An Austrian Critique of Transaction Cost Theory

An Austrian Critique of

Transaction Cost Theory En østrigsk økonomisk kritik af transaktionsomkostnings teori

A paper at the School of Economics and Management, Aarhus University

Course: 4810: Topics in Economics and Management – 10 ECTS Written by: Jesper Juul Andersen Student ID: 20062256 Supervisor: Niels Peter Mols Hand-in date: 28-01-2011 The paper may be publicized Internal grading

An Austrian Critique of Transaction Cost Theory – Jesper Juul Andersen – Arhus University – School of Economic and Management

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Contents

Contents ............................................................................................................................................................ 2

Introduction ....................................................................................................................................................... 3

The Austrian Understanding of the Market ...................................................................................................... 4

Human Action ................................................................................................................................................ 4

The Use of Knowledge in Society .................................................................................................................. 5

Solving the Hayekian Knowledge Problem ................................................................................................ 5

The Entrepreneur .......................................................................................................................................... 6

The Pure Entrepreneur .............................................................................................................................. 7

Entrepreneurial profit, alertness and knowledge ..................................................................................... 8

Disequilibrium Analysis.................................................................................................................................. 9

The Evenly Rotating Economy ................................................................................................................... 9

The Equilibrating Entrepreneur ............................................................................................................... 10

An Austrian Critique of Transaction Cost Theory ............................................................................................ 11

A Critique of Equilibrium analysis ................................................................................................................ 11

The Market Theory Problem ....................................................................................................................... 12

Transaction Cost Theory and the MTP ........................................................................................................ 13

Equilibrium used as a foil, description or benchmark? ........................................................................... 14

Uncertainty and open ended vs. closed view of the universe ................................................................ 15

Information and Knowledge .................................................................................................................... 16

Disequilibrium analysis and the (Absent) Entrepreneur ......................................................................... 16

Conclusion ....................................................................................................................................................... 17

References ....................................................................................................................................................... 19


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Introduction

Transaction Cost Theory (TCT) is one of the most successful explanations for the existence of the Firm. It

has become one of the dominant explanations, and is also supported by a substantial empirical litterateur.

(David & Han 2004.) However it has also its fair share of critics, one of them being the Austrian school of

economics. (Foss & Klein 2010a)

The Austrian school has only in recent years seen an emerging litterateur within the theory of the firm. Foss

(1994a) finds this a puzzle, since the Austrian School have had many relevant tools early in its development

in the thirties, which if put together, could be the building blocks for a new theory of the firm based on the

Austrian principles and market understanding. Both Williamson (1985:47), which pioneered TCT, and scho-

lars within the Austrian tradition, such as Foss (1993, 1994a) and Klein (1996), predicts that research across

transaction cost theory and the Austrian School of Economics could be a rewarding exercise. This paper will

try to do this by giving a critique of TCT from the viewpoint of the Austrian School. Even though a critique

may not seem to be the obvious way to start collaboration between these two approaches, it is important

to know the differences between the theories, before it is possible to assess the potential outcome of com-

bining them.

I will in this paper give an Austrian critique of Oliver Williamson's Transaction Cost Theory by showing how

TCT is suffering under what Frederic Sautet (2000) calls the “market theory problem” (MTP). The MTP is the

inconsistency involved in trying to answer questions (such as; why does firms exist?) that would not exist in

an equilibrium-always world, by using equilibrium theory. Thus it exists if a market theory uses the equili-

brium concept as a benchmark, as a description of reality, or as an instrument (Sautet 2000.) I will in my

last half of this paper show how TCT suffers from the MTP.

To understand the MTP we must first understand the Austrian understanding of the market. To get this

understanding it will be important to go through the basic notion of human action by Ludwig Von Mises,

the Hayekian knowledge problem, the entrepreneur as understood by Israel Kirzner, and at last explaining

why competition and the entrepreneur cannot be separated. At this is point, it will be clear that the market

in the Austrian tradition is understood as a process and not as a state.

In my presentation of the Austrian understanding of the market, I will as key sources use the classical works

of the Austrian School and will abstain from including later investigations of these theories. I will do this,

partly because Austrian economics is an a priori science, a science where the propositions is based on logic

and not empirical observations,1 but also to give a short and general description of the theory. In the criti-

que of TCT, Williamson and his works will be my focus. I will base my critique on the critique already pre-

sented by especially Frederic Sautet (2000), Nicolaj Foss (1993, 1994b) and Esteban Thomson (1992.) These

are from the latest wave of contributions to the Austrian school, which has taken the firm up as a subject of

interest.2

1 This is one of the major distinguishing mark of Austrian School of Economics, when compared to other schools of

economics. Hoppe (1995) 2 I will throughout this paper integrate my citations in the text by putting them in cursive, and make my reference in

the footnotes. I have done this to integrate the citations smoothly in my own text.


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The Austrian Understanding of the Market

In the first half of this paper, I will go through the Austrian understanding of the market process. First I will

introduce the notion of human action and the Hayekian knowledge problem. With the notion of human

action the entrepreneur can be introduced, who will play a crucial role in how the market solves the Haye-

kian Knowledge Problem. At last it will all be put together, so it becomes clear that Austrian economics is

not an analysis of equilibrium, but an analysis the market process and disequilibrium.

Human Action

I will in this section describe the basic notion of human action as theorized by Ludwig von Mises in his mag-

num opus of same name, Human Action. This concept is important for most Austrian Litterateur and will be

crucial for the understanding of the market process; especially the entrepreneur.

