproduce and legitimise organisational practices. Therefore they define the bounds within which corporate strategies are developed and they act as a filter through which control systems and routines function. In terms of the formulation presented in Chapter 4, organisational relationships facilitate the development of a body of idiosyncratic tacit knowledge that can only be effectively shared by common experience within a firm. Or in language more common to economists, the preferences of intra-firm actors are endogenised which is necessary to minimise ambiguity and prevent co-ordination breakdown. The filtering of organisational activities will facilitate the development of incentive mechanisms requiring less direct managerial expenditure. In short, decision-making and management control process economies are evident by moving beyond a mechanistic framework. This perspective on organisational culture suggests that it is a determinant of governance structure costs (Casson 1991), in much the same way that Williamson (1975:37– 9) suggests that ‘atmosphere’ is important. In particular the latter concept is important when ‘attitudinal spillovers are thought to be strong’ and when ‘the intensity with which

124  Transaction cost economics and beyond transactions are metered’ is central. In other words internal organisation can facilitate a ‘quasimoral’ involvement in which ‘reciprocity’ is emphasised rather than ‘calculative relations’ that tend to be encouraged with market exchange. At the same time however the fact that culture is organisationally specific implies that internal organisation may not just benefit from an abstract atmosphere in certain conditions, but rather atmospheres (in the plural) are idiosyncratic. This has two implications, first the transaction cost perspective must be developed beyond a simple reciprocal versus calculative dichotomy. Market-based relationships may be more efficient because the particular reciprocal relationships are not readily consistent with an organisation’s practices and norms. As discussed in Chapter 7, this may be one part of an explanation of quasi-integration. While this first implication of idiosyncratic advantage develops a transaction cost perspective the second presents it with a major problem. A number of writers (for example Peters and Waterman (1982) and Clutterbuck and Goldsmith (1984)) have stressed the central importance of intra-organisational socio-political processes as determinants of consistently superior (inferior) corporate performance. From this perspective performance differences are based on dynamic idiosyncratic advantage, i.e. a differential ability to adapt to, mould and exploit market developments. Using the Penrosian formulation outlined earlier in this chapter, a similar explanation may be couched in terms of a firm’s subjective productive opportunity. In terms of the framework developed in this work, these dynamic advantages determine governance structure benefits rather than costs—the ability to change a unit rather than minimise costs with exogenous organisational parameters. This is perhaps an underlying reason why Williamson ignores idiosyncratic (rather than general) atmosphere because it compromises a universal transaction cost analysis. To recognise the importance of unconscious habits, routines, etc. is not to claim that everybody within an organisation is identical and that the assumptions and beliefs are static. Corporate culture should not therefore be regarded in a uniform, one-dimensional manner; rather, three important factors should be stressed (Whipp et al., 1989). First, culture is not a unitary notion of the beliefs and values of a group, but a reflection of its diversity. Secondly, it follows from this that seen from within, organisations are seldom homogeneous but are frequently multi-cultural having more than one culture. Finally, culture is not simply a conditioning device or barrier to action. It is both the shaper of human action and the outcome of processes of social creation and reproduction. The recognition of this cultural complexity is important because it implies that a firm’s (subjective) productive opportunity is similarly non-homogeneous. Different organisational actors may have differing strategic perspectives. If the motor of change is exogenous this diversity can be understood in ways suggested by behavioural theorists. But if change is endogenously generated, organisational dynamics must recognise intra- (as well as inter-) organisational rivalry, and how one of the subjective productive opportunities comes to dominate. As discussed later in this chapter, this is likely to become a central issue when strategic reorientation that involves cultural change is considered necessary. While the recognition of cultural diversity is central to developing a general model of the firm as a system, this does not detract from the view suggested earlier that a firm can be conceptualised in terms of strategic coherence. As Bauer and Cohen (1983) argue consistent high-level organisational performance must be based on loyalty of members and the coherence of sub-units. From this perspective,

The firm as a system  125 the success of the M-form derives not as Williamson states from the differentiation it carries out upon the cybernetic sub-systems, but from the fact that it enables a homogeneous culture to be created within the firm. No matter how important the formal properties of an organisational structure and the actual content of a particular ideology (the ideology of decentralisation and of the entrepreneurial model), these are effective only in so far as they ensure consensus between the members of the organisation and compatibility between the sub-objectives of each of its sub-units; all other ways of creating an internal culture in the firm would lead in the end to the same result. (Bauer and Cohen 1983:85–6) While taking issue with the view that culture is homogeneous the sentiment of the view expressed by Bauer and Cohen is important. For example at pre-Harvey-Jones ICI there was little common identity which acted as a drag on performance (Pettigrew 1985). In short as Mayhew (1987:560) cogently argues it ‘is obvious that culture is necessarily a creation of people and that this is so even if we accept that people are creations of their culture’. This brings us back to the critique of organisational perspectives based on procedural rationality developed earlier. Recognition of the importance of organisational culture creates an important means of shifting towards an expressive rationality which involves forging a link between strategic management and the functioning of firms as described by behavioural and evolutionary theorists. Organisational beliefs and assumptions underlie organisational routines and managerial rules of thumb, and mould and channel the goals, aspiration levels and search activities of individuals within a firm. We therefore have two links that might give a strategic coherence to current operations. An economic link operating via side payments and a socio-political—cultural link working via organisational beliefs and assumptions. The way in which these two links work together can be placed in a framework suggested by Grinyer and Spender (1979), as depicted in Figure 9.1 which describes the dynamics of corporate change. Given an unsatisfactory performance, initially management will work within existing strategies by tightening existing side payments or controls. If this is insufficient the more fundamental step of reconstructing strategy will be explored, but the new developments will continue to apply the same underlying assumptions within which a company operates, for example, exploiting a given product-market position. Using the language of behavioural theory, search activity will lead to a satisficing solution. Or within Nelson and Winter’s (1982) framework, business policy development will be dominated by existing organisational routines. Finally, if this restructuring is insufficient to cope with environmental developments, a company will have to change its underlying beliefs and assumptions and thereby change organisational practices, managerial motivations, etc. Step 3 in Figure 9.1 cannot fit into a view of the firm that stresses organisational reaction to exogenous change because the transformation of corporate culture implies an endogenisation of goals, organisational practices, etc. More precisely, the fundamental restructuring involved here renders irrelevant the old knowledge base of a company, to a greater or lesser extent depending on how radical the restructuring attempted. This in turn implies that learning processes will become more central to strategy development. The parameters of new problems cannot be specified ex ante because past practice ceases to be a good

126  Transaction cost economics and beyond guide to current decision making. In short, productive opportunities are endogenised and decision making becomes proactive rather than reactive.

Figure 9.1 The dynamics of corporate change This perspective on the functioning and behaviour of firms does not imply that change is an unproblematic process. The problems involved in the transformation of corporate beliefs and assumptions should not be underestimated. Frequent and major changes in cultural—social practices are impossible because of disruption to the knowledge base of an organisation. This disruption will in turn generate ambiguity and unpredictability. Furthermore, the power of conservatism and inertia can itself inhibit the development of the dynamism necessary for fundamental corporate restructuring. Following Schein (1985) we can suggest that inertia is likely to be a greater problem for organisations that rely on negative rather than positive reinforcement. The former involves operating in previously characteristic ways, positive reinforcement is based on learning and hence is likely to be more flexible—a matter discussed further below. But even with positive reinforcement and learning, change is frequently incremental (Lindblom 1959) and strategies can ‘emerge’ from management processes rather than just be the result of explicit planning (Mintzberg 1987). What is being described here is a form of locked-in, or path dependent, behaviour. As presented in Chapter 8, path dependency will exist when users of a technology become

The firm as a system  127 locked-in by externalities and falling unit costs. Organisational culture functions in the same way because of the advantages of not having to ‘reinvent the wheel’ with each decision. As Banerjee (1992:809) points out, a ‘herd externality’ can develop when ‘the choices made by some agents affect the information that subsequent decision makers have’. In this regard we can use Dosi’s (1988) perspectives on the microeconomics of innovation. He uses Michael Polanyi’s (1967) idea of the tacitness of some elements of knowledge and insight. As discussed in previous chapters tacitness will develop when knowledge is ill-defined and uncodified and consequently cannot be fully expressed. At the same time, however, such knowledge may be shared to a significant degree by individuals who have a common experience. Thus Dosi (1988:1127) defines a technological paradigm as ‘a “pattern” of solutions of selected technoeconomic problems based on highly selected principles derived from the natural sciences, jointly with specific rules aimed to acquire new knowledge…’. A shift of attention from innovation to management means that an equivalent ‘managerial or organisational’ paradigm can be defined as a characteristic set of solutions to an organisational problem.5 Detailed implications of the existence of organisational paradigms will be developed in the next chapter. For the moment we can restrict ourselves to a few suggestive comments. In the same way that Dosi (1988) defines technological trajectories that depend on technological paradigms, organisational paradigms define organisational trajectories i.e. path dependent decision making. In short there must be a ‘cultural fit’ (Johnson and Scholes 1989) between intended strategies and the underlying organisational way of life. It follows that progressive strategies are useless if they are not supported by consistent collective beliefs. In terms of the language introduced in Chapter 8 this implies that the relevant performance space is not a ‘level playing field’ but rather has ‘valleys’ and ‘peaks’ with associated local and global optima. Hence any suggestion of necessary optimal behaviour in the long-run is inappropriate because competitive pressures will not automatically promote positive strategies. In addition the channelling of organisational behaviour and strategies has its intra-firm corollaries, a matter that will now be taken up. THE OBJECTIVES OF FIRMS It is standard practice in the strategic management literature to link organisational objectives to coalitions and stakeholders. The former are groups of individuals inside an organisation that have common expectations, the latter are defined equivalently for external actors. Clearly conflicts will exist with regard to the desirability of different strategic developments. For example, a supplier of finance may stress short-run profitability and cash flow generation, while a research and development unit may emphasise long-run engineering goals. Hence detailed strategies will respond to the relationships between coalitions and stakeholders. It follows from this perspective that if we are to understand the firm as a strategic unit the differential ability to control strategic developments is of central importance. In other words differential sources of power become significant. It is possible to identify a number of factors that are likely to affect the distribution of power within an organisation (Johnson and Scholes 1989): the position in the organisational hierarchy; the nature of this hierarchy

128  Transaction cost economics and beyond in terms of the extent to which discretion is decentralised and hence where control over strategic activities lies; and individual and group leadership characteristics which depends crucially on the nature of organisational culture. It is clear from behavioural and evolutionary perspectives on the firm that each company will be unique in terms of the way that routines function and organisational coalitions interact and hence the detailed strategic objectives that will be generated. But this uniqueness is bounded because of the central importance of organisational culture. Feasible corporate beliefs and assumptions will be constrained by dominant economic and societal practices and cultural norms (Whittington 1989). This does not imply a unique one-to-one mapping from extra- to intra-corporate systems, not least because societal practices are diverse in the same way as organisational culture. In addition feedback effects are likely to be evident. While it is important, on one level, to recognise this bounded idiosyncrasy to avoid over simplistic organisational analysis, it is equally clear that capitalist firms have undertaken major organisational innovations, for example, the development of the multi-divisional structure, to maintain centralised control over major strategic developments. In this regard Brooke and Remmers’ (1970:90) comment about ‘new’ organisational relationships in multinational companies is pertinent: The new close relationship is like that described in the oldest companies of colonial times, where the man on the spot was left alone for long periods, but his area of discretion was limited. No doubt this represents the trend throughout business, domestic as well as foreign, a trend towards greater personal independence within narrowing limits of decision-making. This is the form that the close relationship can be expected to take in the future. Hence it is possible to make the generalised claim that organisational strategies further the interests of those in senior hierarchical positions who have effective control over organisational practices (Cowling and Sugden 1991). It is for this reason that it is possible to talk meaningfully about the strategic or long-run objectives of the firm which is more problematic for operating or short-run matters, as was clear from the earlier discussion of behavioural and evolutionary theory, except in as much as short-run matters are channelled by strategic objectives. The objectives of firms, however, will also respond to the power of stakeholders and in this regard a number of factors are important (Johnson and Scholes 1989). Links to a company based on resource dependence may be significant, along with knowledge and skills. This implies that in some circumstances suppliers of finance may be powerful given the role of finance in investment decisions and the strategic advice which may be forthcoming. In different circumstances supplier—buyer relations may be dominant particularly if subcontracting and quasi-integration (see Chapter 7) are important. Finally the importance of legal—social factors should not be ignored.6 These latter influences may have a number of effects, for example, the legal framework may define a sole responsibility to shareholders—owners or stipulate health and safety responsibilities. More generally such factors may institutionalise non-managerial influence (for example, trade union or government) over strategy.

The firm as a system  129 It follows from this brief discussion of stakeholders that we once again end up with a non-determinate framework in which each company is likely to be idiosyncratic. Detailed organisational strategies will depend on particular organisation—stakeholder interactions. Once again, however, uniqueness is bounded by dominant economic and societal practices and cultural norms. But as was suggested at the end of the previous chapter, survival in a capitalist economy requires increases in long-run profits. This general objective is consistent with different strategic trajectories which will be defined by stakeholder—coalition characteristics, which has important policy implications to be discussed in the next chapter. While this stakeholder—coalition framework is useful in terms of conceptualising the firm as a strategic system it relies on an overly homogeneous conception of organisational functioning. One of the central points of the discussion in the previous section suggested that organisational culture is not static and uniform. To accommodate this complexity we must move beyond the traditional conception of the employment relation. In Chapter 4 this was described as a situation where ‘the employee stands ready to accept authority regarding work assignments provided only that the behaviour called for falls within the “zone of acceptance” of the contract’ (Williamson 1985:218). In addition (p. 220), ‘explicit and implicit understandings regarding the zone of acceptance of the employment relation… need to be reached. Once agreement has been reached…boss and worker essentially agree to “tell and be told”.’ It is clear from this description that cultural diversity is removed by assumption because intra-firm characteristics are seen in a simple top-down manner. A conception of management, or more accurately an ideal-type, based on Taylor’s (1911) scientific management ideas is consistent with this view of the employment relation. It can be described in terms of a simple two-layer firm made up of workers and managers. Management make (strategic and operational) decisions, set up control procedures, and give instructions to the workforce for whom proactive behaviour is dysfunctional. In other words, intra-firm activity is seen only in narrow resource allocation terms. When this is extended to a multi-level hierarchy, middle managers have to accept an employment relationship, involving agreeing to be told, but at the same time giving instructions. The relative importance of these two responsibilities changes at different hierarchical levels. This conception of the firm allows us to conceive of a single subjective productive opportunity determined by senior management.7 But once the possibility of cultural diversity is acknowledged, managerial activity involves not only line responsibilities and development of control procedures but also the meshing together of sub-unit activity. In Chapter 4 this was described in terms of the development of just-in-time and total quality management which facilitates more flexible responses to environmental contingencies. These developments are based on a conception of management and human behaviour that tends to encourage and expect responsibility from lower level organisational units (Drucker 1988). This, of course, is based on the principle that all organisational actors have the scope to make creative choices based on learning activity rather than simply responding to external stimuli. One implication of this is that entrepreneurial activity is no longer identified with unitary organisational leadership; rather it is embodied in decentralised organisational practices. To this extent entrepreneurship is endogenous to organisational characteristics.8 The rationale for this perspective on the firm can be formulated in terms of systems theory or cybernetics. Ashby (1952, 1956) has developed his ‘law of requisite variety’

