Comparative Economic Organization: The Analysis of Discrete Structural Alternatives

Williamson, Oliver E., Administrative Science Quarterly

Comparative Economic Organization: The Analysis of Discrete Structural Alternatives

This paper combines institutional economics with aspects of contract law and organization theory to identify and explicate the key differences that distinguish three generic forms of economic organization--market, hybrid, and hierarchy. The analysis shows that the three generic forms are distinguished by different coordinating and control mechanisms and by different abilities to adapt to disturbances. Also, each generic form is supported and defined by a distinctive type of contract law. The cost-effective choice of organization form is shown to vary systematically with the attributes of transactions. The paper unifies two hitherto disjunct areas of institutional economics--the institutional environment and the institutions of governance--by treating the institutional environment as a locus of parameters, changes in which parameters bring about shifts in the comparative costs of governance. Changes in property rights, contract law, reputation effects, and uncertainty are investigated.(*) Although microeconomic organization is formidably complex and has long resisted systematic analysis, that has been changing as new modes of analysis have become available, as recognition of the importance of institutions to economic performance has grown, and as the limits of earlier modes of analysis have become evident. Information economics, game theory, agency theory, and population ecology have all made significant advances. This paper approaches the study of economic organization from a comparative institutional point of view in which transaction-cost economizing is featured. Comparative economic organization never examines organization forms separately but always in relation to alternatives. Transaction-cost economics places the principal burden of analysis on comparisons of transaction costs--which, broadly, are the "costs of running the economic system" (Arrow, 1969: 48). My purpose in this paper is to extend and refine the apparatus out of which transaction-cost economics works, thereby to respond to some of the leading criticisms. Four objections to prior work in this area are especially pertinent. One objection is that the two stages of the new institutional economics research agenda--the institutional environment and the institutions of governance--have developed in disjunct ways. The first of these paints on a very large historical canvas and emphasizes the institutional rules of the game: customs, laws, politics (North, 1986). The latter is much more microanalytic and focuses on the comparative efficacy with which alternative generic forms of governance--markets, hybrids, hierarchies--economize on transaction costs. Can this disjunction problem be overcome? Second, transaction-cost economics has been criticized because it deals with polar forms--markets and hierarchies--to the neglect of intermediate or hybrid forms. Although that objection has begun to be addressed by recent treatments of long-term contracting in which bilateral dependency conditions are supported by a variety of specialized governance features (hostages, arbitration, take-or-pay procurement clauses, tied sales, reciprocity, regulation, etc.), the abstract attributes that characterize alternative modes of governance have remained obscure. What are the key attributes and how do they vary among forms? This is responsive to the third objection, namely, that efforts to operationalize transaction-cost economics have given disproportionate attention to the abstract description of transactions as compared with the abstract description of governance. The dimensionalization of both is needed. Finally, there is the embeddedness problem: Transaction-cost economics purports to have general application but has been developed almost entirely with reference to Western capitalist economies (Hamilton and Biggart, 1988). Is a unified treatment of Western and non-Western, capitalist and noncapitalist economies really feasible? This paper attempts to address these objections by posing the problem of organization as one of discrete structural analysis.

DISCRETE STRUCTURAL ANALYSIS

The term discrete structural analysis was introduced into the study of comparative economic organization by Simon (1978: 6-7), who observed that As economics expands beyond its central core of price theory, and its central concern with quantities of commodities and money, we observe in it...[a] shift from a highly quantitative analysis, in which equilibration at the margin plays a central role, to a much more qualitative institutional analysis, in which discrete structural alternatives are compared.... [S]uch analyses can often be carried out without elaborate mathematical apparatus or marginal calculation. In general, much cruder and simpler arguments will suffice to demonstrate an inequality between two quantities than are required to show the conditions under which these quantities are equated at the margin. But what exactly is discrete structural analysis? Is it employed only because "there is at present no [satisfactory] way of characterizing organizations in terms of continuous variation over a spectrum" (Ward, 1967: 38)? Or is there a deeper rationale? Of the variety of factors that support discrete structural analysis, I focus here on the following: (1) firms are not merely extensions of markets but employ different means, (2) discrete contract law differences provide crucial support for and serve to define each generic form of governance, and (3) marginal analysis is typically concerned with second-order refinements to the neglect of first-order economizing.

Different Means

Although the study of economic organization deals principally with markets and market mechanisms, it is haunted by a troublesome fact: a great deal of economic activity takes place within firms (Barnard, 1938; Chandler, 1962, 1977). Conceivably, however, no novel economizing issues are posed within firms, because technology is largely determinative--the firm is mainly defined by economies of scale and scope and is merely an instrument for transforming inputs into outputs according to the laws of technology--and because market mechanisms carry over into firms. I have taken exception with the technology view elsewhere (Williamson, 1975). Consider, therefore, the latter. In parallel with von Clausewitz's (1980) views on war, I maintain that hierarchy is not merely a contractual act but is also a contractual instrument, a continuation of market relations by other means. The challenge to comparative contractual analysis is to discern and explicate the different means. As developed below, each viable form of governance--market, hybrid, and hierarchy--is defined by a syndrome of attributes that bear a supporting relation to one another. Many hypothetical forms of organization never arise, or quickly die out, because they combine inconsistent features.

