Tuesday, October 13, 2009
I think it’s great that Oliver Williamson was awarded the Nobel Prize in Economics with Elinor Ostrom. Williamson’s work in organizational economics and transaction-cost economics goes to the heart of why and how private actors form firms, vertically integrate and pursue acquisition strategies. It’s also the intellectual center of much of what happens in the “Deals” class. Although it’s offered in a law school, the Deals class is not really a “law” class. It’s more like a course in applied organizational economics (for lawyers).
The Nobel Prize citation summarizes some of Williamson’s contributions here:
Although Williamson’s main contribution was to formulate a theory of vertical integration, the broader message is that different kinds of transactions call for different governance structures. More specifically, the optimal choice of governance mechanism is affected by asset specificity. Among the many other applications of this general idea, ranging from theories of marriage (Pollak, 1985) to theories of regulation (Goldberg, 1976), one has turned out to be particularly important, namely corporate finance.
Williamson (1988) notes that the choice between equity and debt contracts closely resembles the choice between vertical integration and separation. Shareholders and creditors not only receive different cash flows, but have completely different bundles of rights. For example, consider the relationship between an entrepreneur and different outside investors. One class of investors, creditors, usually do not acquire control rights unless the entrepreneur defaults, whereas another class of investors, stockholders, typically have considerable control rights when the entrepreneur is not in default. Williamson suggests that non-specific assets, which can be redeployed at low cost, are well suited for debt finance. After a default, creditors can simply seize these assets from the entrepreneur. Specific assets on the other hand are less well suited for debt finance, because control rights lose their value if they are redeployed outside the relationship.
Williamson’s work along is critical to thinking about how and why market participants undertake deals and the structures they adopt. In particular, his insights into the importance of asset specificity, opportunism and the hold-up problem to investment decisions is critical to thinking about structuring transactions and private ordering.
His books, Mechanisms of Governance as well as The Economic Institutions of Capitalism, are dog-eared and kept close at hand. In addition, Corporate Finance and Corporate Governance (J. Fin., 1988) is an excellent application of his ideas to corporate finance and the problem of organizing firms.
All in all, good choice.