Transaction Costs and the Theory of the Firm: The Scope and Limitations of the New Institutional Approach

Abstract

The new institutional approach to the theory of the firm represents a welcome advance over neoclassical theory in that, instead of treating the firm merely as a device to explain equilibrium under different market structures, it delves into the workings of the firm in an effort to understand why enterprises undertake the activities they do and how they grow over time. The theoretical framework for much of the new approach was developed by Oliver Williamson, who argued that firms evolved not because of technological non-separabilities but to economise on transaction costs. The object of this essay is to demonstrate that Williamson's comparative static methodology is ill-suited to explaining how firms actually evolve. It argues that far greater insights are provided by capability- or resource-based theories of the firm, which combine the concepts of transaction costs and firm-specific advantage in order to show that the boundaries of the firm are in fact determined by the non-separability and tacit nature of knowledge that lies at the heart of every enterprise.