The Modern Firm, Corporate Governance and Investment (2009)

8/4/2019 The Modern Firm, Corporate Governance and Investment (2009)

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The Modern Firm, Corporate Governanceand Investment


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NEW PERSPECTIVES ON THE MODERN CORPORATION

Series Editor: Jonathan Michie, Director, Department for Continuing

Education and President, Kellogg College, University of Oxford, UK

The modern corporation has a far-reaching influence on our lives

in an increasingly globalized economy. This series will provide an

invaluable forum for the publication of high-quality works of

scholarship covering the areas of:

corporate governance and corporate responsibility, including

environmental sustainability

human resource management and other management practices, andthe relationship of these to organizational outcomes and corporate

performance

industrial economics, organizational behaviour, innovation and

competitiveness

outsourcing, offshoring, joint ventures and strategic alliances

different ownership forms, including social enterprise and employee

ownership

intellectual property and the learning economy, including knowledge

transfer and information exchange.

Titles in the series include:

Corporate Governance, Organization and the Firm

Co-operation and Outsourcing in the Global Economy

Edited by Mario Morroni

The Modern Firm, Corporate Governance and Investment

Edited by Per-Olof Bjuggren and Dennis C. Mueller


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The Modern Firm,Corporate

Governance andInvestment

Edited by

Per-Olof Bjuggren

Jnkping International Business School, Sweden

Dennis C. Mueller

University of Vienna, Austria

NEW PERSPECTIVES ON THE MODERN CORPORATION

Edward ElgarCheltenham, UK Northampton, MA, USA


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Per-Olof Bjuggren and Dennis C. Mueller 2009

All rights reserved. No part of this publication may be reproduced, stored ina retrieval system or transmitted in any form or by any means, electronic,mechanical or photocopying, recording, or otherwise without the priorpermission of the publisher.

Published byEdward Elgar Publishing Limited

The Lypiatts15 Lansdown RoadCheltenhamGlos GL50 2JAUK

Edward Elgar Publishing, Inc.William Pratt House9 Dewey CourtNorthamptonMassachusetts 01060USA

A catalogue record for this bookis available from the British Library

Library of Congress Control Number: 2009922767

ISBN 978 1 84844 225 2

Printed and bound by MPG Books Group, UK


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v

Contents

List ocontributors viiPreace viii

1 Introduction: the modern frm, corporate governance andinvestment 1

Per-Olo Bjuggren and Dennis C. Mueller

PART I KEY ISSUES

2 Opening the black box o frm and market organization: antitrust 11Oliver E. Williamson

3 The corporation: an economic enigma 43Dennis C. Mueller

PART II THE THEORY OF THE FIRM FROM ANORGANIZATIONAL PERSPECTIVE

4 A contractual perspective o the frm with an application tothe maritime industry 63Per-Olo Bjuggren and Johanna Palmberg

5 The use o managerial authority in the knowledge economy 8Kirsten Foss

6 Competence and learning in the experimentally organized

economy 104Gunnar Eliasson and sa Eliasson

PART III INVESTMENTS AND THE LEGALENVIRONMENT

7 Corporate governance and investments in Scandinavia ownership concentration and dual-class equity structure 139Johan E. Eklund

8 The cost o legal uncertainty: the impact o insecure propertyrights on cost o capital 167Per-Olo Bjuggren and Johan E. Eklund


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vi Contents

9 The stock market, the market or corporate control and thetheory o the frm: legal and economic perspectives andimplications or public policy 185

Simon Deakin and Ajit Singh

PART IV THE BOARD, MANAGEMENT RELATIONSAND OWNERSHIP STRUCTURE

10 Institutional ownership and dividends 5Daniel Wiberg

11 Contracting around ownership: shareholder agreements inFrance 53

Camille Madelon and Steen Thomsen1 Board governance o amily frms and business groups with a

unique regional dataset 9Llus Bru and Rael Cresp

13 Better frm perormance with employees on the board? 33R. ystein Strm

14 The determinants o German corporate governance ratings 361Wolgang Drobetz, Klaus Gugler and Simone Hirschvogl

15 Top management, education and networking 38

Mogens Dilling-Hansen, Erik Strjer Madsen andValdemar Smith

Index 401


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vii

Contributors

Per-Olo Bjuggren, Jnkping International Business School, Sweden

Llus Bru, Universitat de les Iles Balears, Spain

Rael Cresp, Universitat de les Iles Balears, Spain

Simon Deakin, The Faculty o Law, Cambridge University, UK

Mogens Dilling-Hansen, School o Economics and Management, Universityo Aarhus, Denmark

Wolgang Drobetz, Department o Corporate Finance, University o Basel,Switzerland

Johan E. Eklund, Jnkping International Business School, Sweden

sa Eliasson, IBMP CNRS Strasbourg and Vitigen GmbH, Siebeldingen,Germany

Gunnar Eliasson, KTH, StockholmKirsten Foss, Copenhagen Business School, Denmark

Klaus Gugler, Department o Economics, University o Vienna, Austria

Simone Hirschvogl, Department o Economics, University o Vienna, Austria

Camille Madelon, HEC School o Management, Paris, France

Erik Strjer Madsen, Department o Economic, Aarhus School o Business,Denmark

Dennis C. Mueller, University o Vienna, Austria

Johanna Palmberg, Jnkping International Business School, Sweden

Ajit Singh, Queens College, Cambridge University, UK

Valdemar Smith, Centre or Industrial Economics, University o Copenhagen,Denmark

R. ystein Strm, stold University College, Norway

Steen Thomsen, Copenhagen Business School, Denmark

Daniel Wiberg, Jnkping International Business School, Sweden

Oliver E. Williamson, University o Caliornia, Berkeley, USA


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viii

Preace

This book is a collection o papers rom two workshops held in Jnkping,Sweden, in 006 and 007. The theme o the workshop in 006 wasCorporate Governance and Investment in a wide sense. Topics o paperscould be: to describe and analyse the ownership and corporate governancestructure o a given country; to make a comparative analysis o govern-

ance structures in dierent countries; to study corporate governance andperormance in dierent types o frms (or example, amily and non-amilyowned frms); to explain the levels o investment o companies; and to drawpolicy implications about how capital markets might be altered to improvethe allocation o capital and the overall perormance o companies. Theworkshop arranged in Jnkping was one in a series o annual meetings oa European Corporate Governance Network. The networks frst meetingwas at Cambridge University (UK) in 1998 by initiative o ProessorDennis C. Mueller and Proessor Alan Hughes. Since then several meetings

have been organized. The 006 workshop in Jnkping was the seventh.The second workshop, held in Jnkping in September 007, was thefrst o its kind inspired by the emerging literature on the economics o thefrm. The background to the workshop was the revolutionary developmento the theory o the frm that has taken place during the last 35 years. Inspite o all the progress in the feld, traces o the new developments in micr-oeconomic and industrial organization textbooks are scant. The commentsmade by Ronald Coase in 1971 at an NBER meeting about a non-existenttreatment o organization o economic activities within and between frms

in industrial organization textbooks are still valid.But in other ways the situation today is quite dierent rom 35 years ago.At the same NBER meeting Coase also commented upon his celebratedarticle rom 1937 (The Nature o the Firm) with the words much citedand little used. This comment turned out to be a truthul description o thesituation in 1971, but not true or the rest o the 1970s. In the same year asthe NBER meeting (1971) Oliver E. Williamson published a seminal articlein the American Economic Review, which was the start o a large number obooks and articles that, like Coase, centred on the importance o transac-tion costs in analyses o economic organizations. A new feld o transactioncost economics emerged.

Some other articles rom which new felds o research have emanated


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Preace ix

were also published in the 1970s. The team production and the propertyrights perspective introduced by Alchian and Demsetz (197) and thecorporate governance perspective in Jensen and Meckling (1976) have

been especially inuential. From the 1980s the evolutionary theory o thefrm presented by Nelson and Winter (198) and the new property rightsapproach by Grossman and Hart (1986) have reshaped research in asimilar ashion.

These and other branches o the growing tree o the theory o the frmwere the sources o inspiration or the workshop on The Economics o theModern Firm.

The output rom the two workshops is merged in this book under thetitle The Modern Firm, Corporate Governance and Investment. To merge

contributions rom the two workshops makes sense given the close con-nection between the topics and papers presented at the workshops. Forexample, several papers at the second workshop were on corporate govern-ance. In all, 14 papers rom the two workshops have been selected, ninerom the second workshop and fve rom the frst. The keynote addresseso Oliver E. Williamson and Dennis C. Mueller at the second workshopare the frst two chapters ater the introduction.

