Background on institutional economics

Oliver Williamson, Nobel Laureate in Economics in 2009, is widely considered the father of transaction cost economics. However, in discussing the latter, he not only emphasized its grounding in a previous tradition of institutional economics, but also recited the ‘Carnegie Triple’, which turns out to be very relevant to the concern with interdiscplinarity. The Carnegie Triple, in Williamson's words, exhorts the following: ‘be disciplined, be interdisciplinary, have an active mind’ (Williamson, Reference Williamson2007). Following this dictum, Williamson explored the deficiencies of neoclassical economics in seeking to explain economic behavior, especially of organizations. Williamson found the stance of neoclassical economics that viewed the ‘firm as a production function’ unsatisfying in the face of organizational complexity. He realized that an interdisciplinary approach is needed to uncover the ‘inter-temporal realities of complex organizations’ (Williamson, Reference Williamson2007).

Drawing on the tradition of the Carnegie School, and scholars such as Herbert Simon, Franco Modigliani, Merton Miller, Richard Cyert, James March, John Muth, Allan Meltzer and William Cooper, Williamson sought to meld economics with organizational theory. The issue was explaining how the need for economic actors to interact, in particular to contract with each other, calls into being different organizational forms. This focus on contracting, among others, led to the development of the concept of transactions costs as the determinant of organizational form. In his Markets and Hierarchies (Williamson, Reference Williamson1975), Williamson developed an ‘organizational failures framework’, on the basis of the insight that all organizations seek to minimize transactions costs. He then proceeded to illustrate how employment relations and internal organization supplant market interactions, when the latter are subject to unduly high transactions costs, followed by the development of even more complex hierarchies and networks.

It is instructive to present the organizational failures framework in the context of a discussion of interdisciplinarity. The framework is laid out in Figure 1.

Figure 1

Organizations failures framework, Williamson (Reference Williamson1975).

The diagram suggests that contracting is made difficult by the combination of human characteristics and environmental conditions. Therefore, for example, the well-known concept of bounded rationality, previously enunciated by Herbert Simon (Simon, Reference Simon1951), and usually not accounted for in neoclassical optimizing models, is brought to bear when there are conditions of significant uncertainty. When bounded rationality and uncertainty are combined, contracting, especially of a long-term nature, becomes difficult. Another couple is small numbers and opportunism. Small numbers relates to situations of existing long-term commitments between parties, such as when one party relies on the other for access to specialized, specific assets. If the owner of the specific asset tends to behave opportunistically, for instance, by seeking to raise the price of access, obvious transactional difficulties are posed. In the middle of the diagram, we see the ‘derived’ condition of information blockages, particularly important in the data-driven economy and social policy today, which arises when actors with specialized information can exploit information asymmetries.

The micro-analytic inside of the framework provides the tool for analyzing the ability of different organizational forms to minimize transaction costs. Numerous analysts, including those in health policy, have sought to apply this transaction cost economics approach to explain the structure and regulation of insurance arrangements, franchise bidding for natural monopolies, and whether horizontal and vertical integration flow only from considerations of market power, or also from economizing on transaction costs.

Interdisciplinarity is clearly implicated in the transaction cost approach. Psychology is brought to bear through recognition of bounded rationality. This has implications for articulation of goals, interpersonal communication, performance assessment and more. The tendency to opportunistic behavior is influenced by culture, requiring input from sociology and anthropology. One social phenomenon, about which Williamson is skeptical (Williamson, Reference Williamson1993) but which seems to make its way into any discussion of health policy and management, is trust. There is a huge literature on trust that has almost become a discipline in its own right (Hardin, Reference Hardin2006). Elinor Ostrom, who shared the Nobel Prize with Williamson, paid much attention to trust (Ostrom and Walker, Reference Ostrom and Walker2005).

