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Oliver Williamson and the pin factory
In Adam Smith there is the pin factory and the market and from that beginning we trace the long literature in economics focused on the twin questions, What price to set? How much to produce? Following Coase, Williamson asks different questions, Why a pin factory? Why are the 18 steps to make a pin performed by a single firm rather than two or more? Why are there many firms instead of one large firm? Why does the pin factory not vertically integrate upwards to buy the steel factory and downwards to buy the retail hardware shop?
Williamson's answer rest on the notions of bounded rationality, contract incompleteness, asset specificity and opportunism. Start at the end, asset specificity and opportunism. When a deal has been sealed the parties typically move from having many potential partners to being locked in. That's bad because it raises the possibility of opportunism--one party can exploit the other. But it's also good because when the lock-in is credible each party may be more willing to invest in assets which are extra-productive but specific to the relationship.
Marriage, for example, takes away some possibilities but it adds others. With marriage, for example, comes a greater willingness to invest in children (n.b. asset specificity, the child is of extra value but only to the specific parties involved in the marriage) but that very benefit also means that one of the parties has the leverage to be opportunistic. Knowing all of this when they enter the contract the parties bargain ex-ante, they exchange promises and make investments (the ring), they establish rules for ex-post bargaining or decide on the background rules to apply in that eventually (pre-nup, no fault divorce, covenant marriage). The rules are never perfect and the contacts are always incomplete.
Transaction cost economics is all about applying these ideas in different settings to figure out the best governance structures (marriage, vertical integration etc.) in different circumstances. How does one deal with expensive investments (such as highly individual dies or plant construction) that are specific to a given trade and put the investor at risk yet which increase productivity? Williamson analyzes how firms come to rely on long term contracts or vertical integration or other seemingly non-competitive solutions to enhance market productivity. Early generations of antitrust enforcers often saw these as monopolistic dealings, but scholars such as Williamson helped us understand how these are essential to the workings of the invisible hand.
Williamson's paper, The Economics of Governance (working version) published in the May 2005 AER is an excellent recent summary of his views in the area. Williamson's work is notable for inspiring a large body of empirical and theoretical work in modern industrial organization and having influence in law, political science, and management. His work has been widely cited, and by some counts he was the most widely cited economist in the world.
I especially thank John Nye who contributed to this post.
Posted by Alex Tabarrok on October 12, 2009 at 10:14 AM in Current Affairs, Economics | Permalink
Comments
Didn't Coase already win a Nobel for this idea? What did Williamson add?
Posted by: Norman Pfyster at Oct 12, 2009 10:18:53 AM
Regarding Coase already winning the prize for transaction costs: Here is the text from today's Scientific Background
"While Coase’s argument eventually convinced economists about the need to look inside the boundaries of firms, it offered only the preliminaries of an actual theory of the firm. Without specifying the determinants of the costs associated with individual bargains or the costs of administrative decision-making, Coase’s statement has little empirical content. The challenge remained to find ways of sharpening the theory enough to yield refutable predictions."
http://nobelprize.org/nobel_prizes/economics/laureates/2009/ecoadv09.pdf
Posted by: Michael at Oct 12, 2009 10:33:30 AM
Think you could ask Professor Nye to guestblog on MR for a week?
Posted by: Max at Oct 12, 2009 10:40:50 AM
Just in time to clarify exclusivity between mobile phones/devices and network carriers.
Posted by: Ed Lopez at Oct 12, 2009 10:51:27 AM
Were Smith's pins the wee chaps used for cloth, or the small nails used in woodwork?
Posted by: dearieme at Oct 12, 2009 11:58:57 AM
Nice summary and a well deserved award. On Econospeak I had forecast
that it would be for environmental or behavioral finance, but listed
as first choice if it was not them, Williamson. I think the committee
did not want an award that was viewed as "political" or too tied to
current events this year. In any case, Oliver Williamson is without
question deserving. He has substantially moved forward the ideas
initiated by Coase, combining them with ideas from Alfred Chandler
and many others, including his mentor in bounded rationality at
Carnegie-Mellon, earlier Nobel recipient, Herbert Simon.
