3.2 Coordination and transaction costs
In the late 1970s and 1980s, much attention was focused on transaction costs as an explanation for the organisation of activity within or outside firms. This work focused on the firm as an entity able to govern transactions which markets could not provide. In particular, this work focused on the problems created by asset-specificity and the potential for opportunistic behaviour (hold-up) created when specific assets were owned by contractors independent of the firm. However, this form of organisation came at the expense of high costs (management costs) by comparison with the simpler incentive systems that could be used when sourcing non-specific inputs from the market (Williamson, 1979, 1999).
An extension of this transaction-costs approach focuses on the costs of conflict over the “appropriable quasi-rents” resulting from the activities of one or more firms (the costs of attempting to avoid such conflict being one form of transaction cost). Where these rents are large, conflict will be more intense, and the benefits of integration of activity within the firm will be large.
To the extent that transaction-cost approaches provided a theory of who owns the firm, it was developed within the “nexus of contracts” theory of the firm that underlay the work of Jensen and Meckling. Here the firm is “a legal fiction which serves as a focus for the complex process in which the conflicting objectives of individuals . . . are brought in equilibrium within a framework of contractual relationships” (1976:312). In this view, each party is fully protected by its contract within the nexus with the exception of shareholders, who accept a residual return because of their comparative advantage in diversifying risk, and residual control rights to guard against managerial appropriation of this residual return. But this view is inconsistent with the observation that contracts are never complete.
Despite its predominance in the literature at the time that the NPM models of the 1980s were being developed, transaction-cost approaches are now regarded as providing limited insight into the most interesting questions about the firm. Transaction-cost explanations for contractual incompleteness are unsatisfactory, because there is more incompleteness than can be accounted for by transaction costs (specifically, because there are many elements where contracting is not possible rather than just more costly than the alternative). Examples include situations where information is symmetric, but key contractible elements are not verifiable by either party. Even when transaction costs are zero, incomplete contracts may arise because parties cannot observe relevant economic variables, cannot verify those variables to a legal standard of proof, or prefer not to disclose information about themselves that would be required for a complete contract (Schwartz, 1998).