Ludvig von Mises defines human action as purposeful behavior. And he continues: Action is will put into

operation and transformed into an agency, is aiming at ends and goals, is the ego’s meaningful response to

stimuli and to the conditions of its environment, is a person’s conscious adjustment to the state of the un-

iverse that determines his life.3,4 The difference between action and Mises notion of human action is that

the observer attributes a goal to the action. Human action is in other words different from reflexive beha-

vior, such as vomiting from drinking too much alcohol. Human action is purposeful behavior; it is conscious

behavior. If man suppresses reflexive behavior, then this is human action, as it is conscious and from our

point purposeful (Mises 1949.)

The study of human action is named praxeology. The science of praxeology contains the results deduced

from the fact that people have goals, which they seek to obtain by selected means. It is not the science of

the psychological events which result in the action, but the human action itself.

An action is a choice which involves both taking and renunciation, one alternative is chosen before another.

In other words praxeology is the study of means and ends. No man is in a position to superimpose his own

value judgment on others and tell another acting man what will remove his uneasiness or make him happy.

This means that every end is as such rational5 (Mises 1949.)

Mises list three prerequisites for human action. First of all, acting man must be in a state of uneasiness, if

he was in a state of full satisfaction he would have no incentive to change things. Furthermore acting man

must be able to imagine a state of higher satisfaction; he must imagine that he can remove his uneasiness.

The final and third condition for human action is causality, the expectation that purposeful behavior will

remove the felt uneasiness (Mises 1949:14.)

3 Mises (1949:12)

4 The definition and existence of human action is also called the Action Axiom since it is true by definition, any at-

tempts to disprove it will only validate it, but since it is not my goal to prove this, I will take the action axiom as true. (Hoppe 1995.) 5 And all human action is therefore by definition rational action. This rationality concept differs substantial from the

neoclassical rationality concept, and also from the concept of bounded rationality used in TCT (Williamson 1985.)


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Even though the subject of human action and praxeology is in no way exhausted, this is enough to describe

the Austrian understanding of the market process. Thus I will move on to the next stepping stone on our

path, namely the understanding of knowledge and the use and discovery of it in the market process.

The Use of Knowledge in Society

My headline for this section is also the title of F.A. Hayek’s famous paper from 1945. According to Hayek,

the main economic problem which society faces is that of the utilization of knowledge not given to anyone

in its totality6. There of the title of his paper, and also that of my section.

Thus, the economic problem of society is not to find the best available use of means, given all relevant in-

formation, including a predefined set of preferences and knowledge of all the means and ends. If so, the

problem would be purely one of logic, namely the well known result that the marginal rates of substitution

between two commodities must be the same (Hayek 1945.)

Knowledge in reality only exists as dispersed bits of incomplete and frequently contradictory information

which all the separate individuals possess.7 This is especially true for what Hayek calls the knowledge of the

particular circumstances of time and place.8 This is what I will call local knowledge, and a concept which will

turn out to be important for the Austrian understanding of the market and the entrepreneur. Hayek also

identifies the other main type of knowledge, scientific knowledge. This is knowledge which may be put in

the hands of an authority; here a body of experts could command all available information. This is however

not a possibility for local knowledge. Local knowledge cannot by its definition be centralized. Most of this

knowledge is tacit in nature. For example the knowledge of how to operate a machine, avoid downtime,

make repairs on the repairs which have altered it from the originally drawings; this is knowledge which is

hard to centralize. Another example is the tradesman who works as an arbitrageur by selling and buying

over time or geographical distance, he can only do this because of his local knowledge. Yet another exam-

ple of local knowledge is unrevealed preferences. Since these preferences is not acted upon they are unre-

vealed, and they are therefore hidden from all other than the person holding them (Hayek 1945.)

Solving the Hayekian Knowledge Problem

The Austrian theory of the market process in Hayek’s view aims at explaining how knowledge reaches those

who need it. How the market solves this problem, and thereby coordinates knowledge between the market

participants, can be shown by an imaginary example:

Let us start with considering a single commodity market in competitive equilibrium. Each participant knows

the price and does not need to know more than this to trade without disappointment or regret. Now an

external event happens that shifts the supply curve left. Market prices will rise and buyers will start econo-

mizing on this commodity. This happens without the need to know why the price rose. This is the achieve-

ment for the market, for it solves the knowledge problem by using disperse information without one single

mind planning the process, and at the same time economizes on the information. This is what Hayek calls

the marvel of the market.

6 Hayek(1945 (in Hayek 1948:78))

7 Hayek(1945 (in Hayek 1948:77))

8 Hayek(1945 (in Hayek 1948:80))


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I will now follow Kirzner (1992) and elaborate on how this price adjustment happens, and show that the

Hayekian Knowledge problem in fact consist of two knowledge problems, which both arises because of

dispersed knowledge, but results in two different errors, to be solved in two different ways.

Knowledge problem A comes to existence when a seller is overly optimistic, and offers to sell at a price

above what the buyers want to buy at. This situation is possible since the seller does not know what other

market participants know about them self; their reservation price. So because of this disperse knowledge

the market may fail to clear.

This error is however self-revealing. The seller knows there is a problem since his offer did not get ac-

cepted. Hayek explains that the relevant knowledge which he (an individual) must possess in order that

equilibrium may prevail is the knowledge which he is bound to acquire in view of the position in which he

originally is, and the plans which he then makes.9 So knowledge problem A is so to say, self-correcting.

Knowledge problem B is the other side of the story. To describe this I will use an imaginary construct of two

markets completely separated by an invisible wall. In each of these markets Knowledge Problem A has been

solved and two different market clearing prices exist10. These two prices mean that someone in one of the

markets has overlooked the possibility to buy the commodity cheaper in the other market. Also, other par-

ticipants have refrained from buying in the high priced market, since they had a reservation price below the

price the product was offered at, even though they could have bought it in the lower priced market. And in

the lower priced market, some sellers have refrained from selling at the low price, but they would have sold

in the high priced market. Here the market participants are not overly optimistic, but simply unaware of the

price they might be able to obtain or buy at. They act as they were overly pessimistic about the prices (Kirz-

ner 1992.)

