A
SHORT TRIBUTE TO OLIVER WILLIAMSON (1932-2020)
Ajit
Chaudhuri – August 2020
‘Economics
went astray because economists mistook beauty, clad in mathematics, for truth’[1]
It is a birthday month (I turn 57) and therefore time for
some reflection. When, in the course of a career, do you do your most important
work? Is it in the early years, when brain power is at its peak and a spouse,
if one exists, is less demanding? Or later, when you have figured out the ways
of the world and made the mistakes that enable learning? Or even later, when you’re
the boss and can get things done? Or maybe towards the end, when you have reached
where you are going to reach, have nothing to prove, don’t need to kiss ass,
and can focus upon what you want to do?
This note is not an attempt at an answer! However, I do remember
a discussion with a professor in the mid-2000s in which he mentioned an
encounter with Ronald Coase, who was awarded the Nobel Prize for
Economics in 1991. Coase was waiting at the lift of a hotel at a conference he
was attending, as was another economist and his son. The latter economist
recognized Coase and introduced himself, they made some polite chit-chat, and
Coase then asked his son what he was doing. The young man was studying
economics, so they talked about what he (the son) was working on. As Coase got
off the lift, he told the young man ‘you know, when I was your age I had already
written the paper that won me the Nobel.’
The paper in question, ‘The Nature of the Firm’[2] was written in 1932 and
then languished for five years until it was finally published. It then
languished further, until the 1960s – the period in economics when the ‘efficient
markets’ school of thought was at its peak; when neo-classical economists saw
their chief function as one of understanding how pricing coordinates an
economy, when organizations were a mere black box or a production function that
converted inputs into outputs through a price structure, when humans were the rational
and selfish homo economicus, and when complexities were simplified with the
extensive use of abstract mathematics.
Coase’s thinking was brought in from the cold by a group of
scholars who challenged the domination of ‘efficient markets’ and asked the
questions – if markets are so good at directing resources, why do companies
exist? Why are some activities directed by market forces and others by firms? Why
is there such a plurality of organization forms; family firms, franchises,
alliances, big corporations, natural monopolies, inter alia; and how do these
structures impact the economy? They were led by Oliver Williamson, who
developed Coase’s ideas and used them to understand realities through a field
of study entitled ‘New Institutional Economics’, thereby making economics more
tangible and accessible[3] to generalists like me.
According to Coase, the firm is a response to the high cost
of using markets – it is cheaper to direct tasks by fiat (i.e. via orders to
employees within a hierarchical organization) than to negotiate and enforce
separate contracts for every economic transaction because of what he called
‘transaction costs’. Coase was the first to spot an enduring truth, that
successful economies combine the benign dictatorship of the firm with the
invisible hand of the market. His ideas raised the counter question – if firms
exist to reduce transaction costs, then why have market transactions at all?
It was Williamson who delved into the ‘make or buy?’
question. When should a firm buy something, rather than make it in-house? He
identified three inter-related factors that governed such a decision;
specificity of asset, openness of contract, and scope for opportunism. He
defined an asset as specific to a transaction if its value is lower outside of
a transaction than within it, and said that vertical integration (i.e. bringing
it in-house) is better than going to the market when the asset is specific to
the transaction. Similarly, he distinguished between spot transactions
(purchasing a product once, upon immediate payment) and long-term contracts
(committing to purchase a product at different times in the future at an agreed
quantity and price) and said that the latter are necessarily incomplete,
slightly open-ended, and sustained largely by trust – a contract stays in force
primarily because its breakdown would hurt both parties. If market forces change
the relative bargaining power of the parties in the future, there is scope for one
party to exercise rational opportunism and break the contract. Such
transactions would be better managed within an alternative form of governance,
the firm. Complicated? I will try to simplify below!
Take for example the case of car manufacturer Company X and
car body maker Company Y, wherein X has the option of buying car bodies from Y
or the option of purchasing Y outright and bringing it within X’s operations.
In the former option, i.e. X buys car bodies from Y, if Y has to purchase an
expensive manufacturing die that is specific to X’s car design, it needs
assurance of future purchases – if X declines to purchase car bodies in future,
the expensive asset (the die) has little value and Y is screwed. Alternatively,
if demand for the produced car skyrockets, Y can hold X to ransom by pushing up
its price. Due to the likelihood of such opportunism in the future, it is
better for X to exercise the latter option and purchase Y.
It always felt that, deserving as he was, Williamson would
never be a Nobel Laureate because of Coase being awarded the Nobel Prize in
1991. The 2009 Nobel Committee’s announcement of the Nobel for Economics was
therefore a wonderful surprise – Williamson had won it jointly with another
giant, Elinor Ostrom, whose work on the role of institutions in natural
resources management helped puncture the ‘tragedy of the commons’ doctrine that
assumed humans as selfish and calculating[4].
Oliver Williamson’s passing on 21st May 2020 did
not hit the headlines in these pandemic-affected times. But his work affected
many fields, and helped make policies and form regulations on the relative
roles of the state, the market and institutions. This note is a short tribute
to a man who ‘switched on the light where the keys were, rather than searching
for keys where the light was’.
[1]
Krugman, Paul; The New York Times; 2009
[2]
Coase, Ronald; “The Nature of the Firm”; Economica 4(16) pp 386-405; 1937
[3]
Ghosh, Ranjan and Goyal, Yugank; “Oliver Williamson: The Man Who Reduced the
Transaction Cost of Economics”; The Economic and Political Weekly 55(28-29), 11th
July 2020.
[4] Two more Coase acolytes have since
won the Economics Nobel – Oliver Hart and Bengt Holmstrom in 2016
for their work on the theory of incomplete contracts that helped understand
which government services can benefit from being privatized, and which are
better off under government control.
