Transaction cost economics builds on Coase's work (specifically: (1937) The nature of the

firm) by offering a more realizable theory and set of tools for studying organizations.
Williamson's theory treats transactions as the basic unit of analysis and claims that
economizing on these costs drives organizations' design of governance structures. The
theory assumes opportunism among actors and bounded rationality (a la Simon, 1957).
A transaction, as defined by Williamson, "occurs when a good or service is transferred
across a technologically separable interface." (p552) Williamson argues that the critical
dimensions for describing transactions are (1) uncertainty, (2) frequency, and (3) the degree
to which transaction-specific investments are required to realize least cost supply (i.e., "asset
specificity").
Williamson argues that asset specificity is the most important dimension. This is in part
because actors are assumed to be opportunistic, and a transaction regarding a specific asset
puts people in both sides in a vulnerable position. In the case of one supplier, for example, a
buyer can be forced to pay a higher price and if there is only one seller, the opposite situation
is in play. In Williamson's terms, under high asset specificity, "buyer and seller are effectively
operating in a bilateral (or at least quasi-bilateral) exchange relation for a considerable period
thereafter." (p555) In general, Williamson claims that high specificity will drive transaction
costs up.
Speaking specifically to the question of organizational boundaries (a key issue in
organization theory, see Santos and Eisenhardt (2005)), Williamson's key argument is that
we can view a firm based on a series of what to include inside a firm and what to keep
outside. Essentially, firms are attempting to design "efficient" boundaries in a world where
there is a firm-market dichotomy. Firms allow hierarchy to invoke fiat to resolve differences to
provide better access to information. Similarly, increased uncertainty may drive the firm to
internalize resources and/or work upon which it is dependent.
Williamson argues that his model also applies to human assets. For example, if a company is
investing in firm-specific skills, it won't want to lose employees with those skills. It might
therefore choose to focus on internal labor markets

Main Contribution:
This article introduces and outlines the transaction cost approach, which regards the
transaction as the basic unit of analysis and proposes that an understanding of
transaction cost economizing is central to the study of organizations.
Summary of Major Points:
Transaction Cost Economics (TCE) Transaction is the basic unit of analysis. The focus
is on assessing alternative governance structures (e.g., firms versus markets), in terms of
their capacities to economize on transaction costs.

Level of Analysis TCE approach has been applied at the following three levels of
analysis: (1) Examine overall structure of the organization to determine how operating
parts should be related one to another; (2) Examine operating parts of the firm to
determine which activities should be performed within the firm, which outside, and why;
(3) Explore the manner in which human assets are organized and identify appropriate
governance structures given the attributes of particular work groups. Only the latter two
issues are explored in this article.
Related Literature (1) Economics (e.g., Commons, 1934; Coase, 1937; Hayek, 1945);
(2) Organization theory (e.g., Barnard, 1938; Simon, 1947; March and Simon, 1958;
Cyert and March, 1963; Thompson, 1967; Chandler, 1962; (3) Contract law (e.g.,
Llewellyn, 1931; Macaulay, 1963; Fuller, 1964; Summers, 1969; Feller, 1973; Macneil,
1974).
Transaction A transaction occurs when a good or service is transferred across a
technologically separable interface. One stage of activity terminates and another begins.
Transaction Cost Analogous to friction in mechanical systems. Costs arise when parties
to an exchange operate disharmoniously, or there are frequent misunderstandings and
conflicts lead to delays, breakdowns, or other malfunctions. TCE is concerned with the
examination of the comparative costs of planning, adapting, and monitoring task
completion under alternative governance structures.
Behavioral Assumptions Two assumptions which add realism to TCE and distinguish
the approach from neoclassical economics are: (1) the recognition that human agents
exhibit bounded rationality. Boundedly rational agents are intededly rational, but are
limited in terms of formulating and solving complex problems and in processing (e.g.,
receiving, storing, retrieving, transmitting) information. Given humans experience
bounded rationality, it is impossible to devise comprehensive contracts and thus
incomplete contracting is the best that can be achieved; and (2) human agents are often
opportunistic. Human motivations are more complex than suggested in neoclassical
economics.
Dimensions of a Transaction There are three dimensions for describing transactions: (1)
uncertainty, (2) the frequency with which transactions recur, and (3) the degree to which
durable, transaction specific investments (asset specificity) are required to realize least
cost supply.
Asset Specificity Asset specificity is the most important dimension for describing a
transaction. Describes the degree to which investments are specialized to a particular
transaction. Assets that are unspecialized among users pose few hazards since buyers can
easily turn to alternative sources and sellers can sell output intended for one buyer to
other buyers without difficulty. Conversely, assets that are specialized among users locks
in buyers and sellers, since buyers cannot turn to alternative sources of supply and
suppliers cannot find alternative buyers willing to pay an equitable price for the assets.
Accordingly, when asset specificity is high, buyers and sellers will devise contracts that

