AER05 2 Williamson the Economics of Governance

8/3/2019 AER05 2 Williamson the Economics of Governance

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American Economic Association

The Economics of GovernanceAuthor(s): Oliver E. WilliamsonReviewed work(s):Source: The American Economic Review, Vol. 95, No. 2, Papers and Proceedings of the OneHundred Seventeenth Annual Meeting of the American Economic Association, Philadelphia,PA, January 7-9, 2005 (May, 2005), pp. 1-18Published by: American Economic AssociationStable URL: http://www.jstor.org/stable/4132783 .

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RICHARDT. ELYLECTURE

The Economics of GovernanceBy OLIVERE. WILLIAMSON*

The economics of governanceis an effort toimplementthe "studyof good orderand work-able arrangements,"where good orderincludesboth spontaneousorderin the market,which isa venerated tradition in economics (AdamSmith, 1776; FriedrichHayek, 1945; KennethA. Arrow and GerardDebreu, 1954), and inten-tional order, of a "conscious, deliberate, pur-poseful"kind (ChesterIrvingBarnard,1938 p.9).1 Also, I interpretworkablearrangementsomean feasible modes of organization, all ofwhich are flawed in comparisonwith a hypo-thetical ideal (Avinash Dixit, 1996 pp. 4-9).2The objectis to work out theefficiency logic formanagingtransactionsby alternativemodes ofgovernance-principally spot markets,variouslong-termcontracts(hybrids),and hierarchies.

Interestamong social scientists, economistsincluded,in the studyandpracticeof good orderand workable arrangementshas been steadilygrowing.3In contrastwith the orthodox lens of

choice (pricesand output,supply anddemand),the economics of governance is a lens of con-tractconstruction,broadlyin the spiritof JamesBuchanan's (2001 p. 29) observation that"mutuality of advantage from voluntary ex-change ... is the most fundamental of all un-derstandings in economics."The economics of governance, as herein de-scribed, is principally an exercise in bilateralprivate ordering,by which I mean that the im-mediatepartiesto an exchange are actively in-volved in the provision of good order andworkablearrangements.To be sure,the need forprivate ordering varies with the rules of thegame as providedby the state. Distinctions be-tween lawlessness where the stateprovideslim-ited or unreliable protection for property andcontract Dixit, 2004) andlawfulness,wherethestateundertakes o protect propertyandenforcecontracts n a principled way, arepertinent.Thefirst of these applies mainly to primitive andtransitioneconomies. The second is commonlyassociated with Western democracies.Recourse to private ordering under condi-tions of lawlessness is altogether understand-able: given the absence of state support, the

* Walter A. Haas School of Business, University ofCalifornia,Berkeley, CA 94720-1900. The paperhas ben-efited from workshop presentationsat the University ofCalifornia-Berkeley,the University of Valencia, INSEAD(Fountainebleau),and the 2004 annual conference of theInternationalSociety for New InstitutionalEconomics. Anabbreviated version was also given as the Horst ClausRecktenwald Lecture at Nuremburgon 4 November 2004.Comments and suggestions from Fred Balderston,ErnestoDalbo, Avinash Dixit, RobertGibbons,Witold Henisz, IanLarkin,StevenTadelis, and Dean Williamson areespeciallyacknowledged.1Lon Fuller's (1954 p. 477) definitionof "eunomics"as"the science, theory, or study of good order and workablearrangements"s verymuch in the spiritof whatI refer to asgovernance.2 One of the immediate ramificationsof insistentlycom-paringfeasible alternatives,all of which are flawed, is thatthe purported nefficiencies that are ascribed to failures toachieve "firstbest"optimalityare not dispositive,but invitethe query"Ascomparedwith what?" return o this issue inSection IV.3 Excluding"corporategovernance," he numbers of ar-ticles that used the word "governance"during the period1998-2000 as compared with the period 1977-1979 in

selected economics, business/management,sociology/orga-nization,andpolitical sciencejournalswere 60 vs. 1, 76 vs.4, 79 vs. 18, and 60 vs. 25, where the journals surveyedwere: theAmerican Economic Review,Journal of PoliticalEconomy,QuarterlyJournalof Economics,RandJournalofEconomics, and Journal of Economic Perspectives in eco-nomics; Strategic ManagementJournal, ManagementSci-ence, Academy of Management Journal, and Academy ofManagementReview in business/management;Administra-tive Science Quarterly, Organization Science, AmericanJournal of Sociology, American Sociological Review, andAnnualReview of Sociology in sociology/organization;andAmericanPolitical Science Review,Political Science Quar-terly, Journal of Politics, and Political Research Quarterlyin political science. Combiningthese four categories, arti-cles using the word governance increasedfrom 48 to 275over this 20-year interval. Dixit (2004 pp. 149-50) reportsthat the numberof web pages that turnup under the searchfor "governance"s huge.1


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parties have no choice but to do their best tocreate their own bilateral or groupmechanismsto supportotherwiseproblematicexchange.Butwherein does the need for private orderingariseif the state has created and enforces efficaciousrules of law, as assumed by the "legal central-ism" tradition?Privateorderinghere resides in the inherentlimitations of legal centralism.Albeit an analyt-ical convenience, for both law and economics,to assume that "disputes require 'access' to aforum external to the original setting of thedispute [and that] remedies will be providedinsome body of authoritativelearning and dis-pensed by experts who operateunder the aus-pices of the state"(Marc Galanter,1981 p. 1),the facts disclose otherwise. Most disputes, in-cluding those that undercurrentrules could bebroughtto a court, are resolved by avoidance,self-help, and the like (Galanter, 1981 p. 2).That is because in "manyinstances the partici-pants can devise more satisfactory solutionsto their disputes than can professionals con-strainedto apply general rules on the basis oflimited knowledge of the dispute" (Galanter,1981 p. 4).The upshot is thatprivate orderingis centralto the performanceof an economy whatevertheconditionsof lawfulness. Adaptation s taken tobe the central problem of economic organiza-tion. Conditionalon the attributesof the activ-ities (transactions)to be organized, I focus onthe comparativeefficacy with which alternativemodes of governanceeffect good order (adap-tation) duringthe ex post contract mplementa-tion interval.Section I sketches the background out ofwhich theeconomics of governanceworks.Sec-tion II sets out the basic logic of efficient gov-ernance with respect to the puzzle of verticalintegrationand more generally. Microanalyticfoundations-from law, economics, andorgani-zationtheory-on which the economics of gov-ernance rests are examined in Section III.Applicationsare addressed n Section IV. Issuesof lawlessness are briefly discussed in SectionV. Concludingremarksfollow.

I. BackgroundI begin with a sketch of the governance ofongoing contractualrelations. The four concep-tual cornerstonesout of which the lawfulness

branch of the economics of governanceworksare described next. I then turn to the crisis inpublic policy toward business duringthe 1960sthat gave impetus to a rethinkingof the pur-poses servedby complex contractand economicorganization.As against simple marketexchange, gover-nance is predominantly oncernedwithongoingcontractual relations or whichcontinuityof therelationship is a source of value. Given thatincompletecontractsneed to be adaptedto dis-turbances for which contractualprovision wasnot made or was incorrectlymade at the outset,continuitycan and will benefit from a spiritofcooperation.But therein lies the rub:continuitycan be put in jeopardy by defecting from thespiritof cooperationandrevertingto the letter.Maladaptation to disturbances is where themain costs of governancereside.4Takenby itself, the possibilityof defectionisbad news. But there is also an upside:contrac-tualhazards, ike othercosts, invitemitigation-which is where the realchallengeandanalyticalimport of potential breakdown resides. Uponlooking ahead and recognizing that possiblebreakdownsare in prospect,cost-effective pri-vate orderingmechanisms that have thepurposeand effect of mitigatingcontractualhazardswillbe devised, therebybetter to assure that mutualgains from trade are realized.The 32-yearcoal supplycontractbetween theNevada Power Company and the NorthwestTradingCompany s an example.Out of aware-ness that disturbancescould lead to conflictandpossible breakdown,this contractprovidedinpartthat "In the event an inequitableconditionoccurs which adversely affects one Party, itshall then be the joint and equal responsibilityof bothparties o actpromptlyandin good faithto determinethe action requiredto cure or ad-just for the inequity and effectively implementsuch action." It furthermoreinstructed "TheParty claiming the inequity shall include in itsclaim such information and data as may be

4 The economics of informationalso deals with contrac-tualhazards,butmainlyof a differentkind thanthose dealtwith here.Thus,whereas nsurance s the paradigmproblemfor the economics of information,vertical integrations theparadigm problemfor governance.Also, law, organizationtheory, adaptation,and transaction costs all figure moreprominently in studying the governance of contractualrelations.


