It’s been a week of celebrations at Berkeley following the announcement that the Nobel Prize in Economics was shared by my friend and colleague, Oliver (Olly) Williamson. Certainly, many outside the field are asking three simple questions: First, what did Olly do? Second, why was it path-breaking? And most importantly, what does this have to do with anything we should care about? I’ll begin by answering these questions succinctly: First, Olly demonstrated when it is more efficient for a firm to produce a component in-house rather than outsourcing it to another firm. Second, it was path-breaking because economic research at the time was largely fixated on market transactions and treated firms as black boxes of production. Olly’s work made economic scholars realize the need to analyze governance and incentives within and between firms in order to better understand how efficiency can be maintained in a capitalist society. Third, Olly’s original insights and the research area he pioneered (now often referred to as Transaction Costs Economics) offered clear guidance for at least three important practical areas. One is the way in which business strategy can evaluate the costs and benefits of outsourcing. Another is the way in which local and federal governments should decide what to privatize. Yet another is to help regulators decide when and how to intervene with antitrust policy.
If all you wanted are three short answers to three short questions, you can move on to another blog posting right now. I hope, however, that I just whet your appetite, so let me start with some background. More than four decades ago Olly was invited to serve as Special Economic Assistant to the Head of the Antitrust Division of the U.S. Department of Justice, so he took a year off from the ivory tower to do just that. This is not too common among academic economists, but those who know Olly would not be surprised: he really does want to know what’s actually going on and how economics can help us both understand the world and make it better. During that year Olly observed that the DOJ eas is guided by one major paradigm in its antitrust policy: if two firms want to merge, it almost certainly must be because they want to gain market power and raise prices. This harms consumers, and hence must be blocked. In other words, these are instances where capitalism will give some actors incentives to engage in behavior that will harm consumers. (And no, I won’t be talking about the past year’s financial crisis – I’ll leave that for another occasion!) Determined to figure out when mergers might benefit both firms and consumers led Olly to publish his insightful (in my view Nobel worthy) 1971 article in the American Economic Review titled “The Vertical Integration of Production: Market Failure Considerations”, later followed by his path-breaking book, Markets and Hierarchies, published in 1975.
Fast forward another decade to 1985 when Olly published his second influential book, The Economic Institutions of Capitalism. Economists realized then, thanks to Olly’s influential writings (and some others from his generation), that we need to “open the black box” of the firm if we really want to understand what’s going on inside it. Economists needed to venture beyond the well-trodden grounds of prices and markets and learn how to maneuver the less comfortable terrain of governance. What Olly offered was not only a departure from the mainstream at the time, but a theory based on observations that are testable and refutable. His basic insights were simple, widely applicable, and many scholars since have confirmed them with data-driven research.
Here’s a simple illustration that I like to use in class. To produce the 787 Dreamliner, Boeing will need many components, two of which are screws (lots and lots of screws), and a fuselage (its main body section). I don’t have to tell you that Boeing doesn’t have to reinvent screws: there are so many screws being produced, in size, shape and material, that they can easily find what they need on the market – no need to try and produce their own screws. What about the fuselage? This is the centerpiece of the aircraft and many other parts will have to fit in with it. If Boeing were to outsource the development and production of the fuselage then two problems will arise. First, whoever designs and builds the fuselage will have to spend a lot of time, training and resources that are dedicated to the Dreamliner, but will not necessarily be as useful for other projects. Olly called this problem “asset specificity”: the assets developed in the process, either physical (machines) or human (know-how), are more valuable for the Dreamliner project than they are for other projects. The second problem is due to the complexity of the transaction: the initial design will most likely have to be modified many times over till the final product is ready for a variety of reasons, usually that are hard to foresee. Olly called this problem “incomplete contracts”: any contract Boeing would put in place will have to be renegotiated every time a change is needed. Olly convincingly argued that when asset specificity and incomplete contracts are both present then market transactions will be plagued by haggling over changes (due to incomplete contracts) and that this haggling will be inevitable and severe because the parties are locked in (due to asset specificity). In this case it would be better if the fuselage production was part of Boeing’s operation because haggling is then replaced by managerial control, and things will adapt more smoothly. Case in point, after almost four years of delays Boeing agreed this past July to buy Vought Aircraft Industries, the company that designed and will produce the fuselage. I wish they read Olly’s work before they engaged in their revolutionary outsourcing plans at the onset of the Dreamliner project. (I am certain that Boeing executives wish that even more than I do!)
So, now you know what Oliver Williamson did, why it was so important, and what we can learn from him today. It basically changed the way microeconomists viewed the function of firm governance, and did so in a way that can help firms design their outsourcing strategy. Though technology changes, the basic insights of when to outsource have not changed and will remain relevant for years to come. It offers insights for start-ups and growing firms about how to best utilize the market and when to do things themselves, and for established firms to see if their own strategic outsourcing plans meet the logic that he proposed. Developing countries with low labor costs can try and encourage industries that will attract outsourced products (that is, simple, non-specific goods and services). It doesn’t end here: the DOJ can accept some vertical-mergers as creating more gains in efficiency beyond the simple economies of scale arguments. And last but not least, federal and local governments that are in the business of providing services for their residents can also read a page or two from transaction costs economics. Not all government services are best provided by the government, and not all are best provided by private sector markets. What better way to end than with such an apolitical, noncontroversial claim!