The function of authority in transaction cost economics

Journal of Economic Behavior ard Organization 8 (1987) 13-38. North-Holland

THE FUNCTION OF AUTHORITY IN TRANSACTION COST ECONOMICS

Gregory K. DOW* University of Alberta, Edmonton, Alberta, Canada T6G 2114 Received May 1985, final version received June 1986 This paper questions the transaction cost characterization of observed authority relations as efficient governance structures. Various inadequacies in the transaction cost account of work organization and the limits of firm size are traced to its neglect of the possibility that authority may be abused opportunistically. This exemplifies a more general propensity in the transaction cost literature: that of explaining economic organization in functionalist terms, with little attention to the causa| me~:hai~i.~msthrough which effident governance structures might actually arise. Three such mechanisms are considered, but none is found to provide an adequate rationale for the imputation of dfici~acy to observed structures.

!. Introduction The transaction cost analysis of the firm initiated by Coase (1937) has gained increasing influence in the last decade. Since the publication of Oliver Wiiliamson's Markets and Hierarchies in 1975, a number of authors have elaborated the transaction cost framework, using it to study vertical integration, product diversification, the organiT~tion of work, the multidivisionai structure of large corporations, and the regulation of natural monopoly, among other topics. It would be impossible to carry out a comprehensive critique of this literature within the compass of a journal article. This paper takes on a more limited task: that of assessing the explanations offered by transaction cost theorists for the appearance of authority relations within a market economy. Any satisfactory theory of economic organization must address this problem, and a careful study of the solutions developed within the transaction cost framework can be expected to shed some light on its general intellectual premises. My critique will proceed on two levels. First, I shall argue that even if we accept the premise that en'3ciency is the overriding determinant of observed governance structures, as the transaction cost school would have us do, the *Comments on a previo~s draft of this paper by Sid Winter, Charles Perrow, Richard Nelson, I t ,-~ i~1~. Louis Putterman, Richard Langlois, arLd two anonymous referees are gralefut!y ac~,nv~,,,.dged. All opinions expressed arc tho~e of the author. 0167-2681/87/$3.50 dZ3 1987, Elsevier Science Publishers B.V. ( No~th-Hoiland)

14

G.K. Dow, The function of authority in transaction cost economics

reasons for the efficiency advantages of authority remain poorly understood. The common statement that decision by fiat can restrain opportunistic bargaining neglects the fact that novel forms of opportunism may emerge within the authority relationship itself. This selective invocation of the opportunism postulate undercuts the claim of transaction cost theorists to have carried out a full comparative institutional analysis, and obscures the limitations of authority as a mode of resource allocation. At a deeper level, I argue that the functionalist imputation of efficiency to observed governance structures is suspect. The transaction cost school has not attempted to defend this practice in any detail, and each of the causal mechanisms which might be adduced to justify this postulate appears to conflict with other major elements in the transaction cost research program. Unless this postulate can be justified, the concepts of transaction cost analysis may remain useful for normative assessments of specific governance structures, as judged by criteria of "good engineering design', but will not provide any causal explanation fer the origin or persistence of these structures. Section 2 presents an exegesis of thr~ ~ntra! co¢~pts - transaction attributes, governance structures, and transaction costs. Section 3 develops the proposition that opportunistic behavior may be directed against subordinates by those who wield authority, and demonstrates the significance of this fact for the study of work organization and the limits of bureaucracy. The reliance of transaction cost theory on functionalist efficiency explanations is criticized in section 4. which concludes that no adequate justification for this research strategy has yet been given. Some final methodological remarks appear in section 5. Throughout the discussion, I shall take Oliver Williamson's writings as the definitive statement of the transaction cost research program. This is appropriate in light of Williamson's influence on the field and his interest in providing a systematic set of first principles for use ila applied work. Howewr, other contributions, including those of Go!dberg (1976, 1980), Klein, Crawford and Alchian (1978), and Teece (1980, 1982), have also been important and will be cit~ where appropriate. 2. Transactions, governance structures, and transaction costs

Some familiarity with the general approach of transaction cost economics will be assumed. The core hypothesis of this research program is that 'transactions are assigned to and organized within governance structures in a discriminating (transaction-cost economizing) way' [Williamson (1981b, p. 1564)]. As a prelude to later scrutiny of this proposition, I shall sketch out an interpretation of transaction attributes, governance structures, and transaction costs. The essent-:al points are as follows:

G.K. Dow, The function of authority in transaction cost economics

15

(a) Transaction attributes must be defined independently of the governance structures by which transactions are executed. (b) A governance structure should be understood as a distinctive procedure for decision-making utilized by the parties to a transaction as they adapt to changing circumstances. (c) The transaction cost arising from the use of an arbitrary governance structure to execute a given transaction is just the value of the resources which are sacrificed by not using a Pareto efficient structure to execute that transaction. 2.1. Transaction attributes

The transaction cost school accepts Commons's dictm-n that ,,he transaction is the basic unit of analysis [Williamson (1975, p. 254); Teece (1980, p. 234)]. A transaction occurs 'when a good or service is transferred across a technologically separable interface' [Wilfiamson (1981b, p. 1544)]. This narrow techaological definition often becomes rather elastic in a c t ~ practice, since "the "appropriate" level of transactional detail is not well defined and may vary with circumstances" [Wilfiamson (1976, p. 102)]. Indeed, long-lived physical assets may give rise to transactions consummated only over decades [Goldberg (1976); Williamson (', ~76)]. The objective of transaction cost economics is "to match go'¢e.,'nance structures to the attributes of transactions in a discriminating way' [Williamson (1981, p. 1544)]. This program evidently requires some compact way of classifying t~nsactions. Wil!~amson (1979, pp. 246-247) describes three dimensions along which transactions diffec the specificity of the assets required to execute a transaction, the frequency ~vith which the transaction recurs, and the level of uncertainty surrounding its e;ecution. In applying the analysis to product diversification by firms, Teece (1982) has stressed the additional dimensions of asset indivisibility and fungibility, for transactions relying upon the asset of organizational knowledge. s, useful conceptual device is to think of these (or other) dimensions as defining a characteristics space within which any specific transaction can be located. [Diagrammatic versions of this idea are presented by Williamson (1979, p. 253) and Teece (1980, p. 231).] This location represents a sufficient statistic summarizing the transaction's content for the purpose of further analysis. Once various concrete transactions have been mapped onto corresponding points of the characteristics space, the task is to identify a governance structure, from among those deemed to be feasible, which is best suited to each point in this space. 2.2. Governance structures

The transaction forms the substrate upon which governance structures are

16

G.K. Dow, The function of authority in transaction cost economics

superimposed. Governance structures are conceived of as implicit or explicit contractual arrangements [Wiiliamson (1979)], which are used by the parties to a transaction to effect adaptations as circumstances change. Spot market exchange and hierarchy are widely recognized as endpoints serving to define a continuum of contractual alternatives: Suppose that transactions were to be arrayed in terms of the degree to which parties to the trade maintained autonemy. Discrete transactions would thus be located at the one extreme, highly centralized, hierarchical transactions would be at the other, and hybrid transactions (franchising, joint ventures, other forms of nonstandard contracting) would be located in between. ['Williamson (1985, p.8~;)]. Among the intermediate forms which have been identified are informal reciprocity arrangements [Richardson (1972)], franchising [Rubin (1978)], long-term contracts [Wiiliamson (1979)], inside contracting in the "quasifirm' [Eccles (1981)], and quasi-vertical integration [Monteverde and Teece (1982b)]. A venerable tradition in the economics of organization holds authority relations to be the distinguishing feature of the firm [Coase (1937)] and indeed of organization quite generally [Arrow (1974, ch. 4); Simon (1976, ch. 7)]. Authority relations form the bedrock of internal organization in a way which ownership or the degree of performance monitoring do not. For exa~nple, employment relationships are widely agreed to fall within the ambit of internal organization, although ownership of human and physical capital remains separated. Intensive monitoring often appears in conjuction with internal organization [Alchian and Demsetz (1972)], but does not imply it, since such monitoring can equally well be used to enforce p~omises arrived at zhrough bargaining in a market setting. Williamson is therefore correct to use "degree of autonomy' as the fundamental dimension along which governance structures are arrayed; another way of expressing this is to s~,y that as one moves toward the 'hierarchy' end of the contractual sp~:trum, authority relations grow in scope and complexity. T_,:, for~.sta!! misunderstandings, it should be stressed that although authority relations are fundamental to the distinction between firm and market, these relations arise endogenously via the bargains struck among initially autonomous agents, rather than through crude coercion. This is the precise sense in which the firm constitutes internal organization relative to the market environment: authority relations are internal features of the contracts (implicit or explicit) accepted in the market. Hence, the contracting agents will retain certain rights which can be exercised in an autonomous fashion, including the right to terminate the relationship unilaterally, and authority will be limited to an 'area of acceptance' ESimon (1976, p. 133-134)].