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VOL.95 NO. 2 RICHARDT. ELY LECTURE 3

reasonablynecessary to substantiatethe claimand shall freely and withoutdelay furnishsuchother information and data as the other Partyreasonablymay deem relevant andnecessary.Ifthe Partiescannot reachagreementwithin sixty(60) days the matter shall be submitted toarbitration."Plainly, the parties to this contract wereaware that things could get out of alignmentduringcontractexecution andprovideda frame-work for corrective action. Very general lan-guage notwithstanding,the parties were alsohard-headed.The party requesting correctionswas expectedto provide supporting nformationand data to substantiate he request.And so as

better to assure that conflicts would be resolvedknowledgeably by a specialist in the industry,provisionwas made for arbitrationn the eventthepartiescould not reachagreement.Althoughit boggles the mind that"reasonably lever busi-nessmenandlawyers cope withproblemsschol-ars might consider intractable" (Victor P.Goldbergand John R. Erickson, 1987 p. 369),evidently contractpractitionerscan and do de-sign workableorder-preservingmechanisms foradapting o disturbancesn the service of mutualgains. Some scholars, moreover,had been forg-ing the relevant concepts. The four conceptualcornerstones out of which the economics ofgovernance works are governance, transactioncosts, adaptation,and interdisciplinarysocialscience.

Governance.-The study of governancewasprefiguredby John R. Commons,who was oneof the leaders of older-style institutional eco-nomics in the United States. Of the many goodideas that originatedwith Commons,none wasmoreimportant o the economics of governancethan his abiding interest in "going concerns."As againstthe preoccupationof orthodoxywithsimple marketexchange and the resource allo-cation paradigm(M. Reder, 1999), Commonsobserved that the continuity of an exchangerelationship was often important, whereuponthe problem of economic organizationwas re-formulated as follows: "the ultimate unit ofactivity ... must contain in itself the three prin-ciples of conflict,mutuality,and order.This unitis a transaction" Commons, 1932 p. 4). Com-mons thereafter 1950 p. 21) recommended hat"theories of economics center on transactionsandworkingrules,on problemsof organization,

and on the ... [ways] the organizationof activityis ... stabilized."A coherenttheoryof organizationfor imple-menting these novel ideas nevertheless eludedCommons and his followers, possibly becausethe concept of transactioncost had yet to sur-face and because of the primitive state of orga-nization theory at the time.5 Such a fatenotwithstanding,the Commons triple of con-flict, mutuality,and order anchors the conceptof governanceas hereinemployed, in thatgov-ernanceis the means by which to infuse order,thereby to mitigate conflict and realize mutualgains. The transaction, moreover, is made thebasic unit of analysis.TransactionCosts.-As Ronald Coase (1937)developed in his article on "The Nature of theFirm,"the standardassumptionthat transactioncosts were zero presentedneoclassical econom-ics with a logical lapse. Thus whereas ortho-doxy took the distributionof economic activityacross firm and marketorganizationas given,whereuponattention was focused on "the eco-nomic system as being coordinatedby the pricesystem"(Coase, 1937 p. 387), firmand marketare properly regardedas "alternativemethodsof coordinating production" 1937 p. 388 [em-phasis added]).Rather han take thedistributionof economic activity as given, this should bederived. Coase's 1937 paper thus took as itspurpose"tobridgewhat appears to be a gap ineconomic theory.... We have to explain thebasis on which, inpractice, this choice betweenalternatives is effected" (Coase, 1937 p. 389[emphasisadded]).Orthodoxyremained unmoved over the next35 years, but pressures were mounting as in-

terim developments in the market-failure iter-ature revealed that disregard for positivetransactioncosts was responsible for confusionover externalitiesand other puzzling practices.Upon reformulating he tort problem(or, more

5 Commonsturned nstead to W. N. Hohfeld's system of"fundamental egal concepts"to implementhis ideas. (Forhis reliance on Hohfeld, see especially the extended foot-note in Commons [1968 p. 91].) The resulting effort tointerpret ransactionsandongoing concerns with the use ofjuridical reasoningresulted n an elaborate axonomy(Com-mons, 1968 pp. 90-142), but a predictivetheoryof contractandorganizationanda follow-on empiricalresearchagendadid not materialize.


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generally, the externality problem) in contrac-tualterms,Coase (1960) showedin his paperon"TheProblemof Social Cost" that the external-ity problemvanishedif the logic of zero trans-action costs was taken to completion. Plainly,provision for positive transaction costs wouldthereafterhave to be made if externalities,andthe study of complex contracting more gen-erally, were to be accurately described andassessed.Kenneth Arrow's (1969) examination of"The Organizationof Economic Activity: Is-sues Pertinent to the Choice of Market versusNon-marketAllocation" ikewise made a prom-inentplace for transaction osts, both in generaland with respect to vertical integration. Thegeneral argument s that "market ailure is notabsolute;it is better to consider a broadercate-gory, that of transactioncosts, which in generalimpedeand in particular ases completelyblockthe formation of markets" Arrow, 1969 p. 48).Arrow's remarks about vertical integrationareespecially pertinent:"An incentive for verticalintegration s replacementof the costs of buyingand selling on the marketby the costs of intra-firmtransfers; he existence of vertical integra-tion may suggest that the costs of operatingcompetitivemarkets are not zero, as is usuallyassumed by our theoretical analysis" (1969 p.48 [emphasisadded]).The time was ripe for the concertedstudy ofpositive transaction costs, yet obstacles re-mained. For one thing, the concept of transac-tion costs lacked definition.Being a vague andmalleableconcept, transactioncosts came to beinvoked as an all-purpose explanationfor puz-zling practices, whereupon he conceptof trans-action cost acquired a "well-deserved badname" (Stanley Fischer, 1977 p. 322). Relat-edly, transactioncost is an expansive concept.Of the variety of ways in which transactioncosts can manifestthemselves (of which searchcost was Coase's candidate),6where does themain comparative nstitutional action reside?

