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Organizational Economics: Notes on the Use of Transaction-Cost Theory in the Study ofOrganizationsAuthor(s): James A. RobinsSource: Administrative Science Quarterly, Vol. 32, No. 1 (Mar., 1987), pp. 68-86Published by: Johnson Graduate School of Management, Cornell UniversityStable URL: http://www.jstor.org/stable/2392743 .

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OrganizationalEconomics: Notes onthe Use of Transaction-Cost Theory in the Studyof OrganizationsJames A. RobinsUniversity of California,Los Angeles

(? 1987 by CornellUniversity.0001 -8392/87/3201-0068/$1 .00.Iwould like to thank RichardDaft, Scott Ed-mundson, GarethJones, Michael Masuch,and the anonymous ASQ reviewers for in-sightful comments on earlier drafts of thispaper. The ideas presented in italso owe agreat deal to discussion and debate amongmembers of the Organizationand StrategicStudies group of the UCLAGraduateSchool of Management, including (amongothers) Jay Barney, WilliamOuchi, andRichardRumelt. None of these individualsbears any responsibility for errors or idio-syncratic opinions that remain inthe paper.An earlier version was presented at theAcademy of Management Annual Meetingin 1985.

Transaction-cost theory has helped to give new life to someof the classic issues of organization studies through the useof microeconomic models. However, the assumptions un-derlying these models have not been examined carefully,and this has produced serious logical and empirical weak-nesses in recent works. This paper reviews transaction-costapproaches to organizational analysis, examines their useof microeconomic theory, and identifies some importantflaws in the work. It concludes by arguing that transaction-cost theory can be a powerful tool for organizational andstrategic analysis but that it must be set within the frame-work of more general organization theory.The last decade has witnessed rapidgrowth of interest ineconomics among students of organizations. The developmentof what has been called the new institutional economics(Williamson, 1979) has helped to renew concern for some ofthe central questions of organizationtheory. Issues such as theanalysis of vertical integration have turned the attention ofeconomists to traditionalproblems of the definition of organiza-tional boundaries, and their work has begun to have an impor-tant impact on the field of organization studies. Recent re-search in the field has recast the organization as a "stablepattern of transactions" (Ouchi, 1980: 140) and employed con-cepts from economics to analyze internalexchange.The influence of economics on organization studies has been amixed blessing. Ithas had the positive effect of pushing thefield in the direction of greater rigor by encouraging theorists touse more precise definitions and to buildsystematic theoryfrom general axioms about social behavior. But it also has car-ried with it the liabilities of any effort to step outside the field insearch of new concepts or metaphors. Ithas been conducive tothe sort of incautious borrowing of ideas that Pinder and Bour-geois (1982) identified as an endemic weakness of organiza-tional research.Some of the recent work inorganization studies reflects thisweakness. A growing body of research has attempted to applyconcepts borrowed from areas such as the economics of law oreconomics of industrialorganization to analysis of the originsand structure of complex organizations (Williamson, 1975;Ouchi, 1980; Jones, 1983). The uncritical use of market modelshas led to serious logical and empirical flaws in much of thiswork.The principalpurpose of this paper is to review these flaws andlook at their implications for the development of organizationstudies. This entails discussion of three general issues. First,the paper will examine how recent work on transaction costs isshaped by concepts borrowed from economics. Second, it willidentify assumptions that are criticalto the use of these con-cepts in neoclassical economics. And third,the paper will indi-cate ways in which transaction-cost analysis of organizationsfails to meet some of the fundamental assumptions of the mi-croeconomic logic.Iwill argue that the weaknesses of the work on transactioncosts are not due to inherent flaws in the approach but stemfrom an excessively ambitious objective: the attempt to explainthe causes or origins of organization structure. There are press-

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Formaldefinitions of transaction costs areremarkablyrare in the literature.The defini-tion suggested here has the virtue of high-lightingthe relationship between transac-tion costs and market imperfection.Transaction cost is a residual category es-sentially composed of the factors that pro-duce idiosyncratic prices, i.e., prices thatvary across purchasers of a good (see Dahl-man, 1979, for a discussion of alternativedefinitions of transaction costs).

Organizational Economicsing reasons for this attempt, but the attempt proves to be theAchilles heel of the current literature. As the conclusion of thepaper will suggest, the fact that transaction-cost analysis hasbeen yoked to causal explanation has resulted not merely inflaws in the current work, but in the loss of important oppor-tunities for the development of research on strategic organiza-tion. Iftransaction-cost analysis is relieved of the burden ofcausal explanation, it may provide valuable tools for organiza-tional and strategic analysis.THE TRANSACTION-COST LOGICIN ORGANIZATIONSTUDIESAlthough transaction-cost theory has been used to analyze awide variety of organizationalactivity, including bureaucracy(Williamson, 1979), vertical integration of production (William-son, 1971; Klein,Crawford, and Alchian 1978), clan-like rela-tions within firms (Ouchi, 1980), and organizationalculture(Jones, 1983), its underlying concepts are not complex. Inbasicterms, transaction costs are those costs associated with aneconomic exchange that vary independent of the competitivemarket price of the goods or services exchanged.1 They includeall search and information costs, as well as the costs ofmonitoring and enforcing contractual performance. Althoughthese costs are independent of the competitive market price ofthe goods or services, they are determined by the nature of theexchange. Issues such as the difficultyof setting prices or mea-suring the performance of services are instrumental indeter-mining transaction costs.The determination of transaction costs and their effect on ex-change have been explored at some length by Williamson(1975, 1979) buildingon the earlierwork of Coase (1937).Williamson (1979) cited factors such as uncertainty in deter-mining appropriate (competitive) prices, difficulty in monitoringand enforcing postcontractual performance, and the necessityof specialized (transaction-specific) investments as majorsources of transaction costs. He argued that these costs maybe reduced by the organization of exchange through a variety ofnonmarket mechanisms, including bureaucratic administration.While administered transactions may involve higher costs thanmarket organization ina purelytheoretical world with friction-less exchange, costs of administration inthe realworld oftenare outweighed by reductions that administered exchangeachieves in transaction costs.Bureaucratic organization, for example, involves both the costof maintainingan administrative apparatus and a potential lossdue to the (theoretically)greater efficiency of the market intransmitting information. However, these costs may be smallerthan the alternative costs that would be associated with con-tracting for complex labor skills on a task-by-task basis. Re-duced to essentials, the argument is a simple one; wheremarket organization of economic exchange is cumbersome andcostly, other forms of transaction governance (such as con-tingent contracting, third-partyarbitration,or bureaucratic orga-nization) may prove efficient. Nonmarket forms of exchangewill arise in situations in which markets "fail,"that is, when al-ternative forms possess greater efficiency.Ouchi(1980) carried his line of reasoningone step furtherandarguedthat there also are situations n whichbureaucratic d-691ASQ,March 1987

