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This article assesses the usefulness of transaction cost economics when we view economic organizations, such as firms, as complex adaptive systems. Modern complexity science is a radically different in orientation to neoclassical economics, which deals with decision making in contexts that are presumed to be simple and, therefore, disconnected from complex reality. However, transaction cost economics can be related to aspects of modern complexity science: bounded rationality, opportunism, and asset specificity are all associated with behavioral complexity. Furthermore, the emphasis of transaction cost economics on hierarchy and organizational rather than technological considerations is also consistent with complexity science. Drawing on literature in psychological economics, this article synthesizes transaction cost economics with aspects of complexity science in a manner that offers a new research agenda, not only in the context of the organization of production but in economics generally Such theoretical d evelopments are vital if policy makers are to have at their disposable analytical perspectives that are coherent and applicable in complex historical settings. (JEL A12, A13, D23, L14, L22, O31, Z13)


Over the past decade, transaction cost economics (TCE) has provided a major stimulus to research on the firm and other organizational forms in the economic system. Developed and promoted vigorously by Oliver Williamson (see particularly Williamson, 1985), it represents an important departure from the conventional neoclassical vision of the firm and its activities: Rationality is bounded, the firm is not viewed through the lens of a production function but is seen as a governance structure; uncertainty is acknowledged; the specific character of human capital is recognized. We can trace TCE back to Coase (1937), who argued that the existence of transaction costs explains the extent of the firm relative to a subcontracting arrangement. The firm, as an organizational structure, achieves lower transaction costs than would prevail in a set of market transactions. This is because subcontracting involves asymmetric information that can result in moral hazard and, therefore, contractual uncertainty that is costly to monitor. In recent years, TCE has dealt with many of the implications of asymmetric information and attendant opportunism in a range of contexts. With regard to intrafirm contracts, TCE adopts a principal-agent perspective on relations between, for example, managers and workers that also involve monitoring costs. However, TCE is an approach that has generated controversy:

Economists object to it because limits on rationality are mistakenly interpreted in non-rationality or irrationality terms. Regarding themselves as they do as the "guardians of rationality" (Arrow, 1974, p. 16) economists are understandably chary of such an approach. (Williamson, 1985, p. 45)

Also, those who belong to a much older dissenting tradition that emphasizes the importance of institutions have been critical of attempts to deal with institutions in a conventional maximizing setting and see TCE as no more than "old wine in new bottles" (see Rutherford, 1989). However, although "bounded rationality invites attacks from both sides" (Williamson, 1985, p. 45), TCE has proved to be a congenial analytical compromise for many economists and economic historians (e.g., North, 1990) who feel that institutions should play a more prominent role in economic analysis.

Over roughly the same time that TCE has developed, we have witnessed a rapid expansion in interest in the manner in which complex structures emerge, particularly in the natural sciences. This began in physics and chemistry, where the phenomenon of "self-organization," that is, an endogenous tendency for both complexity and organization to increase, was identified in "dissipative structures," that is, structures capable of importing free energy and exporting high entropy waste. Two Nobel prizes have been awarded for pioneering contributions in this field-to Ilya Prigogine (chemistry) and Murray Gell-Mann (physics). In biology, an understanding of self-organization has led to a transformation in the way that the evolution of species is viewed (Kauffman, 1993). As this kind of thinking has spread through the disciplines it has become apparent that we are not dealing with an analogy--the principles of self-organization operate in distinctive ways as we move from the physiochemical to the biological and into the social and economic domains (Foster, 1997).

Like TCE, complexity science is concerned with why, in a complex reality, distinctive organizational structures form. This has led to the conceptualization of the firm as a "complex adaptive system" in the business management literature. Such systems not only actively search for appropriate energy sources to create and maintain the "organized complexity" necessary to produce goods and services but also search for appropriate knowledge, embodied in labor services, capital goods, and the information flow that is accessible in the environment. The greater is the diversity, that is, complexity, of the environment, the more opportunities there are for aspects of such diversity to be organized into productive structures, such as firms. In contrast to TCE, it is difficult to maintain the conventional dichotomy of equilibrium and disequilibrium--self-organizational processes do tend toward limiting stationary states ("saturation"), but these are viewed as unstable. Therefore, such processes are seen as nonequilibrium in nature moving through phases of structural stability and instability.

In this paper, the objective is to try to address the following question: If we adopt a view that firms are complex adaptive systems, is there a role for transaction cost thinking? On the face of it, the answer might seem to be negative because notions of economic self-organization are constructed on nonlinear dynamic foundations, and TCE is neither dynamical nor nonlinear in construction. However, it is argued that such a conclusion is premature if it is recognized that, to comprehend the complex economic reality that surrounds us, we require analytical constructs that capture in some abstract and relatively straightforward way the main cognitive and motivational drivers of economic behavior. This leads us into considerations relating to the psychological disposition of economic decision makers. TCE, introduces bounded rationality--"a semi-strong form of rationality in which economic actors are assumed to be 'intendedly rational, only limitedly so' (Simon, 1961, p. xxiv)" (Williamson, 1985, p. 45)--and opportunism-"the incomplete or distorted disclosure of information, especially to calculated efforts to mislead, distort, disguise, obfuscate, or otherwise confuse" (Williamson, 1985, p. 47). Thus, it is clear that TCE contains much more psychological content than neoclassical economics, and this provides an important link with representations of economic entities, for example, firms, as complex adaptive systems.

The psychological evidence suggests that individuals are motivated to act through the formation of aspirations that are idealistic and based on simple abstractions and, as such, only loosely associated with complex reality (Earl, 1984). However, complexity science tells us that a myriad of individuals attempting to achieve aspirational goals in quite simple ways in different contexts can result in a reality that is behaviorally complex, that is, it is difficult to ascertain what the outcome of behavioral interactions will be. In such circumstances, the "rational" solution for individuals is to form and adhere to institutions. However, this kind of rationality is not the same as "economic" rationality that involves people optimizing within their cognitive limitations. The evidence from psychology indicates that individuals also rely on their emotional dispositions in adopting and conforming to institutional rules.