6.K. Dow, The function of authority in transaction cost economics

17

2.3. Transaction costs

Assume now that transaction attributes and a set of feasible governance structures have each been specified, and consider the determination of transaction costs. If one accepts the axiom that the only economicall~ meaningful cost is an opportunity cost, the question immediately arises: what is foregone upon completing a transaction? A nmnher of receni commentators have attempted either to di,ctit~guish transaction costs from costs of a more conventional sort, or to demonstrate the superfluity of the concept [Dahlman (1979); Langlois (1984); Goidberg (1985); Barzel (1985); Buchanan (1985)]. i shall offer an interpretation which I believe to be consistent with the usage of transaction cost theorists themselves, and which sidesteps the twin pitfalls of (a) reducing the concept to 'just another cost', or (b) rendering it entirely circular. Two points should he noted, First, a consensus has emerged that transaction costs should be evaluated comparatively, varying governance structures while holding f~cd the transaction to be implemented. As Williamson puts it, Only to the extent that frictions associated with one mode of organization are prospectively attenuated by shifting the transact~.'on, or a related set of transactions, to an alternative mode can a failure be said to exist. (1975, p. 20). Therefore, we can just as "well refer to the net benefits of a governance structure, relative to its alternatives, rather than the transaction costs attributable to that structure. Second, it is necessary to provide a substantive classification of the resources sacrificed, and the benefits obtained, by applying a gove~ance structure to a transaction. Only in this way can we distinguish transaction costs from more mundane costs. To simplify, let us take for granted that some specified transaction will ~e executed, and suppose that trade-offs between transaction and production costs are ignored. By the opportunity cost criterion, the transaction cost incurred when an arbitrary governance structure is applied to tl'.is transact:6i, ~nust be the value of the resources sacrificed if a Pareto-effi~'ient structure is not adopted. As the literature implicitly adheres to an assumption of transferable utility or wealth maximization, it is natural to value these foregone resources by computing a suitable sum of co lpensating variation~ in money units. In effect, then, strt, ctures are compared using a potential Pareto improvement test. Clearly, a Pareto e~cient governance structure entails zero transaction cost by construction. This definition presupposes a well-defined set of feasible governance structures, and downplays be,untied rationality ideas in favor of more orthodox optimization concepts. However, these features become less objec-

18

G.K. Dow, The fienction of authority in transaction cost economics

tionable if we construe transaction costs only as abstract elements in a theoretical model, and do not insist that they be fully known by the transactors (see section 4.1). A more subtle caveat is the following: in comparing costs across governance structures, it is essential that the relevant transaction be specified independently of the governance structure which is superimposed upon it. Otherwise, the claim that 'transaction X is organized under governance structure Y" would express not an empirical truth, but only a concealed tautology. If the attributes of a transaction do not remain invariant when one governance structure is replaced by another, the transaction costs involved are meaningless. Now return to the question of which resources should be considered in evaluating transaction costs. WiUiamson calls for a study of the 'comparative costs of planning, adapting, and monitoring task completion under alternative governance structures" (1981b, p. 1544, emphasis deleted). More specifically, ex ante and ex post transaction costs arise. Ex ante, there are "costs of drafting, negotiating, and safeguarding an agreement'. Ex post, apart from normal administrative set-up and operating costs, there are "maladaption costs incurred when transactions drift out of alignment" 'haggling costs incurred if bilateral efforts are made to correct ex post misalignments~, ahd "bonding costs of effecting secure commitments" [Williamson (1985, p. 20)]. From this exposition, it is apparent that the gross benefit of a governance structure - that feature which makes a governance structure of any sort worth having - is the value to the parties of the adaptations to changing circumstances which that structure makes possible. The other items listed are merely the resources needed to effect these adaptations in an incentivecompatible fashion, and are deducted to determine the net benefit of a governance structure. In short, governance structures arc judged t,y their capacity to produce a 'better' transaction, in the potential Pareto improvement sense. Clearly, transaction costs cannot be assessed only by examining the inputs used_ to support the decision process, as this would yield the trivial (and incorrect) conclusion that less governance is always better. As a concrete example, we may take Wiiliamson's (1980) analysis of work organization, where he classifies transaction costs using 'product flow', 'assignment" and "incentive' dimensions. Each of these categories registers some aspect of decision-making performar.ce, either in adapting to new circumstances or in motivating other agents to undertake appropriate adaptations. In a rigorous net benefit assessment, these various dimensions would be aggregated and the resources used to set up and operate each structure would be netted out. The principal difficulty with the present approach is that a 'better' transaction must in some way be a different transaction. This undermines the premise that the transaction under discussion remains fixed, while governance structures can be varied to assess the transaction costs of each. To

G.K. Dow, The function of authority in transaction cost economics

19

avoid a paradox, one must distinguish the 'details' of the transaction, which are subject to sequential adaptation in ways which vary from one governance structure to anotber, irom the "general' features of the transaction, which remain invariant. As yet, the literature has not suggested any means by which this distinction can be operationalized; but unless it can Ix maintained successfully, transaction costs do indeed collapse to ordinary costs, becau~ transactions subjected to different governance structures reduce to different transactions. I shall assume in what follows that this is not a fatal objection to transaction cost analysis. 3. The me and abuse of aulherity Given the conceptual framework sketched above, efforts to explain internal organization inevitably center on the proposition that authority relations provide net benefits in organizing certain transactions, as compared with bargaining between autonomous agents. This proposition is defended by identifying certain desirable functions performed by authority relations which allegedly could not be performed as well or as cheaply through direct negotiation. The specific argument most often encountered in the literature is that under conditions of uncertainty, bounded rationality and asset specificity, authority relations economize on costly bargaining when adaptation to nove" situations is required. Wiiliamson's discussion of the functions of authority is the most compre• hensive, but his views parallel those of other writers on the subj~t, including Klein, Crawford and Alchian (1978) and Teece (1982). In Markets and Hierarchies, he specifies three ways in which internal organization can restrain the opportunism which would otherwise infect market exchange:

Appropriability.

By depriving agents of independent profit streams, inte~al organization ensures that 'the parties to an internal exchange are less able to appropriate subgroup gains, at the expense of the overall organization (system)'. Opportunism is mitigated because 'the terms of trade are circumscribed; and 'present and prospective compensation (including promotions) can be easily varied by the general office to reflect noncool~ration' (1975, p. 29).

Monitoring.

Informational asymmetries are mitigated because 'internal organization can be more effectively audited' - internal auditors are not limited solely to written records, and when 'audits of operating divisions are made by the general office, [a] stigma is not attached to such disclosure' (1975, p. 29).

