Transaction Cost Economics as a Theory of the Firm, Management, and Governance
- Mikko KetokiviMikko KetokiviOperations Management and Organizational Design, IE Business School
- and Joseph T. MahoneyJoseph T. MahoneyDepartment of Business Administration, College of Business, University of Illinois at Urbana-Champaign
Which components should a manufacturing firm make in-house, which should it co-produce, and which should it outsource? Who should sit on the firm’s board of directors? What is the right balance between debt and equity financing?
These questions may appear different on the surface, but they are all variations on the same theme: how should a complex contractual relationship be governed to avoid waste and to create transaction value? Transaction Cost Economics (TCE) is one of the most established theories to address this fundamental question.
Ronald H. Coase, in 1937, was the first to highlight the importance of understanding the costs of transacting, but TCE as a formal theory started in earnest in the late 1960s and early 1970s as an attempt to understand and to make empirical predictions about vertical integration (“the make-or-buy decision”). In its history spanning now over five decades, TCE has expanded to become one of the most influential management theories, addressing not only the scale and scope of the firm but also many aspects of its internal workings, most notably corporate governance and organization design. TCE is therefore not only a theory of the firm, but also a theory of management and of governance.
At its foundation, TCE is a theory of organizational efficiency: how should a complex transaction be structured and governed so as to minimize waste? The efficiency objective calls for identifying the comparatively better organizational arrangement, the alternative that best matches the key features of the transaction. For example, a complex, risky, and recurring transaction may be very expensive to manage through a buyer-supplier contract; internalizing the transaction through vertical integration offers an economically more efficient approach than market exchange.
TCE seeks to describe and to understand two kinds of heterogeneity. The first kind is the diversity of transactions: what are the relevant dimensions with respect to which transactions differ from one another? The second kind is the diversity of organizations: what are the relevant alternatives in which organizational responses to transaction governance differ from one another? The ultimate objective in TCE is to understand discriminating alignment: which organizational response offers the feasible least-cost solution to govern a given transaction? Understanding discriminating alignment is also the main source of prescription derived from TCE.
The key points to be made when examining the logic and applicability of TCE are:
(1) The first phenomenon TCE sought to address was vertical integration, sometimes dubbed “the canonical TCE case.” But TCE has broader applicability to the examination of complex transactions and contracts more generally.
(2) TCE could be described as a constructive stakeholder theory where the primary objective is to ensure efficient transactions and avoidance of waste. TCE shares many features with contemporary stakeholder management principles.
(3) TCE offers a useful contrast and counterpoint to other organization theories, such as competence- and power-based theories of the firm. These other theories, of course, symmetrically inform TCE.
Consider a situation in which two parties interested in a complex exchange of goods or services are trying to determine the best way of organizing the transaction. Both want to ensure their interests are being served, and both want to avoid unnecessary costs, delays, and wasted effort. Both also realize that all transactions involve risk but that unnecessary risks must be avoided. How are they to proceed with organizing the transaction? What kind of a contract will they strike?
In a resource-constrained world, seeking economic efficiency is always not only relevant but also common sense: if there are several alternative ways of conducting a business transaction, why not choose the one that consumes less resources? At the same time, in a world where work is complex, the future is uncertain, and both rationality of decision makers and availability of information are constrained, choosing the best among feasible alternatives requires effort, skill, foresight, and prudence.
At the most general level, Transaction Cost Economics (TCE) is a theory of how business transactions are structured in challenging decision environments. TCE is chiefly concerned with transactions that are complex in that they are recurring, subject to uncertainty, and involve commitments that are difficult to reverse without significant economic loss (Williamson, 1975, 1985). The fundamental objective in the early formulation of TCE in particular was to understand the specifics of an individual transaction involving two exchange partners and a transaction. But understanding a dyadic transaction paves the way toward understanding any transaction, and ultimately, an understanding of what a firm essentially is and how its scale and scope are determined (Santos & Eisenhardt, 2005). In this sense, TCE is a theory of the firm (Chandler, 1990; Conner, 1991). At the same time, the insights that TCE can offer are not limited to informing us on organizational boundaries: TCE is also a theory of management in that it has much to say about the internal organization of firms as well. Finally, TCE is not only a theory of transactions, but it also applies more generally to any situation where a contractual arrangement of some kind is used to organize activities involving various stakeholders with only partially overlapping objectives. TCE may thus justifiably be labeled also a theory of governance.
The purpose of this article is to examine the applicability of TCE as a theory of the firm, a theory of management, and a theory of governance. Our exposition is structured as follows. We start by clarifying what transaction costs are and why they are relevant. We then revisit the historical origins and the logic of TCE, after which we proceed to examine empirical research and evidence. We close with a discussion of current debates, extensions, and future research.
What is the “Cost of Transacting”?
Suppose you go to the grocery store to buy a carton of milk. You get the carton from the refrigerator, pay $3 at the register, and walk out.
The transaction in this example is simple in that we seldom stop to think about it. Simplicity stems from two pillars that most of us take for granted. One, we know how much a carton of milk is supposed to be priced at retail, and those who do not can find out at a negligible cost. In short, the price system works to the buyer’s advantage in the transaction. Two, at least in the United States, we are assured that the quality of dairy products is intact. Both federal and state governments have established safety regulations for dairy products, and violations are heavily sanctioned (e.g., Sumner & Balagtas, 2002). In short, the system of institutions works to the buyer’s advantage in the transaction as well. Symmetrically, the seller benefits, because the buyer is confident enough to make the purchase. Because of these two established pillars, there is very little uncertainty associated with the transaction, and for all practical purposes, the cost of the transaction itself is negligible (you of course pay $3 for the product, but that is the cost of the product, not of the transaction). Even if upon arriving at home you realize the milk you bought is past its expiration date, the transaction is easily reversible and the problem thus remediable. There is nothing transactionally complex about buying a carton of milk.
