Transaction Cost Economics

By Scott E. Masten (Stephen M. Ross School of Business, University of Michigan)

Transaction cost economics (TCE) and the New Institutional Economics (NIE) have been virtually synonymous since the 1975 publication of Oliver Williamson's Markets and Hierarchies, with its first chapter titled "Toward a New Institutional Economics." Pretty much anyone working on organizational or institutional issues will be familiar with aspects of the transaction cost framework. The number who would regard themselves as "transaction cost economists," however, is considerably smaller.

Although the club of TCE cognoscenti is not quite that exclusive, full assimilation of transaction cost principles is hardly the norm. To some, especially in business and management areas, transaction cost economics consists almost entirely of the relation-specific investment hypothesis. Others regard TCE as a pre-formal contribution to the analysis of organizations that, while important, has largely been superseded by more modern approaches. For its proponents, however, transaction cost economics represents a distinct orientation or "lens," as Williamson often describes it, for viewing organizational problems. The seminal focal adjustment comes from the "true" Coase theorem, specifically, the insight that any and all gains from cooperation will be realized, in the absence of any impediments to doing so, regardless of organizational form or institutional arrangements. Although a truism, Coase's insight has two immediate implications. First, it focuses our attention on the impediments to cooperation, what we have come to call transaction costs. Second, it means that organizational and institutional arrangements matter only to the extent that transactional frictions differ among them.

The success of Williamson's framework at explaining firm boundaries and contract design largely explains the narrow association of TCE with specific investments referred to above and, by making transaction cost economics easy to "apply," may, ironically, have retarded deeper examination of its methods and implications. One such implication is the centrality of adaptation in the problem of economic organization and the role of organizations and institutions in establishing the processes through which adaptation occurs.

A context that illustrates this process orientation is the choice of remedies for breach of contract. Economists typically view contract remedies as an incentive problem, that of defining appropriately scaled damages to induce efficient performance. The logic that makes process concerns central to analyzing the efficiency of alternative contract remedies also applies to the analysis of organizational forms. Given the same technology, information, and actors, anything that could be accomplished within the firm could, in principle, also be accomplished in a market transaction (or any other arrangement), and vice versa. Again, what varies as transactions are relocated from one organizational form to another are the processes through which adaptations can be effected: the rights, duties, procedures, and sanctions associated with each arrangement and, hence, the tactics transactors can employ.

None of this should be read as a rejection of other approaches to organization. TCE is informed by agency and game theory. And parallels can certainly be drawn between the concepts and concerns of transaction-cost economics and other theories. Concerns with the effects of bounded rationality, opportunism, and asset specificity in transaction-cost economics overlap more mainstream concerns with information asymmetries, moral hazard, and bilateral monopoly. For some problems, however, TCE provides unique and useful insights and has produced a body of testable implications and a largely supportive empirical literature.

Why aren't there more transaction cost economists?

TCE has been difficult to model. The central behavioral attributes, bounded rationality and opportunism, are notoriously difficult to model. The world of non-zero, finite transaction costs is where much of the action is, however, and the reluctance to incorporate positive transaction costs show signs of receding in mainstream modeling.
TCE is difficult to do. As Cheung noted, "transaction-cost economics is real-world economics, and the real world is too often a place where academic economists fear to tread."
TCE is difficult to teach. A transaction cost orientation seems to be best acquired through repeated confrontation with deep and often subtle organizational puzzles, a regrettably unappealing learning technology for the impatient.

Transaction Cost Economics

Why aren't there more transaction cost economists?

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