Explaining the forms of transactions that firms take within and between themselves is one of the enduring puzzles in economics. Ronald Coase (1937, 1960) was the first to formulate this question by asking why we do not see one large firm and offers the view that any transaction carried out comes with costs. One answer came from Oliver Williamson (1975, 1979, and 1985) who pioneered what is now known as the transaction cost theory of the firm. Following on this, other theories have developed. The most prominent among these is the property rights theory of the firm (Grossman and Hart 1986, Hart and Moore 1990) and the multi-task theory (Holmstorm and Milgrom 1991). These theories seek to explain firm organization in terms of ownership of residual control rights[1]. As such they focus on ex-ante investments.
The transaction cost theory of the firm focuses instead on ex-post inefficiencies generated by the fundamental condition of asset specificity[2]. Recently a theory has been proposed that stresses a different source of ex-post inefficiencies – the complexity of the transaction (Bajari and Tadelis 2001, Tadelis 2002, Tadelis and Williamson 2010). More complex transactions carry a greater risk of deviations from a previously agreed upon plan. Thus more adaptation ex-post is required. For complex transactions therefore, contracts that can adjust better to such ex-post changes will be chosen. This is not had without cost – more flexible contractual forms also tend to have weaker incentives. The level of complexity thus works as an exogenous shifter to determine the trade-off between incentives and adaptability. The optimal contractual form is derived in this manner.
Being a recent advance, empirical evidence of the workings of this theory is limited. The theory offers two comparative static predictions that one can test with data. First, more complex transactions will tend to be organized within a firm, that is, integration (vertical or horizontal) is more likely when the transaction engaged in rises in complexity. Second, more complex transactions will affect the choice of compensation scheme that the buyer offers the seller. With complex transactions, a cost-plus type of contract will be chosen. With simple transactions, a fixed-price type of contract will be chosen. Out of these the first has seen some beginning work. Forbes and Lederman (2009) test, with success, whether airline integration decisions in the US can be understood along these lines. Costinot, Oldenski and Rauch (2010) conduct an investigation on international trade using this theoretical construct and find validation for the predictions of the model. The second prediction has not been subject to any empirical test to the best of my knowledge, and this is what I seek to do.
[1] A residual control right, as defined by Hart (1995) is that collection of rights not already contained in current custom, law or contract. The owner of a firm is he or she who holds residual control rights.
[2] Asset specificity arises in conditions where the identity of the contracting party matters and refers to assets that cannot be redeployed to a different use or user without significant loss in value.
(Notice the temporal flow of ideas.)
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