The participants at the workshops and the reerees o the dierentarticles in this book have helped to improve the contents. We thank them

or their questions and comments. The workshops and the preparation othis book were fnanced by Sparbankstitelsen Ala, Torsten and RagnarSderbergs oundation and CESIS (Center o Excellence or Science andInnovation Studies). We are grateul or their support that allowed us toengage in this research. We are also indebted to Ibteesam Hossain andMaria Eriksson or excellent research assistance with this book.


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1. Introduction: the modern frm,corporate governance andinvestmentPer-Olo Bjuggren and Dennis C. Mueller

The book is organized into our parts. Part I contains overviews o thetheory o the frm. Part II is devoted to frms and organization o eco-nomic activities. Part III deals with how the institutional ramework o aneconomy aects investments made by frms. Part IV looks at the impact oownership structure and board composition on frm perormance.

I. OVERVIEWS

Part I contains two overviews o the theory o the frm rom dierent per-spectives. Opening the black box o frm and market organization: anti-trust by Oliver E. Williamson presents an overview o the characteristicso the transaction cost approach to the study o economic organization.The antitrust implications o this new view o economic organization arealso considered. Thus, this chapter reviews both the positive and norma-tive aspects o Williamsons theory o the frm, and oers a contractualview o economic organization. The black box o the frm is opened inthe sense that the governance attributes that distinguish the frm rom the

market are outlined. The market o the pure vanilla type (spot contractcharacter) ound in most textbooks is complemented by the contractualdeviations that can be characterized as hybrids o market and frm. Thenew explanations o antitrust phenomena provided by transaction costanalysis are discussed. Instead o solely ocusing on market power aspectso vertical market relations, pricing practices and horizontal and conglom-erate mergers, a transaction cost analysis provides a broader picture byalso including cost-reducing explanations. Williamson shows how thesealternative explanations gradually have been recognized by US antitrust

authorities.The corporation: an economic enigma by Dennis C. Mueller looks


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The modern frm, corporate governance and investment

at how the view on the corporate orm o business has changed amongsteconomists since Adam Smith. The chapter addresses the key issue in cor-porate governance about e ciency implications o ownership and control

in corporations. An overview is provided on how economists views othe corporation and its perormance had changed over time. The earlyeconomists such as Adam Smith, John Stuart Mill and Alred Marshalloered descriptions o corporate behaviour based on their observations ohow companies unction. Berle and Means book The Modern Corporationand Private Property rom 193 is also based on observations that are sup-ported by an impressive amount o descriptive data. The neoclassical viewemerging during the 1930s and 1940s represents a dierent way o doingresearch on the frm and corporate orm. For pedagogical and simpliying

reasons the frm is looked upon as a proft maximizing entity. The mana-gerial challenge o this neoclassical view and the ongoing debate betweenthese two schools o thoughts are then discussed. One way to resolvethe conict between these two views is to look at the return on invest-ments. Such studies have been done recently and show that investmente ciency has actually improved since the 1990s in some countries like theUnited States. Possible explanations are disciplining takeovers, increasedproduct competition due to globalization and the growth o institutionalshareholding.

II. ORGANIZATION OF ECONOMIC ACTIVITIES

In Part II, chapters studying the frm rom an economic organization per-spective are ound. The frst chapter, by Per-Olo Bjuggren and JohannaPalmberg, (entitled A contractual perspective on the frm with applicationto the maritime industry) introduces a contractual model o the frm andapplies it to explain how the maritime sector is organized. The capacity o

the frm as a legal person to enter into contracts with suppliers o goods andservices, customers and creditors is highlighted. It is argued that mutualdependency is what determines the character o contractual relations. Theemployment contract and ownership o assets in adjacent vertical stagesenables the frm to supplant price as coordination mechanism in the pro-duction o goods and services. The maritime industry oers a rich orao contractual relations due to diering degrees o mutual dependencebetween shipper and carrier. Both the frm and the reight contract areanalysed rom a contractual perspective. A contractual explanation is alsooered or the phenomenon o third-party management.

A second chapter, by Kirsten Foss, (entitled Authority in the knowledgeeconomy) takes a closer look at authority relations between employer and


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Introduction 3

employees. In transaction cost economics, it is claimed that the possibilityto use authority as a mode o coordination is what primarily characterizesfrms. Authority is a key concept in the theory o the frm, and Foss throws

light upon it. She claims that the emerging knowledge economy makes itnecessary to take a closer look at the dierent dimensions o the authorityconcept in order to understand ongoing changes in economic organization.From a review o authority in the economic literature, the conditions underwhich it is e cient to use authority or coordination, contract enorce-ment, and dispute resolution are identifed. Finally, how these conditionshave to be adapted to an emerging knowledge economy is discussed.

The third chapter, by Gunnar and sa Eliasson, (entitled Competenceand learning in the experimentally organized economy) oers a new evo-

lutionary perspective on how frms emerge and disappear. The authorspicture an economy with boundedly rational and myopic actors who tryto take advantage o perceived business opportunities. Success is to a largeextent dependent on the interaction o actors in so called competence blocs.In a successul competence bloc, customers, innovators, entrepreneurs,fnanciers, exit markets and industrialists interact e ciently in the senseo minimizing the cost o keeping losers on or too long and losing thewinners. The customer has a key unction in a bloc by being the ultimatearbiter o value. In the experimentally organized economy that Gunnar

and sa Eliasson envision, economic organization and the frm are aresult o how the competence bloc is structured. E cient ways to organizethe relations between the actors in a bloc will be rewarded by increasingreturns, which make the organization viable.

III. IMPORTANCE OF THE INSTITUTIONALENVIRONMENT

Part III consists o chapters dealing with investment and legal environ-ment. Johan Eklunds contribution (entitled Corporate governance andinvestment in Scandinavia ownership concentration and dual-class equitystructure) looks at how ownership structure aects investment perorm-ance in the dierent Scandinavian countries. As a measure o investmentperormance, the marginal q developed by Dennis Mueller and ElisabethReardon is used. From legal and political perspectives the Scandinaviancountries are rather similar. But there are still distinctive dierences inseparation o ownership and control through the use o dual-class shares.Sweden has the highest raction o listed frms that use dual-class shares,while Norway has the lowest raction. The implications o these dierenceson investment perormance are investigated. It turns out that in Norway


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4 The modern frm, corporate governance and investment

the marginal q estimate indicates overall e cient investment perormanceamong the listed frms, while the estimate or Swedish and Danish frmsindicates over-investment marginal returns on investment are lower

than costs o capital. A non-linear eect o ownership concentrationin Scandinavian frms is also ound, implying a positive but marginallydecreasing eect o ownership concentration on investment returns.

In a second chapter (The cost o legal uncertainty: the impact o insecureproperty rights on cost o capital) Per-Olo Bjuggren and Johan Eklundstudy how institutional risk inuences the required return on internationalinvestments. Institutional risk due to weak property rights and investorright protection represents a non-diversifable risk to international inves-tors, as these rights are airly stable over time. Hence investors are likely

to demand a risk premium in those countries where these rights are weak.The required return on investment in such countries will accordingly behigher. The capital asset pricing model (CAPM) is used to test or theimportance o taking institutional risk into consideration, and to fnd outthe risk premium associated with institutional risk. It turns out that theexplanatory power o the CAPM is considerably increased i such a riskis taken into account. Furthermore, the risk premium due to institutionalrisk is ound to be signifcantly higher or developing than or developedcountries.

A third chapter, by Simon Deakin and Ajit Singh, (The stock market,the market or corporate control and the theory o the frm: legal andeconomic perspectives and implications or public policy) takes up thequestion o how important an active market or corporate control is oreconomic e ciency. The authors have severe doubts about whether hostiletakeovers have positive eects on e ciency and growth in developedcountries. Their discussion o the pros and cons o a market or corpo-rate control starts with the observation that shareholders do not own acompany in the sense o being entitled to a particular segment or portion

o the companys assets, at least while it is a going concern. Furthermore,directors fduciary interests o loyalty and care are owed to the company.Even though in practice it is oremost the interests o the shareholders thatare catered to, other stakeholders interests are to a diering degree alsorecognized. This is especially the case in civil law systems. It is argued thatit cannot be taken or granted that company law and articles o associa-tion that serve as obstacles to takeovers are at the expense o economice ciency.

Two strands o thought in the economic literature are reerred to inDeakin and Singhs economic analysis; On one hand, there is the principalagent view o the market or corporate control that is used in fnancial eco-nomics. On the other hand, there is a more antitrust oriented analysis used


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Introduction 5

in industrial organization. The views o these schools dier. While fnancialeconomists have ocused on takeovers and mergers as a mechanism to dis-cipline managers, industrial economists also stress their negative eects on

the overall economy. Balancing dierent views o e ciency implications,Deakin and Singh come to the conclusion that hostile takeovers are likelyto harm the prospects or growth in developing and transition economies.