130  Transaction cost economics and beyond which states that if a stable target outcome is to be attained the variety of the controlling system must be at least equal to that of the activity which it is directing.9 It follows that intra-organisational diversity, with the implied flexibility, is a system response to environmental complexity and dynamism. The ideal-type organisation resulting from this different perspective, that goes beyond the traditional employment relation, can still be described in terms of a strategic framework. The nature of this framework has shifted, however, from a single strategic and cultural orientation towards the coexistence of quasi-autonomous perspectives that are channelled by organisational dynamics based on a dominant culture. A firm’s productive opportunity should therefore be viewed as the strategic framework within which sub-unit opportunities are developed. Of course, the management of any capitalist firm still has its economic aspects based on line responsibility and centrally organised control procedures. Hence autonomy becomes increasingly constrained at lower hierarchical levels, and proactivity is increasingly enabled at higher levels. While this conclusion, about the decentralised nature of creativity and entrepreneurship, is useful to deflect attention away from conceptualising the firm as a single productive opportunity, important complexities should be recognised. It will be recalled from Chapter 7 that the development of core firms, with stable employment patterns and high levels of firm specific skills, has a corollary in terms of peripheral firms that are used to absorb uncertainties. It follows that while core activity will be characterised by a non-homogeneous productive opportunity, peripheral firms with their ‘traditional’ hierarchies can still be conceptualised in unitary terms with a traditional entrepreneur. But while recognising the non-universal nature of, what might be called, embedded entrepreneurship, at the same time we should recognise the wider implications of a strategic framework. If peripheral firms are locked into the strategic arena of a core firm, peripheral organisations should be viewed as part of this wider network. It follows that ‘traditional’ entrepreneurs in peripheral companies are embedded in a wider strategic framework, reinforcing the diversity of productive opportunities. The same point applies for a Marshallian industrial district where an atomistic industrial structure is tied together by external economies; as Lipietz (1992:72) argues: There is no basic difference of paradigm between the forms of ‘social entrepreneurship’ found, for example, in the precision engineering of Emilia-Romagna in Italy… and collective negotiation in a large firm about the control of production management. Intra-firm diversity will exist in all situations except where a strategically independent small firm has an overwhelmingly dominant entrepreneur, or more generally organisational leader, or in organisations where a powerful common ideology exists (Mintzberg 1979). This implies that even in a Taylorist firm, rather than its ideal type, diversity will exist even though it is denied by organisational practice. This is likely to be the case for the same three reasons cited in Chapter 4 against the Alchian and Demsetz view of the firm: the psychic costs of monitoring, the inefficiencies of intra-firm vertical relationships, and the improbability of universal detailed monitoring. It follows that some activities will always be beyond the direct control of managerial decision making, the extent of which depends on the importance of these three factors. In a Taylorist firm these lower level choices will be

The firm as a system  131 directed by autonomously defined aspirations and appear as an indicator of dysfunctional activity, in terms of overall organisational logic. For this reason Simon (1965) suggests that the circumventing of formal procedures may be a sign of inefficiency. But as Brooke and Remmers (1970) have pointed out informal relationships, rather than explicit formal procedures and agreements, can be recognised and developed to further organisational objectives. It follows from this perspective that, in terms of a more general organisational analysis, the denial of autonomous activity is a locked-in, local response to a global problem. This conclusion is similar to that drawn by Pugano (1991) who suggests a general framework to integrate New Institutional and Radical theorists. The former derive efficient organisational form from the characteristics of transactions: degree of specificity and monitoring requirements. But given the nature of the governance system this will guide decisions regarding technology and internal organisation, which is suggested by, for example, Marglin (1974, 1982) and Braverman (1974). Because of this two-way relationship there is no necessary efficiency of an existing organisational form—a sentiment echoed in Chapter 8 of this work. The importance of Pugano’s and the present formulation is that it does not lead to the conclusion evident in Braverman’s work (and less so in Marglin 1982) that Taylorism is a necessary result of capitalist development, rather it is a locked-in response to particular developments. ORGANISATIONS AND DECISION MAKING The framework developed in this chapter has shown how it is possible to combine the firm as a system and as a strategic unity. But this still leaves the topic of individual decision making underdeveloped. In the final part of this chapter this matter will be taken up not only for its own sake but also to facilitate application to the later discussion of policy. There would appear to be three important principles that can be derived from earlier discussion: (1) that decision making is creative rather than a simple processing of information; (2) but goals are endogenous to organisational processes; and (3) that decision making can be understood in a psychological context rather than as a logical or utility maximising problem. Taking up this third point first it will be useful to follow the distinction in psychology between behaviourist and cognitive approaches (see Earl 1990). Behaviourist approaches (which should not be confused with behavioural economics) restrict attention to observable phenomena and view actions as if they are determined by the environmental changes that followed prior actions of the same kind. In economic terms such approaches have a parallel with orthodox positivism, and in terms of the analysis of the firm we can cite Williamson’s assumption of opportunistic behaviour. As Earl (1990:726) points out, there are two problems that behaviourist approaches must confront. First, behaviour cannot be predicted when agents are forced into new environments. Secondly, there is much scope for making erroneous inferences about causation. These problems are the analogue of the discussion of opportunism undertaken in Chapter 2. Cognitive approaches in psychology suggest that when attempting to understand or predict behaviour it is necessary to assume that actions are preceded and determined by cognition and information processing which is an intervening variable between changes

132  Transaction cost economics and beyond in circumstances and behaviour. This broad approach is in line with that adopted in this work, and in particular given the suggested endogenisation of aspirations within a strategic framework it has much in common with social psychology (Hodgson 1988). The disparate parts of the latter contain two core ideas (Earl 1990). First, any mental models possessed by decision makers are simplified ones that have been constructed as a result of experience in a social setting. Secondly, such models are not simply mappings from an objectively specified ‘outside world’ because this would involve a problem of infinite regress (see Hodgson 1988). Each time a mental model is refined a basis is needed for deciding which aspects of the ‘outside world’ should be incorporated, but to make this decision requires a mental model. In terms of analysing individual decision making a (brief) attempt will be made here to use Festinger’s (1957) cognitive dissonance theory.10 This approach has the advantage of being based on a view of the individual which is goal oriented and creative, not an information processor that simply responds to external stimuli (Wicklund and Frey 1981). More pragmatically the use of dissonance theory can complement and support economic perspectives on the firm, and in particular the earlier cited view that learning involves revision of a mental model because of a discrepancy between expected and actual outcomes. Dissonance will exist when there is an inconsistency between a mental map and events, i.e. non-fitting relations among cognitions. Festinger (1957:3) saw dissonance as a reason for human action, in particular the existence of dissonance is uncomfortable because of increased tension, hence people will try to reduce its significance and achieve consonance. In addition, as discussed below in an organisational setting, when dissonance exists people will actively avoid situations and information which increases the problem. This is a particularly useful framework for present purposes because as Earl (1990:736) notes it implies that economic behaviour is path dependent. As an introduction to the use of a decision making framework along the lines suggested here the following account by Chandler of the organisational problems faced by an over extended functional (U-form) structure is instructive: Executives…had neither the time, the information, nor the inclination necessary to stick to entrepreneurial and strategic decision making. The details of the departmental activities for which they were responsible had priority over what often seemed vague long-term planning and appraisal. Moreover, each was a specialist rather than a generalist. Normally, his whole business career had been in one functional field. Thus he had professional pride as well as institutional responsibility in knowing just how his speciality was being carried on throughout the company… Worse yet, just because each senior officer viewed the company’s problems from the point of view of a single function, he tended to reflect in…the activities of the enterprise as a whole, the outlook of one of the parts. (Chandler 1962:296) Here decision making is clearly embedded in a social context, involving reference to career paths and professional pride, and decisions are channelled in ways consistent with attempts to minimise the effects of dissonance. On the other hand Williamson’s (1975:133–5) explanation of the problems with the U-form revolves around ‘partisan interest’, ‘opportunities

The firm as a system  133 for [managers’] discretion, because information is impacted to their advantage’, and ‘deliberate distortions…in support of subgoals’. The differences are stark. More general use of this decision making framework can be undertaken by reference back to discussion of proactive behaviour earlier in this chapter where particular stress was placed on learning processes. If organisations are conceptualised in diverse rather than homogeneous terms it is clear that individuals in different sub-units will have different characteristic mental maps that will structure expectations and perceived opportunities. It follows that minimisation of the effects of dissonance implies different strategies will result from learning processes and responses to environmental change. There is no a priori reason to suggest that any of these strategic responses is necessarily more rational than any other, rather they respond to the perceived needs of different individual and collective decision makers. But given the organisational hierarchy some strategic responses will dominate. This formulation of the issues involved with strategic change makes it clear why successful strategic reorientation requires a powerful coalition of interests at senior hierarchical levels and sometimes the intervention of an outsider followed by action which must have an important symbolic significance (Johnson and Scholes 1989). This latter point can be interpreted in terms of minimising the effects of dissonance to facilitate a restructuring of sub-unit aspirations. In a similar vein Aoki (1988) has suggested that while characteristic Japanese corporate organisation, based on horizontal information flows, is an effective response to incremental developments, a more ‘entrepreneurial’ system will become appropriate when managerial leadership is required. In terms of earlier discussion this shift is necessary because of the required homogenisation of organisational practices. It follows from the above that unless we assume an identical population of individuals, strategic reorientation must always involve an imposition of a particular orientation over alternative perspectives. These alternatives may, of course, be unformulated or implicit, particularly if organisational functioning denies the importance of quasi-autonomous activity. In such circumstances two responses can be identified which correspond to two different ways that cognitive dissonance can affect decision making: either that dissonance leads to balance restoring activity, or that dissonance leads to anxiety justifying behaviour. First, the resulting dissonance of individuals whose aspirations diverge from dominant trajectories may have the common psychological response of denying that any differences exist and adjusting behaviour accordingly (Earl 1990). But such a response need not imply that original perspectives and aspirations are being fulfilled which has clear implications for an analysis of organisational efficiency based on an instrumental view of rationality. Secondly, ‘selective exposure’ (Wicklund and Frey 1981) may result. This is where information that has low credibility, from an individual’s point of view, is acknowledged so that it can be refuted whereas highly credible information is ignored. One possible organisational implication of this is that if quasi-autonomous activity is denied lower hierarchical levels may reinforce divergent aspirations on this basis which among other things will generate intraorganisational rivalry. Furthermore, if it is accepted that the basis of organisation is the development of a body of idiosyncratic tacit knowledge, ceteris paribus the mental maps of individuals will increasingly diverge the greater the organisational distance involved (assuming a non-homogeneous organisation). It follows that differences between perspectives will become increasingly significant with the resulting dissonance from an imposition of a dominant trajectory leading to an increasing possibility of (open or disguised) conflict. In the limit the strategic framework of the firm may not reproduce itself, in which case it

134  Transaction Cost Economics and Beyond will cease to have a single economic identity. But this conflict response need not dominate because dissonance resolution can be creative in a positive sense: ‘If the existence of dissonant cognitions is arousing, subjects should be better at…[group] learning than subjects who are not in an arousal state (Wicklund and Frey 1981:157).’ In economic terms this implies that dissonance can lead to learning and creative (entrepreneurial) behaviour. Furthermore, as the mental maps of individuals are complex a dissonance reduction activity in one area may imply incongruence in other respects which may stimulate further change. But the development of these positive effects is contingent on the existence of organisational processes to facilitate learning. It follows that different responses to dissonance have economic effects in terms of dynamic and static efficiency, a matter that will be discussed further in the next chapter. SUMMARY This chapter has developed a framework to analyse the firm as a system. Key elements in the discussion have been: 1 Traditional behavioural and evolutionary approaches to the firm are limited in that they see decision making in terms of responses to exogenous changes which leaves no role for learning and proactive behaviour. 2 To view the firm as a dynamic system implies conceptualising it in terms of its strategic framework. 3 A strategic framework is defined not only in economic terms but also in terms of sociopolitical—cultural factors that endogenise aspirations and organisational routines. 4 Organisational beliefs and assumptions are diverse and complex rather than being homogeneous. This diversity presents a problem for the way the employment relation is usually understood in economics. 5 The psychology of decision making is briefly examined to complement and support the economic perspectives on the firm.

10 ECONOMIC POLICY AND THE FIRM This chapter shifts the focus of the discussion to use the framework developed in Part I to analyse the rationale for public sector activity and in particular, interaction with private sector firms. Economists, working within a liberal tradition, would in general terms agree with the guidelines developed by Adam Smith (1910:180–1) that define the responsibilities of a ‘sovereign’: The sovereign is completely discharged from a duty, in the attempting to perform which he must always be exposed to innumerable delusions, and for the proper performance of which no human wisdom or knowledge could ever be sufficient; the duty of superintending the industry of private people, and of directing it towards the employments most suitable to the interest of the society. According to the system of natural liberty, the sovereign has only three duties to attend to…: first, the duty of protecting the society from the violence and invasion of other independent societies; secondly, the duty of protecting, as far as possible, every member of the society from the injustice or oppression of every other member of it, or the duty of establishing an exact administration of justice; and thirdly, the duty of erecting and maintaining certain public works and certain public institutions which it can never be for the interest of any individual, or small number of individuals, to erect and maintain. There appear to be two important principles in this formulation that have had an enduring influence over economic perspectives on the public sector and its relationships with private activity. First, the two sectors are involved in separate activities with different responsibilities. Secondly, the public sector should restrict itself to developing a legal and economic infrastructure within which private activity operates. Neo-classical theorists capture these infrastructure effects in terms of a general category of market failure. Failure, in this context, is described as Pareto sub optimality arising from public goods, externalities, or monopoly power. While this neo-classical perspective is dominant within ‘textbook’economics, it is not useful for our purposes as a framework to understand public—private sector relationships. Just as the neo-classical firm is based on unbounded rationality, black-box, timeless principles which cannot capture the essential features of the firm as a system, the same tradition is inadequate in terms of understanding public—private sector relationships in the spirit of the framework developed in this work, which among other things will suggest that the public sector is an active agent rather than simply responding to market failures. ECONOMICS AND PUBLIC SECTOR ACTIVITY To develop a framework that can be used to understand the nature of public sector activities in ways consistent with the perspectives on the firm developed here, we can initially

136  Transaction cost economics and beyond examine critics of the dominant market failure perspective. A view that supposedly minimises the role of the public sector has been developed by property rights theorists (for example, Furubotn and Pejovich 1974; Coase 1960; Demsetz 1967). Their central contribution is to suggest that externalities are not a justification for public sector activity instead they are an indication of undefined property rights. Once these have been specified individual incentives and bargaining between the relevant parties will generate optimal levels of any externalities. While property rights theorists at least attempt to analyse the (minimalist) role of the public sector there are two problems with their perspective. First, individual incentives and bargaining will operate in the way suggested only if there are no transaction costs and minimal power differentials. It is clear for reasons that do not need repeating here that these necessary conditions describe an economic utopia that offers minimal understanding of the real world. This first shortcoming implies a second problem with the property rights perspective. If the existence of transaction costs is acknowledged the role of the public sector is not minimised; rather, as Hodgson (1988) suggests, it is shifted. An extension of individual property and ownership, with the resulting bargaining and incentives, implies an increase in public sector litigation activity not least because a legal structure is needed to police and enforce agreements and property rights. Hence the public sector becomes ever-more deeply involved in the daily intercourse of social life…. In place of measures such as strict laws against pollution, everyone becomes involved in a tangled and inescapable web of ceaseless potential or actual litigation and recourse to law. (Hodgson 1988:152) Williamson (1985, 1986) has reacted against this ‘legal centralism’ of the property rights perspective. Instead of universal ‘court ordering’ Williamson suggests that ‘private ordering’ will be more important. Arbitration, with the resulting bilateral or trilateral governance, is a more efficient way of dispute settlement than recourse to litigation, particularly when parties are locked-in. Williamson’s perspective is clearly an improvement on that offered by property rights theorists. But the emphasis placed on ‘private ordering’, which is used to buttress a laissez-faire approach to economic policy, has a number of shortcomings. First, Williamson (1985) cites Auerbach (1983:4) that the ‘success of non-legal dispute settlement has always depended on a coherent community vision’. But the analytical importance of this ‘vision’ is played down by Williamson: ‘Assuming that the term “communitarian” is given its ordinary signification, such baggage is both unneeded and unhelpful’ (Williamson 1985:166). The significance of the view expressed in this quotation can be understood by reference back to the discussion of Chapter 9. There emphasis was placed on the way that organisational culture rendered decision making feasible given informational uncertainty and complexity. But an implication is that organisational behaviour will tend to be path dependent. Similarly, a common set of values is necessary to render private ordering and dispute settlement feasible (Casson 1991). If arbitration is not constrained in this way, following the organisational logic, inevitable ambiguity and co-ordination breakdown will result. Williamson assumes such complexities away. But in doing so he simultaneously

