A Dynamic Theory of Interfirm Behavior Oliver BE. Williamson The Quarterly Journal of Econom 8, Vol. 79, No. 4 (Nov., 1965), 579-607. Stable URL: btp//links jstor.org/sici?sici=0033-5533% 281965 11% 2979%3A4%3C579%3A ADTOIB%3E2,0,CO%3B2-W The Quarterly Joumal of Economics is cusrently published by The MIT Press. ‘Your use of the ISTOR archive indicates your acceptance of JSTOR’s Terms and Conditions of Use, available at hhup:/www.jstororg/about/terms.hml. JSTOR’s Terms and Conditions of Use provides, in part, that unless you have obtained prior permission, you may not download an entire issue of a journal or multiple copies of articles, and you may use content in the JSTOR archive only for your personal, non-commercial use. Please contact the publisher regarding any further use of this work. Publisher contact information may be obtained at hup:/www jstor.org/journals/mitpress.huml Each copy of any part of a JSTOR transmission must contain the same copyright notice that appears on the sereen or printed page of such transmission, STOR is an independent not-for-profit organization dedicated to creating and preserving a digital archive of scholarly journals, For more information regarding JSTOR, please contact support @jstor.org. bupswww jstor.org/ ‘Mon May 30 17:36:38 2005A DYNAMIC THEORY OF INTERFIRM BEHAVIOR * Ouver E. Winutamson Introduction, 579.—1. A gross deseription, $80.—II. A dynamic model, ‘582; the interfirm relationships, 552; a differential equations model, 585; pro” posed measurements, 594.—IIT, Extensions, 508; a solf-recovery mechanism, 506; the influence of structure, 599; the effects of regulatory restrain, O03. TV, Conclusions, 606, A survey of the failures of oligopoly theory has led Almarin Phillips, in @ previous article in this Journal, to take the position that a theory of “interfirm organization” is required if we are to obtain significant insights into certain types of oligopoly behavior. He argues that a unified framework that combines organizational with economic variables is frequently neoded, and he proposes a general set of relationships designed to achieve this end ‘The prosent analysis is directed at a similar objective. How- ever, it differs from Phillips’ approach in two important. ways, First, whereas he is concerned from the outset with devising gen- ‘ral approach to the subject, we direct our initial attention instead at discovering the factors that are responsible for generating a par- ticular elase of oligopoly behavior. Once we have devised a model that reproduces the basie features of the behavior in question (and is in other ways satisiactory), we then elaborate the model to ex- amine issues thet range beyond the initial description. Second, the proposed model is dynamic rather than static, Although this com- plicates the analysis in some respects, it permits us to extract im- plications that are not easily, if at all, obtainable otherwise. ‘The phenomenon that oceupies our attention in Sections I and I1is the widely reported tendency for certain classes of oligopolistie industries to alternate between competitive and collusive solutions Boulding has characterized this behavior in the following terms: tis of some interest to note that under conditions of perfect oligopoly is some tendency for price wars to break out, and then we are apt to *L would like to thank R. M. Cyert, J. W. MeKie, R. R. Nelson, and H, A. Simon for helpful comments’on an eater version’ of thig paper.” The research on this paper was supported under a contract from the National Sete ‘ence Foundation, An earlier version ofthe paper was presented at the ‘ember 1064 mecting of the Econometric Society, A Theory of Tnterfirm Organization,” this Journal, LXXIV (Nov. 1960), "602-13. “Almarin Phillips hus elaborated this argument in hia “Boley Hepiations of the Theor, of Inertm /Ongnization, dmerican Reonomic Review, LE (May 1961), 245-54, and Market Structure, Organisation, ond Performance (Carbridge’ Harvatd University Press 1908). ‘er580 QUARTERLY JOURNAL OF ECONOMICS have rather curious fluctuations around some equilibrium, with prices fall in the price war and then rising aguin in what T suppose we ought to call a price peace, in which « happy state of collusion, gentlemanlines, or just plain political ganization prevails Based on this recurrent eyele of cooperation and conflict, we take as our preliminary objective the following paradigm suggested by Simon: “given the description of some natural phenomena, . . find the differential equations for processes that. will produce the phenomena.” * This accomplished, the basic model is extended in Section III to investigate the influence of market structure on inter- firm behavior, and to study the effects of (and adaptations to) regu- latory restraints, ‘The advantages of the proposed approach are summarized in Section IV. L.A Gross Descmrion The factor that appears to be mainly responsible for