IV. OWNERSHIP STRUCTURE, BOARDCOMPOSITION AND FIRM PERFORMANCE

Part IV contains chapters that examine how the composition o the

board, management relations and ownership structure aect frm per-ormance. A frst chapter by Daniel Wiberg (Institutional ownership anddividends) studies the relationship between institutional ownership anddividends. Wiberg wants to see both whether there is a positive relationbetween institutional ownership and dividends, and whether there aremore rational reasons than short-termism or explaining such a relation.Swedish data are used to test the hypotheses. The Swedish institutionalramework is interesting as there is widespread use o dual-class shares andthe tax rules make dividends more attractive to institutional than to other

ownership categories. Through the use o dual-class shares, ownershipcan be separated rom control, leading to pronounced agency problems.One way to overcome these agency problems is to insist on dividends. Isuch a relationship exists it implies that dividends are higher in frms withgreater separation between ownership and control due to dual-class shares.Wiberg fnds this to be the case, and that institutional ownership has a posi-tive impact on dividend growth.

Camille Madelon and Steen Thomsen (Contracting around ownership:shareholder agreements in France) use data rom large, French listed frms

to examine the eects and determinants o shareholder agreements. Theseagreements represent a way to contract around the o cial ownershipstructure. While the relationship between observable ormal ownershipand behaviour/perormance has been extensively studied, there has beenno study o the relationship between real ownership structure (consider-ing contracts between shareholders as well) and behaviour/perormance.Madelon and Thomsenss study is one o the frst steps towards flling thisvoid. It is an explorative study that analyses agreements rom a trans-action cost approach view. The costs and benefts o acquiring controlthrough contracting amongst shareholders are compared with the alterna-tive o outright ownership. Several theoretical propositions are derivedthat consider ownership and industry characteristics and network ties as


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6 The modern frm, corporate governance and investment

explanations as to why contractual agreements are chosen. Propositionsabout the impact o shareholders agreements on economic perormanceare also derived.

Board governance o amily frms and business groups with a uniqueregional dataset, by Llus Bru and Rael Crespi, is both a methodologicalpaper about how to empirically study amily business and a description owhat amily businesses look like in the Balearic region o Spain. They havemanaged to trace amily ownership and management by use o the Spanishtwo-surnames system. This system has two eatures. Married womenusually do not change their name and newborns have both the athers andthe mothers surname. This surname system has made it possible to traceboth ownership and involvement in boards and management by amily

members. Besides amily companies, it has been possible to trace businessgroups under the control o associated amilies. The importance o amilyfrms and groups in the Balearic economy and the characteristics o thediversifcation patterns o amily business groups are described.

Reidar ystein Strm (Better frm perormance with employees onthe board?) uses data rom Norwegian listed frms to analyse howco-determination aects perormance. He distinguishes between directand indirect eects o employee directors. In the theoretical literature bothpositive and negative eects o employee directors on perormance are

envisioned. Employee directors might contribute to positive perormanceby bringing more inormation about how the frm unctions and enhanc-ing the incentives to invest in frm-specifc human capital. On the otherside, owners and employees interests might not be aligned, producinga negative eect on perormance. Most empirical studies fnd a negativeimpact on perormance. Strm takes the analysis one step urther by takingaccount o the reactions o the shareholders to anticipated negative eectso employee directors. By adjusting the composition o the board and thefnancial leverage o the frm, these negative eects can be counteracted.

This indirect eect is taken into consideration in a simultaneous equationsramework. A three-stage least squares methodology with fxed eect isused to estimate both the direct and indirect eects. Even though indirectendogenous eects are taken into account, the results o the empiricalanalysis show a negative impact o employees on the board.

Wolgang Drobetz, Klaus Gugler and Simone Hirschvogl (The determi-nants o German corporate governance ratings) analyse corporate govern-ance rating in Germany. As in many other European countries, Germanyhas since 00 had a Corporate Governance Code o a comply or explainkind. Instead o assessing the impact o code ulflment on perormance ofrms, Drobetz, Gugler and Hirschvogl choose to analyse the determinantso corporate governance rating. One advantage with this approach is that


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Introduction 7

an endogeneity problem due to sel-selection is avoided. The analysis isto a large extent based on the assumption that there is a positive relationbetween frm perormance and a high corporate governance rating. The

determinants o perormance studied are ownership concentration, thesize o the supervisory board, choice o strict accounting rules, and theuse o an option-based remuneration plan. Ownership concentration ishypothesized to be non-linearly related to ratings. The rationale is that itis only at high levels o ownership concentration that the entrenchmenteect o ownership is balanced by the rewards associated with better per-ormance. For the other determinants, a negative eect is ound or boardsize, stricter accounting rules are positively related to perormance, andstock-option schemes have a positive relation to rating. All the hypotheses

are corroborated in the empirical analysis based on survey data rom 91German frms.

Mogens Dilling-Hansen, Erik Strjer Madsen and Valdemar Smith(Top management, education and networking) use Danish data tostudyhow management can beneft rom networking. Networking takes placethrough board participation by top management. They look at networkties between frms linked by ownership and between independent frms.The ormer ties are labelled internal ties while the latter are called externalties. Networking through external ties can increase the top managements

knowledge o the competitive and technological environment o the frm. Itcan also acilitate collusion. Networking can then be expected to improveperormance. Networking o an internal character can improve the controlo subsidiaries. The extent to which networking will have a positive inu-ence on perormance can be expected to be dependent on education. Anempirical analysis o a large sample o Danish frms fnds a signifcantpositive eect o internal network activities on frm perormance, andthat education implies a positive attitude towards networking. No othersignifcant relationships can be traced.


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PART I

Key issues


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. Opening the black box o frm andmarket organization: antitrust*Oliver E. Williamson

The task o linking concepts with observations demands a great deal o

detailed knowledge o the realities o economic lie. Tjalling Koopmans

Opening the black box o frm and market organization and examiningthe mechanisms inside is a defning characteristic o the transaction costapproach to the study o economic organization (Arrow, 1987, 1999; Dixit,1996; Kreps, 1990). But questions remain. Do the details matter or a widerange o phenomena or only a ew? Which, among the endless number odetails that could be recorded, have conceptual and operational signif-

cance? What, i any, are the public policy ramifcations?My responses to these queries are that the details matter or a wide rangeo phenomena, that many relevant details are uncovered by examiningeconomic organization through the ocused lens o contract/governance,1and that public policy toward business has been a benefciary. Antitrustapplications are developed here. Regulatory applications are examinedelsewhere (Williamson, 007a).

I begin with a statement o the crisis in antitrust as o 1970. A synopsiso the microanalytic setup is then sketched in Section . The paradigm

problem or transaction cost economics is the intermediate product markettransaction, as described in Section 3. Antitrust applications are developedin Sections 48. Concluding remarks ollow and there is an Appendix onthe antecedents on which transaction cost economics builds.

1. THE CRISIS IN ANTITRUST

Victor Fuchs opens his oreword to the National Bureau o EconomicResearch 50th anniversary volume,Policy Issues and Research Opportunitiesin Industrial Organization, with the query Whither industrial organiza-tion?, to which he opines that all is not well with this once ourishing feld


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1 Key issues

(197, p. xv). O the various answers that could be advanced to explain thisdecline, the ones to which I attach the greatest weight are the all-purposereliance by industrial organization economists (and others) on a black

box theory o the frm and a plain vanilla theory o markets. Because thefrm was described as a production unction that transormed inputs intooutputs according to the laws o technology, non-technological or non-price theoretic explanations or reshaping the boundary o the frm werethought to be deeply problematic. Contractual deviations rom simplemarket exchange were likewise regarded as suspect.

Since economists were dismissive o the possibility that the internalorganization o transactions had important economizing consequences,vertical integration and other organizational practices that lacked a physi-

cal or technical aspect were presumed to have the purpose o increasingthe market power o the frms involved rather than reduction in cost(Bain, 1968, p. 381). Vertical market restrictions (and other deviationsrom simple market exchange) were also regarded as deeply problematic.As the then head o the Antitrust Division o the US Department o Justiceput it, I approach customer and territorial restrictions not hospitably inthe common law tradition, but inhospitably in the tradition o antitrust.3Indeed, some protectionist antitrust enorcement o cials regarded pro-spective e ciency gains rom a merger to be anticompetitive because less

e cient rivals would be disadvantaged.4

Such upside-down reasoningencouraged respondents to merger litigation to disclaim that any e ciencybenefts would accrue.5 Ronald Coase summarized the prevailing state odisarray as ollows: I an economist fnds something a business practiceo one sort or other that he does not understand, he looks or a monopolyexplanation. As in this feld we are very ignorant, the number o ununder-standable practices tends to be rather large, and the reliance on monopolyexplanation, requent (197, p. 67).

