In 2009, Oliver E. Williamson, along with elinor ostrom, was awarded the Nobel Prize in economics. Williamson received it “for his analysis of economic governance, especially the boundaries of the firm.” He did this by bringing together economics, organization theory, and contract law. According to the Nobel committee, Williamson provided “a theory of why some economic transactions take place within firms and other similar transactions take place between firms, that is, in the marketplace.” Williamson found that common ownership, in the form of firms, helps to solve some market failures by mitigating transaction costs and uncertainty.
The turning point in Williamson’s thinking about markets and firms happened when he was an economist in 1966-67 with the Antitrust Division of the U.S. Department of Justice. In his biography at the Nobel site, Williamson writes:
Although the leadership and staff of the Antitrust Division in the late 1960s were both superlative, the prevailing attitude toward nonstandard and unfamiliar contractual practices and organization structures was that such “abnormalities could be presumed to have anticompetitive purpose and effect.” Indeed, given that the prevailing price theoretic orientation effectively disallowed economies of a non-technological kind, it could hardly have been otherwise. That economies could result from organizational and contractual design was simply outside the canon.
Williamson changed “the canon.” Drawing on 1991 Nobel laureate Ronald Coase’s work on why firms exist, Williamson showed that these voluntary institutions solve problems that arms-length market transactions have trouble solving. Take, for example, a coal mine that depends on a railroad line to ship its coal. Before the mine owner develops the mine, he wants to be assured that the railroad owner won’t charge him a monopoly price. Before the potential railroad owner builds the spur, he wants to be sure that the coal mine owner, his only customer, will pay him a price that compensates for the high cost of building the railroad. Once the railroad is built, that cost is sunk. The solution in this case is to vertically integrate: that is, the railroad owner is also the mine owner. Thus, firms serve as a means of resolving conflicts.
But where should the firm stop? Should it also produce the steel used in the trains? If so, should it produce the machinery used to refine the steel? Williamson proposed that firms will buy from the external market inputs that are uniform or nonspecific. Inputs that are more specialized will be more likely to be produced internally. In the prior example, the rail line was, from the mine owner’s perspective, specialized because it served the mine exclusively. If the mine had been able to use an existing rail spur, it would have been inefficient for the mining firm to acquire the railroad.
Prior to Williamson’s work, many legal scholars and economists had seen vertical integration as a way to acquire market power. This argument made little sense, as antitrust scholars Robert Bork and the late Ward Bowman had pointed out much earlier: it’s hard to multiply market power using vertical integration and, indeed, vertical integration solves the problem of “successive monopoly” that can exist otherwise. Williamson’s work led to even less concern that vertical integration enhances market power. This lessening of concern has caused judges and antitrust officials to be less hostile to vertical integration.
In his classic 1968 article, “Economies as an Antitrust Defense,” Williamson showed that horizontal mergers of companies in the same industry, even those that increase market power and even those where the increase in market power leads to a higher price, can create efficiency. The reason is that if mergers reduce costs, the reduction in costs can create more gains for the economy than the losses to consumers from the higher price. With an elasticity of demand of two, for example, even a one-quarter percent reduction in costs would cause more gains for the firm than the consumer losses from a five-percent increase in price. For such a merger, therefore, society, which, after all, includes consumers and producers, would benefit. For lower elasticities of demand, the required decrease in cost for the merger to be efficient is even lower than one quarter of a percent.
Economics is typically thought of as the science of choice. Williamson avers that it should be equally treated as the science of contracts. This would better describe forms of organization, such as firms. When the transaction, rather than the commodity, is the base unit analyzed, the structure of firms becomes clearer.
Williamson earned his B.S. in Management from MIT in 1955, his M.B.A. from Stanford in 1960, and his Ph.D. in Economics from Carnegie-Mellon in 1963. From 1963 to 1965 he taught industrial organization and public policy at the University of California, Berkeley. He was a professor at the University of Pennsylvania from 1965 to 1983 and a professor at Yale from 1983 to 1988. In 1988, he returned to the University of California, Berkeley, where he currently teaches.
About the Author
David R. Henderson is the editor of The Concise Encyclopedia of Economics. He is also an emeritus professor of economics with the Naval Postgraduate School and a research fellow with the Hoover Institution at Stanford University. He earned his Ph.D. in economics at UCLA.