Governance and the Nobel Prize

Recently, the Royal Swedish Academy of Science announced that Oliver Williamson, professor of economics at UC Berkeley, had been awarded the Nobel Prize for economics (technically, the Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel) for 2009. The press release said that Williamson was being recognized “for his analysis of economic governance, especially the boundaries of the firm.”

Since I teach corporate governance and organization theory at a business school, I find it important to analyze the significance of Williamson’s award. Economics Nobel prizes have been given very rarely for economists who have analyzed what goes on inside a company. Mostly, recipients have worked on entire economies and industries comprising many companies, with each company pretty much treated as a black box. The only other prize recipient who looked inside companies was Herbert Simon, who received the Prize in 1978 for his analysis of decision-making within companies. Of course, Simon was Williamson’s teacher at Carnegie Institute of Technology (now, Carnegie-Mellon University) so their being recognized for related areas makes sense.

I’m glad that an academic specialist on economic governance of Williamson’s stature has been recognized. I’m also wary, however, that the Prize may serve to gloss over some serious criticisms of Williamson’s theories among others who study how people behave within companies. Williamson is one of the pioneers in an area called “transaction cost economics” or TCE, for short. He analyzed the classic make-or-buy decision and asked why entrepreneurs would prefer to produce something it needs within the company rather than buying it from the market. He argued that markets are not always the easiest sources of inputs because of the resources needed (transaction costs) to haggle with suppliers to agree on a contract and enforce it later. He concluded that in order to minimize transaction costs for highly customized inputs, the entrepreneur would choose to produce the input within the company.

This is where my concern about TCE begins. Williamson reasons that it is more efficient to produce within the company because the entrepreneur can impose his authority on his employees to produce the input instead of using the time for haggling for and enforcing a contract. A company is then an instrument for imposing power on people when one wants to avoid the need for agreement in the marketplace. But how does the entrepreneur then ensure employees comply with his wishes, given their tendency for opportunism and guile? Williamson says that the entrepreneur needs to closely monitor employees and to use incentives to motivate them to do what he requires.

Subsequently, other academics such as Jensen and Meckling built on TCE to develop Agency Theory. One of AT’s implications was for top corporate executives, since they couldn’t be closely monitored by shareholders and the board, to be given powerful incentives such as stock options to motivate them to work harder for the shareholders. It is now a matter of US business history in the 80s and 90s that many executives, motivated by their stock options, resorted to stock price manipulations and caused major corporate failures in the process, including Enron.

It may seem like a big leap from the plausible ideas of TCE to the pattern of financial scandals featuring greedy executives and negligent boards that by now has already wreaked global financial damage. But I agree with a number of social scientists that an economic theory of companies which prescribes too much monitoring and control against opportunism while ignoring company members’ capacities for shared values and learning gives a limited—even distorted—view of economic governance. I hope that the Nobel Prize will inspire Williamson and his collaborators to expand the very limited view of man in TCE.