Conflict resolution. 'Internal organization realizes an advantage over market

20

G.K. Dow, The J,:action of authority in transaction cost economics

mediated exchange in dispute settling respects' in part because with limited appropriability and suitable incentive systems, 'parties are more inclined to adapt cooperatively' (1975, p. 29), Also, internal organization 'is able to settle many such disputes by appeal to fiat' (1975, p. 30). In each of these instances, authority at a higher level is invoked as a means of restraining opportunism among subordinate agents. This illustrates a more general phenomenon: transaction cost ~hve,rist3 tend to see authority primarily as a remedy for opportunism, rather than as a device which might be abused in an opportunistic fashion. Little attention is given to the prospect that agents holding positions of authority might use the data obtained through internal audits to gain strategic advantages over lower level parties, use fiat to settle disputes in ways which suit themselves, or impose self-serving incentive systems. Systematic analysis of the ways in which authority relations may elicit novel forms of opportunism, qualitatively different from those found in direct bargaining relations, is virtually absent. This omission is puzzling, because transaction cost analysis itself indicates that a potential for opportunistic abuse is intrinsic t_o authority relations. It is widely recognized that hierarchy concentrates information at a central node for decision making purposes [Arrow (1974, pp. 68-70)1; indeed, this is one reason why intensive monitoring geaerally appears in ce ..~unction with authority relations. But this fact implies that information is impacted at the top as an explicit l,rmciple of organizational design when authority relations are used. A situation of small numbers and impacted information is precisely the case in which transaction cost theory suggests that opportunism will pose the greatest difficulties [Williamson (1975, ch. 2)'!. The consequences of this omission can best be appreciated by considering two questions in the economics of organization: (i) the role of authority relations in work organization, and (ii) ~he nature of the limits to hierarchy.

3.1. Authority relations and work organization Radical economists have maintained that hierarchy does not serve primarily to promote allocative efficiency, but rather to exploit workers [Marglin (1974, 1982); Gintis (1976); Edwards (1979); Bowles (1985),1. Goldberg (1980) has suggested that some aspects of the radical view, i~~cluding an interest in power relationships, may be compatible with transaction cost analysis, and Pfeffer (1982, p. 166) has even remarked that in some respects, 'it is not easy to distinguish' the radical analysis of Edwards (1979) from the transaction cost framework. Nonetheless, in his analysis of ..... " " Wiiiiamson vigorously w•,.,,'~ organizatioih contests the thesis that 'bosses exploit workers and hierarchy is the organiza-

G.K. Dow, The function of auti~ority in transaction cost economics

21

tional device by which this result is accomplished' (1980, p. 7). He concludes that capitalist authority relations outperform the worker peer group and a number of other governance structures on transaction cost dimensions. However, while his performance criteria account for various types of worker opportunism such as malingering and equipment abuse (1980, p. 23), no symmetric category is provided for employer opportunism. Hence, the analysis sidesteps the very features of work organization which the radical writers attempt to address. Examples of employer opportunism include the distortion or hoarding of information about the product market [Klein, Crawford and Alchian (1978); Hashimoto (1981)] or the magnitude of labor costs relative to other firms [Willman (1982)], as well as the unilateral introduction of technical innovations which undercut labor's bargaining position [Dow (1985)]. If potential dysfunctions of this sort had been included in the analysis, the peer group form of organization, which incorporates democratic checks on such behavior, would have tied or outranked the capitalist authority relationship according to Williamson'~ own evaluation scheme (1980, p. 29). The existence of restraints on managerial abuse is not just an ad hoc assumption about the worker peer group, which Putterman (1981) and Russell (1985) rightly regard as a straw man in any case, but is instead the defining feature of labormanaged firms generally. In describing the organizational structures of such firms, Horvat remarks: In order to work efficiently and to react in a timely way to changing business conditions, the management must be given certain discretionary power. Yet this power, like any power, may easily be abused. Therefore, an institutional control is needed. The supervisory committee [made up of worker representatives] serves this function (1982, p. 246). This reasoning is almost identical with that used two centuries earlier by .~,~,~s Madison when he campaigned for the safeguards against tyranny built into the U.S. Constitution [Madison (1964)]. A recognition that opportunistic behavior can crop up on both sides of the authority relationship has figured in a number of commentaries on transaction cost ceasoning, including those by Goldberg (1980), Perrow (1981, 1986), Putterman (!98!~ !984)~ _Jones (1982), and Willman (1982). However, more is at st~V~ than just an awareness that employers and employees alike suffer frorri the nl,,ral flaws of 'humaa nature as we know it'. The decor difficulty is t:'~at autho~ity relations ge1.,erate t~c .~tructural preconditions under which employer opportuais~ is most likely to be. encouraged; namely, information impactedness, small numbers, and availability of a tool (decision by fiat) which is tailor-made for unilater~d pursuit of self-interest. Appealing to higher authorities as a solution only displaces the problem:

22

G.K. Dew, The function of authority in transaction cost economics

what is needed to limit opportunism by authorities is reciprocal monitoring by gubordinates and a capacity to impose sanctions when abuses are detected. As Putterman puts the point, echoing Williamson's own diagnosis of the worker peer group: If workers are ... tied to firms, and if managers, 'having more complete information', have a 'strategic advantage over everyone else', and 'inordinate influence over both the value and factual premises of other members of the group', why should workers relinquish all controls over management? (1984, pp. 178-179). It is indeed striking that in discussing the hypothetical peer group (1975, p. 52), as well :is in comments on the 'iron law of oligarchy' propounded by Michels (1975, p. 127), Williamson clearly recognizes issues of leadership opportunism, only to lose sight of this problem when analyzing the hierarchical capitalist firm, which lacks even the modest restraints available in a peer group. A related example involves the role of unions. Williamson endorses court rulings which prevent individual workers from compelling their unions to take grievances to arbitration, saying The practice ... of giving the union control over arbitration claims plainly permits group interests ... to supersede individual interests, thereby curbing small-numbers opportunism (i979, p. 256). This argument fails if union leaders can behave opportunistically toward the individual workers whom they nominally represent. Apart from exit to another job, which is impractical when workers have idiosyncratic skills, restraints on leadership opportunism require some bottom-up check in the hands of the rank and file, such as the ability to vote opportunistic leaders out of office. In a reply to Putterman (1981), Williamson questions the value of granting workers a check on managerial authority: The intrusion of operating into strategic decision making (or the reverse) can easily impair performance ... [A]ithough some of the worker participation literature seems to presume extensive involvement of workers in strategic affairs, this can come at a high cost. in the degree to which efficiency is highly valued, worker participation programs will recognize the hazards and attempt to provide safeguards against 'excessive' strategic involvement (1981a, pp. 282-283). While this is a valid concern, several points should be made. First, the design

G.K. Dow, The fi~,nction ~f o~,thority in ~,:ai~saction cost economics

23

principle of hierarchical decomposition into strategic and operating levels [Simon (i9~|~ oh. 7)] assumes that strategic decisions can be (nearly) decomposed from the operating level. Where workers acquire idiosyncratic knowledge, tapping this via worker participation in strategic decisions may yield net benefits. Second, it is not necessary for workers to be involved in making specific strategic decisions in order for them to evaluate overall managerial performance, and to remove inept or abusive managers. Finally, this rationale for hierarchical decomposition of decision-making neglects that actors at the strategic level may behave opportunistically toward actors at the operating level. When this is overlooked, it is not surprising that the benefits from internal checks on authority disappear. Recently, Williamson (1985, pp. 302-304) has agreed that worker repre.~entation on the board of directors is sometimes necessary to secure a flow of credible information to workers about the firm's profit prospects, though he would limit workers to nov.-voting seats. This proposal constitutes an acknowledgement that the dangers of managerial opportunism are real. Shareholders, however, are held to require more than just information; they need the power to replace managers. While one may grant that shareholders face a serious threat of expropriation by managers, it is not clear that this threat outweighs the parallel risk facing workers, who are often more limited it, their ability to diversify their assets or to exit from a deteriorating situation. One can thus argue that elficiency would be served by giving labor information and the power to enforce contracts by imposing real sanctions on managerial opportunists (e.g., by firing them). 3.2. The limits of organization

Most of the transaction cost literature approaches the question of internal organization by asking, 'What can authority relations achieve that direct market contracting cannot?' For the purposes of comparative institutional choice, however, one might just as well star~ by asking 'Why is not all production carried on by one big firm?' [Coase (1937, p. 394)]. Wi!liamson has recently sharpened this question by posing it in the context of two previously autonomous firms, newly merged: [D]ecision~ need not be forced to the top but can always be assigned to the level at which the issues are most appropriately resolved . . . . Those decisions ... that are most effi.ciently made at operating levels will remain there. Intervention at the top thus always occurs selectively, which is to say only upon a showing of expected net gains. The resulting combined firm can therefore do everything that the two autonomous firms could do previously~ and me~e (1985, p. 133, emphasis in original).