Adaptation.-The economics of governancelocates the basic action in the differentialcapac-ities of alternative modes of governance toeffect adaptation. nterestingly,both the econo-mist FriedrichHayek and the organization he-orist Chester Barnardwere in agreementthatadaptation s the central problem of economicorganization.Hayek(1945 pp. 526-27) focusedon the adaptationsof economic actors who ad-just spontaneously to changes in the market.Upon looking "at the price system as ... a mech-anism for communicating information," themarvel of the marketresides in "how little theindividualparticipantsneed to know to be ableto take the right action."By contrast,Barnard(1938 p. 9) featured coordinated adaptationamong economic actors working through ad-ministration (hierarchy).The latter is accom-plished not spontaneouslybut in a "conscious,deliberate, purposeful" way with the use ofadministration.In effect, the adaptationsto which Hayekrefers are autonomous adaptations accom-plished in the market,whereas the adaptationsof concern to Barnardare consciously coordi-nated adaptationsaccomplishedthrough he useof managementwithin the firm. To the widelycelebrated "marvel of the market"(Hayek) isnow therefore oined the hithertoscorned"mar-vel of hierarchy"Barnard).7Becauseefficiencyis the product of adaptive capacities of bothkinds, an understandingand appreciationforboth markets and hierarchies (ratherthan themore familiar dichotomy between marketsorhierarchies)is needed. The firm for these pur-poses is described not as a production unction(which is a technologicalconstruction),but as agovernance structure (which is an organiza-tional construction). And the market is de-scribed as an organizational alternative. The

6 Coase (1937 p. 391) argued hat "The mainreasonwhyit is profitable o establish a firmwould seem to be that thereis a cost of using the price mechanism,the most obvious... [being] that of discoveringwhat the relevantprices are."Although this soundsplausible, the price discovery burdenthat Coase ascribes to the market does not survive compar-ative institutionalscrutiny(Williamson,2002 pp. 179-80).

7 Interestingly, Jean-JacquesLaffont and David Marti-mort (2002 p. 11) credit Barnardas "the first to define ageneral theory of incentives in management,"where theyinterpretBarnard's views as broadly in the spirit of theirown agency theory work. Laffont and Martimort 2002 p.13) also write that "Barnard ecognizedthat incentive con-tracts do not rule all of the activities within an organiza-tion." In particular,"the ncompletenessof contractsand theboundedrationalityof members of the organizationrequirethat some leaders be given authority,"presumably o exer-cise ex post governance.Barnardadvancedprescient deasthat werepertinent o bothagency theoryand theeconomicsof governance.


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VOL.95 NO. 2 RICHARDT. ELYLECTURE 5lens of contract,as againstthe lens of choice, ismade the cutting edge.

InterdisciplinarySocial Science.-This is thelast of the fourcornerstones hatI associatewiththe economics of governance.As discussed inSectionIII,both organizationheoryand aspectsof the law (especiallycontract aw) bearimpor-tantlyon the economics of governance. merelyobserve here that doing interdisciplinaryocialscience is demandingand that the teachingandresearchprogramn economics,organizationhe-ory, and operationsresearch at the GraduateSchool of IndustrialAdministration,Carnegie-Mellon University, duringthe 1950s and 1960shelpedto openthe door to a disciplinedapproachto interdisciplinaryocial science.

To these four cornerstonesI would add thatthe developing crisis in public policy towardbusiness duringthe 1960s provided added im-petus and urgency to the economics of gover-nance. Victor Fuchs (1972 p. xv), in hisForeword o Policy Issues andResearchOppor-tunities in IndustrialOrganization,pronouncedthat "all is not well in this once flourishingfield."Various reasons canbe advanced,amongwhich is that economic organizationis muchmore complex than was widely appreciated.Coase's explanationwas that industrialorgani-zation had been become an exercise in appliedprice theory(Coase, 1972 pp. 60-62), to whichHarold Demsetz's (1983 p. 377) observationthat the neoclassical theoryof the firmis not anall-purposeconstruction s also pertinent: t is a"mistaketo confuse the firm of [neoclassical]economic theory with its real-world namesake.The chief mission of neoclassical economics isto understandhow the price system coordinatesthe use of resources,not the inner workings ofreal firms."

My prior studies of organizationtheory andmy experience as Special Economic Assistantto the headof the AntitrustDivision of the U.S.Departmentof Justice during 1966-1967 reso-nated with these concerns. Thus, although ap-plied price theorywas one useful lens, uncriticalapplicationof such reasoning ed to a presump-tion that nonstandardand unfamiliar forms ofcontract and organizationhad monopoly pur-pose and effect-as witness the inhospitalitytraditionin antitrust,accordingto which non-standard(complex) practices were interpreted

"not hospitably in the common law tradition,but inhospitably in the tradition of antitrust."8Such convoluted reasoning carried over tomergers as well, where Justice Potter Stewartobserved, in a dissenting opinion in 1966, thatthe "sole consistency that I can find in the[merger]litigation under Section 7 [is that] theGovernment always wins."9 Failures to con-nect with the real purposes served by contractrestrictions and the inner workings of realfirmscould often, evidently, have overreachingconsequences.Confusion,moreover,also reignedin thereg-ulatory area, in large measure because regula-tory issues were treated in a one-sided way.Thus, whereas therewas an extensive literatureon market failure, there was no mention of,much less a corresponding iteratureon, regu-latory failure (Coase, 1964). Taken together,antitrust and regulatory policies toward busi-ness were careeningout of control. The needforother perspectives, possibly of a comparativecontractualkind, came knocking.

II. The BasicLogicA strippeddown version of the basic logic isset out here, first with reference to vertical in-tegration, which would become the paradigmproblem for the economics of governance,andthereafter by formulating the discriminatingalignment hypothesis. Additionalmicroanalyticsupportson which the argumentsrest are takenup in Section III.The modeling precept"keepit simple"(Rob-ert Solow, 2001 p. 111) has its origins in com-plexity (HerbertSimon, 1957bp. 89; E. Wilson,1999 p. 183). Choosing vertical integrationas

the specific phenomenon on which to hone inwas both a simplifying move and the obviousplace to start. Not only was vertical integration(the make-or-buydecision) the puzzle to whichCoase referred in his 1937 article, but it re-mained a puzzle, in a zero-transaction-cost

8 The quoted language is that of the then head of theAntitrustDivision, Donald Turner(see Alan Meese, 2004p. 47). Because durable market power is the exceptionratherthan the rule, the economics of governance,like thecommon law, works out of the rebuttablepresumption hatvoluntaryexchange serves affirmativeeconomic purposes.9 United States v. Von's GroceryCo. 384 U.S. 270, 301(1966) (StewartJ. dissenting).


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world, thereafter(Arrow, 1969). Also, verticalintegrationwas an unsettled issue in antitrustenforcement.As comparedwith other candidatetransactions(such as the employment relationor final product market transactions),verticalintegrationhas the advantageof being simpler,in that a variety of complicationsthat arise intransactionsbetween firms and workers or be-tween firmsand consumers(such as disparitiesof information,differential access to technicaland legal expertise,differentialcapacityto bearrisk, and the like) are of lesser importanceintransactionsbetween firms, where the special-ization of labor withinandbetween functions isextensive. Accordingly,the actionin intermedi-ate product market transactionsresides moreassuredly in the attributes of transactions inrelation to thepropertiesof alternativemodes ofgovernance.My 1971 paperon "TheVerticalIntegrationof Production:Market Failure Considerations"drew on all of the foregoing and more. Keyfeatures of this article that would find theirwayinto the economics of governanceincluded:(1)focusing on a specific phenomenonin compar-ative contractual erms;(2) taking adaptation odisturbances to be the central problem of eco-nomic organization; (3) ascribing contractualincompleteness to bounds in rationality, anddefection hazards to opportunism;(4) tracingbilateraldependencycontractualhazards to in-tertemporal ransformationsn the exchange re-lationship;and(5) recognizingthat marketsandhierarchiesdifferin kind, in that each possessesdistinctive strengthsand weaknesses, wherehi-erarchy enjoys the advantage for managingcooperative adaptations,and the marketfor au-tonomous adaptations.