The dairy product transaction looks simple to us because it is supported by the price system and the system of institutions. Those who live in the developing countries, or travel in them, know that simplicity is in fact only ostensible. Specifically, absent the proper system of institutions, buying even dairy products becomes so complex and risky that many will refrain from using them. In economic terminology, “the market fails” in that even though both supply and demand exist, the transaction will not take place. Such market failures are always cause for concern, which is why a general understanding of the price system and the institutional environment warrants the scholar’s and the policy-maker’s attention. Indeed, “getting the institutional environment right” is logically prior to seeking “to get the transactions right” (Williamson, 2000, p. 597).
Consider in contrast a situation where the exchanging parties cannot fully rely on the price system or the system of institutions. Let us briefly put ourselves in the position of a purchasing manager of an automobile manufacturer, seeking a supplier for ten thousand make-and-model-specific automatic transmission assemblies, priced at a thousand dollars per unit (e.g., Monteverde & Teece, 1982). These assemblies are engineered to model specifications, which means their quality probably cannot fully be ascertained ex ante; even the precise price may be unknown. Further, the purchasing manager may or may not have prior experience with the pool of candidate suppliers. It is easy to see how in this situation, both the buyer and the supplier expose themselves to considerable risk. What if some unforeseen development brings about disagreement? Consider the worst-case scenario: what if inferior quality of the final product leads to horrible outcomes? Recall the faulty ignition switches in General Motors’ automobiles supplied to GM by Delphi Automotive, which was ultimately linked to over one hundred fatalities. Who is responsible? How much will it cost to determine who is at fault? Use of poor-quality inputs is of course always cause for concern; however, what is relevant from the point of view of TCE and the costs of transacting is that in situations where the supplier and the buyer are separate firms, addressing the consequences of quality problems can be much more costly. If Delphi were a part of GM, the situation would be comparatively simpler.
In complex settings, transactions can still occur, and we are clearly all better off for the fact that they do occur. If in addition to the final assembly, automakers made all parts and sub-assemblies in-house, cars would be much more expensive than they are now. The higher prices would result from lack of economies of specialization, which is known to give rise to immense productivity benefits. At the same time, in complex settings there are many costs to transacting that were absent in the grocery store example. Contracting parties must seek information that may be costly to obtain; they must agree upon and enforce a potentially complex buyer-supplier contract; potential disputes may require renegotiation, arbitration, sometimes even litigation; et cetera. These are examples of transaction costs, which may be significant enough to have far-reaching consequences. Fundamentally, TCE is a theory that emphasizes the importance of understanding these consequences, which in turn, helps us direct attention to the relevant antecedents in an informed way.
The Special Case of Vertical Integration
In the 1960s the bicycle manufacturer Schwinn’s franchising policies garnered the attention of the U.S. Supreme Court. Schwinn had, among other things, restricted the sale of its bicycles to certain distributors. The Supreme Court ruled (United States v. Arnold, Schwinn & Co., 388 U.S. 365, 1967) that such vertical restrictions were in violation of the Sherman Act, the aim of which is to outlaw monopolistic business practices. The Supreme Court took the position that a manufacturer’s placing of restrictions on the sale of its products was abusive and anti-competitive.
But is market power the primary reason for why firms seek vertical restrictions, or in the extreme case, vertical integration? Are there no alternative plausible explanations and motivations behind such vertical actions? Why did the Supreme Court ascribe specifically opportunism to Schwinn’s actions? How was this alleged motivation demonstrated? Why was the Supreme Court not convinced by Schwinn’s own account that “the restriction was designed to deny access of Schwinn [high-quality] product to discount houses” (Williamson, 1985, p. 183). To be sure, vertical restrictions similar to Schwinn’s are common business practice in contemporary corporations. Are they all examples of anti-competitive abuse? Are firms guilty unless they prove themselves innocent?
It was specifically the Schwinn case, and a number of others, that prompted Oliver Williamson, a pioneer of TCE, to ask: how well do we understand vertical integration? In one of his early treatments of the topic, Williamson submitted that it was not our theoretical understanding but specifically the lack of theory that had led policymakers and courts to pessimistically view vertical integration “as having dubious if not outright antisocial properties” (Williamson, 1971, p. 112). To Williamson, formulating policy based on a lack of understanding was a great cause for concern. Or as Coase (1988, p. 67) bluntly put it: “[I]f an economist finds something—a business practice of one sort or other—that he does not understand, he looks for a monopoly explanation. And as in this field we are very ignorant, the number of un-understandable practices tends to be very large, and the reliance on a monopoly explanation, frequent.”
Building on the works of Coase (1937) and Arrow (1971) in particular, Williamson challenged the policy of routinely labeling “un-understandable practices” anti-competitive. Williamson (1985, p. 185) specifically criticized the Supreme Court’s ruling in the Schwinn case: “[t]he government turned all its powers of advocacy to the description of an imagined anticompetitive offense. It ignored possible differences among customers and their marketing ramifications.” The kernel of Williamson’s (1985) critique was the Court’s failure to consider alternative explanations. Further, it was specifically this critique that sparked the formal development of TCE, the early formulations of which can be described as a search for an alternative explanation of vertical integration (Williamson, 1971). Vertical integration here means changes in financial ownership in the value chain (e.g., Mahoney, 1992), such as a firm purchasing the assets of either its supplier (backward integration) or its customer (forward integration). This is in contrast with horizontal integration, where a firm buys the assets of a similar company, such as one of its competitors. Unlike the monopoly explanation, TCE is an account of vertical integration that has nothing to do with market power and everything to do with transacting in an efficient way, without wasting resources (Santos & Eisenhardt, 2005). Yes, vertical integration may spell trouble, but it may also spell efficiency that benefits all the stakeholders involved. Above all else, Williamson claimed, the field needed a theory of vertical integration that could provide empirically testable predictions: the ability to predict an outcome is a much greater merit and sign of understanding than the ability to formulate an ad hoc explanation after the fact.