Economic policy and the firm  137 removes the possibility that private activity will generate local rather than global solutions to problems because of locked -in behaviour. The implications of lock-in are centrall important to the role of the public sector to be suggested in this chapter, as discussed below. The second problem with Williamsonian ‘private ordering’ follows from that just discussed and is suggested by Hodgson (1988). Just because the majority of disputes are not resolved by recourse to litigation does not imply that the public sector is thereby removed from the processes involved: the mere possibility of access to the courts is sufficient for the legal system to bear upon contractual agreements. It is not necessary that people actually appear in court for the state to have such a function. Whilst both formal and informal norms and rules play an important part in a system of exchange, in a modern society these rules are buttressed and sometimes created by law and the state.’ (Hodgson 1988:154–5) Underlying this shortcoming is a more general problem that Williamson shares with property rights theorists, and much orthodox economic thinking on the role and functioning of the public sector, that is inherited from Adam Smith and the liberal tradition of which he was a part. As suggested earlier it is assumed that there is a clear division between the activities of the public and private sectors. Furthermore there is a common lack of clarity about what exactly the public sector is. Stepan (1978:xii, cited in Hodgson 1988) is helpful in this regard: The state must be considered as more than the ‘government’. It is the continuous administrative, legal, bureaucratic and coercive systems that attempt not only to structure relationships between civil society and public authority in a polity but also to structure many crucial relationships within civil society as well, (emphasis in original) It follows that whilst there may be a distinction that is more or less clear between government and private sector activity the same is not true for the state which is inevitably involved in structuring and defining the functioning of the economy. Clearly, however, government activity is based on the power of the state. This suggests two ways of conceptualising public—private sector relationships. First, in the spirit of the liberal tradition, contacts are based on arms-length relationships: the state and government determining infrastructural conditions within which the private sector operates autonomously. Secondly, public—private sector contacts may be direct and interactive, the relationships involved being more accurately described in terms of networking. These formulations facilitate the application of theoretical perspectives developed in earlier chapters to public—private sector contacts. This leads us to the third problem with Williamson’s ‘private ordering’. Clearly, in the light of what has just been said, it is artificial to examine private governance structures without simultaneously examining the state’s role in dispute settlement, governance structure formation, etc. Furthermore, it has been suggested (Dugger 1983) that the state itself

138  Transaction cost economics and beyond exists as an efficient transaction cost economiser given private sector (market and firm) failure. This formulation suggests that the framework developed in Part I of this work can be applied to the state and public sector involvement in the economy, a possibility that is developed in the next section of this chapter. Following this the organisational complexities of state activity are developed which imply, among other things, that the public sector is not neutral in its economic (and other) activities. Finally, the discussion turns to the specific issue of industrial policy.1 This aspect of state activity is arguably the most controversial area of public sector influence on the activities of firms because of the weight of liberal ideas. The general conclusions drawn are that a proactive organisational view of the firm requires a similar active public policy stance. THE PUBLIC SECTOR AND ECONOMIC ACTIVITY Following Max Weber (1919) we can suggest an initial definition of the state in terms of a body, within a given territory, that has a monopoly over the legitimate use of force. This is consistent with a view of the state as a regulator of conflicts or as a ‘night watchman’. In economic terms this latter is equivalent to the earlier mentioned perspective that stresses the state as a provider of (legal and economic) infrastructure which involves mediation of disputes (in the first or last resort depending on the school of thought). It is possible to develop this role into a ‘welfare state’ which encompasses social as well as economic and legal infrastructure. While these perspectives are useful they omit any explicit reference to the state as an active (rather than arms-length) regulator. Using equivalent reasoning Dugger (1993) suggests that for economic purposes we should play down a definition of the state based on legitimate physical force and stress its role as an agent that exercises sovereignty, in much the same way as a firm does within its boundaries. It follows from this that just as the firm can be conceptualised as a strategic framework, as discussed in Chapter 9, we can similarly understand the state as an active agent under the strategic (not necessarily day to day) control of government. Hence we can identify government as ‘the apparatus and processes of legislation, administration and legal regulation’ (Bottomore 1979:8). In this regard note that just as control of a company can be changed by merger/acquisition and senior management succession, a similar perspective is possible for government, either by democratic or other means. Furthermore, just as the economic (rather than legal) significance of a firm depends on the existence of a strategic framework, a similar point applies to the public sector. If government credibility, i.e. its ability to provide a strategic framework, ceases to exist, it will be replaced—once again by democratic or other means. The ‘other’ here implies that the senior echelons of the state might have considerable potential autonomy and there will be differential ability to control the functioning of state activity—a point taken up later. In addition, civil war can be understood as the non-existence of a single strategic perspective, with violent consequences. The break up of states can be similarly conceptualised. While the above comments clarify what is meant by the public sector they beg the question why it should exist. Hodgson (1984, 1988) has suggested that the answer to this question can be formulated in terms of systems theory or cybernetics, which can be used to support historical evidence regarding the necessity of state activity in a complex society.

Economic policy and the firm  139 He uses Ashby’s (1952, 1956) ‘law of requisite variety’, as introduced in Chapter 9, to derive his ‘impurity principle’: more than one control structure is required for a system to operate and reproduce itself through time. One such control structure for socio-economic systems is the state which must exist, to prevent system breakdown, given economic and social complexity and variety. An important difference between Hodgson’s use of Ashby’s framework and the latter’s work concerns the source of variety. Ashby suggests this exists in the external environment. Hodgson argues that in socio-economic systems, because of human agency, an additional source of variety is generated endogenously. This latter formulation is central to an understanding of the economic role and functioning of the public sector. A more economic, rather than cybernetic, analysis that applies this necessity for variety can be formulated in transaction cost terms. Pitelis (1991) suggests that ‘private sector failure’ can be understood in this way. The existence of a general legal framework will reduce private sector transaction costs by structuring negotiation and policing activity. From this perspective transaction cost savings will be evident in two areas: first the legal framework itself can be provided at lower cost by state monopoly, for reasons equivalent to traditional internalisation arguments; secondly, given this framework private sector transaction costs will be reduced. Similar logic can be applied to other activities that have public goods characteristics. In terms of the framework developed in Part I of this work this perspective on state activity can be accommodated in the following way. First the possibility of direct state provision of activities can be introduced as a third governance structure with its attendant costs (perhaps logically denoted as Cs, for any one activity, to distinguish it from private sector provision Cf).2 In addition, however, given the way that the state provides a framework for private activity the costs of operating firms and markets must be augmented to include or exclude state regulation. It follows from this setting out of the issues that ‘government failure’ (see Cullis and Jones 1987; Wolf 1979) is not simply a matter of the inefficiency of the public sector, which for our purposes is where Cs is greater than Cf for any particular activity, but rather the effects on Cf and Cm of state activity must be acknowledged. It is clear from earlier discussion of the property rights school and Williamsonian private ordering that positive effects of this sort can exist. The reverse, of course, is also true: Cs may be reduced given the existence of Cf and Cm which has obvious bearings on the inevitable gross inefficiencies of any attempt to completely plan an economy (see Dietrich 1986). As with the private sector analysis discussed in previous chapters the possibility of governance structure benefits can be introduced into this framework. What can be called the orthodox justification for the state is shown in Figure 10.1. Cf and Bf imply that private internal organisation of the activity in question is not feasible; use of the activity must involve production elsewhere. But public sector intervention will result in the cost and benefit curves shifting as shown by the arrows. Lower governance structure costs may be evident because of a commonly accepted legal system. Greater benefits may be derived from the public sector taking over production of an under-supplied activity that generates external benefits, such as education and training (the property rights critique of this suggestion will be taken up shortly). While this analysis is useful in an interpretative sense it adds little to textbook economics because the state as a governance structure is left implicit or in the background. Further

140  Transaction cost economics and beyond conclusions can be derived by specifying the relevant costs and benefits of the management of state activity itself. In terms of the systems theory framework discussed earlier, the fact that state and private sector costs and benefits can differ increases the control potential of the socio-economic system because of the increased variety involved.

Figure 10.1 The orthodox justification for the state The derivation of a governance structure cost curve for any one state activity would seem to be straightforward, the framework set out in Part I above can be duplicated. An equivalent benefit curve, however, is a different matter because the relevant advantages may not be readily measurable in monetary terms in practice. But as with much public sector economics we can assume that such measurement is possible in principle. It follows that the framework should be understood in an heuristic rather than literal sense. A further difference between the two sectors is that the general strategic objective of a private sector company, an increase in long-run profits, is not likely to be appropriate for a public sector organisation. But a simple transposition would seem to be relevant in terms of an increase in longrun net benefits. As with the private sector, however, the details of this formulation depend on the perceived productive opportunity and stakeholder-coalition power, matters which are discussed below. Note that one possible objection to this framework that is not tenable is that public sector agents do not act in a commercial manner. It is clear from earlier chapters that it is inappropriate to assume an abstract technical efficiency when individual and collective objectives determine particular governance structure costs and benefits; the same argument applies to the public sector. Furthermore, a non-commercial orientation may be positively advantageous for reasons argued below. Against this background we are now in a position to specify the determinants of governance structure benefits for any one state activity. As with the private sector, increased

Economic policy and the firm  141 management activity will result in a movement around any benefit curve but with diminishing effect. The relative size of such benefits, compared to the private sector, will be a function of the same two general factors: idiosyncratic advantage and economic power. We will concentrate on the first of these initially, the possibility of the second will be introduced below. For the sake of brevity the discussion will ignore cases where any particular governance structure has an absolute advantage over another, in the sense of benefits being greater and costs being lower than any alternative. In addition we will concentrate on the production of goods and services and ignore their allocation, hence, comparisons will involve Cf and Cs. A more complete analysis would necessitate development of this narrow framework to include a direct allocative function for the public sector as an alternative to markets. Finally, as in previous chapters, cost and benefit curves will be drawn such that relatively inefficient organisational forms are not feasible (cost greater than benefits for all levels of managerial activity)—this simplifies initial presentation. Given these restrictions Figures 10.2 and 10.3 set out two cases that are relevant. In the first of these figures Cf >Cs and Bf>Bs, hence the state is more efficient in terms of governance structure costs but the reverse is the case with benefits. On the cost side private sector failure exists, perhaps because of the public goods characteristics of the activity in question with resulting free-rider problems. Attempts to overcome these problems lead to relatively high contracting and/or organisational costs. This, therefore, does not deny the possibility of private sector activity, hence the property rights critique is accommodated, but because of litigation and other matters (as discussed earlier) it is relatively inefficient. On the benefit side there is government failure perhaps because the necessary perspective, or organisational culture (see Chapter 9) benefits from commercial orientation.

Figure 10.2 The state: dynamic failure and static advantage

142  Transaction cost economics and beyond This general situation might describe the complementarity of public and private sector research activity (Teece 1988), especially that which is pre-competitive, involving both private sector failure and advantages of commercial orientation. Possible implications might indicate an industrial policy based on networking between the public and private sectors rather than arms-length relationships, as discussed later in this chapter. Alternatively, Figure 10.2 might depict the complexities of the debate surrounding nationalisation/privatisation (see Thompson and Wright (1988) for a survey of the UK literature). Private sector natural monopoly can result in excessive transaction costs because of the possibility of opportunistic behaviour. This implies that Cf>Cs provides a transaction cost rationale for nationalisation. But a possible lack of commercial orientation of public sector firms implies that Bf>Bs. Hence one possible solution is privatisation, but with state regulation. It is clear, however, that in the absence of networking, the antagonistic relationships between the parties renders public sector regulation difficult. Hence the increased benefits of private sector activity may involve monopoly advantages as much as dynamic/ static efficiency gains. Figure 10.3 similarly depicts a complex public—private relationship with Cs>Cf and Bs>Bf. From a governance structure cost perspective the private sector is relatively more efficient indicating that the activity in question is readily marketable. The benefits of resource allocation, however, indicate advantages of state activity. This might indicate the existence of dynamic private sector failures, i.e. a relative inability to change the characteristics of activities. As discussed in the previous two chapters, organisational dynamics can generate path dependencies that constrain company choice of particular strategic trajectories. It follows that an important aspect of a dynamic industrial policy is to shift such developmental paths towards strategic trajectories that generate greater benefits in the long-run, details of which will be discussed below. In such circumstances, therefore, the state has a dynamic advantage because it is, at least potentially, not constrained by private sector organisational and technological lock-in. But in addition, in Figure 10.3 there is a static government failure. Hence, once again, a networked rather than arms-length policy stance is called for. The situations described here are similar to the transaction cost analysis of the state suggested by Dugger (1993). He draws a distinction between low and high efficiency. The former is that generated by private ordering of transactions. This reflects the interests of dominant parties. Or in terms of the framework set out in Chapter 9, the objectives of dominant coalitions and stakeholders. But this is different from higher efficiency which recognises the social costs and benefits of private activity and requires state activity to be achieved. In dynamic terms what is suggested here is that the performance space of the economy has local and global optima and that organisational dynamics cannot generate global efficiency (see Chapter 8). This suggests, in principle, two general policy stances: either a direct influence on private activity by the state; or state activity indirectly shifting path dependencies by altering the constraints on decision making. The former possibility will be most efficient when the governance structure cost and benefit curves are as depicted in Figure 10.2, whereas the latter should be adopted for Figure 10.3.