As comparedwith price-theoreticand tech-nological explanationsfor vertical integration,the comparative contractualapproach locatesthe action in the attributesof transactions,thedifferential capacities of alternative modes ofgovernance to implement autonomous and co-ordinatedadaptations,and the efficient align-ment thereof. This applies not only to verticalintegration,but to economic organizationmoregenerally. The discriminating alignment hy-pothesis is this:(1) If some transactionsare simple and othersare complex, then the attributesof trans-actions that are responsible for these

differencesmust be namedand theirramifi-cationsworkedout. The economicsof gover-nance respondsby namingasset specificity(which can take a varietyof forms),uncer-tainty,and frequencyas three of the criticaldimensions or describing ransactions.(2) If the comparative efficacy of differentmodes of governance(market,hybrid,hier-archy, public bureau,etc.) differ, then thecritical attributes that describe alternativemodes of governance need to be named,and the internallyconsistent syndromesofattributes that define viable modes needto be worked out. Relevant dimensionsinclude incentive intensity, administrativecontrol, and contract law regime, the com-plementaryrelations among which are de-scribed below.

(3) A predictive theory of economic organi-zation resides in the hypothesis that trans-actions, which differ in their attributes,are aligned with governance structures,which differ in their costs and competen-cies, so as to effect a (mainly) transaction-cost-economizing result.10The upshot is that there is a place for eachgeneric mode of organization,yet each shouldbe kept in its place.The criticalattributesof transactionsand thesets of concurrent relations among attributesthat define viable modes of governancearedis-cussed elsewhere (Williamson, 1979, 1988,1991b). I merely offer some summary com-ments on each here.There is general agreementthat asset speci-ficity, uncertainty,and frequency are relevantdimensions for describing transactions. Al-though much of the explanatorypower of thetheory turns on asset specificity (Williamson,1971, 1975, 1985;BenjaminKleinet al., 1978),which gives rise to bilateraldependency(or theabsence thereof),bilateraldependency by itselfwould not pose a problem but for maladapta-

0oAs discussed herein, it will simplify to take the at-tributes of transactionsas given and deploy governancestructures in relation to these. In fact, the attributes oftransactionsand of governancestructuresare chosen simul-taneously (Michael Riordan and Williamson, 1985). Thebasic regularitiesof the simplifiedsetup neverthelesscarryover, althoughsome nuances also appear,when simultane-ity is introduced.


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VOL.95 NO. 2 RICHARDT. ELY LECTURE 7tions between the partiesto an incompletecon-tract that are induced by disturbances.Indeed,the problemof contractingunderfully station-aryconditionsis uninteresting:"Onlywhen theneed to make unprogrammed daptations s in-troduced does the market versus internalorga-nization issue become engaging" (Williamson,1971 p. 113). Uncertainty s the source of dis-turbances o which adaptation s required.Fre-quency is relevant in two respects: reputationeffects and setup costs, the net effects of whichwill vary with the particulars.Asset specificity in conjunctionwith distur-bances is where the main predictive action re-sides. Sometimes asset specificitycan be tracedto non-redeployable urable nvestments hat aremade immediately upon signing the contract.But asset specificity also evolves during con-tract implementation.As discussed in SectionIII-A, such transactionsundergoa fundamentaltransformation, n that, even though a largenumberof suppliers may have been on a parityat the outset, a bilateral dependencyconditionbetween the buyer and initial winning biddersets in during contract implementationand atthe contractrenewal interval.Because transac-tion specific assets can be redeployedto alter-native uses and users only at a loss ofproductivevalue, continuityfor such exchangerelations is important.The economics of governance makes threebasic governance structuredistinctions: classi-cal markets(simple spot-market xchange), hy-brid contracting (of a long-term kind), andhierarchies firms, bureaus).The key featuresofgovernance(differential ncentive intensity,ad-ministrativecontrol, and contract law regime)are postulated to vary among modes in in-ternally consistent ways. Different attributecombinations give rise to distinctive adaptivestrengthsandweaknesses.Specifically,the mar-ket mode works outof high-powered ncentives,little administrativecontrol, and a legal-rulescontract-law regime, which is well suited toimplement autonomousadaptationsbut poorlysuited to effect cooperative adaptations.The setof complementaryattributes hat describes hier-archy is antipodalto the marketmode (in thathierarchyuses low-poweredincentives and con-siderable administrativecontrol, and the courtsare deferential),which reverses these adaptivecapabilities.The hybridis a compromisemodethat is located between marketandhierarchyon

all three attributesand works well, but not sur-passingly well, in both autonomousandcoordi-nated adaptation respects. The viability of thehybridturnscruciallyon theefficacy of crediblecommitments(penalties for premature ermina-tion, information-disclosure and verificationmechanisms, specialized dispute settlement,and the like), the cost effectiveness of whichvaries with the attributesof transactions(Wil-liamson, 1991b; ClaudeMenard,2004).Although such differences among modesmay now appear to be "obvious," it was notalwaysso (A. AlchianandDemsetz,1972p. 777).III. MicroanalyticSupports

The overarching ogic of efficient alignmentis as described above. Somewhat more tedious,but vital to the exercise, are the microanalyticmechanisms described here. Indeed, I conjec-ture that David Kreps's (1999 p. 122) remarkthat "game theory ... has more to learn fromtransaction cost economics than it will haveto give, at least initially" turns as much onthe microanalyticmechanisms as on the basiclogic." Discriminatingalignment s easy to im-plementfor those who know the basic logic, butan understandingof economic organizationre-quires the student of economic organizationtoprobe deeper.Mechanisms of affirmative and contestedkinds are distinguished. Human actors, inter-temporal process transformations,and contractlaw in practice are all affirmativesupports,inthat the shape of private ordering governancefor ongoingcontractualrelations s significantlyinfluencedby each.

A. AffirmativeSupportsHerbert Simon (1985 p. 303) advised socialscientists that"Nothingis more fundamental nsetting our research agenda and informingourresearch methodsthanourview of the natureofthe humanbeings whose behavior we arestudy-ing."The two attributes f human actorsthat areespecially relevant to the economics of gover-nance are cognition and self-interestedness.

1 Arrow(1987 p. 734) likewise emphasizes that"nano-economic reasoning" s a distinguishingfeatureof the newinstitutional economics.


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8 AEA PAPERSAND PROCEEDINGS MAY2005Simon took early exceptionwith the idea thathuman actors are supremelyrational and pro-posed instead that human actors be described asboundedly rational, by which he means thatthey are "intendedlyrational,but only limitedlyso" (Simon, 1957a p. xxiv). Human actors arethus neither nonrationalnor irrational,but areattempting effectively to cope.It is ReinhartSelten's (2001 p. 15) view thatboundedrationality s an encompassing conceptthat "cannotbe preciselydefined.It is a problemthat needs to be explored."I concur. With ref-erence to complex boardgames (such as chess),bounds on rationalityare relieved by heuristics;in the context of search it is manifested as

satisficing; my interest is in contracting,wherethe main lesson of boundedrationality s thatallcomplex contracts are unavoidably ncomplete.Contractual ncompletenessnotwithstanding,the economics of governancealso assumes thatpartiesto a long-termcontractpossess "feasibleforesight,"by which I mean that they have thecapacity to look ahead, uncover possible haz-ards,and work out the ramifications, hereuponto incorporate hazard-mitigatingmechanismswithin the ex ante contractual agreement,broadlyin the spiritof RobertMichels' (1962)classic studyof oligarchy.Thus whereas Mich-els observed that democratic structurescan beand are subvertedby oligarchy, he did not onthat accountgive up on democracy.Rather thelesson is that "nothingbut a serene and frankexamination of the oligarchical dangers ofdemocracy will enable us to minimize thesedangers"(Michels, 1962 p. 370)-whereuponhazard mitigation can be introduced in cost-effective degree.The subversion of contracts andorganizationraises the issue of how self-interest is to bedescribed. Simon's (1985 p. 303) candidateis"frailtyof motive,"which is a relativelybenign(nonstrategic)construction.Theproposition, orexample, that routines describe the behavior ofmost individuals most of the time contemplatesbenignbehavior. But while most people will dowhat they say (andsome will do more) most ofthe time, much of what is interesting abouthuman behavior in generaland in organizationsin particularhas reference not to routines,but toexceptions.Exceptions pose strains when parties to along-termcontractperceive that individual ad-vantages can be realized by defecting from the

