Williamson, O., Markets and Hierarchies, Free Press, 1975, 20-30
In this chapter Williamson argues for the failures in "free market" transactions that lead to the need and existance of hierarchies and organizations to mediate and economize transactional costs.
Bounded Rationality and Uncertainty/Complexity
Internal organizations are needed when the bounded rationality of individuals are amidst a complex and uncertain enviornment. If everything is known, then contingent claims "contracts" could be used to regulate transactions.
In uncertain environments, alternative "market" forms (like organizations) serve to mediate and thus reduce the transactional costs between individuals.
Chess is a good example of bounded rationality. While theoretically all the possible moves in a chess game could be know, the 10 to the 120 moves are beyond the rationality of humans.
Adaptive, sequential decision processes as those found in internal organizations, can "greatly economize" situations of bounded rationality by reducing the risks vs those in purely contingent contracts in the marketplace. Action is thus placed on the actual outcomes and not all possible ones.
In internal organizations "codes of exchanges" may be more confidently developed and used by individuals. People have less risk of being disadvantaged by opportunism. There is also economy in having exchange partners build on a similar set of assumptions of potential outcomes to avoid too much divergency and conflict.
Opportunism and Small Numbers
Opportunism allows for strategic thinking and guile in exchanges. People can lie, cheat and steal. One cannot necessarily trust everybody. Therefore agreements need to be monitored during execution -- hence the need for an organization.
Theoretically, with large numbers of exchangers one could avoid those who exhibit opportunistic behavior, effectively punishing it. But in situations of small numbers of exchangers, one may not be able to avoid it.
Internal Organizations has three advantages over market modes in instances of opportunistic behavior. First, people are less likely to subvert group goals for individual gain (given the repercussions). Second, organizations can be monitored more easily. Third, the organization can mediate differences more easily than the market.
Organizational rules can set fair boundaries for transactional exchange between members. Since compensation is tied to organizational performance, management can exert control over exchanges. Internal conflicts that may be settled quickly without resorting to the judicial system as in interfirm conflicts.
This situation occurs when one group has more understanding or information about an exchange then the other group. This disadvatage (if known or unknown) can make negotiations difficult or increase the risk of the exchange. Once again, this situation is more serious when there are small numbers of exchangers in uncertain, bounded rational situations where the potential for opportunism exists.
Internal organizations can help with information impactedness. As stated above, the organization serves to inhibit opportunism in situations of information disadvantage.
While transactions and economic theory usually avoids "interaction effects", it's important to acknowledge other factors that may even change the nature of the transaction itself. Societal factors such as loyalty, reciprocity can affect transactions. Thus certain trasactional modes may be rejected in some organizations by the values they hold.
One can understand this system by the following diagram
Human Factors Environmental Factors
- - - - - - - - - -- - - - --Atmosphere_- - - - - - - - - - - - - - - - - - - - - -
Bounded Rationality <-------------------------------> Uncertainty/Complexity