Building the Theory of the Firm

By Oliver Hart*

The framework Oliver Williamson developed provided the foundation for my own contributions to the theory of the firm and the theory of contracts. Coase in his extraordinary 1937 article raised the question of why so much activity takes place inside firms, and provided the beginnings of answers. But his analysis did not provide much of a guidepost for how theorists or empiricists could move forward. Williamson changed this. For me his most important contribution was to identify relationship-specific investments as the reason a transaction can look very different ex post compared to ex ante, and why parties may not be able to rely on the market to regulate it: they need a bespoke “governance” structure, such as a long-term contract or (vertical) integration. This idea of the “fundamental transformation”—ex-ante competition giving way to ex-post small numbers-- is one that I have used repeatedly in my own work, as have many others. It also has stimulated empiricists to show that relationship-specific investments are indeed an important driver of long-term contracts and integration.

Williamson also analyzed the differences between integration and a long-term contract. He emphasized particularly the ex post renegotiation costs that arise between independent contractors when events occur that a long-term contract did not anticipate (the current pandemic is a painful example of this). Within the firm costly bargaining is replaced by fiat or authority, something also emphasized by Coase. Here we get into trickier territory. To paraphrase Alchian and Demsetz, authority over employees is not absolute. Employees often follow the instructions of their employers, but they can quit, and sometimes, particularly if they are important or hard to replace, they can ignore their employers’ commands and still retain their jobs. Authority over human capital may matter but it is less powerful than authority over non-human assets.

Just as Williamson put flesh on the bones of Coase, it has been left to others to develop Williamson’s ideas further. He had relatively little to say about the costs of integration, and also did not emphasize the distinction between contractual imperfections resulting from contingencies not being specified (what modern theorists would call contractual incompleteness) and those resulting from moral hazard or asymmetric information.

Coase kicked off the work on why firms exist, and Williamson significantly moved things forward. The cup is fuller because of him, and there is still some room at the top.


*Oliver Hart is the Lewis P. and Linda L. Geyser University Professor, Harvard University, and the winner of the 2016 Nobel Prize in Economic Sciences.