Asset Specificity and Economic Organization

7/27/2019 Asset Specificity and Economic Organization

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In te rna t iona l Journa l of Indus t r ia l O rganiza t ion 3 (1985) 365-378. N or th-H ol land

A S S E T S P E C I F I C IT Y A N D E C O N O _ M I C O R G A N I Z A T I O N *

M i c h a e l H . R I O R D A N

Stanford University Stanford CA

9 4 3 0 5

U S A

O l iv er E . W I L L I A M S O N

Yale U~dversi ty New Haven CT 06520 USA

Fina l t ,ersion received M ay 1985

Th i s pape r exam i nes t he op t i m i za t ion p r ob l em o f f ir m and m a r ke t o r gan i za ti on i n w h i ch bo th

product ion cost and t ransact ion cost di fferences are expressed as a funct ion of asset specif ici ty.

I n gene r a l , m a r ke t s en j oy advan t ages by agg r ega t i ng t he dem ands o f m any buye r s , t he r eby

rea l inng economies of sca le or scope . Such product ion cos t savings need to be assessed in

re la t ion to the t ransac t ion cos t advantages tha t in te rna l organiza t ion somet imes enjoys over

marke t s in adapt ing to changed c i rcumstances . As i t tu rns out , both product ion cos t economies

and the t ransac t ion cos t d i f fe rences be tween f i rm and marke t organiza t ion vary sys temat ica l ly

wi th the charac te r is t i cs of the inves tments . Thi s paper emp loys a uni f ied framew ork to assess the

choice of organ izat ion form . Th e c on di t ion o f asset specif ici ty is featured.

1 . I n t r o d u c t io n

T r a n s a c t i o n c o s t e c o n o m i c s r e g a r d s t h e t r a n s a c t i o n a s t h e b a s i c u n i t o f

a n a l y s is a n d h o l d s t h a t th e o r g a n i z a t i o n o f e c o n o m i c a c t iv i ty i s l a r g e ly t o b e

u n d e r s t o o d i n tr a n s a c ti o n c o s t e c o n o m i z i n g t er m s . S u c h e c o n o m i e s a r e

r e a li z e d b y a l i g n i n g g o v e r n a n c e s t ru c t u r e s ( o f w h i c h f i r m s a n d m a r k e t s a r e

t h e l e a d i n g t y p e s ) w i t h t h e a t t r i b u t e s o f t r a n s a c t i o n s i n a d i s c r i m i n a t i n g w a y .

T e c h n o l o g i c a l f ea t u re s o f e c o n o m i c o r g a n i z a t i o n a r e th u s r e le g a t e d t o a

s e c o n d a r y r o l e b y t h i s a p p r o a c h . G i ~ ,e n t h a t s u c c e s s iv e s t a g e s o f e c o n o m i c

a c t i v it y a r e t e c h n o l o g i c a l l y s e p a r a b l e , h o w o u g h ~, t h e t r a d i n g i n t e r f a c e t o b e

o r g a n i z e d ? V e r t i c a l i n t e g r a t io n - o r , i n m o r e m u n d a n e t e r m s , t h e m a k e - o r -

b u y d e c i s i o n - i s t h e p a r a d i g m p ro bk ~m . T r a n s a c t i o n c o s t e c o n o m i c s

m a i n t a i n s t h a t t h e r e s o l u t i o n o f th i s is s u e t u r n s o n t h e a t tr i b u t e s o f t h e

*The autho rs a re Ass is tan t Professor of Economics , S tanford Univers i ty and G ord on B.

Tw eedy Professor of Eco nom ics of Law and Orsaniza t ion . Yale U niversi ty , r espec tive ly . Helpfu l

com me nts f rom A vinash Dixit , Da vid Sappington , Richard Schmalensee , Pa blo Spil le r and

ano nym ous referees a re gra te fu l ly acknow ledged.

0167-7187/85/ 3.30 1985, Elsevier Science Publ ishers B.V. (N orth-H olland )


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366

M .H . Riordan and OE . Will iam~on ~. ~et spec if ici ty and economic organization

t r a n sa c t i o n , o f w h i c h t h e c o n d i t io n o f a s s c t sp ec if ic it y is th e m o s t i m p o r t a n t )

A v a r ie t y o f r e la t e d a n d so m e r a t h e r d i s t a n t c o n t r a c t u a l r e l a t io n s t u r n s o u t

to be va r i a t ions on th i s sam e unde r ly ing theme . 2 Th i s i s g r a t i fy ing s ince , a s

F r i ed r i ch H aye k (1967, p . 50) obse rved , w hene ver the capa c i ty o f r ecogn iz ing

a n a b s t r a c t r u le w h i c h t h e a r r a n g e m e n t o f t h e se a t tr i b u t e s f o ll o w s h a s b e e n

acqu i r ed in one f i e ld , t he same mas te r mould wi l l app ly when the s igns fo r

those a bs t r a c t a t t r ibu tes a r e evoke d by a l tog e the r d i f fe r en t e l emen t s .

A l t h o u g h t h i s t r a n sa c t i o n c o s t a p p r o a c h t o c o n t r a , i n g h a s b e e n g a i n i n g

w i d e r a c c e p t an c e , 3 i t is n o t n o w a n d d o e s n o t t h r e a t e n t o b e c o m e t h e n e w

o r t h o d o x y . E v en , m o r e o v e r , a m o n g t h o s e w h o a r e p e r s u a d e d t h a t a t r a n s -

ac t ion cos t o r i en ta t ion i s needed to ge t a t t he co re i s sues o f com pa ra t iv e

e c o n o m i c o r g a n i z a t i o n , t h e r e i s so m e d i s c o m f i t w i t h t h e a p p a r e n t d i s j u n c t i o n

b e t w e e n n e o c la s si c al a n d t r a n sa c t i o n c o s t m o d e s o f e c o n o m i c a n a l y s i s

w h e r e t h c f o r m c r e m p h a s i z e s p r o d u c t i o n c o s t s a n d v i e w s t h e f i r m a s a

p r o d u c t i o n f u n c t i o n , w h i l e t h e l a t t e r f o c u se s o n t r a n sa c t i o n c o s t s a n d r e g a r d s

the f i rm as a governance s t ruc ta r e .