An altogether dierent lens through which to examine complex con-

tracting and economic organization would be needed to break the grip osuch convoluted thinking. As described in Section , the lens o contract/governance describes frms and markets as governance structures, the di-erent mechanisms o which matter in e ciency respects. An economicso organization takes shape in the process as monopoly is reduced to animportant but special case.


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Opening the black box o frm and market organization 13

. THE MICROANALYTICS: A SYNOPSIS

2.1 General

As Herbert Simon observes (1984, p. 40):

In the physical sciences, when errors o measurement and other noise areound to be o the same order o magnitude as the phenomena under study theresponse is not to try to squeeze more inormation out o the data by statisticalmeans; it is instead to fnd techniques or observing the phenomena at a higherlevel o resolution. The corresponding strategy or economics is obvious: tosecure new kinds o data at the micro level.

Inasmuch, however, as the social sciences are hypercomplex (Wilson,1998, p. 183; Simon, 1957, p. 89), the details prolierate. Where preciselydo the relevant microanalytics reside? That will vary with the phenomenato be investigated and the lens through which the phenomena are viewed.

2.2 The Rudiments6

Rather than operate out o the neoclassical lens o choice (with emphasison prices and output, supply and demand, in relation to which organiza-

tion is held to be unimportant), transaction cost economics works outo the lens o contract/governance. The building blocks are transactionsand governance structures and the e cient alignment thereo, whereuponorganization is not only important but is susceptible to analysis.7 In addi-tion to simple market exchange (contract as legal rules), provision is madeor hybrid contracting (contract as ramework, or which continuity othe exchange relationship is important) and hierarchy, each o which isdescribed as an alternative mode o governance. Note that the decision touse one mode o governance rather than another depends on the transac-

tions or which governance support is required. Hitherto neglected trans-action costs take their place in the analytical frmament.I both transactions and governance structures dier, then the relevant

microanalytics or describing both o these will need to be worked out.Herbert Simons advice, to little discernible eect, that Nothing is moreundamental in setting our research agenda and inorming our researchmethods than our view o the nature o the human beings whose behaviorwe are studying (1985, p. 303) is pertinent in this connection. Cognitivecompetence is especially relevant, but so too is the manner in which sel-interest is described.

I, or example, human actors possess the cognitive ability to imple-ment comprehensive contingent claims contracting, then we are in the


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14 Key issues

world o ArrowDebreu and, in such a contractual world, organization isunimportant. I instead the list o six assumptions that are made by DrewFudenberg, Bengt Holmstrom and Paul Milgrom (1990) apply, then we

are in a world where a sequence o short-term contracts can implementan optimal long-term contract.8 More generally, the point is this: dier-ent assumptions about cognition lead into dierent theories o contractand organization (and the same holds or descriptions o sel-interest(Williamson, 1985, pp. 647)).

Transaction cost economics describes both cognition and sel-interest ina two-part way. Specifcally, cognition combines bounded rationality witheasible oresight while sel-interest joins benign behavior with opportun-ism. Thus all complex contracts are unavoidably incomplete (by reason o

bounded rationality) yet human actors are assumed to have the capacityto look ahead, recognize hazards, work out the mechanisms, and, albeitimperectly, actor the ramifcations back into the ex ante contractualdesign (which is a maniestation o easible oresight). Also, most humanactors will do what they agree to and some will do more most o the time(benign behavior), but outliers or which the stakes are great will elicitdeection and/or posturing (which are maniestations o opportunism)with the purpose o inducing renegotiation.

Whether contractual incompleteness (bounded rationality) and deec-

tion hazards (opportunism) pose serious governance issues depends onthe attributes o transactions. Transactions or which continuity o theexchange relationship is important and or which coordinated adaptationsare needed to restore e ciency are those or which the e cacy o simplemarket exchange breaks down. Behavioral attributes in combination withtransactional attributes thus underpin the need or added governancesupports (or not) where governance is defned as the means by which toinuse order, thereby to mitigate conict and realize mutual gain.

The three attributes o transactions that are especially important or

preserving continuity by implementing coordinated adaptations are assetspecifcity (which is a measure obilateral dependency, to which maladap-tation hazards accrue), uncertainty (the disturbances, small and great, towhich transactions are subject), and the requency with which transactionsrecur, which has a bearing on both reputation eects (in the market) andprivate ordering mechanisms (within frms).

Governance structures are described as discrete structural syndromeso attributes that dier in their adaptive capacities, o which two typesare distinguished: autonomous adaptation to changes in relative prices asdescribed by Friedrich Hayek (1945) and coordinated adaptations o a con-scious, deliberate, purposeul kind as described by Chester Barnard (1938).Incentive intensity, decision and administrative control instruments, and


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contract law regimes are the defning attributes with respect to which gov-ernance structures are described.

As discussed in Section 3, the three main modes o governance or organ-

izing intermediate product market transactions are market, hybrid, andhierarchy. Interestingly, but not surprisingly, spot markets and hierarchiesare polar opposites in that spot markets are characterized by high-pow-ered incentives, negligible administrative control, and a legal rules contractlaw regime, thereby to support autonomous adaptation, whereas hierar-chies use low-powered incentives and hands-on administrative control, andsettle internal disputes administratively under a orbearance law regime9 insupport o coordinated adaptation. Hybrid contracting is located betweenmarket and hierarchy in all three attributes and in both adaptation respects

and thus can be thought o as a compromise mode.The discriminating alignment hypothesis provides the predictive link

between transactions and governance structures to wit, transactions,which dier in their attributes, are aligned with governance structures,which dier in their costs and competences, so as to eect a transactioncost economizing match.

3. TRANSACTIONS IN THE INTERMEDIATE

PRODUCT MARKET: THE PARADIGMTRANSACTION

The intermediate product market transaction (or in more mundane terms,

the make-or-buy or outsourcing decision) is the obvious paradigmatic

transaction or transaction cost economics or two reasons. First, this is

the transaction to which Coase reerred in pointing up a lapse in economic

theory in 1937: The purpose o this paper is to bridge what appears to

be a gap in economic theory between the assumption (made or some

purposes) that resources are allocated by means o the price mechanismand the assumption (made or other purposes) that this allocation is

dependent on . . . [hierarchical mechanisms]. We have to explain the basis

on which, in practice, this choice between alternatives is eected (Coase,

1937, p. 389). Secondly, intermediate product market transactions are

simpler than are labor market, capital market, and fnal product market

transactions because they are less beset with asymmetries o inormation,

budget, legal talent, risk aversion, and the like. The simple contractual

schema, as described herein, ocuses on the intermediate product market

transaction but applies (with variation) to the study o transactions more

generally.

Thus assume that a frm can make or buy a component and assume


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16 Key issues

urther that the component can be supplied by either a general purposetechnology or a special purpose technology. Letting k be a measure o

asset specifcity, the transactions in Figure .1 that use the general purposetechnology are ones or which k 5 0. In this case, no specifc assets areinvolved and the parties are essentially aceless. Transactions that use thespecial purpose technology are those or which k . 0. Such transactionsgive rise to bilateral dependencies, in that the assets cannot be redeployedto alternative uses and users without loss o productive value. The partiesthereore have incentives to promote continuity, thereby to saeguardspecifc investments. Let s denote the magnitude o any such saeguards,which include penalties, inormation disclosure and verifcation proce-

dures, specialized dispute resolution (such as arbitration) and, ultimately,integration o the two stages under unifed ownership. An s5 0 condition isone or which no saeguards are provided; a decision to provide saeguardsis reected by an s . 0 result.

Node A in Figure .1 corresponds to the ideal transaction in lawand economics: there being an absence o dependency, governance isaccomplished through competition and, in the event o disputes, by courtawarded damages. Node B poses unrelieved contractual hazards, in thatspecialized investments are exposed (k . 0) or which no saeguards (s5 0) have been provided. Such hazards will be recognized by arsightedplayers, who will price out the implied risks.10 Conronted with the addedcosts o these hazards, buyers have the incentive to mitigate the hazards (in

B (unrelieved hazard)

A (unassisted market)

h = 0

h > 0

s = 0

s > 0

D (integration)

administrative

market safeguard

C (crediblecommitment)

Figure 2.1 Simple contractual schema


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cost-eective degree), which is to say that node B is an ine cient mode ogovernance or ongoing (as against episodic) supply purposes.

Added contractual supports (s . 0) are provided at Nodes C and D.

