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Journal of Economic Behavior and Organization 17 (1992) 335-352.

North-Holland
Markets, hierarchies, and the modern
corporation
An unfolding perspective
Oliver E. Williamson*
University of California, Berkeley, CA, USA
Received October 1990, final version received January 1991
What is now referred to as the New Institutional Economics and/or the New
Economics of Organization began to take hold about twenty years ago
[Arrow (1969), Davis and North (1971), Williamson (1971), Coase (1972),
Alchian and Demsetz (1972)]. Neil Kay focuses on one strand of that
literature - transaction cost economics - and assesses its strengths and
weaknesses as of 1985. Although I can relate to many of Kays concerns,
others miss the mark and/or are mistaken. That he misses the mark is partly
because, even as of his cutoff date of 1985, I read the record differently.
But I would also emphasize that there have been developments in trans-
action cost economics since 1985 that are specifically responsive to and
mitigate some of his key objections. Furthermore, I do not think that
transaction cost economics is played out. Some of his objections can or will
be dealt with during the decade of the 1990s. Finally, transaction cost
economics does not purport to be an all-purpose theory of economic
organization. My reading of the literature on economic organization is that
we are at a pre-unified state of development and that several well-focused
Correspondence to: Oliver E. Williamson, University of California, Haas School of Business
Administration, Berkeley, CA 94720, U.S.A.
*The author is Transamerica Professor of Business, Economics, and Law at the University of
California, Berkeley.
Kay contends that The Economic I nstitutions of Capitalism (1985) may be taken as the
definitive and currenf statement of Williamsons approach to economics (p. 3; emphasis added).
*Note that I trace the origins of the New Institutional Economics to the early 1970s. Being
young, transaction cost economics has continued to unfold. Kays cutoff date of 1985 is arbitrary
and inappropriate. Not only have there been numerous developments in the past live years, but
more are in prospect. Interestingly, a conference on The New Science of Organization has been
organized for January 1991. I anticipate that the decade of the 1990s will be the period when the
new science of organization comes of age.
0167-2681/92/$05.00 0 1992-Elsevier Science Publishers B.V. All rights reserved
336 O.E. Williamson, Markets, hierarchies, and the modern corporation
and internally consistent perspectives are needed. Some perspectives will
inform one set of problems; some will inform another set; some will be
bankrupt; and the more productive will lead to the variations on a theme of
a kind to which Friedrich Hayek has made reference elsewhere: whenever
the capacity of recognizing an abstract rule which the arrangement of these
attributes follows has been acquired in one field, the same master mould will
apply when the signs for those abstract attributes are evoked by altogether
different elements (1967, p. 50). The research record documents that many
disparate phenomena turn out to be variations on a common underlying
transaction cost economizing theme. 3 One way of looking at a purported
weakness of transaction cost economics is that it is a research opportunity. If
the subsequent application of transaction cost economics reasoning advances
our understanding little or not at all, so be it. The possibility, however, that
transaction cost economics can be responsive, but simply has not gotten
around to it, should not be dismissed. As I have argued elsewhere, any
problem that arises as or can be reformulated as a contracting problem can
usefully be examined in transaction cost economizing terms. My response to
Kay is subtitled as an unfolding perspective - where unfolding is used in the
sense of moving toward full development - because transaction cost
economics has been responsive to research opportunities in the past and, I
anticipate, will be responsive in the future. For example, an early critique
that was often made of transaction cost economics is that it dealt almost
exclusively with markets and hierarchies while in fact a great deal of
economic activity was organized by hybrid modes - long term contracting,
franchising, reciprocal trading, regulation, and the like. To be sure, trans-
action cost economics did predominantly emphasize polar modes at the
outset [Coase (1937), Williamson (1971, 1975)]. But the extension of
transaction cost reasoning to deal with hybrid modes followed quickly
thereafter [Williamson (1976, 1979, 1983, 1985), Goldberg (1976), Klein
(1980), Klein and Murphy (1988), Joskow (1988), Masten and Cracker
(1985)]. Or consider what I once thought was beyond the reach of
transaction cost economics: the oligopoly problem. I originally approached
the issue in market structure terms, primarily because that was the prevailing
orientation. Upon reflection, however, it was obvious that the cartel problem
pre-dated antitrust and that the cartel problem is fundamentally a contract-
ing problem in which access to court-ordered enforcement is denied. Market
structure is pertinent in that it affects the efficacy of tacit, privately enforced
agreements. That leads into a reformulation of the oligopoly problem in
3Apparent differences notwithstanding, the following phenomena turn out to be variations on
a theme: vertical integration, vertical market restraints, labor market organization, the discrimi-
nating use of debt and equity, corporate governance, regulation, share cropping, and career
marriages. Applications to business strategy, politics, and international relations have developed
apace.