B o t h a p p r o a c h e s , h o w e v e r , m a i n t a i n a n e c o n o m i z i n g o r i e n t a t i o n . A n d

p l a i n l y p r o d u c t i o n a n d t r a n sa c t i o n c o s t s b o t h n e e d t o b e t a k e n i n t o a c c o u n t

in any e f fo r t t o r ea l i ze a b road ly concc ived economiz ing r esu l t . Th i s paper i s

a n e f f o r t t o p u l l t h e se t w o c o s t c a t e g o r i e s t o g e t h e r i n a c o m m o n f r a m e w o r k .

I t i s h igh ly p re l iminary , i n tha t we (1 ) dea l on ly wi th po la r a l t e rna t ives ,

nam ely ncoc lassi ca l ma rke t s and h ie r a r ch ica l f i rms o f ve ry s ty l ized k inds , (2 )

l o o k a t o n l y o n e t r a n sa c t i o n a t a t i m e , a n d ( 3 ) e m p l o y a r e d u c e d f o r m t y p e

o f a n a l ys i s, in t h a t w e a sc r ib e r a t h e r t b a n d e r iv e t h e b a s i c p r o d u c t i o n a n d

g o v e r n a n c e c o s t c o m p c t e n c i e s o f f ir m s a n d m a r k e t s . 4

Th e p a p e r m a i n l y c o n f i r m s i m p l i c a t i o n s t h a t h a v e b e e n a d v a n c e d e a r l i e r

us ing more heur i s t i c a rgument s . I n th i s sense , t hc re a r e f ew su rp r i ses -

though th i s may be a su rp r i se to those who ho ld d i f f e r en t p r io r s . Surp r i ses o r

1 T h e a r g u m e n t i s a d v a n c e d a n d a s s e s s e d i n t h e t h e o r e t i c a l , e m p i r i c a l , a n d p u b l .~ c p o l i c y

l i te r a t u re s i n w h i ch t r a n s a c t i o n c o s t e c o n o m i c s is f e a t u re d . T h e t h e o r y i s se t o u t i n W i l l i a m s o n

( 1 9 7 1 , 1 9 75 , 1 9 7 9 , 1 9 83 , 1 9 85 ), K l e i n e t a l . ( 19 7 8 ) , M a s t e n ( 1 9 8 2 ), a n d A l c h i a n ( 1 9 8 4 ).

C o r r o b o r a t i n g e v i d en c e is d e v e l o p e d in S t u c k e y (1 9 8 3) , M o n t e v e r d e a n d T e e c e (1 98 2) , P a l a y

( 1 9 8 4 , 1 9 85 ), M a s t e n ( 1 9 8 4 ) , W a l k e r a n d W e b e r ( 1 9 8 4 ), A n d e r s o n a n d S c h m i t t le i n ( 1 9 84 ), a n d

J o s k o w ( 19 8 5) . A p p l i c a t i o n s t o p u b l i c p o l i c y i n c l u d e W i l l i a m s o n ( 1 9 7 6 , 1 9 82 ), a n d J o s k o w a n d

S chmalens ee (1983) .

2 V a r i a t i o n s o n t h e b a s i c t r a n s a c t i o n c o s t e c o n o m i z i n g t h e m e i n c l u d e a p p l i c a t i o n s t o l a b o r

m a r k e t o r g a n i z a t i o n , v e r t i c a l r e s t ri c t io n s o f v a r i o u s k i n d s , f r a n c h i s in g , r e c i p r o c a l t r a d i n g

( in c l u d in g p r o d u c t e x c h a n g e a g r e em e n t s ) , re g u l a t io n , c o r p o r a t e g o v e r n a n c e , a n d e v e n fa m i l y

o r g a n i z a t i o n . T h i s i t o t i s t r e a t e d b y B e n - P o r a t h ( 1 9 8 0 ) a n d P o l l a k ( 1 9 8 5 ) . T h e o t h e r s a r e

d i s c u s s e d i n W i l l i a m s o n

1 9 8 3 ) .

a A I c h ia n , w h o o n c e h e l d o t h e r w i s e , n o w a g r e e s t h a t a s s e t sp e c i f ic i t y .~ t h e k e y c o n d i t i o n o n

w h i c h t h e s t u d y o f f ir m a n d m a r k e t o r g a n i z a t io n t u r n s ( 1 9 8 4, p p . 3 8 - 3 9 ). T h e r e c e n t t r e a t m e n t

o f v e r ti c a l i n t e g ' a t io n b y G r o s s m a n a n d H a r t ( 1 98 4 ) a l s o a s s u m e s a c o n d i t i o n o f a s s e t

specif ic i ty .

* I t i s t h u s a k i n t o M ~ s t e n ' s e a r li e r t r e a t m e n t o f t h e s e m a t t e r s ( l ' .~ z ) . W h i l e o u r a n a l y s i s i s

m o r e e x p a n s i v e , h i s t r e a t m e n t a n d ~ u r , ; b o t h e m p l o y r e d u c e d f o r m e x p r e s s i o n s .


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M .H . R iordan and O.E. Wil liamson Ass et speci fici ty and economic organization

67

no t , t he sp i r i t o f t he ana lys i s is co nso na n t wi th th a t o f econo m ics q u i te

genera lly : u se m ore genera l m ode s o f ana lys i s a s a check on the lh -n it a tions

t h a t i n f o rm m o r e s~ c i a l i z e d t y p e s o f r e a so n i n g . Th i s p a p e r e m p l o y s a u n if ie d

f r a m e w o r k t o m a k e a m o d e s t s t e p i n th e d i re c t i o n o f f o r m a l i z a ti o n . W h i le w e

remain somewhat agnos t i c - be l i ev ing , a s we do , t ha t t he re a r e bo th cos t s

and benef it s t o fo rmal i za t ion - i t i s i n the sp i r i t o f K enn e th A r row 's r ecen t

r e m a r k s t h a t n e w t h e o r ie s o f e c o n o m i c o r g a n i z a t io n t a k e o n g r e a t e r 'a n a l y ti c

use lu lness when these a r e founded on more d i r ec t ly neoc lass i ca l l i nes ' [Ar row

(1985, p. 303)].

The heur i s t i c mode l and the f ac to r s r e spons ib le fo r cos t d i f f e r ences among

f i r m a n d m a r k e t m o d e s a r e sk e t c h e d i n s e c t i o n 2 . Th e m a i n m o d e l , i n w h i c h

asse t spec i fi c ity has on iv cos t bu t no de m an d e f fec ts , i s t hen se t ou t i n sec t ion

3 . D e m a n d f e a tu r e s a , e t h e o b j e c t o f a n a ly s i s in s e c t io n 4 . C o n c l u d i n g

r e m a r k s f ol lo w .