Economic policy and the firm  143

Figure 10.3 The state: static failure and dynamic advantage

THE STATE AND ORGANISATIONAL COMPLEXITY In the previous section the discussion, while reflecting the complexity of possible relationships between the public and private sectors, treated the state in an over simplified way. If, as suggested, it possesses a comparative advantage in some respects (be they economic, political or social) this introduces organisational problems that must be recognised. The organisational complexity of the state can be analysed in similar terms to that suggested in Chapter 9 for the firm. Its strategic framework can be understood in terms of the configuration of coalitions and stakeholders. The government can be understood as the political equivalent of organisational senior management, to this extent it may be called a top-level coalition (ignoring problems of different coalitions within government) that has ultimate control over the activities of the state. The nature of political stakeholders can be conceptualised in a number of ways. Neoclassical economists stress the neutrality of the state in which, in a political democracy, government represents the views of the general public and therefore embodies social preferences. But this formulation ignores the insights presented by Arrow’s (1963) possibility theorem. This states that if there are at least three social outcomes there is no social choice rule that can simultaneously satisfy the following properties: (1) transitivity, (2) Pareto efficiency, (3) independence of irrelevant alternatives, and (4) the absence of a dictator. Consequently in practice social choice must be based on eliminating or relaxing one (or more) of Arrow’s properties (Kreps 1990b).3 Changing (1) and/or (3) might be based on

144  Transaction cost economics and beyond a recognition of bounded rationality problems. Questioning (2) can imply that decisions involve socio-economic or political interpersonal comparisons rather than a logical rule. Finally the (partial) inappropriateness of (4) might be based on an alternative conceptualisation of stakeholder characteristics, as will now be discussed. The power of different political stakeholders can be analysed in terms equivalent to that suggested in Chapter 9. This implies, among other things, that political and socioeconomic influence on the state will be a function of bargaining power and resources that can be mobilised to support information generation and lobbying activity. In addition the dominant culture of the state as an organisation recognises and defines what are (or are not) important issues. The end result is that some stakeholders will have greater influence than others. This differential influence will define the state’s ‘subjective productive opportunity’ (see Chapter 9) or the perceived strategic role of the public sector. Recognition of these organisational complexities implies that the state is not neutral in its activities (Pitelis and Pitelis 1991). Marxist approaches to the state are based on a similar non-neutrality. They have a common theme that the state works to ensure the reproduction of socio-economic relations. Such relations are based on differential class power defined in terms of control over economic processes. There are obvious parallels between this view and the approach suggested in this and previous chapters, but two important qualifications should be stressed. First, it is not being suggested here that organisational or socio-economic relations, be they within private organisations, or within the state, can be reduced to a fundamental class character. For example, it is argued in Dietrich (1991b) that there are important national based supply-side idiosyncrasies in the European Community that must be recognised. This is not to argue that control over economic decisions is neutral in terms of its power implications, but rather the idea of, for example, organisational culture is more diverse than this. A second necessary qualification is that there is no single Marxist theory of the state: Jessop (1977) suggests six different approaches under this general heading. Hence the current work has more in common with some approaches than others. In particular the logic of the framework developed here implies a degree of autonomy in the activities of the public sector because a state’s productive opportunity is not defined in an objective way that would involve policy decisions being responses to exogenous conditions. This autonomy is equivalent to the discretion that allows senior management opportunism in private organisations. A number of important implications follow from this. A degree of autonomy in the activities of the public sector is necessary to render any discussion of different economic policies meaningful. In its absence we could only talk of the (single) set of state activities, in much the same way that orthodox transaction cost theorists (implicitly) suggest private sector senior management decisions are rational. But, the existence of particular state policies are no guarantee of their efficiency, no matter how the latter is defined (a possibility that was removed by assumption in the previous section). In the private sector it can be argued that ‘subjective’ and ‘objective’ productive opportunities interact which, ignoring disequilibrium dynamics, will generate in the long-run local efficiency. In the public sector, however, the possible monopoly on power can create problems in this respect, even though this monopoly may be economically rational. Using similar logic ‘new right’ theorists4 suggest that state functionaries maximise their own utility implying inevitable inefficiency with a self-generating bureaucracy. There is,

Economic policy and the firm  145 of course, a germ of truth in this perspective but a major omission is to concentrate solely on individual choice and hence ignore the strategic unity of the state. As discussed for the private sector in Chapter 9 this unity implies that individual aspirations are channelled by particular coalitions and stakeholders. For example in the UK the economic activities of the state appear to be dominated by the short-term requirements of the Treasury (as a powerful coalition) and the City of London (as a powerful stakeholder). But, a real and analytical problem is still present that in a centralised state there is no external economic challenge to inefficient locked-in behaviour. This conclusion echoes North’s (1981) theory of the state. It is suggested that a utility maximising ruler exists. The presence of potential rivals to the ruler’s leadership implies a necessity to provide services to a population. Hence, given a rivalry threat and transaction costs of service provision and wealth accumulation property rights will be structured to further the utility maximising objective. The property rights will therefore be idiosyncratic with inefficiencies possible. There would appear to be two ways of breaking this path dependency of public sector activity, which is necessary to overcome the dynamic private sector failures discussed in the previous section. First, we could rely on political democracy. Without discounting its importance this, by itself, may have difficulties given the non-neutrality of the state. Hence a second necessary means of overcoming public-sector lock-in is to rely on (quasi) autonomous activity within the state itself, which in effect will break down its centralised nature. The importance of this second strategy is clear from the discussion undertaken in Chapter 9. There the inefficiencies of artificially homogenising a complex organisation were stressed. In addition, the way in which decentralised conflict resolution can be creative was emphasised. A similar argument applies to the state: decentralised responses to problems can generate creative public sector intervention by reducing the possibility of co-option by any single socio-economic group. Decentralisation, in this context, means two things: first recognising coalition complexity at a given hierarchical level; and secondly, incorporating hierarchical complexity. In a sense this is simply an application of Ashby’s cybernetic principles. The complexity of the socio-economic environment requires a similarly complex response if a system is to effectively reproduce itself. To reiterate an earlier point, however, this decentralised activity does not remove the importance of the strategic unity of the state, if the latter is to have any reality. So, for example, overall macroeconomic management and institutional (legal, socio-economic, cultural, etc.) coherence must be recognised. INDUSTRIAL POLICY AND THE FIRM In this section the framework developed in the previous two sections will be applied to the specific case of industrial policy. The underlying message is that long-run dynamics offer greater opportunities to increase welfare than short-run allocative and technical improvements. The long-run emphasis is consistent with much industrial policy practice. For example, Japanese strategy emphasises products and sectors with high income elasticities of demand and large scope for technological advance (Donald and Hutton 1991). In Germany policies emphasise the funding of R&D and are oriented towards diffusion and the development of research networks (Grewlich 1987, Streit 1987, Stoneman and Vickers 1988). In the US a similar emphasis revolves around the defence sector acting as a catalyst

146  Transaction cost economics and beyond for change (Johnson 1984). UK policy has been somewhat the exception since the reorientation of Department of Trade and Industry practice in the 1980s (see Shepherd 1987). It appears, therefore, that traditional economic arguments for industrial policy based on static market failure reasoning (see Dietrich 1992),5 suitably reformulated in terms of governance structure costs as discussed earlier, provide an inadequate framework to understand this role for the state. We can suggest the following general principles to guide our understanding of industrial policy. At a general level such policies can be characterised as long-run supply-side initiatives aimed at restructuring or promoting the activities of particular firms or sectors. Johnson (1984) has characterised this in terms of policies to develop dynamic competitive advantage. Using more recent theoretical developments this advantage can be conceptualised in terms of path-dependent dynamics which set the parameters within which these policies operate. Standard market failure arguments are appropriate given a particular strategic orientation. It follows that public sector policies concerned with long-run economic welfare are involved in facilitating the emergence of developmental paths, even if this is in the negative sense of reinforcing current paths by default. Consequently we can agree with Cowling (1990) that industrial policy should be proactive and selective being restricted to restructuring those parts of an economy deemed strategically important. This formulation leaves open the way in which industrial policy is enacted. Traditionally even an active policy stance has been conceived in arms-length terms. For example, Saunders (1987) highlights the following industrial policy tools: selective promotion of particular sectors or branches of an economy; financial aid to investment and R&D; and/ or regulation of foreign trade in the interests of a national (or international) economy. Without wishing to deny the importance of these tools the main emphasis is that given the industrial policy stance private sector activity is autonomous. It is clear from discussion earlier in this chapter that this formulation is a special rather than general case, in particular it is inappropriate as a guide to an interactive policy stance that is aimed at shifting organisational dynamics. Chapter 7 emphasised that the advantages of networking, rather than arms-length, relationships rely on the joint use of different knowledge inputs and the combination of trust with market incentives. Hence a networked industrial policy can gain its rationale from these principles. It is apposite, in this regard, to remember Johnson’s (1984:74) message that: ‘Industrial policy is first of all an attitude, and only then a matter of technique’. Rather than develop these comments in an abstract way it will perhaps be more straightforward, and useful, to attempt a more applied development based on specifying the nature of possible developmental paths that current industrial policies must accommodate. It is generally recognised that economic restructuring is being channelled by fundamental organisational—technological change. As briefly discussed in past chapters, a shift away from previously dominant mass production of homogeneous products, with characteristic technologies and organisational processes based on rigid hierarchy, is occurring, towards more flexible production processes, based on microelectronic and other technologies, with flatter, more decentralised hierarchies (Piore and Sabel 1984, Freeman and Perez 1988). While the recognition of these trends is important, the emphasis sometimes placed on a resulting increasing comparative advantage of smaller firms (for example Dosi 1988) seems misplaced. The rise of an oligopoly-based capitalism, with its attendant internationalisation, is

Economic policy and the firm  147 based on financial, marketing and R&D advantages of large firm size (Prais 1976, Hannah 1983), technological changes are correspondingly relatively unimportant. More precisely we can distinguish between economies of size and growth (Penrose 1980). The advantages of large size are based on exploiting the dynamics of organisational advantage. It follows that technological change, and its effect on economies of size, need not lead to the reversal of oligopolised and internationalised economic activity. If current organisational—technological imperatives unfold in a deregulated environment they will be dominated by existing historical trends (Amin and Dietrich 1991a). In other words autonomous private sector activity will be channelled by existing path dependencies. Hence if the creation of dynamic small—medium firm activity is an industrial policy objective, the constraining non-technological factors must be confronted (cf. SBRC 1992). It is perhaps no accident that examples of thriving innovative small firm activity rely on quasi-integration (see Chapter 7) to afford a degree of strategic protection. Such protection, or strategic havens (Dietrich 1992), either obviates or facilitates the exploitation of dynamic financial, marketing and/or research-diffusion economies, and in practice seems to rely on either core firms, as in Japan, or strong private—public institutions, as in Emilia Romagna in Italy (Best 1990). This suggests an important role for industrial policy, to be developed shortly. Geroski (1992) points out that in general terms economic change and efficiency gains may be achieved by the state facilitating either horizontal or vertical contacts between firms. These can be discussed in turn to examine the extent to which they facilitate, or impede dynamic advantage. Horizontal policy is based on restructuring innovation producing firms, characteristic policies being market concentration (the formation of ‘national champions’) and developing quasi-integration contacts to co-ordinate strategic changes (as discussed in Chapter 7). Such an approach appears to inform much European Community policy, the objective of which is to stimulate joint action in the pre-competitive stage of technological development (see Dietrich 1991b). This approach has been criticised for the passive way that it simply invites applications (House of Lords 1985) which reinforces incremental management practice (Moynot 1988). Such criticism is not to argue against European Community initiatives in principle, which are obviously necessary given the internationalisation of strategically important activities (Amin and Dietrich 1991a). In general terms, a danger with horizontal policies is that they reduce rivalry by reinforcing monopoly power and hence reduce the incentive to undertake radical redirection (Geroski 1992). This implies that they may reinforce, rather than facilitate the shifting of path dependencies. We can therefore suggest that horizontal industrial policies should be avoided in favour of vertical alternatives. As discussed in Chapter 7, strategic capability depends on a ‘value chain’ rather than a single company (Porter 1985) which can be best developed by vertical co-operation rather than integration (Johnson and Lawrence 1988). In principle this co-operation can be developed by ‘top-down’ or ‘bottom-up’ policies (Cook 1987). Top down policies involve inducing the main large firms to undertake innovative projects, following which networks are developed in response to the demands of the core activities. Particularly important, in this respect, is strategic government procurement (Geroski 1992). Its importance is indicated in the US semi-conductor and computer industries (Levin 1982, Katz and Phillips 1982). But two shortcomings may be evident with top-down policy: first, if the leading firms are multinational, networks may not be based on indigenous firms; secondly, the approach is contingent on the leading firms responding to restructuring initiatives, which may be a particular problem if top-down initiatives are

148  Transaction cost economics and beyond combined with a horizontal policy. The first possibility requires a bottom-up policy stance, to be discussed shortly. The second problem appears to be countered in practice by industrial policy initiatives being based on networking between the public and private sectors rather than arms length relationships, which is consistent with Figure 10.3 discussed earlier. For example, in Japan close contacts exist between the state (focused on the Ministry for International Trade and Industry) and the private sector (Dore 1986, Donald and Hutton 1991) which facilitates the restructuring of corporate strategies and the underlying organisational beliefs and assumptions in which they are embedded. This networking helps break down the scepticism and antagonism of the parties involved which is likely to be reinforced with arms-length contacts. In short, financial inducements are unlikely to succeed in shifting path dependent organisational activity by themselves. Bottom-up policies seek to improve the capacity to supply goods—services by exploiting particular comparative advantages and needs. We can start by concentrating on regional—local initiatives, the rationale for which is based on a number of factors. If industrial policy is understood in a dynamic sense then at a minimal level this must concern itself with (a) the birth of new firms, and (b) what in the management literature is called ‘turnaround’ of existing firms. Taking the latter first, it is obvious from discussion in previous chapters that when organisational considerations are introduced there is no direct link between competitive pressures and organisational success, rather corporate beliefs and assumptions need to be transformed to promote strategic reorientation. In the management literature6 turnaround is usually discussed as an organisation-specific problem, emphasis being placed on new senior management, tighter financial control and so on. As Pettigrew and Whipp (1991:25) point out ‘concern with managerial remedies necessarily has led to an over-emphasis on the firm at the expense of the competitive environment. The problem of competition is immanent with [turnaround] accounts’. As discussed already, competition offers large firms a dynamic advantage in terms of finance, marketing and R&D. Hence small—medium firm turnaround can be based on, what was called earlier, strategic havens to exploit economies in one or more of these support services. In the absence of such havens the arms-length nature of economic relationships will lead to reactive rather than proactive behaviour, which is perhaps a generally accurate description of economic processes in the UK. In particular it may be appropriate to make reference back to discussion of the relationship between companies and large external owners in Chapter 6. It follows that a major industrial policy problem is to facilitate institutional restructuring to allow effective strategic reorientation. The development of strategic havens may be based on either direct public sector provision or the public sector facilitating the formation of private sector collective institutions. The transaction costs and learning effects involved with the latter possibly imply that public sector subsidy may be appropriate. An important principle, however, is that such support is based on strategic redirection not operational subsidy. Needless to say, while the rationale for strategic havens has been developed in terms of turnaround their function can be expanded to be incubators of new activity which, in dynamic sectors, will suffer from the same disadvantages as existing small firms. This rationale for bottom-up industrial policy, involving the development of strategic havens, has been based on economic reasoning involving the dynamic or strategic disadvantages of small-scale activity. An additional reason, however, has been suggested

Economic policy and the firm  149 earlier in this chapter. It is important in an economy to have many loci of autonomous public—private strategic initiatives, and inter-agency networking and institutional competition, to help overcome path dependent behaviour or facilitate redefinition of the state’s ‘subjective productive opportunity’. In a wider context, decentralised public sector activity is important for socio-political/democratic reasons. But to reiterate an earlier point such activity does not remove a role for national economic policy, or in the current context industrialinitiatives. National industrial policies are important for at least two reasons. First is the obvious point that some economic activity is nationally based and hence requires initiatives at this level. But perhaps more importantly, the detailed characteristics of socio-economic norms are overwhelmingly nationally based. It is clear from earlier discussion that strategic management systems nest into these wider characteristics, hence industrial policy frameworks must be ‘home grown’ in terms of their detailed functioning. Institutional idiosyncrasies have constrained the UK’s economic development along a dominant trajectory defined by Cowling (1987, 1990) in terms of three characteristics: transnationalism, centripetalism and short-termism. It follows from this that industrial policy must be based on institutional innovation involving a Strategic Development Agency and a National Investment Bank (Cowling 1990) that can work alongside regional—local initiatives. While these initiatives would be aimed at directly shifting the developmental trajectory of the UK economy, a dynamic industrial policy would also be concerned with fuelling institutional change to facilitate the emergence of developmental paths in a more decentralised way. If the arguments presented in Chapter 9 are accepted, an important factor involved here may be to promote a shift in organisational logic away from Taylorist principles towards an acceptance of decentralised, quasi-autonomous activity (Lipietz 1992). A welfare (as well as an efficiency) justification for this can easily be identified. The shift away from equilibrium theorising, implied by an emphasis on strategic management and organisational dynamics, means that allocative and technical norms can no longer be taken as efficiency indicators. It follows that accountable senior management, in terms of major strategic issues, is a basic requirement so that decisions recognise the aspirations and objectives of currently subordinate organisational actors. Hence there are both positive and normative arguments for intra-organisational democracy or power sharing (Knight and Sugden 1990). A movement towards more efficient (in both high and low senses: Dugger 1993) developmental paths would therefore seem to require a shift in perspective away from sole corporate legal accountability to shareholders to acknowledge the importance of other stakeholders and coalitions. This is as much an element of a dynamic industrial policy aimed at improving long-run supply-side potential as more traditional components such as innovation and diffusion activities. SUMMARY This chapter has applied the framework developed in this work to the public sector and its relationships with private activity. Important aspects of the discussion are: 1 The state can be understood as a governance structure with its attendant costs and benefits.