Knowledge problem B is not self revealing; it does not lead to an unrealized plan, but to failure to obtain

potential gains, as they do not perceive them. This problem is not self-correcting, and both of these prob-

lems of course have to be solved before a market clearing price will arise. How will the market overcome

this problem, how will people learn about others, what they do not know, they do not know?

The answer is that this problem creates an incentive for its solution by discovery in the activity of the profit

alert entrepreneurs.11 The knowledge of this profit opportunity first has to be discovered by an entrepre-

neur. The entrepreneur has to realize that the wall is invisible, and he can trade in both markets. How this

is done will be explored in more detail later, but for now I will go on to identifying the entrepreneur in

depth, before exploring his role in the market process.

The Entrepreneur

Now I will use our description of human action to introduce the entrepreneur, so I later in detail can estab-

lish his role in the market process. The entrepreneurs’ behavior and action is best described by the Mise-

sian concept of human action. This is opposed to the classical understanding of human behavior; here the

9Hayek (1936 (in Hayek 1948:53)) My comments in brackets

10I will point out that the use of the equilibrium concept in this section is a good example of how Austrians scholars

use it. It used as a foil to contrast changes against. More on this in later chapters. 11

Kirzner(1992: 170)


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individual is allocating his scarce means towards his given ends. This is according to Kirzner (1973) best

described by the discussion of Lionel Robbins (1932.) Here the individual is faced with the problem of how

to allocate his resources, so he will reach as many as his ends as possible. He is economizing his resources

to obtain certain ends. Mises human action on the other hand involves action to remove uneasiness. It is

not merely a reflection of the manipulation of given means to correspond faithfully with the hierarchy of

given ends, but also the very perception of the ends-mean framework.12 To put it differently, the agent in

Austrian market theory does not only economize on the given means, he can also identify which means are

available and which ends he should strive for by using his alertness and drive. Austrian economics thus have

a broader view of individual behavior and actions. The ends-mean framework there is prevalent can thus be

explained in the Austrian market process theory as a result of human action (Kirzner 1973.)

Above it was mentioned that the individual identifies these ends and means by being alert. This requires

some elaboration as to what alertness is. Alertness to possibly new worthwhile goals and to possibly newly

available resources is what Kirzner calls the entrepreneurial element in human decision making.13 He elabo-

rates further on alertness in the book: Discovery and the Capitalist Process (Kirzner 1985). Alertness must,

importantly, embrace the awareness of the ways the human agent can, by imaginative, bold laps of faith,

and determination, in fact create the future for which his present acts are designed.14 It is this element

which explains the creativity and innovative part of the human. Whereas the Robbinsian economizer is

rather passive and mechanic, as he does not seek out new means, or becomes aware of new and better

ends, the Austrian entrepreneur is creative and active.

The Pure Entrepreneur

Now I will characterize the pure entrepreneur, whose role only exists because of his alertness to not pre-

viously seized opportunities. He might not exist, but nevertheless will this help us in characterizing the role

of the entrepreneur in the market process. This is no different than when we talk about the consumer, the

landowner, the laborer or the capitalist. But we have to keep in mind, that the entrepreneur is more an

element inherent in every human actor, than a specific person (Mises 1949.)

The entrepreneur will only exist in a world of imperfect knowledge; he is a decision maker whose sole role

is to be alert to hitherto unnoticed profit opportunities. To create this pure entrepreneur we have to envi-

sage a decision maker, who starts out with no means whatsoever. This decision maker, this entrepreneur,

would not exist was it not for information asymmetry, since he would have nothing to do without any

means. His role is solely to be alert to profit opportunities. In this way he identifies for example a seller,

who sells for prices too low. He could rent the resources for this product and use them in the production of

another product, he could rent another resource he has knowledge of and add it to the production, or he

could simply buy the product and sell it for a profit to those who will pay the higher price (Kirzner 1973.) He

is bridging the knowledge gap by using his alertness to profit opportunities.

By the use of this pure entrepreneur, the economic agents can be divided into entrepreneurs and econo-

mizers. The economizer optimizes by taking the ends-means framework for given, they are passive price

12

Kirzner (1973:33) (both citations) 13

Kirzner 1973:35) 14

Kirzner (1985:56)


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takers. The entrepreneurs are the ones who are causing changes in prices, quantities and qualities. Thus in

this world with imperfect knowledge changes cannot be explained without the entrepreneur (Kirzner

1973.)

The pure entrepreneur can be hard to identify. An example of an almost pure entrepreneur could be the

arbitrage hunter, who for example knows that the price of meat is higher in Latvia than in Denmark and

trades thereafter. But by making a single simplifying (though unrealistic) assumption, the producer can be

identified as an entrepreneur. The producer can be seen as a resource owner, who contributes resources

for the conversion of inputs to products. This resource owner could contribute with his ability to run a fac-

tory effectively, or the ability to calculate the optimal input and output, or simply just the capital. But if we

assume that production is instantaneous and he hires all resources, he can be seen as a pure entrepreneur.

The producer-entrepreneur realizes an opportunity in front of him by the help of his alertness and hires the

resources and sells a product on a market. He identifies a lack of coordination in the market, he either sees

resources used to produce products less needed than another product, or he may see products been pro-

duced with very costly resources. Either way he identifies this opportunity and improves the coordination

of the market. To do this he does not need anything else than his alertness.15 (Kirzner 1973.)