TCE has had a fundamental impact on how we view vertical integration in particular. As Shapiro (2010, p. 139) fittingly observed, “[a]ntitrust economics has evolved so much over the intervening 40 years that we now take many of Williamson’s ideas and observations for granted.” Students of strategy and management should also appreciate the fact that the Supreme Court’s rulings in the 1960s established many strategic actions taken by individual companies as anti-competitive. In the case of Schwinn, the Supreme Court was effectively denying Schwinn a competitive strategy based on product differentiation: the vertical restrictions that Schwinn had implemented were meant specifically to support the integrity of the supply chain of a high-quality product (Williamson, 1985, p. 183). As a more general point, we may not realize that many of the business practices and strategies we now consider strictly competitive were—only 40 years ago—indeed considered largely anti-competitive. Just imagine what our strategy textbooks would look like if the courts continued to restrict strategic firm actions, such as vertical coordination. Indeed, the fact that the label of vertical restrictions was applied implied an immediate value judgment that such actions are dubious. But even continuing with the antitrust language, we ask: if vertical restrictions were considered illegal today, would we have as many luxury products, for example? Why would a firm want to build a competitive advantage on the idea of offering high-quality products if it could not decide how, where, and by whom these products are sold? What would happen to product innovation?
Much of the early TCE was developed in the context of the special case of examining the empirically salient vertical integration decision. Further, the aim was to develop a theory of vertical integration that would have testable implications. This intention involved identifying the critical dimensions in which transactions differed, deriving the transaction cost implications, and then matching governance modes to the critical dimensions of the transactions (Monteverde & Teece, 1982). But this exercise was merely the first step in a journey that has now spanned several decades: “Once the vertical integration problem had been made operational in this way, a variety of related applications followed. In this sense, the puzzle of vertical integration was a paradigm problem that, once solved, provided a research strategy that could be repeated” (Williamson & Ouchi, 1981, p. 349). This insight brings us from TCE’s special case of vertical integration to the general case of the governance decision.
The General Case of the Governance Decision
The more general question underpinning the make-or-buy decision pertains to governance of contractual relationships. Williamson (1994, p. 86) elaborates: “Transaction cost economics holds that economizing on transaction costs is mainly responsible for the choice of one form of capitalist organization over another. It thereupon applies this hypothesis to a wide range of phenomena—vertical integration, vertical restrictions, labor organization, corporate governance, finance, regulation (and deregulation), conglomerate organization, technology transfer, and, more generally, to any issue that can be posed directly or indirectly as a contracting problem. As it turns out, large numbers of problems that on first examination do not appear to be of a contracting kind turn out to have an underlying contracting structure.” In this section, we explore in detail this general contracting structure is and how it can be applied.
Let us return to the general premise that TCE starts at trying to specify how transactions differ. According to TCE, the three dimensions that merit attention are frequency, uncertainty, and specificity (Williamson, 1985, p. 52). All three should be thought of as characteristics of a contractual exchange relationship between two exchange parties; the principal unit of analysis in TCE is indeed the individual transaction.
Frequency refers to the volume of transactions between the two exchange parties. Contractual relationships are always associated with a cost, and with larger volumes (i.e., recurring transactions), costs of specialized governance structures can be justified, for instance (Williamson, 1985, p. 60).
Uncertainty refers to the contracting parties’ limited ability to predict environmental changes and one another’s behavior under unforeseen circumstances. The two exchange parties always have interests that are only partially overlapping, and disagreements are a source of cost. In complex exchange relationships, it is simply impossible to write a complete contract that covers all possible contingencies. TCE works out of the assumption that contracts are incomplete.
Specificity refers to specialized investments made by one party, or both parties, to enable the exchange.
Of the three dimensions, specificity deserves closer attention. For example, the supplier may build a sub-assembly plant that is co-located with the customer’s final assembly plant. The economic value this sub-assembly plant generates would suffer greatly should the exchange relationship terminate. More generally, specificity takes many different forms (Williamson, 1985): site specificity (e.g., an electric plant), physical asset specificity (e.g., specialized tools), and human asset specificity (e.g., firm-specific knowledge). Importantly, specificity gives rise to dependency, which may be either unilateral or bilateral. In many situations, even though the actual investment may appear on the balance sheet of just one of the transacting parties (e.g., investing in the sub-assembly plant), some kind of mutual dependency tends to develop over time (Williamson, 1994, p. 101). If the customer were to terminate the contract with the supplier who made the specific investment, it would either have to make the same investment itself, or alternatively, convince another supplier to do so. Of course, a dependency relationship is always at least somewhat asymmetric, and purely unilateral dependency tends to be rare in situations that involve specificity. In the complete absence of specificity, markets are competitive in the sense that no buyer is dependent on a specific supplier, or vice versa.
Commitment to specificity can, of course, create a situation in which one party to the transaction may see a possibility to take advantage of the other party. Indeed, such economic “holdup problems” (Goldberg, 1976) sometimes occur in practice. However, the position taken by TCE is that taking advantage of one’s exchange partner by engaging in opportunistic behavior is both ill-advised and myopic. Williamson (1985, p. 48) labeled opportunism “a very primitive response” that has an adverse consequence on transaction efficiency. Transacting parties who are about to commit to specificity should be wiser than that. A better option is to engage in farsighted contracting that is based on both giving and receiving credible commitments to support the exchange relationship. Exchanging credible commitments is, among other things, aimed at avoiding a potential holdup problem developing into an actual problem.