O.E. Williamson, Markets, hierarchies, and the modern corporation 331
contracting terms [Williamson (1975, Ch. 12)]. The lesson is this: just
because an issue has not yet been addressed in transaction cost economizing
terms does not mean that the issue is beyond the reach of transaction cost
economics reasoning. Often a comparative contractual reformulation of the
issue turns out to be both possible and illuminating. But sometimes not. My
rejoinder to Kay deals first with markets and hierarchies and then turns to
the modern corporation.
1. Markets and hierarchies
While Kay grants that transaction cost economics has been instructive, he
takes exception with my definition and contends that transaction cost
economics overuses contractual imagery, does not make allowance for fiat, is
underdeveloped in property rights respects, and does not deal with dynamic,
evolutionary phenomena. Kay sows confusion in definitional respects.
Moreover, I maintain that (as of this date) the contractual approach is
under- rather than over-used. Also, fiat occupies a prominent place in the
transaction cost scheme of things; and property rights can be and have been
brought within the ambit. Transaction cost economics has been less respon-
sive in dynamic, evolutionary respects.
I . 1. Defining transactions
Kay maintains that transactions can be described in both contractual and
physical terms and believes that my treatment confuses the two. The
contractual definition to which he refers is this: Each feasible mode of
conducting relations between technology-separable entities can be examined
with respect to the ex ante costs of negotiating and writing, as well as the ex
post costs of executing, policing, and, when disputes arise, remedying the
(explicit or implicit) contract that joins them [Williamson (1986, p. 139)].
What he calls the physical definition is this: A transaction may thus be said
to occur when a good or service is transferred across a technologically
separable interface [Williamson (1986, p. 139)].
Kay queries whether these are consistent by examining two examples. The
first involves Robinson Crusoe (by himself and with Friday). The second
involves three farmers. Both examples are confused. I focus on the latter.
Kays initial scenario involves three plots of land, each owned by a
different individual. Each owner hires a separate manager to cultivate his
plot. The three owners purchase and share one tractor among them. The
tractor sharing contract is the source of repeated disputes.
Under the second scenario, one owner buys up the land of the other two
and consolidates ownership of the tractor. Unified ownership of the land and
the tractor thereby obtain, but each plot continues to be cultivated by a
338 O.E. Williamson, Markets, hierarchies, and the modern corporation
separate manager. According to Kay, The tractor is allocated to farms in
much the same fashion as before (p. 320).
Kay concludes that the net effect is therefore the elimination of the
[tractor] transaction in the contractual sense and the preservation of the
[tractor] transaction in the physical transference sense (p. 11, emphasis in
original). I contend that the ownership and use of the tractor are usefully
decribed in contractual terms for both scenarios.
Interestingly, although Kay avers that the tractor gets allocated to farms
in much the same fashion as before, he never tells us how it was allocated
before. By a fixed formula? On a first-come, first-served basis? Other? What
exactly are we comparing? If the managers were having disputes previously,
why not now? Has the common owner taken on an active tractor allocation
function, which involvement explains the superiority of unified ownership
over what was done previously? If so, then the tractor does not get allocated
in much the same fashion as before. Also, what are the opportunity costs?
And have the contracts with the managers been adjusted to reflect this more
active ownership involvement? More generally, the fact that fiat is now used
to avoid or settle disputes does not eliminate a contractual relation but
merely transforms it. What had been a joint ownership condition with
stipulated usage rights becomes a unified ownership relation with dis-
cretionary usage rights. Kay and I evidently agree that fiat is empowered by
unified ownership. His mistake is that he does not regard unified ownership
as a meaningful contractual alternative (see 1.3, below).
1.2. On the merits of contractual imagery
Albeit instructive to characterize the firm as a production function to
which a profit maximization purpose has been ascribed, that is also a
restrictive perspective. A different view of the firm - that of a governance
structure - has been promoted by formulating the issues in contracting
terms4 Specifically, transaction cost economics differs from the more
familiar neoclassical approach in the following significant respects: (1)
marginal analysis gives way to discrete structural analysis; (2) within-firm
analysis of efficient factor proportions gives way to comparative analysis of
the adaptive efficacy of alternative governance structures; and (3) although
the analysis of technologically nonseparable activities is interesting and
important, the more interesting issue, for students of the modern corporation,
is to understand how and why technologically separable stages of business
As David Kreps remarks, In textbook (neoclassical) economics the firm is of the category
of the individual agent. Agents have utility functions - firms have the profit motive. Agents
have consumption sets - firms have production possibility sets. But in the transaction cost
scheme of things, firms are more of the category of markets both [firm and market] are
[governance structures] within which individuals can transact (1984, p. 8).