2 T h e h e u r is t ic m o d e l

2 1 A s : : e t s p e c i f i c i t y

Tr a n sa c t i o n c o s t e c o n o m i c s m a i n t a i n s t h a t t h e p r i n c i p a l f a c t o r t h a t i s

r espons ib le fo r t r ansac t ion cos t d i f f e r ences among t r ansac t ions i s va r i a t ions

in asse t spec i f i c i ty . Transac t ions tha t a r e suppor t ed by non- spec i f i c ( r ede -

p loyab le ) i nves tmen t s a r e ones fo r wh ich neoc lass i ca l ana lys i s i s we l l - su i t ed

to dea l. As a cond i t ion o f a sse t spec if ic i ty becomes m ore im po r t an t , however ,

e x c h a n g e r e l a t i o n s t a k e o n a p r o g r e s s i v e l y s t r o n g e r b i l a t e r a l t r a d i n g c h a r a c -

t e r . The r eason i s t ha t pa r t i e s to such t r ades have a s t ake in p rese rv ing the

con t inu i ty o f t he r e l a t ionsh ip . S imu l t aneous ly , however:, p rob lem s o f ada p t ing

b i l a t e r a l c o n t r a c t s t o c h a n g i n g c i r c u m s t a n c e s p r e d i c t a b l y a r i s e . A u t o n o m o u s

m a r k e t c o n t r a c t i n g is th u s s u p p l a n t e d b y m o r e c o m p l e x f o r m s o f g o v e r n a n ce

as a sse t speci fi c ity deepens . N ew fo rms o f d i spa te se t t l emen t ( such as

a r b i t r a t i o n ) m a y b e c r e a t e d . S o m e t r a n sa c t i o n s m a y b e r e m o v e d f r o m t h e

m a r k e t a n d o i g a n i z e d i n t e r n a l l y i n s t e a d . Th e h e u r i s t i c m o d e l g i v e s c o n t e n t t o

t h i s f i r m o r m a r k e t ( m a k e o r b u y ) o r i e n t a t i o n .

2 2 G o v e r n a n c e c o s t s

Tr a n sa c t i o n c o s t e c o n o m i c s m a i n t a i n s t h a t t ; o m p l e x , b i l a t e r a l c o n t r a c t s a r e

invar i ab ly incomple te . Con t ingenc ies wi l l t hus a r i se fo r wh ich the appropr i a t e

adap ta t ions have no t been express ly a reed upon ex an te . Al though i t i s

a lwa ys in the m utua l i n t e r es t o f t he pa r t i e s to ad ap t e f fi c ien tly , t he

d i spos i t ion o f the ga in mu ' ; t be r e so lved . As co m par ed wi th un i f ied ow ner -

sh i p o f t h e t w o s ta g e s, a u t o n o m o u s o w n e r sh i p n o r m a l l y g i v es ~ is e t o m o r e

in tens ive , se l f- in t e res t ed ba r ga in ing over the a l loca t ion o f the ada p t ive ga ins .


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3 6 8 M .H. Riordan and O .E. Williamson Asset specificity and economic organization

Added con t rac t execu t ion cos t s the reby resu l t . Autonomous ownersh ip may

therefore forego some potent ia l ly benef idal adapta t ions a l together . The

upshot i s tha t in ternal organizat ion enjoys a progress ive governance cost

adv antag e over m ark et o rganizat ion as the con di t ion of asse t specifici ty

deepens.

The se differential costs of ad ap tatio n (expressed as a function of asset

specifici ty) are not, however, the only transaction costs that dist inguish firm

and m arke t. A lso im po rtan t , tho ug h ic3s well deve ,oped, are the d ifferential

incentive an d burea ucra t ic costs of f i rm an d m ark et organizat ion. A o

developed e lsewhere [W il l iam son (1985 , ch . 6)] , mark ets are e xtrao rdin ar)

insti tution s for delivering high-pow ered incentives. Best efforts to p reserve

m arket-l ike incentives (e.g., t ransfer pricing an d a po rop riab il i ty rules) w ithin

unif ied ownership notw iths tan ding , in ternal orga nizat ion u nav oida bly ex-

periences incentive degradation. Also, internal organization experiences a

ser ies of bureaucra t ic d is tor t ions (m anag em ent excesses , investm ent renewal

biases, an d the l ike) as comp ared wi th m ark et organizat ion. Bo th of these

incentive and bureaucra t ic effec ts , mo reover , a re re lat ively independ ent of the

co nd ition of ass,~t specificity.

Accordingly , whereas in ternal orgdnizat ion is a t a t ransact ion cost d is-

advantage to the market where asse t specif ic i ty is s l ight , th is d isadveatage

deCreases and is even tually reversed as th e c ond it ion of asset specifici ty

deepens. This is shown in f ig. 1 by the curve

AG) ,

which shows the

t ransact ion cost d i f ference between f i rm and market organizat ion as asse t

specifici ty increases (for a given lev el of ou tput) . Th e intercep t (f lo) is posit ive

and the curve has a negat ive s lope throughout .

13o

F i g 1 H e u r i s t i c m o d e l


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M.H. Riordan and O.E. WiUiamson, Asset speco ~city ard economic organization 69

2.3 . Product ion cos ts

I t c a n b e a n d h a s b e e n a rg u e d th a t f i rm a n d ma rk e t a r e i d e n t i c a l i n

prod uc t io n cc =t re spec ts . To be su re , ou ts ide p roc urem ent m igh t appea r to

be favored i f a f i rm ' s needs fo r a goo d o r se rv ice a re n o t su f f ic ien t to supp or t

a p l a n t o f m in i m u m e ff ic ie n t s ca le . Th e s a m e wo u ld a p p e a r t o b e t r u e fo r

i t e ms th a t e x p e r i en c e e c o n o mie s o f sc o pe . Bu t s in c e th e f i rm c a n a lwa y s

rea l ize the same sca le o r scope ec tmora ies a s an ou ts ide supp l ie r , by se l l ing

p ro d u c t t h a t e x c ee d s i ts o wn n e e d s o n t h e m a rk e t , t h e f i rm n e e d n o t a n d

p re s u m a b ly w i l l n o t e x p e r i e n c e p ro d u c t io n c o s t d i s e c o n o m ie s o f e i t h e r k in d.

