April 27, 2017

Nobel Laureate Oliver Williamson’s impact on 21st century capitalism

Oliver Williamson
Oliver Williamson

When Professor Oliver Williamson won the Nobel Prize in Economics in October, Professor David Teece wasn’t surprised. He said he knew Williamson’s work was Nobel worthy decades ago. "Oliver outlined a conceptually elegant new framework for thinking about the very essence of business enterprise – how it is structured internally and how managers can invent new business organizations," Teece explains. "Secondly, he outlined what he called a ‘discriminating framework’ for helping us think through how firms should choose what to do inside and what to do outside – the outsourcing decision we currently think of."

The Royal Swedish Academy of Sciences said it awarded the Nobel to Williamson "for his analysis of economic governance, especially the boundaries of the firm." (Williamson shared the prize with Elinor Ostrom of Indiana University.) In the simplest terms, those boundaries refer to when a firm decides to outsource a process, service, or manufacturing function or perform it in-house – the "make or buy" decision.

Williamson pioneered an area of research now known as, “Transaction Costs Economics.” In practical terms, transaction costs economics helps businesses evaluate the costs and benefits of outsourcing, guides governments in deciding what to privatize, and assists regulators when reviewing antitrust policy. Because his analysis has been so methodical, detailed, and thorough, Williamson and hundreds of others have been able to apply his framework to many other situations and enterprises beyond just the firm and its outsourcing decision.

Williamson’s work stems from his position as Special Economic Assistant to the head of the Antitrust Division at the Department of Justice in the late 1960’s. He observed that when two firms want to merge to gain market power and command higher prices, consumers would be hurt. In response, Williamson chose to study when mergers might benefit both firms and consumers. He published his insights in the 1971 article in the American Economic Review, “The Vertical Integration of Production: Market Failure Considerations”, and later in his 1975 path-breaking book, Markets and Hierarchies.

Associate Professor Steve Tadelis explains, “Olly demonstrated when it is more efficient for a firm to produce a component in-house rather than outsourcing it to another firm.” His work influences how the capitalist mechanism functions and succeeds in the 21st century, both here and in developing countries.

Williamson’s research broke the mold of firms that were largely fixated on market transactions and treated firms as black boxes of production. Williamson discovered how firms themselves drive competition and efficiency. The influence of his work on the power and potential of a firm’s structure is as widespread and essential to business strategies today as the computer is for just about every business transaction.

"I originally thought of make-or-buy as a stand-alone problem," Williamson explains. "But now I think of it as being an exemplar. If you understand make-or-buy, which is a simple case, you can understand more complex cases."

Those more complex cases include joint ventures, decisions on industry privatization, labor contracts, and antitrust analysis. Williamson, for instance, has applied his framework to evaluate cable TV franchises and antitrust regulation for vertically integrated firms. Williamson spawned a huge new wave of empirical literature testing his framework in a wide range of industries, from aerospace to semiconductors – an estimated 800 empirical studies, according to a 2006 survey done by his students.

“Olly’s work made economic scholars realize the need to analyze governance and incentives within and between firms in order to better understand how efficiency can be maintained in a capitalist society,” says Tadelis.

Tadelis, who often cites Williamson’s influential theories in class, observes, “What Olly offered was not only a departure from the mainstream at the time, but a theory based on observations that are testable and refutable. His basic insights were simply, widely applicable, and many scholars since have confirmed them with data-driven research. “

Oliver Williamson’s Nobel win and biography

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