Williamson, following the interdisciplinary imperative, leaves room for such approaches, both within micro-analysis of transactions and in the concept of atmosphere, seen in the diagram as surrounding the internal micro-analytic model. By atmosphere Williamson refers to cultural tendencies, social tensions and values that are not inherent in the technical mechanisms of transactions but can certainly interact with them. Atmosphere can influence and constrain organizational forms that arise to solve transactional difficulties, and can also be influenced by organizational shifts based on transaction cost minimization. It seems fair to say that most applications of Williamson's work have dealt less with atmosphere than with transaction cost economics in the spirit of the internal micro-analytic part of the framework (Pessali, Reference Pessali2006). This is a manifestation of the tendency to focus on the more quantifiable, or clearly strategic, assessment of organizational performance, and on the adversarial nature of contracting, as opposed to the cooperative tendencies that some institutional arrangements might encourage through atmosphere.

However, and in a way following Simon, Williamson leaves the broadest possible interdisciplinary approach open by encouraging use of the organizational failures framework to perform ‘comparative institutional analysis’ (Williamson, Reference Williamson1980), according to which organizational design and policy analysis are less about sequentially setting goals and then determining he means to achieve them and more about choosing from discrete institutional alternatives that combine ends and means (Wildavsky, Reference Wildavsky1979; Bardach, Reference Bardach2011). The criteria for evaluating institutional alternatives can be wide ranging. While a transaction cost analysis might lead to the conclusion that hierarchy is called for in some cases, if cultural conditions are unfriendly to hierarchy, a different organizational form, such as one that involves less intrusive monitoring and supervision, may be called for (Simon, Reference Simon1978; Chinitz et al., Reference Chinitz, Meislin and Grau2009). Following Simon, comparative institutional analysis is particularly potent in public policy where goals are difficult to enunciate and often emerge with more clarity from the act of comparing institutional alternatives (Simon, Reference Simon1978).

To sum up, institutional economics, as developed by Williamson, was born of dissatisfaction with the disciplinary approach of neoclassical economics that could not account for psychological, social and other variables that have an impact on economic interactions between human beings. Transaction cost economics takes account of the social interactions in economic activity, thus requiring an interdisciplinary approach. Practitioners of transaction cost economics, however, tend to focus on the relatively quantifiable and strategic aspects of transaction costs, and less on ‘atmospheric’ aspects, thus sagging back toward a disciplinary posture. Comparative institutional analysis continues to allow for a structured integration of less quantifiable aspects such as culture and trust (to be discussed further below) in the assessment of organizational alternatives.

The disciplinary tendency

Supplementing transaction cost economics with trust: a challenge to the interdisciplinary dictum?

Until now, we have explored how institutional economics, relative to other approaches, encapsulates interdisciplinariness and seems to provide a manageable way of retaining a multi-faceted approach to social policy and decision making. In this last section, we review how the ‘elusive’ notion of trust fits in with institutional economics (Williamson, Reference Williamson1993). Another way of putting it is to see where the rubber of transaction cost economics meets the road of ‘atmosphere’. This is important, because, although transaction cost economics has been widely applied in the field of industrial organizations, this seems usually to avoid issues of atmosphere. It seems that in areas such as health policy the application of institutional economics encounters the need to confront outcomes in which softer issues such as trust are unavoidably implicated.

Williamson himself is very reticent about notions of trust that are devoid of what he calls ‘calculativeness’.Footnote ² He argues that the emergence of social networks that manage to complete transactions without explicit, observable safeguards can be explained by the fact that such networks are themselves the safeguards. It is in the interests of the parties to a transaction to reduce the costs of monitoring. Thus, it would be inefficient to introduce monitoring into situations of consummate cooperation. If physicians are likely to follow clinical guidelines without monitoring, it would be a folly to introduce obtrusive measures that might elicit a backlash. Indeed, it might be that simple awareness of inefficiencies due to divergence from guidelines might induce physician cooperation (Kahan et al., Reference Kahan, Kahan, Kitai and Chinitz2009). In Williamson's view, the calculation of whether to rely on perceived cultural norms, or move to reliance on explicit monitoring or pecuniary incentives, ought to take into account social contingencies, in particular ‘atmosphere’. The health economics literature, including transaction cost economics, should take atmosphere, including tendencies to behave opportunistically, into account more than they do. This clearly requires an interdisciplinary posture in which the assessment of the role of competition, regulation, health education, health promotion and other tools of health policy considers the degree to which atmosphere encourages trust based on social norms as opposed to confidence in transactions based on legal and economic safeguards.