O.E. Williamson, Markets, hierarchies, and the modern corporation 339
activity are linked. Contractual imagery is vital for these purposes. A large
number of additional phenomena come within the ambit of economic
analysis as a consequence.
Among the issues that are illuminated by adopting a contractual perspec-
tive, but that are beyong the reach of the usual production function setup,
are the limits of firms and the requisites for fiat. The first of these is briefly
considered here. The second is discussed in 1.3, below.
As I have discussed elsewhere, one of the chronic puzzles of economic
organization was Why cant a large lirm do everything that a collection of
smaller firms do and more? That troublesome issue has been around since
the 1920s. Efforts to deal with it all suffered from a serious defect: they did
not pose the issue in a genuinely comparative way.
There were two problems with the usual proof of limitations to firm size.
First, merely to show that internal organization experiences bureaucratic
costs is neither here nor there (as a comparative institutional matter) if those
bureaucratic costs would merely be spread out - but, in the aggregate, would
be unchanged - were the same transaction to remain in the market.
Differential transaction costs needed to be but were not displayed. Second,
the hierarchical structure within which internal transactions were to be
organized was arbitrarily constrained: implicitly, if not explicitly, internal
transactions were managed in a centralized way. That precludes use of a
more interesting and, as it turns out, more illuminating option: employ
selective intervention.
Selective intervention is really the key. The idea is to replicate the market
mode within the firm in all respects save those where intervention is the
source of expected net gains. If hierarchical control is reserved for the latter
and if the firm replicates the market in all other respects, then the firm never
does worse than the market (by replication) and sometimes does better
(through selective intervention). Accordingly, the firm will everywhere do as
well as and will sometimes do better than the market.
This formulation disclosed that prior explanations for limitations to firm
size [as in Williamson (1967)] relied on arbitrary constraints. The core
condition that needed to be explained is wherein does selective intervention
break down [Williamson (1985, Ch. 6, 1988a)]. Suffice it to observe here that
the main sources of breakdown - asset dissipation, the unavoidable loss of
incentive intensity, and added latitude for politicking - are ascertained by
examining firm and market organization in comparative contractual terms.
1.3. Fiat
Kay characterizes my hierarchies as false, at least partly because I do not
make allowances for fiat. That, however, is mistaken. I expressly identify fiat
as one of the distinguishing features of hierarchies, as compared with
340 O.E. Williamson, Markets, hierarchies, and the modern corporation
markets, in my very first article on transaction costs (1971, p. 114).
Moreover, I expressely take exception with Armen Alchian and Harold
Demesetzs contention (1972, p. 777) that firms and markets have identical
access to fiat [Williamson (1975, pp. 67-70, 101)].5 Differences between
firms and markets in adaptive, sequential decision-making respects are
largely explained by differential access to fiat [Williamson (1981, p. 1549)].
The zone of acceptance in the employment relation is crucial in this
connection [Williamson (1985, p. 249)].
One could nevertheless argue that the differential access to fiat within
firms, as compared with between firms, warrants further explication. I not
only agree but have recently argued that contract law differences between
firms and markets contribute significantly to the differential efficacy of fiat in
these two organizational forms. The basic hypothesis is this: each generic
form of governance - market, hybrid, hierarchy, bureau - is supported by a
distinctive form of contract law [Williamson (1990, 1991)]. Whereas market
governance is supported by classical contract law [Macneil (1974)], the
(implicit) contract law of hierarchy is that of forbearance: technical disputes
that arise within firms are exempted from court-ordered enforcement. The
efficacy of fiat turns critically on the fact that hierarchy is its own court of
ultimate appeal.
One could complain that there is more to fiat than this. I do not disagree.
I submit, however, that the efficacy of fiat needs to be established comparati-
vely. Kay nowhere indicates that a comparative institutional approach is
needed to assess fiat, much less does he identify the crucial comparative
features on which the differential efficiency of fiat rests. Rival explanations for
fiat to which transaction cost economics can be compared are nowhere
mentioned (or even hinted at) by Kay.
Perhaps that is because fiat differences are obvious and hence can be taken
as given. As Chester Barnard remarked, Either as a superior or as a
subordinate,. . . I know nothing more real than authority (1962, p. 170.
n. 5). Appearances, however, can be deceiving - which presumably explains
why Alchian and Demsetz asserted that firm and market were indistinguish-
able in fiat respects. My position is that all significant differences between
alternative forms of organization need to be explicated. An examination of
alternative forms of governance in comparative contractual respects has been
instructive for these purposes.