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ministration of exchange is extremely costly. Inthose situa-tions, clan-likeforms of organization may be efficient. Complexforms of work, for example, may requirea degree of flexibilityand innovation that precludes standardized monitoring andmerit-reward systems. Under those circumstances, compen-sation must be based on other criteria,such as tenure inthe organization or group performance. Strong norms of organi-zational solidarityare required for these incentives to be effec-tive in securing individualperformance.This perspective is amplified by Wilkinsand Ouchi's (1983) ex-amination of organizationalculture. Intheir analysis, organiza-tional culture is treated as the set of solidarity norms referred toabove. Due to the nature of exchange processes, some organi-zational settings make more severe demands on these normsthan others and thus requirestronger forms of organizationalculture.Jones (1983) took this line of reasoning to one of its logical con-clusions by equating the structure of property rights in an orga-nization to its culture. Inhis view, a variety of technical factorsmandates the forms of exchange that must be carriedoutwithin an organization, and the allocation of property rights di-rectly affects the level of cost associated with those ex-changes. Jones argued that transaction-cost minimizationdetermines the efficient property rights system and thus de-fines the organizationalculture.These works, and others that use transaction-cost economizingto analyze organization structure, share an underlying model ofsocial causation that is borrowed from neoclassical economics.They employ what might be termed a doctrine of economicefficiency to explain social organization. Insimple terms, this isthe idea that forms of organization that are more efficient foreconomic exchange will supplant less efficient ones, with theresult that observed organization structure comes to representan efficient solution to problems of exchange.Although the concept of efficiency is criticalto the transaction-cost model, it is not elaborated inthe transaction-cost litera-ture. Transaction-cost analysis relies on an implicitanalogy toneoclassical economics, and the analogy is flawed. The con-cept of efficiency that is employed ineconomics has only lim-ited relevance to organization studies.THEUSES OF EFFICIENCYAS A BASIS FORCAUSALITYThe Concept of Efficiency in EconomicsEfficiency has a very specific connotation ineconomics: it isthe matching of supply to demand that produces the greatestconsumer surplus. This idea is not necessarily related to effi-ciency as measured by an engineering relationship betweenthe physical inputs and outputs of a production process. Itisthe provision of a socially desirable mix of goods and services,as determined by demand revealed through the price system.This notion of efficiency stems from some of the root conceptsof microeconomic theory. Each individual nsociety is assumedto have a set of preferences for goods and services and a set oftrade-offs he or she is willing to make among those goods andservices. Collectively, these individualutilityfunctions deter-mine the aggregate demand for each good and the elasticities70/ASQ,March1987

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2This is not intended to imply that a singleutility-maximizing solution exists. The as-sertion made here is far less strong; it isthat no alternative solution exists that of-fers a greater level of social welfare (i.e., atleast equal utility to all individuals andgreater utility to some).3The idea of causality or causal explanationhas a long and difficult history in the sci-ences (Brown, 1977), and it would be im-possible to do justice to it in this paper. Theidea is used conservatively here, followinga concept commonly attributed to DavidHume (1969). Causality involves an-empiri-cal regularity in which two events are ob-served only in sequence; the antecedentevent is treated as the cause of the subse-quent event. The theoretical construct thatlinks these phenomena is a causal law, andit may designate only a probable relation-ship between events - although the prob-ability should be, as Russell (1948: 308) ar-gued, "considerably more than half."

Organizational EconomicEof substitution among goods. Under given resource con-straints, the production of some specific mix of goods andservices will come as close as is possible to satisfying the pref-erences of the population. Any mix of goods and services thatis less effective in satisfying demand is less efficient (from thestandpoint of social welfare). Since the goods and services pro-duced are a consequence of social organization, it is possible tospeak of one set of social arrangements as more economicallyefficient (producinga higher level of social welfare under givenresource constraints) than another. The claim laidby capitalismto theoretical superiority as an economic system is based onthe idea that more efficient social arrangements will displaceless efficient ones in a market economy. The price systemmoves society toward efficiency by directing productiontorevealed demand.The power of the price system to move society toward efficienteconomic arrangements relies on competition within indus-tries. In microeconomic theory, an industryconsists of a groupof firms that employ a common set of resources to producegoods that are perfect substitutes. Competition among thesefirms will force them to adopt an identical price for thosegoods. In the absence of collusion among the members of anindustry, this price will be equal to the minimum average costof production. A firmthat adopts a higher price will be unable tosell its output, and any firm unable to produce at the minimumaverage cost of competitors will take losses that will drive it outof business. Inperfectly competitive markets for products andfactors of production, the firms of an industryare nothing morethan identical combinations of resources that serve the func-tion of paying factors of production the value of their marginalproducts.Pure competition is the force that drives this process. Cost-efficient organization structure and efficiency inthe provision ofsocial welfare are not independent of each other. The operationof the price system produces both results under conditions ofcompetitive equilibrium. In the absence of equilibrium,theeconomic logic supports no causal inferences about the role ofefficiency indetermining social or organizationalstructure.2The Uses of Economic Efficiency in Transaction CostAnalysisThe transaction-cost analysis of organizations gives a causalrole to efficiency that is similarto the role it takes in economics.Transaction-cost minimization becomes a primarydeterminantof organizationalform under the assumption that the most effi-cient internalstructure will displace allothers. This is aneconomic model ratherthan an engineering or input-outputconcept of efficiency; it involves maximization of the value ofthe output of the firm relative to production cost. The underly-ing argument is analogous to the microeconomic analysis ofindustry structure. Just as the microeconomic model of an in-dustry involves a set of firms that are constrained to commonprices and common levels of productive efficiency, thetransaction-cost model of the firmassumes a common, cost-minimizing organization structure. This assumption is the cor-nerstone of the efforts made by Ouchi (1980), Williamson(1975), and others to identify the origins of organization struc-ture and the underlying ationale or formalorganization.371/ASQ, March1987

