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.

The Economics Prize Went to ...

Sunday, when I took a stab at predicting that the Swedish central bank would do, I distinguished two different sorts of recent award recipient -- those who may not have any economic background, but whose work drew economic applications from game theory considerations, and those who certainly had an economic background, and whose work fits within the traditional, autonomous, body of economic theory.

Monday, the prize committee gave its award to two people -- one of each of those two descriptions.

Today I'll say something about one of them, leaving the other for next week (and leaving the latest developments in the Bear Stearns trial until tomorrow).

Let's begin with the phrase "the tragedy of the commons," which was coined by Garrett Hardin, in a seminal article in 1968. This is a variant of the game theory conception of the "prisoner's dilemma (PD)" As you may know, the point of the PD is that decisions rational for each of the prisoners taken separately will lead to a sub-optimal result for both of them. In Hardin's variation, there are no human interrogators getting between the "prisoners," so the focus not on who outsmarts whom, but on how humans use their natural resources.

Hardin asked his readers to think of a common patch of land in the middle of an agrarian village, in which custom provides that any village member can let his cattle graze on that land.

The tragedy is that actions that are individually rational will prove collectively disastrous. Each herdsman will fatten up his own cows as much as possible, increasing their value as beef. All the benefit of that over-grazing goes into his own pocket, whereas he only bears a fraction of the risk from it -- the risk of overgrazing.

Wars or disease may delay a day of reckoning over time -- even for centuries. But when there is a social equilibriumn for long enough to allow full sway to the profit maximizing choice, then the commons will be over-grazed, and will become useless.

Hardin's parable has been invoked by two different sets of people -- regulators and libertarians. The former say, "This shows why we have to regulate the use of common property, such as the atmosphere or water rights, to avoid the equivalent of over-grazing." The latter say, "The best choice is generally to privatize the commons -- each rancer will worry about the long-time future of his own plot when it really is his own," though in the case of the atmosphere, applying that insight requires some ingenuity.

Hardin's parable continues both to fascinate and to depress. For one wants to believe that a smal group, a village or a co-op, not necessarily organized on hierarchical lines, and not necessarily reliant on a charter from Delaware, could manage to maintain a commons over a long period of time. Are we so pathetic as a species we can't manage that?

This brings us to the work of Elinor Ostrom, one of the two new economics laureates. She is not trained in economics, but in political science, and she approached the problem of the tragedy of the commons with the instincts of a historian. Thus, she came to write Governing the Commons: The Evolution of Institutions for Collective Action (1990).

She has asked in effect: have there in fact been communities that have handled their common property well over a long period of time? and, if so, what can we say about how they have done this? She applied the old rule: whatever is actual, is possible. Various sorts of commons' -- forests and fisheries, for example -- have proven susceptible to community use without over-use along the lines Hardin's model predicts.

I don't think she gets us to a "comedy of the commons," but her work does help to mitigate the sense of tragedy.