Book Review of Organizational Theory of Williamson
Yun Zhang
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: noneconomic 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
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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
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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
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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 relationshipspecific 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
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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 principalsupervisor-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.
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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.
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