Transaction Cost Economics

By Scott E. Masten (Stephen M. Ross School of Business, University of Michigan)

Transaction cost economics (TCE) and the New Institutional Economics (NIE) have been virtually synonymous since the 1975 publication of Oliver Williamson’s Markets and Hierarchies, with its first chapter titled “Toward a New Institutional Economics.” Pretty much anyone working on organizational or institutional issues will be familiar with aspects of the transaction cost framework. The number who would regard themselves as “transaction cost economists,” however, is considerably smaller. How small? Right around the time that Ronald Coase, Douglass North, and Oliver Williamson were inaugurating the International Society for New Institutional Economics, Deirdre McCloskey quipped that only a handful, “a bare half-dozen,” economists truly understood the Coase theorem. By that reckoning, the number with a reliable grasp of transaction cost economics, given that the former is prerequisite to the latter, was tiny indeed — hardly a promising base on which to build an academic society!

Although the club of TCE cognoscenti is not quite that exclusive, full assimilation of transaction cost principles is hardly the norm. To some, especially in business and management areas, transaction cost economics consists almost entirely of the relation-specific investment hypothesis. Others regard TCE as a pre-formal contribution to the analysis of organizations that, while important, has largely been superseded by more modern approaches. For its proponents, however, transaction cost economics represents a distinct orientation or “lens,” as Williamson often describes it, for viewing organizational problems. The seminal focal adjustment comes from the “true” Coase theorem, specifically, the insight that any and all gains from cooperation will be realized, in the absence of any impediments to doing so, regardless of organizational form or institutional arrangements. Although a truism, Coase’s insight has two immediate implications. First, it focuses our attention on the impediments to cooperation, what we have come to call transaction costs. Second, it means that organizational and institutional arrangements matter only to the extent that transactional frictions differ among them. Williamson’s work beginning in the 1970’s (with important early contributions by Victor Goldberg and Benjamin Klein, among others) to “operationalize” Coase’s crucial discernment traced the primary sources of transactional frictions to bounded rationality and opportunism, characterized the distinguishing features of internal organization and contractual exchange, and identified attributes of transactions, notably asset specificity and complexity/uncertainty, that differentially affect the incidence of frictions under each.

The success of Williamson’s framework at explaining firm boundaries and contract design largely explains the narrow association of TCE with specific investments referred to above and, by making transaction cost economics easy to “apply,” may, ironically, have retarded deeper examination of its methods and implications. One such implication is the centrality of adaptation in the problem of economic organization and the role of organizations and institutions in establishing the processes through which adaptation occurs. A context that I have found useful to illustrate this process orientation is the choice of remedies for breach of contract. Economists typically view contract remedies as an incentive problem, that of defining appropriately scaled damages to induce efficient performance. A legal rule requiring specific performance of contracts, it is argued, would prevent breaches even when nonperformance is efficient and thus cause parties to trade too often. Requiring the breaching party to pay expectation damages or "lost profits," in contrast, would induce breach only when doing so would leave that party better off even after compensating the other party and therefore lead to efficient breach.

A problem with this formulation, however, is that buyers and sellers are free to negotiate mutually advantageous adjustments regardless of the legal rule governing breach whenever nonperformance is the desired result. Thus, under a specific performance rule, if exchange with a third party is the efficient thing to do, that result can be achieved by, for instance, the seller negotiating a release from his contractual obligation to the original buyer. If the new trade is in fact efficient, then the seller could induce the buyer to release him from his obligation by offering the buyer some share of the additional surplus generated by the new opportunity. Of course, bargaining around specific performance requirements is likely to be costly. But so is litigating damages under a damage rule. The gains from performing or not performing the contract are the same regardless of the legal rule. What changes with the rule — and thus should be the focus of the analysis — is the process or procedures, and the tactics or strategies, available to the transactors seeking to realize those gains, and the costs associated with those efforts. (For additional discussion of differences between agency and transaction cost approaches to contact design and enforcement, see Masten (2000).)

The logic that makes process concerns central to analyzing the efficiency of alternative contract remedies also applies to the analysis of organizational forms. Given the same technology, information, and actors, anything that could be accomplished within the firm could, in principle, also be accomplished in a market transaction (or any other arrangement), and vice versa. Again, what varies as transactions are relocated from one organizational form to another are the processes through which adaptations can be effected: the rights, duties, procedures, and sanctions associated with each arrangement and, hence, the tactics transactors can employ. Given that the legal system plays a central role in regulating those duties and delimiting and enforcing sanctions, identifying differences among organizational forms will often find their ultimate basis in the law.

