Academic journal article Administrative Science Quarterly

Taking Coase Seriously

Academic journal article Administrative Science Quarterly

Taking Coase Seriously

Article excerpt

In 1937, Ronald Coase launched the modern economic theory of the firm by asking, "If markets worked perfectly, why would there be firms?" Coase argued that firms will exist only in environments in which firms perform better than markets could. But ever since Adam Smith, the predominant research question in economics had been, In what environments will markets perform efficiently (i.e., produce an allocation of resources that cannot be altered so as to make every individual better off)? To create space for firms, Coase suggested that some environments might be plagued by "transaction costs" that cause markets to perform inefficiently.

For several decades, Coase's paper was "much cited . . . [but] little used" (Coase, 1988: 62). Then Williamson (1975) took two important steps: identifying some of the conditions that create transaction costs, such as imperfect contracts and relationship-specific investments, and suggesting that firms might deal with these conditions more effectively than markets could because firms can use relational contracts, as envisioned in Simon's (1951) theory of the employment relationship. The resulting transaction-cost economics (see also Williamson, 1985, 1996) has made substantial progress on subjects such as vertical integration, supplier relationships, and complex contracts. As these subjects suggest, however, the transaction-cost literature has focused disproportionately on activities at the boundary of the firm, largely ignoring its internal functioning.

In this essay I make three claims about formal economic models of internal organization and their potential relationship to noneconomic organizational research. The first is that Coase's argument has implications not only for the boundaries of firms but also for their internal functioning. If firms arise only in environments in which transaction costs would cause markets to perform imperfectly, then it is one thing to assert that firms may perform better than markets would, but quite another to assert that firms will perform perfectly. That is, firms may be second-best - the best that can be achieved - but their internal functioning seems unlikely to be first-best - the best that can be imagined. After all, why should firms be oblivious to conditions that wreck markets?

Of course, organizational sociologists have long appreciated that organizations are typically not well-oiled machines. For example, the classic case studies by Blau (1955), Crozier (1964), Dalton (1959), Gouldner (1954), and Selznick (1949) depict organizations that differ radically from a hypothetical Weberian bureaucracy, with its "precision, speed, expert control, continuity, discretion, and optimal returns on input" (Merton, 1940: 561). Instead, "rules are often violated, decisions are often unimplemented. . . . and evaluation and inspections systems are subverted" (Meyer and Rowan, 1977: 343). Moreover, "informal structures deviate from and constrain aspects of formal structure, and . . . the organization's intended, rational mission [is undermined] by parochial interests" (DiMaggio and Powell, 1991: 12).

My second claim is that economics has recently begun to produce formal models of internal organization that fit nicely with this post-Weberian conception of life inside organizations. Consistent with Coase's informal argument, these formal models involve some kind of transaction cost. Some models follow Williamson, emphasizing imperfect contracts and specific investments, but others draw additional inspiration from strands of economic theory developed in the 1970s and '80s such as information economics, agency theory, and the theory of repeated games.(1) These recent economic models of internal organization predict that organizations will be a mess but not a mystery. By "mess" I mean that the predicted organizational outcome is typically not first-best (i.e., the outcome is worse than can be imagined). By "not a mystery" I mean two things - one micro, the other macro. …

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