The Theory of the Firm as Governance Structure: From Choice to Contract
Oliver E. Williamson
Oliver E. Williamson is Edgar F. Kaiser Professor of Business Administration, Professor of Economics, and Professor of Law at the University of California, Berkeley, California. His email address is . The helpful advice of Timothy Taylor and Michael Waldman for revising this manuscript is gratefully acknowledged.
2 The propositions that organization matters and is susceptible to analysis were long greeted by skepticism by economists. To be sure, there were conspicuous exceptions: Alfred Marshall in Industry and Trade (1932), Joseph Schumpeter in Capitalism, Socialism, and Democracy (1942), Friedrich Hayek (1945) on knowledge. Both institutional economists (Thorstein Veblen (1904), John R. Commons (1934), and Ronald Coase (1937)) and organization theorists (Robert Michels (1915), Chester Barnard (1938), Herbert Simon (1947), James March (March and Simon, 1958) and Richard Scott (1992)) also made the case that organization deserves greater prominence. One reason why this message took a long time to register is that it is much easier to say that organization matters than it is to show how and why.1 The prevalence of the science of choice approach to economics has also been an obstacle. As developed herein, the lessons of organization theory for economics are both different and more consequential when examined through the lens of contract. This paper examines economic organization from a science of contract perspective, with special emphasis on the theory of the firm.
The Sciences of Choice and Contract Economics throughout the 20th century has been developed predominantly as a science of choice. As Lionel Robbins famously put it in his book, The Nature and Significance of Economic Science (1932, p. 16), “Economics is the science which studies human behavior as a relationship between ends and scarce means which have alternative uses.” Choice has been developed in two parallel constructions: the theory of consumer behavior, in which consumers maximize utility, and the theory of the firm as a production function, in which firms maximize profit. Economists who work out of such setups emphasize how quantities are influenced by
3 changes in relative prices and available resources, a project which became the “dominant paradigm” for economics throughout the twentieth century (Reder, 1999, p. 48). But the science of choice is not the only lens for studying complex economic phenomena, nor is it always the most instructive lens. The other main approach is what James Buchanan (1964a, b, 1975) refers to as the science of contract. Indeed, Buchanan (1975, p. 225) avers that economics as a discipline went “wrong” in its preoccupation with the science of choice and the optimization apparatus associated therewith. Wrong or not, the parallel development of a science of contract was neglected. As perceived by Buchanan (1987, p. 296), the principal needs for a science of contract were to the field of public finance and took the form of public ordering: “Politics is a structure of complex exchange among individuals, a structure within which persons seek to secure collectively their own privately defined objectives that cannot be efficiently secured through simple market exchanges.” Thinking contractually in the public ordering domain leads into a focus on the rules of the game. Issues of a constitutional economics kind are posed (Buchanan and Tullock, 1962; Brennan and Buchanan, 1985). Whatever the rules of the game, the lens of contract is also usefully brought to bear on the play of the game. This latter is what I refer to as private ordering, which entails efforts by the immediate parties to a transaction to align incentives and craft governance structures that are better attuned to their exchange needs. The object of such self-help efforts is to better realize the “mutuality of advantage from voluntary exchange…[that...
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