Monday, December 2, 2019

Williamson 2002 the Theory of the Firm as Governance Stru Essay Example

Williamson 2002 the Theory of the Firm as Governance Stru Essay The Theory of the Firm as Governance Structure: From Choice to Contract Oliver E. Williamson Oliver E. Williamson is Edgar F. Kaiser Professor of Business Administration, Professor of Economics, and Professor of Law at the University of California, Berkeley, California. His email address is . The helpful advice of Timothy Taylor and Michael Waldman for revising this manuscript is gratefully acknowledged. January 2002 2 The propositions that organization matters and is susceptible to analysis were long greeted by skepticism by economists. To be sure, there were conspicuous exceptions: Alfred Marshall in Industry and Trade (1932), Joseph Schumpeter in Capitalism, Socialism, and Democracy (1942), Friedrich Hayek (1945) on knowledge. Both institutional economists (Thorstein Veblen (1904), John R. Commons (1934), and Ronald Coase (1937)) and organization theorists (Robert Michels (1915), Chester Barnard (1938), Herbert Simon (1947), James March (March and Simon, 1958) and Richard Scott (1992)) also made the case that organization deserves greater prominence. One reason why this message took a long time to register is that it is much easier to say that organization matters than it is to show how and why. 1 The prevalence of the science of choice approach to economics has also been an obstacle. As developed herein, the lessons of organization theory for economics are both different and more consequential when examined through the lens of contract. This paper examines economic organization from a science of contract perspective, with special emphasis on the theory of the firm. We will write a custom essay sample on Williamson 2002 the Theory of the Firm as Governance Stru specifically for you for only $16.38 $13.9/page Order now We will write a custom essay sample on Williamson 2002 the Theory of the Firm as Governance Stru specifically for you FOR ONLY $16.38 $13.9/page Hire Writer We will write a custom essay sample on Williamson 2002 the Theory of the Firm as Governance Stru specifically for you FOR ONLY $16.38 $13.9/page Hire Writer The Sciences of Choice and Contract Economics throughout the 20th century has been developed predominantly as a science of choice. As Lionel Robbins famously put it in his book, The Nature and Significance of Economic Science (1932, p. 16), â€Å"Economics is the science which studies human behavior as a relationship between ends and scarce means which have alternative uses. † Choice has been developed in two parallel constructions: the theory of consumer behavior, in which consumers maximize utility, and the theory of the firm as a production function, in which firms maximize profit. Economists who work out of such setups emphasize how quantities are influenced by 3 changes in relative prices and available resources, a project which became the â€Å"dominant paradigm† for economics throughout the twentieth century (Reder, 1999, p. 48). But the science of choice is not the only lens for studying complex economic phenomena, nor is it always the most instructive lens. The other main approach is what James Buchanan (1964a, b, 1975) refers to as the science of contract. Indeed, Buchanan (1975, p. 25) avers that economics as a discipline went â€Å"wrong† in its preoccupation with the science of choice and the optimization apparatus associated therewith. Wrong or not, the parallel development of a science of contract was neglected. As perceived by Buchanan (1987, p. 296), the principal needs for a science of contract were to the field of public finance and took the form of public ordering: â€Å"Politics is a structure of complex exchange among individua ls, a structure within which persons seek to secure collectively their own privately defined objectives that cannot be efficiently secured through simple market exchanges. Thinking contractually in the public ordering domain leads into a focus on the rules of the game. Issues of a constitutional economics kind are posed (Buchanan and Tullock, 1962; Brennan and Buchanan, 1985). Whatever the rules of the game, the lens of contract is also usefully brought to bear on the play of the game. This latter is what I refer to as private ordering, which entails efforts by the immediate parties to a transaction to align incentives and craft governance structures that are better attuned to their exchange needs. The object of such self-help efforts is to better realize the â€Å"mutuality of advantage from voluntary exchange†¦[that is] the most fundamental of all understandings in economics† (Buchanan, 2001, p. 29), due allowance being made for the mitigation of contractual hazards. Strategic issues—to which the literatures on mechanism design, agency theory, and transaction cost economics/incomplete contracting all have a 4 bearing—that had been ignored by neoclassical economists from1870 to 1970 now make their appearance (Makowski and Ostroy, 2001, pp. 482-483, 490-491). Figure 1 sets out the main distinctions. The initial divide is between the science of choice (orthodoxy) and the science of contract. The latter then divides into public ordering (constitutional economics) and private ordering parts, where the second is split into two related branches. One branch concentrates on front end incentive alignment (mechanism design, agency theory, the formal property rights literature) while the second features the governance of ongoing contractual relations (contract