Institutions are crucial in the formation and pursuit of aspirations--they provide both limitations on what is feasible and opportunities for creative and cooperative activities that yield desirable outcomes. Clearly, institutions are associated with cultural, political, and social dimensions of human societies. However, TCE attempts to keep the treatment of institutions largely in the fold of economic analysis rather than to argue for interdisciplinary analysis with all its attendant difficulties. In employing TCE to help explain why economic structures and processes exist, factors highlighted in other disciplines are not ignored; instead, an attempt is usually made to translate their impacts into a cost calculus that is appropriately economic. TCE enthusiasts clearly believe that there is little possibility of understanding why organizations that are centrally engaged in economic activity exist and survive without reliance on analytical constructs that are distinctively economic.

In this short article it is not possible to explore in any depth the various implications of thinking in terms of transaction costs in the context of complex adaptive systems. The objective here is more modest--to identify a research agenda that can help bring together the TCE and complexity perspectives via the incorporation of well-established findings in psychology that have a direct bearing on economic behavior. In a sense, what is suggested is not new but has been held back by a tendency in the profession to analyze "long-run" outcomes in terms of general equilibrium constructs that require strong neoclassical assumptions to remain tractable. Williamson (1985, p. 45) notes this difficulty and also recognizes that TCE has important historical antecedents. It is notable, in this regard, that he draws inspiration from the work of American institutionalist John Commons, who was one of the first to depict the economic system as a complex web of transactions in an explicit contractual setting. Commons provide d intuitive observations on the nature of organizational arrangements in the economic system that are consistent with some aspects of modern complexity thinking that will be discussed here. It should also be noted that Herbert Simon saw his concept of bounded rationality, a key building block in TCE, as pertaining more to situations of behavioral complexity than to fundamental uncertainty (see Loasby, 1989, ch. 9).

The article is organized as follows. In section II the scene will be set with an assessment of the distinctive perspectives of TCE proponents and modern evolutionary economists concerning the firm as an organizational structure. Section III inquires into the notion of bounded rationality from the perspective of the psychological evidence. Section IV considers the explanatory role that TCE can play in the presence of organized complexity, and in section V the subjective aspects of TCE are considered. Section VI contains some concluding remarks.


It has been conventional in economics to think of productive organizations, such as firms, in terms of production functions and transactions in terms of market arrangements, either in spot or fully contingent contract form. In TCE, firms exist as organizational forms because of the conjunction of bounded rationality, opportunism, and asset specificity, that is, a recognition that labor is not homogeneous but rather a complex bundle of heterogeneous skills. Following principal/agent thinking, opportunism can be controlled internally by adequate monitoring through hierarchical structures. Otherwise, firms are perceived in neoclassical terms in several respects (Posner, 1993). In opposition to this so-called contractarian view of the existence of firms, we have the "competence" perspective that stems in large part from the work of Nelson and Winter (1982) in evolutionary economics, although it can be discerned in much earlier studies (see Foss, 1996). Static efficiency considerations are less important than those concerned with dynamic efficiency. To survive in an evolving environment, the firm's capabilities must keep on changing and with them, input-output relationships (see Loasby, 1998). Competences are seen as forming and reforming as a response to uncertainty--firms attempt to take up opportunities by forming organizational bonds that are institutionally based. Such an approach leads to a range of criticisms of TCE, but, as Williamson (1985, p. 404) stresses that it is not the purpose of TCE to provide insights into the processes of change focused upon by evolutionary economists and, furthermore, that "the study of economic organization in a regime of rapid innovation poses much more difficult issues than those addressed here.... new hybrid forms of organization may appear in response to such a condition" (Williamson, 1985, pp. 143-144).

Nelson and Winter (1982) entered this difficult terrain by depicting firms as involved in an 'evolutionary' process in which institutions, such as habits, norms, and conventions, figure more prominently than transaction costs. They argue that the uncertainty associated with evolutionary change makes it very difficult to assess the costs and benefits of engaging in transactions and that the formation and adherence to institutions is in fact a response to the existence of uncertainty. Institutions are thus central to the process whereby useful knowledge is accumulated. Following Alchian (1950), they also argue that processes of change that are analogous to natural selection may yield outcomes that are "efficient" in some sense without the requirement that pervasive rationality exists amongst decision makers in firms. Reliance on selection arguments is also a feature in TCE. However, in the competence approach, static efficiency need not be the outcome of such winnowing processes and indeed may even be a handicap to the achievement of dynamic efficiency.

In TCE, as with other schools of thought that use comparative static equilibration in the core of their theorizing, contact can only be made with the historical record by envisaging ongoing processes of disequilibrium that emanate from exogenous shocks, which, in this context, change the structure of transactions costs. However, such disequilibrium processes by definition are outside the theoretical core, and "storytelling" is generally used to fill in the explanatory gap. Adherents of the competence perspective have the reverse problem: The central preoccupation with processes of innovation and competition in historical settings makes it difficult to use theoretical constructs in any systematic way to deduce equilibrium outcomes. Thus, many conventional economists view this perspective as "atheoretical" in nature.

We know that in economics, abstract theories concerning outcomes and the processes we encounter in history do not mix well. However, in some respects, we can view each of these approaches as offering a different perspective on the same phenomena, one focusing more on analytical constructs that are independent of time and the other on dynamics that are embedded in historical processes. Both schools share the view that neoclassical theories of the firm, based on a special production function construct, are of limited usefulness. The contractarians view the firm as a governance structure, whereas those stressing competence see the firm as a bundle of routines and techniques that adapt through learning. Both schools share the Simonian view that rationality is bounded. For contractarians, this is a device, along with opportunism, that provides a foundation for the notion of transaction costs, while at the same time it is possible to employ a mode of analysis that is closely related to conventional neoclassical ec onomics. "Economic man" is replaced by a "contractual man," who is faced with behavioral uncertainty that can be boiled down to transaction cost comparisons. Bounded rationality means, quite simply, that in addition to the normal costs involved in the contractual process, there are costs in monitoring the behavior of opportunistic economic agents. By expressing an unmeasurable phenomenon in this way, TCE propositions can be expressed in the grammar of mainstream economics.