150  Transaction Cost Economics and Beyond 2 A relative governance structure cost advantage for the state, compared to the private sector, implies static private sector failures. A benefit advantage will exist when private activity suffers from a relative inability to change the characteristics of activities, i.e. dynamic failures exist. 3 Using a similar framework to that developed in Chapter 7, to analyse quasi-integration, two non-arms length cases of public—private relationships are developed. 4 The organisational complexities of the state are analysed in terms equivalent to that suggested in Chapter 9, and suggests among other things that the state is not neutral in its activities. 5 The framework developed in this chapter is applied to the specific case of industrial policy. It is argued that the state should be involved in shifting path dependent activity, i.e. developing specific developmental trajectories.

11 CONCLUSIONS This final chapter will pull together the elements of the discussion by returning to the themes set out in Chapter 1. In particular the special case status of transaction cost reasoning will be examined from two perspectives: static—dynamic analysis and individual— social causation. It should be clear from Chapters 2 to 10 that transaction cost economics ignores the complexities of a dynamic analysis within a social context by (implicitly) assuming unchanged governance structure benefits. This is, of course, a perfectly acceptable approach, in a methodological sense, if the insights gained from the analysis are not generalised beyond appropriate analytical bounds that are set by the assumed conditions. It is clear from the analysis presented in this work that transaction cost economics does stray beyond the bounds of acceptability. In this chapter approaches to the evolution of organisational form will be examined with three objectives in mind: first to link these literatures to a transaction cost framework; secondly, to show that the analytical bounds of transaction cost reasoning are inevitably breached; and finally to show that transaction cost reasoning is still relevant but in a more restricted field than is usually presented. The intention here is not to weaken transaction cost reasoning but to set it in a wider framework that can suggest underlying reasons why organisational logics shift over time, and related to this why competitive and socio-economic conditions change. In terms of the framework set out in Chapter 8, the discussion will address why and how the performance space of an economy has changed its contours and the implications of this. Clearly such contours will channel the ways that governance structure benefits are exploited. More specifically, for any given overall organisational and competitive logic (the precise meaning of which will be defined shortly) the general characteristics of economic units will be defined. In such conditions, transaction cost reasoning, with its approach based on economising behaviour with given organisational characteristics, is useful. Furthermore, when the general nature of organisational, technological and product-market characteristics is given, changing governance structure benefits will reflect the comparative advantages of economic units, i.e. individual rather than system characteristics. But if organisational and competitive logics change it follows that potential governance structure benefits in general will shift, with attendant restructuring in competitive advantages and organisational power relationships. In terms of understanding the general nature of the firm, it follows that systemic shifts in governance structure benefits may be of greater long-run importance in explaining the evolution of organisational form than more narrowly defined transaction cost reasoning. To examine these claims in more detail two approaches to understanding systemic evolution will be discussed: Neo-Schumpeterian and Regulation schools of thought. These two approaches suggest different, but related, explanations of long-run institutional change. An important general point is that a given organisational and competitive logic or world view should be seen as a structuring of perceptions. This structuring makes no claim of absolute dominance of the perspective, rather that it is generally accepted as the most significant set of institutional principles. For example, a dominance of Taylorist principles did not eliminate batch production with considerable organisational decentralisation of conceptual,

152  Transaction cost economics and beyond rather than manual, activity; alternatively, an increasing dominance of what was called in Chapter 9 embedded entrepreneurship is unlikely to eliminate rigid hierarchies. At times, in the final two sections of this work, this complexity may drift into the background. THE NEO-SCHUMPETERIAN SCHEMA The neo-Schumpeterian approach to shifting organisational—technological logics is most forcefully expressed in the works of Perez (1983) and Freeman and Perez (1988). Stress is placed on an amalgam of Kondratiev long-waves in economic development and Schumpeterian business cycle theory. Long-run economic evolution is explained in terms of a bunching of innovative activity that forces socio-economic change. Four types of innovation are highlighted by Freeman and Perez (1988): 1 Incremental innovations are small ongoing changes that result from learning by doing and using. Cumulatively they are an important source of productivity improvements but their effects are apparent in steady state growth. 2 Radical innovations imply novelty and discontinuity. In recent times, they have been the result of deliberate research and development. 3 Changes in the technology system combine 1 and 2 with organisational and managerial innovation affecting several branches of an economy, as well as giving rise to new sectors. Frequently clusters of technology are involved here. 4 Changes in techno-economic paradigm, combining 1, 2 and 3, are so far-reaching that they have a pervasive effect throughout the whole economy. They determine overall technological trajectories. Economic evolution is explained in the neo-Schumpeterian schema in terms of matches and mismatches of socio-institutional and techno-economic paradigms. In the downswing of a Kondratiev cycle the innovative and productive potential of a techno-economic paradigm runs out. Innovative activity during this phase of the cycle leads to the development and emergence of a new paradigm. At the bottom of the cycle a mismatch is evident between the emerging technology and old socio-institutional arrangements. A crisis of structural adjustment ensues involving social and institutional changes, as well as the replacement of the motive branches of an economy. The new techno-economic paradigm is not simply based on new products and productive systems but more importantly key inputs dominate change in terms of: facilitating cost reductions; being characterised by elastic long-run supply conditions; and having the potential for use with existing activities. Using this framework Freeman and Perez identify five long waves or modes of growth (see also Tylecote 1991): 1 2 3 4 5

1770/80–1830/40: early mechanisation. 1830/40–1880/90: steam power and railways. 1880/90–1930/40: electrical and heavy engineering. 1930/40–1980/90: Fordist mass production. 1980/90–?: information and communication.

Conclusions  153 While this neo-Schumpeterian approach to economic evolution can be subjected to a number of criticisms, as discussed shortly, for the moment we can draw out the following implications for transaction cost analyses of the firm. Each long cycle has with it a particular organisational—technological logic, it follows that over time the performance space of an economy will change implying shifts in governance structure benefits that will dominate institutional development. In this light it is clear why the discussion in Chapter 4 of this work, involving the development of the factory, followed by the rise of the hierarchical firm and in turn the characteristics of the modern firm, stressed the importance of governance structure benefits. Furthermore, each long wave has had its characteristic geographical centres of growth: UK followed by USA/Germany followed by Japan is illustrative. The existence of particular centres of growth seems to suggest that organisational—technological features lock-in corporate decision making in ways suggested in Part III of this work. Centres of growth may be exploiting a set of institutional arrangements that may be an example of a global optimum in a performance space defined by a particular longwave, but follower economies are locked into local trajectories, an implication being a role for a developmental industrial policy as argued in Chapter 10. In short, the power of the neo-Schumpeterian account of economic evolution is that it clearly shows that a universal economising logic cannot explain the evolution of economic institutions. Orthodox transaction cost reasoning with its economising behaviour is only relevant within a given techno-economic paradigm when general organisational and technological characteristics are not subject to systemic change. But this conclusion is based on an uncritical acceptance of the neo-Schumpeterian account of economic evolution. Radosevic (1991) and McKelvey (1991) suggest a number of problems that are evident with the neo-Schumpeterian understanding of institutional evolution. Techno-economic and socio-institutional characteristics are assumed to be separable. This separability is necessary if socio-economic characteristics are to react to techno-economic changes rather than shape them. In short a technological determinism is evident. Arguably this separability is difficult to sustain because individual decisions in non-steady state conditions, that underlie techno-economic innovative activity, are based on subjective expectations rather than objective conditions. McKelvey’s (1991:128) comment is consistent with arguments presented in previous chapters: Costs and prices are not, however, given and objective measuring tools. Instead, costs reflect demand and distributional conditions, and thus are partly based on cultural values and social relations and conventions. Thus [Freeman and Perez]…simultaneously deny significant scope for the autonomy of each actor in this area, and miss out the processes of cultural and social formation of costs. These problems with the neo-Schumpeterian schema echo discussion presented in this work. It has been suggested that a simple juxtaposition of governance structure costs and benefits is inappropriate. Governance structure benefits based on exploiting characteristic organisational advantages are a dynamic factor defining the ability to adjust to, exploit and mould environmental developments. But transaction cost economising is a static effect based on given organisational characteristics. The only way that static effects can be consistently isolated is to impose a s teady-state framework that is inconsistent with

154  Transaction cost economics and beyond institutional innovation that is the object of analysis. In other words, economising behaviour is not an autonomous principle but rather its detailed nature is determined by evolutionary dynamics, i.e. governance structure benefits. Furthermore, an additional complicating factor is that static transaction costs will also inevitably coexist with governance structure benefits because of monopoly advantages. In addition, organisational characteristics and monopoly advantages will nest into wider institutional factors that are likely to be historically and nation-state specific. REGULATION THEORY AND INSTITUTIONAL ­DEVELOPMENT It follows that the earlier conclusion, that within a particular long-wave transaction cost factors are likely to dominate, is merely suggestive and ignores these problems of institutional evolution. Institutional development involves non-separable governance structure costs and benefits. These complications can be accommodated within, what has come to be called, Regulation theory.1 Central to this school of thought is the idea of a ‘regime of accumulation’ which is a ‘set of regularities which allow a general and more or less consistent evolution for capital formation’ (Boyer 1988:71), five elements of which are particularly important: 1 A pattern of productive organisation within firms. 2 A time horizon for capital formation decisions, within which managers can use a given set of rules and criteria. 3 Income shares between wages, profits and taxes. 4 A volume and composition of effective demand. 5 Relationships between capitalist and non-capitalist modes of production. Any regime of accumulation (which will be discussed in less abstract terms in a moment) involves particular institutional forms that provide ‘the basis of social regularities which channel economic reproduction’ (Boyer 1988:71). It follows that any particular institutional form may have an economic significance that can vary over time and/or between different countries. Rather than discuss the full range of institutional forms that regulation theorists make use of we can restrict ourselves here to those being relevant to the arguments presented in previous chapters: the wage-labour nexus, the type of competition, and the forms of state intervention.2 The wage-labour nexus characterises the relationship between management and employees, or in more Marxist informed language: capital and labour. Of importance here are five factors: the form of control over productive activity; the division of labour and its implications for skilling—deskilling; the degree of stability of employment relationships; the determination of direct and social wages; and the standard of living of wage-earners. It is clear from previous chapters that factors such as these have shifted over time. With regard to the type of competition significant changes have occurred in its operation. In the nineteenth century ex post price adjustment dominated. From 1945 to the 1970s, however, characteristic competition has been oligopolistic in nature with its implications for product differentiation and internal organisational planning.

Conclusions  155 Finally, it is clear that the forms of state intervention have changed over time. From early capitalist forms, which emphasised private property protection, state activity has developed both quantitatively and qualitatively. In addition, if the analysis presented in Chapter 10 is accepted, forms of intervention based on networked rather than arms-length relationships will become more important in the area of industrial initiatives. Institutional regularities such as those highlighted here can be combined into characteristic ‘modes of regulation’ that provide coherent adjustment processes for the economy as a whole. In particular a mode of regulation has three properties: 1 It makes possible decentralised decision making without any necessity to understand the logic of the whole system. 2 It controls and regulates the prevailing accumulation regime. 3 It reproduces basic social relationships through historically determined institutional forms. This regulation perspective on the nature of institutions has implications for transaction cost economics that are consistent with the message presented in this work. A particular regime of accumulation and its mode of regulation define the nature of particular organisational characteristics (i.e. governance structure benefits) and the resulting transaction costs from economic activity. Therefore, transaction cost explanations, in the absence of governance structure benefits cannot be generalised over time or in different settings at a given moment in time. The sorts of confusions that are likely to result if inappropriate generalisations are attempted have been developed in earlier chapters. For example, in Chapter 4 Williamsonian perspectives on worker participation were criticised on the grounds that they were inappropriate to a new organisational logic. Alternatively, in Chapter 6 transaction cost explanations for the existence of the conglomerate firm were questioned on the grounds of inappropriate generalisation from institutionally specific circumstances. But in addition to confirming and systematising the perspectives on the firm presented in this work, regulation theory provides an understanding of institutional evolution via its discussion of crisis. A distinction is drawn between ‘cyclical’ and ‘structural’ crises. The former develop within a stabilised mode of regulation because of disequilibria between economic aggregates. Structural crises imply a contradiction between regulatory functioning and existing institutional forms which leads to fundamental structural change. Given the institutional and technological basis the system cannot reproduce itself. Obviously, cyclical and structural effects are non-separable in real time, but for analytical purposes the dichotomy is useful. Note that the logic underlying this approach is different to the neoSchumpeterian schema discussed earlier because techno-economic and socio-institutional factors are assumed non-separable. While technology has a role to play its significance is part of a wider set of institutional factors. In terms of our understanding of the economics of the firm we can suggest the following. Cyclical crises will reinforce economising behaviour and hence transaction cost explanations of institutional development. But decision making is channelled by the dominant mode of regulation which, using the language introduced in Chapter 8, defines the performance space of an economy. Shifts in governance structure benefits due to cyclical effects on revenues and production costs will tend to reinforce transaction cost

156  Transaction Cost Economics and Beyond economising because of overall institutional stability. To this extent institutional comparative statics would seem to be appropriate. But structural crises imply fundamental shifts in institutional form with the implication of changes in organisational characteristics that are likely to dominate economising and transaction cost effects. It is clear from discussion in previous chapters that radical institutional developments revolve around governance structure benefits and furthermore evolutionary dynamics (rather than institutional comparative statics) can lead to increases in transaction costs to exploit potential benefit effects. With regard to recent history it is clear that ‘monopolist regulation’ is giving way to a regime frequently called post- or neo-Fordist. The former has been characterised by, among other things, ‘Taylorist’ hierarchies with mass production and consumption and a central macroeconomic and welfare role for the state. But this ‘Fordist’ regulation is now becoming counter-productive. Particularly important in this regard are the disadvantages of rigid hierarchies, as discussed in this work. But in addition the following factors are important: the internationalisation of economic activity with the erosion of a pivotal US role and nationally based public-private sector strategies; the disadvantages, in terms of inflation and inflexibility, of centrally controlled wage determination. The developing growth regime has been characterised by Coriat and Petit (1991) in terms of three ‘challenges’: the potential offered by information technologies; the major role of flexible high-volume production; and the internationalisation of markets. The second of these factors is different to the commonly cited Piore and Sabel (1984) view that new flexibility will reduce the role of high-volume production.3 As argued in Chapter 10, however, the importance of dynamic marketing, R&D and financial economies will outweigh the production based incentive to smaller scale. This, of course, is in the absence of specific public-private institutions to overcome the dynamic disadvantages of small size. Similar changes are emphasised by Boyer (1991) when he refers to the shift from Fordism to what he calls ‘Sonyism’. The characteristics of the latter involve: permanent product/ process innovation; highly skilled and committed workers with long-run employment; an implicit compromise over surplus sharing; implicit/ informal planning within and outside the firm; multiple tier subcontractors with networking to exploit information about markets, products, and technologies, but competition among sub-contractors; long-term strategies shared by manufacturers, bankers and civil servants. The parallels between this perspective and the economics of the firm suggested in this work are obvious. The picture painted here provides a rich analysis of institutional change that does not rely on a trans-historical economising logic that (unlike other decision making from an institutionalist perspective) is free of institutional constraint. Needless to say the comments linking particularly Regulation theory and the perspectives on the firm developed in this work are suggestive rather than definitive. A complete analysis would involve a volume in its own right. The intention in this final chapter has been to show that transaction cost economics requires an evolutionary dynamic, that is at present absent, if it is to provide a convincing analysis of the firm in its historical and institutional complexity. The provision of such a dynamic makes clear the special case status of the orthodox position.