Th is a rgument a ssumes , however , tha t a f i rm can se l l to o the rs , inc lud ing ,

o f ten , it s r iva l s , a s e f fec tive ly as ca n an ind epe nd en t supp l ie r . I t a l so igpores

th e p o s s ib i l it y t h a t t h e i n c e n t iv e a n d b u re a u c ra t i c c o s ts r e f er re d t o a b o v e

h a v e c u mu la t i v e f e a tu r e s . Up o n ma k in g a l l o wa n c e fo r t h e s e , t h e f i rm wo u ld

a p p e a r t o b e a t a p ro d u c t io n c o s t d i s a d v a n ta g e i n r e l a t i o n t o t h e ma rk e t .

These p roduc t ion cos t d i seconorn ies , however , a re a l so a func t ion o f a sse t

speci fic ity . Th e d isecon om ies a re a rg uab ly g re a t where asse t spec if ic ity i s

s l igh t , s ince the ou ts ide supp l ie r he re can p roduce, to the needs o f a wide

var ie ty o f buyers us ing the ve ry same ( la rge sca le ) p roduc~.on techno logy . As

asset specif ic i ty increases , howe ver , the outs ide suppl ie , ~pecia lizes h is

in v e s tme n t i n r e l a t i o n t o t h e b u y e r . Th i s i s t h e mc a t , p g o f n o n -

redep loyab i l i ty . As these asse t s become h igh ly un ique , moreover , the f i rm can

essen t ia l ly rep l ica te the inves tm ents o f an ou ts ide supp l ie r wi thou t pena l ty .

T h e f ir m a n d m a r k e t p r o d u c t i o n t e c h no l o g y t h u s b e c o m e i n d i s ti n g u i s h a b le a t

this stage.

P ro d u c t io n c o s t d i ff e re n c es b e twe e n f i rm a n d ma rk e t , w h c , 'e b y th e f irm

exper iences a p rodu c t ion cos t p ena l ty wh en asse t spec i f ic i ty i s s l igh t bu t

these cos t d i ffe rences asy m pto t ic a l ly ap pro ac h ze ro as a sse t spec if ic i ty

b e c o me s g r e a t , a r e s h o wn b y th e c u rv e A C in f ig 1. As w ith the A G curve,

the

A C

curve i s d ra w n fo r a f ixed leve l o f ou tpu t .

2.4 . C om bin ed e f fec ts

To ta l c o s t d i ff er e nc e s o f f i rm a n d m a rk e t o rg a n iz a t i o n a r e g iv e n b y th e

ver t ica l sum, A C A G . Th is cu rve i s pos i t ive in i t i a l ly bu t has a ne lza t i', e

s lop e t h ro u g h o u t a n d b e c o me s z e ro a t ,4. Th e h e u r i st i c mo d e l o f f i rm a v J

m arke t o rga n iza t ion thu s supp or t s the lo t owing genera l conc lus ions : (~)

m a rk e t o rg a n iz a t i o n i s t h e l ea s t c o st m o d e i f t h e o p t ima l v a lu e o f a s se t

spec if ici ty i s smal l ; (2 ) in te rna l o rgan iza t ion i s the leas t cos t m od e i f the

op t im a l va lue o f a sse t spec i f ic i ty i s g rea t; an d (3 ) ne i the r m ode en joys a

s ig n i fi c a n t a d v a n ta g e ( t h a t is , i t d o e s n ' t m a t t e r m u c h wh ic h m o d e i s c h o se n )

fo r a sse t spec i f ic i ty va lues in the ne ig hbo rho od o f A.

Th e s e r e s u lt s ar e o b t a in e d , h o we v e r, b y a s s u m in g th a t b o th mo d e s

prod uce the same leve l o f ou tp u t and tha t the op t im a l level o f a ssel


6/14

37

M.H. Ric: dan and O.E. Williamson, Asset specificity and economic organizction

spec i f i c i ty i s t he same fo , each . What happens when these : f impl i fy ing

a s su m p t i o n s a r e re la x ed " ., M o r e g e n e r al ly , w h a t h a p p e n s w h e n t he a b o v e

r e l a ti o n s o f f ir m a n d m a r k e t o r g a n ~ a t i o n a r e d ig e s t ed i n a m a x i m i z i n g

f r a m e w o r k o f t h e m o r e f a m i l ia r n e o c la s s ic a l k i n d ?

3 T h e m a i n m o d e l

The cos t d i f f e r ences d i scussed above a r e r espons ib le fo r t he r educed fo rm

geomet ry shown in f ig . 1 . The main mode l examined here i s i n the same

sp i r i t . T~e r e su l t i n g m o d e l s a r e so m e w h a t m o r e g e n e r a l , h o w e v e r . W e

e x a m i n e ~h e i r f i rs t -o r d e r m a x i m i z i n g a n d c o m p a r a t i v e s t a ti c s p r o p e r t ie s . I t

wi l l f ac i i ; a t e the a rgument to assume in i t i a l ly tha t f i rm and marke t have the

iden t i ca i a roduc t ion cos t t echno logy . Th i s a ssumpt ion wi l l be r e l axed in

sec t ion D em an d f ea tu res o f a sse t spec if ic i ty a r e r ese rved fo r sec t ion 4 .

3.1. Con;ton production technology

Revenue i s g iven by R = R X ) , a n d p r o d u c t i o n c o s ts o f m a r k e t a n d

i n t e r n a l p r o c u r e m e n t a r e a s su m e d t o b e g i v e n b y t h e r e l a t i o n

C = C X , A ; ~ ) , C x > O ,

C A < 0 , C x A < 0 ,

where the pa ram ete r i s a sh i ft pa r am ete r , a h igher v a lue o f ~t y i e ld ing

greater cost reducing consequences to asset speci f ic i ty ,

CA~ < O, Cx~ < O.

Asse t specif ic i ty i s ass um ed to be av ai lab le a t the co ns tan t pe r un i t cost o f ~,.

The nec ss ica l p ro f i t express ion co r r e spo nd in g to th i s s t a t e m en t o f r evenue

a n d p r o d u c t i o n c o s t s i s g i v e n b y

7 r * X , A ; ~ ) =

R X ) - C X , A ; ~ ) - 7 A .