24

G.K. Dow, The function of authority in transaction cost economics

That is, an authority relationship can be superimposed upon an existing relationship of arms-length bargaining, to be activated only when remediable efficiency losses would otherwise occur. Apart from mistaken interventions by the central authority, there appear to be only two reasons why selective intervention cannot succeed. First, bounded rationality considerations may enter in. Since there are limits on the rate of information processing for any de~ision-maker, when central control replaces local autonomy it becomes necessary for the new subordinates to reallocate some of their attention away from old information channels toward new ones, so as to monitor the flow of commands emanating from the center. An ineluctable trade-off arises: the advantages of central coordination can be had only by foregoing some responsiveness to local conditions. The alternative possibility is that the central authority may intervene for self-interested reasons, ignoring the losses inflicted on other agents, and there may be no cheap mechanism by which the losing agents can detect or abort such interventions. That is, because authority can be wielded opportunistically, the injunction to intervene only upon a showing of expected net gains to the collectivity is not incentive-compatible. The resulting direct losses, along with the resources expended by subordinates to guard against these self-interested interventions, could well outweigh any gains from greater coordination or adaptability. Any organization which relies on internal authority as a means of resource allocation must face the question of who guards the guardians. The question can be framed more precisely as, who monitors those in positions of authority, in order to ensure that their self-interest does not threaten collective interests? The unaided market cannot accomplish this, in part because asset idiosyncrasy is often substantial on both sides of the authority relationship, and in part because the relevant information is unlikely to pass easily across organizational boundaries [Teece (1982)], thus disabling reputational protections which might emerge via the managerial labor market. Also, as Alchian and Demsetz (1972) point out, new team members will be subject to the same incentives as the incumbents whcJ are displaced. The solution proposed by Aichian and Demsetz, granting residual claimancy to the wielder of authority, may or may not restrain 'shirking' by this agent, but will often enhance the payoff from opportunistic abuses, and thus exacerbate the situation. A superior solution is that of reciprocal monitoring within the organization, where subordinates themselves detect and punish abuses of authority~ as in repeated games where mutual monitoring of past actions deters short run defection IAxelrod (1981); Aumanv (1985)]. The later chapters of Markets and Hierarchies devote much attention to opportua~sm by managers of functional divisions in relation to the general office, and by the general office in relation to stockholders. [This theme is not confined to the transaction cost school; see also Fama and Jensen

G.K. Dow, The function of authority in transaction cost economics

25

(1983).] The cure for opportunism at each successive level is sought in the authority wielded by a higher organizational level, and given the collective action probiems i'acing stockholders, ultimately in the market for corporate control. For opportunism which is directed upward, this seems entirely appropriate. However, opportunism may also be directed downward, and opportunism of this variety is most readily curbed if authorities are monitored by subordinates. Let us grant for argument's sake that a hierarchical form of organization is needed for reasons of efficient design. As firm size increases, we can expect to obtain not only familiar top-down control losses [Williamson (1967); Cairo and Wellisz (1978); Beckmann, 1983)], but also an attenuation of internal checks on managerial opportunism. This occurs because (a) increasing size and bounded spans of control imply greater distance of most subordinates from their ultimate superiors, and hence the availability of less information about abuses by peak managers, (b) increasingly severe free-rider effects will impede efforts to combat abuses at top management levels by lower echelon members, since the benefits of suppressing these abuses will be spread over a wider membership base, (c) if standard principles of task decomposition are followed, subordinates in a large organization will find themselves performing heterogeneous tasks that have been "decomposed' from one another, and will therefore have difficulty in communicating about the abuses they have experier.ced, or in organizing a collective response. Not only will subordinates generally lose collective 'control' over their superiors as size increases, but unchecked opportunism by peak managers can easily be more damaging to organizational efficiency than opportunism at lower levels. Eventually, the protections afforded by autonomous market exchange may outweigh the advantages of authority and 'one big firm" for this reason. 4. Functionalism and the question of causal mechanism

The transaction cost program owes its "distinctive powers' to 'its unremitting emphasis on efficiency' [Williamsol, and Ouchi (1981, p. 367)]. Indeed, adherents to this approach often infer the efficiency of an observed governance structure directly from its existence, holding that [A] presumption of market failure is warranted where it is obser,'ed that transactions are shifted out of a market and into a firm, [and] a presumption of internal organizational failure is warranted for transactions that are unshifted ... [Williamson (1975, p. 20)].

26

G.K. Dow, The function of authority in transaction cost economics

Belief in the efficiency of observed governance structures leads to functionalist explanatory statements: governance structure X exists because efficiency requirements dictate X for transactions of type Y. It may be noted in pa¢~"~ng that transaction cost theory is hardly unique in this respect: all explanations which posit the existence of optimal contracts have this methodological foundation, including the discussiol~s of authority relations by Stigiitz (i975) and Hess (1981). Causal explanations, on the other hand, describe how later structures have emerged out of earlier ones. The use of functionalist theory in the physical sciences and biology is surveyed by Nagel (1979~ Ch. 12). The status of functionalist theory in the social sciences has been the subject of heated debate. The current spectrum of opinion ranges roughly from Donaldson's (1985) wholehearted defense of functionalism in organization theory to Elster's (1983) view that functionalist theories in economics or sociology almost never pass methodological muster. Without taking sides here in this larger debate, I shall examine the causal ~rtechanisms which transaction cost theorists might adduce to justify their imputation of efficiency to observed structures. To fix ideas, two applications of functionalist analysis to authority relations will be cited. First, take Williamson's (1975, Ch. 4) interpretation of ,,,~,: . . . . .,,u' . ,auu,'-k^- markets as devices for economizing on transaction costs. Under conditions where workers may exploit their possession of job-specific skills to demand higher ex post wages, Williamson proposes hierarchical authority structures with fixed wages attached to each job as a remedy, arguing that 'it is plainly not in the interests of the system that employees should behave in this way' (1975, p. 73, emphasis in original). The second example invoh,es production knowhow and vertical integration. Monteverde and Teece (1982a) argue that an auto manufacturer is likely to integrate upstream i~io parts production when a parts supplier would tend to acquire transaction-specific knowhow~. . enabF.-~. . . . . . ~. ~.t.~ l,,. s~pplicr to ,,l,,,,~'-"t'~opportunistic demands for ex post recontracting. (In fact, they find significant empirical support for this hypothesis.) In each of these cases, the primary function imputed to authority relations is to economize on resources which would otherwise have been expended on opportunistic bargaining, or to forestall such behavior. Authority structures are predicted to arise when these benefits outweigh any drawbacks authority may possess. As Ulimann-Margalit (1978) points out, to demonstrate that an institution performs a valuable social function is not the same as explaining the causal process through which it arose. Until an explicit mechanism capable of generating e~cie~t governance structures and sustaining them over time is identified, the claim that observed structures are efficient will remain unpersuasive, given the inability o~ researchers to establish efficiency through direct empirical methods. Ther~ are three arguments which could be advanced to provide the required causal grounding. These involve appeals to: (1) intentionality, (2) adaptive learning, and (3) competitive market pressures.