implementation). This paper is mainly concerned with governance, especially with reference to the theory of the firm. Organization Theory through the Lens of Contract Organization theory is a huge subject. Macro and micro parts are commonly distinguished, where the former is closer to sociology and the latter to social psychology. Also, it is common to distinguish among rational, natural, and open systems approaches (Scott, 1992). My concern is with macro organization theory of a rational systems kind (with special reference to the contributions of Herbert Simon). In addition to delimiting organization theory in this way, I also examine the lessons of organization theory for economics not through the lens of choice but through the lens of contract. Whereas those who work out of the dominant paradigm have been dismissive of organization theory (Posner, 1993; Reder, 1999, pp. 46-49), the lens of contract/private ordering discloses that lessons of organization theory for economics that are obscured by the dominant paradigm are sometimes fundamental. 5 Five Lessons from Organization Theory to the Economics of Contracts A first lesson from organization theory is to describe human actors in more realistic terms. Simon (1985, p. 03) is unequivocal: â€Å"Nothing is more fundamental in setting our research agenda and informing our research methods than our view of the nature of the human beings whose behavior we are studying. † Social scientists are thus invited (challenged) to name the cognitive, self-interest, and other attributes of human actors on which their analyses rest. Bounded rationality is the cognitive assumption to which Simon refers, by which he has reference to behavior that is intendedly rational but only limitedly so (1957, p. xiv). The main lesson for the science of choice is to supplant maximizing by â€Å"satisficing† (1957b, p. 204)—the quest for an alternative that is â€Å"good enough. †2 The study of governance also appeals to bounded rationality, but the main lesson for the science of contract is different: all complex contracts are unavoidably incomplete, on which account the parties will be confronted with the need to adapt to unanticipated disturbances that arise by reason of gaps, errors, and omissions in the original contract. Such adaptation needs are especially consequential if, instead of describing self-interest as â€Å"frailty of motive† (Simon, 1985, p. 303), which is a comparatively benign condition, strategic considerations are entertained (as well or instead). If human actors are not only confronted with needs to adapt to the unforeseen (by reason of bounded rationality) but are also given to strategic behavior (by reason by opportunism), then costly contractual breakdowns (refusals of cooperation, maladaptation, demands for renegotiation) may be posed. In that event, private ordering efforts to devise supportive governance structures, thereby to mitigate prospective contractual impasses and breakdowns, have merit. To be sure, such efforts would be unneeded if common knowledge of payoffs and costless bargaining are assumed. Both of these, however, are deeply problematic (Kreps and 6 Wilson, 1982; Williamson, 1985). Because, moreover, nonverifiability problems are posed when bounded rationality, opportunism, and idiosyncratic knowledge are joined (Williamson, 1975, pp. 31-33), dispute resolution by the courts is costly and unreliable. Private ordering efforts to craft governance structure supports for contractual relations during the contract implementation interval thus make their appearance. A second lesson of organization theory is to be alert to all significant behavioral regularities whatsoever. For example, efforts by bosses to impose controls on workers have both intended and unintended consequences. Out of awareness that workers are not passive contractual agents, naive efforts which focus entirely on intended effects will be supplanted by more sophisticated mechanisms where provision is made for consequences of both kinds. More generally, the awareness among sociologists that â€Å"organization has a life of its own† (Selznick, 1950, p. 10) serves to uncover a variety of behavioral regularities (of which bureaucratization is one) for which the student of governance should be alerted and thereafter factor into the organizational design calculus. A third lesson of organization theory is that alternative modes of governance (markets, hybrids, firms, bureaus) differ in discrete structural ways (Simon, 1978, pp. 6-7). Not only do alternative modes of governance differ in kind, but each generic mode of governance is defined by an internally consistent syndrome of attributes—which is to say that each mode of governance possesses distinctive strengths and weaknesses. As discussed below, the challenge is to enunciate the relevant attributes for describing governance structures, thereafter to align different kinds of transactions with discrete modes of governance in an economizing way. A fourth lesson of the theory of organizations is that much of the action resides in the microanalytics. Simon nominated the â€Å"decision premise† (1957a, p. xxx) as the unit of analysis, which has an obvious bearing on the microanalytics of choice (Newell and Simon, 1972). The 7 unit of analysis proposed by John R. Commons, however, better engages the study of contract. According to Commons (1932, p. 4), â€Å"the ultimate unit of activity†¦must contain it itself the three principles of conflict, mutuality, and order. This unit is a transaction. † Whatever the unit of