Governar ; ce cos t s a r e consp ic ious ly omi t t ed f rom th i s p ro f i t r e l a t ion , t he re

be ing no p rov i s ion fo r such cos t s i n the neoc lass i ca l s t a t emen t o f t he

prob lem.

W e a s su m e t h a t t h i s f u n c t i o n i s g l o b a l l y c o n c a v e . A t a n i n t e r i o r m a x i m u m

the dec i s ion va r i ab les X* , A* a re de te rmined f rom the ze ro marg ina l p ro f i t

c o n d i t i o n s

rc](X, A; ~) = 0 , x* (X , A; ~ )= 0.

C o n s i d e r n o w t h e g o v e r n a n c e c o s ts o f i n t e rn a l a n d m a r k e t o r g a n i z a t i o n .


7/14

M.H. Riordan and O.E. Williamson Asset specificity and economic organization 37

Le t t h e s u p e r s c r ip t s i d e n o t e i n t e r n a l a n d m d e n o te m a r k e t o r g a n i z a t i o n .

G ov ern anc e cos t express ions cong ruen t w i th the cos t d if ferences desc r ibed

a b o v e a r e g iv e n b y

Gi=fl+ V(A), f l>O , V A >O ,

Gm=W(A), W A > O ,

where WA> I+ i, e v a lu a t e d a t c o m m o n A .

Th e c o r r e s p o n d in g p r o f i t e x p r e s s io n s f o r i n t e r n a l m a r k e t p r o c u r e m e n t i n

the face o f pos i t ive governance cos t s a re

u I = R X ) - C X , A ; a ) - ~ A - f l + V A ) ) ,

n m= R( X) -C (X , A; a) - ~,A- W(A).

Th e z e r o m a r g in a l p r o f i t c o n d i t i o n s f o r i n t e r n a l p r o c u r e m e n t a r e

n x=Rx-Cx=O, rr ~= - C a - y -

VA=0.

T h o s e fo r m a r k e t p r o c u r e m e n t a r e

~ ~ = R x - C x = O , l r ~ = - C a - 7 - W A = O .

In e ach in s tance , there fo re , op t im a l o u tpu t , g iven a sse t spec if ici ty , i s

o b t a in e d b y s e t t i n g m a r g in a l r e v e n u e e q u a l t o t h e m a r g in a l c o s t s o f

p rodu c t ion , wh i le op t im a l a s se t spec i f ic i ty , g iven ou tpu t , i s chosen to

m in im iz e t h e s u m o f p r o d u c t i o n a n d g o v e r n a n c e c o s ts .

Given that rr~.A= - CxA>0 , t h e n e o c l a ss i c a l l o c u s o f o p t im a l o u tp u t g iv en

asse t spec i f ic i ty an d the co r r esp ond ing locus o f c , p t im a l a s se t spec i f ic i ty g iven

o u tp u t w i l l b e a r t h e r e l a t i o n s s h o w n b y n =0 a n d ~ r * =0 in f i g . 2 . Th e

c o r r e s p o n d in g l o c i f o r i n t e r n a l a n d m a r k e t o r g a n i z a t i o n a r e a l s o s h o w n .

I n a s m u c h a s t h e z e r o m a r g in a l p r o f i t e x p r e s s io n s f o r o u tp u t f o r a l l t h r e e

s t a t e m e n t s o f th e m a x im a n d a r e i d e n ti c a l, th e l oc i z r ~r =0 a n d 7 r ~=0 t r ac k

re* = 0 exact ly . Th e zero m ar gi na l prof i t exp ress io ns for asse t specif ici ty , how ever ,

d if fer. G ive n tha t WA > VA > 0 , the locus r r ~ = 0 is everyw here be low 7r~ = 0,

wh ich in tu rn i s be low r r~=0 . Accord ing ly , we obse rve tha t p ro f i t max imiz -

in g v alu e s o f X a n d A f o r th e s e th r e e s t a t e m e n t s o f th e o p t im iz a t i o n p r o b l e m

bear the fo l lowing re la t ion to each o ther : X* > X i > X m and A* A > Am.

The output e f fec ts a re indirec t or induced effec ts , a t t r ibutable to sh if ts in the

zero marginal prof i t asse t specif ic i ty loc i .

O f course , the X * and A* cho ices a re pu re ly hypo the t ica l s ince , in rea li ty ,

a ze ro t ransa c t ion cos t cond i t ion i s no t a m em be r o f the feas ib le set . The


8/14

372 M .H . Riorda n and O.E. Wil liamso 1 Ass et speci f ici ty

nn

economic organiza t ion

= 0

m

A:U

/ l i n

t I / i

/ - / | :

/ /

|

I / i n

n

/ i

u /

i n

t / i . a

i

X X~ X X

F i g . 2 . F o r nxA > O.

r e le v a n t c h o ic e s t h u s r e d u c e t o u s i n g i n p u t c o m b i n a t i o n s I u n d e r i n t e r n a l

p r o c u r e m e n t o r M u n d e r m a r k e t p r o ~ u r em e n t . A n im m e d i a t e i m p h c a t i o n is

t h a t i f t h e fi rm w e r e o p e r a t i n g i n t w o i d e n t ic a l m a r k e t s a n d w a s c o n s t r a i n e d

t o b u y i n o n e a n d t o m a k e in th e o th e r i t w o u l d s e ll m o r e g o o d s o f a m o r e

d i s t i n c t i v e k i n d i n t h e r e g i o n w h e r e i t p r o d u c e d t o i t s o w n n e e d s .

O r d i n a r i l y h o w e v e r t h e f ir m w i ll n o t b e s o c o n s t r a i n e d b u t w ill c h o o s e

t o m a k e o r b u y a c c o r d i n g t o w h i ch m o d e o f fe r s t h e g r e a t e s t p r o f it in e a c h

r e g i o n . F i g . 3 s h o w s p r o f i t a s a f u n c t i o n o f a s s e t sp e c i fi c it y t h e c h o i c e o f

o u t p u t a s s u m e d t o b e o p t i m a l f o r e a c h v a l u e o f A . W h e r e a s t h e r e is a fa m i l y

o f n i c u r v e s o n e f o r e a c h v a l u e o f t h e b u r e a u c r . f i c c o s t p a r a m e t e r fl t h e r e i s

A m A

F i g . 3

A


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M H. Riordan and O.E. Williamson, Asset specificity and economic organization

373

o n ly a s in g le gm c u rv e . W h ic h m o d e i s f a v o re d d e p e n d s o n wh ic h h a s t h e

h ig h e s t p e a k . T h i s i s t h e i n t e rn a l mo d e fo r f l=flo b u t t h e m a r k e t m o d e f o r

f l=f l l , wh e re f l : > f lo . T h e o p t im a l v a lu e o f A a n d X d e p e n d s o n ly o n th e

m ode se lected and no t on f l, however , s ince fl does no t in f luence the

m a rg in a l c o n d i ti o n s .