ensure continuity of the relationship. Asset specificity can arise in any of three ways: (1)
site specificity (e.g., co-locate assets to economize on inventory and transportation costs),
(2) physical asset specificity, and (3) human asset specificity.
TCE Logic A firm is faced with the following three possibilities: (1) First, the
ownership of certain assets (e.g., those that comprise the firms core technology) is
sufficiently obvious that a careful, comparative assessment is unnecessary (e.g., site
specificity); (2) Second, in the case where self supply is clearly uneconomical, market
supply is the obvious choice (e.g., raw materials); (3) Third, for certain assets, a make or
buy decision can only be made after assessing the transformation and transaction cost
consequences of alternative modes. The crucial issue is how the choice between firm and
market governance structures are made for decisions related to point 3 above. There are
four central points concerning this decision: (1) physical asset specificity is never valued
by itself but only because demand is thereby increased in design or performance respects;
(2) such valued demand consequences are often realized only at greater production
expense; hence (3) the optimal choice of asset specificity requires that demand and
production cost consequences be taken into account simultaneously; and (4) governance
costs also vary with asset specificity, and these have to be introduced into the calculus.
Asset Specificity and Governance Mechanisms If assets are nonspecific, markets are
superior in terms of production and governance costs. When assets become semi-specific,
bilateral or market contract will appear. Internal organization will displace markets as
assets become increasingly specialized.
Advantage of Firms over Markets (1) Common ownership reduces the incentives to
suboptimize; (2) Internal organization is able to readily solve differences, whereas costly
negotiation is required when an impasse develops between firms; (3) Internal
organization has easier and more complete access to relevant information when disputes
occur.
COASE, R. H. (1937)

The Nature of the Firm

Economica
, New Series, Volume 4, Issue 16, pp. 368-405
(revised 9/2013)
Summary:
The author states that there is a chronic affliction of the economic theory, which is the
inability to cope withits underlying assumptions. One of those fundamentals
is the question of the locus of control within aneconomic system. The economic system
supposedly needs no central survey. It is assumed to work itself, as
it fluidly reacts to changing conditions and maintains equilibrium in the long run. Many
economists thereforeclaim that tinkering with the system is counterproductive as it upsets
the equilibrium and inevitably bringsabout undesirable consequences. Such a claim,

however, is a misconception, as there are processes akin toeconomic planning routinely

present in any given economic system. One of such is the firm.The distinguishing mark
of the organization of a firm is the supersession of the price mechanism. Instead, afirm is
being placed under the control of an entrepreneur, who maintains an alternative means
of organization. The undertaker still collaborates with the external market mechanisms
and flexibly steers theworking of the firm accordingly. Internal affairs, however, are
being centrally governed.
We could ask: What are the advantages of central government vis--vis the pricemechanism? There aresome rather mundane motivations for the existence of a firm. As
some people prefer to govern and someprefer to be governed, the hierarchical
organization can simply be desired for its own sake. The corporateway of organizing can
be also said to be advantageous thanks to different treatment from regulators. Theactual
reason that could explain the advent of the firm is to be sought, however, in costs of using
the marketmechanism, and those arise from the principle of uncertainty. If everyone were
in possession of perfectknowledge of the situation and with ability to predict the future,
such costs would not exist. No marketingtransactions would be present; the flow of
material and productive services would be entirely automatic.That is not the case. In a
situation where uncertainty is present, forecasting of behaviour of the market is acrucial
task and function of the entrepreneur.
As long as there is a cost of using the price-mechanism, it is advantageous to organize
within a firm andreduce uncertainty by making a promise of loyalty to a certain extent.
Within a firm, an unsustainably largenumber of contracts is replaced by one. Certain
number of contracts could hypothetically be replaced by along term contract. Such a
contract would lack the desired flexibility, though. Instead, employers andemployees
create hierarchical structures and subject themselves to a master-servant relationship.We
made the case for the existence of the institution of firm. What remains to be explained is
size. If thistype of organization brings merit, why isnt there one almighty firm, gradually
consuming all markets? Thefact that a firm stops growing at some point can be described
by
the law of diminishing returns tomanagement : the cost of organizing rises with
additional transactions due to inability to place resourceseffectively, and at some point
surpasses the costs of carrying out the transaction in the open market. A firmtherefore
tends to be larger a) the less the cost of organizing is and the slower the cost grows
withexpansion, b) the less likely is the entrepreneur to make mistakes and the smaller the
probability of beinginefficient grows with accepting additional transactions and c) the
less the supply price of factors of production rises as the firm grows larger.
OUCHI
The problem of organization is the problem of obtaining cooperation among a collection
of individuals or units who share only partially congruent objectives. When a team of
individuals collectively produces a single output, there develops the problem of how to
distribute the rewards emanating from that output in such a manner that each team
member is equitably rewarded. If equitable rewards are not forthcoming, members will,