A simple transaction has low frequency, low uncertainty, and low specificity. Such transactions can be efficiently handled through a market transaction between a supplier and a buyer. Returning to the grocery store and our purchase of the carton of milk, the transaction is routine in that it has little uncertainty, low asset specificity, and virtually no risk associated with it: therefore, the transaction is most efficiently handled through a straightforward market exchange. TCE provides an explanation for why simple transactions are organized as market transactions between a buyer and a seller, but provides insight particularly in the context of complex transactions that involve high degrees of specificity (Williamson, 1985, p. 52). A supplier of make-and-model-specific components or sub-assemblies to a final automobile assembly plant is a good example (Klein, Crawford, & Alchian, 1978). Applying the TCE logic, Monteverde and Teece (1982) predicted that automakers would be more likely to make in-house components that required greater make-and-model-specific applications engineering. In contrast, components whose specifications are known ex ante immediately become candidates for competitive bidding and outsourcing because the transaction costs are presumed to be comparatively lower. Monteverde and Teece (1982) maintained that the problem with the supplier’s acquiring of transaction-specific know-how is a higher supplier switching cost on the part of the buyer. If the relationship were to terminate, the buyer would need to find another supplier who would need to develop the same transaction-specific know-how. This know-how would likely be difficult to transfer from the previous supplier.
The same line of thinking can be applied to many other decisions made within and across firms. Consider a company’s mix of debt and equity financing. The choice is, of course, between alternative financial instruments, but as Williamson (1988) pointed out, also between alternative governance structures. The decision of debt versus equity financing is thus analogous to the vertical integration decision, where the key factor to consider is again specificity. Assets of low specificity are more effectively financed through debt. Because low-specificity assets are by definition redeployable, the lender will be covered in case the borrower defaults on the loan; no additional contractual safeguards are needed to manage risks. Consequently, the cost of transacting is relatively low. This is why car rental companies, for example, are able to rely on debt financing and various leasing arrangements for their vehicle fleet.
For a nuclear power plant, in contrast, debt financing is generally not feasible. Who is willing to accept highly specific, nonredeployable property as collateral? If the firm wanted to use debt to finance such assets, it would either have to pay a very high interest on the capital or to try to reduce asset specificity to enhance redeployability. The former would be prohibitively costly, indeed, most banks will probably not lend at any price. The latter may be either impossible or, at least, have significant adverse consequences such as increased production costs and lower quality (Williamson, 1988, p. 580). A better option is to finance high-specificity assets using a governance mode where the financier does not receive a collateral-backed fixed interest but is instead made a recipient of the earnings that the specialized assets create. This solution, of course, leads to equity financing.
The choice of debt versus equity financing has a number of important organizational ramifications that pertain to monitoring and control. In firms financed largely by equity, the role of the board of directors is crucial in securing the rights of the providers of equity, the residual claimants. This economic safeguard is needed because there is no contract between the firm and the providers of equity that protects the interests of the latter. In a debt-financed firm, in contrast, the rights of the financier are stipulated in the loan agreement and in corporate law, effectively eliminating the need for additional safeguards. More generally, firms that rely on debt financing tend to organize based on formalization (rule-following); discretion is more dominant in equity-financed firms (Williamson, 1988, p. 581). Again, TCE emphasizes that financing decisions should also be considered contracting problems—with important managerial and organizational implications.
The TCE logic can be applied in any context that can be viewed as a special case of the general contracting decision. These applications are summarized in Table 1. The rows of the Table are organized chronologically: the early applications appear on the top rows and the more recent ones toward the bottom. The table effectively illustrates the broadening of TCE’s scope over time.
Table 1. Applications of Transaction Cost Economics in Various Governance Contexts
Representative Research Question
Which components should a manufacturer outsource and which should it make in-house?
Buyer and supplier
Does the multidivisional firm allocate resources more efficiently than the external capital market?
External financiers and firms
What are the problems associated with franchising?
Franchisor and franchisee
What determines the scope of the multiproduct firm?
Horizontally equivalent firms or activities
Foreign direct investment
What is the proper mode of foreign market entry?
The firm and its foreign subsidiary
Who should have a seat on the corporation’s board of directors?
The firm and its stakeholders
When should a government provide a service in-house, and when should it be contracted out?
The state and private actors
What should the duration of the buyer-supplier contract be?
Buyer and supplier
Which assets are financed through debt and which through equity?
The firm, debtors, and providers of equity
How is Congress organized?
Members of a legislature
Weingast and Marshall (1988)
An elaboration of one of the less conspicuous TCE applications is useful. Consider the organization of the legislature. Weingast and Marshall (1988, p. 132) noted that Congress is organized in a seemingly efficient way. What could account for this efficiency? They further observed that legislatures tend to resemble firms more than they resemble markets. In Weingast and Marshall’s (1988) analysis, the “contracting parties” involved are individual legislators seeking to serve their constituencies.
In order to understand the organization of the legislature using the TCE lens, we start at the premise that “representatives of different constituencies have considerable incentives to exchange support so as to provide benefits to their supporters” (Weingast & Marshall, 1988, p. 157). There is effectively a market where votes are bought and sold at a price. Consequently, an understanding of how and why legislators engage in exchanges with one another would lead to an improved understanding of how a legislature is organized. Vote trading is analogous to market exchange, and indeed, legislators often actively seek trading partners to further the interests of their own constituencies. But as Weingast and Marshall (1988) noted, market exchange runs into severe problems in daily legislative practice, because it applies only to a small subset of problems the legislature faces. One obvious limiting factor is the fact that issues of interest to the “trading partners” of a given exchange do not come up for a vote simultaneously; packaging bills into a single “market exchange” is infeasible. When trading is non-simultaneous, how can one legislator be sure that the other party to the exchange will not renege on its promise? Opportunism aside, what if an unforeseen circumstance were to lead to a situation where one of the parties is simply unable to fulfill its side of the bargain even if it wanted to honor the promise it had made? Enforceability of bargains becomes problematic, and the market form of exchange becomes inefficient.
