How should firms organize their transactions?

Oliver Williamson revolutionized the way economists look at organizations by opening the “black boxes”, the name he gave to the inner working of firms. Economists concentrated on the existence of firms; Williamson on its mechanisms. “Olly” paved the way for business enterprises to be analyzed. According to his research, organizations are sometimes more efficient than markets, because the conflicts are easier and less expensive to solve. The study of Transaction Cost Economics is only one of its highlights. His unique style of interdisciplinary, methodical, detailed, and complex scientific research made it possible for many other economists to build on his groundwork. Williamson’s the founding father of the field of organization sociology, because his work approached both the formal organization of the firm, and also the cultural and social norms found within it.

Oliver E. Williamson

The Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel (shared), 2009

At a glance

Born: 1932, Superior, Wisconsin

Field: Economic governance

Prize-winning work: For his analysis of economic governance, especially the boundaries of the firm

Sentence of his life: “Daaaaad! I think this is the call.”

Favorite place: Summer home on Lake Nebagamon in Wisconsin

Spleens: Starts every sentence with “Well…” and pauses to think

A rich life

Ask anyone who knows Oliver Williamson well to describe him, and four words crop up repeatedly: firms, organization, transaction, and humor. On his terrace in Berkeley Hills, California, Williamson shows us why: “Mr. Williamson, how do you define a rich life?” The question hovers in the air. Williamson has to concentrate, (he admits age is beginning to catch up with him) and, looking out over the Berkley, campus, the hills and San Francisco Bay he says: “Well,” (that’s how he always begins.) “I guess I have a rich house.” He laughs. He knows this isn’t the expected answer, so he apologizes. “You ask good questions, I give bad answers.” His wife, Dolores, died a few years ago and Williamson acknowledges she was the one making his life rich.

Exploring Mr. “Tough Stuff”

Inside the Haas School of Business, Olly is an ‘institution’ himself. His health stops him going into the school now, but his small office is still there. Former colleagues send their regards. Of course, there are lectures addressing his work. While reading a Williamson course, a lay person would become lost almost immediately. Even his students admit that Williamson’s course is the “tough stuff” and that his style is abstract. His language is of a very different kind, agrees fellow Laureate Oliver Hart during the Lindau Laureates Meeting. Not even Hart, who has built on Williamson’s work, is able to understand all of Williamson’s ideas in the field of institutional economics. But he is able to explain one of his namesake’s core theories.

What are relationship specific investments?

In 1930, economist Ronald Coase laid the groundwork for Williamson to build up the field of Transaction Cost Economics. He asked: ‘Why does so much activity take place inside firms when economists say markets are efficient?’ Coase made his point: markets can’t be that good all the time. They’re costly to use and, sometimes, it’s necessary to replace bargaining in the market setting with a firm hand. Years later, Williamson pitched the idea that haggling costs will be important when one - or both - of two independent contractors need to make a relationship-specific investment: investments that bind them together.

In Lindau, Hart shares an example that illustrates the core of Williamson’s ‘Theory of the Firm’. “If you’re a coal mine,” he says “you’re fixed in place. It would be good to have someone next to you using your coal. There are a lot of power companies around the country and any one of them could locate a plant there. So, at that point we’re at a competitive point in the market.” Then Hart brings in something Williamson called ‘fundamental transformation’. “If one of them decided to locate next to you, it’s you versus them and all those other power plants are out of the picture. It’s costly for the power plant to find coal from elsewhere, it would have to ship it in. It has become dependent on you by locating its plant there. Williamson talked about the fact that it’s in these situations that the bargaining costs are going to be large.”

Williamson thought of how to develop better ways of protection. He saw one solution in a long-term contract, which in Hart’s example, specifies the amount of coal, the kind of coal, and the price, so that the coal mine could not take advantage of the power plant. The only problem might be that a contract can be incomplete. This instability led Williamson to something new.

Produce or buy? Is vertical integration the best strategy?

When we meet a friend and colleague of Williamson, Professor Christian von Hirschhausen, we discuss the second opportunity, called ‘vertical integration’: Should the power plant buy the coal mine? “Let’s take Amazon”, he says, introducing a contemporary example. “It’s becoming not only a sales platform but also a logistics provider, so it integrates logistics within its sales-platform, to deliver Amazon Prime products within one hour.”

Get new questions as they launch

Other companies are unlikely to follow this strategy and, of course, are at a disadvantage, due to the expense of logistics. “But then they might be more diverse for other services,” von Hirschhausen says. “It’s not one organizational structure that prevails. But the structure depends on the business strategy, the technologies available, and also the cost of contracting these services.”

Is a monopoly a benefit or a threat?

The traditional way of thinking would ultimately lead to answering this question with a clear ‘threat’, because the more markets, the more competition. According to Williamson, that’s wrong; as Hart explains. 

There are benefits of monopolies. You can have a vertically integrated, efficient monopoly that may be more efficient than a diverse universe of competing firms. Williamson has kind of revolutionized competition economics because he says there might be cases where vertical integration and market dominance may be good for society.

The clearest example of such a monopoly is nuclear power facilities. “There cannot be competition in nuclear power because the asset specificity is so high that you can’t just go out to the supermarket and buy a nuclear power plant,” says Hart “Because it’s technically complex, needs specific regulation, needs specific oversights.”

Can we organize economic activity when there is greed?

After receiving the Nobel Prize, Williamson quickly realized he was now expected to know all the answers, in the same way that scientists are expected to know about things outside of their specialism. During Olly’s first performance, at the press conference at Berkeley, a young man wanted to know: what if greed is the threat to our economy?

Williamson, who’s not a behavioral economist – but still takes social norms and cultural aspects into account – took a moment to think. In his usual manner, he said “Well…” and then answered that he could neither negate nor affirm the threat. He agreed that there are forms of greed out there. “But if you start thinking about organizing economic activity through the length of contract, the main benefits to accrue the contract are those of mutual gain. There are sellers and buyers and mutual gains to be realized,” Williamson explained. More intelligent organization could help avoid excesses of intervention and regulation. Then he shared an important piece of advice with a colleague:

Do not assume that a system is fundamentally corrupt, but try to make improvements to prevent corruption from happening.

“We’ve come a long way and we’ve made some mistakes,” he said. “Some of them we should have had the intelligence to [foresee] and avoid, and that’s the challenge for the future.” The audience could see: a Nobel Laureate was born.

Back at his home in Berkeley Hills, Williamson sits in his living room chair, surrounded by framed photos of his wife and their five children. With a big family, and a playful dog, it’s no surprise that Williamson is an expert in organization. He admits jokingly, that intelligence sometimes can be an obstacle to being called an expert. In some situations, as he says with smile, the only advice he could think of was: “Take the water and run!”

See how UBS can help

Whether it's about investments, your business, or anything to do with your financial future

More Nobel Laureate stories

Why’s the no such thing as
a perfect contract?

Oliver S. Hart
Nobel Laureate, 2016

How can we deal with uncertainty?

 

Lars Peter Hansen
Nobel Laureate, 2013

Get new questions as they launch