T h e c o m p a ra t i v e s t a t ic s r a m i f i c a t i o n s o f t h e p ro d u c t io n c o s t p a r a m e te r

a r e mo re c e n t r a l t o o u r i n te r e st s . Ap p l i c a t i o n s o f th e e n v e lo p e t h e o re m r e ve a l

th a t

7fma= - - C : X m,

A m , ~ x , ~ i = _

C a X i,

A i, 0t .

I n a sm u c h a s X i > X m a n d A i > A m , i t f o ll o ws f ro m o u r e a r l ie r p ro d u c t io n c o s t

ass um pti on s tha t n ~_> n~. In o the r words , a s a sse t spec i fic ity has g rea te r cos t

r e d u c in g imp a c t , i n t e rn a l o rg a n iz a t i o n i s p ro g re s siv e ly fa v o re d .

3.2. Production cost differences

Co n s id e r n o w th e c a s e , t o wh ic h we r e f e r r e d e a r l i e r a n d i s a rg u a b ly t h e

mo re r e a l i s t i c , wh e re t h e f i rm i s u n a b le t o a g g re g a t e d e ma n d s a n d s e l l

p ro d u c t t h a t e x c e e d s i t s o wn d e ma n d s w i th o u t p e n a l ty . L e t H X , A ) deno te

th e p ro d u c t io n c o s t d i s a d v a n ta g e p e r u n i t o f o u tp u t a s s o c ia t e d w i th i n te rn a l

o rg a n iz a t i o n . T h e p ro d u c t io n c o s t s o f t h e two m o d e s t h e n a r e

c m = c X , A , o t ) ,

Ci=C X,A;a)+H X,A)X.

A s s u m e t h a t H x < 0 a n d H a < 0 b u t th a t H X , A ) X i s pos i t ive and asympto t i -

c a l ly a p p ro a c h e s z e ro a s X a n d A a p p ro a c h in f in i ty . De n o te t h e ma rg in a l

p ro d u c t io n c o s t d i s a d v a n ta g e b y M X , A ) = H x X , A ) X + H X , A ).

T h e a n a ly s i s d e p e n d s o n th e wa y in wh ic h t h e t o ta l p ro d u c t io n c o s t

d i s a d v a n ta g e e x p e r ie n c e d b y in t e rn a l o rg a n iz a t i o n c h a n g e s fo r o u tp u t s w i th in

the re levan t range . At low leve ls o f ou tpu t , dec reas ing un i t cos t d i s -

a d v a n ta g e s w i l l n o rm a l ly b e a t t e n d e d b y a n i n c r e a s in g to t a l c o s t, w h e n c e

M X , A )> O . Bey ond som e th resh o ld leve l o f ou tpu t , how ever , the to ta l

p ro d u c t io n c o s t d i s a d v a n ta g e o f i n t e rn a l o rg a n iz a t i o n w i l l b e g in t o d e c l in e .

Indeed , a s the f i rm progress ive ly inc reases in re la t ion to the s ize o f the

ma rk e t , t h e p ro d u c t io n c o s t d i s a d v a n ta g e p r e s u m a b ly a r ;p ro a c h e s z ero -

s in c e f i rm a n d ma rk e t h a v e a c c e s s t o i d e n t i c a l e c o n o mie s o f s c a l e a s a

mo n o p o ly c o n d i t i o n e v o lv e s . Ac c o rd in g ly , M X , A ) < 0 once th i s th resho ld i s

crossed.

O u r m a in r e s u lt s a r e s tr e n g th e n e d wi th in th e l a rg e o u tp u t ) r a n g e wh e re

M(X,A)< xm~xi; A m < A i ; a n d i m

, ,>n , , . W i th in the smal l ou tpu t ) range ,

however , where M x > O , t h e ma rg in a l p ro d u c t io n c o s t d i s a d v a n ta g e o f

i n t e r n a l o r g a n i z a t i o n a n d t h e m a r ~ n a l g o v e r n a n c e c o s t d i s a d v a n t a g e o f


10/14

374

M .H. R iordan-and O.E. W ill iamson Asse t speci fici ty and economic organizat ion

ma rk e t p ro c u re me n t o p e ra t e i n o p p o s i t e d i r e c t i o n s . An u n a mb ig u o u s o rd e r -

ing o f op t im al ou tpu t an d asse t spec if ic ity i s no t poss ib le in te rms o f the

above-desc r ibed qua l i ta t ive fea tu res o f the p rob lem in th i s ins tance . An

anomaly thus a r i ses tha t ,~as no t ev iden t in the heur i s t ic p resen ta t ion in

section 2.

4 D e m a n d e ff ec t s

A noth er poss ib i l i ty i s tha t a sse t spec if ic ity y ie lds des ign benef i t s bu t has no

d i rec t e f fec t on p roduc t ion cos t s . Thus suppose tha t a d ie can be shaped to

prod uce a very specia l effect a ta i l f in on a n au tom obile ) , a sem i-spe cia l ..~ect

{ in tha t the d ie can be redep loye d , a lbe i t a t red uced va lue) , o r a s ta nd ard

p ro d u c t. P ro d u c t io n c o s t d if fe re n c es m a y b e a n d wi l l b e a s s u m e d to b e )

insubs tan t ia l . The main e f fec t s t ake the fo r ra o f demand sh i f t s and gover -

nance cost chat~ges.

The th ree p ro fi t express ions cor respo nd in g to th i s s ta ten :en t o f the

p r o b l e m a r e

= R X , A ; - C X ) - r A ,

7c = R X , A ; ~ ) - C X ) - ? A - W A ) ,

r c ~ = R X , A ; ~ ) - C X ) - T A - f l + V A ) ) ,

where

R a

>0 Rxa> 0 , RA~> 0 , Rx~ Oa n d 6 i s a d e m a n d s h i f t p a r a me te r .