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Causal explanation of this sort is vital to transaction-cost anal-ysis; it helps to rescue the approach from a deeply damagingtautology. As Williamson (1979) has noted, the bate noire oftransaction-cost theory is the complaint that it can be used torationalizevirtuallyany economic phenomenon. Ifthe perspec-tive is employed for purely static analysis, the charge is wellfounded. Itreduces too readily to the circularityof inferringtransaction costs from the existence of formal organizationand explaining organization on the basis of inferred transactioncosts. This type of reconstructed logic (Kaplan, 1964) makesthe transaction-cost approach vulnerable to the sort of crit-icisms that have been leveled at it by Perrow (1979, 1981) andothers. Itsuggests a conception of social order not unlike thenotion of progress associated with Leibniz(Nisbet, 1980)and parodied by Voltaire (1966: 1-2) in Candide, when Pan-gloss teaches that "there cannot be an effect without a cause. . . inthis best of all possible worlds."Ouchi (1980), Williamson (1975), and some of the other recentproponents of transaction-cost analysis escape this sort of tau-tology by making the leap to causal explanation. Transaction-cost theory then provides a basis for identifying the forces thatshape organization structure in response to changing economicconditions. In the strong causal form of this explanation,economic efficiency takes on an evolutionary significance asthe motive force of social change, and transaction-cost mini-mization emerges as the mechanism by which it is realized inorganizations.But this use of the doctrine of efficiency also imposes new de-mands on transaction-cost analysis. While it elevates thetransaction-cost approach from tautology to causal analysis, itexacts a price inthe form of stringent logical and empirical re-quirements. The economic model involves important assump-tions that also must be met by transaction-cost theory iftheanalogy between the two is to be useful.The Importance of Competition for Economic EfficiencyThe idea of competitive equilibriumis critical to microeconomicconcepts of efficiency. As pointed out above, efficiency is de-fined in economics in terms of the operations of a society com-posed of competitive industries. The individualorganization is avirtualnonentity inthat model. Only under conditions of com-petitive equilibriumis it possible to say anything about the formof the firmand, in that case, the firm becomes a bundle of re-sources combined in the proportions necessary to ensure thateach factor of production will be paid exactly the value of itsmarginal product.The achievement of this sort of equilibriumrelies on the exis-tence of perfectly competitive markets, and the requirementsof a perfectly competitive market are very stringent. Ferguson(1972) suggested four conditions for a perfect market: smallactors in large numbers (no individualcapable of affectingprice), homogeneous products, free mobilityof resources, andperfect knowledge. Although the first of these requirementshas become the object of some debate (Baumol, Panzar,andWillig, 1982), there is substantial consensus on the others, andfew economists would argue that the world abounds in perfectmarkets.72/ASQ, March1987

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Organizational EconomicsEquilibriummodels can playan important partinthe analysis ofeconomic activity at the level of industryand society without of-fering any definite inferences about individual irms. They serveto identify forces that move the economy in the direction ofefficiency, even if efficient solutions stay permanently beyondreach. Ekelund and Tollison (1981: 18) have provided a concisecharacterization of the way these forces work in a competitiveeconomy with imperfect markets:In hisprocess, the presence of rentsprovides he incentive orre-sourceowners to seek outmoreprofitableand herebymoreeconomically fficient)allocationsof theirresources.When competi-tion is viewed as a dynamic.value-creating,volutionary rocess, theroleof economicrentsinstimulating ntrepreneurialecisionsand inprompting nefficientallocation f resourcesis crucial.Rentseekingorprofit eeking in a competitivemarketorder s thereforea normal,healthy eatureof economiclife. Over ime the returnsof resourceownerswill be dissipatedor driven o normalevels bycompetitiveprofit eeking,as some resourceowners earn positiverents,whichpromoteentryby competitors ntotheiractivities,and othersearnnegativerents,which cause themto exit fromtheirpresentundertak-ings. Profit eekingandnormal conomicrents arethus inherently e-latedto the efficiencyof the competitivemarketprocess.Itis importantto note that the economy described by Ekelundand Tollison is not populated by perfectly competitive firms thatare operating at minimum average cost and earning no profits.It is replete with producers who are either earning economicprofits or suffering negative rents. In the long run,positiverents enjoyed by producers who are skilled or lucky may becompeted away, and the losses suffered by others may drivetheir investors away, but firms of any level of profitabilitymaybe found at a given point in time. Although competition in im-perfect markets may push the economy inthe direction of anefficient set of organizationalarrangements, there is no reasonto expect the economy to arrive at one. As long as social condi-tions change (includingthose changed by the rent-seeking be-haviorof firms), opportunities will be created for some firms toearn rents while other firms suffer losses, and the organizationof the firms in an industry may remain in flux.One of the fundamental strengths of neoclassical economics isprecisely this abilityto reconcile imperfect markets with postu-lates of rationalbehavior by economic actors. Firm-leveldeci-sion making may be rationalat the margin in a social settingthat is farfrom economic rationality.If firms produce at thelevel of output that equates marginalrevenue and marginalcost, the requirements of rationalbehavior are satisfied, regard-less of the state of the economy or industryand regardless ofthe outcome of that activity for the firm. Once again, thisreflects the distinction between short-term realityand a hypo-thetical long-term equilibrium.Only under conditions of com-petitive equilibriumwill the level of output that maximizesprofits necessarily result infirms producing at equal (minimumaverage) cost.The economic process described by Ekelund and Tollison alsotells nothing about the abilityof individual irms to respond tocompetitive pressures. Firms that are earning subnormal re-turns at a given point in time may eventually adapt and becomemore competitive, or they may perish as their capital assets areredeployed in more profitable uses. Either process can be seenas a movementof the economy in the directionof efficiency,73/ASQ,March1987