shifting the firms in an oligopoly between cooperative and eonfict solutions is the condition of the environment. Thus, although oligopolists can be assumed to be continuously aware of their interdependency relationship and of the collective advantages of pursuing a quali- fied joint profit maximization strategy,* adherence to a joint profit raximiaation agreement may be made diffcut during times of ad- versity by current pressing demands that cause short-run own-goals of one ot more of the members to override eolletive considerations. Assuming that when adversity is experienced by one it is experi- enced generally, deviation by one member of the coalition is likely to induee defensive responses by others and the entire relationship tends quickly to deteriorate into one of confit and active compet As the condition of the environment improves, however, the oligopolists are likely to perceive own-needs as less pressing and hence a return to a cooperative solution becomes feasible. The above description appears to characterize the primary fac- tors that influence the recurrent cycle of cooperation and conflict that we have taken as the dynamic phenomenon requiring explana- tion. Similar descriptions have been reported elsewhere. Thus Kaysen observes that “in a general environment of declining de- 2. 4, B. Bouling “The Ues of Price Theor” in Models of Markets, ca Ar Houta New Words Coan Daven Hay 6 5 rerio Phill Seay, Vor io, (Dee HOS) pS smog We Fellace Coupettion Ainong the ee ew York: Knopf, 1010 "for « icuion te asaya fafuencequaled eat pee mameA DYNAMIC THEORY OF INTERFIRM BEHAVIOR 581 mand for the product of the group, ... each [oligopolist] has a poor income prospect. . .. Since any gain by one oligopolist can be made only at the expense of his rivals, all changes in prices are likely to be viewed as ageressive, and lead to retaliation... . Tacit agreements are unlikely to last.” Hence, he coneludes, oligopolists “are more likely to maintain agreements, and thus aet monopolisti- cally, in periods of rising... demand.”* Similarly Mitchell’s observations of interfirm behavior led him to eonclude that “pools, working agreements, and combinations of other kinds become far ‘more difficult to sustain in the face of a buyers’ market, and many of them go to pieces because their members suspect one another of secret undercutting of rates.” * In terms of more specific examples we have Bain's description of price behavior in the steel industry in the 1920's and 1930s, ‘Thus he observes: ity a th we af iy iene ay 2 ee a it ee yale Mee Sn aa Sra apy" Sa be pay un SERGE cic on snc eta (ots at Sete aa saa le rece So pg Mt feng aoe Satie Sita aida cae Renae FS 4 ahi Se a ta oe seit cy th ie ha pol ah ca A more recent (and more spectacular) example is afforded by the electrical equipment conspiracy in the 1950’s.* Indeed, at one stage or another of their histories, this alternating pattern of be- havior appears to be representative of a wide variety of oligopolies. In addition to the influence of the condi of the environment. on interfirm relations, are there any other salient features of this process that require attention? If we are to take seriously the argu- ment that socialization influences are important, explicit concern achieved and maintained may be essential. Obviously the effec tog Keen "A Dre et Prt? vi i ing ede ha ent Pin Ce ee cy alt PL PRGA inl Wy, en, a 10, 8, The definitive history of this experience hag yet to be written. For aa overview Of the provecngs ee HAs She The Lacrlile Electrical Conspiracy,” Fortine, LXV (Apri aad May 1981).582 QUARTERLY JOURNAL OF ECONOMICS tiveness of the electrical equipment conspiracy rested on the ¢o- ordinated exchange of information,’ end presumably this is true more generally. ‘Thus Simon inquires “What corresponds, in the social sciences, to the postulate of ‘no action at a distance’? “T think the direct analogue is ‘no influence without communication." And Kaysen and Tumer observe that “parallel price changes by a large number of firms will almost inevitably require . . . [an extensive] machinery of intereommunication. . .. Even industry of small numbers will typically require agreement.” Hence, in addition to a mechanism that transmits changes in the condition of the en- vironment through the system, a communication mechanism may algo be warranted. IL. A Dywanic Moves ‘The first part of this scetion identifies the basic variables, de- seribes the relationships that exist between them, and provides a preliminary mathematical interpretation of the relations proposed. ‘The second part develops, in a qualitative sense, the equilibrium and dynamic properties of the resulting system. A basis for ob- taining quantitative measurements on the variables is suggested in Section IIL. A. The Interfirm Relationships ‘The most important question to raise in attempting to develop ‘@ model that possesses the indicated properties