Also, whereas Kay emphasizes that my treatement of hierarchy is mainly contractual
[referring specifically to Williamson (1985, p. 221)], note that my use of the term contractual
hierarchy refers to the degree to which one or a few agents are responsible for negotiating the
full set of contracts when contract renewal comes due, or if instead each agent contracts directly
with others. That is to be distinguished from the decision-making hierarchy, which has reference
to the use of or access to fiat during the operating interval. As between the two, I specifically
remark that the more critical hierarchy for performance purposes is the decision-making
hierarchy [Williamson (1985, p. 222)].
O.E. Williamson, Markets, hierarchies, and the modern corporation 341
1.4. Property rights
Kay contends that transaction cost economics is underdeveloped in
property rights respects and that non-specificity of assets may frequently
create property right problems (pp. 16-17). I concur with the first of these. I
would restate the latter argument as follows: asset specificity may be used
strategically as a way by which to protect investments in a weak property
rights regime.
(a) Property rights, general
It has been argued that the economic institutions of capitalism with which
I have been predominantly concerned are those of advanced Western
capitalist economies and that other forms of capitalism exist and warrant
explication [Hamilton and Biggert (1988)]. I agree.
One way of doing this is to distinguish between the institutional environ-
ment on the one hand and the institutions of governance on the other. Lance
Davis and Douglass North describe the institutional economics enterprise as
follows (1971, pp. 67; emphasis in original):
The institutional environment is the set of fundamental political, social
and legal ground rules that establishes the basis for production,
exchange and distribution. Rules governing elections, property rights,
and the right of contract are examples.. .
An institutional arrangement is an arrangement between economic units
that governs the ways in which these units can cooperate and/or
compete. It . . . [can] provide a structure within which its members can
cooperate . . or [it can] provide a mechanism that can effect a change
in laws or property rights.
Thus, setting feedback effects aside, the institutions of governance (firms,
markets, hybrids, bureaus) are embedded in the institutional environment
(rules of the game) of which property rights are a part. Changes in the
institutional environment can thus be treated as shift parameters. If these
give rise to differential transaction cost consequences in one form of
organization as compared with another, and if these changes apply at the
margin, then changes in the organization of economic activity can be
predicted [Williamson (1991)].
Not only can property rights differences be used to predict and interpret
organizational differences within (longitudinal) and between (cross-sectional)
economic systems, but the efficacy of, for example, communal property rights
will vary systematically with the governance structure employed [Williamson
(1985, pp. 217-218, 227-228)J and with the nature of the transactions to be
organized [Hansmann (1989)]. What has become apparent only more
342 O.E. Williamson, Markets, hierarchies, and the modern corporation
recently, however, are that organization form and assets relate to property
rights in a strategic way.6
(b) Appropriability
The proposition that investments in transactions specific assets may be
induced by contractual hazards has long been featured in the transaction cost
economics literature. Benjamin Klein and Keith Leffler (1981) make the
argument in conjunction with brand-name capital. Klein elaborates in his
treatments of franchising (1980) and vertical market restraints [Klein and
Murphy (1988)]. I likewise argue that the reciprocal exposure of specialized
assets may be used as a devise by which to infuse credible commitment in
what would otherwise be a hazardous trading regime [Williamson (1983,
pp. 53&537)].
David Teece (1986b) has since extended the argument to deal with the lack
of patent or other legal protection for intellectual property rights. The
argument is that innovators may be induced to integrate into related stages
(backward, forward, lateral) if such integration serves to mitigate contractual
hazards under weak regimes of appropriability. If contracting with related
stages runs the risk that valued knowhow will leak out, and if firms
operating in related stages possess specialized assets, then effective control
over innovations may inadvertently pass into the hands of others.
To be sure, integration into related stages can operate in the service of
trade secrecy whether the newly integrated assets are specific or not. The
denial of knowhow to specialized stages is especially important, however,
where assets specificity has cost reducing effects. If de facto control of the
innovation accrues to those who combine knowhow with asset specificity,
then the leakage of knowhow will be deterred by integrating into co-
specialized stages of production and distribution [Teece (1986)].
A related, but different, argument has been advanced by Jan Heide and
George John (1988) who are concerned with intertemporal hazards that
sometimes arise in distributing a good or service. They consider a manufac-
turer that has developed a new product and needs specialized distribution to
get it to market. The manufacturer could make these investments himself or
could employ manufacturers agents, who already know the market and can
service it more cheaply. These agents will be leery, however, of deepening
their investments if the success of their marketing efforts invites the
manufacturer to bypass the agents and sell directly.