But production is not instantaneously, it takes time. From the above discussion it can be seen that the pro-

ducer actually takes two functions, that of the entrepreneur and that of the resource owner. The resource

owner is the pure Robbinsian optimizer and the entrepreneur is alert and solves a coordination problem. It

gives us a very clear way of understanding the difference between an entrepreneur and a Robbinsian opti-

mizer. The optimizer allocates given resources between ends in the production, the better he is at this the

higher he is paid; he is a resource owner and is paid hereafter. The entrepreneur investigates which re-

sources and which products should be produced. And the entrepreneur is paid a profit. As will be explained

below, entrepreneurship is not to be seen as a factor of production (Kirzner 1973.)

Entrepreneurial profit, alertness and knowledge

Pure entrepreneurial profit is the difference between the two sets of prices16 which the entrepreneur buys

and sells at. This is the reward for his alertness by which he discovers the lack of coordination in the mar-

ket. This is obtained without giving anything back. The entrepreneur is not exchanging something he values

less for something he values more; he does not make an investment nor is he in any way a resource owner.

Pure entrepreneurial profit is pure arbitrage, even though this requires an investment. The profit after in-

terest is paid on the investment is still arbitrage. Thus by involving capitalists who own resources and are

willing to lend these out for a fee (interest or wage), entrepreneurship over time becomes possible. The

entrepreneur may also own resources himself, however there will still be an entrepreneurial profit part and

a pay for use of the resources (Kirzner 1973.) This feature of the Austrian market process is no distinctive

landmark of the Austrian School, since it is well established among most accounting, finance and manage-

ment theories. However it, as Kirzner notes, emerges with exceptional clarity within this framework.17,18

15

And thus there is not a need for capital. If production was not instantaneous the producer would still need a capital to take ownership over time. 16

Kirzner (1973:48) 17

Kirzner (1973:50)


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Alertness is not to be mistaken for superior command over information, as this is easily a thing which most

academics or experts have. These will be paid as a factor of the production and is just another resource

owner. However it is still the lack of coordination in market knowledge, which allows entrepreneurial profit

and behavior. If all economic agents knew everything, then there would be no need for the entrepreneur, it

would be a state without uncertainty. So we need ignorance for this. But we live in a world of ignorance

because much of our knowledge is the previous mentioned local knowledge. Alertness must not be seen as

knowledge about market data, but knowledge of where to find market data19. It is alertness to information

in whatever form the entrepreneur may encounter or seek it (Kirzner 1973.)

Disequilibrium Analysis

In the above section about the entrepreneur it was mentioned that in a world with imperfect knowledge, it

will not be possible to explain changes without the entrepreneur. I will, before explaining how the entre-

preneur fits into disequilibrium analysis, discuss the Austrian understanding of equilibrium analysis, and

what the proper use of it is.

The Evenly Rotating Economy

To quote Mises; “Action ultimately aims at bringing about a state of affairs in which there is no longer any

action, whether because of all uneasiness has been removed or because any further removal of felt uneasi-

ness is out of the question”20 This sums up the Austrian take on the equilibrium concept, or as Mises calls it

the final state of rest.21 This is an imaginary construct which will never occur, however it is still important

since it is the ultimate goal of acting man. Before this stage of the economy is realized, disturbing factors

will derail the economy from its path. The reason for this is the passing of time, as the factors which affect

the economy do not occur at the same time. In this final state of rest, or equilibrium as most economists

know it, the final price is given not by historical prices, but by the conditions for it to emerge (Mises 1949.)

The final state of rest is as such just the eternal goal of the economy, a goal which will never be realized.

But as a tool for economic analysis Mises uses the concept of the evenly rotating economy, in which

changes in market data and time is removed. In this economy prices have reached the final prices, as de-

fined by the final state of rest, and there is perfect price stability. Quantities and production stages remain

the same and the same transactions are done over and over. It is not static but revolves evenly round a

fixed center, it rotates evenly22. This imaginary construct can then be used to contrast different changes in

market data (Mises 1949.) Austrian uses equilibrium as a foil, it is nothing more than a way to allow econ-

omist to think in a simple and clear way, by introducing an isolated factor and analyzing the effect of this

keeping all other things equal (Boettke 1997.)

18

This view of entrepreneurship is very close to that of Frank H. Knight. Entrepreneurship represents for him judgment under true uncertainty that cannot be assessed in terms of its marginal product and which cannot, accordingly be paid a wage. As we will see later, the absence of Knightian uncertainty will be a characteristic of the MTP. (Knight 1921:310-312) 19

Kirzner (1973:67) 20

Mises (1949:245) 21

Mises (1949:246) 22

Mises (1949:242)


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The Equilibrating Entrepreneur

In the evenly rotating economy there is no entrepreneurs, there is only automated and mechanical action,

so we will have a world only with Robbinsian optimizers, who acts within a given ends-means framework.

Since everyone knows everything in this evenly rotating economy there is no need for the entrepreneur

(Kirzner 1973.) This final state and the evenly rotating economy are not our main interest, the interesting

part is how the decisions of the individual market participants in the market interacts to generate the mar-

ket forces which compel changes in prices, in outputs and in methods of production and allocation of re-

sources.23

This is what is meant when the Austrian talks about disequilibrium theory. They are not interested in the

criteria for equilibrium since it well never occur; equilibrium is only a tool for analysis. How the market

moves outside equilibrium and which institutions brings it towards equilibrium, is the subject economists

wishes to investigate, when studying economics in an Austrian framework (Yeager 1997.)

The state of disequilibrium is characterized by ignorance and unawareness of some of all the possible ex-

change opportunities. There is room for improvement and a higher degree of market coordination. If the

world was made up of Robbinsian optimizers then we would get nowhere, since everyone would assume

that the same ends and means which was available yesterday also will be available tomorrow (Kirzner

1973.)