Contract Law

The mapping of contract law onto economic organization has been examined elsewhere (Williamson, 1979, 1985). Although some of that is repeated here, there are two significant differences. First, I advance the hypothesis that each generic form of governance--market, hybrid, and hierarchy--needs to be supported by a different form of contract law. Second, the form of contract law that supports hierarchy is that of forbearance.

Classical contract law. Classical contract law applies to the ideal transaction in law and economics--"sharp in by clear agreement; sharp out by clear performance" (Macneil, 1974: 738)--in which the identity of the parties is irrelevant. "Thick" markets are ones in which individual buyers and sellers bear no dependency relation to each other. Instead, each party can go its own way at negligible cost to another. If contracts are renewed period by period, that is only because current suppliers are continuously meeting bids in the spot market. Such transactions are monetized in extreme degree; contract law is interpreted in a very legalistic way: more formal terms supercede less formal should disputes arise between formal and less formal features (e.g., written agreements versus oral amendments), and hard bargaining, to which the rules of contract law are strictly applied, characterizes these transactions. Classical contract law is congruent with and supports the autonomous market form of organization (Macneil, 1974, 1978).

Neoclassical contract law and excuse doctrine. Neoclassical contract law and excuse doctrine, which relieves parties from strict enforcement, apply to contracts in which the parties to the transaction maintain autonomy but are bilaterally dependent to a nontrivial degree. Identity plainly matters if premature termination or persistent maladaptation would place burdens on one or both parties. Perceptive parties reject classical contract law and move into a neoclassical contracting regime because this better facilitates continuity and promotes efficient adaptation. As developed below, hybrid modes of contracting are supported by neoclassical contract law. The parties to such contracts maintain autonomy, but the contract is mediated by an elastic contracting mechanism. Public utility regulation, in which the relations between public utility firms and their customers are mediated by a regulatory agency, is one example (Goldberg, 1976; Williamson, 1976). Exchange agreements or reciprocal trading in which the parties experience (and respond similarly to) similar disturbances is another illustration (Williamson, 1983). Franchising is another way of preserving semi-autonomy, but added supports are needed (Klein, 1980; Hadfield, 1990). More generally, long-term, incomplete contracts require special adaptive mechanisms to effect realignment and restore efficiency when beset by unanticipated disturbances. Disturbances are of three kinds: inconsequential, consequential, and highly consequential. Inconsequential disturbances are ones for which the deviation from efficiency is too small to recover the costs of adjustment. The net gains from realignment are negative for minor disturbances because (as discussed below) requests for adjustments need to be justified and are subject to review, the costs of which exceed the prospective gains. Middle-range or consequential disturbances are ones to which neoclassical contract law applies. These are transactions for which Karl Llewellyn's concept of "contract as framework" is pertinent. Thus Llewellyn (1931: 737) refers to contract as "a framework highly adjustable, a framework which almost never accurately indicates real working relations, but which affords a rough indication around which such relations vary, an occasional guide in cases of doubt, and a norm of ultimate appeal when the relations cease in fact to work." The thirty-two-year coal supply agreement between the Nevada Power Company and the Northwest Trading Company illustrates the elastic mechanisms employed by a neoclassical contract. That contract reads in part as follows: ...In the event an inequitable condition occurs which adversely affects one Party, it shall then be the joint and equal responsibility of both Parties to act promptly and in good faith to determine the action required to cure or adjust for the inequity and effectively to implement such action. Upon written claim of inequity served by one Party upon the other, the Parties shall act jointly to reach an agreement concerning the claimed inequity within sixty (60) days of the date of such written claim. An adjusted base coal price that differs from market price by more than ten percent (10%) shall constitute a hardship. The Party claiming inequity shall include in its claim such information and data as may be reasonably necessary to substantiate the claim and shall freely and without delay furnish such other information and data as the other Party reasonably may deem relevant and necessary. If the Parties cannot reach agreement within sixty (60) days the matter shall be submitted to arbitration. By contrast with a classical contract, this contract (1) contemplates unanticipated disturbances for which adaptation is needed, (2) provides a tolerance zone (of [+ or -] 10%) within which misalignments will be absorbed, (3) requires information disclosure and substantiation if adaptation is proposed, and (4) provides for arbitration in the event voluntary agreement fails. The forum to which this neoclassical contract refers disputes is (initially, at least) that of arbitration rather than the courts. Fuller (1963: 11-12) described the procedural differences between arbitration and litigation: [T]here are open to the arbitrator ... quick methods of education not open to the courts. An arbitrator will frequently interrupt the examination of witnesses with a request that the parties educate him to the point where he can understand the testimony being received. This education can proceed informally, with frequent interruptions …

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Publication information: Article title: Comparative Economic Organization: The Analysis of Discrete Structural Alternatives. Contributors: Williamson, Oliver E. - Author. Journal title: Administrative Science Quarterly. Volume: 36. Issue: 2 Publication date: June 1991. Page number: 269+. © 1999 Cornell University, Johnson Graduate School. COPYRIGHT 1991 Gale Group.

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