Why people operate within organisations

Manikins 1

The first building block is the theory of transaction cost economics and market failure, which helps explain why people operate within organisations for much of the time rather than conduct their lives entirely through independent transactions.  This is not the only theory addressing the existence of organisations.  Elsewhere I show how the Escondido Framework accommodates and integrates other theoretical models, but this rational choice model provides a useful starting point.

Sometimes it is worth asking the most basic of questions.  Why do organisations exist?  Much of the time we don’t need them:  we can operate as autonomous individuals, relating to each other through a series of transactions.  I am a beekeeper, and tend a couple of colonies of honey bees, each with as many as 50,000 bees behaving like a single organism within the hive.  But Apis Melifera is only one of many bee species, and most of the others are solitary, rather than social.  What determines which parts of our lives we conduct within organisations and which parts we conduct outside?

In most of my life as a consumer, I use the market and engage in series of discrete transactions, outside the framework of an organisation.  But in others, for example during my education – when I was enrolled by my parents in schools for years at a time, and later at two universities where I enrolled myself for a further five years in total – I became part of organisations where, although I remained a consumer, it was in the context of extended and relatively complex implicit and explicitly contractual relationships and hierarchical structures.  In the aspects of my life in which I have contributed to producing goods and services, the picture has been equally mixed, because my working life has involved periods of employment with both large and small organisations and periods when I have been self-employed, working as a consultant on projects of different lengths and even on engagements of only a few days.

Organisations exist because they create value for us as individuals.  However, we do have an alternative, at least in theory.  We can organise our lives through a series of market transactions, and much of our economic lives are organised in this way.  For a great many purposes markets and the pricing mechanism provide very effective means for organising economic activity to realise the benefits of relative advantage (ie that we create value as a society if people concentrate on the things that they do best), of economies of experience and scale (ie there is benefit to us all if people concentrate their efforts on a few things in which they can develop skill and expertise, and if some things can be done more cheaply if we concentrate the effort in a larger production unit), and prices can be effective means for determining how much value individuals place on the different goods and services that they wish to consume and the volumes that should be produced given the costs of production and the choices that producers themselves wish to make.

The balance between the activities that take place within organisations and between autonomous individuals does not appear to be constant but changes over time.  Over the past thirty or forty years we have seen a trend towards greater outsourcing of activities by private firms and by state organisation, and an increase in self-employment.  Over the past century we have seen a progressive fragmentation of the family, with fewer multi-generational households.  I suspect that a case can be made for the collapse of formal organisational structures with the collapse feudalism and tribalism if we look over many centuries and their replacement by more transactional relationships.

The best explanation of the reasons for economic activity taking place within organisations rather than as series of transactions in the market remains the framework provided by Oliver Williamson in Markets and Heirarchies[1]: Analysis and Antitrust Implications (New York, The Free Press, 1975). Williamson argues that markets and firms are alternative instruments for completing transactions and that choice of between them depends on their relative efficiency, and this in turn is affected by the costs of writing and enforcing complex contracts, which in turn depend on human factors and environmental factors that vary:

“The markets and hierarchies approach attempts to identify a set of environmental factors which together with a related set of human factors explain the circumstances under which complex contingent claims contracts will be costly to write, execute and enforce. Faced with such difficulties and considering the risks that simple (or incomplete) continegnet claims contracts pose, the firm may decide to bypass the market and resort to hierarchical modes of organisation. Transactions that might otherwise be handled in the market are thus performed internally, governed by administrative processes instead.

“The environmental factors that lead to prospective market failure are uncertainty and small-numbers exchange relations. Unless joined, however, by a related set of human factors, such environmental conditions need not impede market exchange. The  pairing of uncertainty with bounded rationality and the joining of small numbers with what I share refer to as opportunism are especially important.”

Essentially, Williamson is explaining that markets may fail (or require impossibly costly contingent claims contracts in order to work) because the outlook is often uncertain, because “the capacity of the human mind for formulating and solving complex problems is very small compared with the size of the problems whose solution is required for objectively rational behaviour in the real world”[2], and because the absence of plentiful alternative bidders to provide  for competition may allow one or both parties to engage in opportunistic and less than candid and honest behaviour.

“Heirarchical” (or command and control) structures have their own costs and inefficiencies, as a result of imperfect incentive structures, poor information flows, and also contain costs in terms of their own internal contracting.  The question is, in any particular context, where the balance of advantage lies between the costs of contracting in the market to address the four conditions identified by Williamson (ie uncertainty, small numbers, bounded rationality and opportunism) and the costs of the firm.


[1] Oliver Williamson, Markets and Heirarchies: Analysis and Antitrust Implications.  New York, The Free Press, 1975

[2] Herb Simon, Models of Man. New York: John Wiley & Sons. Inc., 1957