G.K. Dow, The function of authority in transaction cost economics

4.1.

27

lntentionality

The simplest argument for the efficiency of observed governance structures is to assert that these structures are consciously chosen by the parties to a transaction through an explicit evaluation of the transaction costs associated with each possibility. Before any tra~s_ac~ion occurs, the parties foresee the frictions likely to arise under each governance structure, including the costs of restraining any ex post opportunism to an optimal degree, and agree to adopt (second-best) Pareto efficient methods for making subsequent decisions. From a methodological perspective, the visible hand of intcntionality differs from the invisible hand mechanisms of functionalist theory, whose benefits are unintended [Ullmann-Margalit (1978); EIster (1983, Ch. 2)], but as a rationale for efficiency claims, this is clearly the place to start. This approach is also consistent with Wiliiamson's view that 'the parties to a contract are hard-headed and ... the ramifications of alternative contracts are intuited if not fully thought through" (1985, p. 38). Unfortunately, intentionality arguments collide with the transaction cost school's emphasis on bounded rationality. If agents cannot cope with contracts featuring complex contingencies [Williamson (1975, p. 24)], it is doubtful that they can select in advance an efficient decision making procedure to use in adapting to future circumstances. This suggests a provocative corollary: If transaction costs incorporate the value of adaptations to future circumstances (recall section 2.3), then the parties cannot know (or agree upon) the objective transaction costs they face. Such knowledge would imply cognitive abilities sufficient for comprehensive contracting, which has already been ruled out as infeasible. It bears mention at this point that Willl.amson demarcates transaction cost economics from the mechanism design literature [Hurwicz (1985)] on the basis of the latter~s greater willingness to accept comprehensive ex ante planning [Wi!liamson (1985, pp. 30-31)]. This leaves a dilemma: if bounded rationality rules out comprehensive contracting, then good intentions alone cannot ensure adoption of efficient governance structures either. To the extent that ex ante contracting entails small numbers bargaining, the intentionality approach also runs afoul of the opportunism postulate. Of course, this is not a problem if one is willing to assume that many equivalent contractual partners are available at the outset, but we are dealing now with a world where transaction costs are positive. Recall that the specific categories of transaction cost listed in section 2 included not just resources expended ex post, such as those for administration or contract enforcement, but also the classic Coasean costs of learning about potential trading partners, negotiating contracts, and so forth. When large, these costs may severely limit the number of ex ante partners available; as Maicomson (1982) notes, the very existence of positive (ex ante) transaction costs creates market power. Hence, there is no reas-Jn ~o suppose that the hazards of small

28

G.K. Dow, The function of authority in transaction cost economics

numbers bargaining with impacted information are absent ex ante. If such bargaining leads to maladaptation ex post, it should have the san~¢ effzzi ex ante, when the governance structure in question is chosen. To put it a bit paradoxically: the mere existence of positive transaction costs may suffice to prevent transaction cost minimization. Williamson's (1983) analysis of hostages clearly envisages a process of foresighted planning and competition among prospective contractual partnets. He notes that franchise contracts may include provisions intended to restrain opportunistic quality degradation by free-riding franchisees, and remarks that [P]erceptive franchisers, who recognize the demand externality in advance and make provision for it, ... are merely taking steps to realize the full value of the franchise (198~, p. 530). However, in the case of franchise bidding for a natural monopoly, Wiiliamson (1976) indicates severe doubts about the viability of proposals which rely on forecasts of ex post behavior. Also, on bounded rationality grounds he rej~ts lump-sum bidding for jobs as a remedy for problems of ex post opportunism in the employment relation (1975, pp. 68-70). Thus, the transaction cost literature lacks a consistent theory of the ex ante terms on which governance structures are established. With zero ex ante transaction costs and unbounded rationality, entrepreneurs would fill positions in any governance structure on competitive terms. If, in addition, future quasi-rents could be fully capitalized, efficient design of governance structures would be stimulated by the entrepreneur's desire to maximize the residual income from ex ante bidding for positions in these structures. However, pre-payment mechanisms of this sort will support efficient resource allocation only in special cases involving transferable utility and perfect capital markets [Crawford (1986)]. When these restrictions are compounded by bounded rationality constraints and positive ex ante transaction costs, the incentive for entrepreneurs to design and implement efficient governance structures becomes tenuous at best.

4.2. Organizational learning Placing less emphasis on planning, one might argue that experience accumulates within an organ~.~tion over time, not only about how to perform technical tasks, but about how to organize the relevant transactions. Given recurrent transactions, this information could provide the basis for successive modifications in organizational behavior, and such a learning process might converge on an efficient adaptation to the organization's environment. Note that this would qualify as a genuine invisible hand

G.K. Dow, The function of authority in transaction cost economics

29

mechanism because, in principle, convergence might occur through myopic adjustments in decision rules or even unintentional operant conditioning. A detailed discussion of this proposition is not possible here, but enough can be said to show why its general validity is doubtful. First, it can be noted that organizational routines display substantial rigidity [Nelson and Winter (1982, Ch. 5); Hannan and Freeman (1984)], among other reasons because of their dependence upon intangible capital investments [Prescott and Visscher (1980)]. Investments in information systems and the creation of mutually consistent expectations among organizational actors have an irreversible aspect, so that such systems cannot be readily altered once their costs are sunk [Arrow (1974)]. Apart from irreversibilities, the stochastic aspects of learning ensure that accidents of history will play a significant role in shaping the trajectory of organizational behavior [Schotter (1981); Cross (1983)]. Therefore, convergence to a pre-specified 'efficient' structure cannot be taken for granted. Turning to incentive questions, Williamson himself has identified several organizational pathologies which may deflect learning processes away from efficient outcomes. These include the reluctance of managers to abolish their own jobs, overextension of the firm's internal compliance machinery, managerial unwillingness to admit failure, and incentives for gaming the transmission of internal information (1975, Ch. 7). He remarks: IT]he decision to continue a project, once it is begun, the decision to renew oc ex~,,,~d the internal facility, once it is in place, and the decision to procure internally, once that capability exists, may not be decisions for which the ordinary profitability calculus will govern (1975, p. 126). Elsewhere, he comments that 'the prevailing attitudes and distribution of power among the incumbent management [may] make self-reorganization difficult' (1975, pp. 159-160). It is not clear how one might distinguish cases where the profitability calculus will govern from those where it will not, but the upshot is apparent. The information which is needed for adaptation may be suppressed or distorted by organizational participants, and those who have the authority to restructure the organization may sufl~r from opportunistic propensities. Proxy fights and takeover bids may offer some corrective to managerial obstruction, but these are rather blunt instruments, and given the .... e..vt..d :~¢ss of information within the organization, cannot fully offset the internal obstacles to organizational learning. Although the literature is too underdeveloped to perm,t rigorous analytic treatment of ti~ese problems, there is clearly something apr~roaching a consensus on the inability of large organizations to adopt efficient for~ls through spontaneous learning processes.

