Transactions Costs Exaplanation for the Creation of Organizations

A newer, economic-based interpretation expanded by Oliver E. Williamson concerns transaction costs (Williamson 1975, 1985). Transactions are "the exchange of goods or services between persons or across boundaries" (Scott p. 156). Instead of production the exchange of resources is deemed the critical factor in the creation and development of organizational structures.

William contrasts two main governance structures -- the market and the organization. In the market, exchanges are negotiated contracts where all parties are assumed to operate in self-interest. In its pure form little knowledge about the other exchangers is needed, and pricing is purely based on individual interests and the "invisible hand" of a free economy (large number of buyers and sellers, instantaneous exchanges, etc.). Little coordination costs are needed in this pure market.

While these assumptions work well for quick, spot contracts, they are less relevant for contracts that require estimates of future value (contingent claims contract). In these situations, organizations may be viewed as a more attractive alternative to pure market-mediated transaction. The uncertainty of exchange is reduced if it can be brought into an organized group of people with a framework of rationality and organizational mechanisms to dissuade opportunism.

The organization supports the division of problems, simplifies choices, channels information, and restricts alternatives (Scot p. 157). Organizations help individuals deal with cognitive limits to assess and reduce uncertainty and make decisions.

Williamson introduced the market failures framework to explain why in some situations bringing exchanges into organizations is better than leaving them in the marketplace. In situations where exchangers have good opportunities to cheat , and there are few exchangers to choose from, it's better to bring the exchanges "inside" organizations where there can be better surveillance and monitoring and more defined incentive systems that reduce opportunism.

The organization also supplants the need for long-term open contracts among exchange partners (which are replaced by the employment contract). People sell their promise to obey commands (Commons, 1924) which allows the flexibility to alter exchange contracts with internal workers more easily than with outsiders.

"The transactions costs framework provides a general explanation for the origins of organizations as mechanisms for supporting decisions under conditions of uncertainty and supressing opportunism under conditions of restricted exchange" (Scott p. 158). This approach focuses primarily on efficiency (like most economic approaches).

Granovetter notes that Williamson's model fails to note that individual actions are embedded in a matrix of personal relationships that strongly affect this exchange behavior (Granovetter, 1985).