None of this should be read as a rejection of other approaches to organization. TCE is informed by agency and game theory. And parallels can certainly be drawn between the concepts and concerns of transaction-cost economics and other theories. Concerns with the effects of bounded rationality, opportunism, and asset specificity in transaction-cost economics overlap more mainstream concerns with information asymmetries, moral hazard, and bilateral monopoly. Indeed, given that meaningful institutional choice problems simply do not arise in the absence of bounded rationality and opportunism, it would have been surprising had the critical dimensions underlying the problem of economic organization gone unappreciated except by transaction-cost economists. For some problems, however, TCE provides unique and useful insights and has produced a body of testable implications and a largely supportive empirical literature.

So why then aren’t there more transaction cost economists? Allow me to suggest some candidates.

1. TCE has been difficult to model. The central behavioral attributes, bounded rationality and opportunism, are notoriously difficult to model. Economists have yet to settle on a way to incorporate the limits on decision-making capacity such as memory, attention, and computational ability. And while shirking and moral hazard represent forms of opportunism, opportunism also includes (costly) efforts, such as bargaining and hold-ups, aimed at redistributing surpluses, which have resisted satisfactory formalization. Agency theory has largely gotten around this problem by adopting extreme assumptions of, alternately, zero or prohibitive bargaining and information costs. The world of non-zero, finite transaction costs is where much of the action is, however, and the reluctance to incorporate positive transaction costs (often under a different name) show signs of receding in mainstream modeling (compare, e.g., Masten (1988, 2009), Hart and Moore (2008) and Hart (2009)).

2. TCE is difficult to do. In his Presidential Address at the Western Economic Association annual meeting, Steven N.S. Cheung noted the challenges of conducting transaction cost research (1998):

A second reason for economists’ long neglect of transaction costs is that the concomitant constraints cannot be properly specified without knowing a lot about what is going on in the real world. This, unfortunately, is routinely difficult and exhausting. Transaction-cost economics is real-world economics, and the real world is too often a place where academic economists fear to tread. Who would want to commit two years to studying an antitrust case, with an uncertain prospect of eventual publication? Pauca sed matura is a motto only a Gauss can afford.

This “few but ripe” sentiment is also reflected in Williamson’s description of transaction cost economics as a “a microanalytic program [that proceeds] in a ‘modest, slow, molecular, definitive’ way” (1996) (regarding which many a Williamson student has been heard to claim mastery of the “slow” part.)

3. TCE is difficult to teach. Although I have been applying transaction cost reasoning in my research for over 30 years, I find it much easier to teach agency theory than transaction cost economics. Partly this owes to the structure and facility associated with teaching models, of which TCE has relatively few. Beyond that, a transaction cost orientation seems to be best acquired through repeated confrontation with deep and often subtle organizational puzzles, a regrettably unappealing learning technology for the impatient (or untenured).

For those nevertheless interested in joining the “Blessed Half Dozen,” I offer the following — collections and overviews plus a couple of lesser-known pieces — as places to start.

Transaction Cost Economics, Oliver E. Williamson and Scott E. Masten, eds. (Aldershot, UK: Edward Elgar Publishing. 1995)
• A handy collection of the classics.

The Elgar Companion to Transaction Cost Economics, Peter G. Klein and Michael E. Sykuta, eds. (Aldershot, UK: Edward Elgar, 2010)
• Introductions to the issues, methods, discoveries, and debates by some of TCE’s most knowledgeable contributors.

Oliver E. Williamson, “Transaction Cost Economics: The Natural Progression,” American Economic Review 100 (June 2010): 673–690.
• A concise review of major themes in the transaction cost framework.

Barry R. Weingast and William J. Marshall, “The Industrial Organization of Congress; or, Why Legislatures, Like Firms, Are Not Organized As Markets,” Journal of Political Economy, 96 (1988): 132–163.
• An application of transaction cost logic to the design of legislative institutions that illustrates the breadth and generality of TCE and that was an important influence on the development of my own thinking about organization (cf., Masten, 2006).

Calabresi, G., "The Pointlessness of Pareto: Carrying Coase Further," Yale Law Journal, (March 1991): 1211-37.
• A provocative essay pushing Coasean logic to its limits (cf., Cheung (1998): “in the real world the Pareto condition always holds”).

Scott E. Masten and Jens Prüfer, "On the Evolution of Collective Enforcement Institutions: Communities and Courts," Journal of Legal Studies 43(2) (June, 2014): 359-400. 
• Our recent effort to apply the “discriminating alignment” lessons from economic organization to the evolution of contract enforcement institutions.