spirit of cooperationand revertingto the letterof the contract.The general propositionhere isthat when the gainsto be hadby insistenceuponthe literal enforcement of the contractexceedthe discountedvalue of continuing heexchangerelationship,defection from the spiritof coop-eration can be anticipated(Williamson, 1991bp. 273). In thatevent, even if most people willdo what they say (and some will do more)mostof the time, provision also needs to be madefor outliers, where the stakes are great. Self-interested bargainingof an opportunistickindthus becomes the exception to which coopera-tion is the rule.Strategicconsiderations hat hadbeen ignored by neoclassical economists from1870 to 1970 now make their appearance(L.Makowski and J. Ostroy, 2001 pp. 481-83,490-91). Opportunism akes us into the deepstructureof contract and organization n waysthat frailty of motive does not.The bilateraldependencyto which I referredearlier has its origins often in the FundamentalTransformation.Bureaucratizations also an in-tertemporalphenomenon.Both alterthe natureof the contractual relation during the contractimplementation nterval.The FundamentalTransformationapplies tothat subset of transactions or which largenum-bers of qualifiedsuppliersat the outset are trans-formed into what, in effect, is a bilateralexchangerelationduringcontractexecution andat the contract renewal interval. This is to becontrasted with the standardpresumptionthatthe number of qualified suppliersat the outset(large or small) will continue into the future.The key factorin determiningwhether a large-numbers supply condition will evolve into abilateral exchange relation is the degree towhich the transaction n question is supportedby durable investments in transaction-specificassets-by which I mean assets that can beredeployedto alternativeuses andusersonly ata loss of productivevalue. Because continuityof the exchange relation mattersas asset speci-ficity increases, such transactions elicit addedprivateordering governance supports.Specific investments can take the form ofspecialized physical assets (such as a die forstampingout distinctive metal shapes), special-ized human assets (thatarise from firm-specifictraining or learning by doing), site specificity(specialization by proximity), dedicated assets(largediscrete investments made in expectation


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VOL. 95 NO. 2 RICHARDT. ELY LECTURE 9of continuingbusiness, the premature ermina-tion of which would result in products beingsold at distress prices), or brand-namecapital.Also, nonredeployable "organizationalassets"(practices,relationships,complementarities)be-tween firms often have intertemporalorigins.Whateverthe source, failure to appreciatethatmany transactions undergo a FundamentalTransformation,whereupon dentitiesthereaftermatter to which governance ramificationsac-crue, was responsiblefor many misconceptionsabout contract and organization in the zero-transaction-costeconomics era.12

Although bureaucratization s a much ig-nored condition, Oskar Lange (1938 p. 109)describedbureaucratization,orrectlyI think,as"the real danger of socialism." Because, how-ever, he was interested in the pure economictheory of socialism, bureaucratization ssueswere set aside-where they remainedover thenext 50 years until the economies in EasternEuropeand the former Soviet Union collapsed.Even now, bureaucratizations a poorly under-stood intertemporalphenomenon.I will returnto it in my discussion of the impossibility ofreplication/selectiveinterventionbelow.As against one all-purpose law of contractthat was enforced in a legalistic way, KarlLlewellyn adopteda purposive perspective andintroduced he idea of "contractas framework."As Llewellyn (1931 pp. 736-37) put it, the"major importance of legal contract is toprovide ... a frameworkwhich never accuratelyreflects real working relations,but which pro-vides a rough indication around which suchrelationsvary, an occasional guide in cases ofdoubt, and a norm of ultimateappealwhen therelationscease in fact to work."The object ofcontract,so construed,was not to be legalistic,but to get thejob done.To be sure, the norm of ultimate appeal towhich Llewellyn refers is important, in that

recourse to the courts for purposes of ultimateappealserves to delimit threatpositions. But thekey idea is this: the legalistic view of contractthat applies to simple transactions needs tomake way for a more flexible and managerialconception of contract as the preservationofongoing relations takes on economic impor-tance.The convenientnotionof one all-purposelaw of contractgives way to contract aws (plu-ral) in the process.13Such contract-lawdifferencesplay an impor-tant role in distinguishing among alternativemodes of governance.Specifically,the econom-ics of governanceavers thateach generic modeof governance s supportedby a distinctiveformof contract law. The contract law of simplemarketexchange is that of legal rules,14 where-upon each party goes its own way, and courtsawardmoney damagesin the event of a dispute,there being no interest in continuity for suchtransactions.The hybridmode is supportedbycontract as framework,which is a more elasticconceptof contractand(withinlimits)promotescooperative adaptation. f andas those adaptivelimits are exceeded, transactionsare organizedby hierarchy.But what then is the contract lawof internalorganization?The argumenthere is that the implicit con-tractlaw of internalorganization s that of for-bearance (Williamson, 1991b). Thus, whereascourtsroutinelygrantstandingto contracts be-tween firms should there be disputes overprices, the damages to be ascribed to delays,failuresof quality, and the like, the courts havethe good sense to refuse to hear disputes be-tween one internal division and another overidentical technical issues. Access to the courtsbeing denied, the partiesmustresolve theirdif-ferences internally,which is to say that the firm

12Whateverthe source, bilateraldependency has mas-sive public policy ramificationswhich didnot register n thepre-governanceera. Thus contractualpractices that werepreviously thought to be anticompetitive(as with take-or-pay contracts) are now perceived to serve an efficiencypurpose (S. Masten and K. Crocker,1985) if the requisitepreconditionsare satisfied. Also, the purportedefficacy of"ex ante franchisebidding"as a solutionto the problemofnaturalmonopoly is deeply problematicin industries thatwill predictably undergo a fundamental transformation(Williamson, 1976).

13 Contractlaws (plural) can be thought of as the re-sponse by legal realists to the need to supportcontinuityintradesthat deviate fromthe ideal transaction n bothlaw andeconomics-namely, between large numbers of buyersandsellers whose identity was unimportant.Whereas econo-mists made note of deviations from the ideal that took theformof small numbers(by devising monopoly, monopsony,duopoly models and the like), legal realists, if not contract-law specialistsmore generally, were alert to the benefits ofcontinuityas identity became important.

14 As Dixit's (2004) recent examinationof lawlessnessemphasizes,even simple marketexchange can benefit fromprivateordering f courtordering s weak or corrupt.SectionV excepted, I assume that court ordering works well formost simple transactions.


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10 AEAPAPERSAND PROCEEDINGS MAY2005becomes its own court of ultimate appeal. Ineffect, forbearance aw authenticateshierarchyby supporting ts main purpose,namely, timelyresponsiveness to consequential disturbancesfor which coordinatedadaptationsare needed.The upshot is that the differentialadaptiveef-ficacy of alternative modes of governance arerealized, in part, with the supportof comple-mentarycontractlaw regimes.

B. ContestedMechanismsBy contested mechanisms, I mean oneswhich, if costlessly operative,would undo theneed for an economics of governance. These

include claims thattechnology is determinativeof economicorganization, hatbureaucracys ofno account, that two-way common knowledgeand costless bargainingeliminate problems ofmaladaptation n contracts,that reputationef-fects are reliably efficacious, that power ex-plains observed contractualpractices, and thattrust obviates the need for credible commit-ments. I examine all from a microanalytic,com-parativecontractingperspective.I briefly discuss technology, bureaucracy,and reputationeffects here. My examinationofthe other contested mechanisms is reportedelsewhere.15Technological explanations were once heldto be centralto the vertical integrationof sepa-rable stages of production.16 Indeed, verticalintegrationthat lacked a "physicalor technicalaspect"was believed to be deeply problematic(J. Bain, 1968 p. 381). Thus considerthe "clas-sic case ... of integrating ron-makingand steel-making to effect a saving in fuel costs byeliminating a reheatingof the iron before it isfed to a steel furnace" (Bain, 1981 p. 381).Vertical integration of these two stages waspurportedlynecessitatedby thermaleconomies.