For adherents of the competence perspective, bounded rationality also plays a key role. Bounded rationality in contexts that are uncertain (rather than risky in the Knightian sense of there being a known number of outcomes with known probabilities) leads to the emergence of habits, norms, and conventions, that is, "institutions." These institutions form the bedrock of organizational arrangements that have certain capabilities. Uncertainty stimulates learning and "firms exist because they can more efficiently coordinate collective learning processes than market organisation is able to" (Foss, 1996, p. 18).

This, in turn, modifies production techniques and organizational arrangements. Within this knowledge formation process, the firm strives to reduce costs where it can, including transaction costs. Despite an emphasis on corporate culture, the competence perspective does recognize that TCE-style opportunism exists and has to be dealt with within organizations. However, opportunism is not viewed as always resulting in costly outcomes--for example, the Schumpeterian entrepreneur is an opportunist par excellence who, in pursuit of "self-interest with guile," discovers new ways to make profits and, in so doing, provides benefits to both the firm and society.

It is clear that these two schools of thought are not as different as their proponents often imply. The main difference seems to be that the contractarian approach attempts to stay within a definably "economic" framework where many of the aspects of reality discussed in terms of competences are translated into cost constructions. For example, high levels of teamwork in an organization imply low transaction costs that cannot be attained in a more opportunistic marketplace. Processes of learning and so on are just a "disequilibrium" process to a contractarian interested in equilibrium states where transaction costs are fully minimized internally and experimentation in the market has enabled an understanding of the degree of opportunism to be obtained and attendant transaction costs calculated. The fact that processes of learning and selection (which are so strongly emphasized in the competence approach) exist does not present a difficulty to a contractarian because such processes are presumed to result in outcomes that conform with the "as if" assumptions of comparative static theorizing.

That there is at least some compatibility between the two schools is acknowledged by protagonists on each side (see, for example, Hodgson, 1998, p. 181; Williamson, 1985, p. 404). However, quite fundamental methodological difficulties arise in attempting to unify the approaches taken. Much depends on what is to be achieved. Proponents of the competence approach seek to provide a historical explanation of why economic organizations exist and how they develop--social, political, and cultural dimensions are taken into account, and group behavior is emphasized. Economic theory, as it is commonly understood, has a minor role to play, but the question arises: How can we gain an analytical understanding of what is going on amid the complexity that we observe?

This is vital because policy makers will often not have available to them all the institutional and historical detail and, in the spirit of bounded rationality, will find it very hard to know how to interpret the information that they have. In other words, they will be faced with complexity that must be cut through somehow, otherwise the design of policies will become impossible--a point that is often stressed by neo-Austrian economists. Adherents of the competence perspective, such as those referred to in Hodgson (1998), generally believe that policy intervention is essential, yet the sheer complexity of the historical processes that they examine often leads to incoherence and inconsistency in policy prescription. Although it is easy to argue that simple theories are unrealistic, psychologists tell us that individuals use simple theories in thinking about problems and coming to decisions.

The contractarians provide theoretical analysis of how individuals behave that is simple and economic in nature. The assumptions used are not consonant with reality, but the intention is to provide a mode of reasoning, not a summary of history. However, is TCE capable of shedding light on the organized complexity that we observe in economic organizations, such as firms? In TCE, individuals attempt to maximize their well-being, attempt to obtain and use as much relevant information as they can, try to be as efficient as they are able, have the guile to circumvent institutions in some circumstances, and possess knowledge and skills that are nonhomogeneous. These seem to be good starting points in dealing with the specifically economic dimension of human behavior. However, contractarians, in proposing "contractual man" have moved into new psychological territory, beyond the narrowly construed domain of Homo economicus. Let us now enter that territory.


The "transaction costs" in TCE that are crucial form a subset of the actual transaction costs associated with contracting--they relate specifically to behavioral uncertainty. They are incurred because other individuals may behave opportunistically, and therefore monitoring costs must be incurred. Dealing with opportunism in this way suggests, by default, that there must be a preexisting set of institutions that facilitate economic coordination. Where do these institutions come from? Adherents of the competence perspective point to cultural, social, and political sources. Although this is undoubtedly correct, what drives individuals to accept (or not accept) them? This is a psychological question that lies at the heart of TCE.

To answer this question, we must understand that economic agents are not automatons, like Homo economicus, but human beings that engage in economic behavior both because of "rational" economic thinking, as it is conventionally understood, and because of emotional arousal. The manner in which emotions impinge on economic behavior has not been considered very extensively in economics, given the core status of rational choice theory (see Etzioni, 1998; Frank, 1988; Elster, 1998). This neglect contrasts with the emphasis given to the role of emotions in the classical beginnings of economics, for example, in the writings of Adam Smith and David flume. For both, an understanding of economic behavior necessitated a prior understanding of the emotions and their connection to moral and ethical institutions. Furthermore, the founding fathers of neoclassical economics, such as Alfred Marshall, continued to stress the prior importance of ethics and morality, but the connection with the emotional disposition of individua ls became less prominent. Discussions of the role of emotions in economics gradually declined and became rather negative in tone--emotional behavior came to be depicted as destructive of "economizing" rationality and something to be controlled and repressed to allow "civilized" behavior to be manifest (see, for example, Hirshman, 1977; Holmes, 1995). We find this perspective in TCE--"guile" is depicted as an undesired and costly dimension of self-interest.

It is possible to think of opportunistic behavior in political terms (as it is in much of the public choice literature) as simply the exercise of power that lack of knowledge confers on some individuals. Thus, it is no different to other kinds of rent-seeking activities that can be embraced by economic analysis. However, such acts as breaching trust have a clear emotional dimension attached to them. This has been evidenced many times when speculators have suffered moral condemnation and worse for profiteering in the face of shortages, even though their behavior could be construed as rational in an economic sense. The opportunist always runs against prevailing institutional rules, either formal or informal. Once outside these rules, it becomes very difficult to assess the outcomes of behavioral interactions, and emotional as well as cognitive factors are important. In conventional economics, the opportunist is often viewed as a "risk lover" and this "taste" is given expression in a utility function. However, the incorporation of noncognitive aspects of human behavior in a rational economic framework, as in Gary Becker's extensive work in this field, is fraught with methodological difficulties.