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4The term organization, as it is used here,implicitly refers to price-taking privatefirms. This is the most generous assump-tion in terms of the transaction-cost logic;the private sector probably comes closer tocompetitive market behavior than anyother part of the economy. Although all or-ganizations compete for resources, theflaws of transaction-cost arguments ap-pear more egregious when they are ap-plied to the public sector.

and either one can be reconciled with firm-level rationality. Be-cause movement of the economy toward efficiency can bebased on adaptation or attrition, it tells us nothing about theefficiency of existing organizations. Once again, it is possible todraw definite inferences about the nature of individualorganiza-tions from processes that take place at the level of the largereconomy only under equilibrium conditions.In reality, the degree to which any individualorganization will bepushed to find and adopt internal cost economies will reflectboth the level of competitive pressure to which it is subjectedand the available strategic alternatives. Inanything less thanperfect markets, neither factor is certain, and both may varysubstantially across organizations. Under nonequilibriumcondi-tions, the competitive pressures on any individual irm are un-certain, and the organization structure that will minimizetransaction costs is indeterminate.This suggests some important flaws in the work on transactioncosts. Transaction-cost analysis adopts a model that has clearmeaning for organizations only in perfect markets and applies itto highly imperfect situations. The role played by efficiency isespecially problematic in lightof how littlethe neoclassical con-cept says about the behavior of individualorganizations.4SHORTCOMINGS OF CURRENT USES OF TRANSACTION-COST THEORYThese problems become particularlyevident ifwe separatetwo levels of analysis that tend to be intertwined in thetransaction-cost literature. On one level, transaction-cost anal-ysis is applied to the tasks of institutional economic history, i.e.,explanation of the prevailing institutional structure of a societyor group of societies at some point in history. On another level,it is used to explain the adoption of a specific organizationalform in response to conditions faced by the individual irm. Al-though the issues are deeply interrelated, the underlyingeconomic assumptions that shape these uses of transaction-cost theory can be seen more clearly ifthey are examined inde-pendent of each other.Shortcomings of the Historical AnalysisThe work on institutional economic history is important bothbecause it represents one of the principalempirical applicationsof transaction-cost theory to date and because it highlightscertain questionable assumptions that playa significant part intransaction-cost approaches to organizational analysis. The useof transaction-cost theory to explore institutional history and itsuse in analysis of contemporary economic organization sharean important underlying concept imported from micro-economics - the idea that a decentralized market structurerepresents the naturalorganization of exchange. Thisassumption serves a vital purpose in the purelytheoreticalcontext of neoclassical economics, but it can become deeplymisleading when transferred to an empiricallyorienteddiscipline such as organization studies. Some of the recentuses of transaction-cost theory exhibit that problem; they havepaid insufficient attention to the distinction between theory andits applications, with the result that they have failed to giverealitythe sort of priorityover theory that is required by anempirically rounded ield.74/ASQ, March1987

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Organizational EconomicsWilliamson and Ouchi (1981: 365) provided an explicitstatement of the transaction-cost approach to business andeconomic history. They argued that transaction-costeconomics can be used to understand the motive forcesbehind organizational and institutional change in bothpreindustrialand industrial societies. The causal role ascribedto transaction-cost is stated unequivocally:Transactions ost economizing s,we submit,the driving orce that isresponsible or the main nstitutionalhanges.... Applications oftransactions ost economics] will includeproductmarketorganizationand also changing aborand capitalmarket orms of organizationthrough ime.In focusing on the interplay between historical conditions andeconomic processes, Williamson and Ouchi (1981) wereattempting to place organizationaland business history within arichtradition of institutional economic history. The institutionaltradition makes a fundamental distinction between the socialand political conditions that exist at a time and place and theeconomic processes that unfold within that social and politicalframework. Institutionaleconomics directs attention to theways inwhich historical conditions constrain the processesdescribed by economic theory. Economists from Smith toSchumpeter have used the historicalanalysis of economicinstitutions as a means of bridgingthe gap between abstractmodels and the realityof economic life (North, 1978). North(1978: 963) described the institutional traditioninthis way:These scholarsregarded conomic historyas essential because itaddeda dimension o economics. Itspurposewas to analyze heparametersheldconstantbythe economist. Ifeconomics is a theoryof choice subject to specifiedconstraints,a task of economic historywas to theorizeaboutthose evolvingconstraints.Williamson's (1979) objective in the development of the newinstitutional economics evidently was to carrythis traditionforward, but the transaction-cost approach falls short ofactually providingan institutional economic analysis. Althoughtransaction-cost theory offers powerful tools for understandingthe implications of specific social institutions for economicactivity, it is incapable of explaining historical transformations inthose social institutions. The transaction-cost approachultimately is an extension and application of microeconomictheory, and its capacity to describe realityis bounded by thelimits of the theory -that is, by the very institutionalconstraints that Williamson and Ouchi (1981) would attempt toexplain.Williamson's (1980) interpretationof Chandler's (1977) work onthe nineteenth-century economic development of the UnitedStates provides a good illustration of the problem. Indiscussingthe rise of the factory system, Williamson (1980) argued thatfactory production displaced less centralized forms oforganization because substantial costs would have beenassociated with decentralized coordination of large-scaleproduction processes. Williamson (1980) attributed the changein scale of production that made these processes economicalto the appearance of infrastructurein the American west.However, the sources of infrastructure and the reasons for itsappearance in the nineteenth century remain largelyunexplored nWilliamson's 1980)work.75/ASQ, March1987