What could constitute a comparatively more efficient form of organization? The answer resides in the committee system found in legislatures around the world. The committee system provides protection against the uncertainties associated with the market exchange of votes, therefore enhancing the enforcement of legislative bargains. Much like the firm that internalizes a transaction, “[t]he committee system institutionalizes a trade among all the legislators, policy area by policy area” (Weingast & Marshall, 1988, p. 145). Under the committee system, those in charge of the specific committee retain control over the agendas within their jurisdiction and decide which bills are brought to the floor for a vote. The committee system is of course far from perfect, but control over agendas does provide a mechanism that prevents ex post reneging in situations where vote trading occurs across committees within the legislative system (Weingast & Marshall, 1988, p. 144). The committee system can be argued comparatively superior to the market exchange of votes due to its ability to mitigate the problem that arises from non-simultaneity of exchange.
The legislature and the debt-versus-equity-financing examples in particular demonstrate that the ability to identify an exchange situation and subsequently analyzing it as a special case of the general contracting problem can offer a novel point of view to a commonly observed or familiar phenomenon. TCE does just this and often offers an important counterpoint to other, more established interpretations and accounts (e.g., the Schwinn case discussed earlier). Symmetrically, other theories and points of view can further advance TCE and provide important counterpoints to its arguments.
The objective of the early TCE scholars was to develop a theory that could be used as a source of empirical predictions about firm boundaries, management, and governance. Why would an automaker produce some components in-house and outsource others? Why would a firm lean toward equity as opposed to debt financing? Why would a public corporation appoint an employee representative on its board of directors?
Reflecting upon nearly four decades of empirical research, Williamson (2000, p. 605) concluded that “TCE is an empirical success story” in that it had achieved its main objectives of producing testable empirical predictions. Covering all the achievements and contributions is beyond the scope of our exposition here, we direct instead the reader to the thorough, systematic reviews of the TCE literature by Joskow (1991), Shelanski and Klein (1995), Rindfleisch and Heide (1997), Silverman (2002), Mahoney (2005), and Macher and Richman (2008). The overarching conclusion echoed in these reviews is that empirical data have largely corroborated TCE: both case studies and the examination of tendencies in large statistical samples show that economic transaction efficiency can be used to account for the choices about how transactions are governed. Uncertainty, frequency, and asset specificity link to governance decisions in a way that TCE predicts (see the cited literature reviews for hundreds of empirical examples).
TCE has also been subjected to a lot of critique in the management literature in particular. Some of this critique is endogenous in the sense that it accepts the fundamental premises of TCE and then seeks to elaborate and expand TCE’s applicability. This critique and the current extensions of TCE will be discussed in the following section. However, one aspect of the exogenous critique merits attention here. By exogenous critique, we mean critical evaluations of TCE that simply reject some of the fundamental premises of the theory (see Ketokivi & Mantere, 2010, for more details on the distinction of endogenous vs. exogenous critique; in the case of TCE critique in particular, see Ketokivi & Mahoney, 2016).
For some reason, TCE—along with agency theory (e.g., Jensen & Meckling, 1976)—became in the 1990s a target of aggressive critique by management scholars in other disciplines (Ghoshal, 2005; Ghoshal & Moran, 1996; Pfeffer, 2005). Critics maintained that TCE is “bad for practice” (Ghoshal & Moran, 1996, p. 13), that it has “deleterious effects” (Pfeffer, 2005, p. 97), even the potential of “destroying good management practices” (Ghoshal, 2005, p. 75). The details of this critique, and the responses to it, are left outside the scope of this exposition; they are well documented in the published literature as well. For balance, however, we recommend that in addition to the highly cited, rather aggressive critiques by Sumantra Ghoshal and Jeffrey Pfeffer, readers also take a look at the less cited responses to these critiques by Williamson (1996a) and Ketokivi and Mahoney (2016). For some reason, the critiques of TCE—some of which are demonstrably deeply flawed in their logic—have garnered more attention than the responses and the rebuttals.
TCE was borne out of a combination of law, economics, and organization. Interestingly, it appears that TCE has had its most significant impact not on economics or law but indeed on theorizing about organizations. Within theories of organization, various fields of management are prominent: strategic management, general management, human resource management, operations management, and marketing. A quick glance at which fields have cited Williamson’s Markets and Hierarchies (1975) and The Economic Institutions of Capitalism (1985) confirms this claim. To briefly examine this, we created and examined a list of scholarly work that meets two criteria: (1) the work cites either one of these two foundational TCE texts; and (2) the work has accumulated over 10,000 Google Scholar citations. Over 90% of the works on this list of a few dozen pieces of scholarship can be classified as clearly belonging to the domain of management and the organization of firms and industries. This further underscores the notion that TCE has indeed established itself as a theory of management. Table 1 echoes this conclusion.
For some reason, TCE’s impact on economics is clearly less significant, and not a single piece of scholarly work on the list we created is in the domain of law. This of course does not mean TCE has not had an impact on economics or law, but rather, that whatever this impact is, it has been dwarfed by TCE’s impact on the field of management and organization research, fields in which it has also received the most intense critique. Critique is, of course, an indication of scholarly impact, and an important one at that.
Current Discussions, Debates, and Developments
There are many important critiques of TCE that merit attention and that can point to new directions of research. This section focuses on two broad themes that will most likely have broader ramifications. For some of the more minor critiques and extensions, see Ketokivi and Mahoney (2016, p. 131, Table 1). Below, we focus on suggestions for future research directions based on endogenous critique of TCE in particular. In the spirit of endogenous critique (Ketokivi & Mantere, 2010), the focus is on seeking ways to elaborate TCE and to ensure its relevance in addressing novel, contemporary organizational phenomena. Much like most theories of organization and management, TCE started out as a simplification, which has been elaborated incrementally over the past forty years to incorporate more complex and general questions and phenomena. The aim of endogenous critique is specifically to ensure that this progress continues in the future as well.
