Academic journal article
By Pitelis, C. N.
Journal of Economic Issues , Vol. 32, No. 4
The aim of this paper is to critically assess the contribution of transaction costs economics (TCE) in explaining the nature of the firm. TCE suffers from conceptual problems and lacks a historical-evolutionary basis. The pursuit of a historically informed evolutionary perspective exposes the limits of TCE and points to the need for a synthetic, integrative framework.
Transaction costs economics dates back to Ronald Coase's 1937 classic article. There, Cease claimed that given markets, firms should not exist in the absence of inherent market failures related to, what we call today, transaction costs. Such are costs of measurement, information, bargaining, contracting, enforcing, and policing agreements. Following O.E. Williamson's  now classic book, these costs can be attributed to bounded rationality, opportunism, and asset specificity. The internalization of (imperfect) markets by firms (hierarchies) is said to increase overall efficiency. Firms are the result of a contractual arrangement between those involved in transactions. Removing market inefficiency is seen as both the reason for and effect of firms. Given costs of hierarchy (organization, management costs), the boundary of the firm is defined as being where an extra transaction can take place equally efficiently by organizing this transaction by the market or another firm. Accordingly, the observed market-hierarchy mix enhances overall efficiency. Market internalization, due to transaction costs, can also explain the evolution and strategies of firms, notably vertical integration, the M-form organization, the conglomerate, and the transnational corporation (TNC) [Williamson 1981]. Hybrid forms of organization, such as strategic alliances, networks, equity joint ventures, etc., can also be attributed to the quest for efficiency, a progression from markets to hybrids to hierarchies [Williamson 1993]. In short, the quest for efficiency explains why firms, hybrids, and markets exist. Efficiency is also the outcome of the process.
Numerous papers and books, some summarized in Y. Eggertson , C.N. Pitelis [1991, 1993], and John Groenewegen , have debated and critiqued the TCE perspective. In this paper, I focus on some conceptual problems of TCE, starting from the conception of the market and moving critically through the main claims of TCE.
Transaction Costs Economics: Some Problems
Our starting point is the important claim of TCE that "in the beginning there were markets." This is the explicit assumption of Coase and can be seen in a quotation from Williamson [1975, 20]. However, this claim need not be true. It depends on the definition of the market and the firm and also on the context and timing, whether we refer to a particular historical context or to the first emergence of firms (and markets). Let us clarify by using Coase as an example.
For Coase, markets differ from firms in that the former rely on voluntary transactions between individuals, while the latter count on the authority of one party over the other, namely, the entrepreneur over the laborer. This is one (arguably narrow) definition of a firm. One can define a firm as a single producer or as a family or friends (partners) cooperatively involved in production. The firm need not be a multiple person hierarchy, which the Coasean firm is.(1) Logically, one could argue that firms (or organizations) precede the market as firms produce while markets may not. Moreover, it could be questioned whether, historically, markets or hierarchies (families, states) appeared first. All of these criticisms are standard in the literature and are by no means original [Pitelis 1993]. They highlight the point that the Coasean firm is only one of many possible definitions of the firm.
Suppose, however, that we accept the Coasean definition. The question then becomes the context and timing one chooses for the beginning. Is it the beginning of a particular historical period or of life in general? …