Conlisk (1996), in his excellent survey article, depicts bounded rationality as mainly concerned with cognitive problems. However, accumulated evidence in psychology, surveyed by Kaufman (1999), suggests that economic rationality is bounded not only by cognitive limitations but also by emotional considerations. The aforementioned presumption that emotional responses have a negative impact on economic outcomes does not necessarily hold. Yates (1990) argues that in defined contexts there is a level of emotional intensity that yields optimum performance, in line with the century-old Yerkes-Dodson law. This is illustrated in Figure 1--we could think of A1 as the state of a bored worker facing low rewards and low penalties; A2 as a state where the worker feels integrated into the firm and is satisfied that both the incentives and sanctions faced are fair; A3 is a state in which the worker is alienated, insecure, and, in the face of perceived unfairness, preoccupied with strategic considerations.

Recent work by Damasio (1995), who reviews case studies based on individuals with damage to the frontal lobe of the brain, confirms strongly that emotions are an essential part of good decision making. An appropriate level of emotional arousal is required before economic rationality can occur. Emotions also help prioritize actions in important ways. Thus, when there is a lack of emotional arousal or a state of overagitation, we may not observe rational economic behavior. For example, some concern about penalties incurred for poor performance and a desire for recognition and success can contribute to peak performance. But boredom due to routine assignments or excessive fear of dismissal can cause under- and overarousal, respectively, with attendant reductions in performance. There is nothing "irrational" about such behavior--they relate to states where "normal" cognition is less relevant.

Consider an individual entering an economic organization. A lack of understanding of the specific functioning of that organization or any familiarity with the individuals and their roles leads to a state of uncertainty--the behavioral complexity faced is not understood. This is not a threatening state but rather one involving opportunities. Emotional arousal induces the individual to discover and adopt the prevailing institutions, irrespective of any marginal economic calculations concerning work effort or remuneration. Once the institutional setup has been absorbed and adopted, then the individual may be aroused sufficiently to engage in cooperative and/or creative activities in specialist areas. Although this can be seen as largely emotion-driven behavior, whereby the aspirations of the individual and the organization become aligned, it is "rational" because it secures ongoing employment for the individual; for the organization, it is transaction cost reducing. We can view such emotionally driven behavior as opportunistic, because the individual chooses to adopt novel institutions within which he or she will operate--we can call it "constructive opportunism" to contrast with what we can now label as the "exploitative opportunism" emphasized in TCE.

When we are placed in situations in which the behavior of others is too complex to assess adequately, we become emotionally aroused. This leads to the formation of aspirational goals where the aim is a lower level of uncertainty and an improvement in the degree to which an individual's actions are coordinated with those of others. The resulting tension induces individuals to engage in cognitive activity that contributes to the achievement of aspirations (Scitovsky, 1976; Heiner, 1983; Foster, 1987). This can involve learning and experimentation in order to understand behavioral complexity better. However, it can also result in the adoption of institutional rules of various types that both reduce uncertainty and raise the level of coordination. Behavioral complexity is not eliminated--it is adapted within organizational structures, such as firms, to yield the asset specificity that is so central in TCE.

In addition to the psychological evidence that confronting behavioral complexity that is not well understood results in cognitive difficulties, game theorists have demonstrated that games involving more than two players are very difficult to solve, that is, they are behaviorally complex and therefore not amenable to cognitive attempts to make rational calculations concerning anticipated outcomes. Some form of trust has to evolve before cooperation can take place (Axeltod, 1983). However, trusting in the absence of prior trust is not rational in the context of individual cognition. Therefore the adoption of institutional rules, such as mutual trust, has to rely on the emotional dispositions of participating individuals. Once such rules are in place, cognitive rationality can then be employed effectively in the introduction of various incentive and penalty mechanisms, such as "tit for tat," that both reinforce these rules and encourage compliance.

Witt (1998) stresses that in a complex world, there is no guarantee that institutions that hold organizational structures together, such as standards of honesty, identification with organizational goals, and acceptance of lines of authority, will be maintained. As organizational development proceeds, so the pattern of organized complexity that emerges will require a different mix of institutions; these in turn will be met by different emotional responses. The firm is a complex adaptive system that depends on its participants to be cooperative and creative in ways that cannot be fully reflected in the pecuniary rewards that individuals receive. Organizational, process, and product development all depend on individuals discovering ways to generate more organized complexity through new designs, recombinations, and the reduction of transaction costs. As stressed by Adam Smith, in both The Wealth of Nations and The Theory of Moral Sentiments, emotions come before economizing.

In the tradition of complexity theory, self-organization in the firm can emerge from quite simple emotional responses, given a set of initial facilitating institutions and appropriate aspirations. The mutual adoption of institutions and the sharing of aspirations, brought on by emotional responses to uncertainty, can ultimately provide very strong foundations for rational, economizing behavior. In other words, every effort will be made to reduce costs whenever conditions allow. However, in the early stages of organizational development, this will be difficult because so much innovative change will be going on. As processes become well understood and more routine, economizing behavior will become strongly in evidence as it becomes possible to apply marginal costing in the case of many operations.

Routinization has cost advantages, but it can also result in lowered emotional arousal and, therefore, a need to monitor performance more closely. The danger of increased monitoring and cost cutting is that it can induce exploitative opportunism. Indeed, organizational inertia and collapse have been found to follow phases of strict monitoring and cost cutting. For example, rationalization and downsizing have been found to lower profitability due to fear (Cappelli et al., 1997; Bardwick, 1991). Kaufman (1999) argues that this is because employees flip from low emotional arousal to overarousal. Increased behavioral uncertainty coupled with a diminished sense of worth can lead to self-interest with guile as emotional attachments to the institutions of the firm are abandoned. Kahn (1992) also finds evidence that the fear associated with excessive competition often leads to increased exploitative opportunism and fraud.

Thus, the psychological evidence tells us that opportunism is indeed important and will affect transaction costs associated with contractual arrangements. However, it has been argued that opportunism can be a positive as well as a negative force in the economic domain. Taking opportunities in the face of uncertainty is not only the basis of entrepreneurship but also the source of innovative behavior within productive organizations. Neoclassical economists are fond of subsuming emotional behavior into preference functions, that is, utility is derived; thus to be "madly in love" or to engage in gang warfare is simply the outcome of individual optimization. There are two problems with this kind of generalization. First, it is tautological or Panglossian--whatever you choose must have been best. Second, optimization over a preference function is not an option in the presence of uncertainty.