The comparativecontractingperspectivedis-putes this. All that is requiredfor the thermaleconomies in questionto be realized is for theiron-makingand steel-making stages to be lo-cated in the immediateproximityof each other.Common ownership is not, withoutmore, im-plied. Indeed, in a zero-transaction-costworld,interfirm contracting would costlessly imple-ment autonomousand coordinatedadaptationsto disturbances of all kinds. In a positive-transaction-cost world, by contrast, interfirmcontracting between autonomous, site-specificstages poses bilateraldependencyhazards thatare relieved by common ownership.Site speci-ficity,moreover, s merelyone illustrationof thecomparativecontractualargument hattechnol-ogy, by itself, is not determinativeof verticalintegration.I examine the argument hatbureaucracy anbe ignored(becauseit is a wash)by restating helong-standing puzzle of firm size as follows:Can a largefirmdo everythingthata collectionof small firms can do andmore?17 I proceedbyindirectionby postulating wo mechanisms,rep-lication andselective intervention,whichwouldanswer this question in the affirmative, f theycould feasibly be implemented.Thus consider the outsourcingof a good orservice to an independentsupplierand assumethatthecontractworks well most of the timebutoccasionallybreaksdown. Supposethatthepur-chaser proposes to acquirethe supplieron thefollowing terms: the supplier will continue toappropriate ts own net receipts (adjustedforoverheadandusercosts) in the post-acquisitioninterval; and the supplier will continue to dobusiness as usual (by replication) except as theacquiring stage selectively intervenes, when-ever there is a prospect of expected net gains.In that event, incentive intensity will be un-changed after acquisition, and the combinedfirm will never do worse (by replication)and will sometimes do better (by selectiveintervention).Whetheror not this canbe implemented urnson answers to the following questions:Will theaccounting system, transferpricing practices,

15 Fora discussion of the limits of the two-way commonknowledge/costless bargaining argument, see Williamson(1975 pp. 31-33); for assessments of the claim that a se-quence of short-termcontracts can implement an optimallong-termcontract,see Kreps(1990b p. 760) and William-son (1991a);on power, see Williamson(1996 Ch. 9); and ontrust, see Williamson (1996 Ch. 10).16 Note thatI define a stage as a clusterof nonseparableactivities. Vertical integration hus entails the unifiedown-ershipand hierarchicalorganizationof successive separablestages.

17 See Frank Knight's (1965 p. xxiii) preface in thereissue of Risk, Uncertainty,and Profit. Also see Knight(1965 p. 286 [footnote 1]). TracyLewis (1983 p. 1092)alsospeaks to the purportedadvantagesof large size.


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VOL.95 NO. 2 RICHARDT. ELYLECTURE 11and/or user costs be compromised by the ac-quisition? Will selective intervention be com-promised by failures of contract as promise,whereupon a need for three-way commonknowledgearises? Will the combinedenterprisebe more subject to politicization? Examiningthe microanalytics is tedious and is reportedelsewhere (Williamson, 1985 Ch 6). I merelyassert here that integration experiences prob-lems in all three respects, which is to say that(1) replicationandselective interventioncannotbe implementedas described,on which account(2) themove frommarket o hierarchy s alwaysattendedby a loss of incentive intensity andadded bureaucraticcosts, and (3) coming toterms with these conditions is vital to an under-standingof real-world economic organization.further aver that it would be well nigh impos-sible to uncover the relevantmicroanalytic ea-tures withoutposing the issues in a comparativecontractualway.The purportedefficacy of reputationeffects,often examined as a one-sided prisoner's di-lemma game with sequentialmoves, is widelyinvokedto supportefficient trade.But what arethe limits? If fully efficacious, why do we notrely entirelyon reputation ffects to police tradeacross all technologically separablestages?Andif reputation ffects requiresupport,why does itnot suffice to invent a suitable collective-actionmechanism, such as the merchant law system(Paul Milgrom et al., 1990), to perform therequisite information-disclosure and punish-ment functions?

Again, the answers reside in the microanalyt-ics, an examinationof which discloses thatrep-utation effects can be costly and experiencebreakdowns(Kreps, 1990a;Williamson, 1991app. 166-72; Jean Tirole, 1996). Because theefficacy of a reputationeffect varies with thenatureof transactionsandwith the conditionsofembeddedness (local sanctions and the like),this and other theories of spontaneous orderoften need to be augmentedby providingtrans-action-specific intentional order of an ex postgovernancekind.Like many other theories, the economics ofgovernance has moved througha naturalpro-gressionfrom informaltheory (where the earlyintuitions reside) to pre-formal theory (wherethe basic logic is set out) to semi-formaltheory(of a reduced-formkind)to fully formaltheory.Ideally, value is added at each step. One con-

cernwith fully formaltheoryis the possible lossof contact with the phenomenain question. Asecond concernis that the theorybecomes non-testable. RobertSolow (2001 p. 112) speaks tothe first as follows: "A model can be rightin ... [a] mechanical sense"yet be "unenlighten-ing because ... [it] obscuresthe key interactions,instead of spotlighting them." And MichaelWhinston (2003) speaks to the latter.From the perspective of one who is con-vinced that much of the relevant action residesin the ex post contractimplementation stage, Ifind the formal models and related empiricalresearchby StevenTadelis and his co-authors obe especially promising (P. Bajariand Tadelis,2001; Tadelis, 2002; Bajariet al., 2004; J. Levinand Tadelis, 2004). However, the contract ap-proachto economic organizationwill continueto benefit from pluralism.18As discussed inSection V the recent literatureon lawlessnessand economics is pertinent.

IV. ApplicationsVertical integration s the paradigmproblemfor the economics of governance, to which

many other contractualphenomenaturn out tobe variations on a theme. Indeed,any issue thatarisesas or can be reformulatedas a contractingproblemcan be examined to advantagethroughthe lens of transaction-costeconomizing. WhatI have previouslyreferred o as the simple con-tractualschema displays the basic regularities.Assume that a firm can make or buy a com-ponent and assume furtherthat the componentcan be supplied by either a general-purposetechnology or a special-purpose technology,where k is a measure of asset specificity. Thetransactionsin Figure 1 that use the general-purpose technology are ones for which k = 0. Inthis case, no specificassetsareinvolved, and theparties are essentially faceless. Those transac-tions that use the special-purpose technologyare ones for which k > 0. As earlierdiscussed,bilaterallydependentpartieshave incentives topromotecontinuityand safeguardtheir specific

18 The "property ightstheoryof the firm"(S. Grossmanand 0. Hart, 1986; Hart, 1995) andrecent variants thereon(G. Baker et al., 2002; Hart and B. Holmstrom, 2002)obviously qualifies.For a recentsurvey and contribution othe theoryof the firmliterature, ee RobertGibbons(2005);also see Tian Zhu (2004).