In effect, there are three scenarios to be evaluated: (1) the manufacturer
sells directly from the outset, its disadvantages in this respect notwithstand-
ing; (2) the manufacturer initially uses an agent to sell to the market and
6Actually, the strategic importance of asset specificity as a barrier to entry was recongized
much earlier [Williamson (1975, 1976), Caves and Porter (1977), Dixit (1980)]. Appropriability
issues of the kinds discussed below have come up more recently.
O.E. Williamson, Markets, hierarchies, and the modern corporation 343
subsequently enters if the agents efforts are successful but not otherwise;7
and (3) the manufacturers uses an agent but is deterred from subsequent
entry by the use of linking investments made by the agent. Farsighted agents
under the last scenario recognize that their market development efforts will
be expropirated by the manufacturer unless they are able to develop ties to
the customers that preclude the second scenario from materializing. Which
scenario is the most cost effective will vary with the circumstances. As Heide
and John argue, linking investments are often the most effective way to go.
Thus, although Kay may believe that property rights weakenesses are
beyond the reach of transaction cost economics reasoning, that is incorrect.
To be sure, table 1-l (at page 31 of The Economic Institutions of Capitalism)
should carry the proviso that strong property rights are assumed. If,
however, contractual problems can be shown to appear in a strong property
rights regime, then contractual problems can be expected where the appro-
priability regime is weak, a fortiori. Since the authors of each of the
foregoing articles found that transaction cost reasoning was the natural way
to think through and interpret the weak property rights phenomena in
question, the real puzzle is this: Why does Kay resist doing the obvious?
1.5. Intertemporal
Kay refers to the desirability of addressing dynamic, evolutionary pheno-
mena in an internally consistent way. I not only concede merit in this, but I
have previously indicated that transaction cost economics is limited in this
respect [Williamson (1988b)].
It nevertheless bears remark that transaction cost economics has been
concerned with intertemporal issues from the outset - as witness the key role
played by the Fundamental Transformation [Williamson (1971, 1985, pp. 61-
63)] and other process transformations [Williamson (1988a)]. Also, the
R&D process has been described in an intertemporal way [Williamson
(1975, pp. 196207)], Schumpeterian handing on has been expressly dis-
cussed (1985, p. 129), life cycle features have been discussed in conjunction
with vertical integration and investment [Williamson (1985, pp. 127, 152)],
and timing is important in dominant firm (1975, Chapter 11) and in entry
deterring respects (1985, pp. 373-384).
Be that as it may, the need to be alert to a wider array of dynamic,
evolutionary phenomena is real. Although some of that can be introduced
through more self-conscious treatment of the institutional environment (see
There are two variants of the second scenario: The manufacturer could offer to compensate
the agent for any specialized investments should the manufacturer decide to integrate, or the
manufacturer could refuse to compensate. I assume the latter, there being many problems in
establishing value for the former [for a discussion, see Williamson (1985, Ch. 13)].
344 O.E. Williamson, Markets, hierarchies, and the modern corporation
above), that does not exhaust the possibilities. Transaction cost economics
stands to benefit from the further development of evolutionary economics.
2. The modern corporation
Early analyses of the make-or-buy decision (in its various forms) work out
of gross distinctions between markets and hierarchies. But polar distinctions
between markets and hierarchies merely begin the inquiry. Not only are
there a variety of market modes - which is to say that the study of hybrids is
pertinent - but there are a variety of ways to organize hierarchies. Contrary
to the technolo~cal tradition, transaction cost economics insists that organi-
zation form matters and attempts to ascertain and explicate the reasons why.
The latter part of Kays paper is concerned with the modern corporation -
with special emphasis on conglomerates, the multinational enterprise, and
evolutionary economics. I discuss aspects of each.
2. f . The c~~g~orn~ra~e
Kay evidently sees merit in characterizing the multidivisional firm as an
internal capital market.* But he poses the following challenge: Williamson
does not explain why the conglomerate should evolve in preference to
[horizontal or vertical mergers] (p. 22). There are three responses, two of
which are historical.
The first (and nonhistorica~ response) relates to the ~om~rison of vertical
and conglomerate mergers. There are certainly some vertical acquisitions to
which I would attach economizing value. Vertical relations, however, that
involve negligible degrees of bilateral dependency should not be integrated
(for transaction cost economizing reasons). The rule is try markets, try
hybrids, and revert to vertical integration only for compelling cause - the
reason being that to integrate into related stages where dependency is
negligible incurs costs without benefits [Williamson (1985, Ch. 6)]. Leakage
considerations (of the kind referred to in 1.3(b) above) aside, vertical
integration is the governance structure of last resort.