In the section on the use of knowledge in our society I went through how the market solves the main eco-

nomic problem in the eyes of Hayek, namely the Hayekian knowledge problem. The entrepreneur plays a

very important role in how the market solves this problem; he solves the before mentioned knowledge

problem B. Knowledge problem B was not self revealing; it lead to failure to obtain potential gains. The

entrepreneur realizes this because he is alert to profit opportunities. He sees that a buyer is willing to pay,

say DKK 100 for a service, but every other market participants thinks he is only willing to pay DKK 80. There-

fore nobody is offering this service, since resources can be used better for other ends. The entrepreneur

discovers this opportunity and takes action (Kirzner 1992.)

The entrepreneur is an essential part of the market process in Austrian economics. He is the force which

brings the market towards equilibrium.24 He brings change, which corrects the existing patterns of mis-

takes. The entrepreneur and the market process are inseparable.

23

Kirzner (1973:6) 24

This is the exact opposite of the widespread understanding of the entrepreneur advanced by Joseph Schumpeter. Here the entrepreneur is a disequilibrating force which brings the market away from equilibrium by creative destruc-tion. The entrepreneur does this by entrepreneurial innovation and he generates new opportunities (Schumpeter 1934.) Kirzners entrepreneur brings the market towards equilibrium by realizing that existing opportunities exist and increases coordination by seizing these opportunities in the search for profit.


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An Austrian Critique of Transaction Cost Theory

Now for the main purpose of this exposition; an Austrian critique of Transaction Cost Theory. Before I move

on, I will go through a simple and convenient tool for this; the market theory problem (the MTP). The MTP

is the inconsistency involved in trying to answer questions that would not exist in an equilibrium-always

world,25 by using a theory build upon an equilibrium theory framework. The critique of TCT can be seen as a

special case of the Austrian critique of neoclassical economics. Therefore I will first go through the Austrian

critique of equilibrium analysis, or rather a critic of the misuse of equilibrium concept in the understanding

the competitive process of the market.

A Critique of Equilibrium analysis

Most Austrians do not criticize the concept of equilibrium analysis; rather they criticize what they see as the

misuse of this tool. We have already explained how Austrian economists use equilibrium as a tool for analy-

sis, now we will see how the equilibrium concept is used in other schools of economics.

Equilibrium analysis is properly best known through Walras’s Law. Here Adam Smith’s invisible hand is

proven to exist under some very strict conditions.26 It’s the existence of this equilibrium, its stability and

pareto optimality, which the neoclassical school of thought is mainly concerned with. (Boettke & Prychitko

1998.)

Equilibrium analysis is used differently across various other schools of economic thoughts. Boettke (1997)

identifies three uses of equilibrium theory. Keynesian have often used it as an indictment, as a benchmark

to measure the real world and any suggested changes to it. Equilibrium and perfect competition becomes a

static ideal, and if the real world does not live up to this ideal we have an example of market failure. The

Chicago School on the other hand uses equilibrium as a description of reality, here markets act as if they

were in competitive equilibrium (Boettke 1997.) The Chicago school further uses equilibrium as an instru-

ment for predictions. In Chicago style empirical analysis, the assumption of markets in equilibrium is used

as a maintained hypothesis. (Sautet 2000) The Chicago school thus has an “equilibrium always” view of the

market. The problem then becomes that the Chicago school have no way of explaining how markets

achieve equilibrium. The Keynesians on the other hand does not see the coordinative power markets may

have under imperfect information and ignorance (Boettke 1997.) In the Austrian School, departures from

equilibrium are a natural part of the market system. They are caused by human imperfection and are not a

failure of the market, as seen by Keynesians. Even though these two neoclassical schools are concerned

with convergence and stability of equilibrium, the adjustments in the market still becomes footnotes in the

literature and not the main economic problem under investigation.

25

Sautet (2000:10) 26

Walras’s law shows that there exist a price vector which gives zero aggregate demand and therefore the market clearers. This requires zero transaction costs, perfect information, large numbers of buyers and suppliers, and thereby price taker behavior. If these conditions are met, we will have a competitive equilibrium under which the two welfare theorems hold (Boettke & Prychitko 1998.) These conditions are normally known as the perfect competition condi-tions.


12

In a world where everyone is a price taker, the question of how the market moves towards equilibrium, are

unanswered, since there in these equilibrium models is no agent of change. What comes closest is the mys-

terious Walrasian auctioneer (Boettke & Prychitko 1998.) The entrepreneur or his equal is absent.

Mises (1949) put the critic in the following way: The image (the evenly rotating economy or equilibrium) is

merely a tool for our thinking. It is not a description of a possible or realizable state of affairs. It is even out

of the question to carry the imaginary construct of the evenly rotating economy to its ultimate logical con-

sequence. For it is impossible to eliminate the entrepreneur from the picture of a market economy. The vari-

ous complementary factors of production cannot come together spontaneously.27 Thus the Austrian critique

of equilibrium analysis can be summed up as a critique of the use of equilibrium analysis in any way, which

indicates that it is a description of the real world, or an attainable state which can be used for benchmark-

ing.

As mentioned, the Austrian critique is about the misuse of the equilibrium concept. For some potential

areas where the Austrian school could use equilibrium theory see Yeager (1997), Yeager (1999) and Boettke

& Prychitko (1998). I have not mentioned every aspect of the Austrian critique of equilibrium analysis, but

only those relevant for TCT. For other aspects see for example Hayek (1946), Boettke (1997), Mises

(1949:249-252), and Kirzner (1973:26-29). Now I will present the market theory problem as in Sautet

(2000.)