J.E,li.O.~ II

30

G.K. Dow, The function of authority in transaction cost economics

4.3. Competitive market pressures Elster (1983) suggests that reliance on functionalist explanations in biology is warranted by the known workings of natural selection, but argues that there is no feedback mechanism of comparable power and universality which can serve as the basis for functionalist reasoning in the social sciences. Nonetheless, transaction cost theorists often view market competition as a suitable analog to natural selection. As Williamson puts it. The argument reties in a general background way on the efficacy of competition to preserve a sort between more and less efficient modes and to shift resources in favor of the former. This seems plausible, especially if the relevant outcomes are those which appear over intervals of five or ten years rather than in the very near term. This intuition would nevertheless benefit from a more fully developed theory of the selection process (1985, pp. 22- 23). This intellectual strategy is appealing, as Langlois (1984) points out, because an evolutionary invisible hand mechanism is compatible with the bounded rationality assumption used elsewhere in transactioll cost analysis. It is possible, of course, to define the efficiency of a governance structure in terms of its capacity to survive in competition with alternative structures [Goidberg (1980, p. 251)]. However, I shall assume that the independent efficiency criterion 3vggested in section 2 pertains, so that the asserted efficiency of surv;.ving structures is not just tautological. [Similar external criteria of good design are needed to avoid tautologies involving biological 'fitness'; see Gould (1977, p. 42) and Langlois (1985).] Two distinct claims might then be advanced: (a) that competition from successful firms will induce imitation and learning among others, encouraging the diffusion of efficient organizational forms, or (b) that finns with efficient structures will sire.ply eliminate firms having inefficient ones. Both types of argument are used to explain the sprer: of the multidivisionai structure in Markets and Hierarchies (1975, p. 17~)~ ~ r example. As with functi~na!i~t reasoning more generally, these selection concepts are not limited to transaction cost economics. Alchian (!950) provides an early example, and Friedman's (1953) argument for the profit maximization postulate in selection terms is well known. More recently, Stiglitz (1975, p. 556) has used selection ideas to defend an optimal contract model of hierarchy. Nelson and Winter (1982, Ch. 6) identify a number of special assumptions which are required in order to reconcile evolutionary dynamics with orthodox concepts of p~'ofit maximization and equilibrium. Parallel issues arise in the context of transaction cost economics, as Wiiliamson recognizes (1985, p. 23). Without pursuing the details here, we may note that the persuasive-

G.K. Dow, The function of authority in transaction cost economics

31

ness of economic selection arguments depends heavily on the surrounding circumstances. When firms perform simple, recurrent tasks in an environment of easy entry and exit, selection forces m~,y indeed tend to remove inefficient modes of organization expeditiously. On the other hand, when highly integrated firms carry out diverse activities in concentrated markets where entry and exit are rare, skepticism seems warranted. These general matters aside, two points require particular attention here: the potential importance of intra-organizational power, and the biases imparted by appropriability limitations.

Power. Williamson recognizes that selection pressures may be resisted; he remarks that 'more efficient modes will e~entually supplant less efficient modes - though entrenched power interests can sometimes delay the displacement' (1985, p. 236). However, Wiiliamson and Ouchi (1981, pp. 363364) claim that over sufficiently long periods, the distribution of power within the firms becomes endogenous, and is determined by efficiency needs. This stance, not surprisingly, is controversial. Wiliman (1982), for example, takes the view that the power of employers relative to employees is exogenously determined by labor market conditions, and that this factor shapes the governance structure of the firm. The belief that market competition will eviscerate attempts to exercise intra-organizational power in the long run seems to be mistaken. Once idiosyncratic assets are in place, the parties are locked into a relation of bilateral exchange. For this very reason, these parties may behave in a strategic, non-cooperative fashion, resulting in substantial inefficiency, without any agent having an incentive to recontraet externally. This is so even in long run competitive equilibrium, with zero ex ante profit for potential entrants. Using this reasoning, Dow (1985) showed that some distributions of bargaining power induce input suppliers to seek rents by implementing inefficient production technologies. The implication for transaction cost analysis is that when asset idiosyncrasy is significant, sunk costs will partially insulate internal organization from market forces, and hence selection pressures toward efficiency will be attenuated. An autonomous theory of internal strategic behavior is required, and given the small numbers involved, power concepts form a natural basis for such theories. External markets cannot ensure that the effects of internal power are evanescent or negligible.

Appropriability.

An essential step in formulating any selection model is to identify the units which are selected upon. In 'conventional' selection models of the Nelson/Winter type, it is reasonably clear that individual firms are the units subject to profit or loss, and thet selection can therefore be expected to operate upon firms as a function of their profitability in a given market

32

G.K. Dow, The function of authority in transaction cost economics

environment [Dow (1986b)]. However, in transaction cost theory, the use of authority relations - that is, the very existence of the firm - becomes problematic, since direct market exchange could also be used. What then does selection act upon? A central dogma of transaction cost economics is that only the aggregate transaction cost of a governance structure, and not the incidence of these costs among agents, affects the likelihood that the structure will be adopted. However, there need not be any economic unit which exactly internalizes the sum of the transaction costs associated with a particular exchange. This is especially clear ex ante, before a governance structure has been created, when separate agents necessarily bear their own costs of search or contract negotiation. Without full internalization of transaction costs (in other words, complete appropriation of the benefits from a governance structure) by the units selected upon, selection outcomes will be decoupled from the efficiency norm.

The best illustration of this point is provided by the recent debate over the merits or" the labor-managed firm (LMF). Proponents of this governance structure usually meet with a simple and powerful rebuttal: such schemes must be inefficient, since they seldom arise spontaneously in market economies [Jensen and Meckling (1979)]. Indeed, skepticism of this sort has been framed explicitly in transaction cost language rWilliamson (1985, pp. 322-324)]. Although this empirical fact surely places the burden of proof upon proponents, it is all too easy to abuse economic selection arguments by simply declaring that surviving forms of organization are efficient ipso facto. This Panglossian logic omits appropriability considerations. Assume for the sake of argument that, compared with a capitalist firm (CMF), an ongoing LMF yields large transaction cost savings, perhaps because it adapts more easily to changing circumstances. Assume also that the governance benefits of any structure, LMF or CMF, flow at least proximately to the agents who wield managerial authorit,~' within that structure. Then the governance benefits of the LMF will inevitably be diffuse, flowing in some measure to each worker in the firm, because labor services are unavoidably attached to separate legal persons and cannot be concentrated in the hands of a single economic agent. However, the (smaller) benefits from control by capital can be I ~ U I l ~ t........... ; l l t l a t u u " quite easily in the hands of a single agent, by bringing all physical capital under an umbrella of common ownership. If an entrepreneur cannot internalize the social benefits of the LMF through direct market transactions - say, by charging entry fees to prospective firm members which fully capitalize the benefits they will enjoy by exercising their control prerogatives [Dow (1986a)] - then to appropriate the governance benefits of the LMF, it will be nece.~sary to participate in the firm oneself, as a coequal member. But only a fraction of the social benefits of the LMF can be captured in this way, as compared with the option of

G.K. Dew, The function of authority in transaction cost economics

33

capturing a much larger sha:e of the governance benefits arising within the CMF by participating as a capitalist manager. The nexus between efficiency and selection forces is broken by appropriation obstacles, since no unit of selection bears all of the costs and benefits of the LMF governance structure. Within the world of transaction cost economies, obstacles to the direct appropriation of governance benefits through ex ante market contracting are plentiful. One need only cite the costs of arranging complex multilateral contracts, valuing info,-nation accurately, making remedies available to workers in the event of fraud, and overcoming the free-rider problems facing workers who seek to enforce contracts ex post. In a similar vein, Marglin (1982) has stressed the public goods problems surrounding private appropriation of the returns to entrepreneurial information. Also relevant are the requirements of transferable utility and perfect capital markets, if prepayment for later control rights is to function effectively [Crawford (1986)]. When transaction costs are positive, there is no reason to suppose that socially efficient LMFs will spring to life of their own accord, any more than one would expect such classic instances of market failure as environmental externalities, deficient public goods supply, or monopoly power to correct themselves through selection forces. It follows that although hierarchical capitalist firms often arise spontaneously in a laissez-faire setting, policies intended to encourage the formation of labor-managed firms may still yield net social benefits. None of this is apparent when the selection argument is advanced in isolation from appropriability questions. Before the efficiency postulate of transaction cost economics can be justified in selection terms, one must come to terms with the fact that selection forces do not act on the costs or benefits experienced by arbitrary social ag~egates. These forces operate only through the private payoffs of the entities selected upon, just as natural selection acts only upon individual organisms, rather than for the good of thee species 9r the ecosystem. 5. Coneh-siou Transaction cost economics regards the authority relations observed within firms as an efficient solution to the problem of allocating scarce resources. I have suggested two reasons for doubting this explanation. First, even if we accept the strategy of explaining governance structures in efficiency terms, the literature has not examined the possibility that authority o ~ n s up new avenues for opportunism. Hence, on the transaction cost school's own criterion for good organizational design, we still lack a full explication of the efficiency advantages generated by authority relations. Second, I have argued that the underlying functionalist explanatory strategy is weak. A number of causal mechanisms migh~ conceivably be used to ground this approach, but each candidate r~iechanism is open to significant objections.