Transactions: From Isolation to Embeddedness
In principle, understanding any single governance decision can pave the way toward understanding any set of interrelated decisions. However, the road is far from being completely paved; possibilities for both theoretical extensions and empirical research on more complex transactions are abundant. One such extension involves revisiting the basic unit of analysis, which in TCE is the dyadic exchange relationship between two transacting parties. This premise is reflected in much empirical research, which is clearly focused on analyzing dyadic exchange relationships. But we know that many exchange relationships and governance decisions are inseparable from one another, and that history matters (Argyres & Liebeskind, 1999; Kang, Mahoney, & Tan, 2009).
As an example, Argyres and Liebeskind (1999, p. 52) discussed how Coca-Cola’s decision to enter into a number of exclusive agreements with independent bottling companies (i.e., individual transactions) limited its future choices regarding forward integration (i.e., potential future transactions). This limitation arose from the fact that the franchising agreement stipulated that only a franchisee would be allowed to bottle Coca-Cola’s products in a given geographic region. With the franchising agreement in force, the only way Coca-Cola could integrate forward in the future would be by buying one of its own franchisees; expanding its own operation by setting up a bottling operation internally would not be feasible. The early versions of the TCE in particular do not consider such intertemporal and intertransactional factors. Yet, in authentic exchange settings, long-term transactions in particular are almost always embedded within an intertemporal network of transactions.
As long as the complicating factors can be modeled and subjected to empirical testing, the scope of TCE can be broadened. Recognizing that individual exchanges are embedded in recurring exchange relationships involving multiple exchanges not only with the same trading partner but also multiple other trading partners, Argyres and Liebeskind (1999, p. 59) noted that because the embeddedness constraints that different firms face are likely heterogeneous, identical transactions may well be governed in different ways in different exchange relationships. This of course exposes a limitation in the earlier formulations of TCE that focus on the characteristics of the individual transaction: TCE indeed predicts an identical governance structure for identical transactions. At the same time, to the extent that these more complex interrelationships can be incorporated into theoretical and empirical analysis, the scope of TCE can be broadened. TCE already incorporates the institutional environments in which transactions occur (e.g., Williamson, 1994), but would benefit from further studies that consider also the idiosyncrasies of the immediate empirical context in which the individual transaction is embedded. An obvious extension is to go beyond the characteristics of the individual transaction, and incorporating the simultaneity of other, relevant transactions.
Building on a similar embeddedness argument, early critiques of TCE called for incorporating also the social structures in which economic transactions are embedded (Granovetter, 1985). The sentiment is the same as above: TCE would benefit from analyses that examine economic exchange not as isolated transactions to be explained by transaction characteristics alone. Instead, the characteristics of the broader economic and social context in which the transaction occurs are relevant as well. These broader examinations could unearth governance mechanisms and safeguards to economic exchange that stem more from the social customs than economic institutions. As Granovetter (1985, p. 489) argued: obligations inherent in personal relationships—not economic institutions—work effectively as safeguards in securing economic exchange. Empirical insight on this proposition would certainly benefit TCE as well.
Here, one must be careful not to interpret abstracting something out as implying that it does not matter. TCE theorists in general and Williamson in particular have clearly acknowledged that social structures matter. What TCE theorists encourage is that in order to move the conversation forward, we must derive the implications and show that they lead to an improved understanding. We may thus invite Granovetter and others arguing for the importance of incorporating social structures to specify in exactly what ways personal relationships or “generalized morality” (Granovetter, 1985, p. 489) act as safeguards in an exchange situation where, say, the two contracting parties are represented by managers about to commit their firm’s resources to a risky project, and where their contractual if not legal obligation is to do what is best for their respective firms? Demonstrating that personal relationships are indeed more effective than formal contractual safeguards in securing a complex and risky transaction across firms would certainly constitute a challenge to the early versions of TCE in particular. But again, the implications must be derived explicitly and brought to the specific context of the complex transaction. As Williamson (1996b, p. 349) noted, “the action resides in the details.”
In a similar vein, in his commentary on opportunism, one of the premises used in TCE, Williamson (1993) noted that opportunism certainly need not be accepted and incorporated as a premise in a theory. But if it is left out, say, for the sake of parsimony, it must be done explicitly and by deriving the implications: “Provided that the analysts who suppress opportunism do this knowingly and come back to assess the ramifications, who could object?” (Williamson, 1993, p. 100). Williamson similarly noted that models based on the assumption that individual economic actors play “a game with fixed rules which they obey” (Williamson, 1993, p. 100) are certainly appropriate as long as their utility is demonstrated: what kinds of empirical predictions do these models produce, and are these predictions corroborated by data?
TCE and Stakeholder Management
All organizations involve several stakeholder groups with only partially overlapping objectives and interests (Freeman, Harrison, Wicks, Parmar, & de Colle, 2010, p. 24):
Business can be understood as a set of relationships among groups which have a stake [hence, stakeholder] in the activities that make up the business. Business is about how customers, suppliers, employees, financiers (stockholders, bondholders, banks, etc.), communities, and managers interact and create value. To understand a business is to know how these relationships work.
Unlike many other economic theories of the firm, TCE not only readily acknowledges the idea that firms consist of heterogeneous stakeholder groups but also derives some of the key implications regarding broader governance issues. In the following, the composition of the boards of directors is examined as an example.
Many economic theories of the firm privilege one stakeholder group, the shareholder, over others. In agency theory, for example, the focus is on the principal, which in the modern corporation consists of the providers of equity capital. Consequently, the theory embraces shareholder wealth maximization as the primary objective. Trying to maximize shareholder value is typically unrealistic (because of bounded rationality and uncertainty), but we could think of a good governance decision or a good contract as one that at least increases shareholder value at a rate that is acceptable to the investors and thus secures their continuing cooperation. Applying this logic, one decision or form of contract could be prescribed over another, because it plausibly increases shareholder value more than the alternatives.