As a drumbeat I shall also note that he authored the very first paper
every to be published in JEBO, the journal I now edit. It was "The
organization of work," JEBO March 1980 1(1), pp. 5-38. He has been on
the editorial board since the beginning, moving to the position of
Honorary Editor as of Jan. 2002.
Posted by: Barkley Rosser at Oct 12, 2009 12:03:14 PM
Do you even think before you post? Marriage adds possibilites? Like children? As if you couldn't have children outside of marriage? Were you born in 1912 or something?
Marriage is a risky social contract whereby people pool their resources to reduce housing costs and increase the chances for health insurance. I like you Tyler, but sometimes you write some really stupid things.
Posted by: Benny Lava at Oct 12, 2009 12:23:52 PM
Pardon me, I mean Alex, not Tyler.
Posted by: Benny Lava at Oct 12, 2009 12:24:42 PM
"people pool their resources to reduce housing costs and increase the chances for health insurance"
So why do people get married outside America? Will universal healthcare lead to a surge in co-habitation? In reality marriage allows you to hold your partner to greater account for cheating, hence increases your confidence that the kids are yours.
Posted by: Millian at Oct 12, 2009 12:56:46 PM
Benny:
Marriage is indeed a very good example of what he was talking about. Children are very analagous to the 'assets that are extra-productive but specific to the relationship,' in that each parent may want a kid, but absent a partner to take some of the load, may not be able to afford/handle it. A marriage acts as an incomplete contract under which the partner is promising to hold up his/her end of the deal, making the investment 'profitable' for each partner by splitting the 'cost'. A marriage contract covers more ground than just childcare, of course, but often contracts between a supplier and a retailer cover more ground than just number of units and price, as well. You can do it other ways - negotiate a separate parenting agreement, get court ordered child support, set up a 'time share' (alternating custody) whatever - but marriage is one of the institutions which allow children to be an economic 'investment'.
Posted by: rvman at Oct 12, 2009 12:58:31 PM
Relax Benny
Posted by: bastiat at Oct 12, 2009 12:58:34 PM
I changed the wording but really Benny I take most MR readers as able to read with subtlety and intelligence and to understand what is in conversational style.
Posted by: Alex Tabarrok at Oct 12, 2009 1:00:31 PM
In reply to Max on cell phone/carrier exclusivity deals:
The carriers want new, cool devices to attract customers. Once an individual is with a certain carrier, she tends to stay (for at least a while), and if you stick with one carrier, you can get a discounted rate talking to other subscribers. So it's "come for the gadget, stay for the network effects."
The device makers get a marketing boost out of it. The carrier will advertise the device on TV (if it's cool enough), the Internet, and inside their stores.
Posted by: Bo at Oct 12, 2009 1:21:36 PM
Great Alex, now I'm wondering about why marriages don't vertically integrate.
Posted by: Apep at Oct 12, 2009 1:23:49 PM
now I'm wondering about why marriages don't vertically integrate.
You never heard of in-laws?
Posted by: Roger Sweeny at Oct 12, 2009 1:35:49 PM
"they establish rules for ex-post bargaining or decide on the background rules to apply in that eventually (pre-nup, no fault divorce, covenant marriage). The rules are never perfect and the contacts are always incomplete."
It would be rational for a guy to enter a prenuptial agreement setting out what he owes if the marriage fails (in some cases it would be rational for the woman to insist upon one as well). But in most cases the woman contemplating marriage reacts negatively to the mention of a prenup. I think in almost every case this is due to emotional reasons rather than some calculation that she would receive extra money courtesy of the divorce court. In most cases she genuinely thinks it is wrong to even contemplate the possibility that the marriage will fail.