As has been noted above, behavioral complexity can be analyzed using game theory, but this requires known rules of the game, known spoils, and known players (preferably not more than two). In other words, uncertainty, in all its complex manifestations, is not presumed. Kahneman and Tversky (1979) and a number of other experimental economists have found that emotional considerations frequently affect choice, even in quite simple settings. Fox and Tversky (1995) have also shown that "ambiguity aversion" exists--people are averse to taking risks on unknown probabilities, that is, in states of uncertainty. The emotional reaction to such situations, if they are behavioral, is either to engage in conflict (exploitative opportunism) outside prevailing rules or to seek some new institutional arrangement that can be employed to reduce uncertainty (constructive opportunism).

Arrow (1974) posed a fundamental problem--"the information paradox"--in attempting to act rationally in acquiring information in line with benefit/cost calculations: "Its value for the purchaser is not known until he has the information, but then he has in effect acquired it without cost" (p. 152). However, this infinite regress in the cognitive domain can be circumvented when we consider the role of emotions. If we cannot collect information rationally from complex environments when we cannot gauge its worth, we must rely on emotions, such as curiosity, to expand our knowledge set (Macleod, 1996). Thus, the aspirations that emanate from our emotional dispositions do not involve actual optimization, only imagined optimization. However, once aspirations are formed, actual optimization can be employed in goal-oriented behavior. For example, the Eiffel Tower, like many monumental constructions, was the product of an aspiration with emotional roots, but considerable optimization was involved in its construction.

Perhaps economists tend to overlook the fact that emotional disposition is prior to economizing because the aspirational goals of individuals in modern societies have become increasingly economic in nature, while the institutions that have come to dominate are those that facilitate capitalism. We feel "passionate" about making millions or about our firm or the product we make or sell. The institutions that we adhere to are framed in terms protecting or facilitating economic value. Love is increasingly linked with prenuptial contracts and de facto financial obligations. The anthropological evidence (Gowdy, 1998) indicates clearly that in primitive societies it was quite untypical to feel emotional about economic goals, and the dominant institutions had little to do with economic valuation. Today, we tend to think that our economic systems are the product of economic rationality, and, in a reflexive way, we pursue economic goals to fulfill emotional needs. However, even though our emotions often drive us towar d economically productive outcomes, the domain of the emotions and their interpersonal interactions is complex, so it is misleading to think that we can deal with the economic system as if economizing rationality is universal.

Summing up, the psychological evidence confirms that rationality must necessarily be bounded but that this is due to emotional as well as cognitive factors. Opportunism is very important, but it can be both constructive and exploitative. Thus, associated transaction costs can be negative as well as positive. Among others, John Maynard Keynes and Joseph Alois Schumpeter both argued a long time ago that such psychological motivations should be separated from conventional economic analysis. The former referred to "animal spirits" and the latter to "entrepreneurship." However, both believed that it was still possible to analyze the economic consequences of emotional dispositions using economic analysis. Let us now examine whether TOE is superior in this role than the body of neoclassical economics at our disposal.


The idea that complex systems are adaptive and capable of self-organization was originally developed in the natural sciences. Over the past decade, this idea has been extended to the social sciences not as an analogy but as a homology (see, for example, Nicolis and Prigogine, 1989; Waldrop, 1992; Holland, 1995; Belew and Mitchell, 1996; Arthur et al., 1997). In the context of economics readers should consult Foster (1993, 1997) (on economic self-organization) and Rosser (1999) (on economic complexity). However, much greater interest in complexity has developed in management science in the 1990s. Notable contributions include Stacey (1992, 1995, 1996), Zimmerman and Hurst (1993), Goldstein (1994), Levy (1994), Thietart and Forgues (1995), Byrne (1998), McKelvey (1997, 1999), and Anderson (1999). A perusal of this literature indicates that TOE is virtually ignored. Furthermore, extended treatments of the role of complexity in firms and industries that stress the importance of institutions, such as those of Pry or (1996) and Ryecroft and Kash (1999), also ignore TOE. These authors tend to link their discussion of complexity and institutions to modern evolutionary economics, that is, the competence perspective.

Thus, forging a connection between TOE and complexity would appear to be an unpromising endeavor. However, management scientists and many institutional economists view the firm differently than conventional economists. The latter are not interested in detail but rather in benefit/cost metrics that seem to be applicable across different firms and, therefore, useful in a general analytical sense. The reduction of activities to monetary valuations, real or imagined, may seem too abstract for some, but the firm as a going concern succeeds or fails on the basis of its financial state, which is, in effect, a summary measure of the firm's health as a system of organized complexity. An effective firm monitors its costs and revenues in a way that permits it to maintain itself and expand. The relevant magnitude through which money flows is the transaction, in spot or contract form, and surviving firms will be those that succeeds in keeping costs low and revenues high in their complex webs of transacting activities. Th us, it makes a great deal of sense to reduce the organized complexity of firms to cost and revenue considerations if we seek some general analytical principles for wide application.

TCE interfaces with the complex adaptive systems literature in its explicit recognition of the importance of hierarchies. Firms must be hierarchical to process materials in complex ways through the specific use of energy and knowledge. Asset specificity is a form of complexity and to must be complemented by a hierarchical structure before production can occur. In such hierarchies, it is difficult to assign costs accurately given the open-ended and joint cost nature of much of productive activity, particularly in areas where processes and products are emerging from both deliberate design and learning by doing. In this regard, Hall (1973) and Lau (1978) provided theoretical demonstrations some time ago that the input costs of joint products cannot be allocated among the products. More recently, Holmstrom and Milgrom (1991) show that in a multitasking model, contracting over goods and services with multidimensional attributes is impossible due to inherent environmental complexity. Thus, the firm cannot accurate ly measure the costs and benefits of organizing the firm in particular ways in any general sense, although partial assessments of the marginal costs and benefits of reorganization are feasible in mature firms. This presents a difficulty for TCE in the context of assessing the costs and benefits of internal monitoring in any detail, but it does not prevent us from thinking in TCE terms about the overall value of internal production systems versus sub-contracting alternatives.