TCE, early formulations in particular, similarly embrace firm value as the main objective: efficient governance decisions are ultimately aimed at increasing firm value, and consequently, shareholder wealth. This is not to say there are no other benefits to efficient transacting, but these other benefits are generally outside the scope of TCE. Clearly, the very desire to transact efficiently is difficult to derive without starting at the profit motive as a premise. This would lead us to conclude that TCE is ultimately primarily interested in just one of the stakeholders, specifically, the shareholder. Consequently, the idea of the board of directors as an instrument to secure the rights of the shareholders can be derived.
But what is the justification for focusing on the shareholder at the board level? Within TCE, the justification arises from the premise that no other stakeholder groups require the board’s attention to ensure they are protected: “Most constituencies are better advised to perfect their relation to the firm at the contracting interface at which firm and constituencies strike their main bargain” (Williamson, 1985, p. 298). The main bargain for an employee is of course the employment relationship, where the employee’s duties and compensation are determined. In most cases, this relationship can be satisfactorily specified in the employment contract, whereby the employees get “their bite at the apple” once or twice a month when their salaries are paid. There are several safeguards that activate if for some reason the firm does not pay its employees’ salaries; contract law, labor law, and collective bargaining agreements are examples of such safeguards. The same applies to buyer-supplier relationships or debt financing: a contract is sufficient, and again, if for some reason the firm reneges on its obligation to pay its invoices or its loan payments, the other contracting parties have safeguards at their disposal, including the extremely powerful mechanisms of litigation and petition for bankruptcy.
Embedded in the logic of TCE—early formulations in particular—is the assumption that when we analyze all stakeholder groups one by one, we likely arrive at the conclusion that the only ones whose rights cannot be secured by way of contract are the shareholders. The shareholder is, by design, a residual claimant who enjoys no contractual safeguards. Shareholders get their only bite at the apple at the distribution of the residual: they receive whatever is left over once all the contractual obligations to other stakeholders have been met. It is illegal for a firm to pay dividends if it has failed to pay its employees’ salaries or has defaulted on its loan payments.
The notion that relationships with all stakeholder groups, save providers of equity, can be perfected by contract is, however, a strong assumption and could reasonably be challenged as unrealistic. The assumption suggests that in formulating the contract, the contracting parties have sufficient foresight to fold the relevant future events regarding the relationship into an ex ante contract, with the requisite safeguards to preempt potential hazards (Williamson, 2000, p. 601). If this is indeed the case, then it is straightforward to derive the conclusion that seats on the board of directors should be reserved for shareholders, the only disadvantaged stakeholders whose relationship with the firm cannot be ex ante formalized into a contract.
There are many arguments that call into question TCE’s early assumption that exchange parties are able “to look ahead, perceive hazards, and factor these back into the contractual relation, thereafter to devise responsive institutions” (Williamson, 1996b, p. 9). Even Williamson himself (1996b, p. 9) noted that this appears to contradict the assumption of bounded rationality. Argyres and Mayer (2007) in particular discuss contracting as an evolving organizational capability that involves various bases of expertise and most importantly, learning over time. Contracting parties may thus well lack sufficient foresight. With highly complex transactions—those beset with high uncertainty in particular—considering all relevant contractual hazards is impossible. Here, uncertainty is not limited to mean uncertainty about how the other contracting party will act but refers more generally to our fundamental inability to anticipate the future, our “limited understanding of nature” (Argyres & Mayer, 2007, p. 1064). We do not know what is going to happen in the future and do not know where innovation will take us. We do not know which skill sets will be useful in the future and which will be obsolete. We do not know what the value of our skills or our technologies in their second-best use is, and we may have no idea what the second-best—or even the primary—use of our skills is ten years from now. Consequently, contracts with stakeholder groups other than the shareholders may be materially incomplete as well, which may require additional safeguards in addition to the contract. Opening the board of directors to broader participation is one obvious alternative.
The question, “Should the board of directors be opened to broader participation?” is relevant and deserves more scrutiny in future research. There are many arguments in the literature suggesting broader participation has benefits (e.g., Aguilera & Jackson, 2010; Osterloh & Frey, 2006). Osterloh and Frey (2006), for instance, argued that in the case of firm-specific knowledge investments by employees, the employment contract may not be sufficient in securing the employees’ cooperation. Or as Aguilera and Jackson (2010, p. 499) put it: “To the extent that the firm contains a stock of firm-specific capital invested by employees, the board should not be seen merely as ‘agents’ of the shareholders but as trustees of stakeholders.” Consider a case in which a software firm asks its software engineers to commit to a high degree of specificity by having them learn and further develop the firm’s own, proprietary programming language. The engineers know that this skill will be useless if they have to seek employment elsewhere. In such cases, Osterloh and Frey (2006) recommend that participation on the board of directors be opened to those making such firm-specific knowledge investments, and that the board be chaired by a neutral person, specifically, a disinterested outsider.
The logic of the stakeholder approach is compelling, but it turns out it is not only readily compatible with TCE, but also that TCE theorists early on acknowledged the general possibility of broader participation: “[A]lthough the stockholders may at one time have had defensible exclusive claims on the board of directors, that has since become an anachronism … [A]ll constituencies require direct access to corporate governance lest their legitimate interests be ignored or abused” (Williamson, 1985, pp. 299–300); and specifically, that “the first and simplest lesson of transaction cost economics is that corporate governance should be reserved for those who supply or finance specialized assets to the firm” (Williamson, 1991, p. 86). Osterloh and Frey’s (2006) notion of firm-specific knowledge investment is a special case of asset specificity, discussed in TCE already twenty years earlier (Williamson, 1985). Again, asset specificity is in no way limited to physical or financial assets; idiosyncratic employment relationships fall within the general category of specificity as well.
