Just for fun: theory of the firm 8

The obvious missing discussion from the previous seven theory of the firm postings, and one on the theory of the farm, is a discussion of Oliver Williamson's work on the theory of the firm. This omission is all the more glaring now that Williamson has won the Nobel Prize in Economics. This posting is drawn from an interesting attempt at a formalisation of Williamson's work by Robert Gibbons.

In his 2005 essay (see also here) on the major mainstream economic theories of the firm, Robert Gibbons argues that there are two (formal) theories which can be discerned within the informal theoretical arguments offered in Oliver Williamson's work. The first theory is what Gibbons refers to as a "rent seeking " theory and the second an "adaptation" theory. Within Gibbons's discussion, the theory of the firm means the Coasian "make-or-buy " decision, that is, vertical integration or the theory of the boundaries of the firm.

Gibbons argues that the rent seeking theory was first articulated in Williamson (1971, 1979, 1985) and Klein et al (1978). In the rent seeking theory, the advantage of vertical integration is that it can stop socially destructive haggling over "appropriable quasi-rents" (AQR). Williamson (1971: 114-5) argues, for example, that "fiat is frequently a more efficient way to settle minor conflicts ... than is haggling". The important point here is that given the existence of AQRs, non-integration cannot avoid inefficient haggling because, while "jointly (and socially) unproductive, it constitutes a source of private pecuniary gain," so integration, including its dispute-resolution by fiat powers, can be more efficient.

An important source of AQRs is relationship specific investments, that is, investments that have a higher value within a successful, on going, relationship between the contracting parties than they do should the relationship breakdown. This can trap the investing party in the relationship. If the investment is only (or at least, largely) productive within a given relationship, it will have a higher value or higher rents within that relationship than within any other relationship. These additional rents can be haggled over. The basic idea is that the larger are AQRs, the more likely is integration. This is because the larger the AQRs the more likely or costly (or both) is socially destructive haggling.

There is a problem here. One feature of this theory is that its assumptions are not entirely clear. As Gibbons explains

[...] the rent-seeking theory explicitly assumes that integration can stop the haggling induced by AQRs, but this explicit assumption requires an implicit focus on certain kinds of haggling. Specifically, if the haggling were accomplished by manipulation of alienable (say, physical) capital, then integration could remove the relevant control rights from the haggler, but if the haggling were accomplished by manipulation of inalienable (say, human) capital, then integration could not stop rent-seeking. More generally, the most that integration can do is to unify the alienable control rights; any inalienable control rights are staying put, by definition. Thus, the distinctive point in (this telling of) the rent-seeking theory of the firm is that ownership can stop haggling that is undertaken via alienable instruments. (Gibbons 2005: 204-5)

Looking at the world around us, what we see is many hold-ups between firms that do not result in integration. Gibbons continues,

To explain these observations, the rent-seeking theory has two options: (1) assert that these hold-ups utilized inalienable instruments (so that the observed hold-ups are unavoidable), or (2) enrich the theory to include a downside of integration (so that the observed hold-ups are a lesser evil than integration would have been). As I have so far told the rent-seeking theory, it says nothing about what life was like as the Fisher division of General Motors and, hence, gives no insight into whether integration could ever be the greater of two evils. As a result, the prediction I stated above is flawed: so far, we can conclude that larger AQRs make non-integration more costly, but we cannot draw an inference about the likelihood of integration until we say something about the costs of integration. (Gibbons 2005: 205)

Thus the rent seeking theory is, in the main, a theory of the benefits of integration and not the costs of integration.

The second theory, the adaptation theory of the firm, is based on work from Simon (1951); Williamson (1971, 1973, 1975, 1991); Klein and Murphy (1988, 1997); Klein (1996, 2000). The question here is whether or not integration facilitates "adaptive, sequential decision-making" (Williamson 1975: 40) in environments where uncertainty is resolved over time better than non-integration.