What we learn from complex adaptive systems thinking is that hierarchy is a universally observed organizational solution to a complexity problem. In TCE, the transaction cost calculus results in hierarchically organized firms because of asset specificity, which is another way of saying that complexity is involved in the production of goods and services and that this requires a particular form of organization, given the communication and monitoring technologies that are available. Complexity science gives us a much clearer idea why the costs associated with different organizational arrangements to produce different kinds of products vary so much. It also tells us that focusing on the microelements of an organizational structure need not be very enlightening because all that will be observed will be component complexity--it is necessary to choose an appropriate level of organization, such as the firm, before an understanding can emerge. In thinking in terms of governance structures, rather than production func tions, TCE recognizes this in a much more fundamental way than neoclassical economics.

Another parallel between TCE and complex adaptive system thinking is the emphasis that is placed on organizational rather than technological innovation. An individual may join a firm for clearly economic reasons, but his or her effectiveness in the organization depends on cooperative and creative qualities. We can think of this in TCE terms: The firm attempts to recruit employees that we have labeled as constructively opportunistic and, therefore, involve low transaction costs. However, it is difficult to imagine this as the outcome of rational calculation on the part of a manager because these qualities will be emergent "on the job." If the firm happens to recruit well, then transaction costs will be relatively low and the firm will be a viable entity that will have a chance to survive and prosper. Although we can look at the viability of the firm, ex post, in terms of transaction costs, ex ante, we face the problem of uncertainty that complex interactions imply. As discussed in the previous section, the te amwork and "tacit" knowledge that are essential to the successful to the development of the firm are very difficult to quantify, yet they are crucial to transaction cost outcomes, which will dictate the ultimate profitability of the firm (Nooteboom, 1992). In such circumstances we cannot presume profit maximization with respect to transaction costs and benefits but only profit seeking in the Schumpeterian sense (Hodgson, 1998).

When we think of economizing with respect to transaction costs and benefits as something that emerges from a process of self-organization, we can then begin to think of conditions where the ex ante TCE approach might be a reasonable approximation. Clearly this will be the case when uncertainty is relatively low and approximates risk in the Knightian sense. Following Foster and Wild (1999a, 1999b), as the firm becomes simultaneously more complex and more organized, we can think of it as going through three phases: emergence, peak growth, and saturation. These can be represented in an abstract manner by a logistic diffusion curve (see Figure 2). In saturation, the firm faces structural instability where it may switch on to another developmental path by virtue of some core organizational and/or technological innovation, or it may go into rapid or slow demise and face bankruptcy or takeover. For this reason, astute managers may attempt fundamental transitions in their organizational structure before the onset of saturation, abandoning products and/or processes while they are still highly profitable and the organization is structurally stable (see Foster, 1986). Such an adaptive strategy is likely to involve rationalization and reorganization, that is, transaction costs will enter into the calculations of managers in deciding on the best organizational arrangements.

Complexity science tells us that a degree of irreversibility will be inherent in organizations, such as firms, that have a hierarchical structure. Existing "core" competence keeps the firm "alive," yet resources are required to embark on new kinds of activities that involve a higher level of uncertainty. Loasby (1998) makes this point and notes that it was also made by Alfred Marshall in his discussions of the problem of complexity:

Brains and firms are thus self-organising systems in which the development of well-honed skills releases time and energy for more complex problems, and in particular those which do not recur often enough to allow the appropriate connections to be selected and then reinforced by trial and error. (Loasby, 1998, p. 149)

Thus, attempting to minimize transaction costs is rational because it can provide a surplus for reinvestment in new opportunities. TCE is therefore applicable provided that productive processes, product markets, and input markets are well understood and organizational complexity is sufficiently developed and static to be subject to economizing refinements.

Consequently, TCE would seem to be useful in understanding the behavior of firms that are moving toward a prevailing limit to their organizational development. In such firms, the organization of existing tasks is likely to have become highly routinized with little creative involvement by employees who may, as has been noted, be increasingly "calculative" in assessing their position in the firm. An alternative to tighter employee monitoring in such circumstances is labor force reduction accompanied by more extensive subcontracting. The mature firm is likely to have very well-defined input/component requirements, more carefully specified contact conditions, and enhanced desirability as a valued customer. In other words, the transaction cost involved in subcontracting should be much lower for the relatively mature firm, and applying TCE in such circumstances should provide insights into the organization of production.

Complexity science also tells us it is not axiomatic that always attempting to reduce transaction costs by increasing internal monitoring is the best survival strategy. Innovation stems from cooperative and creative endeavours that generate variety (Metcalfe, 1997)--organized complexity emerges from disorganized complexity, so innovation is inevitably associated with considerable "waste" from a static perspective. Thus, closer monitoring may stifle constructive as well as exploitative opportunism. This, of course, applies to the asset specificity that is a cornerstone of TCE, and it is primarily an internal matter because most of the skills that are important to a firm are specific and are acquired within the organization (Kay, 1997). We can think of the firm as a duality whereby both cognitive efforts to optimize and emotionally based attempts to invent and innovate parallel each other.

Emotional responses are stimulated by states of uncertainty, and the outcomes are institutional rules and organizational routines. In firms, these both reduce behavioral uncertainty and enable employees to engage in repeated activities in a semi-unconscious way that allows them to move on to higher-level problem solving (Foster, 1987, 1998). We can think of economic self-organization as a process of "contractual diffusion." At every point in this process, managers have to make the decisions that TCE focuses on, namely, what can be done in the prevailing situation to ensure that members of the organization do not behave in exploitative, opportunistic ways that are counter to productive efficiency and harmony. As Witt (1998) stresses, when organizational loyalty is high, the cost of monitoring for exploitative opportunism tends to be low, and this is typically the case in young, fast-growing firms. Therefore, TCE is not likely to be very helpful in understanding the decisions of such firms, simply because the gains from creativity and cooperation will reduce transaction costs as time passes and output rises. Static optimization makes no sense when such dynamic gains are being enjoyed.