NOTES 1 INTRODUCTION 1 This growing interest in transaction cost perspectives on the firm is indicated by the number of books that all or in part are in the area, such as Francis et al. (1983), Stephen (1984), Clarke and McGuiness (1987), Putterman (1986), Ricketts (1987), Thompson and Wright (1988), Pitelis and Sugden (1991), Pitelis (1991). In addition the Journal of Economic Behaviour and Organization is oriented towards furthering transaction cost analysis. 2 Langlois (1986, 1989) and Rutherford (1989) widen the New Institutionalist net to include, besides the contributers referred to in text, property rights theorists (Demsetz 1967, Alchian and Demsetz 1972); other Austrian approaches (for example Kirzner 1981); evolutionary theory (for instance Nelson and Winter 1982) inspired by Schumpeter (1934, 1942); and transaction cost theory as applied to economic history (North 1978, 1981, 1990). The inclusion of property rights theorists and transaction cost historians is consistent with the definition provided by Hodgson, furthermore they are highlighted by Williamson (1975). But evolutionary theory is a different matter because this is not based on rational economic agency, this makes it a useful contributor to the ‘new economies of the firm’ suggested in this book. 3 In addition to the property rights theorists mentioned in the previous note reference should be made to Coase (1960). The agency approach is identified with for example Hurwicz (1973), Spence and Zeckhauser (1971), Ross (1973) and Jensen and Meckling (1976). 4 A more general analysis of institutions could define a family in similar terms to the definition of the firm presented in the text. Families use various human and non-human inputs to produce labour which is then usable in the wider economy. 5 This statement, that an assumption may be more or less useful in particular circumstances, is based on a rejection of Friedman’s (1953) view that the usefulness of theory can be based only on prediction whereas assumptions, in themselves, are irrelevant; see Chapter 8 of this work for a more detailed discussion. 6 Moss (1981), in addition to the factors highlighted in the text, defines markets to include transportation of goods and resources required to render services from suppliers to customers. This is omitted from the definition adopted here because it appears to be an aspect of services that a firm can provide. It is for this reason that a firm is defined as a production-distribution unit, rather than simply a production unit. 7 (1934) wings (Rutherford 1989). The latter wing is an important input into Williamsonian transaction cost economics and is therefore complementary to New Institutional Economics rather than being an alternative. 8 The term ‘strategy’ is somewhat ambiguous. It has two meanings corresponding to broadly economic and organisational uses. On the one hand, strategy can be understood in the context of rivalry, as in game theory. On the other hand, strategy is forward looking activity. The latter meaning is adopted in this work.

2 THE TRANSACTION COST PARADIGM 1 Coase was not the first theoretician to grapple with the problem that if the price mechanism can effectively allocate resources why should resource allocation be planned/directed with firms;

158  Notes Marx (1976) clearly pre-dates Coase. While Marx’s work will not be discussed in its own right his insights have informed many aspects of this work. 2 Williamson (1975, 1985) discusses in some detail the work of earlier writers upon which he is building. The material discussed here makes reference to only those contributions that are useful for the purposes of this book. In particular the work of the institutionalist economist John R.Commons (for example, 1934) is omitted. In addition, the legal literature to which Williamson makes reference is not considered here. 3 At times Herbert Simon appears to stress the role of informational complexity rather than uncertainty. For example, in his discussion of the game of chess he argues that ‘uncertainty’ is ‘uncertainty introduced into a perfectly certain environment by inability—computational inability—to ascertain the structure of the environment. But the result of uncertainty, whatever its source, is the same: approximation must replace exactness in reaching a decision’ (1972:170). To avoid any possible ambiguity bounded rationality will be defined as in the text. This approach is consistent with the view presented in Simon et al. (1992:3). While discussing bounded rationality Simon argues that it is ‘not that people are consciously and deliberately irrational, although they sometimes are, but that neither their knowledge nor their powers of calculation allow them to achieve the high level of optimal adaptation of means to ends that is posited in economics’—knowledge (imperfect information) and powers of calculation (complexity) are both involved. See also Heiner (1983) and Dosi and Orsenigo (1988), the latter draw attention to inevitable information and competence gaps of economic agents that mirrors the distinction between imperfect information and complexity. 4 Langlois (1984) uses different terminology to that adopted in the text. He distinguishes between parametric and structural uncertainty. The difference involved mirrors the difference between risk and uncertainty as explained above.

3 A GENERAL FRAMEWORK 1 This discussion draws heavily upon Dietrich (1991a). To render the material more accesible, however, the current presentation will use a less formal approach than the original development of the argument. 2 Kornai (1971) similarly draws a distinction between control and real activities. 3 These complementary resources are physical rather than human inputs required for managerial activity. A technical point is that in addition to the assumptions made in the text it simplifies presentation to assume that managerial and complementary non-human inputs occur in fixed proportions in the short-run. 4 Note that organisational hierarchy is important here. New senior members in a hierarchy are likely to shift organisational dynamics to a greater extent than entrants lower down. Such complexities will be discussed in more detail in Part III below. 5 Marx’s (1976) distinction between labour and labour power serves a similar analytical purpose to the distinction between factor inputs and services, i.e. it allows emphasis to be placed on the importance of intra-firm organisational effort. There are obvious differences, however, not the least is Marx’s use of a labour theory of value and his resulting theory of exploitation. 6 It might appear appropriate to develop the arguments presented here in terms of short-run profit maximisation, rather than suggesting a general increase in profits as an objective. For reasons discussed in Chapter 8, the latter objective is preferable to the former.

Notes  159 7 The constraining of the analysis to a monetary framework precludes the introduction of nonmonetary benefits, e.g. a desire for independence from intra-firm authority. Such non-pecuniary objectives are likely to be important in practice (Francis 1983). 8 Nelson and Winter (1982) give the illuminating example of learning to drive a car as the aquisition of a skill that eventually can be performed without conscious acknowledgement of the many sub-activities involved as long as normal conditions exist. The learned nature of this skill becomes apparent when someone, who has learned to drive in the USA, takes a short trip to Britain and has to consciously cope with driving on the ‘wrong’ side of the road. 9 he argument developed here is informed by the ‘contestable markets’ literature (see Baumol 1982, Baumol, Panzer and Willig 1982). The central insight, of contestability is that the ability to enter a market is a function of the extent to which entry—exit costs are sunk. With no sunk costs even high entry expenditures can be realised if market penetration fails. 10 This discussion ignores decisions concerning the use of existing assets in new ways or areas, i.e. diversification. While such decisions are more complex the same principles apply, see Chapter 5 below. 11 Bottomore (1979:7) has defined power as ‘the ability of an individual or a social group to pursue a course of action (to make and implement decisions, and more broadly to determine the agenda for decision making) if necessary against the interests, and even against the opposition, of other individuals and groups’. Clearly this definition covers many different aspects of power relationships. Economic aspects are restricted to power over resource allocation decisions and processes. In addition, note that power is not indentical to influence or authority. Authority relationships may or may not be based on power.

4 THE DEVELOPMENT OF THE FIRM 1 For detailed discussions of the rise and demise of the putting-out system see Dobb (1963), and Landes (1969). A useful summary is presented in Salaman (1981). Its demise does not imply extinction—the putting-out system still exists in the form of home-working. 2 Rather peculiarly, Williamson (1985:224) claims that the putting-out system was good in terms of work intensity, which ‘refers to the amount of productive energy expended on the job’. Such a claim is clearly inconsistent with the evidence cited in the text. 3 This chapter will ignore the current use of inside contracting that is evident in, for example, the construction industry (see Eccles, 1981). 4 Williamson’s (1985:256) argument is perhaps marginally more subtle than implied in the text. He cites Vogel (1981:24): arbitration ‘gives management…a low-cost method of ascertaining when low-level supervisors are failing to follow the wishes of upper management.’ Williamson goes on to claim that ‘arbitrary and capricious behaviour by foremen is at the expense of the firm’s longrun interests. Practices that deter suboptimization will naturally be favored.’ Thus middle management are allowed opportunistic behaviour but not people at the highest organisational levels. The reasoning underlying this asymmetry appears to be based on a claim of optimal organisational behaviour. This is consistent with Williamson’s (1975) claim that use of the multidivisional structure, rather than functional organisation, allows a shift back to profit maximising conceptions of the firm. Rather than examine this issue here detailed discussion will be undertaken below in Part III. 5 The reasoning used in Williamson (1975), as cited in the text, is also present in his 1985 work: ‘Successive stages of manufacture are separable in the sense that placing a buffer inventory between them permits work at each stage of proceed independently of the other’ (p. 213). This

160  Notes appears to be inconsistent, in the absence of any discussion indicating otherwise, with the use of an Alchian and Demsetz framework in the same book. 6 JIT production systems were found to be in use in 57 per cent of a sample of 132 British companies by Voss and Robinson (1987); Oliver and Wilkinson (1988) report that 64 per cent of companies sampled had adopted such production techniques. On JIT systems more generally see Schonberger (1982). 7 Detailed discussion of TQC can be found in Feigenbaum (1983), Ishikawa (1984), and Cullen and Hollingum (1987). 8 It is not appropriate to discuss here participative management systems as a topic in their own right, suffice to say the following. If from the perspective of no more than a few years ago, when JIC systems were dominant, participative management was deemed ineffective, but following major organisational restructuring such management is considered of central importance, it would appear to be highly inappropriate and unscientific to claim the universal inefficiency of participation for all management systems that have and may exist, as Williamson appears to do.

5 RELATED INTEGRATION AND THE FIRM 1 Note that the discussion presented in the text involves a subtle shift in transaction cost reasoning. In an earlier work, Williamson (1983) linked dedicated asset specifity to vertical integration. 2 Williamson’s attempt to integrate economies of scale into his contracting framework appears to be based on similar reasoning to that used in Stigler’s (1951) life-cycle explanation of vertical integration. While the latter’s analysis is not based on transaction costs he argues that extensive vertical integration will occur in new industries, followed by disintegration as industries grow, and reintegration with decline. The reasoning involves divestment of decreasing cost activities to exploit maximum scale economies during the expansion phase (and vice versa with maturity). Wright and Thompson (1986) show that there is little evidence to support this view. This (lack of) evidence similary applies to Williamson’s analysis. 3 This configuration of curves is the same as that used in Chapter 3 when introducing quasi-integration. The equivalence here is no accident because quasi-integration can involve leasing arrangements (see ch. 7 below, Silver 1984:ch. 9, Williamson 1983:527–8). 4 Note that one route to skill acquisition is via merger or acquisition (see, for example, Penrose 1980, Berry 1975, Scherer and Ravenscroft 1984). Without discounting this possibility it will be ignored in the text for two reasons. First, and most important, the analysis presented here is of the determinants and nature of the boundaries of the firm. This discussion is different to the processes used to shift these boundaries, i.e. internal or external growth. Analysis of these processes would unnecessarily complicate the central issues. Secondly, in practice there appears to be no obvious relationship between merger-acquisition activity and increased efficiency and profitability (see the literature survey in Mueller 1988). The central problem involved here seems to be that companies frequently underestimate the barriers to effective merging of organisational practices rather than simply legal entities. Possible reasons for this will be (indirectly) explored in Part III of this work. 5 Something along these lines was used by the Japanese automobile producer Nissan when first entering the British market as an exporter. Sole rights to distribute Nissan vehicles were granted to a single car dealer, which obviously became very lucrative for the latter as Nissan’s UK turnover grew. Nissan subsequently broke this agreement, with perhaps inevitable but unsuccessful legal challenge from the distributor, because its presence in the UK market, along with production facilities, implies greater control over distribution is desirable.

Notes  161 6 This differential impact of dominance, via information asymmetries, on the boundaries of the firm may imply the increased importance of quasi-integration in non-consumer goods industries. See note 3 of this chapter. 7 Rhoades (1974) did a follow-up study for 1967 which indicated a negative effect of diversification on profitability. He put this down to a wider definition of industry two and a half to three digit level rather than four digit level in his 1973 paper. Scherer (1980), on the other hand, suggests that the 1967 firms were going through a temporary period of adjustment following merger activity. 8 Other scope economies have received scant attention in econometric studies, the exception being Gorecki (1975) who includes marketing intensity. The statistical results he found imply a negative relationship between marketing intensity and diversification, the opposite of that predicted by scope economy arguments. Gorecki, however, points out that this may be because his sample is restricted to manufacturing industries, hence possible diversification (vertical integration) into distribution or retailing to exploit marketing economies of scope is not picked up in his sample; relatedly the dummy variable attempting to differentiate between consumer and non-consumer industry marketing effects on diversification is statistically insignificant. 9 The seminal work suggesting this shift is Piore and Sabel (1984). For a critique and details of subsequent contributions see Amin and Dietrich (1991a) and the references cited therein.

6 UNRELATED INTEGRATION AND THE FIRM 1 Note that the diversity of net cash flows across divisions may or may not be correlated with firm size. Hence the problem discussed in the text is different from Williamson’s suggestion, mentioned in passing earlier in this chapter, that there is likely to be eventual diminishing returns to internalisation. 2 The formulation of the argument presented in this paragraph suggests (in principle) a fairly straightforward empirical investigation of the Williamsonian perspective on conglomerate development. A specific hypothesis might be along the lines of: if there are minimal management motivation problems in cash cow divisions and if internal capital markets economise on transaction costs, the profitability of conglomerates will be (on average) greater than that of independent companies involved in the same markets that have the same variance of cash flows between activities. It is obvious that investigation of this hypothesis would shift the centre of gravity of the current work, hence it is sufficient to rely on the more indirect evidence outlined in the text. 3 The following discussion will not include socio-political implications of diversification and domination. Such implications would cover, for example, such varied activities as inequitable financing of legal, lobbying, covert activities and political contributions, as well as the increasing concentration of effective economic decision making and its effects on intra-firm alienation. The latter topic will be taken up, to some extent, in Part III below. Apart from this, any downgrading of such practices is because of the focus of this work rather than any implied unimportance in practice. 4 The internalisation approach to the study of MNCs is one of five approaches identified by Cantwell (1991), the others being: market power (for example Cowling and Sugden 1987); the eclectic paradigm (Dunning 1977, 1988); the competitive international industry approaches which is based on a diverse tradition (for example, Vernon 1974; Pavitt 1987; Cantwell 1989; Jenkins 1987; Warren 1980); and macroeconomic development approaches (for example, Kojima 1978; Ozawa 1982; Dunning 1982; Cantwell and Tolentino 1987). Some of these alternative perspectives, particularly market power and competitive advantage approaches, will be introduced in the text as necessary complements to internalisation. See Pitelis and Sugden (1991) for a useful set of readings on MNCs, of which Cantwell (1991) is one.