Because conglomerate acquisition involve a negligible amount of intratirm
trade, the likelihood of intra~rm cost excesses of these same kinds is
mitigated. Assuming, therefore, that the firm to be acquired is either a generic
supplier or is a business with which the acquiring firm has no current or
prospective trading association, the acquisition of the latter could easily be
the less disadvantageous.
sOthers who viewed the M-form in a somewhat similar way include Heflebower (1960),
Alchian (1969), Drucker (1970), and Bower (1971).
Kays discussion is context-free. That may be because he believes that a timeless rationale for
the conglomerate is needed. I am persuaded that context matters.
O.E. Williamson, Markets, hierarchies, and the modern corporation 345
That is a rather extreme hypothetical, however. More important to an
understanding of the conglomerate are historical changes that have ocurred
in antitrust enforcement and in competition in the capital market during the
past 25 years, Although Kay mentions neither, context matters.
There have been massive changes in antitrust enforcement since 1965. The
1960s and early 1970s was an era during which mergers with even very small
degrees of horizontal and vertical overlap were routinely challenged by the
antitrust enforcement agencies, which challenges were invariabily sustained
by the courts. (As Justice Stewart put it, in a dissenting 1966 opinion, the
sole consistency that I can find is that in [merger] litigation under Section 7,
the Government always wins.) That has changed. Antitrust has become
progressively more sensitive to possible efficiency gains in horizontal and
vertical mergers - especially since 1980.
Also, competition in the capital market has undergone substantial change
since the 1960s. Challenges to incumbent managements principally took the
form of proxy contests before the conglomerate movement in the late 1960s.
The proxy contest was a beauty contest and incumbents were rarely defeated.
Lacking credibility, claims by challengers that they would somehow do better
were discounted. Merger is an alternative corporate control device [Manne
(1965)] with superior credibility properties. Rather than rely on mere
promises to add value, the shareholders of acquired firms could examine the
terms under which the merger would be made.
To be sure, horizontal or vertical mergers could sometimes yield added
value (in market power, scale economy, and/or transaction cost economizing
respects) over and above the corporate control benefits of the con~omerate
merger. But that is operationaily irrelevant if antitrust enforcement blocked
mergers of both horizontal and vertical kinds. If the conglomerate merger
was the only game in town, and if the alternative corporate control
instrument was the proxy contest, then conglomerate acquisitions in the late
1960s and early 1970s - at least those of the M-form kind, which excludes
conglomerates of the Go-Go variety12 - had redeeming qualities.
As it turns out, that was a transitional condition. Not only did antitrust
enforcement change, but new corporate control instruments took shape.
Challenges to incumbent managements that took the form of tender offers -
paying a permium for shares - relieved the need for mergers as a managerial
United States t. Vans Grocery Co., 384 U.S. 270, 301 (1966) (Stewart, J., dissenting).
The March 1983 issue of the Ca&rnia Law Rsuiew traces the key changes in the Merger
Guidelines up through 1982. There have been subsequent relaxations in the Guidelines since.
Some early congtomerate acquisitions might have been mistaken. As I have repeatedly
emphasized, the conglomerate form to which I ascribe potential benefits is organized as an M-
form enterprise. The so-called Go-Go conglomerates do not display M-form features and should
not be expected to function as miniature capital markets. Many critics of conglomerates do not
make organization form distinctions but treat them as being all of a kind (usually of the Go-Go
kind).
346 O.E. Williamson, Markets, hierarchies, and the modern corporation
displacement device. Recourse to takeover by tender offer supported by new
or perfected forms of finance - leveraged buy-outs, bust-up takeovers, junk
bonds - progressively took shape during the 1970s and 1980s.
Indeed, a further consequence of the relaxation of antitrust endorcement
against horizontal and vertical mergers is that earlier conglomerate acqui-
sitions could be (and some were) sold off and reconfigured into what were
arguably higher-valued horizontal and vertical relations. I do not, therefore,
wholly disagree with Kays argument that Williamsons own transaction cost
tool-kit provides arguments for specialization rather than conglomerates
(p. 22). I would only urge that (1) the issues need to be examined in context
and (2), subject to size and variety limits, the M-form conglomerate possesses
affirmative features. Those who argue that history matters should be mindful
of that advice.
2.2. Multinationals
Kay observes that my treatment of multinationals is brief and incomplete.
I agree. The fact, however, that my treatment of multinationals is limited
does not imply that transaction cost economics cannot be made to apply
more generally. Not only have others found that transaction cost economics
usefully informs the study of multinationals,3 but I anticipate that further
applications can and will be made. I would note in this connection that all of
the puzzling multinational practices to which Kay refers in his article are
ones to which transaction cost economics can be brought to bear.