We can think of this in an abstract way. In the upper half of Figure 3, we again have a stylised logistic curve representing self-organizational development in terms of a value measure. In the lower half, we have Williamsonian "net" transaction cost drawn over the corresponding time interval, implicitly holding asset specificity constant. It is depicted as a U-shaped curve because, in the early stages, significant transaction costs must be incurred to take advantage of constructive opportunism:

In their enquiries about the most efficient governance system for a particular pattern of specialisation... economists too often neglect the historical process by which transaction costs have been deliberately incurred to make new patterns of specialisation viable, and subsequently been justified by the increases of productive efficiency which they have made possible. It is precisely such a story of increased productivity, at some increase--often substantial--in transaction or governance costs that Chandler (1977, 1990) has offered us. (Loasby, 1998, p. 142)

As has been discussed, transaction costs rise again in the later stages of development because of increases in exploitative opportunism. The early phase of quasi-exponential growth can be associated with falling transaction costs and the late slowdown phase to rising transaction costs. Thus, transaction cost thinking can provides a rational for the S-shaped developmental path that we often observe--aspirations and institutions initially facilitate development but, ultimately, can constrain it if adaptation does not occur.

Although it is valid to argue that managers of firms will attempt to minimize transaction costs, like other costs, TCE is not generally applicable in an "objective" sense to understanding the structure of the firm and its juxtaposition to the market in real time except in appropriate conditions. TCE is a theory of outcomes, not processes; as Williamson (1985) acknowledges, it must be viewed as a partial equilibrium theory in its application to real-world situations. Self-organization in complex adaptive systems unfolds, not as some equilibrium-disequilibrium-equilibrium sequence but as a coherent nonequilibrium process with varying structural stability properties. Given its partial nature, TCE can, much like the partial equilibrium approach of Marshallian neoclassical economics (see Foster, 1993), be set in such an analytical context, but only in situations that approximate the assumptions made.


Economists have tended to think analytically about economic systems in terms of simple, representative agent models with convenient analytical properties. More recently, interest has turned to complex, heterogeneous agent models that lack tractable analytical properties, so that solutions cannot be deduced but obtained only by simulation (Tesfatsion [1997] calls these "ALife" models). Something of a paradox becomes apparent when we examine the properties of simple versus complex models. Simple depictions of economic systems that we typically find in neoclassical economics tend to become intractably complex if they are rendered dynamic and/or nonlinear. Furthermore, the literature using the analogy of "hysteresis" in economics has demonstrated that the addition of even a small amount of historical content to an abstract piece of equilibrium reasoning destroys its equilibrium properties unless some kind of compensating mathematical restriction is imposed (see Setterfield, 1993).

In contrast, the trajectories of complex adaptive systems are often quite well behaved for significant periods of time before they experience structural discontinuities of some type. This is largely because such systems are self-referential and, through the operation of systems of repair and maintenance, manage to be "dynamically homoeostatic" (see Foster and Wild, 1999a, 1999b). The apparent simplicity of the growth properties of such systems means that economists can often fit conventional linear models with neoclassical underpinnings to the data. However, sooner or later, structural discontinuity results in embarrassing failures, even at high levels of aggregation, where we might expect discontinuities at the microlevel to average out. Complex adaptive systems are clearly not chaotic except in short bursts when structural discontinuity occurs. The limited prevalence of chaos at the microlevel means that tests for chaos in aggregated time series have generally indicated no or extremely weak evidence of cha os (see Brock et al., 1991; Granger, 1994).

As a static theory, TCE cannot encapsulate the emergent character of transaction costs (or benefits) in organizational structures--it can only be used to explain historical phenomena in a partial way if we can assume that the structure of transaction costs is approximately fixed. Thus, it appears that TCE can tell us little about why firms and other organizational structures exist in any general sense. However, in assessing the usefulness of TCE, an important distinction arises concerning the difference between theory in the service of empirical investigation and theory in its role as an abstract analytical framework for thinking in complex contexts. Nelson and Winter (1982, p. 46) try to tease out this distinction in their discussions of "appreciative" versus "formal" theorizing. For them, formal theorizing constitutes exercises in abstract logical deduction that is a source of inspiration for the appreciative theorizing that is used in empirical endeavors. Introducing complexity makes this more difficult b ecause formal theory lacks a capacity to deal with the complex--traditional mathematical approaches to formal theorizing lose their tractability and thus their usefulness as a source of inspiration for appreciative theory.

Conventional economic theorizing is not set in complexity: It presumes a psychological disposition attuned to a simple, static world where problems can be solved in well-defined ways. However, such theorizing can be viewed differently. Following in the tradition of neo-Austrian economics, in particular, Shackle (1973), a more appropriate distinction is between "appreciative" and "subjective" theorizing:

the entities amongst which men choose are necessarily thoughts, things conceived, existent only in their minds, since things existent in the present outside the mind are unique portions of a unity. Choice is made amongst the invented, subjective creations of thought.... Theory, let us boldly say, is not right or wrong but less or more powerful in affording a "good state of mind" to men confronted with an unfathomable universe. (Shackle, 1973, pp. 354-355)

Subjective theorizing need not be complex, dynamic, or mathematically sophisticated because it is intended to reflect the cognitively limited and motivationally constrained intentionality that must necessarily exist in a highly complex and uncertain world. TCE recognizes more aspects of the psychological disposition of decision makers facing a complex world than the Homo economicus construct, so how does it measure up as subjective theorizing, and how useful is it in such a role?

From a subjective perspective, an entrepreneur is viewed as trying to imagine that, if he or she combines skills, materials, and energy into a productive organisation, then a profit-seeking aspiration will be achieved (Witt, 1998). As we have discussed, this is an emotionally driven process, but the aspiration itself is specifically economic. However erroneous it turns out to be, an assessment of benefits and costs will be made, including an assessment of the likelihood of being able to strike contracts with trustworthy people--this is why networking is so crucial. Thus, in the domain of aspiration formation, TCE, with all its unrealistic assumptions, would appear to be a reasonable economic representation of an imagined future. Aspirations are idealistic, not realistic. Realism is confronted in the process of attaining aspirations.