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Williamson's analysis stops just short of actually dealing withthe problems of institutionaleconomic history. It explores theimplications of institutionalconstraints without confronting theissues involved in theorizing, in North's (1978: 963) words,"about those evolving constraints." In consequence,Williamson's (1980) attempt to forge a causal explanation doesnot go beyond a model shaped by "the parameters heldconstant by the economist" (North, 1978: 963). Williamson'svantage point is the interior of the economic model, and hisview of historical processes is distorted by the prism ofmacroeconomic theory.This inverted analyticalapproach leads to an inverted economichistory. Williamson (1975) saw a process of economic evo-lution in which markets exist in the beginning. Growth in thecomplexity and scale of organization involves the substitutionof hierarchyfor market exchange. In the absence of certainconditions of market failure, formal organization can be ex-pected to deteriorate under the omnipresent pressure towarddecentralization that is exerted by market alternatives.Williamson may have been influenced inadopting this per-spective by Alfred Chandler. Chandler(1977, 1980) presentedan interpretationof the economic development of the UnitedStates as a process in which market coordination of theactivities of small firms gave way to administered productionand exchange organized within large hierarchies. Chandler(1980: 1-1)described the transformation in this way:The traditionalirmwas a single-unit nterprise,with an individual r asmall numberof owners operating shop, store,factory,bankortransportationine out of a singleoffice. Normally,histypeof firmun-dertook o fulfill nlya singleeconomicfunction,producedor sold asingle lineof products,andoperated none geographicarea. Beforethe rise of the modern irm, he activitiesof these small, personallyowned and managedenterpriseswere coordinated ndmonitoredpri-marilybymarketandpricemechanisms. The modernmultiunit nter-prise,incontrast,hascome to operatein different ocations,oftencarrying ut a numberof economic activitiesandproducing rsellingseveral lines of goods andservices.Theoperationof its unitsand thetransactionsamong them have been internalized ithin he firm.Theactivitiesof these units have come to be monitoredand coordinatedbythe decisions of salariedmanagersratherhanbymarketmechanisms.This description is misleading, primarilybecause it implicitlyequates the economic activities characteristic of the earlier,small-enterprise period with those of the later, industrial era.The transformation discussed by Chandlerinvolved more thanjust organizational change; it also involved fundamental changein the nature and level of economic activity inAmerican society.The local communities of the early nineteenth century were notembedded ina dense web of national commerce and ex-change. They existed in relative isolation, and a large portion ofthe production of that period took place within small commu-nities and individualhouseholds for consumption in those com-munities and households. The rise of the large firm wasassociated with an increase in the level of commerce, i.e., withgrowth in the density and activity of the economy (Bruchey,1975). The history of nineteenth-century economic develop-ment is less a story of hierarchy displacing markets than a taleof social and politicalcentralization creating the conditions for76/ASQ, March1987

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Organizational Economicslarge-scale commerce and large-scale production of goods(Knowles, 1967).The shortcomings of the market-centered approach employedby the transaction-cost theorists are even more apparent in thecase of European economic history. The history of the indus-trializationof Western Europe provides strong testimony to therole of social and political development insetting the stage foreconomic growth. Perhaps the most telling example of this canbe seen in one of the truly singular phenomena of Europeaneconomic history: the early industrializationof England.In his monumental work, Mercantilism, Eli Hecksher (1935) de-tailed the role played by political development in paving the wayfor the consolidation of markets and the growth of industry inEngland.At a time when local autonomy in France had givenrise to an arrayof tolls on the Rhone River so extensive thatshipment of goods over unpaved roads was less costly thantheir transportation by water, English trade flourished under acentralized system of tariffs and a unified currency. The central-ization of authority in England undoubtedly did reduce the costof exchange dramatically,but national political developmentcannot be explained on the basis of its role in minimizingtrans-action costs without begging a variety of other important ques-tions - such as why France took so long to arrive at a commonsystem of tariffs orwhy the German states were slow toachieve unity. InFrance and Germany, economic unificationmight have produced benefits that dwarfed the advantagesthat it offered to England, yet local authorities successfully re-sisted the centralization of authorityfor centuries.These weaknesses inthe transaction-cost approach toeconomic history spring from an underlyingtheoretical as-sumption: the idea that markets are the naturalform ofeconomic exchange. From the standpoint of history, this idea isdeeply flawed. Marketorganization was preceded by (amongother things) feudalism, city-states, and cave-dwelling tribes.Large-scale market activity is relatively recent and remains rela-tively rare as a means of coordinating exchange. Althougheconomic forces may push society inthe direction of efficientforms of exchange, they act within the bounds of social andpolitical systems. As Weber (1958) argued, the balance of his-torical evidence probably tips in the direction of seeingideological, religious, and culturalchange as occurring ex-ogenous to and often prior o economic change.A fundamental distinction emphasized by North (1978) appearsto have been lost in the transaction-cost approach. Itis the dis-tinction between the idiosyncrasies of real economic institu-tions and the abstractions of economic theory. Althoughtransaction-cost theorists startwith the type of objectives thatChandler (1971) defined for the analysis of business organiza-tion - a reintegration into the institutional economic tradition-they ultimately subordinate realityto theory. What is lost inthe process is precisely the distinctive contribution of an em-piricallygrounded discipline such as organization studies oreconomic history. Tawney's (1932: 102-103) eloquent descrip-tion of the tasks faced by economic historians might be appliedequally well to students of virtuallyany aspect of economicorganization:

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Economic historians have sometimes made too much of the institu-tional side of their subject; but they cannot ignore the masonry whichcanalizes and deflects economic currents. They are concerned notmerely with the market, but with the forces behind it.They cannot in-vestigate the rise of new forms of economic enterprise without refer-ence to the conditions which have given enterprise its opportunity, orunderstand historical changes in the distributionof wealth without astudy of corresponding changes in the institution of property, theclass-structure of society, and the policy of states.Shortcomings of the Organizational AnalysisThe assumption that market organization is the natural form ofeconomic exchange also accounts for many of the weaknessesof the transaction-cost approach to organizational analysis. Aspointed out above, considerations of efficiency can be rig-orously applied to organizations only under conditions of com-petitive equilibrium. Although some degree of technical or costefficiency may be a prerequisite of organizational survival innonequilibrium situations, it cannot be assumed to be an ex-planation of organization structure. On the contrary, any one ofa large number of specific structural configurations might beadequate to carry out basic organizational functions of the sortthat Simon (1957) identified: provision of incentives to individ-uals within the organization and acquisition of social andeconomic resources for the organization.There are a number of reasons why the fact that an organiza-tion can achieve what Simon (1957) characterized as a balanceof "inducements" and "contributions" tells us little about theefficiency of its organizational structure. Simon (1957), Cyertand March (1963), and their colleagues discussed many ofthese issues more than twenty years ago in the early work onthe behavioral theory of the firm. They argued that the behaviorof individuals within firms cannot be assumed to be directedtoward optimization of a common set of economic values. Inthe absence of that sort of optimizing behavior, the internalworkings of an organization will not be accurately approximatedby a market model in which competition among employeesproduces efficient operations. The types and amounts of spe-cific inducements sought by individuals, and the quantities ofthose inducements offered for the performance of specifiedroles, may vary quite considerably among individuals andacross organizations. Moreover, firms are not necessarily effi-cient in the satisfaction of those potentially idiosyncratic indi-vidual needs. On the contrary, the inefficiency of organizationsin supplying the variegated needs of employees is one of thefoundations on which the field of organizational developmenthas been built, and it has been the focal point of major bodies ofresearch such as the work of the human relations school(Vroom, 1964) or studies of sociotechnical systems (Davis andCherns, 1975).Compelling arguments against the assumption of economicefficiency also have been mounted at the macro-organizationallevel. Meyer and Rowan (1977) have argued that legitimationand, consequently, the access of organizations to resourcesnecessary to provide inducements, may rely on the perform-ance of activities that contribute little to economic efficiency.They suggest that the functions performed by organizations (in-cluding private firms) reflect a variety of different social impera-tives, includingmany hat have onlya tenuous relationshipo78/ASQ,March 987

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Organizational Economicseconomic ends. While an organization may be obliged to per-form certain economic functions in order to subsist, thoseeconomic functions may represent only a small subset of thelarger range of activities requiredfor organizational survival, andmany of the activities carried out by organizations may not becritical to survival (i.e., organizationalslack may exist). The factthat an organization is successful incarrying out the activitiesthat allow it to subsist does not necessarily imply that all of itsoperations are essential or that its observed structure isefficient.Finally,microeconomic theory offers powerful argumentsagainst the idea that observed organization structure can be as-sumed to be efficient inthe absence of competitive equilib-rium. The costs of administration are only one component ofthe costs incurredby an organization indoing business. Intheabsence of perfect markets for all inputs to production, the as-sumption that firms will be pushed in the direction of a com-mon, transaction-cost minimizingorganizationalform is unwar-ranted. Organizationform may be heterogeneous even underconditions that come close to perfect competition in other re-gards. A group of firms might operate at common cost and pro-duce products that are perfect substitutes, yet nonethelessemploy different organizationalforms with different levels oftransaction costs if the firms are situated in imperfect factormarkets. Each firm could arrive at the same average cost ofsupplying the product as the others by means of a unique com-binationof administrative cost and other production costs.Deprived of the assumption that perfect markets are either his-toricallyor logicallythe naturalstate of economic exchange,transaction-cost approaches to organizationalanalysis exhibitdeep flaws. On one level, they promote a sort of historical in-version; markets are portrayed as an original state of social or-ganization that gives way to bureaucracy and clan-like relationsas economies become more complex, much as thougheconomic history were being read backward from the presentto the Middle Ages. At another level, they lead to a dubiousmodel of causal processes within organizations - one inwhichformal organization owes its existence to a variety of obstaclesthat stand in the way of otherwise inescapable pressurestoward decentralization.The weaknesses of the recent transaction-cost work are inlarge parta consequence of overambitious application of thetheory to the problems of organization studies. The transaction-cost perspective is not alone in its inability o provide causalmodels for organizationalanalysis. For more than a century, so-cial scientists rangingfrom Max Weber to Herbert Simon havegrappled with these problems, and their most cogent worksgenerally have avoided strong causal explanations (Runciman,1972).ALTERNATIVEUSES OF TRANSACTION-COST THEORYMore modest applications of transaction-cost theory hold thepromise of important insights into the activities of organiza-tions. When set ina more general theoretical context, thetransaction-cost perspective can be used for organizationalanalysis without reduction to tautology and without the abor-tive attempt to raise it o the status of a causal model. Althoughtransaction-costheory cannot,in itself, provideanaccouint f79/ASQ,March 1987

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5The concept of strategic analysis used hereis very close to the idea of contingency as itis commonly employed in organizationstudies (Lawrence and Lorsch, 1967). Theterm strategic is chosen in preference tocontingent because it highlights the usesof transaction-cost theory in competitiveanalysis.

the relationship between the individualand organization or theorganization and society, it can help to explore those relation-ships once they are defined.Simon's (1957) classic treatment of the organization insocietyillustrates the sort of theory that can make transaction-costanalysis more useful inorganization studies. Following Weber,Simon recognized the key role that formal organizations havecome to play indealing with the central problem of social orga-nization: complex coordination of individualbehavior to achievesocietal ends. Inmodern societies, organizations typically me-diate relationships between individuals and the majorinstitu-tions of the polity and economy. In order to play that part insociety, organizations must be able to provide incentives thatwill secure individualperformance of organizational roles, andthey must produce outputs that will allow them to claim the re-sources required to supply those individual ncentives.As Ouchi (1980) has suggested, transaction-cost theory can of-fer some real insight into how organizations perform thesefunctions. Itgives a rigorous form to one of the critical issues oforganization: internalgovernance. Inprovidingincentives thatare adequate to ensure individualperformance, organizationsacquire a judicialcharacter; they must measure and rewardperformance according to legitimate standards. A substantialbody of work (cf. Cyertand March, 1963; March and Olsen,1976) has argued that this cannot be reduced to a simple ra-tional calculus. Itinvolves a variable combination of rationalandnonrational elements.Transaction-cost analysis provides a means of discussing therelative importance of those rationaland nonrational elements.Under specific social and technical conditions, certain forms ofinternalcoordination may be less viable than others. A greatdeal of research has been done on the ways in which factorsexternal to organizations can mandate the type of internalflex-ibility hat renders formal systems of control costly (BurnsandStalker, 1961; Lawrence and Lorsch, 1967; Thompson, 1967).Transaction-cost theory provides a common framework foranalysis of both the problems that environmental uncertaintymay pose for internal coordination and the implications of dif-ferent solutions to those problems for the competitive positionof the organization.Applications of Transaction-Cost Theory to StrategicAnalysisThis approach to governance involves an explicitly strategic for-mulation of the organization-environment relationship.5 Al-though transaction-cost economizing alone is not sufficient todetermine organization structure in the imperfect markets ofthe realworld, organizational form does have an important roleinstrategic competition. The restructuringor redesign of orga-nizations to suit changing environmental conditions is one ofseveral areas inwhich competitive strategies can be formu-lated and implemented (Ansoff, 1968; Andrews, 1971).Transaction-cost theory can play an important partinstrategyformulation by providingan analyticalframework for discussionof the relative cost advantages offered by different forms of or-ganization under specified environmental conditions. However,as argued above, organization structure cannot be assumed tobe the sole source of interfirm differences in cost of production80/ASQ, Ma ch 1987