162  Notes 5 Gross substitutability will exist if ( qi pj)>0 for all i and for all j i, where q is output and p is price. 6 This statement ignores the complexities discussed in Chapter 5 that even with a ‘market’ solution the licensing or franchising must be managed. 7 Hymer’s original work on MNC development was his doctoral thesis submitted in 1960. This work, however, was not published until 1976, although it informed the work of Kindleberger (1969). On Hymer’s work see, for example, Yamin (1991). 8 The reasoning set out in the text is marginally different from that used by Casson (1979). He refers to competition eliminating rents because of the low marginal cost of using technology. This formulation seems to give no attention to firm specific advantages which are likely if knowledge is given a central role in the analysis. The underlying reasoning however is not affected by this change in formulation. 9 The efficiency of patent protection will depend on two factors (Hennart 1991:87): government policies, such as the length of the patent and penalties for infringement; and technological factors, such as the extent to which knowledge can be defined and described and the possibility of designing around the patent.

7 QUASI-INTEGRATION AND THE FIRM 1 What Williamson (1985) does not make clear is whether he believes his earlier views to be mistaken or obsolete. 2 This game theoretic link between self-seeking behaviour and co-operation arguably oversimplifies the issues involved. Durkheim (1933) distinguishes between three forms of ‘solidarity’: mechanical, organic and instrumental. The first occurs in a (usually small-scale) community with clearly defined roles and norms. Organic solidarity can (not necessarily will) occur in more complex and differentiated societies. Finally, instrumental solidarity is that usually presented in economics with individual assessment of benefits and costs. The possibility of systemic structuring of network development will be incorporated in later chapters in terms of behaviour being constrained, or locked-in, by institutional parameters. 3 This generalisation from a specific set of circumstances appears to be a characteristic of flexible specialisation theorists (for example Piore and Sabel 1984, Hirst and Zeitlin 1989). They stress the universal importance of market fragmentation, flexible company responses and decentralised production. See Amin and Dietrich (1991a) for a critical perspective and Dietrich (1992) for industrial policy conclusions. 4 This conclusion is based on the variables in the game between retailers (i.e. prices) being strategic complements. If a Cournot analysis is adopted, the strategic variables (outputs) are more likely to be substitutes which results in vertical separation being in the individual but not general interest of manufacturers (Bonanno and Vickers 1988). A Cournot analysis, however, introduces the possibility of collusion as a strategy which returns us to the arguments presented in this and previous chapters. 5 Badaracco (1991), whose work on strategic alliances is used in this section, draws an equivalent distinction between migratory and embedded knowledge.

Notes  163 8 THE FIRM AND ECONOMIC THEORY 1 A tendency towards monoplisation does not necessarily imply a reduction in competition. Competition is being viewed as a process rather than a structure. Differing perspectives on competition are discussed in Pitelis (1991). 2 This ability of organisations to transform themselves suggests that economic evolution is more Lamarckian than Darwinian. Lamarck suggests that organisms can be creative. Darwin’s framework is based on the constancy of an organism’s characteristics. As Kay (1992) notes, the introduction of Lamarckian logic would not solve the problems evident with Williamson’s reasoning. 3 Note that this discussion will not address the issue of whether the traditional theory of the firm is an adequate basis for a theory of price determination and markets in all circumstances. There is obviously much dispute in this area (see, for example, Hodgson 1988). 4 If utility/benefit maximisation was adopted the logic of the analysis might parallel that suggested by Niskanen (1968), for the public sector, in which organisational units are assumed to maximise budget allocations. 5 This perspective on organisational objectives is fairly uncontentious in the more organisationally based business policy literature, as discussed in the next chapter.

9 THE FIRM AS A SYSTEM 1 While the discussion in the text ignores any direct reference to pre-20th century writers the influence of Marx (particularly 1976) should be noted. This is evident in three areas: intra-firm rivalry is (potentially) as important as that existing between firms; the distinction between labour and labour power upon which his organisational analysis hinges; and that human behaviour exists in a social context. 2 The idea of bounded rationality was introduced in Chapter 2 of this work where references were given. 3 While being less relevant for the discussion in this chapter it may be useful to note that viewing the firm in terms of a strategic framework implies that Galbraith’s (1974) formulation that large firms are dominated by their organisational technocracy is similarly somewhat problematic. 4 Johnson and Scholes (1989) describe the ‘cultural web’ of an organisation being a function of six factors: power structures, organisational structures, control systems, routines, rituals and myths, and symbols. These factors combine to form a ‘recipe’ which is a shorthand for organisational beliefs and assumptions. While this level of detail is needed for the analysis of individual companies, it is not necessary for the more abstract discussion undertaken in the text. 5 The term ‘organisational paradigm’ is not original. In the management and organisation literature it has been used by Pfeffer (1981), Sheldon (1980) and Johnson (1987). 6 Johnson and Scholes (1989) surprisingly ignore the importance of legal—social factors. 7 In terms of organisational analysis a single, homogeneous productive opportunity will tend to develop when mechanistic rather than organic procedures are evident (Burns and Stalker 1961), or ‘X’ rather than ‘Y’ principles are used (McGregor 1960). 8 This endogenisation of entrepreneurship is similar to the view expressed by Earl (1990). His survey of the relevant psychological literature suggests that entrepreneurial traits such as creativity and attempting to control one’s life can be developed in a non-centralised society that encourages divergent and open-minded thinking.

164  Notes 9 In economics, a well known framework that is equivalent to Ashby’s law is formulated by Tinbergen (1952): policy instruments must be independent and at least equal in number to the number of policy targets. 10 Cognitive dissonance theory has been applied to economics by Akerlof and Dickens (1982). Closely allied to cognitive dissonance is ‘personal construct theory’ developed by Kelly (1955) which is based on the idea that people are trying to predict and control events. But as Earl (1990:740) points out personal construct psychologists deny the importance of what is called in this work tacit knowledge, the difference being learning on the basis of reconstruction of experience in the light of new information and learning automatically due to repetition. It follows that it would be inconsistent to use personal construct theory in the text.

10 ECONOMIC POLICY AND THE FIRM 1 The discusion in the text will largely ignore the social welfare role of the state. Such issues can be formulated as transaction cost problems (Dugger 1983) hence the framework developed is potentially useful in this area. 2 If the level of detail warranted it we could distinguish between (a) different levels of government and (b) public sector production which is directly allocated or that which uses market allocation. Such developments, however, are unnecessary given the objectives of the discussion. 3 A pragmatic neoclassical response to the problems presented by Arrow’s theorem is provided by Kreps (1990b:181). He reasons that

Rather than thinking normatively about desirable properties for social choice, we regard ‘social choice’ as the product of individuals interacting in various institutional environments. We describe those institutions and predict the outcome of individual actions within those institutions… But our approach is that of taking the institutions as given exogenously and describing…what ‘social choices’ will be made. This promising approach is limited because the institutions emphasised are general equilibrium exchange and the perfectly competitive firm. Arguably this avoids the implications of Arrow’s work. 4 New right theorists encompass neo-liberal, anarcho-capitalist, public choice, Chicago school and Austrian perspectives. See Green (1987) and Pitelis (1991) for further discussion. 5 Traditional economic justifications for industrial policy are based on one, or more, of the following (see Dietrich 1992): a general lack of information about the potential of new technologies and/or managerial-organisational methods; the public goods characteristic of information; a divergence between private and social rates of return because externalities or excessive private sector discount rates; and an infant industry case. 6 The management literature on turnaround is voluminous. See, for example: Slatter (1984), Taylor (1983), Grinyer and Spender (1979), Grinyer et al. (1988), Hofer (1980), Melin (1985) and for a useful introductory summary Bowman and Asch (1987).

11 CONCLUSIONS 1 The principles of Regulation theory were originally developed in France. Important works, in English, in this tradition are Agglietta (1979), Lipietz (1986) and Boyer (1988). The latter is the

Notes  165 basis of much of the discussion in the text. The usual English meaning of ‘regulation’ does not adequately convey the sense of the French régulation . A more accurate translation is ‘socio-economic tuning’ (Boyer 1988) but without the connotation of a conscious adjustment mechanism. 2 In addition to the wage-labour nexus, type of competition, and forms of state intervention, Boyer (1988) makes reference to monetary and credit relationships, and the mode of adhesion to the international regime as two further important institutional forms. 3 An even more extreme version of this flexible specialisation thesis is provided by Hirst and Zeitlin (1989) when they argue that the current restructuring involves ‘returning’ to craft-based and decentralised forms of organising production within both large and small firms. Interpreted literally this implies either no fundamental change in the general performance space of capitalist economies over the last two centuries with intervening development being locked into suboptimal trajectories, or current restructuring has moulded the performance space in such a way that efficient trajectories now and two hundred years ago happen to be the same. Needless to say, such literal interpretations of the idea of institutions ‘returning’ are considered unacceptable.

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AUTHOR INDEX Casson, M 42, 94, 95, 96, 97, 98, 100, 104, 105, 107, 119, 142, 158, 187 Caves, R. 94 CBI 90 Chandler, A. 83, 86, 153 Channon, D. 142 Cheung, S. 6 Clarke, R. 75, 86, 89, 182 Clegg, S. 86 Clutterbuck, D. 64, 143 Coase, R. 15, 16, 17, 157, 182 Cohen, E. 144 Comanor, W. 98 Commons J. 182, 183 Cook, P. 170 Coriat, B. 180 Cowling, K. 90, 148, 169, 172, 187 Cubbin, J. 91 Cullen, J. 185 Cullis, J. 161 Cyert, R. 137 David, P. 130 Davidson, W. 97 Davies, S. 68, 70, 74, 107 Demirag, I. 92 Demsetz, H. 6, 16, 58, 60, 61, 62, 157, 182 Devine, P. 138 Dickens, W. 189 Dietrich, M. 4, 42, 93, 111, 114, 126, 135, 161, 166, 168, 170, 183, 186, 188, 190 Dimsdale, N. 91 Dirrheimer, M. 91 Dobb, M. 184 Donald, D. 168, 171 Dore, R. 101, 108, 110, 171 Dosi, G. 146, 169, 183 Dow, G. 4, 59, 66 Downie, J. 129 Drucker, P. 149 Dugger, W. 159, 160, 164, 173, 189 Dunning, J. 187 Durkheim, E. 187 Earl, P. 152, 153, 154, 189 Earley, J. 123 Eccles, R. 101, 184 Edwards, C. 89

Einhorn, H. 65 Ellman, M. 93 Eltis, W. 114 Feigenbaum, A. 185 Festinger, L. 152 Fischer, S. 16 Fisher, F. 130 Fitzroy, F. 60 Fourie, F. 17 Fox, A. 27 Francis, A. 1, 55, 57, 72, 182, 184 Freeman, C. 169, 175, 176 Friedman, M. 125, 127, 133, 182 Frey, D. 152, 154 Furubotn, E. 157 Galbraith, J. 188 Gallagher, W. Jr. 65 Georgescu-Roegen, N. 26 Geroski, P. 111, 170, 171 Gillies, D. 140 Gintis, H. 65 Goldberg, V. 101 Goldsmith, W. 64, 143 Goold, M. 123, 124, 125 Gorecki, P. 80, 186 Gort, M. 80 Graham, D. 74, 107 Grant, R. 80 Green, D. 190 Grewlich, K. 168 Grinyer, P. 144, 190 Hamel, G. 64, 81, 113, 124, 131 Hannah, L. 169 Hargreaves-Heap, S. 140 Harris, J. 59 Hayek, F. 2 Heal, G. 93 Heiner, R. 183 Hennart, J-F. 23, 33, 36, 93, 95, 97, 99, 105, 187 Hill, C. 84, 85 Hippel, von E. 110 Hirschman, A. 101

182  Author index Hirst, P. 188, 190 Hodgson, G. 1, 2, 6, 7, 26, 27, 127, 129, 130, 131, 133, 139, 140, 152, 157, 158, 160, 188 Hofer, C. 190 Hollingum, J. 185 House of Lords 170 Hurwicz, L. 182 Hutton, A. 168, 171 Hymer, S. 89, 95, 187 Ietto-Gillies, G. 140 Ishikawa, K. 185 Jenkins, R. 187 Jensen, M. 87, 182 Jessop, B. 166 Johnson, C. 168, 169 Johnson, G. 41, 64, 125, 147, 148, 154, 189 Johnston, R. 101, 103, 111, 170 Jones, P. 161 Katz, B. 171 Kay, J. 91 Kay, N. 7, 23, 24, 33, 35, 42, 63, 85, 88, 92, 94, 97, 105, 131, 138, 188 Kelly, G. 189 Keynes, J. 26 Kindleberger, C. 187 Kirzner, I. 182 Knight, F. 18 Knight, K. 125, 173 Kogut, B. 105, 110 Kojima, K. 187 Kornai, J. 183 Koutsoyiannis, A. 125, 126, 133 Kraft, K. 60 Kreps, D. 166, 189 Landes, D. 52, 184 Langlis, R. 26, 128, 182, 183 Lawrence, P. 85, 101, 103, 111, 170 Leach, D. 91 Leibenstein, H. 38, 65 Lev, B. 89 Levin, R. 171 Levy, D. 69 Lindblom, C. 146 Linge, G. 61 Lipietz, A. 150, 173, 190

Littler, C. 55 Livesy, H. 69 Lorsch, J. 85 Lundvall, B. 100 Machlup, F. 125, 126 Magee, S. 94 Malcolmson, J. 29, 44 Malerba, F. 126 March, J. 137, 138 Marcus, A. 89 Marginson, P. 59 Marglin, S. 8, 29, 54, 151 Marris, R. 89, 90, 134 Marx, K. 7, 183, 184, 188 Mayhew, A. 144 McFetridge, D. 97 McGregor, D. 189 McGuiness, T. 29, 182 McKelvey, M. 177 Meeks, G. 90 Meckling, W. 182 Melin, L. 190 Mintzberg, H. 85, 125, 146, 151 Mises, L.von 26 Monteverde, K. 68, 101, 108 Moss, S. 7, 182 Moynot, J-L. 170 Mueller, D. 89, 90, 186 Musgrave, A. 8 Nelson, D. 55 Nelson, R. 20, 34, 40, 110, 126, 131, 140, 145, 182, 184 Niskanen, W. 188 Nixson, F. 42, 96 North, D. 120, 130, 167, 182 Nyman, S. 90 Oliver, N. 61, 62, 64, 185 Orsenigo, L. 183 Ouchi, W. 25, 62, 63, 102, 124 Ozawa, T. 187 Panzer, J. 75, 184 Pavitt, K. 187 Pejovich, S. 157 Penrose, E. 11, 16, 20, 34, 38, 81, 113, 131, 132, 135, 138, 169, 186 Perez, C. 169, 175, 176

Author index  183 Peters, T. 64, 143 Petit, P. 180 Pettigrew, A. 64, 124, 131, 144, 171 Pfeffer, J. 189 Phillips, A. 171 Pickering, J. 84, 85 Piore, M. 169, 180, 186, 188 Pitelis, C. 1, 2, 6, 60, 135, 160, 166, 182, 187, 188, 190 Pitelis, I. 166 Polanyi, M. 20, 29, 146 Pollard, S. 52, 54 Pollen, A. 112 Porter, G. 69 Porter, M. 91, 111, 170 Powell, W. 101 Prahalad, C. 64, 81, 113, 124, 131 Prais, S. 169 Pugano, U. 151 Putterman, L. 29, 61, 182 Radner, R. 133 Radosevic, S. 177 Ravenscroft, D. 90, 186 Remmers, H. 85, 148, 151 Rhoades, S. 81, 186 Richardson, G. 41, 74, 110, 113 Ricketts, M. 182 Robinson, S. 185 Rose, M. 57 Rosenfeld, R. 64 Ross, S. 182 Rugman, A. 94 Rutherford, M. 8, 182 Sabel, C. 169, 180, 186, 188 Salaman, G. 52, 56, 184 Sale, J. 84 Saunders, C. 169 Sawyer, M. 90, 91 Sayer, A. 60, 61 SBRC 170 Scapens, R. 84 Schein, E. 146 Scherer, F. 86, 89, 90, 186 Scholes, K. 41, 64, 125, 147, 148, 154, 189 Schon, D. 139