The key theoretical challenge in developing such a theory is to define an environment in which neither contracts ex ante nor renegotiation ex post can induce first-best adaptation after uncertainty is resolved, so that the second-best solution may be to concentrate authority in the hands of a “boss” who then makes (potentially self-interested) decisions after uncertainty is resolved. This emphasis on the boss’s authority places the adaptation theory together with the rent-seeking theory in making control the central issue in the theory (whereas the incentive-system theory ignores control in favor of incentives and the property-rights theory blends the two). (Gibbons 2005: 208)

Williamson (1971: 113) hints at the adaptation theory of the firm, arguing that "only when the need to make unprogrammed adaptations is introduced does the market versus internal organization issue become engaging". This idea gets much more development in Williamson (1975). Chapter 4 of the 1975 book used Simon (1951) to explain why many labour transactions are more efficiently conducted in a firm instead of over a market.

In Simon’s model (which is cast as a theory of employment rather than a theory of the firm), two parties choose between (a) negotiating a decision before uncertainty is resolved or (b) allocating authority to one party (the “boss”) who can then make a self-interested decision after uncertainty is resolved. Simon calls the latter an employment contract. Under such a contract, the subordinate faces a tradeoff between flexibility and exploitation: she can sacrifice flexibility by locking in a decision now, or she can risk exploitation by allowing the boss to decide later. Simon provides plausible conditions (roughly, that the parties’ payoffs depend importantly on tailoring the decision to the state, and that the parties’ preferences regarding such tailoring are not too divergent) under which it is optimal for the parties to choose the employment contract. (Gibbons 2005: 2008)

Williamson then carries the argument from Chapter 4 into Chapter 5 where he makes an explicit parallel case for intermediate products: "The argument here really parallels that of Chapter 4 in most essential respects” (Williamson 1975: 99). Thus Willaimson turns Simon’s argument for the labour contract into an argument for the make-or-buy decision and thus a theory of the firm's boundaries.

Gibbons then asks is Williamson been inconsistent or confused or wrong given that he has two theories.

Thus, I do not conclude from this close textual analysis that Williamson has been inconsistent or confused or wrong; rather, I conclude that his collected works suggest two theories of the firm—rent-seeking and adaptation. Much of the literature has focused on rent-seeking, often with AQRs created by specific investments and sometimes without any mention of adaptation. Williamson himself typically emphasizes both asset specificity and adaptation—probably reflecting the view that both will be important if a full-blown theory of the firm is to be realistic, but possibly reflecting the view that both are necessary if an elemental theory of the firm is to be coherent. (Gibbons 2005: 208-9)

References:

• Klein, B. (1996). ‘Why hold-ups occurs: the self-enforcing range of contractual relationships’, Economic Inquiry, 34: 444-63.
• Klein, B. (2000). ‘The role of incomplete contracts in self-enforcing relationships’, Revue D’Economie Industrielle, 92: 67-80.
• Klein, B., R. Crawford and A. Alchian (1978). ‘Vertical integration, appropriable rents and the competitive contracting process',Journal of Law and Economics, 21: 297-326.
• Klein, B. and K. M. Murphy (1988). ‘Vertical restraints as contract enforcement mechanisms’, Journal of Law and Economics, 31: 254-97.
• Klein, B. and K. M. Murphy (1997). ‘Vertical integration as a self-enforcing contractual arrangement', American Economic Review, 87: 415-20.
• Gibbons, Robert (2005). 'Four formal(izable) theories of the firm?', Journal of Economic Behavior and Organization, 58(2) October: 200-45.
• Simon, Herbert (1951). 'A Formal Theory of the Employment Relationship', Econmetrica, 9(3) July: 293-305.
• Williamson, Oliver E. (1971). 'The vertical integration of production: market failure considerations', American Economic Review, 61(2) May: 112-123.
• Williamson, Oliver E. (1973). 'Markets and hierarchies: some elementary considerations', American Economic Review, 63(2) May: 316-25.
• Williamson, Oliver E. (1975). Markets and Hierarchies: Analysis and Antitrust Implications, New York: The Free Press. Press.
• Williamson, Oliver E. (1979). 'Transaction cost economics: the governance of contractual relations',Journal of Law and Economics, 22: 233-61.
• Williamson, Oliver E. (1985).The Economic Institutions of Capitalism, New York: The Free Press. Press.
• Williamson, Oliver E. (1991). 'Comparative economic organization: the analysis of discrete structural alternatives',Administrative Science Quarterly, 36: 269-96.