Note in this connection that the discussion of weak appropriability (in
section 1.3, above) is pertinent to an assessment of the licensing puzzle to
which Kay refers. Thus Kay observes that there is evidence that specificity of
transactional relationships may encourage the licensing (market exchange)
option in some circumstances (p. 29) and quotes Farok Contractors finding
that The disadvantages of licensing arising from licensee independence are
often removed if the licensee is kept dependent for trademarks, required
components, foreign market access, technical improvements, etc. [Contractor
(1981, p. 78)]. Kay regards this as a contradiction of transaction cost
reasoning.
As hitherto remarked, however, the contractual hazards that arise in a
strong property rights regime need to be distinguished from those that arise
under weak property rights. Licensing in a strong property rights regime
works well if assets are nonspecific. That is the standard argument. If,
however, licensing poses leakage hazards (because property rights are weak),
Applications of transaction cost economics to the study of multinational enterprise include
Richard Caves (1982), J.F. Hennart (1982), Wilfred Ethier (1986), Alan Rugman (1986), David
Teece (1986b). Eirik Furubotn (1989) and Saul Klein, Gary Frazier and Victor Roth (1990). See
also John McManus (1971) and the book by Mark Casson and Peter Buckley (1985).
O.E. Williamson, Markets, hierarchies, and the modern corporation 347
then efforts to seal leaks are indicated. One possibility is to forego licensing
in favor of direct foreign investment. Another is to license only if the licensee
is dependent on the licenser in the ways described by Contractor. Note,
however, that the dependencies described by Carpenter do not entail
investments in specialized assets (of a cost saving kind) by the licensee.
Indeed, trading under a weak property rights regime with licensees who
invest in co-specialized assets invites precisely the loss of control condition
referred to by Teece (1986).
It is relevant in this connection to distinguish between the licensing
problem and the franchising problem. Both pose leakage hazards, but
whereas the franchisee can be deterred from dissipating quality by (1)
requiring him to make nonredeployable investments in the franchise and (2)
imposing a termination-at-will clause [Klein (19X0)], this same strategy will
not work for licensing. That is because termination is of no concern to the
licensee, once he has acquired the relevant knowhow. Accordingly, the
licensing agreement needs to be embedded in a larger contractual relation in
which penalities other-than-termination have integrity infusing properties.
Absent the ability to effect deterrence - by the credible threat of enforcing
trademarks more vigorously, using politics to limit foreign market access,
restricting access to proprietary technical improvements, etc. - and assuming
that direct foreign investment is prohibitively expensive, licensing will
predictably take the form of a one-time, lump sum fee rather than a royalty
agreement. i4
2.3. Evolution of the M-form
Kay splices a 1971 quotation of mine together with his interpretation of a
1985 statement of mine and expresses dissatisfaction with the result. Kays
argument reads as follows (p. 26):
. . .it is important to identify exactly what Williamson is saying: expan-
sion of the U-form leads to crisis and collapse and the development of
the M-form to solve these problems eventually the U-form structure
defeats itself and results in the M-form structure to solve these problems
[Williamson (1971, p. 350)]. The evolution of the M-form is regarded as
an evolutionary process operating according to natural selection criteria
[Williamson (1985, p. 296)].
Readers who are advised by Kay that he wants to establish exactly what I
am saying have reason to expect that he is representing me correctly and
preserving the context. Surely readers have reason to believe that the passage
appearing in quotes - eventually the U-form structure defeats itself and
14This last is a node B transaction cost argument [Williamson (1985, pp. 32-35)].
J.E B.O. B
348 O.E. Williamson, Markets, hierarchies, and the modern corporation
results in the M-form structure to solve these problems - is mine. What I
actually wrote, at the cited page, is this [Williamson (1971b, p. 350)]:
Functional organization . . . was and is the natural way to decompose
simple tasks. Preserving the functional form as the firm is gradually
expanded is also to be expected. Eventually, however, the U-form
structure defeats itself. This will obtain even if the U-form enterprise
undergoes a simple radial amplification in size without concurrent
diversification. If accomplished through diversification, coordination
within the functional form can be expected to present even more severe
problems.
The organizational innovation that was devised as a reponse to these
conditions involved substituting quasi-autonomous operating divisions
(organized mainly along product, brand, or geographic lines) for the
functional divisions of the U-form structure as the principal basis for
achieving compartmentalization.
I stand by these remarks with one modification: the second paragraph should
being with the article An rather than The.
