Oliver Williamson and the pin factory

by on October 12, 2009 at 10:14 am in Current Affairs, Economics | Permalink

In Adam Smith there is the pin factory and the market and from that beginning we trace the long literature in economics focused on the twin questions, What price to set?  How much to produce?  Following Coase, Williamson asks different questions, Why a pin factory?  Why are the 18 steps to make a pin performed by a single firm rather than two or more?  Why are there many firms instead of one large firm?  Why does the pin factory not vertically integrate upwards to buy the steel factory and downwards to buy the retail hardware shop?

Williamson’s answers rest on the notions of bounded rationality, contract incompleteness, asset specificity and opportunism. Start at the end, asset specificity and opportunism.  When a deal has been sealed the parties typically move from having many potential partners to being locked in.  That’s bad because it raises the possibility of opportunism–one party can exploit the other.  But it’s also good because when the lock-in is credible each party may be more willing to invest in assets which are extra-productive but specific to the relationship.

Marriage, for example, takes away some possibilities but it adds others.  With marriage, for example, comes a greater willingness to invest in children (n.b. asset specificity, the child is of extra value but only to the specific parties involved in the marriage) but that very benefit also means that one of the parties has the leverage to be opportunistic.  Knowing all of this when they enter the contract the parties bargain ex-ante, they exchange promises and make investments (the ring), they establish rules for ex-post bargaining or decide on the background rules to apply in that eventually (pre-nup, no fault divorce, covenant marriage).  The rules are never perfect and the contacts are always incomplete.

Transaction cost economics is all about applying these ideas in different settings to figure out the best governance structures (marriage, vertical integration etc.) in different circumstances. How does one deal with expensive investments (such as highly
individual dies or plant construction) that are specific to a given
trade and put the investor at risk yet which increase productivity? Williamson analyzes how firms
come to rely on long term contracts or vertical integration or other
seemingly non-competitive solutions to enhance market productivity.
Early generations of antitrust enforcers often saw these as
monopolistic dealings, but scholars such as Williamson helped us
understand how these are essential to the workings of the invisible
hand.

Williamson’s paper, The Economics of Governance (working version) published in the May 2005 AER is an excellent recent summary of his views in the area.

Williamson’s work is notable for inspiring a large body of empirical and theoretical work in modern industrial organization and having influence in law, political science, and management. His work has been widely cited, and by some counts he was the most widely cited economist in the world.

I especially thank John Nye who contributed to this post.

Norman Pfyster October 12, 2009 at 10:18 am

Didn’t Coase already win a Nobel for this idea? What did Williamson add?

Max October 12, 2009 at 10:40 am

Think you could ask Professor Nye to guestblog on MR for a week?

dearieme October 12, 2009 at 11:58 am

Were Smith’s pins the wee chaps used for cloth, or the small nails used in woodwork?

Benny Lava October 12, 2009 at 12:23 pm

Do you even think before you post? Marriage adds possibilites? Like children? As if you couldn’t have children outside of marriage? Were you born in 1912 or something?

Marriage is a risky social contract whereby people pool their resources to reduce housing costs and increase the chances for health insurance. I like you Tyler, but sometimes you write some really stupid things.

Millian October 12, 2009 at 12:56 pm

“people pool their resources to reduce housing costs and increase the chances for health insurance”

So why do people get married outside America? Will universal healthcare lead to a surge in co-habitation? In reality marriage allows you to hold your partner to greater account for cheating, hence increases your confidence that the kids are yours.

bastiat October 12, 2009 at 12:58 pm

Relax Benny

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In reply to Max on cell phone/carrier exclusivity deals:

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Roger Sweeny October 12, 2009 at 1:35 pm

now I’m wondering about why marriages don’t vertically integrate.

You never heard of in-laws?

JSK October 12, 2009 at 1:55 pm

@Millian:
So why do people get married outside America?

At a far lower rate! Just compare marriage statistics between the U.S. and Europe. Economic benefits change a large part of the picture. And whining about cheating spouses is just loser talk.

@Alex: Why change the wording if you are right all along? When is Tyler coming back?

Ricardo Quiel October 13, 2009 at 1:46 pm

Benny Lava, Ruman…are you a trainned economists?
Benny, read the whole thing before misquoting.
Ruman, children has nothing to do with assets. Parents expect no return on them. And are willing to carry them as long as they are alive.
I might concede there is a return, but only within spiritual realm.
Besides, no action of your children or yours will diminish their value.
Marriage is a ritual.
And its “market value” rest on social networks expanded by the expansion on personal ID of both persons.

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