Node C governance corresponds to what Karl Llewellyn reerred to as con-tract as ramework, as distinguished rom contract as legal rules, where theormer better preserves continuity o the transaction through a rameworkhighly adjustable, a ramework which almost never accurately describesreal working relations, but which aords a rough indication around whichsuch relations vary, an occasional guide in cases o doubt, and a norm oultimate appeal when the relations cease in act to work (1931, pp. 7367).This is the aorementioned hybrid transaction where credible contractingmechanisms are introduced in support o cooperative adaptation. Such

hybrids are not, however, indefnitely elastic. As disturbances becomehighly consequential, . . . an incentive to deect [arises]. The general propo-sition here is that when the lawul gains to be had by insistence uponliteral enorcement exceed the discounted value o continuing the exchangerelationship, deection rom the [cooperative] spirit o the contract can beanticipated (Williamson, 1991a, p. 73). Benjamin Klein subsequentlydescribes the sel-enorcing range similarly: i and as changes in marketconditions move outside the sel-enorcing range, . . . the one-time gainrom breach [will] exceed the private sanction (1996, p. 449).

But this is not the end o the governance story. As the expected mal-adaptation costs o hybrid contracting progressively mount, best eortsto crat cost-eective credible commitments notwithstanding, transactioncost economics predicts that transactions will be removed rom the hybridand organized under unifed ownership (vertical integration). Inasmuchas added bureaucratic costs accrue upon taking a transaction out o themarket and organizing it internally, hierarchy is useully thought o asthe organization orm o last resort: try markets, try hybrids, and haverecourse to the frm (Node D) only when all else ails.

Node D governance (hierarchy) involves (1) unifed ownership o succes-sive stages, () coordinated adaptation at the interaces by the applicationo routines (to manage disturbances in degree) and by the use o hierarchy(to manage disturbances in kind), (3) internal dispute resolution or settlingdisputes that cannot be resolved by the parties by appealing these to acommon boss, and (4) the aorementioned bureaucratic cost burdens.

Transaction cost economics thus predicts that generic (k 5 0) transac-tions will be assigned to Node A (the market mode, where continuity is ono importance and disputes are settled in court), more complex transac-tions (k . 0) to Node C (the hybrid mode, where continuity matters andadaptations are accomplished under the more elastic concept o contractas ramework), that very complex transactions (k .. 0) will be taken


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18 Key issues

out o the market and organized within hierarchy at Node D, and thatew transactions (mistakes or adventitious transactions) will be located atine cient Node B.

What is urthermore noteworthy is that empirical tests o the predictionso the theory have ensued and have been broadly corroborative. Indeed,despite what almost 30 years ago may have appeared to be insurmount-able obstacles to acquiring the relevant data [which are oten primarydata o a microanalytic kind], today transaction cost economics standson a remarkably broad empirical oundation (Geyskens, Steenkamp andKumar, 006, p. 531). This applies, moreover, not merely to the tests othe paradigm problem o vertical integration but to a vast variety o otherphenomena that are interpreted as variations on a theme (Macher and

Richman, 006). There is no gainsaying that transaction cost economicshas been much more inuential because o the empirical work that it hasengendered (Whinston, 001).

4. APPLICATIONS TO ANTITRUST: GENERAL

The over-reaching excesses o monopoly reasoning during the 1960scontained the seeds o their own destruction. Conronted with escalat-

ing implausibility, Supreme Court Justice Potter Stewart, in a dissentingopinion, observed that the sole consistency that I can fnd is that in [merger]litigation under Section 7, the Government always wins.11 Alarmist excesseso monopoly reasoning eventually elicited a series o challenges to includeboth allocative e ciency and transaction cost reasoning,12 where the lattermade express provision or economies o organization, the myopic quality oentry barrier reasoning was conronted with remediableness considerations,nonstandard and unamiliar contracting practices that had been declared tobe anticompetitive under the inhospitality tradition were re-examined and

ound, oten, to serve credible contracting purposes, and selective appeal tozero transaction costs was supplanted by an insistence that positive transac-tion costs be recognized wheresoever they may reside.13

Antitrust scholars rom the Chicago School (Stigler, 1968; Demsetz,1974; Posner, 1976; Bork, 1978) receive and deserve much o the credit, buttransaction cost economics was also a contributing actor. Thus whereasthe Chicago School ocused on explaining why vertical integration andnonstandard vertical contracts did not create or enhance market power . . .transaction cost economics ocused on why these vertical arrangementsemerged as cost-reducing responses to certain transactional characteris-tics (Joskow, 1991, p. 56; emphasis added). Without such an a rmativerationale,


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it is hard to believe that the Chicago critique o antitrust policies regardingvertical arrangements would have had as much inuence, especially amongproessional economists and antitrust scholars, . . . or [whom] the theoretical

and empirical work in transaction cost economics . . . demonstrated that previ-ously suspect vertical arrangements oten could be explained as contractual andorganizational responses motivated by a desire to reduce the cost o transacting.(Joskow, 1991, p. 57)

As between critiques o wrong-headed reasoning and explanations orthe practices in question or which the mechanisms have been expresslyworked out, the latter is the more demanding.

Interestingly, Timothy Muris, during his term as chair o the FederalTrade Commission, held that much o the New Institutional Economics

literature has signifcant potential to improve antitrust analysis andpolicy. In particular, . . . [the transaction cost branch has] ocused ondemystiying the black box frm and on clariying important determi-nants o vertical relationships (003, p. 15). Opening the black box andacquiring an understanding o the mechanisms inside has had an impact,moreover, on practice:

The most impressive recent competition policy work I have seen reects theNIEs teachings about the appropriate approach to antitrust analysis. Mucho the FTCs best work ollows the tenets o the NIE and reects careul, act-based analyses that properly account or institutions and allrelevant theories,not just market structures and [monopoly] power theories. (Muris, 003, p. 11;emphasis in original)14

A comprehensive examination o the applications o transaction costeconomics to antitrust is beyond the scope o this chapter. My purposeis merely to illustrate the ways in which examining the microanalytics ocomplex contract and economic organization through the lens o contract/governance has served to alter and deepen our understanding o many

antitrust related phenomena. I successively examine applications to verti-cal market relations, price theoretic issues, credible contracting, and themodern corporation.

5. VERTICAL MARKET RELATIONS

Lateral integration into components, backward into raw materials, andorward into distribution are successively examined. The analysis through-out tracks the logic o the simple contractual schema in that the moverom market to hybrid to hierarchy is predicted as asset specifcity andoutlier disturbances increase. Asset specifcity refnements as among


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0 Key issues

physical, human, site, dedicated, and brand name capital are also con-sequential. With respect, or example, to mobile physical assets (such asspecialized dies), it may be possible or the specialized investments to be

made by the buyer, who relieves bilateral dependency by assigning the spe-cialized dies to the winning bidder or the duration o the supply contractand repossessing and reassigning these to a successor i the original bidderdoes not win the renewal contract.15 The need or unifed ownership is alsorelieved by the use o credible commitments to support hybrid contract-ing as with exchange agreements, or or organizing distribution througha large number o geographically dispersed outlets by ranchising ratherthan by orward integration (although there is also merit in dual distri-bution). As, however, asset specifcity and disturbances increase, unifed

ownership is predicted.

5.1 Lateral Integration

Economies are commonly ascribed to the integration o successive stagesin the technological core, an example o which is the unifed ownership oiron- and steel-making stages by reason o thermal economies (Bain, 1968,p. 381). By contrast, lateral integration into components that lack such aphysical or technical aspect is (under technological reasoning) believed to

be deeply problematic. As discussed above, monopoly purpose and eectwere commonly ascribed to these.Transaction cost economics disputes such reasoning. All that is implied

by thermal economies (or, more generally, by the physical or technicalaspects to which Bain reers) is that the two stages be located adjacent toeach other. The governance issue is whether the exchange o product acrossthese co-located stages should be mediated by market or by hierarchy.Unless contractual problems are projected, there is no reason why eachstage could not be independently owned and the two stages joined by an

interfrm contract. I, thereore, co-located stages are integrated, that isbecause transaction cost economies are thereby realized: unifed owner-ship relieves the contractual hazards that would otherwise arise betweenindependent, site-specifc trading entities.