The Market Theory Problem

The MTP is, as mentioned above, the inconsistency involved in trying to answer questions that would not

exist in an equilibrium-always world.28 The MTP exist when a theory uses the equilibrium concept as a de-

scription of reality, an instrument or as an indictment, and at the same time tries to investigate problems

which only exist in disequilibrium. Frederic Sautet (2000) identifies four concepts that represent the core of

Austrian market theory and shows, how the absence of these is the distinguishing mark of the MTP.

Uncertainty: The Austrian understands uncertainty as Knight (1921) understood it, and genuine change can

therefore take place in this open ended universe. This is not stated explicit in the above, but lies implicit in

the concepts of human action and alertness. Since the entrepreneur can create the future, it must neces-

sarily be characterized by genuine uncertainty, because of genuine ignorance of the future. This means it

cannot be modeled by probabilities as in the neoclassical modeling of uncertainty. The MTP is thus charac-

terized by the absence of genuine uncertainty and a closed ended view of the universe (Sautet 2000.)

Information and knowledge: Hayek identified the economic problem as that of the discovery of dispersed

information and not just the allocation of known resources. This is in contrast to the bookshelf approach29

where there is an optimum level of ignorance, a level, which can be found by a simple cost benefit analysis

within a given information framework. So the MTP is characterized by the absence of a need for knowledge

to be discovered, and treatment of information as a commodity (Sautet 2000.)

27

Mises (1949:249) My comments in brackets 28

Sautet 2000:10) 29

Sautet (2000:13)


13

Disequilibrium analysis: This should not need much more elaboration and should be clear from the pre-

vious critique of equilibrium analysis. Disequilibrium analysis is the keystone of the modern Austrian eco-

nomic explanation of the market30. Thus the MTP is characterized by absence of disequilibrium analysis

(Sautet 2000.)

Entrepreneurship: In the imaginary construction of the evenly rotating economy there is no room left for

entrepreneurial activity, because this construction eliminates any change of data that could affect prices.31

Thus the MTP is characterized by the absence of entrepreneurship.

Thus I have presented the basic properties of the MTP. Next is to investigate whether the MTP is present in

Oliver Williamsons transaction cost theory.

Transaction Cost Theory and the MTP

TCT is concerned with the rationale for the firm; it tries to answer why firms exist and why its boundaries

go where they do. Thus it tries to answer a question which would not exist in an equilibrium always world.32

I will start this section with a very short presentation of TCT. I will afterwards give the Austrian critique of

TCT. I will mainly use TCT as theorized by Oliver Williamson in his book “The Economic Institutions of Capi-

talism” from 1985, since TCT and its focus is developed and expanded much from “Market and Hierarchies”

from 1975. However I will still use some of Williamsons other works both the 1975 book and especially

later works.

TCT takes it root in the 1937 paper by Ronald Coase, “The nature of the firm”. This paper was the first to

explain the boundaries of the firm, from the cost of transacting business and not only from the production

cost view. In this framework the decision to organize transactions within the firm as opposed to the market,

the "make or buy decision", depends on the relative costs of internal versus external exchange.

According to Foss (1994b) this Coasian framework branches out in two directions. One being the “nexus of

contracts” approach promoted by for example Alchian & Demsetz (1972) and Jensen & Meckling (1976),

the other being the “Asset Specificity” approach (Williamson 1985.) I will solely focus on the Asset Specifici-

ty branch.

TCT is focused around the notion of asset specificity. Asset specificity exist when an asset have a significant-

ly lower opportunity cost in its other uses, than its value in its present use. This difference being a Marshal-

lian quasi-rent, which can be appropriated through opportunism. This happens when a transaction under-

goes the fundamental transformation. Before the transaction we have a large open market setting, after a

contract is put in place and the transaction is performed, this setting is transformed to small number bar-

gaining situation, due to asset specificity. Thus there is a lock-in effect, due to asset specificity, when a

transaction undergoes the fundamental transformation (Williamson 1985.)

Besides opportunism and asset specificity, bounded rationality, the frequency of the transactions and un-

certainty is the driving force behind the firms’ changing boundaries. The transaction is the basic unit of

30

Sautet (2000:13) 31

Mises (1949: 253) 32

Since under the perfect competition conditions we would not have either uncertainty nor transaction costs.


14

analysis and differs in the way it put strains on bounded rationality and the scope it gives for opportunism.

Opportunism and bounded rationality being behavioral assumptions. The best contractual framework for

the transaction will then depend on the nature of the transaction. The relevant variables used to assess the

nature of the transaction in TCT are the frequency of the transaction, the degree of uncertainty and the

asset specificity of the assets in the transaction (Williamson 1985.)

As market transaction cost rises, it at some point becomes more efficient for the involved parties to organ-

ize the transaction by hierarchy or “intentional governance” instead of the market or “spontaneous gover-

nance” (Williamson 1991a.) This makes the rationale for the existence of the firm. I have in above pre-

sented the theory in a very simplistic way, but as we develop the Austrian critique we will see some more

aspects of the theory.

TCT does draw influence from Austrian theory, especially Hayek (Foss & Klein 2010b). But the theory is still

grounded in neoclassical economics (Williamson 2010), which makes it open to Austrian critique. I will first

investigate in which way Williamson uses the equilibrium concept, and afterwards go through the four con-

cepts, which absence makes the distinguishing mark of the MTP.

Equilibrium used as a foil, description or benchmark?

The fundamental transformation indicates that there is disequilibrium analysis in the works of Oliver Wil-

liamson. Also the use of Hayek and emphasize on the adaption as the central problem of economic organi-

zation (Williamson 1991b) gives the same impression. But as we shall see below, even though Williamson

indeed uses the equilibrium concept as a foil, his use of the equilibrium concept is complex and not consis-

tent through his works (Sautet 2000.)