Entrepreneurs forming aspirations know full well that producing goods and services involves the organization of complexity and that it is quite uncertain just how an aspiration will be achieved. Thus, it is essential that constructive opportunists are chosen as employees and monitoring is undertaken to discover and deter exploitative opportunists. It would make little sense to do otherwise. Thus, entrepreneurs are likely to enact TCE ex ante in their imagination (Nooteboom, 1992). Therefore we can say that TCE is associated with the existence of the firm as an organizational form, as Williamson (1985) argues. The success of the firm is governed to a large extent by imagined calculations made by emotionally driven entrepreneur(s) when the firm is founded. Hannan and Freeman (1989) have shown that the organizational features of a firm when it is founded tend to remain fixed in most firms, resulting a lack of adaptability that results in their demise after a relatively short time. Evidence also exists showing t hat the emotional disposition of entrepreneurs leads them to be grossly overoptimistic concerning the prospects of their enterprise (Masden, 1994).

Of course, locating TCE in the subjective realm seems to distance it from economics as we know it. But this is not so for two reasons. First, for economic activity to exist at all there must be an emotional commitment to goals that are identifiably economic. Thus, in TCE, we do not have to account for all emotional behavior but only that which impinges on economic outcomes. Aspirational goals are critical in motivating human activity, and TCE simply states that when aspirations take account of what is viewed as economically possible within a governance structure, we shall observe different types of organizational forms. This is valuable because the complexity that we observe will be heavily influenced by such aspirations. How successful TCE will be in assisting us to understand organizational outcomes will depend on the extent to which the emotional disposition of entrepreneurs is tied to economic assessments in setting goals. Furthermore, the extent to which stable institutions exist that can permit such as sessment will also be important. Historically, aspirations and institutions that are economic in nature have clearly become more pervasive.

Second, if we allow for the existence of selection mechanisms of various types, we should observe a tendency for aspirational choices that reflect TCE to be revealed in the historical record because relatively higher profits should eventuate, ceteris pan bus. However, we should remember that TCE is only a theory of organizational form, not a complete theory of the firm (Dietrich, 1994). So it need not be decisive with regard to a firm's survival. This will also depend on technologies, resource availability, and, importantly, demand conditions. Thus, the evidence in favor of TCE cannot be clear-cut and further blurring arises because, as Metcalfe (1997) stresses, selection mechanisms tend to spawn monopolistic structures that use acquired power to seek rents. As exploitatively opportunistic organizations, they impose transaction costs on everyone else and, as such, turn the predictions of TCE on their head. However, this is really because the firm has mutated into an exploitative alliance rather than an effic iency-seeking organization, and, as such, it represents a transient "political" state that is beyond the compass of a specifically economic theory like TCE. In this sense, the comments of Williamson (1985, pp. 23-26) concerning the limited validity of monopolistic theories of the existence of the firm as an organizational form would seem to be valid. Monopolistic rent seeking can be encompassed in TCE as a particular form of opportunism.


If we view the firm through the lens of complexity science, as a complex adaptive system with self-organizational qualities, it becomes clear that a range of forward-looking contractual arrangements can be used to permit organized complexity to develop. TCE can be employed usefully in such a context, but only if we consider, in a much more explicit manner than has hitherto been the case, the motivational dispositions of individuals engaged in economic activity. In suggesting that opportunism is important, TCE has opened a door that has not been entered to any significant extent by its adherents because it involves a step into the domain of psychological complexity and, therefore, is a departure from a well-understood analytical perspective that presumes a simpler world. Homo economicus is already an abstraction that is based on psychological presumptions about individual motivation and cognition, so an extension in this direction is both compatible and highly worthwhile if it can shed light on the seemingly "irrational" behavior of entrepreneurs that is viewed as pivotal to business success and economic development in the historical accounts of, for example, Schumpeter (1934), Mokyr (1989), and Chandler (1977, 1990).

TCE can play an analytical role in settings where firms are viewed as complex adaptive systems. First, it can be used as a partial equilibrium tool at appropriate points in the developmental phases that firms experience, particularly as they approach saturation states. Second, it can be used to understand the economic content of subjective, forward-looking aspirations and, therefore, the initial conditions from which self-organizational processes emerge in real time. Third, the operation of sorting and selection mechanisms tends to bias organizational outcomes toward aspirations that reflect the particular TCE calculus that, with hindsight, was most profitable. Therefore, it is useful to examine the historical record to see whether TCE has explanatory content relative to, for example, monopolistic explanations of organizational arrangements and attendant profitability.

From a policy perspective, TCE is useful in providing a simple analytical framework to guide the design of general policy instruments and in the formalization of institutional rules. For example, TCE can offer quite a different perspective on the design of contractual law, competition policy, and patent law to that offered by neoclassical economics. However, great care must be exercised in thinking in terms of TCE in too much detail because it remains an "outcome" theory that lacks any real "process" orientation. In particular, it requires careful integration with competitive theories that emphasize the importance of variety and inefficiency in promoting innovation and development. On balance, TCE is really a theory suited to economists and economic policy makers, with limited relevance for management scientists who are interested in business strategy. For the latter, the goal is to understand processes that, in effect, change transaction costs and, thus, the developmental potential of the firm--in this rega rd, evolutionary economics offers more relevant insights.

Perhaps the most important message that TCE conveys is that we must think much more carefully about the psychological foundations of economic analysis. It is not enough to simply say that "institutions matter," we must understand why they are important to individuals, and this in turn forces us to deal with behavioral complexity. This does not constitute a plea for interdisciplinary studies but rather for a considered adaptation of our theorizing to take explicit account of emotional as well as cognitive determinants of economic behavior. A good example of a move in this direction is provided by Macleod (1996) who permits the Homo economicus abstraction to have an added emotional dimension to cope with bounded rationality in conditions where there is environmental complexity. Thus, the "contractual man" abstraction, proposed by Williamson (1985) as the foundation of TCE, has sparked off a research program that reaches far beyond questions as to why certain forms of productive organization exist, toward the di scovery of more appropriate theoretical representations of economic behavior in the core of our discipline.

(*.) The author would like to thank Oliver Williamson for his comments on a previous draft of the paper, as presented at the 4th Biennial PRAEO Conference in Sydney, January 2000. Thanks are also due to members of the UQ Emergent Complexity and Organisation in Economics Research Group for their useful comments. The usual caveat applies.

Foster: Department of Economics, The University of Queensland, Brisbane QLD 4072 Australia, Phone 61-7-3365-6780, Fax 61-7-3365-7299, Email


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