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12 AEAPAPERSAND PROCEEDINGS MAY2005A (Unassistedmarket)

k = B (Unrelievedazard)s=O

C (Hybrid)k >

c r e d i b l econtractings>Oadministrative

( H i e r a r c h y )

FIGURE 1. THE SIMPLE CONTRACTUAL SCHEMA

investments. Let s denote the magnitudeof anysuch safeguards,which includepenalties, infor-mation disclosure and verification procedures,specialized dispute resolution (such as arbitra-tion), and in the limit, integrationof the twostages underunifiedownership.An s = 0 con-dition is one for which no safeguardsare pro-vided; a decision to provide safeguards isreflectedby an s > 0 result.Absent anarchy or inept or corrupt courts(which would pose lawlessness issues of thekind examined in Section V), node A in Fig-ure 1 corresponds o the ideal transactionn lawand economics: "sharp n by clear agreement;sharp out by clear performance"(I. Macneil,1974 p. 734). There being both large numbersand an absence of dependency, governanceis accomplished through competitive marketprices and, in the event of disputes, by court-awarded damages. Node B poses unrelievedcontractualhazards,in that specialized invest-ments are exposed (k > 0) for which no safe-guards (s = 0) have been provided. Suchhazardswill be recognized by farsightedplay-ers, who will price out the implied risks ofcontractualbreakdown.Added contractualsupports(s > 0) are pro-vided at nodes C and D. At node C, interfirmcredible contractingmechanisms serve to sup-port cooperative adaptations across a widerrangeof disturbances.Shouldcostly contractualbreakdownscontinuein theface of best bilateralefforts to craftcost-effective safeguardsat nodeC, the transaction may be taken out of the

marketand organizedunderhierarchy unifiedownership;vertical integration),therebybetterto implementcoordinatedadaptations.Becauseadded bureaucratic osts accrue upon taking atransactionout of the market and organizingitinternally, internal organization is usefullythought of as the organizationform of last re-sort:trymarkets, ryhybrids,and have recourseto the firmonly when all else fails. Node D, theunified firm, thus comes in only as higher de-grees of asset specificity and addeduncertaintyawardpriorityto coordinatedadaptation.Note that the price thata supplierwill bid tosupplyundernode C (hybrid)conditionswill beless than the price that will be bid at node B.Thatis because addedsecurityfeatures(s > 0)serve to reducethe risk at node C, as comparedwith node B, so the contractualhazardpremiumwill be reduced. One implicationis thatsuppli-ers do not need to petition buyers to providesafeguards.Becausebuyerswill receiveproducton betterterms(lower price) when addedsecu-rity is provided, buyers have the incentive tooffer cost-effectivecredible commitments.Applications of the schema to phenomenaotherthanverticalintegration ncludenonstand-ard contractingpractices(customerandterrito-rialrestrictions, ake-or-paycontracts,exchangeagreements, price discrimination,andthe like),regulation(and deregulation),labor-market r-ganization, the uses of debt and equity, agri-cultural cooperatives, networks, multinationaleconomicorganization, orporate trategy manymarketingpracticesincluded),and the list goes


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VOL.95 NO. 2 RICHARDT. ELY LECTURE 13on.19 Surveysof empiricalapplicationsof trans-action-costeconomics,20 the growing literatureon governancewithinthe new institutionaleco-nomics,21and citations to this literatureall attestto the wide reach of this reasoning.22The economics of governance subscribes tothe propositionsthat "thepurposeof science ingeneral is not prediction,but knowledge for itsown sake," yet that prediction is "the touch-stone of scientific knowledge" (N. Georgescu-Roegen, 1971 p. 37). Some scoff at prediction,evidently in the belief that predictionis easy.Also, sinceeveryoneknows that"it is easy to liewith statistics,"what useful purpose is servedby empiricaltesting? My experienceis thatpre-diction is a demanding standardand that cor-roboration is not easy, but difficult. Takentogether, prediction and empirical testing per-form the vital function of helping to sort thesheep from the goats among rival theories.Why then are not more social scientists in-sistentupon derivingrefutable mplicationsandsubmittingthese to empiricaltests? One possi-bility is thatthe world of pure theoryhas its own

orbitandrules of the game (R. Lipsey, 2001). Asecondpossibility is thatsome theories aretrulyfanciful. A third is that the refutable implica-tions of some would-be theories are contra-dicted by the data. A multiplicity of theories,some of which arevacuous, others of which arefanciful, and still others of which are contra-dicted by the evidence, is an embarrassmentopragmaticallyorientedsocial scientists. Amongthis subset, insistence upon the injunction toderive refutable implications and submit theseto the data has attractions.The economics of governancehas respondedto the challenge by deriving refutableimplica-tions and inviting empirical testing. As of theyear 2000, there were over 600 publishedem-pirical articles on transaction-cost economicswith exponential growth therein (C. Boernerand J. Macher,2002). Still, thereis no occasionto rest content. All theories of economic orga-nization, the economics of governance in-cluded, will benefit from more and betterempiricaltests: betterdata,additionalphenom-ena, and better statisticalprocedures.Given thatthe economics of governancewasstimulated in part by the evolving crisis in an-titrust enforcement and regulation during the1960s, little wonder that many of the public-policy applicationsof governancehave been toantitrust Joskow, 2002) andregulation/deregu-lation (B. Levy and P. Spiller, 1994). But it isalso noteworthythat the lens-of-contract/gover-nance approachhas had influence on public-policy analysis more generally.As Dixit (1996p. 9) remarks, the era of black-box appliedwelfare economics had left

... some very importantgaps in our under-standing and [gave] us some very mis-leading ideas about the possibilities ofbeneficialpolicy intervention.Economistsstudyingbusiness and industrialorganiza-tion have long recognizedthe inadequacyof the neoclassical view of the firm andhave developed richer paradigms andmodels based on the concepts of variouskinds of transactioncosts. Policy analysisalso stands to benefit from ... opening theblack box andexaminingthe actual work-ings of the mechanism inside.Applicationsof such reasoningto policy analy-sis is not only a themeof Dixit's 1996 book, buthas taken hold more generally.

19Interestingly,the make-or-buydecision refuses to goaway, havingrecentlybeen renamedas the worrisomeprac-tice of "outsourcing"or, even worse, as "offsourcing,"which entails procurementfrom a foreign country. Somecritics wouldhave us believe that domestic verticalintegra-tion is the ideal to which marketprocurement s a deeplyproblematicalternative.20 As ScottMasten(1995 p. xi-xii) observes,"surveysofthe empirical transaction cost literature attest .. [that] thetheoryand evidence have displayedremarkable ongruity."Paul Joskow (1991 p. 81) moreover, describes empiricalwork of a transaction cost kind as "in much better shapethan much of the work in industrialorganizationgenerally"(also see Whinston, 2003). Interestingly,much of the em-pirical researchon the economics of governancedoes notrely on published data that have been collected for analtogetherdifferentpurpose (e.g., to satisfy census or reg-ulatory requirements).Instead,much of the best empiricalresearch on governance uses primarydata that have beencollected with the microanalyticneeds of the discriminatingalignmenthypothesis foremost in mind. Those who havedone this modest, slow, molecular, cumulative work de-serve enormous credit.21 For collections of articles thatwork out of the logic ofgovernance,see Williamson and Masten(1995) and ClaudeMenard(2005), especially those articles that Menard clus-ters underheadings VII-XIII.22 For an examinationof the growing citationsto trans-action-cost economics/the economics of governance, seeWilliamson (2005). The uses of such reasoning are espe-cially great in business and economics but also extend toinclude law, sociology (organization theory), and politicalscience.