analysis, operationalization turns on naming and explicating the critical dimensions with respect to which the unit varies. Three of the key dimensions of transactions that have important ramifications for governance are asset specificity (which takes a variety of forms—physical, human, site, dedicated, brand name—and is a measure of bilateral dependency), the disturbances to which transactions are subject (and to which potential maladaptations accrue), and the frequency with which transactions recur (which bears both on the efficacy of reputation effects in the market and the incentive to incur the cost of specialized internal governance). Given that transactions differ in their attributes and that governance structures differ in their costs and competencies, the aforementioned discriminating alignment hypothesis applies. A fifth lesson of organization theory is the importance of cooperative adaptation. Interestingly, both the economist Friedrich Hayek (1945) and the organization theorist Chester Barnard (1938) were in agreement that adaptation is the central problem of economic organization. Hayek (pp. 26-527) focused on the adaptations of autonomous economic actors who adjust spontaneously to changes in the market, mainly as signaled by changes in relative prices. The marvel of the market resided in the use of the price system to communicate information, whence â€Å"how little the individual participants need to know to be able to take the right action. † By contrast, Barnard featured coordinated adaptation among economic actors working through deep knowledge and the use of administration. The marvel of hierarchy is accomplished not spontaneously but in a â€Å"conscious, deliberate, purposeful† way (p. 9). 8 Because a high performance economic system will display adaptive properties of both kinds, the problem of economic organization is properly posed not as markets or hierarchies but rather as markets and hierarchies. A predictive theory of economic organization will recognize how and why transactions differ in their adaptive needs, whence the use of the market to supply some transactions and recourse to hierarchy for others. Follow-on Insights from the Lens of Contract Examining economic organization through the lens of contract uncovers additional regularities to which governance ramifications accrue. Three such regularities are described here: the Fundamental Transformation, the impossibility of replication/selective intervention, and the idea of contract laws (plural). The Fundamental Transformation applies to that subset of transactions for which large numbers of qualified suppliers at the outset are transformed into what, in effect, are small numbers supply relations during contract execution and at the contract renewal interval. The distinction to be made is between generic transactions where â€Å"faceless buyers and sellers †¦meet†¦for an instant to exchange standardized goods at equilibrium prices† (Ben-Porath, 1980, p. 4) and exchanges where the identity of the parties matters, in that continuity of the relation has significant cost consequences. Transactions for which a bilateral dependency condition obtains are those to which the Fundamental Transformation applies. The key factor here is whether the transaction in question is supported by investments in transaction-specific assets. Such specialized investments may take the form of specialized physical assets (such as a die for stamping out distinctive metal shapes), specialized human assets (that arise from firm-specific training or learning by doing), site specificity (specialization by proximity), dedicated assets (large discrete investments made in expectation of continuing business, the premature termination of which business would result in product being sold at distress prices), or brand name capital. Because parties to transactions that are bilaterally dependent are â€Å"vulnerable† (in that buyers cannot easily turn to alternative sources of supply, while suppliers can redeploy the specialized assets to their next best use or user only at a loss of productive value (Klein, Crawford, and Alchian, 1978)), value preserving governance structures—to infuse order, thereby to mi tigate conflict and realize mutual gain—are sought. Simple market exchange thus gives way to credible contracting (to include penalties for premature termination, information disclosure and verification mechanisms, specialized dispute settlement mechanisms, and the like). Unified ownership (vertical integration) is predicted as bilateral dependency hazards successively build up. The impossibility of combining replication with selective intervention is the transaction cost economics answer to an ancient puzzle: What is responsible for limits to firm size? Diseconomies of large scale is the obvious answer, but wherein do these reside? Technology is no answer sine each plant in a multiplant firm can use the least cost technology. Might organization provide the answer? That possibility can be examined by rephrasing the question in comparative contractual terms: Why can’t a large firm do everything that a collection of small suppliers can do and more? Were it that large firms could replicate a collection of small firms in all circumstances where small firms do well, then large firms would never do worse. If, moreover, large firms could selectively intervene by imposing (hierarchical) order on prospective conflict wherever expected net gains can be projected, then large firms would sometimes do better. Taken together, the combination of replication with selective intervention would permit large firms to grow without limit. Accordingly, the issue of limits to firm size turns to an examination of the mechanisms for implementing replication and selective intervention. 