If the guy doesn't insist upon the prenuptial agreement, it won't be signed. And, in the event of divorce, this means that the woman (again, in most cases) will be better off than she would have been under the prenup. This is because very few rational people would agree to sign a prenup that transfers as much wealth as divorce law transfers. I can imagine a guy's reaction upon being presented with a prenup that mirrors divorce law wealth transfers, "You want half of whatever wealth I accumulate during the marriage, alimony for ten years, and me to pay your divorce lawyer, in addition to child support?"
Posted by: Larry at Oct 12, 2009 1:37:55 PM
@Millian:
So why do people get married outside America?
At a far lower rate! Just compare marriage statistics between the U.S. and Europe. Economic benefits change a large part of the picture. And whining about cheating spouses is just loser talk.
@Alex: Why change the wording if you are right all along? When is Tyler coming back?
Posted by: JSK at Oct 12, 2009 1:55:33 PM
Larry:
I think that, in your hypothetical, the woman takes the request for a prenup as a signal that the man's commitment is limited in time. Children (at least in America) tend to be more of a burden on women than on men (start with the fact that women miss time at work due to child-bearing and go from there). So, her response is rational to the signal being sent in the hypothetical. (It may also be emotional, of course; but that doesn't change the fact that it is probably rational.)
I could modify the hypothetical to make it one where she didn't react that way. The man would need to introduce the idea as saying that he thinks that divorce laws are insufficiently generous to women who have taken a lot of time off work for child-bearing and -rearing. He'd then make the prenup less generous if she doesn't do those things.
One interesting proposal I once saw was to change the background divorce law to make no-fault divorce unavailable while any children of the marriage were minors. Divorce could still be arranged by mutual consent. The idea was to force bargaining in the presumed scenario of the stay-at-home child-rearer being divorced by the (not necessarily wealthy) income-generator. The article contended that this used to be the effective practice, where the party interested in getting a divorce would pay the other spouse enough to file for divorce on grounds of adultery or abandonment, to which the first spouse would admit. Changing it to consent would simply eliminate the need to pretend to facts that didn't exist.
I'm not sure that the whole prenup / divorce issue is meaningful in a society that readily accepts cohabitation and children of parents who are not married to each other (or who are married to other people entirely). It seems like the relevant background law is now the child-support statute. And that structure is awfully close to the proposal above that would allow divorce only with consent while there are minor children of the marriage.
For those interesting in thinking more about it, here is a link to Texas's child support statute:
http://www.statutes.legis.state.tx.us/Docs/FA/htm/FA.154.htm#154.001
The interesting parts to me are section 154.125, which sets a guideline award at a different percent of "net resources" depending on the number of children being supported, and section 154.124, which allows the parents to set the child support by agreement, so long as the court ratifies the agreement as being in the child's best interest.
Max
Posted by: Maximum Liberty at Oct 12, 2009 4:36:50 PM
Benny Lava, Ruman...are you a trainned economists?
Benny, read the whole thing before misquoting.
Ruman, children has nothing to do with assets. Parents expect no return on them. And are willing to carry them as long as they are alive.
I might concede there is a return, but only within spiritual realm.
Besides, no action of your children or yours will diminish their value.
Marriage is a ritual.
And its "market value" rest on social networks expanded by the expansion on personal ID of both persons.
Posted by: Ricardo Quiel at Oct 13, 2009 1:46:52 PM
I believe the idea of discussing marriage in these terms is wholly unscientific and amounts to nothing less than the economic imperialism. I would certainly take my economist's hat off and sit comfortably in an armchair before I started discussing these issues. One can trace parallels all he wants, but in the end, as I think this discussion thread illustrates, the focus is lost and the economics is out the window. I would reserve these discussions to dinner table talks with relatives I wanted to allienate.
Posted by: Gil at Oct 14, 2009 6:21:08 PM
As the time for disciplanary bounds may be opening, people should revisit Alfred Chandler's THE VISIBLE HAND OF MANAGEMENT. Won the Bancroft and Pulitzer. Key in business history.
Posted by: RPC at Oct 15, 2009 9:42:32 AM