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6Organization structure would be the solesource of interfirm differences in produc-tion cost or price only under conditions ofcompetitive equilibrium in factor and prod-uct markets. However, under equilibriumconditions, the concept of firm-level strat-egy becomes meaningless.

Organizational Economicsor the price of goods.6 Organizationis one competitive factoramong many, and its relative importance in business strategywill be determined by the relationship between environmentalconditions and the existing structure of the firm. Much of thepower of transaction-cost analysis stems from the fact that itcan help to clarifythe specific conditions that lend strategic im-portance to organizationaldesign.Williamson's (1975) interpretationof Chandler's (1962) classichistory of the Dupont Corporationoffers a good example of thisuse of transaction-cost theory. InStrategy and Structure,Chandler(1962) detailed changes in the business and eco-nomic environment of the early twentieth century that led Du-pont to diversify production and described ways in which theadoption of a multidivisionalorganizationalform helped Dupontmanagement deal with the problems of coordinating a large-scale, diversified enterprise. Chandlerargued that change inthe organizationalstructure of Dupont (and several other firms)came in response to environmentally driven strategies.InMarkets and Hierarchies, Williamson (1975) usedtransaction-cost theory to develop a more general interpreta-tion of the strategy-structure relationship portrayed byChandler. He argued that a multidivisionalstructure is moreeffective than either the traditionalfunctional organization orthe holding company in minimizing costs of coordination asso-ciated with diversified enterprise. Williamson (1975) supple-mented Chandler's (1962) observations about the liabilitiesoffunctional administration with economic arguments for thestrategic weakness of pure holding companies. InWilliamson'sanalysis, the transaction-cost logic is particularlyuseful indraw-ing out the strategic implications of organizational issues by re-casting them in terms of the relative cost advantages offeredby different structuralarrangements. When combined withChandler's (1962) work on the ways inwhich diversificationserved as a response to changes inthe social, economic, andpoliticalenvironment, it provides an effective means of explor-ing the strategic implications of organization-environmentrelations.Itis importantto recognize that this is not a causal explanationof organizationalchange. The potential advantages of the multi-divisional structure ultimately relyon exogenous environmentalconditions, and the impact of adoption of a multidivisionalformof organizationvaries across firms and over time. This emergesparticularlyclearly in studies that deal with the effect of themultidivisionalform on firm performance, such as the work ofRumelt (1974) or Armourand Teece (1978). Both Rumelt (1974)and Armour and Teece (1978) found that adoption of a multidivi-sional organization structure appeared to improve performanceunder certain specific conditions, but they also found signifi-cant variation among firms in the adoption of structuralchanges. Both studies observed firms that managed to survivefor years with operating structures that apparently wereanomalous.These empirical studies help to illustrate the difference be-tween the application of a transaction-cost logic to strategicanalysis and its use in causal explanation. Instrategic analysis,transaction-cost theory provides a set of tools for examiningthe economic environmentandidentifying he potentialcom-81/ASQ, March1987

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7Perhaps the most obvious example of thisis in the unionized manufacturing indus-tries where work rules and practices de-signed to protect job security have contrib-uted to the inability of domestic firms tomeet foreign competition. However, itmerits comment that similar argumentsalso may be applied to many of the funda-mental legal protections afforded toworkers in the United States. The issues ofsocial policy that come into play in this sortof situation are complex, and economictheory can serve to illuminate only a rela-tively narrow spectrum of those issues.

petitive advantages of specific organizationalconfigurations.The use of transaction-cost theory instrategic analysis involvesapplication of a general economic logic to specific organizationsand the particular ettings inwhich they operate. Although theanalytical logic is quite general, each application of it is poten-tially idiosyncratic. Causal explanation, incontrast, involvesgeneralization across cases and the attempt to anticipate (orpredict) common elements of organization structure from the-oretical laws or principles. While transaction-cost analysis of-fers considerable potential as a prescriptive approach to theproblems of business strategy, it has far less promise as ameans of dealing with the larger issues associated with theevolution of organizational form.Applications of transaction-cost theory that do not attempt tomake it the basis for causal explanation have the virtue of rein-tegrating broad social issues that have dropped out of some ofthe recent research. Social and cultural factors appear as ana-lytical variables ratherthan unanalyzed "given conditions" inthis type of work. When transaction costs are dislodged fromtheir position as the motive force of organizational change, theconditions that mandate more or less costly forms of gover-nance become an integral partof the analysis. Forexample,long-term employment and promotion based on seniority mightoffer a solution to the problem of providingincentives for am-biguous work roles inone social setting (Ouchi, 1980), whilecompensation systems builtaround those practices might beunacceptable or even illegal in a different milieu. In the lattercase, economic activities that were costly to organize inanyother fashion might not be sufficiently profitable to beundertaken.7