10 Examining how and why both replication and selective intervention break down is a tedious, microanalytic exercise and is beyond the scope of this aper (see Williamson, 1985, Chap. 6). Suffice it to observe here that the move from autonomous supply (by the collection of small firms) to unified ownership (in one large firm) is unavoidably attended by changes in both incentive intensity (incentives are weaker in the integrated firm) and administrative controls (controls are more extensive). Because the syndromes of attribut es that define markets and hierarchies have different strengths and weaknesses, some transactions will benefit from the move from market to hierarchy while others will not. Yet another organizational dimension that distinguishes alternative modes of governance is the contract law regime. Whereas orthodoxy implicitly assumes that there is a single, allpurpose law of contract that is costlessly enforced by well-informed courts, the private ordering approach to governance postulates instead that each generic mode of governance is defined (in part) by a distinctive contract law regime. The contract law of (ideal) markets is that of classical contracting, according to which disputes are costlessly settled by courts by the award of money damages. Galanter (1981, pp. 1-2) takes issue with this legal centralism tradition and observes that many disputes between firms that could under current rules be brought to a court, are resolved instead by avoidance, selfhelp, and the like. That is because in â€Å"many instances the participants can devise more satisfactory solutions to their disputes than can professionals constrained to apply general rules on the basis of limited knowledge of the dispute† (p. 4). Such a view is broadly consonant with the concept of â€Å"contract as framework† advanced by Karl Llewellyn (1931, pp. 36-737), which holds that the â€Å"major importance of legal contract is to provide†¦a framework which never accurately indicates real working relations, but which affords a rough indication around which such relations vary, an occasional guide in cases of doubt, and a norm of ultimate appeal when 11 the relations cease in fact to work. † This last is important, in that recourse to the courts for purposes of ultimate appeal serves to delimit threat positions. The more elastic concept of contract as framework neverteless supports a (cooperative) exchange relation over a wider range of contractual disturbances. What is furthermore noteworthy is that some disputes cannot be brought to a court at all. Specifically, except as â€Å"fraud, illegality or conflict of interest† are shown, courts will refuse to hear disputes that arise within firms—with respect, for example, to transfer pricing, overhead, accounting, the costs to be ascribed to intrafirm delays, failures of quality, and the like. In effect, the contract law of internal organization is that of forbearance, according to which the firm becomes its own court of ultimate appeal. Firms for this reason are able to exercise fiat that the markets cannot. This too influences the choice of alternative modes of governance. Not only is each generic mode of governance defined by an internally consistent syndrome of incentive intensity, administrative controls, and contract law regime (Williamson,k 1991a), but different strengths and weaknesses accrue to each. The Theory of the Firm as Governance Structure As Demsetz (1983, p. 377) observes, it is â€Å"a mistake to confuse the firm of [orthodox] economic theory with its real-world namesake. The chief mission of neoclassical economics is to understand how the price system coordinates the use of resources, not the inner workings of real firms. † Suppose instead that the assigned mission is to understand the organization of economic activity. In that event, it will no longer suffice to describe the firm as a black box that transforms inputs into outputs according to the laws of technology. Instead, firms must be described in relation to other modes of governance, all of which have internal structure, which structure â€Å"must arise for some reason† (Arrow, 1999, p. vii). 12 The contract/private ordering/governance (hereafter governance) approach maintains that â€Å"this structure† arises mainly in the service of economizing on transaction costs. Note in this connection that the firm as governance structure is a comparative contractual construction. The firm is conceived not as a stand-alone entity but is always to be compared with alternative modes of governance. By contrast with mechanism design (where a menu of contracts is used to elicit private information), agency theory (where risk aversion and multitasking are featured), and the property rights theory of the firm (where everything rests on asset ownership), the governance approach appeals to law and organization theory in naming incentive intensity, administrative control, and contract law regime as three critical attributes. It will be convenient to illustrate the mechanisms of governance with reference to a specific class of transactions. Because transactions in intermediate product markets avoid some of the more serious conditions of asymmetry—of information, budget, legal talent, risk aversion, and the like—that beset some transactions in final product markets, I examine the â€Å"make-or-buy† decision: Should a firm make an input itself, perhaps by acquiring a firm which makes the input, or should it purchase the input from another firm? The Science of Choice Approach to the Make-or-Buy Decision The main way to examine the make-or-buy decision under the firm as production function setup is with reference to bilateral monopoly. The neoclassical analysis of bilateral monopoly reached the conclusion that while optimal quantities between the parties might be realized, the division of profits between bilateral monopolists was indeterminate (for example, Machlup and Tabor, 1960, p. 112). Vertical integration might then arise as a means by which to relieve bargaining over the indeterminacy. Alternativ ely, vertical integration could arise as a means by which to restore efficient factor proportions when an upstream monopolist sold 13 intermediate product to a downstream buyer that used a variable proportions technology (McKenzie, 1951). Vertical integration has since been examined in a combined variable proportions-monopoly power context by Vernon and Graham (1971), Schmalensee (1973), Warren-Boulton (1974), Westfield (1981), and Hart and Tirole (1990). This literature is instructive, but it is also beset by a number of loose ends or anomalies. First, since preexisting monopoly power of a durable kind is the exception in a large economy rather than the rule, what explains vertical integration for the vast array of transactions where such power is negligible? Second, why don’t firms integrate everything, since under a production function setup an integrated firm can always replicate its unintegrated rivals and can sometimes improve on them? Also, what explains hybrid modes of contracting? More generally, if many of the problems of trading are of an intertemporal kind in which successive adaptations to uncertainty are needed, do the problems of economic organization have to be recast in a larger and different framework? Coase and the Make-or-Buy Decision Coase’s (1937) classic article opens with a basic puzzle: Why does a firm emerge at all in a specialized exchange economy? If the answer resides in entrepreneurship, why is coordination â€Å"the work of the price mechanism in one case and the entrepreneur in the other† (p. 389)? Coase appealed to transaction cost economizing as the hitherto missing factor for explaining why markets were used in some cases and hierarchy in other cases and averred (p. 91) that â€Å"The main reason why it is profitable to establish a firm would seem to be that there is a cost of using the price mechanism, the most obvious†¦[being] that of discovering what the relevant prices are. † This sounds plausible, but is it truly comparative? How is it that internal procurement by the firm avoids the cost of price discovery? 14 The â€Å"obvious† answer is that sole-source internal supply avoids the need to consult the market about prices becau se internal accounting prices of a formulaic kind (say, of a cost-plus kind) can be used to transfer a good or service from one internal stage to another. If, however, that is the source of the advantage of internal organization over market procurement, the obvious lesson is to apply this same practice to outside procurement. The firm simply advises its purchasing office to turn a blind eye to the market by placing orders, period by period, with a qualified sole-source external supplier who agrees to sell on cost-plus terms. In that event, firm and market are put on a parity in price discovery respects—which is to say that the price discovery burden that Coase ascribes to the market does not survive comparative institutional scrutiny. In the end, Coase’s profoundly important challenge to orthodoxy and his insistence on introducing transactional considerations does not lead to refutable implications (Alchian and Demsetz, 1972). Operationalization of these good ideas was missing (Coase, 1992, pp. 716-718). The theory of the firm as governance structure is an effort to infuse operational content. Transaction cost economizing is the unifying concept. 6 A Heuristic Model of Firm as Governance Structure Expressed in terms of the Commons triple of conflict, mutuality, and order, governance is the means by hich to infuse order, thereby to mitigate conflict and realize â€Å"the most fundamental of all understandings in economics,† mutual gain from voluntary exchange. The surprise is that a concept as important as governance should be so long neglected. The rudiments of the model are the attributes of transactions, the attributes of alternative modes of governance, and the purposes served. Asset specificity (which gives rise to bilateral dependency) and uncertainty (which poses adaptive needs) are especially important transaction 5 attributes. Incentive intensity, administrative control, and contract law regime is the syndrome of attributes that define a governance structure, where market and hierarchy syndromes differ as follows: incentive intensity is less, administrative controls are more numerous and discretionary, and inte rnal dispute resolution supplants court ordering under hierarchy. Adaptation is taken to be the main purpose, where the requisite mix of autonomous adaptations and coordinated adaptations vary among transactions. Specifically, the need for coordinated adaptations builds up as asset specificity deepens. In a heuristic way, the transaction cost consequences of organizing transactions in markets (M) and hierarchies (H) as a function of asset specificity (k) are shown in Figure 2. As shown, the bureaucratic