Aga in , the locus o f op t imal X g iven A wi l l be iden t ica l fo r each o f these

prof i t express ions , whi le the locus o f op t imal A g iven X wi l l move p ro -

g ressive ly dow n f rom neoc lass ica l to in te rn a l to m arke t in tha t o rder . The

o u tp u t a n d a s se t sp e c if ic it y r e l a ti o n s r e p o r t e d u n d e r t h e m a in m o d e l a r e t h u s

p re s e rv e d . I n c r e a s e s i n t h e d e ma n d e n h a n c e me n t p a r a me te r 6 , mo re o v e r ,

have the expec ted e ffec t: in te rna l o r gan iza t io n i s re la t ive ly favored over

m a rk e t o rg a n iz a t i o n a s t h e d e m a n d e n h a n c e m e n t effe cts o f a d d e d s p e ci fi c it y

in c re a s e . T h e d i f f e r e n t i a l a d v a n ta g e o f i n t e rn a l o rg a n iz a t i o n i s e x p la in e d b y

the respec t ive marg ina l governance cos t pena l t ie s tha i acc rue to asse t

spec if ici ty unde r f i rm and m ark e t modes .

5 C o n c l u s i o n s

T h e f o re g o in g d e m o n s t r at e s t h at c o n v e n t i o n a l d e m a n d a n d p r o d u c t i o n

c o st a n a ly s i s c a n b e a u g m e n te d to i n c l e d e g o v e rn a n c e c o s t f e a tu r es . T h e

comi~,a ra tive ins t i tu t iona l ram if ica t ions o f the tw o can then be ex p lo red . Th e

a p p a re n t g a p b e twe e n th e o r th o d o x th e o ry o f t h e f i .rm a n d th e t r a n s a c t io n

c o st e c o n o mic s a p p ro a c h to t h e s tu d y o f f i rm a n d m a rk e t s t r u c tu r e s i s t h u s

nar rowed as a consequence .


11/14

M . h . R i o r d a n a n d O . E . t V i l l ia m s o : A s s e t sp e c i fi c it y a v d e c o n o m i c ~ g a n i : a t i o n 75

E x t e n s i o n s t o t h is a p p r o a c h a r e , m o r e o v e r ,

p o s s i b l e

A p r o g r e s s i , , e o p e r a -

t i o n a l i z a . i o n o f t h e e c o n o m i c s o f t r a n s a c t i o n c o s t s w il l t h e r e b y r e s u lt . A h i g h

p r i o r it y fo r f u r t h e r r e se a r c h s h o u l d b e a n a ss e s s m e n t o f ; o ~ p a r a , . i~ t r a n s -

a c t i o n c o s t s w i t h i n m o r e s p e ci fi c m o d e l s o i o r g a n i z a t i o n a l c L-)ic e.

W i t h r e f e r e n c e t o c o n s u m e r w e l f a r e , l h e m a i n i m p l i c a t i o n o f t h e a rg ;,A n era t

i s t h is : f i r m s t h a t d e c i d e f o r p r o f i t a b i li t y r e a s o n s t o i n t e g r a t e ( p w d u c e t o

t h e i r o w n n e e d s) w i ll p r o d u c e m o r e a n d r e a li z e lo w e r c o s ts t h a n i f t h e y w e r e

c o n s t r a i n e d b y p u b li c p o li c y to p r o c u r e f r o m t h e m a r k e t . N o t e in th i s

c o n n e c t i o n t l ' a t w e t r e a t a ll c o s t s - p r o d u c t i o n a n d g o v e r n a n c e , m a r k e t a n d

i n t e r n a l - a s so c i a l c o s ts . M a r k e t g o v e r n a n c e c o s t s d o n o t t h e r e f o r e r e fl ec t

r e n t s b u t r a t h e r a r e a d d e d c o s t s d u e t o m a l a d a p t i o n [ b e i n g o f f t h e 's h if ti n g

c o n t r a c t c u r v e ' , in th e l a n g u a g e o f M a s a h i k o A o k i ( 19 8 4) ] e n d h a g g l in g

c o s t s . T h e s e a r e r e a l c o s t s f o r w h i c h f u l l s o c i a l c o s t v a l u a t i o n i s w a r r a n t e d .

T h e m o d e l s a n d th e a b o v e w e l fa re a r g u m e n t m a k e no provis ion h o w e v e r ,

fo r s t ra teg ic behav ior . S t r a te g i c i n c e n ti v e s t o i n t e g r a t e i n t r u d e w h e r e i n t e g r a t i o n

b y a fi r m t h a t is l a r g e i n r e l a t i o n t o t h e m a r k e t , a n d f o r w h i c h i n t e g r a t i o n

p r o m i s e s l it tl e i n t h e w a y o f c o s t s a v i n g s , n e v e r t h e l e s s d i s a d v a n t a g e a c t u a l

a n d p o t e n t i a l r i v a ls - b e c a u s e t h e r e m a i n i n g m a r k e t is t o o s m a l l t o s u p p o r t

c o m p e t i t i v e s u p p l y a n d r i v a ls e x p e r i e n c e c o s t p e n a lt ie s s h o u l d t h e y p r o d u c e

t o t h e i r o w n n e e d s [ W i l l i a m s o n ( 1 9 7 4 ) - I . I n c i r c u m s t a n c e s , t h e r e f o r e , w h e r e

t h e p r e c o n d i t i o n s f o r s t ra t e g i c b e h a v i o r a r e s a ti sf ie d - n a m e l y , i n d o m i n a n t

f ir m s o r h ig h l y c o n c e n t r a t e d i n d u s t r ie s w h e r e t h e c o n d i t i o n o f e n t r y i s

d if fic u lt - d e c i si o n s t o in t e g r a t e c a n n o t b e a c c e p t e d w i t h e q u a n i m i t y b u t n e e d

a l s o t o b e a s s e s s e d w i t h r e f e r e n c e t o t h e i r s t r a t e g i c c o n s e q u e n c e s . T h e d i f f i -

c u lt c as e s, o f c o u r s e , a re t h o s e w h e r e v e r ti c a l in t e g r a t i o n e c o n o m i e s a n d

e n t r y im p e d i m e n t s a r e b o t h n o n - t r iv i a l . I n t e g r a t i o n , h o w e v e r , t h a t g i v e s r is e

t o n e g li g ib l e e c o n o n ~ e s ( m a y b e e v e n , i n c o n s i d e r a t i o n o f t h e a d v e r s e

i n c en t iv e a n d b u r e a u c r a t i c c o s t c o n s e q u e n c e s o f i n t e rn a l o r g a n i z a t i o n ,

d i s e co n o m i e s) a n d i s r e s p o n s i b l e f o r s e v e re e n t r y i m p e d i m e n t s is p l a in l y

p r o b l e m a t i c i f n o t o u t f i g h t a n t is o c i a l.