IMPLICATIONSFORRESEARCHDespite the fact that transaction-cost economics has the po-tential to provide powerful tools for organizationalanalysis,it has spawned relatively little empirical research on orga-nizations. With certain notable exceptions (cf. Teece, 1984;Walker and Weber, 1984), efforts to apply transaction-costtheory have focused on the broadquestions of economic his-tory discussed above. Incontrast to a number of other ap-proaches to organizationalanalysis - such as the work onenvironmental contingency (Pennings, 1975; Lawrence, 1981)organizationalecology (Hannanand Freeman, 1977; Carroll,1984), or resource dependence (Pfeffer and Salancik, 1978)-transaction-cost economics has remained primarilya theoreti-cal perspective, with most research concentrated on concep-tual development and refinement (cf. Leblebici, 1985).The difficulties faced by researchers inapplying transaction-cost theory originate, at least in part, in the logical problems ex-amined above. The use of transaction-cost economics forcausal analysis has deflected attention from some of the issuesto which transaction-cost theory is most germane. Just as theuse of transaction-cost theory for causal explanation hastended to divorce economic history from its social and politicalfoundations, the attempt to move to a causal account of organi-zational change has systematically excluded critical environ-82/ASQ, March 1987

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Organizational Economicsmental variables from the transaction-cost analysis of organiza-tions. Inboth cases, the effort to explain institutionalchange onthe basis of microeconomic processes has obscured the roleplayed by historicaland social forces indefining the conditionsunder which competition takes place.A flawed economic historiography probably is not the most im-portant consequence of the attempt to employ transaction-costtheory for causal analysis. The neglect of opportunities to gainnew insight into organization-environment relations may be amore serious liabilityof the approach. Transaction-cost theoryoffers the unfulfilledpromise of joining together importantbodies of research in organization studies and industrial-organization economics to create a unified analysis of the waysinwhich organization structure is shaped by the exigencies ofsurvival incompetitive environments.Inthe field of organization studies, few issues have been exam-ined ingreater depth than the linkbetween environmental un-certainty and the autonomy of subunits within firms (BurnsandStalker, 1961; Lawrence and Lorsch, 1967; Mintzberg, 1983).At the same time, an extensive body of economic research hasdetailed a similarrelationship between market structure andthe decentralization of industries (Kamienand Schwartz, 1982).Despite strong parallels in these findings, the connection be-tween internal and interfirm economic organization has not re-ceived a great deal of attention inorganization studies orindustrial-organizationeconomics. Transaction-cost economicsprovides a basis for integrating the research of these two fieldsby eliminating the traditionaldichotomy between organizationsand their environments. Transaction-cost theory treats the firmas a nexus of contracts for the purposes of analyzing theeconomic functions of organizations, and it reinterprets the va-rieties of internal and interfirmeconomic organization as pointson a single, underlying spectrum of forms of exchange.Inan analysis of that sort, differences among types of organiza-tion that range from traditionalbureaucracy to matrix structureor even disintegrated production would become matters of de-gree rather than distinctions in kind.Strategies that involve re-definition of the boundaries of organizations (such as merger ordivestiture) would be treated as explicit alternatives to man-agerial strategies based on internalreorganization.These dif-ferent types of economic organization could then be analyzedas sets of contractual relations among the individuals involvedin economic activities (MacNeil, 1980; Leblebici, 1985).Transaction-cost theory bridges the gap between strategicanalysis and the study of organizationalbehavior by providingaframework for understanding the economic implications of be-havioral research. By reinterpreting problems of organizationalbehavior in terms of the governance of economic activity,transaction-cost economics provides tools for identifying theorganization-environment linkages that lie at the root of thecompetitive advantages associated with different organiza-tional strategies.Inmany ways, this type of transaction-cost analysis representsa return to the research agenda laid out by Barnard 1938) andSimon(1957) beginningmorethan fortyyears ago. Theattempt83/ASQ,March 1987

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to understand the structures that govern economic activity in-volves analysis of the balance of "inducements" and "contribu-tions" organized through administrative hierarchy. Inatransaction-cost approach, the study of inducements focuseson analysis of the ways inwhich specific types of contractualrelations provide incentives and informationto individuals en-gaged in economic activity (MacNeil, 1980; Arrow, 1985;White, 1985). To the degree that this economic activity takesplace in the privatefirms of a capitalist economy, the study ofcontributions to organizationalsubsistence becomes researchon competitive strategy. The analysis of organizational gover-nance lies at the heart of these two areas of inquirybecausegovernance structures balance the two aspects of organization.Governance mechanisms serve to coordinate the economic ac-tivities of individualsin a manner that is compatible with the re-quirements of the competitive environment.Itis importantto recognize that the conditions under whichcompetition takes place are likelyto be idiosyncratic, and the in-sights provided by transaction-cost analysis may be specific toa firm or industry.This is one of the ways inwhich noncausal orstrategic applications of transaction-cost theory depart frommuch of the organizational research that has been undertakensince Simon's (1957) early work. Transaction-cost economics isuseful in organization studies not as a basis for general laws oforganization, but as a means of integrating research on the be-havioralaspects of organization into an economic and strategicanalysis of the firm.This approach to transaction-cost economics suggests a pro-gram of empirical research focused on the ways in which firmsreorganize in response to changes in the competitive condi-tions of industries over time. Inresearch of this type, the dif-ferent forms of organization employed by firms would beinterpreted as sets of formal and informal contracts with spe-cific incentive and information-bearing properties that couldbe analyzed using the techniques of behavioral research.Transaction-cost theory would provide a framework for under-standing the economic or strategic implications of those be-havioralobservations and linkingthem to the competitiveconditions faced by the firm in its industry.Transaction-cost analysis can be a powerful technique whenused in this way. The weaknesses of its current applications toorganization studies indicate a misapprehension of the scopeof the theory more than any intrinsic flaws inthe theory. Theanalysis of transaction costs must be set within a broaderthe-oretical context - itcannot serve as the basis for a more gen-eral historical or strategic analysis.Ifthe scope of transaction-cost analysis is understood in thismanner, the approach can be made to serve vital purposes inorganization studies. As an adjunct to more general theory ofthe role of organizations inthe economy and society - such asthe work of Weber or Simon - it can help to provide a singleframework for discussing processes of exchange within andamong organizations. When used in that fashion, transaction-cost theory can make a majorcontribution to the effort tobridge social and economic perspectives and create a unifiedanalysis of organizations.84/ASQ, March 1987

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