Crossroads—The Organization of Economic Activity: Transaction Costs, Firm Capabilities, and the Nature of Governance

In a recent 1993 paper in Organization Science, Hennart discussed the underlying logic, based on transaction cost and agency theory, for explaining the choice between firms and markets and the reason why most transactions have both firm-like and market-like properties. Relying on Williamson's comparative institutional approach, which studies economic organization from a transaction cost minimizing point of view under the assumption of opportunism, the argument was made that transaction cost (TC) logic provides a complete theory of the organization of economic activity. In this paper, I argue that, with its purely incentive-based logic governed by assumptions of opportunism, TC economics is fundamentally incapable of being a complete theory of economic organization. The notion of the firm as a bundle of transactions or contracts is an inadequate and shallow basis for a theory of the firm since it basically ignores the essential notion of the firm as a bundle of knowledge, and the underlying processes therein. My arguments are based on the organizational capability (OC) view of the firm, which provides a central role to bounded rationality and to organizational routines in the organization of economic activity. In the paper, I show how OC-based logic can provide an alternative (and complementary) explanation to TC theory for understanding boundary and governance decisions. TC reasoning does not realistically address issues pertinent to firms' capabilities, both as a source of competitive advantage and constraint, and has a static approach towards the benefits of a particular governance form. A more complete theory of economic organization needs to also address the more dynamic costs and benefits of an organizational form. The paper demonstrates how the OC perspective contributes towards a more balanced view. After arguing why TC does not provide a complete understanding of economic activity, and the contribution of organizational capabilities in this regard, organizational capability logic is applied to a transaction between two firms. Here, I examine in some detail the impact of a firm's resource/capability attributes on governance decisions, and the difficulties of contracting posed therein. In particular, I show how the transaction will not be effectuated, i.e., the market fails, but for reasons which have nothing to do with opportunism. The paper shifts the pivotal focus of governance decisions from the failure of markets due to the prevalence of opportunism to the failure (or success) of firms due to bounded rationality. Furthermore, it broadens the focus from minimizing the costs involved in the organization of an activity under a particular governance arrangement to also incorporate the managing of value inherent in a firm's knowledge base, in terms of both erosion and enhancement. These two inter-related concerns of firm failure and management of value are argued to be critical to a fuller understanding of firm behavior with respect to governance decisions. In general, it is argued that by replacing less restrictive assumptions in trying to understand economic organization and governance, that of bounded rationality alone, while simultaneously being able to explain the same economic phenomena as TC, and even some that TC explanations may face difficulty in fully explaining, the OC perspective has both greater and more realistic explanatory capacity.