But there is more: transaction cost economics also selectively oers

an economizing interpretation or transactions that lack the physical or

technical aspects to which Bain reers. As discussed in Section 3 above,

the outsourcing o separable components o a non-site-specifc kind is

the paradigm problem on which transaction cost economics is based and

to which empirical tests were frst applied (Monteverde and Teece, 1982;

Masten, 1984).16 The upshot is that the same comparative contractual

logic applies to the organization o asset-specifc transactions o all kinds,


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site-specifc or not. The contrast with earlier antitrust predilections is

stark.17

5.2 Raw Materials Procurement

Except perhaps or very atypical cases, an e ciency case or verticalintegration backward into raw materials is believed to be rare i not non-existent. Surely the lesson o the Ford Motor Companys ully integratedbehemoth at River Rouge, supplied by an empire that included ore lands,coal mines, 700,000 acres o timberland, sawmills, blast urnaces, a glassworks and coal boats, and a railroad (Livesay, 1979, p. 175) is that thiswas vertical integration run amok.

Exactly right: maybe comprehensive vertical integration has the appear-ance o being an engineers dream, but it is not an economic ideal. AsJohn Stuckeys examination o backward integration rom the refninginto the raw materials stage in the Australian aluminum industry reveals,the transactional details matter. Bauxite ore, it turns out, is not a uniormmineral but, instead, is a heterogeneous commodity, . . . [where] the ore inany deposit has unique chemical and physical properties (Stuckey, 1983,p. 90). That is consequential: the cost dierence o processing a mixed-hydrate bauxite, which is e ciently processed with a high-temperature

technology, in a low-temperature refnery instead, comes to almost 100percent (Stuckey, 1983, pp. 534). Other details also matter. Bauxitestorage covers are needed or some ores and not or others (p. 49); residueprocessing costs vary greatly (p. 53); and air pollution equipment is tailoredto the attributes o the bauxite (p. 60). Moreover, although smelting is lessidiosyncratic, there is, nevertheless, an art part o smelting, which is upseti the aluminum supply is varied (p. 63).

Not every refnery, however, is dependent on a specifc bauxite deposit.Thus, whereas most o the above described economies are realized by spe-

cializing the characteristics o a local refnery to a local bauxite deposit (asin Australia), the same cannot be said or remotely located refneries, asin Japan, where a general purpose refnery that can process bauxite oresprocured on the world market has countervailing advantages.

Interestingly, regulatory concerns sometimes get in the way o back-ward integration an example o which is the bilateral dependency thatsometimes arises between uel source and operating stages in electricitygeneration by coal-burning generators (Joskow, 1987). Lest utilities inte-grate backward into coal production to shit profts rom a regulated to anunregulated activity, the regulatory process has discouraged this (Joskow,1987, p. 84, n. 17).

As with bauxite, The type o coal that a generating unit is designed to


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Key issues

burn aects its construction and its design thermal e ciency (Joskow,1987, p. 84). In some regions, as in the Eastern United States, coal orelatively uniorm quality is available rom a large number o small nearby

mines; in other regions, as in the West, deposits are large and coal qualityvariation among mines and the distances or shipment are great (1987, p.84). Mine mouth generating plants o specifc design are oten observedor the latter. More generally, comparative contractual reasoning predictsthat longer-term and more nuanced contracts will be observed or the Westthan in the East, which is borne out by the data: as relationship-specifcinvestments become more important, the parties . . . fnd it advantageousto rely on longer-term contracts that speciy the terms and conditions orepeated transactions ex ante, rather than relying on repeated bargaining

(Joskow, 1987, p. 96).

5.3 Forward into Distribution

A huge ranchising literature in economics and marketing examines thedecision o whether producers should own some or much o their distribu-tion system or contract with others to manage the distribution o goodsand services instead. In the event o the latter, vertical market restrictionsoten apply, a common purpose being to protect the network against brand

name devaluation (Klein and Le er, 1981).Many economizing issues are posed by orward integration into market-ing and the uses o vertical market restrictions, o which asset specifcity(especially in the orm o brand name capital) is only one. Transactioncost reasoning nevertheless plays a central role in the marketing decision(Coughlan et al., 005) as to which contractual mode to choose and, i themarket, whether contractual restrictions should be imposed. Contrary tothe inhospitality tradition in antitrust,18 vertical market restrictions willyield social benefts i the requisite transaction cost pre-conditions are

satisfed.

6. PRICE THEORETIC ISSUES

6.1 Price Discrimination

The price theoretic argument in avor o price discrimination (especially

perect price discrimination) is that discrimination permits parties whose

valuation is below a uniorm monopoly price but above marginal costs

to buy the good or service in question, as a result o which allocative

e ciency benefts accrue. A problem with the argument is that perect


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price discrimination assumes that the transaction costs o discovering

true customer valuations and o policing against arbitrage are zero,

which are heroic assumptions. Upon taking the costs o discovering

price valuations and enorcing arbitrage restrictions into account, itcan be shown that costly price discrimination can lead to bothprivate

benefts (monopoly profts increase) and social losses (Williamson, 1975,

pp. 1113).19

6.2 Robinson-Patman

Transaction cost economics also has a bearing on the Robinson-PatmanAct, which has been interpreted as an eort to deprive a large buyer o [dis-

counts] except to the extent that a lower price could be justifed by reason oa sellers diminished costs due to quantity manuacture, delivery, or sale, orby reason o the sellers good aith eort to meet a competitors equally lowprice. 0 The concern, plainly, is that large buyers will use their muscle toextract better deals rom suppliers, as a result o which smaller buyers willbe disadvantaged. To this, however, should be added the possibility thatdierent buyers are prepared to oer dierent contractual supports or thesame good or service. With reerence to Figure .1, suppose that a supplieruses specialized assets to produce the same good or service or two buyers.

Assume that one o the buyers reuses to oer contractual saeguards whilethe other does oer saeguards. These two correspond to Node B and NodeC contracting, respectively. Plainly, the supplier will sell on better terms tothe Node C buyer than to the Node B buyer.

The upshot is that quantity and meeting competition considerations donot exhaust the legitimate reasons or oering lower prices to some buyersthan to others. Application o the lens o contract/governance, as againstall-purpose reliance on textbook micro theory, serves to uncover theseadditional purposes.

6.3 Predatory Pricing

Transaction cost economics disputes the merits o the marginal cost pricingtest or predatory pricing, as advanced by Philip Areeda and DonaldTurner (1975), in two respects. First, although marginal cost pricing can bethought o as a hypothetical ideal (second best considerations aside), suchan ideal is a deceptive standard i the measurement o marginal costs invitesaccounting manipulation and deceit in the courtroom. Additionally,Areeda and Turner apply the same marginal cost pricing test to pricereductions o both continuing and temporary kinds which is to say thatthey make no provision or strategic price reductions: now its there, now


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4 Key issues

it isnt, depending on whether a new entrant has appeared or been van-quished. That is unwarranted, since the welare benefts o temporary pricecuts are at best small and could easily be net negative.

Here as elsewhere, however, objections to a proposed criterion do not,alone, carry the day. There is an obligation to advance a superior easi-ble alternative. The output test proposed in Williamson (1977) has threeadvantages over the marginal cost pricing test: (1) repositioning, () meas-urement, and (3) contingent versus continuing responses. Repositioningmakes allowance or the possibility that parties to which predatory pricingrules apply will adapt (reposition) in relationship to them. Areeda andTurner ignore this incentive, yet it is noteworthy that their test has ine-rior repositioning properties in comparison with the output test. Output,

moreover, is much easier to measure than is marginal cost. And the outputtest expressly avors continuing over contingent supply now its here,now it isnt, depending on whether an entrant has appeared or perished by the established frm. The upshot is that transaction cost considerationsare very relevant or uncovering the e ciency ramifcations o two pricetheoretic tests or predation.

6.4 Over-searching

The market or gem-quality uncut diamonds employs two nonstandardcontracting practices that are puzzling at best and are easily interpreted aseorts by de Beers to exercise muscle in its dealings with the buyers o uncutdiamonds. The two trading restrictions in question are the all-or-noneand in-or-out trading rules. Inasmuch as de Beers had market power inthe supply o uncut diamonds, these trading rules were believed to have themuscular purpose o extracting proft rom diamond cutters.

Although the web o cooperative practices among diamond cutters inNew York (Richman, 006) might be interpreted as collusive, the de Beers

trading rules applied to a global market. Consider thereore the possibilityraised by Roy Kenney and Benjamin Klein (1983) that these rules havee ciency purposes.

Whereas uncut diamonds are classifed into more than two thousand cat-egories, signifcant quality variation in the stones evidently remains. Howcan such a market be organized so as to reduce the oversearching costs thatwould be incurred i buyers were to evaluate every stone, or at least everygrouping o stones, oered by de Beers? The combination o all-or-nonewith in-or-out trading rules arguably serves to reduce over-searching.1

The all-or-none trading rule requires that a buyer accept the entiregrouping o diamonds assembled by de Beers (a sight) or none at all.Buyers are thereby denied the opportunity to pick and choose among


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individual diamonds, yet nonetheless have the incentive to inspect eachsight very careully. Reusal to accept a sight would signal that the sightwas over-priced but no more.