in future cooperative ventures, adjust their efforts in such a manner that all will be
somewhat worse off (cf. Simon [41], Marschak [26], Alchian and Demetz[1]). It is the
objective of this paper to describe three fundamentally different mechanisms through
which organizations can seek to cope with this problem of evaluation and control. The
three will be referred to as markets, bureaucracies, and clans. In a fundamental sense,
markets deal with the control problem through their ability to precisely measure and
reward individual contributions; bureaucracies rely instead upon a mixture of close
evaluation with a socialized acceptance of common objectives; and clans rely upon a
relatively complete socialization process which effectively eliminates goal incongruence
between individuals. This paper explores the organizational manifestations of these three
approaches to the problem of control. The paper begins with an example from a parts
distribution division of a major company which serves to give some flesh to what might
otherwise be overly-abstract arguments. Through the example, each of the three
mechanisms is explicated briefly and discussed in terms of two prerequisite conditions,
one social and the other informational. The more concrete organization design features of
the three forms are considered, along with some consideration of the unique costs
accompanying each form.

The purpose of this paper is to describe three control mechanisms and their
applicability to organizations. The three types of control include: 1) the market
pricing mechanism, 2) bureaucratic control and 3) the clan. The following
tables provide a summary of Ouchi's discussion of the requirements of each
type or control system.
Ouchi'sThreeControlMechanisms
Requirements
Socialagreements

Information Nature.
needs

Completeness.
Accessibilityand

understandabilitytonewcomers.
Howdeveloped.

Informationsystemscapability
ofcopingwithparticipants

heterogeneityandturnover.

Applicablemethodofcontrollingpeople

Market
Reciprocity.

Bureaucracy
Reciprocityandauthority(i.e.,
theemployeegivesupautonomy
forpay).
Explicitcompetitive Explicitrulesandregulations
priceforeachtaskor e.g.,accountingsystems.
exchange.

Clan*
Reciprocity,authorityand
sharedvaluesandbeliefs.

Complete.
Accessibleand
understandable
Supplyanddemand.
Capable.

Incomplete,butstated.
Accessibleand
understandable
Mustbecreatedordesigned.
Capable.

Complete,butunstated.
Inaccessibleandnot
understandable.
Developsnaturally.
Incapable.

Selfselectbasedon
pricemechanism.

Selectemployeeswithlittle
Selectemployeeswithcareful
screeninganddesignasystemto screeningtoinsuretheskills

Implicittraditions,e.g.,the
U.S.Senate.

instruct,monitorandevaluate
them.

Ouchi'sThreeControlMechanisms
Requirements
Market
Bureaucracy
Costofsystem:
Search&acquisition.
Variable.
Lowcost.
Training
Zero.
Lowcost.
Supervision.
Zero.
Highcost.
Timing,needandfeasibilityof
Notneeded.
Shortrun,criticalneed.
definingtheprocessandmeasuring
efficiency.

andvaluesneeded.

Clan*

Highcost.
Highcost.
Lowcost.
Longrun,lesssignificantneed.
Processmaybeblackboxplus
highinterdependenceand
synergy.
Howparticipant'scommitmentto Selfinterestbasedonprice
Selfinterestsupportedand
Selfinterestbasedoncommon
organization'sobjectivesis
mechanism.
motivatedbytraining,rulesand values.
obtained.
closesupervisioninsure
compliance.
Whenthecontrolmechanism
Wheninterdependenceislow,or Whenthelevelsofworker
Whenthelevelsofworker
shouldbeemphasized,i.e.,willbe zeroandthereisasingletaskor diversityandemployeeturnover diversityandturnoverarelow
themostefficientmethod.
exchange,orwhenitisfeasible arehigh,thelevelof
andthelevelof
(Notethathighinterdependence
andeconomicaltoestablisha interdependenceislowandthe interdependenceishigh.The
causeslowclarityofperformance competitivemarketpricefor
clarityofindividualperformance clarityofindividual
measurement.)
eachmultitaskorexchange.
measurementishigh.
performanceislowand
Theserequirementstendto
teamworkiscritical.
producemanyspecialtiesand
subspecialtiestoreducethe
interdependence.Rulesandclose
surveillancearerequiredfor
eachspecialtyandsubspecialty.

* According to Ouchi, a group of people with a common specialization

represents a profession, the citizens of a political unit make up a culture and the
collection of individuals within a unique organization is a clan.
Note that all organizations have hybrid systems that contain elements of all
three control mechanisms. Systems designers must decide how much emphasis
to place on each form. "In a sense, the Market is like a trout and the Clan like a
salmon, each a beautiful, highly-specialized species which requires uncommon
conditions for its survival. In comparison the bureaucratic method of control is
the catfish - clumsy, ugly, but able to live in the widest possible range of
environments and ultimately, the dominant species. The bureaucratic mode of
control can withstand high rates of turnover, a high degree of heterogeneity, and
it does not have very demanding informational needs."
There is a conflict. American society is becoming more pluralistic, i.e., made
up of more diverse ethnic, religious and cultural groups, but increasingly more

interdependent. The need for Americans to work together is increasing while it

is becoming more difficult for them to do so.