Hierarchies And Markets Research Paper

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Whether the first market entailed the exchange of nuts for berries on the edge of the forest or the first hierarchy involved leadership for the hunt of a wild boar, it is clear that markets and hierarchies go back to antiquity. It is also clear that organizational innovations in both markets and hierarchies have contributed significantly to economic progress.

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As between the two, markets have the better reputation among economists. That goes back to Adam Smith (1922) and continues today. Thus, whereas Smith celebrated autonomy, specialization, and the marvels of the market, he had grave concerns over the separation of ownership and control in large joint stock companies and the excesses of managerial discretion that accrued thereto. Indeed, but for grudging acceptance of economies of scale due to technology, hierarchy has been under a cloud since. Only recently has a symmetrical approach to organizations of all kinds—markets, hierarchies, bureaus—begun to emerge.

1. Foundations

The neoclassical theory of the firm that had taken shape by the 1930s described the firm in technological terms—as a production function—to which a profit maximization purpose was ascribed. The adverse consequences of monopoly, monopsony, and monopolistic competition were all readily displayed with this abstract apparatus, but issues of organization— hierarchy—were scanted by this black box construction.

That, however, began to change with the appearance of radical new ideas about organization by economists (Coase 1937, Commons 1932), lawyers (Llewellyn 1931), and organization theorists (Barnard 1938). Coase advanced the proposition that firms were not pre-existing technological entities but that firms and markets were alternative modes of organization. Whether the firm should make-or-buy was, thus, not technologically determined (although the condition of technological separability between stages was relevant) but needed to be derived. Coase further averred that the choice between market and hierarchy was decided principally by transaction cost differences. The canonical problem, then and since, for the theory of markets and hierarchies, was that of vertical integration.

In principle, this choice was easy: holding technology constant, the firm should produce to its own needs when the transaction costs in the firm were less than in the market, and it should buy in the market when this difference was reversed. Awaiting, however, a predictive theory of when transaction costs went one way rather than another, that remained a tautological construction. Thus, although after-the-fact choices could always be rationalized in transaction cost terms, that was undisciplined and such ad hoc explanations were understandably met with grave skepticism. The twin ideas of treating firms and markets as alternatives and of appealing to transaction costs to explain the allocation of activity between them nevertheless turned out to be very fruitful.

Coase went on, moreover, to pose two deep puzzles. If the market is a marvel, why do we see so much activity organized in firms? And if the firm enjoys management advantages over markets, why is not everything organized in one large firm? Any would-be theory of firms and markets needed to come to terms with both of these issues.

Commons’ approach to economic organization was different than but also complementary to that of Coase. Commons was intensely aware of the tensions that beset organization and averred that ‘The ultimate unit of activity … must contain in itself the three principles of conflict, mutuality, and order. This unit is a transaction’ (1932). Not only does the triple to which Commons referred—conflict, mutuality, order— prefigure the idea of governance, in that governance is a means by which to achieve order, thereby to mitigate conflict and realize mutual gains, but viewing the transaction as the unit of analysis turns out to be very instructive.

Llewellyn took exception with the legalistic way in which both lawyers and economists viewed contract. Rather than interpret contract in the prevailing legal rules tradition, Llewellyn advanced the more elastic concept of contract as framework—according to which a contract between two parties ‘almost never accurately indicates real working relations, but … 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’ (1931). Llewellyn’s ideas prefigure the concepts of incomplete contracting (as against the complete contracting tradition in both law and economics) and of private ordering (as against court ordering).

Barnard brought his experience as a businessman and his instincts as a social scientist to the study of complex organization. Interestingly, both the economist Hayek and the organization theorist Barnard were in agreement that adaptation was the central problem of economic organization. But whereas the adaptations to which Hayek (1945) referred were autonomous adaptations in the market, the adaptations to which Barnard referred entailed ‘the kind of cooperation among men that is conscious, deliberate, purposeful’ (1938). These two work out of different mechanisms. Autonomous adaptations of a spontaneous kind are made in response to changes in relative prices signaled by the market; co-operative adaptations of an intentional kind are implemented through administrative processes within firms. Adaptations of both kinds being crucial to a high performance economy, there is a need to treat hierarchies and markets in a combined way.