Suppose now that an in-or-out trading rule is added. The decision toreuse a sight now has much more serious ramifcations. To be sure, areusal could indicate that a particular sight is egregiously over-priced.More likely, however, it reects a succession o bad experiences. It is apublic declaration that de Beers is not to be trusted. In eect, a disaectedbuyer announces that the expected net proft o dealing with de Beers underthese constrained trading rules is negative.

Such an announcement has a chilling eect on the market. Buyers whowere earlier prepared to make casual sight inspections are now advised that

there are added trading hazards. Everyone is put on notice that a conf-dence has been violated and is warned to inspect more careully.

On this interpretation, the in-or-out trading rule is a way o encouragingbuyers to regard the procurement o diamonds not as independent tradingevents but as a related series o trades. I, overall, things can be expected toaverage out, then it is not essential that the payment made or value receivedcorresponds exactly on each sight. In the ace o systematic under-realiza-tions o value, however, buyers will be induced to quit. I, as a consequence,the system is moved rom a high to a low trust trading culture, then the costs

o marketing diamonds increase. That is an adverse outcome to the systemwhich de Beers has strong incentives to avoid. Accordingly, in a regime whereboth all-or-none and in-or-out trading rules apply, de Beers will take greatercare to present sights such that the legitimate expectations o buyers will beachieved. The combined rules thus inuse greater integrity o trade.

7. CREDIBLE COMMITMENTS

Although credible contracting is the core purpose served by hybrid modeso governance, such a purpose was slow to register in antitrust enorcement mainly because o the monopoly predisposition with which nonstandardand unamiliar contracting practices were viewed. But whereas traditionalmarket power theories [were so predisposed], . . . TCE can [requently] . . .illuminate the meaning o acts particularly in the context o complexcontractual relations that cannot otherwise be explained, or worse, areexplained incorrectly (Muris, 003, p. 18). Credible commitment reason-ing (o a Node C versus Node B kind) has been applied to a wide rangeo contractual practices including ranchise restrictions, exchange agree-ments, take-or-pay agreements, and a host o other nonstandard con-tracting practices (Masten, 1996). Exchange agreements are an especially


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6 Key issues

interesting illustration o opening the black box and interpreting the pur-poses served by the mechanisms inside.

Petroleum exchanges have puzzled economists or a very long time and

have been routinely challenged in antitrust cases and investigations o thepetroleum industry. The 1973 case brought by the United States FederalTrade Commission against the largest petroleum frms maintained thatexchanges were instrumental in maintaining a web o interdependenciesamong major frms, thereby helping to eect an oligopolistic outcome inan industry that was relatively unconcentrated on normal market struc-ture criteria.3 A later study, The State o Competition in the CanadianPetroleum Industry, likewise held that exchanges were objectionable.4 TheCanadian Study, moreover, produced documents contracts, internal

company memoranda, letters, and the like as well as deposition testimonyto support its views that exchanges are devices or extending and perect-ing monopoly among the leading petroleum frms.5 Such evidence on thedetails and purposes o contracting is usually confdential and hence una-vailable. But detailed knowledge is clearly germane and oten essential

to a correct assessment o the transaction cost eatures o a contract.Engineers, managers, and lawyers in the major petroleum companies all

had a benign interpretation o exchanges. I X has a surplus o product inregion A and a defcit in region B while Y has a surplus o product in region

B and a defcit in region A, and i both wish to market their product inboth areas, then the exchange o product will save on cross-hauling. That,however, omits another possibility: why not create a central market intowhich each frm can report its surpluses and defcits and procure in an anon-ymous rather than bilateral way? Petroleum industry engineers, managers,and lawyers ound this query unsettling, yet the critical issue that needs tobe aced is why bilateral exchange rather than simple market exchange?

The Canadian Study lists our objections to exchanges, the frst two owhich I will pass over here (but see Williamson (1985, p. 148)). The other

two are more intriguing: competition is impaired by conditioning supplyon the payment o an entry ee (pp. 534) and by exchange agreementsthat impose limits on growth and supplementary supply (pp. 51).

The antitrust concerns posed by the entry ee are supported by the ol-lowing documentation and interpretation (pp. 53; emphasis added):

Evidence o an understanding that a ee relating to investment was required oracceptance into the industry can be ound in the ollowing quotation rom Gul:

We do believe that the oil industry generally, although grudgingly, will allow a

participant who has paid his ante, to play the game; the ante in this game beingthe capital or refning, distributing and selling products. (Document #7148,undated, Gul)


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The signifcance o the quotation lies equally in the notion that an entry eewas required and in the notion that the industry set the rules o the game. Themeaning o the entry ee as well as the rules o the game as understood by

the industry can be ound in the actual dealings between companies where theexplicit mention o an entry ee arises. These cases demonstrate the rules thatwere being applied the rules to which Gul was reerring. Companies whichhad not paid an entry ee, that is, companies which had not made a su cientinvestment in refning capacity or in marketing distribution acilities wouldeither not be supplied or would be penalized in the terms o the supply agreement.

Once a comparative contractual perspective is adopted, a dierent inter-pretation o these practices presents itsel. So as to keep the comparisonsimple, suppose that there are two would-be buyers and that each places an

order or a signifcant and identical amount o product or delivery over thesame time interval with the same supplier. The buyers dier, however, inthat one o the buyers is prepared to create a saeguard to deter prematuretermination while the other is not. It is elementary that the seller will chargea higher (Node B) price to the latter.

But wherein do exchange agreements relate to such trades? Given thatthe amount o product to be supplied is signifcant, and assuming that thesupply interval is long and that the surplus/defcit geographic relationsdescribed above apply, then buyers and sellers so situated will fnd that anexchange agreement between them not only saves on cross-hauling costsbut, additionally, provides a reciprocal credible commitment in that ter-mination by one party is deterred by the expectation that it will be answeredin kind. Especially i both parties to the exchange agreement experiencecorrelated disturbances, in which event both will want to adapt similarly,exchange agreements have good adaptation and security properties.

Assuming that each party to such a supply agreement constructs and main-tains a larger plant than it otherwise would, the specifc investments made bythese frms take the orm o dedicated assets large incremental additions toplant, the output rom which is earmarked or a specifc buyer as secured byan exchange agreement. Little wonder that petroleum frms will contract onbetter terms with other petroleum frms that have paid the ante to play thegame than they will with buyers whose purchases are unsecured.

Consider thereore the use o growth and supplementary supplyrestraints, an example o which is the ImperialShell exchange agreement,under which Imperial supplied product to Shell in the Maritimes andreceived product rom Shell in Montreal (p. 51):

The agreement between Imperial and Shell, originally signed in 1963, was rene-

gotiated in 1967. In July 197, Imperial did this because Shell had been growingtoo rapidly in the Maritimes. In 19717, Imperial had expressed its dissatisac-tion with the agreement because o Shells marketing policies. Shell noted:


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8 Key issues

[Imperials] present attitude is that we have built a market with their acilities,we are aggressive and threatening them all the time, and they are not going tohelp and in act get as tough as possible with us. (Document #23633, undated,

Shell)

Specifcally, Imperial renewed the agreement with Shell only ater impos-ing a price penalty i expansion were to exceed normal growth rates andurthermore stipulated that Shell would not generally be allowed to obtain

product rom third party sources to service the Maritimes (p. 5; emphasisadded).

The Canadian Study notes that Gul Oil also took the position thatrivals receiving product under exchange agreements should be restrained

to normal growth: Processing agreements (and exchange agreements)should be entered into only ater considering the overall economics o theCorporation and should be geared to providing competitors with volumesrequired or the normal growth only. 26 It urthermore sought and securedassurances that product supplied by Gul would be used only by the recipi-ent and would not be diverted to other regions or made available to otherparties (p. 59).

Limits on normal growth and prohibitions on third parties couldwell have anticompetitive purpose and were so regarded by the CanadianStudy. Examined, however, through the lens o contract/governance, itis also possible that these same restrictions had the purpose and eect opreserving symmetrical incentives between the parties to exchange agree-ments, thereby allowing them to reach Node C credible commitments.Without use restrictions, bilateral dependence could become unbalanced.Also, symmetry could be placed under strain i one party was to grow inexcess o normal in which event it might be prepared to construct its ownplant and scuttle the exchange agreement. Marketing restraints that help toorestall such outcomes encourage parties to participate in exchanges thatmight otherwise be unacceptable.