N o t e t h a t w e t r e a t a s s e t s p e c i f ic i ty a s b e i n g a ll o f a k i n d . I n f a c t, a ss e t

s p e c i f i c i t y t a k e s a t l e a s t f o u r d i f f e r e n t f o r m s : s i t e , p h y s i c a l , h u m a n , a n d

d e d i c a t e d a s s e t s [ W i l l i a m s o n ( 19 8 3) -I . T h e s e d i f f e r e n t f o r m s o f a s s e t s pe c'~ fic -

i ty , m o r e o v e r , h a v e s o m e w h a t d i ff e re n t r a m i f i c a t i o n s f o r t h e e c o n o m i c s o f

o r g a n i z a t i o n . T h e e m p i r i c a l t e s t s d i s c u s s e d b e l o w d o n o t m a k e t h e s e

d i s t i n c t i o n s a n d t h u s c a n b e f u r t h e r r e f i n e d .

T h e c r u d e a r g u m e n t i s i n s t r u c t i v e n e v e r t h e le s s . I t p r e d i c t s t h a t v e r t i ca l

i n t e g r a t i o n w i ll b e m o r e c o m m o n w h e r e ( 1) c o s t s a v i n g s t h a t a c c r u e t o a ss e t

s p e c i f i c i t y a r e g r e a t , ( 2 ) d e s i g n f e a t u r e s d e t e r a s s e t r e d e p l o y m e n t t o a l t e r n a -

t i v e u s e s , ( 3 a ) e c o i i o m i e s -

,~ s c a l e a r e s m a l l o r , ( 3 b ) a s a m o n g f i r m s o f d i f f e r e n t

s iz es , t h a t l a r g e r f ir m s w il l b e m o r e i n t e g r a t e d t h a n s m a l l e r , a n d (4 )

b u r e a u c r a t i c c o s t c o n s e q u e n c e s o f i n t e r n a l o r g a n i z a t i o n a r e le ss se v e re . T h c s e

a r e a l l p l a u s i b l e p r o p o s i t i o n s a n d a p p e a r t o b e c o n .~ o n a n t w i t h t h e d a t a -


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M .H . Riordan and O.E. Williamson Asse t specificity and economic organization

al though these mat ters have only recent ly come under review and the data

need much more sys temat ic development . We never theless submit tha t

cerrob orat ive suppo rt for each of the prop osi t ions can be found - and in

some cases is bountiful . The following are i l lustrat ive:

(1 ) Forw ard in tegra tion ou t o f man ufac tu r ing in to d i s tr ibu t ion i s much

more common fo r durab le p roduc t s tha t r equ i re id iosyncra t i c knowledge o f

product at tr ibutes, in order effectively to sell and service an i tem. than i t is

for products which lack these features. Human asset specifici ty in sales and

service thus favors forw ard in tegra t ion ou t o f m anu factur ing in to dis t r i-

but ion. Am erican exper ience a t the turn o f the century ap pears to correspo nd

with th is predic t ion [P or t er and Livesay (1971) , Ch and ler (1977), W il liamson

(1985, ch. 5)].

(2) Rol l ing s tock that i s eas i ly redeployab le am ong shippers is ow ned by

carriers while that which is specialized to shipper needs and cannot be

redeployed except at great sacrif ice is owned by shippers [Palay (1984)]. This

is a lso consonant wi th the hypothesis .

(3) Casu al observat ion suggests, thoug h the data , to ou r know ledge, are

not very well developed in this respect , that larger f irms are more integrated

than smal ler riva ls . [See Mon teverde and Teece (1982) for supp ort in the

automobi le industry .]

(4) Social scientists hav e not given a great deal of at te ntio n to b ureau -

cratic costs. C om para tive assessments ar e especially few, w hich is especially

regrettable. 5 Alfred Ch an dle r has n evertheless inter prete d the shift from the

funct ional (or U-form) to the mul t id ivis ional (or M-form) organizat ion as

being dr iven in par t by the bureaucra t ic d is tor t ions in the former that are

alleviated by the lat ter . This is responsible for the M-form hypothesis: the

organization and operation of the large enterprise alon g the lines of the M-form

favors goal p ursu it and least-cost behavior m or e nea rly associated with the

neoclassical pr ofit maximization hyp othe sis than do es the U-form organiza-

tional alternative

[W il l iam son (1970 , p . 134)] . Al thoug h the evidence is not

extensive , i t appears again tu be broadly corroborat ive [Armour and Teece

(1978), Steer and Cable (1978)].

We conc lude wi th a cavea t : the a rgument th roughout has emphas ized

polar f irm and market choices. This facil i tates the analysis , but i t ignores an

im portan t c lass of hyb r id m odes of organ izat ion - of which jo in t ventures ,

f ranchis ing, and a var ie ty of complex forms of re la t ional contra c t ing are

examples. R ecent studies of econo mic or gan izatio n disclose th at these hy brid

modes a re much more impor tan t than had h i the r to been rea l i zed [MacNed

5 T he so c i o l o g y li te r a tu re o f t en d o cu m en t s m an ag e r i a l d i s c r e ti o n , b u t r a r e l y i n a co m p ara t i v e

ins t i t u t iona l way . [An example is Da l ton 1959) .] Th us i f a l l fo rm s of org aniz a t ion a re subjec t t o

ident i ca l d i s tor t i on s in re l a ti on to a hyp othe t i ca l idea l , t hen no ne a f ford ~e li ef . Di s tor t i on s th a t

a re i r remediab le l ack com para t ive ins t i t u t i ena l s ign i f icance .


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M .H . Rior dan and O.E. Will iamson As set specif ici ty a nd economic organization

377

1974) , G old be r g 1976) , K le in 1980), Jo sko w 1985), W i l li am son 1985) ] .

Fu tur e de sc r ip t ive , theor e ti ca l, an d e m pir i c a l s tud ie s o f e c on om ic or gan iz a-

t i o n w i l l p r e s u m a b l y m a k e m o r e a d e q u a t e p r o v i s i o n f o r t h e s e h y b r i d m o d e s .

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Asset Specificity and Economic Organization

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