Just for fun: theory of the firm 11

Two of the main theories of the firm are the transaction cost approach, associated with people like last year's Noble Prize winner in economics Oliver Williamson, and the property rights approach, associated with Sanford J. Grossman, Oliver Hart and John Moore. Recently Hart and Moore developed a new approach to contracts which has also been applied to the theory of the firm. This is commonly referred to as the "reference point" approach. An interesting question is how are these different models related?

In the past it was commonly argued that the property rights approach was a formalisation of the transaction cost approach. As Robert Gibbons (2005: 201) has written,

For example, one still sometimes hears the claim that “Grossman and Hart (1986) formalized Williamson (1979).” Indeed, I have heard this claim with two opposite spins: “Grossman–Hart merely formalized Williamson,” and “Finally, someone formalized Williamson.”

This however turns out not to be true. In a discussion of the differences between the Grossman-Hart-Moore (GHM) theory of the firm and the transaction-cost approach, Williamson (2000: 605-6) argues that the most important difference between them is that GHM introduce inefficiencies at the ex ante, that is, before the state of the world is known, investment stage while the transaction-cost approach assumes ex post contractual problems drive inefficiencies. There are no ex post inefficiencies in GHM due to their assumption of ex post common knowledge and costless bargaining. Williamson writes,

The most consequential difference between the TCE and GHM setups is that the former holds that maladaptation in the contract execution interval is the principal source of inefficiency, whereas GHM vaporize ex post maladaptation by their assumptions of common knowledge and costless ex post bargaining. The upshot is that all of the inefficiency in GHM is concentrated in the ex ante investments in human assets (which are conditional on the ownership of physical assets). (Williamson 2000: 605).

This shift from ex post maladaptation to ex ante investment distortions, in Williamson's view, matters. He says,

(1) The TCE rendition of the make-or-buy decision between successive stages (A and B) asks whether A and B should be separately owned and operated or if the ownership and operation of these two stages should be unified. If independent, then each stage appropriates its net receipts (high-powered incentives obtain) but maladaptation problems can arise during contract execution. If unified, then the two stages are man- aged coordinately through hierarchy. (Maladaptation problems are thereby relieved; incentives are lower-powered; and added bureaucratic costs arise.) By contrast, GHM view vertical integration in a directional way: either A buys B or B buys A, and it matters which way this is done. That is because common ownership under GHM does not imply unified management. Instead, each stage (in all configurations A and B are independent; A buys B; B buys A) appropriates its net receipts. This last is a very unusual condition, in that unified ownership is normally thought of as a means by which to effect cooperation. (2) TCE maintains that each generic mode of governance spot market, incomplete long-term contract, firm, bureau, etc. is defined by a syndrome of attributes to which distinctive strengths and weaknesses accrue. Specifically, TCE holds that alternative modes differ in incentive intensity, administrative controls (to include auditing, accounting, and transfer pricing), access to the courts, and informal organization (to include politicking). GHM assume that incentive intensity, administrative controls, and informal organization are unchanged by ownership and that courts are irrelevant (because of costless renegotiation). None of the physical asset utilization and transfer pricing distortions that I associate with the "impossibility of selective intervention" (Williamson 1985, pp. 135-40) thus occur under the GHM setup. (3) TCE examines a wide range of ex post devices for infusing credible commitments into contracts and applies this reasoning to a wide set of transactions. Variations on this theme include hybrid modes of organization, exchange agreements and other uses of hostages to support exchange, the organization of work, the organization of labor and human resources more generally, corporate governance, regulation (and deregulation), public bureaus, and project financing. Because GHM is a property rights and property rights only construction, it relates to some of these issues not at all and others very selectively. (Williamson 2000: 606) (I have removed references from this quote.)

So these theories are, as Gibbons puts it, essentially orthogonal.

What then of the new "reference point" approach to the firm?

I would argue that the reference point approach can be seen as a movement back toward transaction cost type thinking in that contracting is not fully enforceable ex post. Perfunctory performance can be enforced, consummate cannot and thus ex post inefficiencies can arise. Hart (2008) argues that aggrievement/shading costs, which drive the reference point approach, are akin to what he calls "haggling costs". Hart (2008: 405) explains,

He [Coase] suggested that the two most obvious costs of using the market/price mechanism are (i) discovering what the market prices are and (ii) negotiating a contract for each exchange transaction. Economists since Coase have referred to these as ‘haggling’ costs (although I do not believe that Coase uses this term). ‘Argument’ costs might also be appropriate for (ii).

Modelling haggling costs can be seen as a move in the direction of modelling transaction costs. That is, a move towards modeling the costs of market contracting. In the reference point approach ex post inefficiencies return, via shading costs, without the need for ex ante investment problems. So the action in these models, like the transaction cost models, is at the ex post stage. However it can also be argue that provision also needs to be made for the possibility that core features of the transaction cost theory are still being left out.

Thus Robert Gibbons (2010: 283) has a point when he says, while discussing some opportunities for the future of transaction-cost economics, that only time will tell if the reference point theory is an productive path to follow.

References:

• Gibbons, Robert (2005). `Four formal(izable) theories of the firm?', Journal of Economic Behavior and Organization, 58(2): 200-45.
• Gibbons, Robert (2010). `Transaction-Cost Economics: Past, Present, and Future?', Scandinavian Journal of Economics, 112(2): 263-88.
• Grossman, Sanford J. and Oliver D. Hart (1986). `The Costs and Benefits of Ownership: A Theory of Vertical and Lateral Integration', Journal of Political Economy, 94(4): 691-719.
• Hart, Oliver D. (2008). `Economica Coase Lecture: Reference Points and the Theory of the Firm', Economica, 75(299) August: 404-11.
• Williamson, Oliver E., (1979). `Transaction cost economics: the governance of contractual relations', Journal of Law and
• Economics, 22: 233-261.
• Williamson, Oliver E. (2000). `The New Institutional Economics: Taking Stock, Looking Ahead', Journal of Economic Literature, 38(3) September: 595-613.