The Mechanisms of Governance - Review

Administrative Science Quarterly,  March, 1999  by Robert F. Freeland

• E-mail
• Print
• Link

Oliver E. Williamson. New York: Oxford University Press, 1996. 429 pp. $45.00.

Oliver Williamson's work has had enormous influence on the study of organization, bringing issues of governance to the center stage of analysis. The basic tenets of his transaction cost economics (TCE) are set out and developed in his two best-known works, Markets and Hierarchies (1975) and The Economic Institutions of Capitalism (1985), where he argues that, under certain conditions, hierarchical governance is less costly than market exchange. The Mechanisms of Governance is intended as the third installment in a transaction cost trilogy. Whereas earlier works focus on outlining the general framework underlying TCE, however, the primary aim of this book is to elaborate the notion of governance. Responding to criticisms that this central construct remains relatively underdeveloped in his earlier work, Williamson here seeks to operationalize the concept of governance in a way that is consistent with TCE's general model. Retaining the key behavioral assumptions of bounded rationality and opportunism, and focusing on situations of market failure that involve small numbers exchange between interdependent actors, he seeks to identify the mechanisms used to create order when "potential conflict threatens to undo or upset opportunities to realize mutual gains" (p. 12, emphasis in original).

The Mechanisms of Governance makes a number of important contributions that highlight both the considerable promise and the inherent limitations of TCE. The book is less systematic and more repetitious than its predecessors, primarily because it is a collection of previously published essays rather than an attempt to articulate a unified argument.(1) A key premise underlying the various chapters, however, is that distinct forms of governance employ "different means" to create order and regulate exchange. TCE here rejects the agency theory view that firms have "no power of fiat, no authority, no disciplinary action any different in the slightest degree from ordinary market contracting" (Alchian and Demsetz, 1972: 777). The notion of different means is meant to imply that there are a variety of distinct methods for "infusing contractual integrity" that cannot be reduced one to the other (p. 101). While agency theory treats governance as a matter of aligning incentives, TCE aims to focus more generally on the adaptive properties of governance structures. Incentive alignment becomes, at least in principle, only one of several ways to create order; the "challenge to comparative contractual analysis is to discern and explicate" other methods (p. 95).

Although Williamson makes significant progress in exploring these different means of governance, his efforts are ultimately limited by the core assumptions of his theory. TCE assumes boundedly rational actors who evaluate transactions in cost-benefit terms. Within this framework, order is seen as an outcome of rational self-interest. Governance mechanisms create cooperation by aligning the interests of individual actors with those of the firm, and authority rests on mechanisms "that structure incentives so as to make the cost of malfeasance prohibitively high" (Granovetter, 1992: 38). To be sure, Williamson acknowledges that there are limits to this approach and that actors sometimes eschew self-interest, but these limits remain exogenous to the theory (Simon, 1991: 26). Consequently, TCE remains unable to dimensionalize governance fully in a way that goes beyond agency theory's image of incentive alignment; it ultimately falls back on an "undersocialized conception of action" in which authority is reduced to the sanctions that support it (Granovetter, 1985). The result is that the further governance structures depart from the incentive alignment model, the more problematic TCE's explanations become.

Both the strengths and weaknesses of the TCE approach can be seen in Williamson's attempt to identify the factors that account for the "differential costs and competencies" of distinct organizational forms (p. 101). Positing that adaptation to changing environments is the central problem faced by economic organizations, he argues that different modes of organization have unique adaptive capacities that are best suited to specific types of transactions. Williamson takes three related steps in making this argument. He first conceptualizes market, hierarchy, and hybrid (network) forms of organization as discrete structural alternatives, each of which employs different means to achieve order. He then argues that each form of governance is supported by a distinct type of contract law. Third, and as a consequence, he maintains that each possesses unique adaptive capabilities and is characterized by different trade-offs in the use of incentives and controls. This characterization advances the concept of governance in a way that deals a devastating blow to agency theory's claim that there is no fundamental difference between market and hierarchy. By grounding distinct forms of governance in different forms of contract law, Williamson provides a legal-institutional basis for the efficacy of hierarchy, something lacking in his earlier work. Markets are supported by classical contract law wherein the identity of transacting parties is irrelevant and dependence slight; here, "hard" contracting characterized by strict adherence to contractual terms prevails. Network organizations are grounded in neoclassical contract, where the identities of transacting parties matter and where contracting is "softer." Hierarchy is supported by the law of forbearance: while courts regularly become involved in disputes between autonomous firms transacting in the market, they will generally refuse to intervene in similar disagreements occurring within a firm. Forbearance provides the basis for the efficacy of hierarchy. Disputants within a firm "must resolve their differences internally," for with outside intervention foreclosed, "hierarchy is its own ultimate court of appeal" (p. 98). Because agency theory neglects the fact that different forms of contract law apply to distinct forms of organization, it fails to recognize that "firms can and do exercise fiat that markets cannot" (p. 100).