It is also pertinent to examine the passage upon which Kay relies for his
statement that The evolution of the M-form is regarded as an evolutionary
process operating according to natural selection criteria. The relevant
passage (on the page referred to by Kay) reads as follows: Investors will
presumably be prepared to supply capital on superior terms . . . to a large,
diversified M-form corporation than they would be to an equivalent H-form
firm. In the degree to which the M-form is in fact jitter, natural selection,
which includes competition in the capital market, favors this result
[Williamson (1985, p. 296; emphasis added)]. I have no reason to modify this
statement. Note, however, the reference here is to the H-form (not the U-
form). Also, my contention that cost savings favor selection, ceteris paribus,
is a very general weak-form selection argument. If Kay objects to the
preposition that cost savings favor selection, he should elaborate.
Kay subsequently argues that a genuine natural selection argument would
see the M-form innovation generating crisis and collapse in the (inferior) U-
form, rather than the U-form collapse generating the M-form innovation
(p. 26). That is because genuine natural selection selects from among present
competitors (p. 26). Such an argument seems to me to be needlessly
deferential to biological reasoning. If economic actors behave intentionally -
which, within limits, they do - then why eschew intentionality in the study of
organizational innovation?
Specifically, one interpretation of the M-form innovation is that it was an
intenationally crafted response to the severe problems of organization that
U-form and H-form firms experienced as they grew in size and variety. How
did such firms infer that they had problems? One possibility is that their
O.E. Williamson, Markets, hierarchies, and the modern corporation 349
managements reflected upon previous experience (when the firm was smaller
and simpler). Another was to consult the marketplace. Still another would be
to work through the logic of organization. 5 If Donaldson Brown (1924) and
Alfred P. Sloan (1964) are to be believed, General Motors devised and
implemented the M-form innovation in a very conscious, deliberate, pur-
poseful fashion.i6
But I do not insist on an intentional explanation. It could be that the M-
form was one of many spontaneous organizational innovations that occurred
at about the same time. Conceivably, some of these (undescribed) organiza-
tional innovations might have been objectively superior to the M-form. That
the M-form won in the resulting competitive contest was not because it
possessed intrinsic merit but because it was favored by chance and/or
mindless imitation by others.
The problem with reasoning of this kind is that anything goes. As I have
argued elsewhere, if a compelling evolutionary argument for or against an
efficiency outcome cannot be made, then plausible efticiency arguments must
be assessed differently. Abstract selection logic gives way to an examination
of refutable implications [Williamson (1988c, p. 177)]. I therefore propose
that the data bearing on the M-form hypothesis be examined in relation to
Kays rival hypothesis. The M-form hypothesis is this (1971, p. 367; emphasis
in original):
the organization and operation of the large enterprise along the lines of the
M-form favors goal-pursuit and least-cost behavior more nearly associa-
ted with the neo-classical profits-maximization hypothesis than does the U-
form organizational alternative.
Kays rival hypothesis is.. . ???
3. Concluding remarks
Transaction cost economics needs to be refined and extended. It needs to
be qualified and focused. It needs to be tested empirically. Criticism can help
in all of these respects.
Kays paper contributes to the dialogue. But much of his argument is
confused and/or confusing. Not only are many of his arguments mistaken
(as, for example, the false hierarchies claim), but many of the purported
15To be sure, the logic [Ashby (1960) Simon (1962)] of the ultrastable system had not yet
been worked out. Brilliant managers (of which Alfred P. Sloan, Jr. was one) nonetheless appear
to have intuited the benefits of near-decomposability.
r6The words conscious, deliberate, purposeful are borrowed from Chester Barnards charac-
terization of cooperation in the business firm (1938, p. 4).
350 O.E. Williamson, Markets, hierarchies, and the modern corporation
shortcomings of transaction cost economics already have been or can dealt
with by an extension or refinement of transaction cost reasoning.
Kay advises that we re-read Coase. I always find that instructive. He also
suggests that insights can be gleaned from the property rights literature. I
concur and hope that the foregoing indicates that this not only can be done
but has been going on.
More generally, transaction cost economics has displayed the capacity for
growth. To be sure, transaction cost economics may play out as the better
parts are incorporated within and refined by orthodoxy. Indeed, that too has
been going 0n.l But transaction cost economics has also been an unfolding
perspective in both deepening (older applications) and widening (new
applications) respects. Since I regard the past as the best predictor of the
future, I project continuing vitality - at least over the next decade.
The new orthodoxy to which I have reference works out of an incomplete contrasting setup
[the key article here being that of Sanford Grossman and Oliver Hart (1986)]. Interestingly,
some of the language and many of the concepts of transaction cost economics - bounded
rationality, opportunism, information impactedness (including the distinction [Williamson (1975,
pp, 31-37)] between observability and verifiability), asset specificity, incomplete contracting,
hostages, governance, and the like - now appear routinely in the formal modelling literature.
David Kreps examination of transaction cost economics in his recent microeconomic theory
text is illuminating (1990, Chapter 20).
See note 2, supra.
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