This collection of deep insights—from economics, law, and organization theory—provided an interdisciplinary foundation for a science of organization. Aside, however, from work at Carnegie (by Simon (1947, 1957) and by Cyert and March (1963)), much of which was inspired by Barnard, such a program was slow to take shape. Instead, many of the prescient insights from the 1930s remained fallow for the better part of the next 35 years. The pressing but unmet needs were (a) to combine and (b) to operationalize these profound insights. Law, economics, and organization theory needed to inform one another, thereafter to be joined in a predictive theory of economic organization.

2. Operationalization

Work of a combined kind got under way in the 1970s (Williamson 1971, 1975, 1979; Alchian and Demsetz 1972; Jensen and Meckling 1976; Klein et al. 1978) and has grown exponentially since. Six key moves in the progressive operationalization of the markets and hierarchies research program are sketched here.

2.1 Human Actors

According to Simon (1985), ‘Nothing is more fundamental in setting our research agenda and informing our research methods than our view of the nature of the human beings whose behavior we are studying.’ Both the cognitive and self-interestedness features of human actors are crucial to the economics of organization. Bounded rationality, according to which behavior is intendedly rational but only limitedly so, gradually has supplanted hyper-rationality as the basic cognitive condition. Opportunism, whereby economic actors are sometimes given to strategic behavior, has come into common use to describe self-interestedness. Bounds on rationality notwithstanding, economic actors are also presumed to possess foresight, which is crucial to the Commons triple. Taken together, these three attributes lead to the following: (a) all complex contracts are unavoidably incomplete (bounded rationality), (b) contract as mere promise unsupported by credible commitments poses hazards (opportunism), and (c) parties who are alert to prospective hazards will work out the ramifications and factor these into the organizational design (foresight).

2.2 Transactions

If the transaction is the basic unit of analysis, then the key dimensions with respect to which transactions differ need to be named and the ramifications worked out. Among the main attributes of transactions are: (a) the frequency with which transactions recur, (b) the uncertainty (disturbances to which transactions are subject), and (c) the condition of asset specificity. This last attribute has reference to the degree to which the assets that are used in support of a transaction can be redeployed to alternative uses and users without loss of productive value. Asset specificity takes several forms, of which physical asset specificity (specialized dies), human asset specificity (firm-specific learning), site specificity (locational), dedicated assets, brand name capital, and temporal specificity are leading types. A condition of bilateral dependency develops when significant investments in transaction-specific assets are made. Intertemporal governance complications arise as a consequence.

2.3 Organization

Alternative modes of organization are described not in marginal but in discrete structural terms, which is to say that each mode of organization—market, hybrid, firm, bureau—is described as a syndrome of internally consistent attributes. Key dimensions for describing alternative modes of governance include (a) incentive intensity, (b) administrative controls, and (c) the contract law regime (Williamson 1991). (The market mode—with strong incentives, limited controls, and legalistic dispute settlement—favors autonomous adaptation; the firm mode—with weak incentives, extensive controls, and internal dispute resolution— favors co-operative adaptation.) The upshot is that alternative modes have distinctive strengths and weaknesses. They differ from one another in kind rather than in degree.

Whereas standard economic theory describes the firm as ‘a point or at any rate a black box,’ the economics of organization maintains that ‘firms are palpably not points. They have internal structure. This structure arises for a reason’ (Arrow 1999). The markets and hierarchies research paradigm describes the firm as a complex hierarchy in which both governance and specialization purposes are served. Cognitive and behavioral variance among the human actors in the population presents opportunities for specialization; and transactions for which co-operative adaptations are needed (namely, those for which assets are highly specific and need to be adapted to successive disturbances, given that contracts are incomplete) are ones for which added governance supports are needed. The concept of firm-as-governance structure—as a means by which to induce order, relieve conflict, and realize mutual gains for transactions that are in need of co-operative adaptations—thus comes to the fore.