burdens of hierarchy place it at an initial disadvantage (k=0), but the cost differences between M(k) and H(k) narrow as asset specificity builds up and eventually reverse as the need for cooperative adaptation becomes especially great (kgt;gt;0). Provision can further be made for the hybrid mode of organization X(k), where hybrids are viewed as marketpreserving credible contracting modes that posses adaptive attributes located between classical markets and hierarchies. Incentive intensity and administrative control thus take on intermediate values and Llewellyn’s concept of contract as framework applies. As shown in Figure 2, M(0) lt; X(0) lt; H(0) (by reason of bureaucratic cost differences) while M gt; X gt; H (which reflects the cost of coordinated adaptation). This rudimentary setup yields refutable implications that are broadly corroborated by the data. It can be extended to include differential production costs between modes of governance, which mainly preserves the basic argument that hierarchy is favored as asset specificity builds up, ceteris paribus (Riordan and Williamson, 1985). The foregoing relations among governance structures and transactions can also be replicated with a simple stochastic model where the needs for adaptation vary with the transaction and the efficacy of adaptations of autonomous and 6 cooperative kinds vary with the governance structures, and shift parameters can also be introduced in such a model (Williamson, 1991a). More fully formal treatments of contracting that are broadly congruent with this setup are in progress. Whereas most theories of vertical integration do not invite empirical testing, the transaction cost theory of vertical integration invites and has been the subject of considerable empirical ana lysis. Empirical research in the field of industrial organization is especially noteworthy because the field has been criticized for the absence of such work. Not only did Coase once describe his 1937 article as â€Å"much cited and little used† (1972, p. 67), but others have since commented upon the paucity of empirical work on the theory of the firm (Holmstrom and Tirole, 1989, p. 126) and in the field of industrial organization (Peltzman, 1991). By contrast, empirical transaction cost economics has grown exponentially during the past 20 years. For surveys, see Shelanski and Klein (1995), Lyons (1996), Crocker and Masten (1996), Rindfleisch and Heide (1997), Masten and Saussier (2000) and Boerner and Macher (2001). Added to this are numerous applications to public policy, especially antitrust and regulation, but also to economics more generally (Dixit, 1996) and to the contiguous social sciences (especially political science). The upshot is that the theory of the firm as governance structure has become a â€Å"much used† construction. Variations on a Theme Vertical integration turns out to be a paradigm. Thus although many of the empirical tests and public policy applications have reference to the make-or-buy decision and vertical market restrictions, this same framework has application to contracting more generally. Specifically, the contractual relation between the firm and its â€Å"stakeholders†Ã¢â‚¬â€customers, 17 suppliers, and workers along with financial investors—can be interpreted as variations on a theme. The Contractual Schema Assume that a firm can make or buy a component and assume further that the component can be supplied by either a general purpose technology or a special purpose technology. Again, let k be a measure of asset specificity. The transactions in Figure 3 that use the general purpose technology are ones for which k = 0. In this case, no specific assets are involved and the parties are essentially faceless. If instead transactions use the special purpose technology, k gt; 0. As hitherto discussed, bilaterally dependent parties have incentives to promote continuity and safeguard their specific investments. Let s denote the magnitude of any such safeguards, which include penalties, information disclosure and verification procedures, specialized dispute resolution (such as arbitration) and, in the limit, integration of the two stages under unified ownership. An s = 0 condition is one for which no safeguards are provided; a decision to provide safeguards is reflected by an s gt; 0 result. Node A in Figure 3 corresponds to the ideal transaction in law and economics: there being an absence of dependency, governance is accomplished through competitive market prices and, in the event of disputes, by court awarded damages. Node B poses unrelieved contractual hazards, in that specialized investments are exposed (k gt; 0) for which no safeguards (s = 0) have been provided. Such hazards will be recognized by farsighted players, who will price out the implied risks. Added contractual supports (s gt; 0) are provided at nodes C and D. At node C, these contractual supports take the form of interfirm contractual safeguards. Should, however, costly breakdowns continue in the face of best bilateral efforts to craft safeguards at node C, the 18 transaction may be taken out of the market and organized under unified ownership (vertical integration) instead. Because added bureaucratic costs accrue upon taking a transaction out of the market and organizing it internally, internal organization is usefully thought of as the organization form of last resort: try markets, try hybrids, and have recourse to the firm only when all else fails. Node D, the unified firm, thus comes in

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