Sautet (2000) mentions two specific examples of Williamson’s use of equilibrium as a foil. First Williamson

mentions in the first pages of The Economic Institutions of Capitalism that transaction cost analysis ex-

amines the comparative costs of planning, adapting, and monitoring task completion under alternative go-

vernance structures.33 This is possible by the use of equilibrium as method of contrast. Second Williamson

does not see territorial restrictions as anticompetitive. This conclusion is possible because Williamson uses

equilibrium as a foil and not as a benchmark (Sautet 2000.)

It is when we examine the fundamental transformation we see that Williamson also use the equilibrium

concept as a benchmark. Sautet (2000) sees it as a window on Williamson’s theory of the market.34

Williamson says about the fundamental transformation: Monopolistic terms will obtain if there is only a

single highly qualified supplier, while competitive terms will result if there are many. Transaction cost

economics fully accepts this description of ex ante bidding competition but insists that the study of

contracting be extended to include ex post features35. This is a strong example of how TCT is grounded in

neoclassical economics. In the above quote, Williamson uses the neoclassical understanding of competitive

prices and thus uses equilibrium as benchmark. But the fundamental transformation is also using

equilibrium as a foil, as Sautet explains; he (Williamson) shows that if the world is in equilibrium at the

outset (equilibrium as a benchmark), changes can sometimes occur that lead to small-number situations

33

Williamson (1985:2) 34

Sautet (2000:34) 35

Williamson (1985:63)


15

and which explains the existence of specialized governance structures (equilibrium as a foil.) 36 This use of

the equilibrium as a benchmark is overlooked in Foss (1993), which partly explains why Foss evaluates TCT

more favorably than Sautet.

The empirical work of TCT uses the equilibrium concept as description of the world. To investigate TCT em-

pirically, the market assumes to function as a sorting mechanism between different governance structures.

This implies that the world is in perfect competition, and therefore functions as an efficient selecting me-

chanism of different governance mechanisms (Sautet 2000.) Williamson realizes this himself (Williamson

1985:23.)

Thus, I follow Sautet (2000) and conclude that even though Williamson uses equilibrium as a foil most of

the time, he does it in an inconsistent way, which opens the theory up for the Austrian critique.

Uncertainty and open ended vs. closed view of the universe

Uncertainty in TCT mainly comes from the two assumptions, opportunism and bounded rationality.

Bounded rationality, because without this (or rather, with rationality), the individuals in this world would

be able to plan the future in every detail. Bounded rationality arises because of the complexity of the world

and the limitations of the human mind; we can simply not hold all the worlds’ information in our mind.

Uncertainty besides this cognitive origin also has a behavioral origin in opportunism. Opportunism means

that individuals are self-interest seeking with guile. Absent the hazards of opportunism, the difficulties

would vanish- since then the gasps in long-term, incomplete contracts could be faultlessly filled by recourse

to […] general clause devises.37 General clause devices could be applied was it not for the assumption of

opportunism, and the following possibility of non-disclosure and distortion of information.

So is this uncertainty open ended Knightian uncertainty, or is it a closed ended neoclassical type uncertain-

ty? There is some disagreement over this among the critics, Sautet (2000) and Thompson (1992) criticize

the use of bounded rationality, which he explains builds on a neoclassical framework and Foss (1993, 1994)

argues it is open ended.

It would at first seem that Foss is on the right track as Williamson writes “Events that involve ´novelty´ can-

not be described by probability distributions” and “the capacity for novelty in the human mind is rich beyond

imagination.”38 This surely does seem to describe an open ended universe. The use of bounded rationality

is also a major difference from traditional neoclassical economics. But, it is the use of Herbert Simon’s

bounded rationality which gives rise to the critique of Sautet (2000) and Thomsen (1992). Williamson also

notes himself that the Austrian School has another understanding of rationality, namely what he calls or-

ganic rationality (Williamson 1985:46-47.)

Bounded rationality does, in Thompsen’s (1992) critique, still endorse a neoclassical view of the firm, as

individuals still maximize their utility under certain budget constraints. But since the world is complex and

the human mind is limited, they do so by making simplifying assumptions, and therefore the functions and

constraints do not include the whole world with all its detail. Thus if we did not live in a complex world, and

36

Sautet (2000:35) 37


Williamson (1985:58)


16

our cognitive ability still could handle all information, there would be no uncertainty as we could make

complete contracts. So we are still in a close ended universe. Opportunism does not change this, in a com-

plex world with bounded rationality and opportunism, agents will still not questioning the given ends-mean

framework. Uncertainty will still not be a general feature of the universe, but a consequence of moral

choices made by individuals (Sautet 2000.)

So even though Williamson writes that he uses Knightian uncertainty, he builds his uncertainty on a neoc-

lassical rationality concept which leads to closed ended view of the universe. This could, according to Sau-

tet (2000), be spillovers from his 1975 book where he rejects to be concerned with the distinction between

Knightian and neoclassical uncertainty “the distinction between risk and uncertainty is not one with which I

will be concerned – if indeed it is a truly useful one to imply in any context whatsoever.”39

This is the real difference, which leads the Austrian scholars to their different view on TCT. Foss (1994) sees

bounded rationality as consistent with an open ended universe, while Sautet (2000), following Thomsen

(1992), sees it as inconsistent with open-endedness.