Both early and contemporary formulations of TCE invite us to understand the implications of specificity in particular. The starting point is to determine which stakeholder groups exhibit strongest specificity. All relationships that involve negligible specificity should be governed by a contract, because they are much more flexible than the more “heavy-duty” arrangements such as awarding board seats. But in contrast with some of the stakeholder approaches, TCE does caution against broader participation on the board of directors. Williamson (2008, pp. 250–251) noted three potential undesirable consequences. One, giving the board stakeholder (as opposed to shareholder) responsibility dilutes the effectiveness of the board with regard to the shareholders; two, the inclusive stakeholder perspective may provide management with an ad hoc rationale to make just about any decision whatsoever; three, sharing of control between multiple stakeholders may lead to an impasse on decisions.
In TCE, governance questions are always context specific. Whether the task of the board is to act as an agent of the shareholders or as a trustee of the stakeholders must be examined in context, not promoted as a general principle. Consider the case where raising equity financing is critical to an operation; a high-technology manufacturing startup that must invest extensively in highly specific technologies is a good example. In such contexts, the only feasible option for financing the operation is obviously equity (or an equity-like instrument), and prospective investors know they would be putting their money at high risk. How does the firm establish credibility in the eyes of potential providers of equity? In a high-technology manufacturing context with high degrees of technological asset specificity, the firm might be well advised to set up the board of directors primarily as a safeguard to secure shareholder interests. Here, TCE logic importantly reminds us that every step that is taken to dilute shareholder interests at the board level will be a step toward eroding this credibility. If the owners choose to open up the board for broader participation (e.g., employees), they must make their reasoning clear to all existing and prospective providers of equity so as to maintain their willingness to continue financing projects. Owners must be able to convince the prospective providers of equity that employees are indeed taking a risk that is sufficiently proportional in magnitude to the risks taken by those who finance the operation. That both shareholders and employees are making an idiosyncratic firm-specific investment is insufficient: employees may be making firm-specific investments, but they are also guaranteed to receive salary payments. The shareholders in turn are both asked to provide more financing and are guaranteed nothing. Potential providers of equity could reasonably argue that in comparison with salaried employees, they are in a much weaker position, and that the most important task of the board must be to secure the rights of the weakest stakeholder: the shareholder. A firm that refuses to incorporate in its governance decisions the fact that shareholders are doubly disadvantaged vis-à-vis the employees in this context will likely find itself unable to raise the requisite equity. Those advocating broader participation would have to present a compelling argument that financing is not materially jeopardized. The situation must be analyzed in its entirety.
From the TCE perspective, board composition—and governance choice more generally—is ultimately an empirical matter, not something to be derived from a priori assumptions or general principles. Whether the board should be reserved to focus on shareholder issues depends on the context. Further, TCE maintains that all attempts to argue that one governance choice is better than another must incorporate an explicit comparison: “[TCE] is relentlessly comparative, maintaining that the merits of particular organizational arrangements can only be assessed relative to the performance of the relevant alternatives constrained by the same human frailties and propensities, technology and information” (Masten, 1999, p. 54).
It is easy to be misled if one glosses over the context. For example, Williamson (1988, p. 571) wrote that the board of directors is regarded “principally as an instrument for safeguarding equity finance.” What those citing this tend to overlook is that the statement is made specifically in the context of the manufacturing firm, where raising equity financing is crucial. If a manufacturing firm cannot secure requisite financing, discussion of stakeholder issues becomes a moot point: absent sufficient funds to finance the operation, everyone loses. Those arguing for broader board participation in the case of equity-financed manufacturing firms would have to demonstrate that broader participation leads to a better outcome than current practice. The first step in making the argument is to show that broader participation does not dilute shareholder interests to the point that financing is jeopardized. Of course, in a professional service firm the situation may be entirely different. Equity financing is not central in running a law firm, for example (Williamson, 1991).
The maxim of relentless comparison could of course be prescribed as a general principle in both practical and scientific settings: in critiquing something, one should always seek to offer a demonstrably better alternative. Much of the time, critique centers on exposing shortcomings, not offering alternatives. This is the case with many critiques of TCE as well (Ketokivi & Mahoney, 2016). But TCE readily admits that all governance options are imperfect, a conclusion that arises directly from bounded rationality and uncertainty. The challenge resides in identifying which among the imperfect options offers a superior solution to the governance problem at hand.
This chapter has examined the logic and the broad applicability of Transaction Cost Economics to the study of firms, management, and governance. Extending beyond its initial paradigmatic case of the make-or-buy decision in the early 1970s, TCE has been applied with insight to numerous situations that can be viewed as special cases of the general contracting problem. These situations as diverse as they are ubiquitous in contemporary organizations, value chains, and entire industries. TCE and the associated “lens of contract” can often be applied to offer novel, counterintuitive, and provocative perspectives to these phenomena, whether they involve firm boundaries, employment contracts, or corporate financing decisions. The opportunities for further extensions and elaborations are similarly abundant.
In addition to examining how TCE can inform us on a number of substantive issues, this article has also examined some of the more foundational epistemological and methodological principles underlying TCE. In particular, the importance of addressing issues in their proper context on their own terms and embracing the attitude of being relentlessly comparative are crucial. The latter in particular implies that an intellectually rigorous examination, and managerial prescription in particular, must be based on an explicit analysis of feasible alternatives that take the context seriously. All governance choices have flaws, but in any given context, one may often be demonstrated to be less flawed than others, and therefore, the preferred option.
The fundamental ethos of theorizing within TCE is aptly summarized by Williamson’s (2007) simple yet profound advice: cross disciplinary boundaries, have an active mind, be curious, and ask, “What is going on here?”
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