Firms and Transactions Costs

Last week, I wrote a few inadequate words about one of this year's Nobel laureates in economics, Elinor Ostrom.

Today, I will say a few about the other winner, Oliver Williamson. His work, as it turns out, cuts close to the core subject of this blog, the struggle for power in the corporate suites.

Williamson throughout his career has concerned himself with what is called the "theory of the firm." Crudely put, this is an effort to answer the question: why are some activities undertaken within a firm, and others are contracted for outside of its boundaries, in the market?

Suppose some firm (a corporation in the business of manufacturing widgts) owns the office building where it is headquartered. It could contract with another firm for janitorial services, or it could hire its own on-payroll janitors. In the one case, the maintenance functions of that building would be a market transaction, in the other case they would be a matter decisions made by the in-firm hierarchy. Obviously some firms do the one and other firms do the other. What determines which is which?

Williamson picked up on earlier work answering this sort of question by Ronald Coase (who received the Nobel himself in 1991). The Coase-Williamson answer is that there are costs as well as benefits in contracting a function out. There is the cost of searching among the possible providers, and checking among the competing maintenance servicers to see who has the better price, who has the fewer customer complaints and so forth. All of that requires time and expense. There are also costs asociated with striking a bargain with the outsiders, and costs associated with policing and enforcing compliance with the deal struck.

On the other hand, taking janitors onto the payroll, and creating an inhouse maintenance department for them, has costs, too. Just for example: there are various legal distinctions between "big business" and "small business" designed to favor the latter, and many of those distinctions turn on the number of employees. So creating such a department may push a firm past one or more thresholds whereby it will be treated more rigorously by the law of its jurisdiction as a "big business."

Separately, though, there is possibility that the in-house operation will be lazier than an outsourcing company. For that matter, so might a formally outsourced maintenance company with a sufficiently secure long-term contract. In either case, they won't be as "hungry" in a competitive sense as the widget making corporation might want them to be.

Williamson's point was the apparently simple one that both hierarchical and contractual means of solving a particular problem have costs, and that the relative size of those costs will differ from case to case. Businesses will tend to the approach that economizes on their costs. Or, as the press release put out by the Prize Committee says, Williamson say markets and firms as "represent[ing]. alternative governance structures which differ in their approaches to resolving conflicts of interest."

That is simple enough to say, but more complicated to work out in in sufficiently impressive detail to make a scholarly impression. Williamson did so, and contributed to the development of scholarly rigor in discussions of a range of issues in corporate governance.