Schonberger, R. 185 Schotter, A. 2 Schumpeter, J. 182 Seal, W. 127, 128 Semlinger, K. 108, 109 Shackle, G. 26 Sheldon, A. 189 Shepherd, J. 168 Silbertson, A. 90 Silver, M. 69, 70, 72, 185 Simon, H. 19, 65, 137, 151, 183 Slatter, S. 190 Sloan, A. Jr. 69 Smith, A. 77, 156 Smith, C. 3 Spence, M. 182 Spender, J-C. 144, 190 Stalker, G. 189 Steer, P. 84 Steiner, P. 88 Stepan, A. 158 Stephen, F. 85, 91, 92, 182 Stewart, M. 138 Stigler, G. 185 Streit, M. 168 Stoneman, P. 168 Strong, N. 142 Sugden, R. 2, 148, 173, 182, 187 Taylor, B. 190 Taylor, F. 149 Teece, D. 42, 68, 69, 75, 76, 78, 84, 94, 101, 108, 164 Thompson, G. 101, 139 Thompson, J. 81 Thompson, R. 84, 85, 87, 91, 92, 164, 182, 185 Thorelli, H. 101, 113 Tinbergen, J. 189 Tolentino, P. 187 Tylecote, A. 92, 176 Ullmann-Margalit, E. 131 Veblen, T. 8 Vernon, J. 74, 107 Vernon, R. 187 Vickers, J. 106, 168, 188 Vogel, E. 185 Voss, C. 185

184  Author index Wachter, M. 59 Walsh, V. 111 Warren, B. 187 Waterman, R. 64, 143 Waterson, M. 74, 107, 142 Weber, M. 159 Whipp, R. 64, 124, 131, 143, 171 Whittington, R. 147 Wicklund, R. 152, 154 Wilkinson, B. 61, 185 Williamson, O. 1, 2, 3, 5, 7, 8, 20, 21, 23, 24, 25, 26, 27, 28, 29, 38, 52, 54, 55, 56, 57, 58, 59, 60, 61, 62, 63, 65, 66, 67, 68, 69, 71, 72, 74, 83, 84, 87, 89, 90, 92, 97, 100, 101, 103, 104, 119, 120, 123, 124, 130, 133, 134, 142, 149, 153, 157, 158, 182, 183, 184, 185, 187 Willig, R. 75, 184 Willman, P. 8, 59 Wilson, T. 98 Winter, S. 20, 34, 40, 110, 126, 131, 140, 145, 182, 184 Wolf, B. 80 Wolf, C. 161 Woodward, J. 85 Wright, M. 1, 106, 164, 182, 185 Yamin, M. 42, 96, 187 Yasuki, M. 91 Zeckhauser, R. 182 Zeitlin, J. 188, 190

SUBJECT INDEX acquisitions see mergers adverse selection 20, 38 advertising see marketing agency (human) 32, 33, 119, 125, 134, 135, 140, 160 agency theory 3, 5, 133, 182 altruism 26 aspiration levels 137, 138, 139, 140, 144 asset specificity 21, 22, 24, 25, 26, 36, 37, 42, 44, 56, 68, 72, 76, 77, 80, 94, 98, 104, 114, 121; dedicated 68; financial 91; human 68, 72; and internal goverance structures (forms of work organisation) 58–9, non-specificity 42, 94, 97; physical 68, 78; site 68, 72 asset use (frequency of) 22, 36 atmosphere 28, 142–3 Austrian economics 2, 182 authority relation 9, 55, 58, 61 bargaining costs 33, 104 Behavioural economics 11, 137–8, 140, 141, 144, 145, 147, 148 benefit curve 39 benefits of resource allocation: definition 4–5, 37–9; and dynamic analysis 8, 10, 41–2, 81, 86, 108, 109, 112, 124, 134, 143, 164; with factory system 53–5, 57; and idiosyncratic advantage 40–2, 44, 63, 64, 73, 76, 80, 94, 95, 124, 143, 163; and long waves 176; and managerial opportunism 60; and monopoly advantages 40, 42–4, 44, 45, 76, 79, 80, 89, 107, 163; and non-individualist analysis 8; and production costs 38, 45, 65, 69, 72, 73, 75, 85, 104; with public sector activity 161, 162, 163; with putting-out system 53–4;and revenues 38, 104;and technical/product-market cha acteristics of organisations 6, 39, 105, 106, 108, 174

bounded rationality 9, 11, 19, 20, 21, 24, 25, 26, 27, 28, 29, 31, 33, 34, 38, 40, 43, 55, 56, 61, 68, 90, 93, 94, 96, 104, 130, 137, 139, 140, 166, 183; see also information: complexity and uncertainity business policy see strategic management capitalist firm see firm cartels see collusion cash cows 87, 186 clan organisation 63, 102 classic liberalism see liberalism coalitions see organisation: coalitions cognitive dissonance 152, 153, 154, 155, 189 collusion 10, 79, 95, 96, 100, 104–5, 106 conglomerates see diversification: unrelated contestability 21, 109, 113, 121, 127, 129, 184 contracting: contingent claims 55; long-term 21, 55; process of 33–5; sequential 21, 55; zone of acceptance 54, 65, 149 core competence 64, 81, 124, 131; see also organisation: capabilities court-ordered litigation 22 culture see organisation: culture cybernetics see systems theory dissonance see cognitive dissonance diversification: related 10, 67, 75–81, 97, 186; unrelated 10, 67, 75, 76, 77, 78, 83–92, 179 dominance see power economies of scope see scope economies efficient markets hypothesis 92 employee involvement 65; see also participatory management employment decision 17, 46

186  Subject index enforcement costs 33 entrepreneurs 16, 51, 52, 55, 56, 57, 126, 149, 150, 153, 154, 175, 189 factory system 9, 51, 52–5, see also authority relation firm: capitalist 7, 11, 17, 31, 58, 134, 137, 150; definition 6; the flexible 112, 150; as a governance structure 133–5; legal and economic perspectives 18, 114; non-capitalist 7; one-person 17, 23, 31; as a strategic framework 11, 114, 137, 139, 140, 141, 150, 154, 160; see also organisation; productive opportunity Fordism 81, 176, 180; post-Fordism 180 franchising 10, 69, 74, 75, 94, 100, 101, 104, 106–7, 113 functional organisation 86, 119, 131, 153 game theory 2, 65, 101, 187 goal congruence 63 goverance: bilateral 22, 157; trilateral 22, 24, 157 governance structure benefits see benefits of resource allocation governance structure costs see transaction costs government failure 161, 163

impactedness 20, 43, 44, 55, 57, 72, 73, 153; uncertainty 3, 19, 22, 26, 36, 44, 63, 132, 158, 183; see also adverse selection; bounded rationality; moral hazard; uncertainty information costs 33 information economies 85 innovation 69, 70, 71, 146, 175; see also research and development inside contracting 55–7, 58, 184 institutional economies: new 2, 6, 11, 151, 182, 183; old 8, 182 institutional shareholders 90, 91, 134 internal capital market 10, 84–7, 91, 187 internal contracting see inside contracting internal spot market 58, 59 joint ventures 10, 100, 101, 104, 105, 113 just-in-case (JIC) 60, 61, 185 just-in-time (JIT) 9, 60–6, 74, 108, 111, 149, 185

high powered incentives 104, 106 human agency see agency

knowledge: idiosyncratic 20, 27, 40, 57, 59, 63, 64, 66, 68, 70, 73, 93, 97, 126, 142; proprietary 92, 94, 96; tacit 20, 62, 63, 64, 73, 79, 109, 110, 111, 112, 130, 142, 146, 154; see also core competence; organisation: capabilities; skills Kondratievs 175, 176

idiosyncratic capabilities see core competence; organisation: capabilities industrial districts 101, 150 industrial organisation 1, 2 industrial policy 11, 159, 164, 168–73, 176, 190 information: asymmetry 20, 25, 37, 43, 47, 54, 70, 73, 78, 81, 94, 97, 98, 103; complexity 3, 19, 20, 26, 44, 63, 132, 158, 183;

law of requisite variety 150, 160 learning see organisation: learning leasing 76, 77, 78 liberalism 6, 11, 156, 158, 159 licensing 94, 96, 97, 105 lock-in 37, 68, 72, 73, 75, 80, 108, 109, 112, 114, 130, 131, 135, 146, 150, 151, 158, 164, 167, 176; see also path dependence low powered incentives 104, 106

Subject index  187 marketing 97–8, 100, 124, 169, 170, 171, 180, 186 markets: definition 7; managed or organised 100 matrix organisation 124–5, 133 mergers 86, 90, 92, 186 methodological individualism 6, 8 M-form organisation see multidivisional monitoring costs see policing moral hazard 20, 38 motivation 53, 54, 56, 64, 65, 87 multidivisional organisation 83–7, 90, 92, 119, 123, 124, 131, 141, 144, 148 multinational companies see transnational neo-Schumpeterian theory 175–7, 179 networks 10, 100, 101, 102, 110, 113, 150, 159, 164, 169, 170, 171, 172, 179, 180 new institutionalism see institutionalism: new obligational markets 59, 62 old institutionalism see institutionalism: old opportunism 9, 20, 21, 22, 24–8, 38, 53, 56, 57, 66, 68, 69, 71, 72, 73, 92, 94, 101, 104, 113, 164; managerial 59, 60, 66, 84, 90, 134, 167, 185 optimality: local and global 130, 135, 147, 165 organisation: capabilities 4, 9, 42, 110; coalitions 11, 137, 147, 162, 164, 165, 167, 168, 173; culture 11, 28, 64, 99, 105, 110, 111, 128, 131, 141, 142, 143–4, 145, 146, 147, 149, 158, 163, 166, 189; learning 11, 59, 64, 70, 72, 110, 126, 139, 141, 145, 146, 149, 152, 153, 154, 155; routines 34, 131, 140, 141, 142, 143, 144, 145; stakeholders 11, 147, 162, 164, 173; and the state 165–8, see also core competence; knowledge; skills organisation costs 36; see also transaction costs:

organisation costs organisation theory 9 path dependence 11, 112, 130, 146, 147, 153, 158, 164, 167, 168, 170, 171, 172 participatory management 66, 173, 179; see also employee involvement performance ambiguity 62, 63 planning systems 93 policing costs 33, 99, 104 power 4, 8, 9, 10, 15, 20, 29, 42, 43, 44, 54, 55, 73, 74, 75, 80, 90, 91, 94, 95, 98, 114, 119, 122, 128, 134, 135, 137, 147, 148, 153, 157, 162, 163, 166, 167, 170, 173, 175, 187; definition 184 price discrimination 74 price mechanism 16 principal-agent theory see agency theory private ordering 157, 158, 159, 161, 164 productive opportunity 11, 138, 143, 144, 146, 149, 150, 162, 166, 167, 172, 189 profit maximisation 10–11, 24, 84, 90, 114; and modern management 123–5, plausibility of assumptions 125–7, purpose of the theory 132–3, survival of the fittest reasoning 127–32; and transaction costs 119–22 property rights school 3, 5, 7, 157, 158, 161, 163, 182 psychology: cognitive 11, 152; behaviourist 152; social 152; see also cognitive dissonance public sector 159; neo-classical justification of 156–7, 161; see also state putting-out 9, 51–4, 57, 58, 184 quasi-integration 10, 21, 27, 47, 67, 68, 74, 75, 91, 100, 148, 170; and competitive dynamics 108–112; definition 101–3; see also networks rationality: types of 140–1, 144, 154 regulation theory 175, 178–81, 190 relational contracting 22, 24, 101

188  Subject index relational team 59, 62, 63 research and development 42, 80, 100, 124, 164, 168, 169, 170, 171, 180 see also innovation risk see uncertainty routines see organisation: routines scientific management 57, 149; see also Taylorism scope economies 75–81, 85, 88, 95, 186 search activity 138, 139, 144 search costs 33 skills 10, 40–1, 45, 47, 55, 57, 60, 68, 69, 70, 72, 73, 74, 76, 77, 78, 79, 80, 81, 94, 103, 110, 126, 131, 148, 184; see also knowledge; organisation: capabilities stakeholders see organisation: stakeholders state 11, 158; definition 160; as a governance structure 161–4; and government 159, 160, 165, 166; neutrality 165–6; and organisational complexity 165–8; see also public sector strategic alliances 100, 113 strategic management 9, 11, 42, 126, 129, 141, 147, 172 strategy: definition 183 subcontracting 10, 98, 100, 101, 104, 106, 107–8, 112, 113, 148, 180 systems theory 150, 160, 161, 168 tacit knowledge see knowledge take-overs see mergers Taylorism 11, 57, 151, 172, 175, 180; see also scientific management team organisation 58, 60, 63 total quality 9, 62–6, 74, 98, 108, 111, 149, 185 trade unions 59 transaction: contractual and physical meanings 7 transaction costs: curve 35;

definition 16, 21, 33; and organisation costs 23, 33; as sunk costs in networks 10, 113 transaction cost economics: assumptions of 8, 39, 46, 133; basic approach 3, 19; comparative static method 5, 32, 39–40, 42, 43, 64, 81, 96, 104, 106, 108, 121; as economic orthodoxy 1, 2, 19; and exogenous monopoly advantages 42, 96, 104; and factory system 53–4, 57; fundamental theorem of 36, 40; and long waves 177, 179, 180; and marketing 97–8; and microeconomics 2–8; and production costs 4, 24, 28–9, 33, 73, 133; and profit maximisation 119–22; and putting-out 53–4; and quasi-integration 103–8, 112–13; and related diversification 75–80; special case status of 8, 12, 174, 181; and state activity 159, 161, 164; and transnational companies 92–7; and vertical integration 67–72 transnational corporations 1, 10, 42, 67, 80, 83, 92–7, 148, 171, 187 trust 27, 28, 37, 47, 56, 65, 101, 102, 105, 106, 107, 110, 169 turnaround 171, 190 U-form organisation see functional uncertainty: behavioural and parametric 25, 53; and risk 18, 26; see also bounded rationality; information value-adding partnerships 101, 111 value chain 111, 170 vertical integration 10, 67–75, 80, 111, 185, 186 work relations: separability of 58–9

WHY DO FIRMS EXISTI ARE THEY BEST EXPLAINED BY TRANSACTION COSTS?

ln recent years transaction cost economics has come to dom­ inate discussions of the nature and organisation of Hrms. In Transaction Cost Economics and &yond Michael Dietrich offers a critical exploration of the transaction cost paradigm. He argues that whilst it has much to offer it is still an inadequate basis for a general theory of the firm. Drawing on theories of organisational behaviour as well as economics he concludes by offering a theory of the fum that allows for both hierarchical and creative decision making. Michael Dietrich lectures in economics and business policy at Sheffield University Management School. He has published papers and articles in areas such as the organisation of the fum

and corporate restructuring in Europe. He is joint editor (with Ash Amin) of Towards aN� Europt? Economics/Business studies

II New Fc.tter Lane London EOIP 4EE

ISBN 0-415-07156-9

29 West 35th uc.et New York NY 1000 1 Prin<ed in G...,.t Britain

9

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