Information and Knowledge

Williamson is, as mentioned above, influenced by Hayek and quotes him several times in his work. He espe-

cially adopts the concept of local knowledge. But he also uses the mainstream interpretation of Hayek,

where prices have the role of sufficient prices.40 Thus prices are enough for the allocation of resources and

the clearing of markets. But in Williamson (1975) local knowledge, opportunism and bounded rationality

have the consequence that prices are not sufficient statistics. This is what gives room for the internal organ-

ization of the transactions. But he still maintains this view of prices as sufficient statistics, at least in the

initial case, and uses equilibrium as foil, to state that it is not always the case in view of transaction costs

(Sautet 2000.)

Because he thinks of prices as something which makes information readily available, we end up with the

above mentioned bookshelf view of information. There is no discovery process of information in this inter-

pretation and prices are seen as sufficient statistics, instead of a broader informational channel. This view is

confirmed in Williamson 1991: The adaptations to which Hayek refers are those for which prices serve as

sufficient statistics. Changes in the demand or supply of a commodity are reflected in price changes, in re-

sponse to which "individual participants . . . [are] able to take the right action"41 However there is still room

for error in Williamson (1985) and he still endorse the concept of local knowledge. In other words, William-

son takes some bits from Hayek, but leaves some essential parts out.

Disequilibrium analysis and the (Absent) Entrepreneur

As explained above, Williamson does not embrace Hayeks and Kirzners market process theory in its totality.

Especially prices are taken to be sufficient statistics and his open ended universe is questionable. Compared

with the previous section on the solution of Hayekian Knowledge Problem, it is equal to recognizing the

first part, knowledge problem A, and at the same time overlooking knowledge problem B. Williamson

39


Another example of this is the Grossman-Stiglitz Paradox from their 1980 article (Grossmann & Stiglitz 1980). 41

Williamson (1991:278), parts in quotation marks are a quote from Hayek.


17

avoids the discovery of new knowledge by entrepreneurs. This results in the lack of disequilibrium analysis

and the absence of the entrepreneur in his works. The problem of detecting overlooked profit opportunities

and correcting them is simply not there.42 The managers of the companies are Robbinsian economizers of

transactions costs (and production costs) and not entrepreneurs (Foss 1994a).

The fundamental transformation, though it indicates at least some kind of dynamic analysis, is still a neoc-

lassical state analysis. Williamson analyzes two different states, the ex ante situation and the ex post situa-

tion. This is not a disequilibrium analysis; it can only be called a process analysis in the sense that two on

each other following states are analyzed. There is still no analysis of how dispersed and yet unknown in-

formation is discovered (Sautet 2000.)

Williamson however does recognize the importance of disequilibrium analysis. “An equilibrium approach to

economics is thus only preliminary to the study of the main issue.”43 Even though Williamson recognizes

these and also uses many concepts from the open-ended view of the universe, he does not implement all

the consequences of this view, he only draws partially from this view. Thus Williamson is still grounded in

neoclassical equilibrium analysis.

Conclusion

I have in this paper tried to give an Austrian critique of transaction cost theory, and thereby identifying

what the major differences between these two theories are. I have started with a walk through of the Aus-

trian School of Economics theory of the market process. By presenting the concept of human action, the

ground work for the entrepreneur was laid. The entrepreneur is active and discovers new knowledge by

being alert to profit opportunities. Thereby he is an equilibrating force in the market and helps in solving

the Hayekian knowledge problem. Specifically he solves the Hayekian knowledge problem B, which is not

self correcting as knowledge problem A is.

Thus, the entrepreneur is the equilibrating force in the market. The Austrians view the market as a process

which cannot be explained by investigating equilibrium and the conditions for it to exist. The interesting

part is how the decisions of the individual market participants in the market interact to generate the market

forces which compel changes in prices, in outputs and in methods of production and allocation of re-

sources.44

By analyzing Transaction Cost Theory (TCT) from an Austrian standpoint it is shown, that TCT suffers from

the inconsistency of investigating a disequilibrium phenomenon as the firm, by using a theory based on a

neoclassical equilibrium framework. Williamson uses equilibrium as a foil most of the time, but he is incon-

sistent in his use. Especially by analyzing the fundamental transformation it has been shown that William-

son still endorses an “equilibrium always view of the market.”

Uncertainty is also modeled inconsistently. Even though a Knightian view of uncertainty is endorsed, the

use of bounded rationality still implies a closed end view of the universe. Even when we are not reaching

the limits of the human mind, uncertainty is just a result of opportunistic choices made by individuals, and

42

Sautet (2000:40) 43

Williamson (1985: 8) 44

Kirzner (1973:6)


18

not a state of the world. But most importantly prices are interpreted as sufficient statistics. This gives a

bookshelf view of information and there is no explanation of how knowledge comes into existence. This

results in the absence of the entrepreneur and limited disequilibrium analysis. The conclusion is that TCT

suffers from the Market Theory Problem.

The problem from the Austrian viewpoint is then, that even without transaction cost, there would still be a

Hayekian knowledge problem, and there would still be a need for entrepreneurial discoveries. Knowledge

cannot be bought and picked from a shelf; it still has to be discovered. How this is done, is not a problem

TCT investigates.

This of course does not mean that transaction cost is in anyway irrelevant for the market or the firm, it can

just not be the whole story. The next point from here will be to develop a theory that can encompass both

transaction costs and the entrepreneur.45 Since all theories of the firm necessarily deals with a disequili-

brium concept, the firm, I am convinced that existing theories in this field would benefit from contributions

from the Austrian School, since it, as opposed to the neoclassical schools has its focus on disequilibrium.

45

Sautet (2000) does present such an attempt in his book. See also Yu (1999), Witt (1999) and Langlois (2007). The dynamic transaction cost approach by Langlois & Robertson (1995) is, according to Sautet (2000), still subject to the same criticism as TCT, and does not represent a theory of the firm in line with Austrian economics.


19

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An Austrian Critique of Transaction Cost Theory