is: what are the critical endogenous variables? Once these have been specified, @ connected framework with which to investigate them ean be de- vised and this can then be augmented to include a variety of ex: ‘genous influences. ‘The endogenous variables that I have chosen for this purpose are: (1) a performance variable; (2) an adherence to group goals variable; (3) an interfirm communication variable. The values that these variables take on are not. independent. but are mutually determined as part of a simultaneous system. ‘The performance variable is an index of the level of achieve- ‘ment of the firms in the industry. Ordinarily this will be a profits measure, and obviously it will depend, among other things, on the condition of competition that prevails in the industry. Such a variable is essential to transmit the influence of changes in the 9, Bid, 1-HLA. Simon, Models of Man (New York: Wiley, 1057p. 2. Carl Kaysen and D. ¥, Turner, Antitrust Policy (Cambridge: Harvard University Pree, 1060), p. 14,4 DYNAMIC THEORY OF INTERFIRM BEHAVIOR 583 condition of the environment that occupied an essential role in the description of interfirm behavior in Seetion I. We shall also use it in our analysis of the effects of structural conditions and regulatory restraints. Adherence to group goals is a measure of what Lange has called the “discipline” of the group, which he defines as the “degree to which the individual firms are willing to act in unison as members of the group.”* The group goal will be taken to be one of quali- fied joint profit maximization, and the willingness of firms to place such a long-run collective goal ahead of short-run own goals is a measure of the strength of adherenee, ‘The interfirm communication variable is a measure of the ‘amount of vatid information transfer between firms within the in- dustry, Explicit treatment of the role of communication is fre- quently omitted from economists’ descriptions of the interfirm co- ordination process. Tt is obvious, however, that communication is essential to coordinated response and it is our contention that the amount of communieation both affects and is affected by the level of adherence, ‘To these three endogenous variables we need to add the con- ition of the environment as an exogenous variable. ‘The direct effect of an increase in demand is to improve the level of perform- ance and a deterioration leads to a decline. In a gross senso, these are the basic variables and relationships that the proposed model rests on. Our objective now is to elaborate the description of the qualitative relations that exist between the variables by resorting to the organization theory and social psy- chology literature on small group interaction. With this eompleted, we will be in a position to develop a model that possesses the indi- cated attributes, ‘The proposed relationships between the endogenous variables are the following: (2) the level of collective performance varies directly with the degree of adherence to group goals and with the condition of the environment} (2) the degree of adherence varies directly with the amount of interfirm communication and with the level of performance; (3) the amount of communication varies directly with the de- gree of adherence, at least initially. 3. Oscar Lange, Prize Plesbility and Employment (Bloomington, Tn Principia Pres 108, pf. ¥ us584 QUARTERLY JOURNAL OF ECO) OMICS ‘The proposition that the level of collective performance in- creases as the member firms adhere more closely to the group goal of qualified joint profit maximization follows from the definition of terms. It similarly follows that the direct effect of an improve- ment in the condition of the environment is to increase the level of performance. ‘The second and third relations are perhaps less obvi- ous (although neither are they counter-intuitive), and thus deserve additional elaboration. ‘The observation that communication tends to enhance adher- ence has been widely recorded, It can be found in the organizational studies of Barnard, March and Simon, Thompson, and Cartwright and Zander, among others. Although the precise statement of the relation varies slightly, the general proposition that intragroup com- munication promotes shared goals appears to be a well-established empirical finding, ‘That the level of performance also has a positive influence on the degree of adherence has been less widely observed. However, March and Simon argue that a deterioration in perform- nee (due to an unfavorable change in the condition of the environ- ment) eauses the group to reinterpret the relationship between the membership as being more competitive than cooperative, and con- flict is apt to result.’ Barnard also observes that cooperation is conditional on the eapacity of the environment to produce satisfac- tion, and thus adversity poses a threat to an adherenee relationship which had been quite stable under more favorable conditions. The proposition that the influence of communieation on ad- herence is reciprocated has been made by March and Simon? and constitutes one of the basic linkages in Homan's observations of group aetivity.® ‘That is, not only does communication promote adherence, but adherence in turn induces communication, Ina very general sense, therefore, we emerge with the following basic relations: Q) r=2(4; 8) 4 >0,7_>0 @) A= A(z,C) Ay > 0, Ac > 0 (3) cla) Ca>0 4 Pe Eto ef Bing Cnt: Hag era Od ea ie Ge QE YG ie Pil age ken Wt, ee (New York: Knopf, 190i),"p. 405;" Darwin Cartwright. nd” ‘Alvin' Zander, Os Heel at eC 1 cea sl ee tla! 8.G.'C: Homans, "he Human Group (New York: Harcourt, Brace,A DYNAMIC THEORY OF INTERFIRM BEHAVIOR 585 where x, A, and C are performance, adherence, and communication respectively and E refers to the condition of the environment. Our objective in the next part of this section will be to consider the effects of lagged responses on the dynamic behavior of this system, to examine the equilibrium relations that obtain, and to develop the dynamic response of the system to changes in the condition of the environment. B. A Differential Equations Model We hypothesize that the changes in the level of performance in response to changes in either adherence or the eondition of the environment occur very rapidly but that the adjustments in the attitude of the group (adherence) and in the interaction between group members (communication) take time. That is, the social Processes that characterize group behavior are assumed to require time to come into adjustment, whereas the economic response of the system is assumed to occur relatively quickly. Considering the inertia that is generally associated with making social adjustments, ‘8 compared with the immediaey with which changes in demand or in the degree of interfirm competition affect prices and output, this view seems plausible. ‘Thus we reformulate our system as fol. lows (where (t) designates the time period to which the measures apply) : a) w(t) = x[A(t); B(t)] 4 > 0,1, >0 SOL G0, 6,401 96> 090> 0,02 <0 @ £9 _yaw,cw Ya > Ofor low A ba 0 nd, >6, the an ofthe denominatar bE anblgsoun “Amuni, however hatte foback tect mrely mores bt ey ook Overe ie mala ltrs the dentate ee ae Slr in sholte van a ee Tala oC. eae ae Ra ahs a wi ein tive at lb umenly aes ey wn © hey te nt of he tak ea Tat he one ee Arona te puts i te tem ia een by end unable rel Intion to the model and solving for fie resulng eouliogiuny nae om Eo bin nthing ut ote dope forte ean along wen 9 requires perverse behavior by the entire eysem. ge Reline, op. ey pp: 228-2, Sedge te sae she 0A DYNAMIC THEORY OF INTERFIRM BEHAVIOR 589 Sharper definition of group goals becomes possible, Although this condition seems highly plausible, it is not essential to the argument. Consider next the eurve along which the amount of eonmunica tion is in equilibrium at every level of adherence. Initially this curve also has a positive slope but, in addition to passing through region of inereasing then decreasing retums, it becomes backward bending at very high levels of adherence.*’ ‘The reasons for this have been given already. It follows from the assumption that the felt ned to communicate declines when the agreement, on group goals becomes thoroughly shared. ‘This backward bending property is not essential to the analysis, however. It is sufficient that satura tion conditions set in so that the communication equilibrium curve heed merely approach a vertical asymptote rather than turn back on itself at very high levels of adherence. As drawn, the eurve x 0 has its intereept along the C axis to the right of the interept “A = 9, ‘That is, at sero adherence the equilibrium level of communication exceeds the level of com- munication required to maintain zero adherence. As a result, a system initially in a position of very low adherence will, due to 2 felt need to communicate even when every member is motivated to attend solely to his own interests, tend to move to an equilibrium level of adherence that exceeds zero (to a position such as K). In other words, a completely fractionated industry is an unnatural condition; the level of dealings necessary to transact business in an orderly way generally promotes an identity of interest that ex- ceeds zero. Under extreme conditions this relationship between the two intercepts might be violated, in which ease the system would then possess only a single equilibrium position. It would be at the intercept of the communication equilibrium curve with the C axis. So much, then, for the shapes and positions of the curves. As indicated earlier, the intersections K and M are stable equilibria, 3, Taking the total differential of equation (3'), subject to the condition cs A. Now Yo<0 everywhere, whereas Y4> 0 at low values ac | dc ve wees om i. Seo of A but ¥a = 0 for the same implications to obtain