34

G.K. Dow, The function of authority in transaction cost economics

Serious attention to the fact that authority relations only alter the manifestations of opportunism, without disposing of it, should y~eld an improved account of internal organization, apart from any additional renovations in the transaction cost research program. Of course, it would b¢ still better if transaction cost theorists should decide to buttress their effi~ency postulate with some detailed causal reasoning, or else substitute more adequate theoretical axioms. However, even if the need for such drastic measures is rejected, sweeping claims for the efficiency of authoritative resource allocation should be rejected. One must instead explain why, in any given case, curbs on subordinate opportunism do or do not offset the newly opened possibilities for opportunism by superior authorities. This task will require, at a minimum, some quantification of the trade-offs involved. The temptation to short-cut this task by appealing directly to a presumption that observed authority structures are efficient should be resisted. One cannot legitimately infer the nature of efficient governance structures through empirical observations, while simultaneously using the same data to test the underlying theory. Inferences from existence to efficiency presuppose the truth of transaction cost theory, an unacceptable presupposition for many. As Simon has said: 'the assumption so often made in administrative studies, that an arrangement is effective because it exists, is a circular argument of the worst sort' (1976, p. 247). Related criticisms of inferences from existence to efficiency are developed by Putterman (1984). Useful efforts to test some empirical hypotheses generated by transaction cost analysis have been made, including studies by Armour and Teece (1978) and Mor, teverde and Teece (1982a). Other attempts to test predictions about the relative prevalence of various governance structures will likely yield further insights. However, it is essential that functionalist premises be used only as a heuristic guide to the generation of empirical hypotheses, and not as a tautological rationalization for th~ status quoo A particularly seductive temptation of this type is to use transaction cost theory to explain p:ocesses of his(,orical change extending over many decades, if not centuries. Examples include the transition from the puttingout system to inside contracting, and then to modern capitalist authority relations [Williamson (1980)], as well as the origins of the integrated, multidivisional corporation [Williamson (1981b)]. Whatever merits these accounts may have as economic history, which is a controversial matter [see Jones (1982) and the subsequent debate between Williamson and Jones: Willia[nson (1983b), Jones (1983), and Williamson (1983c)], they raise some troubling conceptual questions. Transaction cost economics as ~nlerpreted in section 2 is a static -'heory, and like neoclassical microeconomics, it generates predictions using comparative static methods. Nothing in this theoretical structure would warrant its use to explain sequences of historica! events unfolding over time. This

G.K. Dow, The function of authority in transaction cost economics

35

tension is papered over in practice by asserting that 'successor modes have superior efficiency properties to predecessor modes' [Wiiliamson (1980, p. 29)], so that economic history is reconstructed as a process bringing about successive :mprovements in economic organization, as judged relative to a fixed efficiency norm. Biologists long ago abandoned teleological interpretations of natural history, and economists would do well to follow their lead. The selection environment for economic organization is in continual flux due to shifts in technology, social and political institutions, demographics, and other factors. To take only one example: the role of the state in defining property rights, supporting or prohibitir,g markets, and taxing or subsidizing organizational forms bears directly on the appropriability issues raised in section 4. If the pace of environmental change is rapid compared with the rate of organizational mutation, dominant structures today may be inefficient relative to contemporaneous rivals, and even relative to extinct structures which failed in an environment differing from the present one. Most important, dominant structures are likely to track theoretical efficiency requirements poorly, if at all [EIster (1983, Ch. 2):]. The static transaction cost apparatus is simply not equipped to address or resolve dynamic problems of this sort. Nature does not optir~;ze in an unconstrained fashion, but must instead select upon small modifications in the products of past evolution [Gould and Lewontin (1979)]. Similarly, in a shifting selection environment, the constraints imposed by past history are likely to explain more of the variance in observed governance structures than comparison with abstract efficiency norms. Consider the differing employment practices of Japanese and U.S. firms, which operate within roughly similar environments from the standpoint of transaction cost economizing. An explicit historical investigation of the origins of these practices, as they have emerged cut of in earlier and perhaps substantially disparate environments, might well prove more revealing than the use of comparative static explanatory procedures. However this may be, it remains true that the functionalist research strategy of transaction cost economics cannot generate non-teleological explanations of historical change in economic organization. References Alchian, A., 1950, Uncertainty, evolution and economic theory, Journal of Political Economy 58, 211-222. Alchian, A. and H. Demsetz, 1972, Production, information costs and economic organization, American Economic Review 62, 777-795. Armour, H. and D. Tcece, 1978, Org~.nizational structure and economic performance-: A test of the multidivisional hypothesis, Bell Journal of Economics 9, 106-122. Arrow, K., 1974, The Limits of Organization (Norton, New York). Aumann, R.J., 1985, Repeated games, in: G.R. Feiwel, ed., Issues in contemporary microeconomics and welfare (State Univer3ity of New York Press, Albany, NY) 209-242.