To be sure, credibility benefts that are valued by the parties may notbe equally valued by society. Such restraints may in some cases have bothmarket power and secure transaction purposes. My purpose is merely toemphasize that, whereas the Canadian Study viewed these entirely in aone-sided (monopoly) way, the perspective o credible contracting addsanother. To repeat, transaction cost economics can sometimes illuminatethe meaning o acts [and words] particularly in the context o complexcontractual relations that otherwise cannot be explained, or worse, areexplained incorrectly (Muris, 003, p. 14).7


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8. THE MODERN CORPORATION

The lens o contract/governance applies to the modern corporation in

numerous ways: limits to frm size, scaling up, divisionalization, horizontalmerger, conglomerate mergers, corporate governance, Japanese outsourc-ing practices, disequilibrium orms o organization, and the list goes on.My discussion here is restricted to limits to frm size, scaling up (to includecorporate governance), and horizontal and conglomerate mergers.8

8.1 Limits to Firm Size

The puzzle o frm size was posed by Frank Knight in 191 when he

observed that the diminishing returns to management is a subject otenreerred to in economic literature, but in regard to which there is a deartho scientifc discussion (Knight, 1965, p. 86, n. 1). He elaborated in 1933as ollows (1965, p. xxxi; emphasis added):

The relation between e ciency and size o frm is one o the most serious prob-lems o theory, being, in contrast with the relation or a plant, largely a matter opersonality and historical accident rather than o intelligible general principles.But the question is peculiarly vital, because the possibility o monopoly gainoers a powerul incentive to continuous and unlimitedexpansion o the frm,

which orce must be oset by some equally powerul one making or decreasede ciency.

Tracy Lewiss later remarks that large established frms will alwaysrealize greater value rom inputs than small potential entrants are apposite(1983, p. 109; emphasis added):

The reason is that the leader can at least use the input exactly as the entrantwould have used it, and earn the same profts as the entrant. But typically, theleader can improve on this by coordinating production rom his new and existing

inputs. Hence the new input will be valued more by the dominant frm.

I the dominant frm can use the input in exactly the same way as theentrant, then the larger frm can do everything the smaller frm could. I itcan improve on the input usage, it can do more. Applied to vertical integra-tion, the parallel argument is that the acquisition o an independent com-ponent supplier is always preerred to outsourcing because the combinedfrm will never do worse (by reason oreplication) and will sometimes domore ithe acquiring stage always but only intervenes when expected netgains can be projected (by reason oselective intervention).

The puzzle o frm size thus reduces to this: what are the obstacles tothe implementation o replication and selective intervention? As I discuss


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30 Key issues

elsewhere (Williamson, 1985, Chapter 6), promises to replicate and selec-tively intervene are not costlessly enorceable. An acquired supplier canneither trust the acquirer to do the accounting (on which the suppliers

net receipts are calculated) in an unbiased way nor trust the acquirer tointervene always but only or good cause; and the acquirer cannot trustthe supply stage to operate the plant and equipment (now owned by theacquirer) with unchanged due care and to adapt appropriately to autono-mous disturbances. The upshot is that neither replication nor selectiveintervention can be implemented without cost, as a result o which the gov-ernance mechanisms o markets and hierarchies dier in kind (Williamson,1991a). The recurrent point to which I call special attention, however,is this: the bureaucratic burdens o integration are discerned only upon

opening the black box and examining the microanalytics.

8.2 Scaling Up

Solow observes that The very complexity o real lie . . . [is what] makessimple models so necessary (001, p. 111). The object o a simple model isto capture the essence, thereby to explain hitherto puzzling practices andmake predictions that are subjected to empirical testing. But simple modelscan also be tested with respect to scaling up. Does repeated application

o the basic mechanism out o which the simple model works yield a resultthat recognizably describes the phenomenon in question?The test o scaling up is oten ignored (possibly out o awareness that

scaling up cannot be done) or is sometimes scanted (possibly in the beliethat scaling up can be accomplished easily). The inuential paper byMichael Jensen and William Meckling, Theory o the Firm: ManagerialBehavior, Agency Costs, and Capital Structure (1976), is an exception.The authors work out o a simplifed setup where an entrepreneur (100percent owner-manager) sells o a raction o the equity o the frm, as a

result o which his incentive intensity is reduced and e cacious monitoringarises as a response. What the authors are really interested in, however,is not entrepreneurial frms but the modern corporation whose manag-ers own little or no equity (1976, p. 356). Although the latter project wasbeyond the scope o their paper, they expressed belie that our approachcan be applied to this case . . . [These issues] remain to be worked out indetail and will be included in a uture paper (1976, p. 356).9

Alas, Jensen and Meckling never produced the ollow-up paper, butmany others have since examined the e cacy o the board o directors asmonitor in the large corporation where the ownership is diuse. The jury isstill out, but I ascertain that serious obstacles stand in the way o acquiringthe relevant inormation to support vigilant monitoring and, urthermore,


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contend that the advisability o assigning the role o vigilant monitor to theboard o directors is extremely problematic (Williamson, 007b). In thatevent, corporate governance does not scale up rom the entrepreneurial

frm to the diusely owned modern corporation.Scaling-up issues relevant to the modern corporation are also posed by

the theory o the frm as team production (Alchian and Demsetz, 197)and the theory o the frm as governance structure. The theory o team pro-duction works through technological nonseparability, which Alchian andDemsetz illustrate with the example o manual reight loading: Two men

jointly lit heavy cargo into trucks. Solely by observing the total weightloaded per day, it is impossible to determine each persons marginal pro-ductivity (197, p. 779). Accordingly, rather than each person being paid

his (unmeasurable) marginal product, such activities are organized cooper-atively, with a team whose members are paid as a team and are monitoredby a boss lest they engage in shirking. This is instructive, but does techno-logical nonseparability scale up to explain the modern corporation?

One possibility is that the large corporation is a vast, indecomposablewhole, in which event everything is connected with everything else and themodel o technological nonseparability goes through. Another possibilityis that, as Simon describes in The Architecture o Complexity (196),large hierarchical systems evolve rom nearly decomposable subsystems

within which subsystems interactions are extensive and between whichthey are attenuated.30

Simons examination o social, biological, physical, and symbolicsystems as well as the logic o complexity supports the proposition thatdecomposability is one o the central structural schemes that the architecto complexity uses (196, p. 468). Inasmuch as such decomposabilityrelieves the condition o technological nonseparability on which Alchianand Demsetz rely, scaling up rom small groups to which nonseparabilityapplies (such as manual reight loading and, possibly, groups as large as the

symphony orchestra) does not extendto the decision to join a series o tech-nologically separable stages, thereby to orm the modern corporation.So how does that transaction cost economics setup are in scaling-up

respects? Does successive application o the make-or-buy decision, as itis applied to individual transactions, scale up to describe something thatapproximates a multi-stage frm? Note in this connection that transactioncost economics assumes that the transactions o interest are those that takeplace between technologically separable stages. This is the boundary othe frm issue as described elsewhere (Williamson, 1985, pp. 968). Upontaking the technological core as given (possibly as derived rom site specifcinvestments, o which thermal economies are an example (see Section 5.1above)), attention is ocused on a series o separable make-or-buy decisions


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3 Key issues

backward, orward, and lateral to ascertain which should be outsourcedand which should be incorporated within the ownership boundary o thefrm. So described, the frm is the inclusive set o transactions or which

the decision is to make rather than buy which does appear to implementscaling up, or at least is a promising start (Williamson, 1985, pp. 968).31

8.3 Horizontal Mergers

My initial inclination was to regard oligopoly to be outside the scope otransaction cost reasoning, mainly because I had become accustomed tothinking about oligopoly in terms o the prevailing structureconductperormance paradigm, where concentration ratios and barriers to entry

were the coin o the realm. Upon viewing oligopoly as a cartel problem,however, its contractual nature is immediately evident.

Consider in this connection the claim that monopoly and oligopoly arenearly indistinguishable in competitive respects.32 Such a claim ails to makeallowance or (1) the advantages o hierarchy (within a monopoly) as com-pared with interfrm contracting (among oligopolists) or dispute settlementand coordinating purposes and (2) the dierential incentives and the relatedpropensity to cheat that distinguish internal rom interfrm organization.Examining the cartel as a fve-stage contracting process contract specifca-

tion, joint gain agreement, implementation under uncertainty, monitoringcontract execution, and penalizing contract violations is instructive.As discussed elsewhere (Williamson, 1975, pp. 3844), oligopolies

dier in their complexity in all fve o these contractual respects. Simpleoligopolies where numbers are ew and products are homogeneous,shares are easy to agree upon, disturbances are small, price and output arepublic knowledge, and penalties or violations are assuredly me

Documents

The Modern Firm, Corporate Governance and Investment (2009)