2.4 Refutable Implications

Most of the refutable implications pertaining to governance are derived from the discriminating alignment hypothesis, according to which transactions, which differ in their attributes, are aligned with governance structures, which differ in their cost and competence, so as to effect a (mainly) transaction cost economizing result. Vertical integration in intermediate product markets is the canonical case, in relation to which a large number of variations on a theme have been worked out—for labor markets, capital markets, vertical market restrictions (such as franchising), regulation (and deregulation), economic reform (especially privatization), and public bureaus. More generally, any problem that arises as or can be posed as a contracting problem can be examined to advantage in transaction cost economizing terms.

A second class of predictions arise in conjunction with specialization. Upon making provision for variance among human actors (in cognitive and self-interestedness respects), many opportunities to realize economies by matching the attributes of human agents to the needs of a task present themselves. This second class of predictions has been less thoroughly worked out but constitutes a promising research opportunity.

2.5 Empirical

Some theories of economic organization make little effort to advance refutable implications. Among those that do, few are empirically tested. Simon (1991) evidently believes that transaction cost economics is remiss in empirical respects: awaiting empirical testing, the new institutional economics and related approaches are acts of faith, or perhaps of piety.

Coase had registered similar concerns about the dearth of empirical work on contract and organization 20 years earlier, but that was before the operationalization of transaction cost economics had begun and predicted alignments were advanced. Empirical applications of transaction cost economics got under way in the 1980s and have grown exponentially since. It could have been otherwise, but the theory and evidence display remarkable congruity (Masten 1995). As Joskow (1991) puts it, ‘this empirical work is in much better shape than much of the empirical work in industrial organization generally.’

2.6 Full Formalization

The 1930s was the decade when the informal ideas for a new science of organization took shape, the 1970s was the decade when these ideas were worked up in a preformal way, the 1980s was the decade of semiformal analysis, and the 1990s witnessed a burgeoning of work of a fully formal kind. The paper by Grossman and Hart (1986) on The Costs and Benefits of Ownership was the first fully formal model of an incomplete contracting kind. Hart’s book on Firms, Contracts, and Financial Structure (1995) elaborates upon and develops these ideas. Additional work of this kind has been published since and more is in progress. As matters stand presently, however, there is a huge gap between the semiformal and fully-formal stages.

A leading reason for the break is that the fully formal analysis of incomplete contracts relies entirely on property rights assignments to assess comparative efficiency. Not only are the discrete structural differences in organization among alternative modes of governance denied, but the proposition that adaptation is the central problem of organization (of which two types are distinguished) is ignored. These differences are consequential, whence Kreps (1999) concludes that ‘If Markets and Hierarchies has been translated into game theory using notions of information economics, it is a very poor translation … In particular, mathematical-based theory still lacks the language needed to capture the essential ideas of bounded rationality, which are central to … transaction costs and contractual form.’ Kreps (1999), nevertheless, remains sanguine that formal efforts will succeed eventually, possibly with the benefit of new mathematical apparatus.

3. Conclusions

Whereas once it was customary to talk about markets or hierarchies, where the former denoted decentralization and the latter central planning, that has changed. Now it is more customary to talk about markets and hierarchies. That entails much more than a replacement of the conjunction ‘or’ by ‘and.’ It represents a veritable sea change in the way economic organization is studied. The combined study of law, economics, and organization that is herein described (a) involves comparative institutional analysis in which economizing is the main case and the action resides in the attributes of human actors, transactions, and governance structures, (b) generates numerous refutable implications, (c) invites empirical analysis, (d) has many public policy ramifications, and (e) invites progressive formalization. Many economists are now persuaded that the study of economic organization needs to be studied in a combined way in which law, economics, and organization are joined. Legal scholars have incorporated many of these ideas into contract law, corporate governance, antitrust enforcement, and regulation. And organization theorists have come to appreciate the pervasive reach of economizing reasoning.

Real headway notwithstanding, new problems and challenges appear to be unending. Productive tension between transaction cost economics and each of the parts on which it stands—law, economics, and organization—can be projected safely into the future.


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