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14 AEA PAPERSAND PROCEEDINGS MAY2005Pertinent n this connection is that the prac-tice of comparingactualalternativeswith hypo-theticalideals has given way to a comparisonoffeasible alternatives, all of which are flawed.Lapses into comparisonswith omniscient, om-nipotent,benevolent alternativesare avoidedby(1) recognizingthatit is impossible to do betterthan one's best, (2) insisting that all of thefinalists in a governance-structure competi-tion meet the test of feasibility, (3) symmetri-cally exposing the strengths and weaknessesof all proposed feasible forms, and (4) des-cribing and costing out the mechanisms ofimplementation.23

V. Lawlessnessand GovernanceThe economics of lawlessness focuses on in-stitutional environments where the "govern-ment is unable or unwillingto provideadequateprotectionof propertyrightsand enforcementofcontracts throughthe machineryof the state"(Dixit, 2004 p. vii). I repeat,however, that evenin states that make best efforts to provide pro-tection for propertyrightsand contractenforce-ment, the state's access to information and the

state's protectionand enforcement mechanismsare inherently limited. Whether, therefore, therules of the game are well-developed (as in theUnited States) or poorly developed (as in Viet-nam [J. McMillan and C. Woodruff, 1999]),propertyand contractualhazards invite the useof private orderingto infuse order, thereby tomitigate conflict and realize mutualgains fromtrade.Circumstances where state law is "verycostly, slow, unreliable,corrupt,weak, or sim-ply absent"(Dixit, 2004 p. 3) neverthelessposeadded private ordering challenges. Dixit's re-cent book on Lawlessness and Economics isnoteworthyfor the rangeof phenomenathatheaddresses and his imaginative developmentof a"toolkit" of game-theoreticmodels, broadly inthe spirit of the pragmatic methodology towhich I referredearlier(Dixit, 2004 p. 22).He begins with "private ordering in theshadowof thelaw,"partsof which track he"con-tract as framework"easoningof Llewellyn.ButDixit also uncovers a nuance in using the courts

for purposes of ultimate appeal: relationsbe-tween the parties can be temporarilycompro-mised if, startingfrom a weak state, there is a"gradual improvement of state law"-whichhas lessons for transition economies (Dixit,2004 pp. 38-40). He thereafterexamines arbi-tration,which often has verifiabilityadvantagesover the courts, combined with court-enforcedbackup. The general finding here is that "arbi-tration based on its information advantageworks well in conjunctionwith the formal egalsystem" (Dixit, 2004 p. 47). Describing ar-bitration as providing superior verifiability(buttressed perhaps by reputation effects) isnevertheless a truncated statement of the pur-poses servedby this mode of governance.Formany transactions,arbitrationalso provides aforum with greater give-and-take, which pro-motes cooperation,continuity,and mutualgains(Fuller, 1963). Dixit's models make no provi-sion for this.

Especially interesting are transactions forwhich "profit-motivated ontract enforcement"is observed,of which the creation of a mafia toprovide order for otherwise problematictrans-actions is an example (D. Gambetta,1993p. 15[as quoted in Dixit, 2004 p. 99]):

When the butchercomes to me to buy ananimal,he knows thatI wantto cheathim[by giving him a low-qualityanimal].ButI know that he wants to cheat me [byreneging on payment]. Thus we needPeppe [that is, a thirdparty] to make usagree. And we both pay Peppe a percent-age of the deal.To be sure,organization, ike the law, has a lifeof its own-which poses intertemporal rade-offs: "protectors, nce enlisted,invariablyover-stay their welcome" (Gambetta,1993 p. 197).Again, lessons for transition economies residetherein (Dixit, 2004 pp. 3, 100, 129).Issues of "private protection for propertyrights" also pose novel issues, both in devel-oped countries, where common pool resourceutilization problems elicit collective action re-sponses, and even more, in less-developedcountries (Dani Rodrik, 2000) and transitioneconomies (McMillan, 2002). As Dixit (2004p. 125) puts it, "threats o propertyrightscomefrom ... individuals [who] encroach on one'sproperty .. [or], even worse, the state itself or

23 I discuss these issues elsewhere with reference to theremediablenesscriterion(Williamson, 1996 Ch. 8).


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VOL.95 NO. 2 RICHARDT. ELYLECTURE 15its agents may engage in extortion of privatepropertyto furthertheir own objectives." Thebalancebetweengovernmentprotection,privateprotection,and efforts made by otherpeople tocaptureone's propertyturns on the underlyingparametersof the model.Althoughthe contractualhazardswith whichDixit is concerned are due mainlyto weakprop-erty rights, rather than bilateral dependency,they can neverthelessbe interpretedas a variantupon the simple contractual schema of Fig-ure 1.24 Absent relief, property-righthazardswould locate the parties at node B, which isinefficient if cost-effective private orderingsup-portsforpropertycan be devised that will movethe partiesto node C. Note, however, that Dixitnever moves beyond node C to include unifiedownership at node D (hierarchy)as a gover-nancealternative.Possibly this will be remediedin follow-on work of the lawlessness kind-although if, as I contend, markets and hierar-chies differ in discrete structuralways, thesedifferences will need to be taken into accountexplicitly. Also, as discussed above, Dixit'streatment of arbitrationemphasizes informa-tional benefits to the neglect of informal pro-cess benefits. Be that as it may, there is noquestion but that the study of lawlessness use-fully expands the reach of the economics ofgovernance.

VI. ConclusionsThe economics of governancehas helped topersuade many economists and other socialscientists that (1) institutions matter and aresusceptibleto analysis, (2) adaptation o distur-bances is a key purposeof economic organiza-

tion, (3) the action is in the microanalytics,(4)positive transactioncosts can be addressed n acomparativeway, and (5) public policy towardbusiness needs to be informedby a broad (or-ganizational) understandingof the efficiencypurposes served by complex contract and eco-nomic organization.Put in the negative, it is nolonger acceptableto treatgovernanceas some-one else's bailiwick, to slight adaptation, toscant the microanalytics, to assume transac-

tion costs to be zero, or to uncriticallyascribemonopoly purposes to nonstandardcontractualpracticesand organizationalstructures.As described herein, the economics of gov-ernancejoins three fundamentalconcepts (ad-aptation, governance, and transaction costs)with the purposeof pouringoperationalcontentinto all three. This is accomplished by makingnot one (or a few) changes in the basic setup-such as a changein the objectivefunctionof thefirm, or the introductionof a new constraint,orinvoking barriers to entry, or assuming differ-ential risk aversion,or the like-but by makinga series of relatedchanges.The economics of governance treats simplemarketexchange as a special case and featuresongoing transactionsfor which adaptations(ofboth spontaneous and intentional kinds) areneeded. As compared with most theories ofeconomic organization,the economics of gov-ernance is more interdisciplinaryand more mi-croanalytic-as with the efficient alignmentoftransactionswith governancestructures whichturnson the attributesof transactions n relationto the adaptivepropertiesof alternativemodesof governance); in working out hitherto ne-glected features of contract (e.g., the Funda-mental Transformation),of bureaucracy (theimpossibility of replication/selective interven-tion), and of contractlaws (plural);and in ex-aminingthe efficacy of contested mechanisms.It is said that theories, like beads, need astring to hold them together. The string thatdraws the foregoing features together is thediscriminating alignment hypothesis, where-upon economizing on transaction costs (whichmainly take the form of maladaptation)s madethe main case. The resultingtheoryof economicorganizationappliesnot merelyto the make-or-buy decision and boundaryof the firm issues,but has ramificationsfor a wide range of con-tractualphenomena-within economics and thesocial sciences more generally. Empiricaltestshave been both numerous andbroadly corrob-orative. The study of good order and work-able arrangements from the economics-of-governance perspective nevertheless entailssetup costs. Is the game worth the candle?I venture a two-partanswer.First,not every-one will want to or should make the requisiteinvestments. The economics of governance,af-ter all, is only one of several instructivelensesfor studyingthe economics of organization.But

24Letting r denote propertyrightshazardsand substitut-ing r for k (asset specificity hazards) n Figure 1, the sameregularitiesappearexcept for the absence of node D.


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second,I submit that ourunderstandings f eco-nomic organizationand public policy pertinentthereto have been needlessly impoverished byfailures to pay heed to the lessons of gover-nance. The economics of governanceis an un-finishedprojectwhose time has come.REFERENCES

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