Transaction costs and Coases theory of institutions

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In his classic 1937 paper, 'The nature of the firm', Coase developed an economic theory of the firm which laid the foundation for understanding a wide range of institutional and organizational structures.2 Coase's pathbreaking insight was that the comparative costs of organizing transactions within firms, rather than through markets, are the main factors that explain the existence and evolution of firms.3 Likewise, the size and scope of firms is determined by the relative costs of accessing the market versus governing an organization at the various levels of production.4

A wide range of empirical and theoretical issues have arisen as a result of Coase's contribution. The most significant extension of his 1937 work has been the application of the transaction cost hypothesis to other forms of institutional structures. These extensions have become a central part of the transaction cost economic tradition. Indeed, several scholars have exploited the explanatory power of the transaction cost hypothesis in order to enhance the understanding of economic organization generally.

The puzzle of the firm: prices versus organizations

Coase developed his theory of the firm contrary to the prevailing economic theory. Economists had demonstrated the informational and functional superiority of the price mechanism over alternative allocative systems based on centralized planning. Coase observed that such a hypothesis did not fit at all within the firm. His view was that the allocation of scarce resources among competing uses within a firm rests not on a price mechanism, but rather on the planning of the entrepreneur who makes allocative decisions without the aid of prices.5 Market transactions are replaced with the controlled choices of the firm's manager. Coase generalized from this point that the distinguishing feature of firms is, indeed, the suppression of the price mechanism.

Coase's theory of the firm thus unveils an important puzzle, that is, why a firm emerges in a specialized exchange economy. Coase considered several possible explanations for the emergence of firms: first, the preference of workers to be subject to a command structure; second, the desire of entrepreneurs to have exclusive control over the planning of production; third, and finally, the cost of using a price mechanism.6

Coase's analysis established the importance of the third explanation: the price mechanism is costly to use.7 Coase provided examples of the implicit costs, such as the difficulty of determining the relevant values of joint inputs and outputs, and the preferability of long-term contracts over spot-market prices for risk-averse individuals.8 Additionally, market transactions are often treated differently from the internal decisions of the firm for both tax and legal purposes. The legal system may, in fact, create additional costs for the use of the price mechanism in the marketplace. Thus, in the internal setting, the firm becomes an island of exemption from those external costs.9

The subsequent transaction cost literature has explored the relative advantages of alternative institutional solutions under various real-world settings.

Transaction costs and the economics of institutions

Transaction cost economics views the firm and the market as alternative means of contracting. Building upon Coase's analysis, Williamson (1985) identified the limitations of the neoclassical analysis of models of perfect competition.10 He reached beyond the assumptions of the neoclassical analysis to consider the roles played by other crucial variables. Williamson and other exponents of the new institutional economics explained the emergence and functioning of economic and legal institutions, not only as a production function, but as an intricate mode of contracting, and as a governance framework alternative to the market.

The allocation of economic activity as between firms and markets is taken as a datum under the neoclassical approach; firms are characterized as production functions;11 markets serve as signalling devices; contracting is accomplished through an auctioneer; and disputes are disregarded because of the presumed efficacy of court adjudication.12 Williamson criticized the neoclassical economic approach to the market and the firm for relying on such simplistic assumptions that too often limit the explanatory power of their models.

In the classical model of economics, the market is a frictionless institution characterized by perfect competition, ease of entry and exit, product homogeneity, unbounded rationality and perfect information. Self-interest and opportunism are not ignored in the classical model, but are only accounted for in the bargaining stage of contract, not in the execution stage.

The new institutional economics makes three additional assumptions regarding contracts. First, contracting is characterized by actors with bounded rationality, second, that those contracting also act opportunistically in the execution stage, and third, that the dimension of asset specificity must be added to the model assumptions. When all three of these elements are present, the contracting outcome calls for a governance solution. Thus, the new institutional economics attempts to explain how institutions with a governance structure emerge as transaction cost-minimizing devices in a world characterized by ex post opportunism and ex ante cognitive imperfections. More specifically, the new institutionalists criticize the alternative perspectives for their unconditional reliance on unrealistic assumptions: planning assumes perfect cognitive competence;13 contract as promise assumes absence of ex post opportunism in the execution stage of the contract;14 the perfect competition model ignores the crucial role played by asset specificity in the execution stage of the contract.15 Williamson points out that when all three of these conditions - bounded rationality, opportunism and asset specificity - are present, the three classical contracting processes fail. In response to these shortcomings, the new institutional economics governance approach is interested in the governance structure and non-standard forms of contracting that emerge in the presence of bounded rationality,16 opportunism17 and asset specificity.18

Coase's legacy in the new institutional economics

As indicated above, the literature of the new institutional economics looks at the firm not only as a production function, but also as a governance function. This school of thought recognizes the intellectual legacy of Ronald Coase, tracing the roots of transaction cost or institutional economics to the writings of John Commons and Coase's 1937 article, 'The nature of the firm'. Coase's idea of the firm as an institutional device to minimize transaction costs is applied to other institutional settings where exchange market transactions are eliminated. The primary role of economic institutions is to decrease transaction costs associated with coordinating market activity. Scholars of the new institutional school generally credit Commons with recognizing that the transaction should be regarded as the basic unit of analysis. Commons recognized that economic organization is not merely a response to technological features, economies of scale or economies of scope, but often has the purpose of harmonizing relationships. The new institutionalists take this analysis one step further, and posit that the imperative of profit maximization should be replaced with the organizational imperative to organize transaction costs so as to economize on bounded rationality while simultaneously limiting the hazards of opportunism. Transaction cost economies are realized by assigning transactions to governance structures and comparing institutional alternatives. With its extensions into the efficiency of institutional alternatives, this trend of research can thus be characterized as pursuing two general themes: the study of incentives generated by alternative legal and economic institutions, and the transaction cost optimization as a main determinant of the institutional choices. The incentive approach is predominantly ex ante, hence its utility in property rights and agency theories. The basic idea is that if rules are formulated so as to properly align incentives, fewer market distortions will result. Without these distortions, outcomes will more closely approximate the ideal outcome of global optimization. The approach followed by the transaction cost economists and by several new institutionalists places great emphasis on the ex post perspective, as contrasted with the traditional perspective of neoclassical economics. The basic unit of analysis is the transaction and the basic idea is to determine which governance structure is best suited to which type of transaction.

This approach is key to understanding the intellectual emphasis of the new institutionalists and their distinctive view of the firm and other governing structures. In this respect, Coase's legacy is well served by the widespread recognition that the neoclassical view of labour and capital as being the primary components of production had to give way to the central role of governance structures within the firm.

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