36

G.K. Dow, The function of authority in transaction cost economics

Ax¢lrod, R., 1981, The emergence of cooperation among egoists~' ~l,ierican Po!it!eal Science Review 75, 306-318. Barzel, Y., 1985, Transaction costs: Are they just costs?, Journal of Institutional and Theoretical Economics 141, 4-16. Beckmann, M., 1983, rinbergen Lectures on Organization Theory (Springer-Vedag, New York). Bowles" S., 1985, The production process in a competitive economy, American Economic Review 75, 16--36. Buchanan, J., 1985, Rights, efficiency and exchange." The irrelevance of transactions cost, in J. Buchanan, ed., Liberty, market, and state: Political economy in the 1980s (New York University Press, New York). Calvo, G. and S. Wellisz, 1978, Supervision, loss of control, and the optimum size of the firm, Journal of Political Economy 86, 943-952. Coase, R, 1937, The nature of the firm, Economica 4, 386-405. Crawford, V., 1986, Long-term relationships governed by short-term contracts, Industrial Relations Section working paper no. 205 (Princeton University, Princeton, N J). Cross, J.G., 1983, A theory of adaptive economic behavior (Cambridge University Press, New York). Dahlman, C., 1979, The problem of externality, Journal of Law and Economics 22, 141-162. Donaldson, L., 1985, in Defense of Organization Theory (Cambridge University Press, New York). DOw, G., 1985, Internal bargaining and strategic innovation in the theory of the firm, Journal of Economic Behavior and Organization 6, 301-320. Dow, G., 1986a, Control rights, C~ml~_-!i.!ivemarkets, and the labor management debate, Journal of Comparative Economics lO, 48-61. Dow, G. 1986b, Stability analysis for profit-responsive selection mechanisms, Methematical ~ i a l Sciences, 12, 169-183. Eccles, R., 1981, The quasifirm in the construction industry, .~ournal of Economic Behavior and Or,oanization 2, 335-357. Edwards, R, 1979, Contested Terrain (Basic Books, New York). Elster, J., 1983, Explaining Technical Change (Cambridge University Press, New York). Fama, E. and M. Jensen, 1983, Separation of ownership and control, Journal of Law and Economics 26, 301-325. Friedman, M., 1953, Essays in Positive Economics, ch. 1 (University of Chicago Press, Chicago, IL). Gintis, H., 1976, The nature of labor exchange and the theory of capitalist production, Review of Radical Political Economica 8, 36-54. Goldberg, V., 1976, Regulation and administered contracts, Bell Journal of Economics 7, 426448. Goldber& V., 1980, Bridges over contested terrain: Exploring the radical account of the employment relationship, Journal of Economic Behavior and Organization 1,249-274. Goldber8, V, 1985, Production functions, transaction costs and the new institutionalism, in G. Feiwel, ed., Issues in contemporary microeconomics and welfare (State University of New York Press, Albany, NY) 395--402. Gould, S., 1977, Ever Since Darwin (Norton, New York). Gou.td, S. and R. Lewontin, i979, The spandrels of San Marco and th~ Panglossian paradigm: A critique of the adaptationist programme~ Proceedings of the Royal Stk~.ietyof London, 8205, 581-598. Hannan, M. and J. Freeman, 1984, Structural inertia and organizational change, American SocioTlogicalReview 49, 149-164. Hashimoto, M., 1981, Firm-specific human capital as a shared investment, Americ,an Economic Review 71,475-482. Hess, J, 1981, The terms of authority, Jouraal of Economic lkhavicr aria.. Org~tdzation 2, 237253. Horvat, B°, 1982, The Political Economy of Socialism (Sharpe, Armonk, NY). Hurwicz, L., 1985, Information and incentives in designing non-wasteful resource allocation systems, in G.R. Feiwel, ed.: Issues in contemporary microcconomics and welfare (State University of New York Press, Albany, NY) 125-168.

G.K. Dow, The f,,nction of authority in transaction cost economics

37

Jensen, M. and W. Meckfing, 1979, Rights and production functions: An application to labormanaged firms and codetermination, Journal of Business 52, 469-506. Jones, S.R.H., 1982, The organization of work: A historical dimension, Journal of Economic Behavior and Organization 3, 117-137. Jones, S.R.H., 1983, Technology and the organization of work: A reply, Journal of Economic Behavior and Organization 4, 63-66. Klein, B., Crawford, R. and Alchian, A., 1978, Vertical integration, appropriable rents, and the competitive contracting process, Journal of Law and Economics 21,297-326. Langlois, R., 1984, Internal organization in a dynamic context: Some theoretical considerations, in: M. Jussawalla and H. Ebenfield, eds., Communication and Information Economics: New Perspectives (North-Holland, Amsterdam), 23-49. Langlois, R., 1985, Rationality, institutions, and explanation, in: R. Langlois, ed., Economics as a process: Essays in the "New Institutional Economics" (Cambridge University Press, New York). Madison, J., 1964, The separation of powers: A hedge against tyranny?, Paper 48 in: A. Hacker, ed., The federalist papers (Washington Square Press, New York). Malcomson, J., 1982, Efficient labour organization: Incentives, power and the transactions cost approach, in: F. Stephen, ed., Firms, organization and labour (St. Martin's Press, New York), 119-126. Marglin, S., 1974, What do bosses do?: The origin and function of hierarchy in capitalist production, Review of Radical Political Economics 6, 60-112. Marglin, S., 1982, Knowledge and power, in: F. Stephen, ed., Firms, organization and labour (St. Martin's Press, New York), 146-164. Monteverde, K. and D. Teece, 1982a, Supplier switching costs and vertical integration in the automobile industry, Bell Journal of Economics 13, 206-213. Monteverde, K. and D. Teece, I ~e~2b, Appropriable rents and quasi-vertical integration, Journal of Law and Economics 25, 321-328. Nagel, E., 1979, The Structure of Science, second ed. (Hackett, Indianapolis, IN). Perrow, C., 1981, Markets, hierarchies and hegemony, in: A. Van de Yen and W. Joyce, eds., Perspectives on organizational design and behavior (Wiley, New York), 371-386. Perrow, C., 1986, Complex Organizations: A Critical Essay, third ed. (Random House, New York). Pfeffer, J., 1982, Organizations and organization theory (Pitman, Marshfield, MA). Prescott, E. and M. Visscher, 1980, Organization capital, Journal of Political Economy 88, 446-461. Putterman, L., 1981, The organization of work: Comment, Journal of Economic Behavior and Organization 2, 273-279. Putterman, L., 1984, On some recent explanations of why capital hires labor, Economic Inquiry 22, 171-187. Nelson, R. and S. Winter, 1982, An Evolutionary Theory of Economic Change (Belknap, Cambridge, MA). Richardson, G.B., 1972, The organisation of industry, Economic Journal 82, 883-896. Rubin, P., 1978, The theory of the firm and the structure of the franchise contract, Journal of Law and E~onomics 21,223-233. Russell, R., i985, Employee ownership and internal governance, Journal of Economic Behavior and Organization 6, 217-241. Schotter, A., 1981, The Economic Theory of Social Institutions (Cambridge University Press, New York). Simon, H., 1976, Administrative Behavior, third ed. (Free Press, New York). Simon, H., 1981, The Sciences of the Artificial, second ed. (MIT Press, Cambridge, MA). Stiglitz, J., 1975, lneentives, risk, and information: Notes towards a theory of hierarchy, Bell Journa! of Economics 6, 552-579. ~.~ece, D., 1980, Economies of scope and the scope of the enterprise, Journal of Economic Behavior and Orga~ii~ation '~, 223-247. Teece, D., 1982, Towards an economic theory of the multiproduct firm, Journal of Economic Behavior and Organization 3, 39-63. Uilman-Margalit, E., 1978, Invisible h~nd explanations, Synthese 39, 263-291.

:°

Jo

G.K. Dow, The function oJ authority in transaction cost economics

Williamson, O., 1967, Hierarchical control and optimum firm size, Journal of Political Ecovomy 75, 123-138. Williamson, O., 1975, Markets and Hierarchies (Free Press, New York). WilliamstJn, O., 1976, Franchise bidding for natural monopolies - in general and with respect to CATV, Bell Journal of Economics 7, 73-104. Williamson, O., 1979, Transact'~on-cost economics: The governance of contractual relations, Journal of Law and Economics 22, 233-261. Williamson, O., 1980, The organization of work, Journal of Economic Behavior and Organization I, 5-38. Williamson, O., 1931a, The organization of work: Reply, Journal of Economic Behavior and Organization 2, 281-283. Wil:iamson, O., 1981b, The modern corporation: Origins, evolution, attributes, Jc~inal of Economic Literature 19, 153%1568. Williamson, O., 1983a, Credible commitments: Using hostages to support ~ch~'~ge, American Economic Review 73, 519-540. Williamson, O., 1983b, Technology and the organization of work: A reply to Jones, Journal of Economic Behavior and Organization 4, 57-62. Wiiliamson, O., 1983c, Technology and the organization of work: A rejoinder, Journal of Economic Behavior and Organization 4, 67-68. Williamson, O., 1985, The economic institutions of capitalism (Free Press, New York). Williamson, O. and Ouchi, W., 1981, The markets and hierarchies program of research: Origins, implications, prospects, in: Van de Ven, A. and W. Joyce, eds., Perspectives on Organization Design and Behavior (Wiley-lnterscience, New York). Willman, P., 1982, Opportunism in labour contracting, Journal of Economic Behavior and Organization 3, 83-98.