Book Review of Organizational Theory of Williamson
Organization Theory, edited by Oliver E. Williamson, is an interdisciplinary summary of various works which follow the spirit of Chester Barnard’s classic book The Functions of the Executive. After reading William’s book, I was quite stunned by the vast differences in the approaches various disciplines have adopted to treat organization theory. It is virtually impossible to review everything of this book. Here, I would only focus on one single question, namely, why organizations exit.
I roughly divide various treatments of this question into two groups: non-economic school and economic school. Ironically, both of them are sort of related to Simon’s Bounded Rationality concept.
According to non-economic view, bounded rationality means that mind becomes a scarce resource. Individuals are reluctant to search for the maximizing point of their utilities. Instead, after they find satisficing actions, their optimizing behavior will come to a stop. In this framework, individuals are not rational, which is in sharp contrast to the economist’s view of organizations discussed below. Organizations exist because through their structure and procedure, they could mitigate the consequences of individuals’ suboptimal actions. The underlying assumption of this view is that there exist so-called organizational goals. Organizational goals are achieved by transforming individual preferences that are in conflict. Changing motives is seen to be an important part of management. It could strengthen cohesion and encourage cooperation within an organization. Corporate culture is a case in point, which is claimed by many to bring individuals’ value in line with the organization’s value system. In specific, corporate culture could create a shared vision of purpose, generate common meanings and enhance commitment. I agree with the claim that organization could transform individuals’ preferences. Economists often neglect this subtle point. In economic analysis of the organization, preferences are usually assumed to be fixed all the time: organizations are working just through a bunch of explicit or implicit contracting processes between various static economic agents. But non-economic view doesn’t explain how the organizational goals are set. It seems to me that organizational goal setting is closely related to the power structure of the organization. It is usually the powerful who has a say on the structure and the procedure an organization should take, and on what kind of commonly shared value an organization shall uphold. And now the question comes: exactly how the power is distributed through an organization?
Oliver Hart, from an economist’s view, gave a neat summary of the development of transaction cost economics out of neoclassical economics. In neoclassical economic theory, a firm is equated to an entrepreneur: it is nothing but a set of feasible production plans, presided over by a manager who buys and sells inputs and outputs in a spot market. There is no need for the existence of complex organizations in neoclassical theory, because everything could be bought from a competitive market. Obviously, this view of the world doesn’t help us at all on questions such as how production is organized in a firm and why different firms have different structures.
Simon’s Bounded Rationality can’t help on these problems either. Economists interpret Bounded Rationality refers to the fact that “individual human beings are limited in knowledge, foresight, skills, and time that organizations are useful instruments for the achievement of human purpose”. But if this is the only obstacle, there is no need for organizations to exist, either: everything could be achieved by comprehensive contracting behavior between different economic agents. For example, in standard principal-agent problems, a risk neutral principal is assumed to be lack of knowledge or ability or time to run the firm (echoing the spirit of Bounded Rationality) and unable to observe the actions taken by a risk-averse manager she hires. However, the principal could achieve second best solutions by making manager’s salary contingent on the realized outcome. In this sense, the boundary of the firm becomes less important, and the firm just boils down to a nexus of contracts.
Transaction cost economics, originally developed by Coase, traces the existence of firms to the contracting cost. Coase’s main claim is that it is costly for a firm to find its transaction partners and haggle over the specific terms of the contract. Incorporating the contracting partner into the firm would save this contracting cost. However, this savings are offset by the increase in administrative rigidity. In Coase’s view, the boundaries of the firm occur at the point where the cost savings from transacting within the firm are, at the margin, just offset by the rigidity cost.
Williamson further develops Coase’s idea. He recognizes that transaction costs are more likely to be important when economic agents make relationship-specific investments, that is, investments are specific to a particular group of individuals or assets. The party which makes relationship-specific investments is susceptible to hold up problem. This is because, once such kind of investment is made, that party is sort of locked in the relationship: there is no competitive price for such investments once they are made. And furthermore, Williamson claims that every contract is inherently incomplete in that people can’t foresee all the contingencies of the future. The existence of incomplete contracts makes the ex post surplus sharing sometimes unrelated to ex ante investments. This is similar to what happens in a group setting. As a result, incomplete contract and relationship-specific investment leads to under-investment, if the two parties are separate firms. Williamson claims that integrating a transaction into the firm mitigates this opportunistic under-investment. The idea is that agent A is less likely to hold up agent B, if A is an employee of B than if A is an independent contractor.
Grossman, Hart, Moore, and Tirole, et al. further elaborate on Williamson’s view. In specific, they fix a loophole on Williamson’s theory: if integration can mitigate the under-investment problem, why don’t the whole society have just one single giant firm carrying out all the productions? In order to answer this question, these researchers formally define property rights, and view the firm as a set of property rights, and claim that property rights determine the bargaining power during the ex post surplus sharing. One’s property rights of a particular asset in their view are one’s ability to exclude others to use the asset. In the presence of transaction cost, incomplete contract and relationship-specific investments, ex post residual rights of control are important because they determine the ex post bargaining power and hence the division of ex post surplus. Consequently, property rights affect the incentives of various agents to invest in their relationship in ex ante stage. A merge of two firms doesn’t give an unambiguous net outcome. For example, if firm A integrate firm B, through acquiring additional bargaining power, firm A’s manager will have more incentive to make relationship specific investment. But on the other hand, losing ex post bargaining power, firm B’s manager faces the hold up problem. She would have less incentive to make such investment. Hence the boundary of the firm occurs where the marginal gains of relationship-specific investment from merge is zero. Or in other words, when two firms are separate, both firms would incur transaction cost when they are dealing with each other. When they are integrated to become one single firm, transaction cost disappears, and it is replaced by agency cost. The boundaries of a firm are determined by the tradeoff between these two kinds of costs.
There are at least three weaknesses of transaction cost economics. First of all, this theory largely focuses on physical assets. Its ignorance of human capital might be a problem in the new economy.
Second, as I pointed before, economic view of the organization assumes that each player in the system has relatively fixed preferences. But could we think of individual utility functions contain some parameter values which could be affected by the organization? If it is the case, I suspect that agency cost would decline as a result of organization’s calculated behavior to influence individual preferences.
Third, In transaction cost economics, all players are assumed to behave rationally. Their bounded rationality results from the fact that they have limited resources, time, energy, etc. This interpretation of bounded rationality not only assists economics in explaining why boundaries of the firm matter, but also in explaining why hierarchies exist in organizations (by span of control argument). Economists are often cautioned against the coalition in the organization. For example, Tirole formal models a principal-supervisor-agent three tier relationship. He claims that an optimal contract should prevent coalition formation between the supervisor and the agent. It seems to me that coalitions or informal channels are a curse rather than a blessing to economists.
On the contrary, Simon stresses the importance of informal channels in supplementing formal channels of communication. In his view, informal channels could also provide valuable information concerning the organization. This sense of repeated dynamic interactions between different players are missing in common economic analysis.
Organizational theory is inherently joint venture between economics, psychology, sociology, etc. For me, it is really hard to discredit one approach in favor of another. However, this is not what I get from reading this book. I still see different approaches stick to their own doctrines and assumptions, and bicker other’s shortcomings. It will be a real blessing that each approach truly appreciates its own weaknesses and learns from others.